Monday, March 12, 2007

The Not-So-Small World of Stocks

News Analysis
March 12, 2007

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The Not-So-Small World of Stocks

U.S. and global markets fell in tandem during the late-February slide. Should investors reconsider the value of international diversification?

Wall Street's recent pullback came as part of a slump felt around the world. On Feb. 27, stocks tumbled across Asia, Europe, and the U.S. in the wake of a 9% drop in China's Shanghai composite index (see, 2/28/07, "Stocks' Great Wall of Worry"). The recovery that lifted markets a week later was an equally global phenomenon.

Such highly correlated movements in world markets might seem to contradict the widely touted merits of investing abroad. After all, modern portfolio theory has encouraged investors to pour money into overseas stocks in recent years, based largely on the notion that such diversification would help protect investors against risk (see, 12/18/06, "In Search of a Global Index Fund"). During the latest sell-off, major indexes in Europe and Asia typically fell even further than the top U.S. benchmarks. How's that for diversification?

Not so fast. The world may be getting smaller, but an international component still remains a fundamental piece of a well-diversified retirement portfolio, analysts say. While global markets will likely swing in tandem on some days, weeks, or even months, a broad stake in international stocks could help investors get ahead over the long-term.

"The cliché is, 'Stocks go down together, but they come up one by one,'" explains Brian Gendreau, investment strategist at ING Investment Management (ING). "The same is true of markets."

Global Correlation

Even beyond last month's skid, world markets have become increasingly linked. Correlation between U.S. markets and bourses overseas is up to about 80%, depending on the market, says Alec Young, equity market strategist at Standard & Poor's Equity Research. That's a sharp jump from correlation levels a few decades ago, when the literature on asset allocation started to get established.

Much of the recent correlation between stocks domestically and abroad likely stems from globalization. As of 2005, companies in the Standard & Poor's 500-stock index received an average of 40% of their revenues from overseas, according to the latest data from S&P Equity Research. Global economic cycles also happen to be in similar stages, with inflation relatively low across most major markets. "The issues that are moving the markets are global," Young says.

However, investors with some international holdings also enjoy the benefits of being diversified against currency risk, specifically the chance of a decline in the U.S. dollar. As the value of the dollar falls against foreign currencies, the value of stocks denominated in those currencies increases, even if share prices stay flat in local-currency terms.

The increasing correlation between global markets also underscores the importance of holding not only stocks, but also fixed-income investments. Bond prices tended to rise during stocks' late-February slump, as traders moved toward asset classes perceived as less risky. "Bond diversification does matter," notes Quincy Krosby, chief investment strategist at The Hartford (HIG).

Hot Commodities

Diversification-minded investors may want to consider, too, some alternative asset classes, such as commodities. The price of commodities like crude oil or gold can move independently from stocks, though that wasn't the case during the most recent sell-off.

Barclays Global Investors' (BCS) Dow Jones-AIG Commodity Total Return Index ETN (DJP) is one convenient way to get commodity exposure. Similar to an exchange-traded fund, this exchange-traded note has exposure to 18 different commodities, with no more than 33% allocated to energy. The ETN aims to deliver the return of the Dow Jones AIG Commodity Index, less a 0.75% fee.

In addition, investors should make sure their international holdings are spread across a variety of foreign markets, analysts say. "If you're broad-based, you're going to get the benefits of diversification and the benefits of international growth, and it's going to be a much smoother ride," says Doug Roberts, founder and chief investment strategist for Channel Capital Research.

Investors with long-term goals may want to endure some short-term pain in international stocks. "In terms of longer-term effects, the differences between markets still depend on the fundamentals, and as you go from country to country the fundamentals can be very different," says Jersey Gilbert, financial products analyst at Consumer Reports. To help diversify your portfolio, markets don't necessarily have to move in different directions all of the time—only some of the time.

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