Diversifying, Yes; Decoupling, No

Decoupling is back?

Well, no, it isn't.

Much has been made in the last few years about the idea of decoupling. A few years ago investing in certain foreign countries was believed to be a way to beat bear markets. Then when the market started to turn down and correlations went up, the folks banking on decoupling were sorely disappointed.

Now it is a few months later and the Wall Street Journal ran an article yesterday titled Finally, Global Markets Are Going Their Own Ways.

This ties in with a lot of the stuff I've written lately. From the beginning of this site I have tried to convey the same message about how to diversify with foreign exposure and what expectations to have about that foreign exposure.

In selecting foreign exposure I believe the most value is added by buying countries with different economic attributes than the US. Different economic attributes means that those countries are very possibly on different economic cycles and so could be on different stock market cycles. These types of countries provide the best shot that an investor has for a volatility-reducing zigzag effect within the portfolio.

That does not mean that some market should be expected to go up 20% when the US goes down 20% but it can mean that some countries roll over into a bear later than the US, emerge out of a bear sooner, or both. For months I have been harping on countries that I think fit this bill (these places will be familiar to long time readers) and generally speaking they did start their bear later and appear to be emerging sooner as well; specifically Chile, Norway, Brazil and China fitting the bill one way or the other.

And while Australia has not done as well as these others I do have long term faith in that country as well. New Zealand is a bit of a dilemma in this regard and I do not have across the board exposure there. Many folks fancy NZ to emerge sooner, and clearly their economy is different than the US, but there is a lot of debt and it is unlikely that the current account will ever be a positive.

The flip side is investing primarily in Western Europe like UK, France, Germany, Spain or Italy. At different times any of them could of course be great holds but they are much less likely to zig when the US zags like the types of countries I mentioned above. This point makes a great case for avoiding the iShares MSCI EAFE ETF (EFA). The correlation between EFA and and the S&P 500 has always been very high.

Comments

[RiskReturnO...:]

Careful with lumping all BRIC countries into one category ... China and Brazil are in better shape than India and Russia ... nevertheless, emerging markets will outperform US/developed markets ... kind of like what used to happen during early stages of bull market when small caps outperform large caps ... this time it will be emerging economies vs. developed economies.

Apr 09 08:15 PM

[THofler:]

I'm a little shocked that no one seems to remember any of the decoupling theses that I heard a few years back.

None of them claimed that emerging markets would be recession proof over the short term, or ever particularly uncorrelated over the short term.

The thesis always was that BRIC or maybe BIC has a rapidly growing middle class. Twenty years ago this middle class was insignificant relative to global GDP. But today it is no longer insignificant. They can now sustain their own economy and even some growth without relying entirely on selling stuff to the US middle class.

That is the essence of "decoupling." That the US used to be the only significant market for "consumption," and now it is not.

If you are keen on anticorrelated assets for your stock portfolio, better look at Treasuries, gold & commodities, short positions, managed futures, etc.

Apr 10 12:05 AM

[dw57:]

except for Brazil, none of the BRIC or BIC have much of a middle class. which is why they don't have much of a chance to decouple from the US. the theory of decoupling was that if the US tanked the others would continue on regardless of that. But you can't do that if you have an export economy. and your biggest market is the US.


On Apr 10 12:05 AM THofler wrote:

> I'm a little shocked that no one seems to remember any of the decoupling
> theses that I heard a few years back.
>
> None of them claimed that emerging markets would be recession proof
> over the short term, or ever particularly uncorrelated over the short
> term.
>
> The thesis always was that BRIC or maybe BIC has a rapidly growing
> middle class. Twenty years ago this middle class was insignificant
> relative to global GDP. But today it is no longer insignificant.
> They can now sustain their own economy and even some growth without
> relying entirely on selling stuff to the US middle class.
>
> That is the essence of "decoupling." That the US used to be the
> only significant market for "consumption," and now it is not.
>
> If you are keen on anticorrelated assets for your stock portfolio,
> better look at Treasuries, gold & commodities, short positions,
> managed futures, etc.

Apr 10 01:09 PM

[Minlita:]

An economy that is able to sustain growth, without experiencing a worsening of environmental conditions, is said to be decoupled.

Emerging Europe and Asia Economies depend on the United States for growth even during a recession.
U.S stocks declined but losses were greater in emerging markets and even in some strong economies (like Germany, Japan) because exports are large portions of economic activity in this places.

So I don't see emerging economies vs. developed economies.

The world is now more interconnected so we face a synchronized downturn in almost all countries, a weakening of confidence among individuals, firms, and government finances.

Apr 10 04:12 PM

[John Lounsbury:]

THofler and dw57 - - -

A little added tid-bit of information for your discusssion: I read recently that China (so far in 2009) is the world's largest car market.

Of course, that condition has occurred at this time partly because the U.S. car market has dropped below 10 Million units annual rate, but sales in China have risen dramatically to reach this level.

Apr 11 01:13 PM

[Brian Dightman:]

I believe emerging markets represent the biggest economic attribute difference compared to the U.S., but information from some countries is suspect and the amount/variation of data considerable. I do think the general trend of increasing capitalism (at a time when it is decreasing in the U.S.), a rising middle class, and stronger monetary systems in emerging markets will represent outperformance versus U.S. equities over the next 3-5 years.

I track a large number of individual country and regional ETFs. I have noted that most emerging markets are showing a strong recovery and as a result I find little reason to use anything beyond EEM (or similar broad emerging market ETF like VWO, PXH, GMM, etc.) at this stage of the recovery. If we move into a full-fledged recovery, supplementing broad coverage with regional or specific country allocations may make more sense. This is an asset class, in my opinion, where additional diversification is helpful. Given the wide participation by emerging countries in this rally, at present does not seem to be a hindrance.

Turing to developed markets, I favor those countries with rich natural resources and a willingness to develop them. It is really disappointing the U.S. is not in his camp, we certainly have the natural resources, but policy is directing us in a different direction at present.

Australia and Canada are my two favorite. I also believe their currencies my rally as the U.S. $ looses the “flight to quality” momentum it is currently benefiting from. I think Australia’s proximity to Asia will serve it well as will Canada’s current account position.

I recently reviewed a bunch of developed market indexes and it was very difficult to find any that did not have large allocations to Western Europe and Japan, two areas I want to avoid at present. I did eventually find one, the First Trust Dow Jones Global Dividend Fund (FGD). I posted an Instablog on the ETF for those that are interested in learning more about it. It is thinly traded, so you need to control the order process which I detail in my post.

Disclosure: Long EEM, Long FGD

Apr 11 02:13 PM

[MINESTEIN:]

Disagree with this article, I beleive the decoupling will commence with unmistakable evidence between July & October this year, Be careful saying that decoupling not going to happen is a done deal, it aint over till the fat lady sings,
see: seekingalpha.com/artic...

May 23 05:47 PM