For economists ensconced in the Ivory Tower, diversification is the idea that comes closest to a free lunch. Once subjected to the cold light of day, however, few academic investment strategies turn out to hold much water in the quest to outperform the market. In contrast, the idea of diversification is almost magical. Diversifying your investments across a wide range of different assets means you can achieve higher returns while reducing your risk.
Diversification also has been the primary argument for investing global stocks. Yet, it's hard to avoid feeling that diversification over the last decade hasn't worked as well as advertised. The correlation of global markets with U.S. markets, following the dotcom crash, shot sky-high as markets across the globe went into a tailspin together. There was no place to hide, not even during the subsequent recovery. This feeling has been backed up by solid research from ING bank. It turns out the correlation between the S&P 500 (NYSEARCA:SPY) and the Morgan Stanley EAFE Index (NYSEARCA:EFA) between 2003 and 2005 was .93 -- as close to a perfect correlation of 1 as you can get.
That has all changed over the past two years. The same research by ING shows that the correlation between foreign and U.S. markets dropped to .63 in the two-year period that ended in February. That drop in correlation has been a boon to global investors, as the Morgan Stanley EAFE Index has outperformed the S&P 500 by a factor of almost three to one. This trend has continued into 2007. So far this year, the Dow Jones World Index is up 8.5% in dollar terms, versus 3.9% for the S&P 500.
The Global Free Lunch and the Great Decoupling
While the seesaw of correlations remains unclear, the bullish case for global stocks could hardly be stronger. Stock prices in the United States relative to earnings are cheaper globally than in the U.S. markets. The perceived risk of investing in global stocks is eroding. The decline of the dollar is also making foreign returns look that much stronger than those of U.S. stocks.
Then there is the "uncoupling" of the U.S. economy from the rest of the world. It used to be that when the U.S markets sneezed, the rest of the world would catch a cold. Today, it's different. Economic and corporate profit growth may be slowing in the United States, but this time the rest of the world -- especially Europe, Japan and developing Asia -- is picking up the slack. Europe is expected to grow faster than the United States for the first time in more than five years. Growth rates in the developing world are easily double the growth rates in both the United States and Europe.
The world's economies also depend less on the United States than in the past. Today, U.S. exports account for less than 3% of Japanese GDP. The economic emergence of the BRICs -- Brazil, Russia, India and China -- and other nations are less dependent on American consumers than they once were. Once economic basket cases, emerging markets are stockpiling cash from the commodities boom.
The Global Free Lunch: Is this Time Different?
Diversification is not as clear cut as the textbooks have it. On the one hand, globalization and instantaneous information have meant that global markets have reason to move in lockstep more than ever before. Markets, after all, are a gauge of collective fear and greed. If someone yells fire in Shanghai, traders from Oslo to Johannesburg head for the exits. On the other hand, improved information should mean that investors would be able to make the finer distinctions that mean you'll make more money in Red China, than say, in Recidivist Red Venezuela.
The truth is that correlations among markets have been all over the place. Looking only at the last five years, as the ING study does, is just a blip in the history of global financial markets. An academic paper examining the correlations of the major world equity markets over 150 years confirms this fact. Correlations among global markets are highest during periods of economic and financial integration that include 1872-1914 and 1972-2000 (the study was published in 2001), when capital is free to flow across borders. The research supports the notion that the diversification benefits of global investing -- at least among developed markets of France, Germany, the United Kingdom and the United States -- are currently low compared to the rest of capital market history.
But that does not mean that diversification no longer makes sense. In today's era of globalization, the number of global markets has expanded greatly. Twenty years ago, China and India were hamstrung by indigenous forms of socialism, while the Soviet Union was in the last throes of its decline. Even as the benefits of diversifying into core, developed markets wane, new markets coming on line make the diversification pie bigger for everyone. More markets mean increased potential for spreading risk. An equally weighted, internationally diversified portfolio of both core and emerging markets had only 35% of the volatility of individual markets -- a risk reduction of 65%. The increase in the number of markets and low correlations of the emerging markets each contribute about half of additional risk reduction.
Crunch the numbers how you will, all of this seems counterintuitive. The benefits of diversification seem to disappear precisely when you need them -- that is, when markets tank. No matter how great a diversifier India may be in academic studies, a 15%-25% drop in the market -- which happens two or three times a year -- turns the blood of most U.S. investors cold. Yet looking back 20 years from now, the emergence of global markets after the dotcom crash will seem like the investment opportunity of the century.