A reader passed along a missive from S&P noting that correlations between domestic stocks and foreign stocks have been going up. Specifically the correlation between the S&P 500 and MSCI EAFE has gone up to 0.89. If memory serves I seem to recall those two correlating close to 0.80 for a quite a while but I may have that wrong.
The reader used the word deworsification to describe what has happened to the tenets of diversification and what it is supposed to do for a portfolio during adverse market conditions.
This hits a few points I have tried to make over the last few years. The broader you go, so something like MSCI EAFE, the more that you blend away any positive attributes that might exist. The EAFE index is heaviest in Japan and the UK. Japan has had a whole bunch of problems while the UK looks very similar to the US. The heavy countries in EAFE are heavy due to size. Big is not necessarily better. How long do want to be be in countries with a headline-making banking crisis, deflationary issues and any other problems you want to throw in?
I'm not sure how many times I've talked about foreign investing at the country level. There are countries whose economies are much healthier than that of the US. There are countries whose economies run on different inputs than that of the US. There are countries whose economies are at different ends of the economic spectrum than that of the US (meaning surplus countries).
Of course all of those markets are down a lot. Other than cash, a couple of absolute return vehicles and inverse funds there hasn't been any place to hide in this bear market. However most of these kinds of markets hit their peaks at different points than the US. Brazil kept going up for nine months after the SPX peaked. Exposure to these sorts of countries combined with a clearly defined defensive strategy is a much better idea than buying the EFA ETF and thinking you are diversified. By the way the EAFE index peaked a couple of weeks after the SPX did.
The bigger idea is simple and you either buy into it or you don't. A country that has surpluses or is an exporter or a commodity based economy or all of the above has a good chance of being at a different point in the economic cycle and by extension a different point in the stock market cycle. Making them potentially better candidates for diversification.
None of this has to be difficult. If you buy into the idea that countries with different economic attributes off a chance for better diversification over the long term then the next step is learning about different countries and then making small investments to spread out the risk.
This won't be right for everyone of course but I have been making this same point about EAFE for ages, it does not provide as good a diversification as going to the country level.
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22 comments:
I say forget about a big, bad recession and get ready for a big, bad global depression. I don't see how it doesn't happen. The more the governments try to do, it appears the worse that things are getting. I know that you think avoiding equities would be catastrophic, but I think between now and at least 2012, avoiding equities will save you a lot of money.
It would be tragically funny if the most prophetic statement from G. W. Bush is "This sucker could go down".
"The only thing going up is correlation."
Roger: TO play the devil's advocate: Why not just invest in high quality companies here in the U.S.? At least you know what you are getting in terms of earnings, dividends, ROE etc. In addition many of our largest corporations have a significant overseas presence, including in the emerging markets. If the stocks go down at least you can confidently hold knowing the fundamentals.If you buy into some of these other countries, can you REALLY have confidence in what you are holding? If the answer is no and the position goes against you, then it seems it would be much more tempting to sell low in the event of a drop. Any comments appreciated. ANdrew
Buying domestic stocks could turn out to be the better exposure, I don't think so, but still.
The knwoing what you are getting is pretty antiquated for many countries and pretty distrusting of some others. Naively or not I tend to believe what companies say, very few of them lie.
If you want to own a stock that benefits from doing business overseas fine but PG selling detergent in Asia is nowhere close to owning an Asian stock, not even remotely despite what some people say on TV.
Roger,
diversification clearly has benefits. But you seem to take it way too far. You want to own everything and you simply can not be an expert in everything. You also consume a lot of time trying to keep up on to many various assets.
I am interested in domestic, asia, emerging market equities, and possibly some reits and commodity funds in a year or two.
With all due respect I think your approach is overly complex for people with full time jobs or fuller lives than you or me.
i caveat many articles with for people willing or able to spend the time or words to that effect.
the blog is a peek over my shoulder for any who cares to look.
Hi Roger, long treasuries were another important asset class that did fine during the storm e.g. TLT and EDV.
My own take away from watching diversified portfolios wither in this market is that US stocks, foreign stocks, private equity, REITs, and even commodity indices and currency plays etc are all tied to the world equity market as a whole. And as such are great for diversifying the EQUITY portion of a portfolio.
I am definitely still dedicated to investing in the equity markets, including individual countries especially at this time! However I realized that for my whole portfolio to meet my personal expectations, I need to more fully commit to other less correlated asset classes such as short / long term debt, and market neutral absolute return strategies.
On another note is everyone in Prescott as Bad$ss as the rabid fox lady?!? http://www.tucsoncitizen.com/ss/arizona/101752.php
i heard about the fox lady over the weekend. crazy eh?
Roger.
What do you think of the new global DOW index? (GDOW)
http://tinyurl.com/6rvkcj
first i have heard of it, people can see the components here, scroll down after the jump.
Equal weighting seems odd. There appears to be a lot of US, western Europe and Japan. If that is correct then I'm not sure how different it really is. If possible I will try to look closer.
here is a little more info inclduing sector and country weights
Thanks.
