Eleanor Laise in the Wall Street Journal notes the rising popularity of international equity allocations on Wall Street. A look at a graph of the relative performance of two ETFs representing foreign (EFA) and domestic (SPY) equities gives us some clue why:

Some Wall Street firms have recommended international allocations as high as 33% and U.S. investors seem to be listening. AMG Data Services reports that more money has poured into global stock funds than domestic stock funds in 2005 to date.

Driving the new recommendations are expectations for continued strong growth overseas and pessimism about U.S. stocks’ returns, which could be crimped by rising interest rates and concerns about a pickup in inflation. Some advisers are especially bullish on international emerging markets, even though these have enjoyed the most substantial gains among foreign stocks in recent years and may have trouble sustaining that performance. Indeed, U.S. investors continue to pour money into overseas funds, with investment flows this year already surpassing those of 2004.

As we wrote earlier the emerging markets have received a fair amount of recognition this due to the belief that higher economic growth will translate into higher equity returns. A note of caution:

But value-minded fund managers warn against chasing past performance in emerging markets. In recent years, emerging markets “went from dirt cheap to richly priced,” says David Herro, manager of Oakmark International Fund. He believes that developing countries that benefited from the natural-resources boom, such as Brazil, now have the most-overvalued markets. What’s more, historical trends have shown that economic growth, especially in developing countries, often doesn’t translate into substantial stock-market gains.

Two factors are at work here: one strategic and benign, the other tactical and less benign. U.S. investors have probably been underinvested in a strategic sense in international equity for some time now. This ’home country bias’ is well documented. This rise in allocations may simply be a sign of the reversal of this effect. On the other hand, the recent strong outperformance of international equities implies that many of these strategists are simply playing catch-up and will be caught off-guard when this trend reverses.