5 bubble-proof foreign stocks

By Jim Jubak

The Shanghai stock market was up 116% for 2007 as of Oct. 10. Hong Kong was up 43%, India 35%, Singapore 28%. The list of stock markets hitting all-time highs this month also includes Sydney, Seoul and Jakarta.

Those gains are especially stunning because they're piled on top of an amazing performance by these markets in 2006. The Shanghai SSE Composite Index, for example, climbed 130% in 2006.

If you haven't reaped any or enough of the gains turned in by these developing-country stock markets, I'll bet you're tempted to jump in now, although you're also worried about catching the wave just as it peaks and then crashes.

Bubbles burst, but . . .

Is the outperformance by the developing-country stock markets of the world a wave you want to catch even now, because it's got months or years yet to run? Or is this just another bubble -- like that in technology stocks in 2000 or real estate in 2007 -- set to explode?

It's a bubble, I'm afraid. But that doesn't mean it will burst tomorrow. In fact, it's almost certain to get larger before it bursts. The moment of reckoning, the explosive pinprick, could, in fact, be not just months but a year or even more away.

Frankly, right now I'd tread very carefully, taking on only limited risk. That may leave some money on the table in the short term, but your portfolio is likely still to be standing when the run comes to a sudden, unexpected end. I'd much rather come back to these markets when valuations have pulled back from current peaks.

And if you like the long-term fundamental story of the developing economies -- these are some of the fastest-growing economies in the world, after all -- there are still ways to invest that don't involve simply following the crowd and hoping that some greater fool will step in to buy from you. I'll give you five suggestions at the end of this column.

Building a bubble

There's no standard definition for what constitutes a bubble. In my role as someone who paid a lot of tuition to learn some lessons from the technology crash of 2000, I'd offer a four-part definition:

• Excessive valuations. Asset prices -- stocks, tulips or real estate -- are inflated way beyond the normal range.

• Market liquidity rather than fundamentals are the fuel. Cash chasing cash characterizes a bubble.

• A conviction that negative fundamentals don't matter. In a bubble, investors are willing to look past almost everything.

• A belief by investors that they'll see the end coming in time to get out, that they won't be the ones left holding the bag.

How high is too high?

In March 2000, as the Nasdaq Composite Index ($COMPX) hit its still-standing record high of 5,049, it traded at a price-to-earnings ratio of 246. By those standards, the developing-country stock markets of the world look cheap. Stocks on China's Shanghai and Shenzhen mainland stock markets are now trading at 50 times projected 2007 earnings per share. India's Mumbai market, the second most expensive in Asia, sells for 24 times earnings.

Cheap, that is, until you compare them to their own past valuations. The normal range for Mumbai's Sensex Index before 2003 was a price-to-earnings ratio between 12 and 13. It had climbed to 17.7 at the beginning of 2005 before moving up to today's 24.

Other developing-country markets show similar patterns. Over the same years, the price-to-earnings ratio on South Korea's Kospi Index has gone from 7.3 to 18.6, the Taiwan market from 13 to 23, and the Indonesian market from 14 to 21. Current valuations aren't the highest in market history -- the Mumbai Sensex hit 29 during the Nasdaq market frenzy -- but they're a lot higher relative to their own history than the bare numbers suggest.

Follow the money

For evidence that these markets have now moved into bubble land, look at what has happened in the Hong Kong stock market since Aug. 20. The Hong Kong Stock Exchange's Hang Seng Index climbed 40% from Aug. 20 to Oct. 10. Why? Because a flood of money from mainland China and overseas moved in to snap up stocks on the heels of an announcement that the Chinese government planned to let individuals in mainland China invest directly in Hong Kong-listed shares.

The plan exists only on paper, but all this cash rushed into the Hong Kong market to take advantage of future cash flows that would drive up stock prices when this plan went into actual operation. Money chasing money chasing money.

You can see the effect clearly in the relative outperformance of mainland Chinese stocks listed in Hong Kong, up 62% versus just 40% for the Hang Seng as a whole and just 23% for the Shanghai market.

Continued: A global liquidity flood

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