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Foreign ETFs Continue To Outperform

Last year our published outlook for stocks in 2005 was for a top in the S&P500 at 1,245 in Q1. This bearish outlook was buffeted by our bullish outlook for Asia which we said would end up showing a bifurcation in the global equity markets in 2005 as European shares looked set to outperform, while Asian currencies and share prices stood the best chance to rally against the U.S. dollar. As such, we felt the best bet of all the markets in 2005 would be in Asia.

Most investors overlook currency risk when investing in U.S. based ETFs that track foreign markets. The performance in US dollar terms for a basket of Asian and European markets shows that neglecting this crucial aspect can lead to serious underperformance.

Last year we listed the currencies expected to appreciate the most against the dollar were the Mexican Peso and SE Asian Currencies. As such, we were continually bullish on these markets and their currencies relative to the dollar.

For example, in our November 20, 2004 ETF Global Weekly update we wrote, "In Korea the mood remains somber as the BoK cut rates for the fourth time in an accommodative move after a credit card bust and rising won have crimped the consumer and exporter. Certainly, none of this sounds bullish, yet a breakout of the 7-year consolidation pattern certainly would be. We are on a lookout for a sustained move above 0.092 in the Won and 950 in Seoul, meaning that EWY might rally above $30."

In the chart below we have highlighted with arrows when we said to begin looking at South Korea as an investment opportunity. Note that this was well before a breakout in both the Won and South Korea Stock Exchange resulted in a 50% gain in the EWY iShare that tracks this joint performance.

By December it looked as if the SE Asian markets would break out. We then wrote to our clients, "Yet what goes totally unnoticed by the financial press is that the peripheral countries like Taiwan, Singapore and S.Korea have some of the oldest free floating currencies and have decided to let their currencies appreciate against the US dollar."

"What that means is that the move is already on and is preceeding the eventual move for China. So while investors are sitting on the sidelines waiting for China to revalue, its neighbors have already done so and their stock markets and currencies are appreciating in tandem, meaning that in US dollar terms investing in Taiwan, Singapore or S.Korea would have seen a 20% gain over the past few months."

"That said, one of the obvious benefactors of regional growth is South Korea which has a striving goal to become a major player in both financial and logistical support."

"Sandwiched between Japan and China, S. Korea calls itself a shrimp between two whales. Moreover, there is a huge US presence there not just because of the aftermath of the Korean war, but because the US was the only country 50 years ago to acknowledge its existence."

"So despite what we hear about "Yankee Go Home," the US economic presence is not going away and can only aid this "shrimp" as it tries to compete with its two neighboring giants."

Alternatively, we said last year that the second best looking chart pattern was in the EuroTop 100, which was poised for a breakout. This did indeed transpire with an 18% gain over the past 12 months. But as we explained before, ignoring currency risk is the primary downfall of investors in the ETF market.

We warned clients that a likely decline in the euro would result in a diminished performance if not a flat market for the EZU iShare that tracks the European Monetary Union Index.

The subsequent decline in the euro this year dragged down the performance of EZU until June of this year, when we began lifting our short EUR/USD position (initiated on January 3) and notifying subscribers of a potential rally in the euro.

In conclusion, we find that trading the US based ETFs that track foreign stock markets and their currency rates provides tremendous opportunities when both the equities and currencies are trending together.

In the case of our SE Asian plays, this has resulted in a 50% gain over the past 12 months in a relatively safe investment. We say safe because South Korea (even after a 50% rally) is still trading at 8.51 times earnings while the Won is still undervalued by at least 30% relative to the dollar.

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