The Great Dichotomy! Again!

While the U.S. economy is still bogged down by massive federal deficits and a new wave of home foreclosures, key foreign economies are already leaping ahead without those heavy burdens.

Just look at the scoreboard:

The Dow is up 20 percent since the first day of trading of last year, thanks in great measure to government bailouts of the U.S. banking system … brokerage industry … housing and mortgage markets … Detroit … and virtually every other sector that got into big trouble.

Meanwhile, in the same period …

The leading ETF that tracks China’s blue chips (FXI) is up 31 percent, over 1.5 times better than the Dow.
The ETF tied to South Korea’s stock market (EWY) is up 68 percent, more than tripling the Dow’s performance. And ..
The Brazil ETF (EWZ) is up 92 percent, four and a half times better than the Dow.

But this is certainly not a new story. We have been avidly telling readers about it for years …

Foreign currencies and stocks exploding higher: In October 2007, we showed you how key currencies and foreign stocks — such as the Japanese yen and the Brazil ETF — were headed sharply higher. In contrast, we stressed unequivocally that a “shocking new plunge in the housing market [was] a heavy-weight on the U.S. dollar and economy.” Both came to pass in aces and spades. (See Global economy surging; U.S. still sagging.)

Great wealth shift: One month later, we explained why the “U.S. stock market has consistently and persistently fallen woefully behind other key markets.” And we warned that the “housing bust, mortgage meltdown and credit crunch guarantee a U.S. recession,” while other key nations would be hurt less and recover sooner. (See The Greatest Wealth Shift of All Time.)

The Great Dichotomy (two years ago): In June 2008, I told you about my travels throughout Latin America and Asia over the past half century, using them as my springboard to explain why “our economy is losing the critical strengths that made it great, while theirs are overcoming the great obstacles that made them weak.”

I concluded that “[this] great dichotomy is not a passing phenomenon. It’s growing larger. And barring drastic changes, it’s likely to be with us for many years to come.” (Read The Great Dichotomy.)

Lehman collapse: In July 2008, two months before the collapse that changed the world, we warned that Lehman was a key danger which threatened to derail the U.S. And, separately, we explained that major emerging markets would be less directly impacted.

I wrote: “Lehman Brothers’ death spiral is, in some ways, even more troubling: If it fails, it will send the message that all the Fed’s horses and the Fed’s men can’t put this Humpty Dumpty back together again.” (See GM, Fannie, Lehman: Too big to fail? Or too big to save?)

Brazil among first to recover: Following up in August of last year, I demonstrated “why Brazil was the last to suffer from the financial crisis and is the FIRST to recover …

“While the U.S. Federal Reserve has cut official interest rates to practically zero, Brazil’s central bank has kept its key rates high, helping to enforce monetary discipline and prevent speculative bubbles. Thus, while the U.S. was experiencing a massive housing boom, Brazil’s mortgage financing was limited to less than 1 percent of GDP. …

“Brazil grew at about double the pace of the U.S. economy in the first nine months of 2008; fell by half the pace of the U.S. in the fourth quarter of 2008; contracted by one-eighth the pace of the U.S. in the first quarter of 2009; and is likely to grow twice as fast as the U.S. in 2010. …

“Another major factor: For the first time in history, China has now surpassed the United States as Brazil’s largest trading partner.” (See Among the First to Recover.)

Take a moment to check out each of these landmark reports. Many of the key facts and forecasts they contain are vividly relevant to what’s happening today — and what’s coming next ..

New Evidence of the Great Dichotomy

Are emerging markets completely decoupled from the U.S.? Of course not. If the U.S. stock market sinks, theirs will too.

Right now, we don’t expect the stock market to suddenly fall out of bed. But we have every reason to believe it will continue to greatly underperform key foreign markets.

The main reason: Time after time and case after case, we see how they recover sooner and rise further. And we have every reason to believe that will be the case in the future as well. Specifically …

China’s fast-track economy has consistently exceeded expectations, including Beijing’s:

It was expected to grow 8 percent in 2009 and clocked in at 8.7 percent, even in the wake of the worst global crisis since the Great Depression.
Economists talked about a slowdown for 2010, but it’s now likely to grow by 9.6 percent.
They expect it to slow to 8.1 percent next year, but it could surprise them again.

In February, retail sales rose 20 percent. Industrial production did the same. And Chinese exports surged 46 percent compared to the year earlier. Yet domestic demand is even stronger — a key reason China is expected to actually report a trade deficit for March.

The government’s challenge ahead: Taming China’s speculative bubble in urban properties without causing a bust. That danger does not warrant shunning Chinese investments. But it does mandate caution and an emerging market portfolio that is not China-heavy.

Brazil’s numbers are not as spectacular as China’s, but its economy makes up the difference with a series of factors that lend it more stability, namely

A more mature, diversified, capitalistic economy, with …
Free, direct elections …
Supported by democratic institutions that rival almost any in the West.

And contrary to popular belief, the primary driver is not exports to China; it’s Brazilian consumers. That’s why Brazil’s retail sales in January rose the most in 18 months … why Brazil’s outgoing president is so popular … and why his chosen successor, Dilma Rousseff, is surging to the polls on her way to presidential elections in October.

South Korea’s exports surged 31 percent from the year earlier, the fourth consecutive monthly increase … while the confidence of its manufacturers has surged to the highest level in more than seven years. Industrial production is up 31 percent compared to last year. And auguring continued growth ahead, its leading indicators have jumped 11.3 percent.

Our recommendations:

Unless you are short-term trader, reduce your exposure to U.S. stocks.
If you feel you are still overexposed, think about hedging against downside risk with a modest amount in inverse ETFs that are designed to profit from U.S. market declines.
Seriously consider a solid, diversified portfolio of emerging markets — either via ETFs or individual stocks. Don’t assume the three I’ve discussed here are necessarily the best going forward. Also look at India, Japan, and others.

Above all, approach ALL investing in this environment with great caution. That means plenty of cash in a safe place and staying vigilant to the unexpected.

Never forget: It was only a year and a half ago that our financial system was on the brink of collapse. And it is largely due to Washington’s Herculean efforts that the U.S. economy is recovering.

Good luck and God bless!

Martin

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