The theory behind global investing is sensible enough. Diversifying internationally avoids overdependence on any particular market; if Dutch stocks go down, perhaps Japanese bonds will go up. Through January, that reasoning held. U.S. stocks had leveled off and Asian markets were struggling, but Europe’s were soaring as the region climbed out of its economic doldrums. That story changed abruptly on Feb. 4, as the Federal Reserve Board’s interest-rate increase spilled across the Atlantic. After a two-month slide, most European stock markets are down in line with this year’s 4.4 percent drop in the U.S. Standard & Poor’s 500 index (chart). Last week stocks in London, Paris and Madrid all hit new 1994 lows. The Pacific picture isn’t much prettier. Japan’s Nikkei index dropped 4.4 percent in March, and many money managers think its three-year rollercoaster ride is far from over. “People aren’t buying right now,” says Jardine Fleming broker Paul Migliorato in Tokyo. Although final figures for March aren’t in, some international funds report that customers have been fleeing in droves.

The year’s worst returns have come from last year’s hottest ticket, emerging market stocks. “I’d call them submerging markets,” says Richard Lemmerman, a Lehman Brothers trader in Tokyo, after Hong Kong’s Hang Seng index registered a 2.2 percent drop Thursday. Three months ago small-time investors were clawing to move their individual retirement accounts into developing country stocks. Now they’re clawing to get out. It’s not that Brazil, Malaysia and Turkey are in economic trouble. Most of the larger developing economies are doing well, thank you, and the long-term signs are bullish. But “well” isn’t enough to justify share prices 40 or 50 times a company’s annual earnings-more than twice the ratio U.S. stocks command. Foreign capital flooding into tiny markets brought about those stratospheric prices, and foreign capital rushing out caused them to collapse. If you’d put $6,093 into Fidelity’s Southeast Asia fund when it opened in February 1993, you’d have had $10,000 at year-end. That stake is now worth $7,640.

As U.S. interest rates dropped last year, many bond investors sought heftier returns in foreign bonds. They, too, have received some unpleasant surprises. Economics teaches that when interest rates fall, bond prices rise. That lesson will bring snickers in Paris or Frankfurt, where interest rates have been tumbling-and bonds have tumbled with them. Politics, not economics, is at work: turmoil in Russia and Mexico, war in Bosnia and nuclear saber-rattling in North Korea aren’t the sorts of background noise bond buyers like to hear. The debacle abroad hasn’t been quite as bloody as in New York, and a falling dollar has turned U.S. bond investors’ losses into profits in Japan and Germany. But the biggest foreign bond markets, Canada and Britain, are down sharply in U.S. dollar terms.

Emerging-market bonds have proven even more volatile. As government and corporate issuers from Argentina, Venezuela, Mexico and Brazil have found their way back to the international bond markets since 1990, their paper has become a staple of U. S. junk-bond funds. The lack of currency risk-almost all Latin American bonds are in dollars-has made the double-digit yields seem too good to be true. The January revolt in southern Mexico and the March 23 assassination of presidential candidate Luis Donaldo Colosio harshly reminded investors that juicy returns have risks attached. Those risks have little to do with distant Chile, but no matter; overnight, all Latin debt is out of favor. “The market treats it as one big neighborhood,” says Thomas Trebat of Chemical Bank.

After last week’s trauma, the major foreign stock and bond markets seem more a e than the U.S. market. Their prolonged price slide makes many European stocks attractive, while lower interest rates bode well for European bonds. The biggest bright spot in the equity world is one your broker probably never dreamed of whispering: Milan. In normal times, Milan’s Borsa is a backwater. If you’d invested there four years ago you’d have lost nearly half your lira by the end of 1993. But last week’s election victory by the right-wing Freedom Alliance has set Italian equities on fire, and foreign cash is pouring in. If you’d been smart enough to buy Italy Fund, you could have made 15 percent on your money in just two weeks.

An overseas comeback, if it occurs, may bring little immediate consolation to U.S. investors. With U.S. interest rates rising as foreign rates come down, the dollar seems likely to strengthen. If it moves up significantly, it will damp the returns from foreign stocks and bonds. But novice international investors, spooked by market swings they don’t understand, are drawing the wrong conclusion if they bring their money home. Global diversification still makes sense, and places like East Asia continue to offer tempting opportunities. True diversification means only that overall returns will be less volatile-not that they will be bulletproof.

Finding shelter from the U.S. markets in international stocks isn’t a sure thing. Here’s a sample of overseas returns:

Thailand -25.7 PERCENTAGE CHANGE YEAR TO DATE* Hong Kong -24.1 Mexico -14.5 U.S. -4.4 Germany -3.6 Japan 19.5 Italy 23.3 Brazil 41.9% *U.S. DOLLARS. NOTE: IBOVESPA (BRAZIL), MILAN MIB TELEMATICO (ITALY), NIKKEI 225 (JAPAN), DAX INDEX (GERMANY), S&P500 (U.S.), BOLSA (MEXICO), HANG SENG (HONG KONG), BANGKOK SET INDEX (THAILAND). SOURCE BLOOMBERG