I suppose it won't be long before Wisdom Tree and others like ishares come out with an ETF to track this index.
OT: If you didn't catch this week's American Experience on PBS, it was about the 1929 crash. You can see it here:
http://www.pbs.org/wgbh/amex/crash/program/index.html
Very interesting......
Speaking of Wisdomtree - are they gonna see any viability concerns?
The ETFs that I'm interested in don't seem to grow much asset-wise. I didn't delve into their last quarterly report, but obviously it wasn't great.
they have soemthing with the funds, if they burn too much cash I think there is something there for a bigger player to be interested in buying.
That is just supposition on my part and I am not suggest anyone buy the stock.
Roger, somewhat off topic, but would be interested to know if you still consider the fear in this bear market to be comparable to other bear markets you've experienced. You've made the point several times (hope I'm paraphrasing right) that it always feels this bad in bear markets, and that this one doesn't feel remarkable to you. Do you still feel that way?
tough to say. people are afraid, seem to want to throw in the towel and think this is different.
as we are in the middle of the event it does seem different based on the headlines and number of failures but how different is the manifestation in stock prices?
Different isn't right very often but people always feel this time is different so i will say not different in the end but i still have a lot of cash for most clients in case it really is different.
In a recent interview (http://tinyurl.com/637s8v), NBER member Jeffrey Frankel, comments, "I have long observed that based on anemic wage and job growth, we really should have experienced a two year recession in 2001 and 2002. Had it not been for the plentiful supply of cheap credit and Home Equity Withdrawals that prompted consumption, we would have had our two year recession 6 years ago. In a sense then, the carnage now, is really just that same recession delayed and magnified."
Frankel made it clear that regardless of beginning date we now seem to be entering the steep part of recession so more bad news is probably coming. It really seems the market resisted, or at least was very slow to accommodate, growing evidence of economic distress but there doesn't seem much doubt it's making up for lost ground in discounting future cash flow now and at nose-bleed velocity too. What's rather weird is equities appear to have entered a trading range for the past month but the oscillation magnitude is simply huge, nosebleed territory again, with a sense prices could smash through any barrier at will.
Psychologically, very large-scale and/or rapid changes tend to breed anxiety and we have both in abundance so the growing sense that the wheels could simply fly off at any moment is entirely understandable. Dread aside, lower resistance on the S&P500 is holding for now, but it is very, very close; interesting times indeed.
PS: Am I the only one who thinks the pressure is addling Hank Paulson's brain? Come to think of it, am I the only one who is astonished that Treasury is still in the process of designing a plan (TARP) after it is already out of the gate and casting taxpayer funds onto the waters? Okay, too many liquid metaphors, I either need a transfusion or a pee now.
Note 1: NBER has not officially dated the recession apparently, in part, because the beginning is in some dispute w/ some arguing for the December '07 employment peak, others the October crisis, etc but there are often competing views at NBER about when to date recessions (the frequently repeated popular view that a recession is marked by two successive quarters of contracting GDP is simply flat wrong).
Note 2: Toward the end of the interview Frankel speaks very approvingly of China's stimulus move and seems to regard their response as among the best of the crop even though structural factors make it unlikely even China will dodge the economic bullet ricocheting around the globe. The video was cut before he finished but may be continued as a separate segment at Bloomberg; I didn't look.
Roger- I thought that you may enjoy this under the radar blog. tom Drake has some insightful comments and remarks under each article.
Enjoy
http://twocents.blogs.com/
To my simple mind (and not to sound argumentative), there is no diversification strategy (save being in cash treasuries) that works in the face of a wholesale credit implosion as we have witnessed.
I still credit the paper, Hedge Funds and Systemic Risk, as helping me understand the (I've mentioned it here)fragility of diversification in light of such a powerful market force as de-leveraging.
My only surprise is how long that it took for (1) the recognition of the issue of systemic risk, which only came to the fore as a reality in August of 2007--and then was quickly dismissed as being fixed; and (2) the full realization of how broadly this systemic risk reaches.
Too many underestimated this reach, and I'm disinclined to believe that any have a full comprehension of the matter. The market is still in price discovery mode, and I have to believe that with the level of liquidity that is likely PERMANENTLY removed, it is likely that p/e historical comparisons are best viewed as distorted through the fun-house mirror called excessive leverage.
The entire thing is just sickening.
leisa wrote - "I have to believe that with the level of liquidity that is likely PERMANENTLY removed, it is likely that p/e historical comparisons are best viewed as distorted through the fun-house mirror called excessive leverage."
I wonder why you think there is a strong connection between liquidity (capital allocated to equites?) and p/e.
After all it does not take a great deal of capital to raise prices - prices are set more on faith and confidence ultimately than as some type of allocation of preexistent capital.
A price will go up on nothing more than sellers not selling, and a few buyers buying.
I see little to argue that equity p/e's need to stay low - unless alternative investments have superior yields that cause that effect - the future of alternative uses of capital is the question to be considered. IMO
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