Note from Our CIO: Global Investing

Happy New Year, everyone! As I write today, January 13, 2016, the S&P 500 stock index (of the largest 500 U.S. companies) dropped 2.5% for the day, closing at 1,890. I am struck by the similarity of the global stock markets in the past few weeks to a similar time period last summer. By all accounts I have studied, the current episode and the one that occurred in the summer of 2015 were both driven by the decline in the Chinese mainland stock market, in which we are not directly invested because it is directly and significantly influenced by the whims of the Chinese government (more on free markets later in this note). As the chart below shows, the declines both occurred after near all-time highs, a bit north of 2,100 for the index, and were characterized by sharp declines of 12% in the past summer and about 10% so far for the current drawdown:

Take a look now at a chart for the S&P 500 index over the past 10 years:

This shows us that the decline, which started shortly before the new year is (1) completely within the range of typical declines over short time periods, and (2) is only a dent in the mountain of recovery that has occurred since the financial crisis of 2007–2009. In fact, including dividends (which are not included on the two charts above), the S&P 500 index is still nearly 50% above its pre-crisis peak (October 2007) and still over three times its low on March 6, 2009. Although the decline could continue, the U.S. economy is the most resilient economy in the world, and its stock market will eventually reflect that fact, as it always has.

Regarding 2015, the big story—and unfortunately a disappointing one—for Abacus portfolios (and those of any reasonably globally diversified investor) was that emerging markets lost over 14% for the year, compared with a 1.4% drop for U.S. companies, as shown in the following chart.¹

Unlike the U.S. stock market, emerging markets as a whole have still not truly recovered from the financial crisis, yet. As this picture shows, although there have been a few times (most notably in 2011) when emerging markets exceeded their October 2007 peak, the 21 investable countries (which include the “BRICs”: Brazil, Russia, India and China) that make up the emerging markets index have clearly not had the momentum to break into convincing new overall heights relative to the high of October 2007.

So why do we diversify and own many countries in our portfolios? Why not simply invest in the U.S., where we are most familiar, and perhaps only a few more countries at most? Why not at least leave out emerging markets? In short, we want to avoid overexposure to extremes. Any one country can have well below- or well above-average stock performance. And that includes the U.S. Every country we invest in has demonstrated a required level of commitment to free-market principles, including the establishment of legal property rights and cross-border flow of capital, to name two important criteria. This explains why we invest in China only through the Hong Kong exchange, not through the mainland exchange. As such, value can and does get created regularly in all these countries. And it is impossible (and not important) to pick which country will dominate from year to year. In case this last point is not already clear, please look over this “periodic table of countries” in which each country is a different color and as you can see, there is no rhyme nor reason to which countries do well or poorly from year to year:

Who knew that Denmark and Belgium would lead the pack in 2015? And good luck guessing the outcome for 2016! Fortunately we don’t need to guess. By prudently spreading out our investments across all the countries based in large part on their relatively size, we position our portfolios to capture the value created by free capital markets with the least amount of risk required. I will leave you with these words from Nick Murray, written in 2013, that summarize why we invest in international companies, and emerging markets in particular:

“Four and a half decades ago, when I entered the financial services industry, economic life on the planet was basically North America, Europe and Japan. The rest of the world was, if not in total darkness, relatively inconsequential economically. The Soviet Union and China were militarized dungeons, and India was the epitome of socialism: that is, perfectly shared poverty and misery. Today, some of these economies (along with countries like Brazil, South Korea, Indonesia and Mexico) are the growth engines of the world. As recently as 2004, General Motors sold ten cars in the U.S. for every one it sold in China; this year that ratio is projected to be one to one.

“I think I’ve learned that, as important as this country is and will be to the world economy, the real growth—the vaulting of tens of millions of people a year out of poverty and into the middle class—is in the emerging economies. I think, too, that sometimes American investors don’t seem able to look past our own very real fiscal woes in order to see where the significant growth opportunities may lie.”.

1 – The three markets in this chart are based on the total return of Dimensional Fund Advisors “Core” funds for the three respective markets.