The Myth of International Diversification

The ultimate contrarian indicator: Magazine covers. For Carl Waynberg, betting against BusinessWeek cover stories is always a good bet…

When I recommended Japan in March 2002, I did so primarily because the Street in general was frowning so broadly, but specifically in contrarian reaction to BusinessWeek’s cover story entitled, "Land of the Setting Sun." More often than not, betting against BusinessWeek has been a damn good bet.

Well, the esteemed mag is at it again. More than three years after I recommended investors look at China, BusinessWeek has finally hopped on the bandwagon. All you need to know about their recent double issue – "China & India: What You Need to Know" – is that it was their cover story, which, if history is any guide, puts the nail in the coffin in which resides China and India as investments with outsized profit potential. As I bellowed repeatedly in Vancouver, "You don’t make money in the market by looking in the same place as everyone else." And if perennial Johnny-Come-Lately BusinessWeek is looking there, then everyone else has been for quite some time.

Indeed, the weakness in Chinese stocks has already begun. Since Dec. 2004, the Halter USX China Index, a basket of 48 Chinese stocks that trade in the U.S., has underperformed the Dow Industrials, the S&P 500, the NASDAQ, the Russell 2000, the French CAC, the German DAX, London’s FTSE, the Toronto Stock Exchange, the Sydney All Ordinaries, the Tel Aviv 25 and 100, etc., etc. etc. Translation: Stick a pair of chopsticks in it: It’s done.

Last weekend, when I first wrote to you, I planned to give you my rationale for looking, instead, to Germany as a potential horn of investment plenty. Then the mail came. Nestled in between my wife’s Victoria’s Secret catalog and my own copy of the Victoria’s Secret catalog, was the latest issue of The Economist, which catalogs a slew of reasons why you might consider throwing a shekel or two behind Germany. At the risk of siding with the mainstream media, The Economist, I must admit, does a good job constructing the argument, dispensing with the need to cover it here.

But there’s a bigger question we should be asking, another bit of conventional wisdom we should be questioning: Is international diversification necessary? Does it really result, as we’re told it does, in superior returns?

Let’s consult not the TV guides but what should be our only guide, the empirical evidence…

International Diversification and Small-Caps: A Literature Review

Since Grubel (1968), Levy and Sarnat (1970), and Solnik (1974) first released their research on the subject, many other studies have also documented the gains that result from international diversification. It’s widely recognized that those gains have been possible because of the relatively low correlation among international and domestic markets and because, as Heston and Rouwenhorst ("Does industrial structure explain the benefits of international diversification?" 1994) and Griffin and Karolyi ("Another look at the role of the industrial structure of markets for international diversification strategies," 1998) demonstrated, the low correlations were a function of country-specific not industry-specific factors.

But the world has changed since those early seminal studies. It’s gotten smaller. International capital markets have become more integrated and more correlated.

Longin and Solnik ("Is the correlation in international equity returns," 1995) were perhaps the first to demonstrate the increasing correlation among international markets in their review of data for the period 1960-90. But many others have followed.

In their same-titled research article, Errunza, Hogan, and Hung asked the questions, "Can the Gains from International Diversification Be Achieved without Trading Abroad?" (Dec. 1999) The trio reviewed monthly data from seven developed markets and nine emerging markets for the period 1976-1993 and concluded that "investment abroad is not necessary to exhaust the gains from international diversification…Return correlations, mean-variance spanning, and Sharpe ratio test results provide strong evidence that gains beyond those attainable through home-made diversification have become statistically and economically insignificant." The authors also demonstrated that gains from international diversification "have diminished over time in a way consistent with changes in investment barriers."

The most-oft provided justification for diversifying internationally is that such a strategy provides greater opportunity for greater gains. But, Butler and Joaquin muse, "if international stock market correlations are higher than normal in bear markets, then international diversification will fail to yield the promised gains just when they are needed most." In their study, "Are the Gains from International Diversification Exaggerated? The Influence of Downside Risk in Bear Markets" (July 9, 2001), Butler and Joaquin assessed the level of correlation during calm, bear, and bull markets. They discovered: "Correlations during calm and bull markets are unexceptional…[whereas] observed correlations during bear markets are significantly higher than predicted." In other words, when it matters most – a bear market – investors cannot hope to do better by allocating more funds to overseas markets.

