Many of you may have noticed that, while our domestic stock markets have been getting hammered after widespread discovery of the deplorable state of our housing and mortgage market, international and emerging markets stocks have fared even worse. I may be one of the few who sees this parallel as a short-term trend.
Students of stock market history and of failed investment theories — such as asset allocation and diversification — already know that a certain correlation exists between different types of investments or asset classes. Some asset classes are highly correlated; others are not.
The asset allocation and diversification theory suggests that one should build an investment portfolio using several different asset classes. While economic trends or investor sentiment will always favor one asset class or another, this investor ignores how different asset classes tend to move up or down simultaneously. Diversifying by including small cap growth and small cap value, for instance, will show similar returns in rising markets.
We saw in the bear market cycle of 2000 â€“ 2002 that virtually all stock funds fell. Of course, some fell faster and deeper than others. Technology stocks suffered most, due mainly to the warning bell that finally rang, alerting those shareholders to the idea that valuations really do matter after.
At that time, international and emerging markets shares fell harder than domestic value shares. But this situation can be predicted rather successfully by using other tools of modern portfolio theory. A fundâ€™s beta rating can help predict how that fund will probably perform in up- or down-market cycles.
Beta ratings, of course, have nothing much to do with the fundamentals of one asset class or another. However, they may have much more to do with the number of advisors and brokers who check such values and react to them accordingly. If one asset class is expected to be more volatile, thus having a higher beta than another asset class, investors expect it to rise more in an up market and fall faster in down cycles. So investors who understand modern portfolio theory and its aspects, like beta, reinforce the theory.
The stock market, as measured by the S&P 500, shows a beta rating of 7.35, using the Vanguard S&P 500 Index Fund as a proxy. Vanguardâ€™s small cap growth fund sports a beta of 13.4, while its emerging markets index fund has a beta rating of 16.64. During the bull cycle of the past four years, the rating indicated just about what has happened, thus predicting what was coming.
So now, with domestic bond markets under pressure from enormous amounts of corruption in the mortgage markets, the stock market finds itself under a cloud of uncertainty about the depth of troubles in housing and sub-prime mortgage debt. What now becomes obvious — even to stock market promoters, who always see the sunny side of the street, even at midnight â€“ is that troubles in housing and sub-prime debt are just beginning. The depth of these problems is yet to be divulged as central banks around the world try helping lenders and other holders of bad debts to buy time in an effort to minimize damage to their balance sheets, not to mention their credibility with investors.
With the announcement of each bit of bad news, domestic stocks can be expected to sell off. Investors relying on beta ratings will be quick to sell the riskier stuff, stocks with the highest beta ratings, and look for shelter in what are considered to be the safest asset classes, short-term bonds and cash.
But why should international and emerging markets shares fall in sympathy with our domestic stock markets when their economies are, for the most part, not at all involved in the sub-prime mortgage mess? Sure, I know the story, and there are elements of truth to it.
Many investors enjoy opportunities to invest globally, and troubles in a big economy like ours are bound to affect other economies. And investors who loaded up on holdings with bad mortgage debts may have also bought international shares as part of their equity allocations. Therefore, they may need to sell the good stuff to offset losses in their debt holdings. The idea also exists that lending in the U.S. will become subject to tougher scrutiny, therefore possibly making borrowing in other places more difficult or expensive.
Another aspect to this perception is that what matters here should matter there, too. An old saying predicts that â€˜â€™When America sneezes, the rest of the world catches cold, too.â€™â€™ And, to a small degree, I guess thatâ€™s true. But to a larger degree, itâ€™s not as true as it used to be. And thatâ€™s where I think many investors will be surprised by the â€œdecouplingâ€ of our home stock markets from those around the world.
Even in normal times, or during typical economic cycles, international shares are not perfectly correlated to our home market. In simpler terms, other markets do not always move in the same direction as ours. Review the table on page 115 of the book, Triumph of the Optimists, which shows the correlation coefficients for different markets. An investor who adds shares in the Canadian stock market can expect that those shares will rise and fall in tandem with our markets about 80% of the time. But investors in Japanese shares would see that market rise along with ours about 45% of the time. Think back to Japan in the decade of the 1990s to see what I mean. The difference in performance of emerging markets vs. our home markets in the 1970s provides another example.
In the past five years, the international markets ran together in up and down cycles about 85% of the time. In the five years that ended on June 30th of 1997, the international markets rose in step with ours only about 28% of the time.
So in normal times, or when no apparent reasons appear for concern about our domestic stock market, a certain degree of such decoupling can be expected. After all, economies around the world are always subject to forces of different types.
And I think the current time will prove to be one when markets go their own ways. Troubles bode ill for our economy, yet stock valuations are higher than those in many international markets. Why, for instance, would the stock market in The Netherlands, selling at about 10 times earnings and with no sign of a housing bubble, sell off in sympathy with our markets?
Sure, doubtless numbers of hedge funds and other portfolio managers who rely on those beta numbers shown above will dump international shares first in an effort to minimize losses. But over the longer term, why would our misfortunes affect economies that do little business with us?
Of course, Iâ€™m not talking about economies that do a lot of business with us! Surely China and other Asian exporting countries will feel the heat from our economic slump, right?
Hey, not so fast! I donâ€™t see our troubles having nearly the effect on China and other Asian exporting economies as many others do. First, assuming that our economy falls into recession, and I think it might already be there, how much effect would that have on China?
A recession means negative economic growth rates. It does not mean that our economy comes to a screeching halt and that no one buys any imported goods from China. It does means that we will buy less, of course. But what we buy from China is, for the most part, unavailable from domestic producers.
But China also enjoys huge exports to other places like the European Union, which is about 50% larger than the U.S., and decidedly more conservative with finances. But then, whose isnâ€™t?
China also benefits from the fact that it has not set up a safety net in the form of retirement savings plans like Social Security. So Chinese people have become huge savers, knowing they will need to rely on their own savings in retirement. And we all know that China is getting richer by the year and that internal demand for consumer goods is rising fast.
The potential also exists that China will allow the Yuan to rise against the dollar, maybe even, at some point, allowing it to float freely as our government leaders continue to demand. And donâ€™t we have some nerve, telling our bankers what they should and should not do?
But with a rising Yuan comes stronger purchasing power of their earnings and savings for Chinese consumers. Surely that combination of positives will allow the Chinese economy to avoid catching the cold that will send our economy into recession!
Also, I believe strongly that other economies exporting food and other commodities to Chinese consumers will fare very well, too. For example, Brazil and Argentina export food, iron ore and other industrial metals to China. Nor does it hurt that countries like Brazil, Canada and Russia enjoy trade and budget surpluses and are paying down their external debt, providing another strong contrast to the economic idiocy affecting our situation.
Look for this â€œdecouplingâ€ to become apparent soon. In the short run, your foreign equity holdings will, no doubt, be affected by our falling stock market. But over the longer term, I find much less to worry about than most others do.
Have a great week.
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.