Profit From the Next Big Bubble

Everywhere you look lately, you find talk about bubbles. Ever since Internet stocks crashed in the early part of the decade, we've had a bubble in bubbles -- housing, followed by oil, and then Treasury bonds, all of which had their day in the sun before crashing back to earth.

But if there's one thing you can count on investors doing, it's chasing performance. And given how well stocks in emerging market countries have done so far this year, it's almost inevitable that the next big bubble will come from abroad. Yet even though there's some real money to be made by investing abroad, the speed at which emerging markets have recovered from their losses in 2008 has to make you wonder whether their recent gains are sustainable -- or are setting investors up for yet another big-bubble burst.

The case for foreign stocks
It's easy to understand why a lot of investors find emerging markets attractive right now. Compared with dour economic news here at home, the news abroad sounds downright rosy:

  • Even at its slowest growth pace in the 16 years that official records have been kept, China still grew at a 6% annual clip in the first quarter, and some believe the worst may be over.
  • India's recent elections have reassured investors who were worried about the possibility of political unrest, given the impact of the global slowdown on the country's economy.
  • The prices of oil, metals, and other commodities have bounced back strongly from their recent lows, helping countries like Brazil and Russia that are rich in resources.

In addition, the U.S. dollar has weakened recently. That isn't always good news for foreign companies -- especially those that sell their goods to American consumers, because the dollars they receive are worth less than in the past. But for U.S. investors, a strong foreign currency makes foreign shares worth more in dollar terms.

The combination of these positive factors has led to a big resurgence of interest in emerging-markets stocks. One exchange-traded fund that tracks emerging countries, the Vanguard Emerging Markets ETF (NYSE: VWO  ) , is up 65% since March 9. Many individual stocks have put up similarly impressive gains:

Stock

Gains Since March 9

Petrobras (NYSE: PBR  )

67%

Vale (NYSE: RIO  )

55.2%

Baidu (Nasdaq: BIDU  )

70.1%

Templeton Russia and East European Fund

195.6%

Source: Yahoo! Finance.

Too far, too fast?
Obviously, such dramatic gains over such a short period raise concerns about whether they're sustainable. Emerging markets are no stranger to volatility -- even with the big gains of 2009, Vanguard's ETF is still down 40% from its highs in late 2007.

But if strong momentum continues to push emerging markets higher, then it won't take long for a real imbalance to form. Although emerging economies are doing better than those in developed countries, they're still dependent on global economic conditions. For emerging-markets stocks to do their best, there needs to be a recovery sooner rather than later.

How to invest
If that doesn't come, then emerging-markets stocks would get too expensive in a hurry. If that happens, then the better strategy would be to look for U.S. companies that will benefit from foreign growth. For instance, as consumers in foreign countries get richer, demand for American brand icons like Coca-Cola (NYSE: KO  ) , Nike (NYSE: NKE  ) , and McDonald's (NYSE: MCD  ) likely will grow. And in combination with a weak dollar, those companies could continue to grow by leaps and bounds in their operations abroad.

U.S. companies have certainly learned their lesson from globalization: While home-field advantage is worth something, it doesn't ensure success. As the platform for high growth moves elsewhere, American business won't hesitate to go where the money is -- and its success could expose what proves to be bubble-like valuations among emerging-markets stocks.

If you don't have any exposure to foreign markets, then adding international stocks to your portfolio makes plenty of sense, even after the recent run-up. But before you decide that all your money belongs abroad, don't forget that a global economy works both ways -- and existing companies with long histories won't give up without a fight.

For more on smart global investing:

To get some ideas for great global investments, check out the Fool's Global Gains newsletter service. Each month, our experts scour the globe to find the best international stocks for your portfolio. Enjoy a free 30-day trial; there is no obligation to subscribe.

Fool contributor Dan Caplinger's daughter loves blowing bubbles, as long as she gets to pop them. He doesn't own shares of the companies mentioned in this article. Baidu is a Motley Fool Rule Breakers pick and Coca-Cola is an Inside Value recommendation. Coca-Cola and Petroleo Brasileiro are Income Investor selections. The Fool owns shares of Vanguard Emerging Markets ETF. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is good around the world.


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