Berben and Jansen ("Comovement in International Equity Markets: A Sectoral View," Nov. 2001) applied their "novel bivariate GARCH model for equity returns with a smoothly time-varying correlation…and then derive[d] a Lagrange Multiplier statistic to test the constant-correlation hypothesis directly" – Huh? What? – to weekly data from the US, UK, German and Japanese markets for the period 1980-2000 and found "that correlations among the German, UK and US stock markets have doubled."

Consulting more of the evidence, we begin to see a way out of the international diversification conundrum.

In "Firm-Level Evidence on International Stock Market Comovement" (June 2005) – soon to be a major motion picture – Brooks and Del Negro "explore the link between international stock market comovement and the degree to which firms operate globally." The dynamic duo discovered "a large and highly significant link: On average, a firm raising its international sales by 10 percent raises the exposure of its stock return to global shocks by 2 percent and reduces its exposure to country-specific shocks by 1.5 percent. This link has grown stronger since the mid-1980s."

And now the prized piece of cheese comes clearly into view…

Borgsen and Glaser ("Diversifikationseffekte durch Small und Mid Caps?" Feb. 20, 2005): "Based on an empirical analysis of European large, small and mid cap stock indices, we find that small caps have relatively low correlations not only with large caps but also with each other. We show that small cap stock returns cannot be spanned by large cap stock returns. Furthermore, we find that diversification in Europe is likely to be more effective with a combination of small and large caps than with large caps alone."

International diversification and Small-Caps: Large-Caps Global, Small-Caps Local

The authors also conclude that "large cap returns are mainly driven by global factors whereas returns on small cap stocks are primarily driven by local and idiosyncratic factors," confirming the earlier work of Hansen and Rowenhorst and Griffin and Karolyi.

Borgsen and Glaser’s findings also corroborate earlier findings by Eun, Huang, and Lai ("International Diversification with Large- and Small-Cap Stocks," Mar. 2004), who put it thusly: "[R]eturns on large-cap stocks are substantially driven by common global factors. In contrast, returns on small-cap stocks are primarily driven by local and idiosyncratic factors. This difference in return generating mechanism is understandable considering that many large-cap stocks tend to be those of multinational companies with a substantial foreign customer and investor base, whereas small-cap companies are likely to be more locally oriented with a limited international exposure. As a result, the gains from international diversification with large-cap stocks can be modest as their returns are substantially driven by common global factors. However, the same skepticism may not be applicable to small-cap stocks as their returns are substantially generated by local and idiosyncratic factors. Thus, small-cap stocks can potentially be an effective vehicle for international diversification."

It seems no matter what part of the globe, no matter what the question, the empirical evidence always points in the same direction: small caps, small caps, small caps, again and again and again.

So I have one question for you: Have you hugged your small-cap guru today?

This has been…

Carl Waynberg
for The Daily Reckoning

August 23, 2005

Carl Waynberg is the cynical, skeptical editor of Penny Sleuth, Penny Stock Fortunes, and The GRIP. The GRIP is a contrarian investment strategy supported by reams of scientific evidence that targets young companies of solid value trading in America’s overlooked small cap exchanges.

Carl’s investing style represents the confluence of gut instinct and a bloodhound-like alacrity for research. He favors bottom-up quantitative and qualitative analysis, but not to the exclusion of reading the chart leaves to highlight appropriate entry points. And while he has shown himself to be skillful at devising successful screening formulas, he is just as inclined to resort to good ol’ fashioned detective work.

No word from Bill today – he’s traveling to Maryland to get Jules settled into college…we’ll hear from him tomorrow…

Meanwhile, this USA Today headline caught our eye this morning:

"Wall Street Tunes Into Housing Boom – or Bubble"

According to the article, investment strategists are spending less time with stocks and devoting more time…to the housing market.

Seems that some people are starting to realize that the housing bubble will not only effect homeowners, but the economy as a whole – sound familiar, dear reader?

"Real estate is a topic that has vaulted to center stage," say Ethan Harris, chief U.S. economist at Lehman Bros. "The real reason the topic is hot and belongs on the front page of research reports is that the housing market is becoming more of an engine of economic growth, but is also the biggest risk to future growth if the boom goes bust."

