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International Markets Show Important Divergences

Global diversification might help least when it is needed most

William Hester, CFA
November 2007
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The weakening U.S. dollar has helped prop up a number of investments this year. Gold, oil, and commodity stocks have been in demand, partly as a hedge against dollar weakness. Many U.S. multinational companies have been helped by export sales. The performances of international markets when viewed in dollar terms have also benefited. Morgan Stanley's index that tracks all countries excluding the US is up 15 percent year to date, in dollars. When calculated in local currencies, the year-to-date return is 6 percent.

The translation of local performance into dollar returns is helping to obscure an important development in the performance of international markets. Of the 22 developed countries that Morgan Stanley tracks (not including the US) only 6 have stock markets with positive 6-month returns. Even after last week's bounce, some markets have suffered noticeable corrections. The MSCI index that tracks Irish stocks is down 29 percent from the prior six months. The benchmarks for Belgium and Austria are down more than 17 percent, and the market benchmark for Japan is down 12.5 percent (all in local currencies).

This is the third week in row that the percent of countries with six-month net gains has been below 40 percent. During global bear markets this weak "performance breadth" is standard stuff. But it happens less frequently when the EAFE index which tracks developed markets worldwide, excluding the U.S. and Canada has not corrected significantly. The EAFE Index is down 6 percent from its level of six months ago, and 6.4 percent from its high.

When you look at periods with poor performance breadth persisting over a few weeks while EAFE is experiencing more modest losses, unfavorable market returns have followed, on average. The graph below shows each instance where the percent of countries with negative 6-month returns fell below 40 percent for three consecutive weeks, and the EAFE Index had not declined by at least 10 percent from a recent high.

This set of indicators does not always provide an early indication of trouble. It didn't register during the 1998 decline, which was too abrupt for the 6-month look-back process. And it often signals after the EAFE index is off at least somewhat from its highs. But its strength has been highlighting markets that are rolling over on their way to more extensive declines. It signaled the 1991 decline, when the EAFE index fell 36 percent from its peak. The signal was also present in 1994, which was followed by an important decline, and in December, 2000.

These especially poor returns have followed periods where the percentage of developed countries with positive 6-month returns was falling, but the EAFE index was still holding up. Think of it as a measure of international "market internals." Much like we observe in long-term U.S. data, when the components that make up an index begin to break down uniformly, a more serious decline in the index often follows. And the dispersion of international markets isn't only effective with this set of criteria. More generally, the EAFE index performs better when there is broad confirmation from its component countries. When at least 80 percent of developed countries have had positive 6-month returns, the EAFE index has advanced at an annualized rate of 7.4 percent over the next three months. The average return drops to 2.2 percent annualized when the percentage of countries drops below 80 percent.

The most recent signal occurred on Friday, November 30. The percentage of countries with positive 6-month returns was 27 percent, making it the third week the measure was less than 40 percent. Meanwhile, the EAFE index has declined 6.4 percent from its high.

Decoupling versus Historical Correlations

In addition to the weakening dollar, another theme affecting stock prices is the idea that developed and emerging countries outside of the US will continue to prosper even in the face of a slowdown in the US. The "decoupling" theme can be witnessed in the performance of many different parts of the market. In the US markets, investors have been bidding up stocks with large non-U.S. sales exposure. The Dow Jones Industrial Average has further widened its performance lead over the average stock in the S&P. The Industrials are up 7.6 percent in price year to date, while S&P's equal-weighted index is up just 1.5 percent. Of the 10 sectors that MSCI breaks the U.S. and World markets into such as materials, energy and utilities - 8 of the categories are being led by global stocks versus their US counterparts (U.S. energy stocks and healthcare stocks are the two groups that are edging out their global benchmarks).

With the decoupling theme so firmly embedded into stocks prices, it will be interesting to watch whether reality mirrors theory over the next few months. A few economic numbers were recently announced that offered up some clues. GDP reports from Europe and Japan came in at or slightly higher than economists had expected. But forecasts compiled by Bloomberg suggest that both areas will slow going forward; the euro area because of the recent strength of its currency, and Japan because of its reliance on exports to the United States. Less positive reports included the news that investor confidence in Germany fell to a 15-year low, according to the ZEW Center for European Economic Research.

Although the economic data is worth watching, the decoupling outlook will probably show up in stock prices prior to reported data. The broad-based breakdown of developed markets questions the theory short term. Longer term trends also question the thesis. The graph below shows the rolling correlation between the S&P 500 and the EAFE index. The blue line in the graph is the S&P 500, on a log scale, and the red bars represent the 6-month rolling correlation between the weekly returns of the EAFE index and the S&P 500.

The graph shows two important trends. One is that previous declines in the S&P 500 have usually sparked a substantial increase in the correlation between EAFE and the S&P. Some of the highest levels of correlation between the two indexes took place in 2002, a particularly brutal period of the most recent bear market. International diversification apparently helps least when it is needed most.

The second trend is the secular rise in the rolling correlation between the S&P and the EAFE index. The correlation between the two indexes has been trending higher as world-wide economies have become more interdependent. Averaged over 10-year periods, the correlation has trended higher from 0.31 to 0.65 recently. As the returns of the two indexes have mirrored each other more closely, the diversification benefits of a long portfolio invested in just these two investments has declined.

These long-term correlation trends will need to reverse if investors expect international developed markets to hold up in the face of meaningful declines in the U.S. stock market. This appears unlikely, so an effective diversification strategy should include a variety of asset classes, regardless of how diversified the basket of international equities might be. On a shorter-term basis, it will be important to watch the breadth of performance of EAFE's component countries over the next few weeks. If various country indexes continue to break down, not only may the EAFE Index be at risk, but so may the widely priced-in decoupling theme.


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