By Joseph Y. Calhoun
Home country bias is the tendency for investors to focus more on their domestic economy and markets. For most of the people reading this, the US markets are home and with the Dow breaking 17,000 this past week, the US is certainly getting a lot of attention. And it deserves it I guess considering the huge run up in US stocks the last few years. With US outperformance these last few years though, it might be a good time to revisit some investing basics, like asset allocation. Since 2009, it really hasn't paid to invest in much of anything other than US stocks, the smaller and more speculative the better. But it is big world out there when it comes to investing and one thing every investor should know is that nothing is permanent in investing except change.
The US, with the largest economy and most liquid markets in the world, does warrant a special place in most portfolios. The rest of the world is dependent, to one degree or another, on US economic growth. As the old saying goes, when the US economy catches a cold, the rest of the world gets the flu. But that isn't as true today as it was when I started my career over 20 years ago and it becomes less so each year. The US is also home to many of the world's great multinational companies and a degree of international diversification can be gained buying US blue chips. But true diversification can only be achieved by overcoming your home country bias and considering investments outside the US and importantly, outside the US Dollar. Diversification also requires remembering that stocks are not the only asset class available to investors and while investing internationally does provide diversification benefits, foreign stock markets are still highly correlated with the US.
At Alhambra one of our most important market based indicators is the currency market. The movement of the US dollar against other currencies as well as its movement versus commodity markets can provide real time information about growth and inflation prospects and expectations. Generally, investors should favor countries with stable to rising currencies (which can dampen inflation) and rising growth (not just positive but improving). A stable or rising currency encourages capital inflows and investment which enhances economic growth so the two are related. I would argue that the stable/rising currency comes first but it could be that the investment opportunities attract capital which raises the value of the currency. Whichever it is - and it is likely a bit of both - an investor in such a country has a tailwind for returns. A rising currency adds to returns while an improving economy is - generally - positive for corporate earnings growth.
The value of the dollar also affects the price of commodities. A rising dollar is generally negative for commodity prices while a falling dollar produces the reverse. All commodities will not be affected the same - there are still relative value shifts and supply/demand fundamentals affecting individual commodities - but if the CRB or another general commodity index is rising, that is an indication of a weak dollar (and some would say the true definition of inflation). Now, again, correlation and causation are hard to determine. It could be that the falling value of the dollar drives investors to hard assets to maintain purchasing power. Or it could be that rising commodity prices drive investment flows that tend to weaken the dollar. Again, it is probably a bit of both but the causation isn't really all that important to an investor.
If you spend all your time on the US stock market, you are likely to miss opportunities in other investment areas. The US stock market is rarely the best performing in the world while commodities and real estate (also affected by the value of the currency) provide important diversification benefits to the long term investor. The markets this year provide plenty of examples. The most widely cited example is the US bond market where long-term bonds have produced double digit returns despite being widely loathed at the beginning of the year, but there are other examples as well. US REITs have produced mid double digit returns already this year while commodity index ETFs have returns similar to the S&P 500. Gold and emerging market stocks - both also shunned at the beginning of the year - are up roughly 10% at the halfway point. The S&P 500 gets the headlines but better returns have been found elsewhere this year.
One thing that has struck me this year is that many of the assets with high returns are also weak dollar assets. Real estate and commodities were among the best performing assets during the weak dollar period from 2002 to 2008. Emerging market stocks and gold also perform well in a weak dollar environment. I find it interesting that these assets have performed well at a time when the US Dollar index has been generally stable to stronger. It may be that these asset classes are providing a glimpse of the future. Indeed, the so called commodity currencies - Aussie $, Canadian $, Brazilian Real - have all been rising against the dollar. These currencies don't have a large weight in the trade weighted dollar index but have in the past been leading indicators for commodity prices (hence the moniker "commodity currencies") and the US Dollar.
One reason weak dollar assets may be gaining is that growth prospects around the world are changing. The US had a very rough 1st quarter and while there has been a bounce back in the 2nd quarter it certainly isn't a boom. And the US growth rate has been falling for three years. Meanwhile, in other parts of the world, growth prospects seem to be improving. Europe's PMIs have been steadily improving, particularly in the peripheral areas such as Spain, Ireland and Italy. The same can be said about China and most of Asia. Amidst all the talk of a bursting credit bubble, Chinese economic statistics have been steadily improving. I know, I know. You can't trust those statistics, but a look at the recent US trade report also offers some encouragement. US imports and exports to and from China are both up year over year. The same is true, by the way, of Brazil, Germany, Italy, South Korea, Mexico, the UK and even France. Improving trade may be an early indication of improving foreign economies.
Another consideration for non-US stocks is valuation. There has been a robust debate as to whether US stocks are overvalued or even in a bubble. One thing I've yet to hear anyone say during that debate is that US stocks are cheap. Most of the argument seems to center around whether US stocks are fairly valued, mildly overvalued or wildly so. Outside the US though, there are plenty of markets which can be termed cheap. Countries trading for below historical average cyclically adjusted P/Es (the so called Shiller P/E) include: Australia, Austria, Belgium, Brazil, Chile, China, Colombia, Finland, France, Germany, Greece, Holland, Hong Kong, India, Italy, Japan, Norway, Russia, Spain and the UK. That doesn't mean that you should go out and buy all those, but they are all considerably cheaper than the US.
If you don't want to spend the time to investigate a bunch of individual stock markets, you could also consider investing in a diversified international index fund. Not only are stocks outside the US cheaper but the EAFE index (a widely used international stock benchmark) has underperformed the S&P 500 since the 2008 crisis. If we are entering a weak dollar period that trend may be about to reverse. These things tend to go in cycles and the last weak dollar period saw the EAFE nearly double the performance of the S&P 500. An even wider disparity was seen in emerging market stocks where the spread was over 3 to 1.
Lastly, don't forget those traditional weak dollar assets, commodities and real estate. These should be, in my opinion, a permanent part of your portfolio and if you don't have them you are missing a great diversification opportunity. Yes, commodities especially are volatile and should be only a relatively small portion of your portfolio, but it is when and how they are volatile that is important. Commodities tend to show low to negative correlation to stocks, zigging when stocks zag. Gold holds a special place within the sphere of commodities and also deserves a look. Gold outperformed US stocks - and the general commodity indexes - by a wide margin from 2002 to 2008 but almost all that outperformance has been reversed in the subsequent gold bear market. The ratio of the two now has returned to a very long term uptrend line and is certainly worthy of watching. Extraordinarily easy monetary policies from the world's central banks would seem to at least warrant a small allocation to the world's oldest form of money.
There's a whole wide world of investments from which to choose. The US stock market dominates the debate right now and that by itself should tell you something. Successful investing is as much about what you don't do as what you do. Rather than buying the S&P 500 and hoping the bulls win the valuation debate, take a look at markets that can be classified as cheap. Make sure you are truly diversified, across all asset classes, not just US stocks and bonds. Maybe it's time to let your portfolio do a little traveling.