While the stuffed shirts on Wall Street try to predict what the impact of the housing bubble bursting while have on the economy, our own Dan Denning is way ahead of this trend. For months, he’s been warning his readers that this unstable house of cards that our economy is depending on is threatening to crumble at any second…and now it looks as though people are starting to listen…

What will happen next though, is anyone’s guess…

Now for the news, from our team at The Rude Awakening…


Justice Litle, reporting from Reno, Nevada:

"Today’s economy, flush with green liquidity, may seem to be beautiful, but in fact is deadly. All it needs is one spark…"


Back in Baltimore…

*** The eleventh tropical storm this season may be brewing in the Gulf of Campeche the largest oil field region in Mexico and the home of the biggest offshore production centers – pumping out 1.2 million barrels a day.

This, along with the recent power outage in Iraq, could threaten oil production – raising prices even higher than $65 a barrel.

The "shutdown of production in Iraq is an ominous sign of just how vulnerable those supplies are to the strained Iraqi infrastructure," Kevin Kerr told MarketWatch today.

"The deliveries of oil to the Ceyhan (Turkey) port have all but stopped due to lack of power and at this rate, there will certainly be an impact on crude supplies," said Kerr. "There really is nobody with spare capacity right now."

There are "just too many uncertainties to expect these prices to back off by much," Kerr said, and it all may be setting crude up to head toward the key $70 mark "very shortly."

*** Recently, Venezuelan President Hugo Chavez threatened to cut off oil supply to the United States if there is any sign of aggression toward his country from the U.S.

In a good representation of what not to do in a situation such as this, televangelist Pat Robertson called for the assassination of Chavez.

Apparently, Chavez is growing more and more distrustful of the United States, speaking out against President Bush, and saying that the U.S. government has a conspiracy to topple his government and is plotting to assassinate him.

To this, Robertson, who is the founder of the Christian Coalition of America and a former presidential candidate, had this to say:

"You know, I don’t know about this doctrine of assassination, but if he thinks we’re trying to assassinate him, I think that we really ought to go ahead and do it. It’s a whole lot cheaper than starting a war…and I don’t think any oil shipments will stop."

"We don’t need another $200 billion war to get rid of one, you know, strong-arm dictator," he continued. "It’s a whole lot easier to have some of the covert operatives do the job and then get it over with."

We can’t imagine why Chavez would think that anyone wanted him dead.

*** The reader responses to Kevin Kerr’s story about his experience with Homeland Security have continued to pour in…

"We know exactly where one cow with mad-cow-disease is located among the millions and millions of cows in America, but we haven’t got a clue as to where thousands of illegal immigrants and terrorists are located. Maybe we should put the Department of Agriculture in charge of Homeland Security!"

Another reader writes: "Returning from Poland (probably the safest country in the world and not exactly a hotbed of anti-American activity), I was stopped because I was carrying a dangerous sunflower. I bought the plastic lawn sprinkler on a whim, thinking it would be fun to put on the lawn for a BBQ we were having so the kids could run through the water. Unfortunately I misjudged the length of the "stem" and it wouldn’t fit in my checked luggage, so I carried it in plain sight. The stem had a plastic spike that I could not detach. I truly believe it would have broken had I tried to skewer a stewardess, but I guess I could have poked out an eye. Of course that could be done with a pen. Oh no, another dangerous weapon! Save me!

"(I am a 53 year old blonde journalist with pacifist tendencies, not your typical terrorist or even anarchist, although the way things are going in this country, I guess it might be a good idea to support the right to bear arms or sunflowers.)"

And one last one…

"I was interested in Kevin Kerr’s story of his being hassled in the airport. It seems so typical of the police state mentality that is being imposed on the erstwhile ‘land of the free’ by this crypto-fascist administration. America doesn’t feel like America anymore, that says it all.

"For me, it was finally too much, too depressing to watch my beloved country slip down the rathole. Now I am living very happily in Penang, a lovely island in the Straights of Malacca, in Malaysia. I am quite taken with Malaysia, which is, strangely enough, a Muslim government. Yet this country sets a high standard for tolerance of religious and racial differences. I never tire of the interplay between the Chinese, Indian and Malay cultures, interwoven with the still-strong influence of the late, great British Empire. Our chief of state, fondly known as "Abdullah" to the citizenry, is a world citizen of some repute. George W could learn a lot from him.

"Finally, you know, here in Asia, the United States isn’t such a big deal. It isn’t the center of things, it’s an important country that throws off a lot of interesting cultural artifacts – from hamburgers to jeans and pop stars – but seems to take itself awfully seriously. For me, it’s nice to be on the other side of the world from Rumsfeld, Bush, Cheney et al.

"Keep up the good work at Daily Reckoning."

More to come…