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Last Sunday, one of my friends asked me to take a look at his retirement portfolio during the Super Bowl halftime show.

Because of extreme market volatility over the last few years, Larry has been keeping most of his investments in a “conservative portfolio model.”

Something caught my attention immediately. He was making a mistake that’s fairly common among investors.

Larry had no exposure to emerging markets at all. None. Not a single stock.

So I told him his portfolio wasn’t diversified enough.

This will turn out to be an even bigger mistake this year.

Let me explain….

How My Friend Got Lucky Last Year

Last year was horrible for emerging-market stocks.

The stock markets of Brazil, Russia, India, and China, the so called BRICs, all declined by at least 25%. They performed much worse than the U.S. market, which was basically flat.

What happened? In one word – Inflation.

Those countries started to face rising inflation in 2010. So central banks in most emerging markets started to raise interest rates aggressively in mid-2010. Brazil, for example, hiked rates from 8.75% to 12.5% to fight inflation.  

As you know, stocks hate higher interest rates because it slows down economic growth. So this was a big reason many emerging market stocks had a poor performance. 

So Larry is definitely happy he didn’t have any exposure to emerging markets. But he needs to rethink his strategy because now the tide seems to be turning…

Two Good Reasons to Go Abroad

Those higher interest rates have worked. Inflation has come down in several emerging-market countries, leading their central banks to stop hiking interest rates. In fact, most of those nations have started to cut rates again to stimulate growth.

All four BRIC countries have been easing monetary policy recently. And so have other emerging markets such as Indonesia, Philippines, Turkey, and Chile. With lower interest rates, the outlook for stocks in those countries is positive.

And there’s something else to consider.

Based on a forward Price to Earnings ratio (a measure of how much investors are willing to pay for $1 of expected earnings), BRIC stocks are cheaper than domestic stocks. The BRICs currently trade at forward P/E ratio of 9.6, compared to the S&P 500 ratio of 12.8.

According to this metric, BRIC stocks would have to rally 33% to match the valuation of the S&P 500 index.

Declining interest rates and cheap valuations are good reasons to jump into emerging market stocks now. Should you do it? The chart below says yes!

BRICs Have Started to Outperform

I personally like to look at relative price strength to help me decide when to increase exposure to emerging markets. To help you understand how this works, let’s take a look at the iShares MSCI BRIC Index Fund (BKF), an ETF that tracks the performance of stocks in BRIC countries.

We can see how the BRICs are doing compared with U.S. stocks by simply dividing its price by the S&P 500 index. This creates the relative strength line you see below.

The idea is pretty simple. If the line is rising, BRICs are outperforming U.S. stocks. If the line is falling, they are underperforming. So you want to add exposure to BRICs when the relative strength line is in an uptrend.

Notice that BRIC stocks underperformed domestic stocks for the past 18 months. But the relative strength line has just violated the downtrend, as you can see in the circle in the chart.

Shaping Up for a Great Year

Please click here to view larger image

 This looks like the beginning of a new trend where BRIC stocks perform better than the U.S. market.

The last time the relative strength line violated a major downtrend line was at the beginning of 2009. At that time, BKF started a rally that ended more than 120% higher. It was the perfect time to jump into those markets.

These trends of relative performance tend to last several months, so these latest signs mean that it’s time to jump in again.

So 2012 is shaping up to be a great year for emerging market stocks.

Make sure you don’t make the same mistake as my friend, Larry.

Best Regards,

Evaldo Albuquerque

P.S. Don’t miss The Sovereign Society’s ONLY offshore event of 2012. This is your big chance to attend the 11th Annual Total Wealth Symposium and join us in beautiful Los Cabos. To make sure you don’t miss the opportunity to attend this action-packed, wealth-boosting event, contact us immediately to make your reservation. Spots are filling up fast. For full details, click here.

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