For as long as I have been in this business, I have been fascinated with global markets. I started my career on the floor of the New York Stock Exchange in January 2000 and my first role was as the back-up clerk for the specialist who traded the ADRs (American Depository Receipts); essentially, US listed foreign stocks. To me this was much more glamorous than trading old fashioned “American” stocks. To trade foreign stocks, the specialist needed to monitor what was happening in the “home” markets. How Alcatel traded in France overnight would impact how it would trade in the US that morning. Additionally, he had to track the currencies of the countries where their stocks were domiciled. It was all amazing to me.
Fast forward to 2005 and I became a specialist at the firm where I was then working, still on the floor of the NYSE. When the time came for me to get my own book of stocks to trade, I made an emphatic plea to be the specialist in our ADRs. I wanted to go back to my beginnings and trade these foreign equities. My wish was granted and I was back in the game of monitoring the foreing markets and currencies to help with my trading on a day-to-day basis. I traded China Telecom and China Unicom. I traded BHP Billiton (now BHP Group), one of the largest diversified mining companies in the world. BHP is an Australian company and when the Prime Minister of Australia came to the NYSE, I got to meet him because he wanted to see how his country’s largest company was traded in the US. In 2007 when I started business school, I went directly to the international designation as part of the finance curriculum.
Given my affinity for the foreign markets, you might think that I would have a bias when it comes to structuring a portfolio toward holding foreign equities. While I am a believer in diversifying across asset classes and markets, I don’t believe that you should diversify just for the sake of being diversified. The simple fact of the matter is foreign stocks have underperformed their US counterparts. In fact, over the past five years, the iShares ACWI Ex US ETF (ACWX) has mostly been a laggard relative to the SPDR S&P 500 ETF (SPY). In the five year chart below, looking specifically at the bottom that shows the ACWX relative strength to the S&P, it is clear that with a brief exception in 2017, for the most part international stocks have underperformed US (domestic) stocks.
And for the most part, so has the iShares MSCI Emerging Markets ETF (EEM).
I am a big believer in the concept of relative strength. I also believe that the best way to outperform is to own what’s outperforming. In this case, that’s US equities. But the question is, how likely is that relative strength to continue. This brings me back to those early days of paying close attention to what is happening in currency markets. In particular, the US Dollar.
Since making a low in early 2018, the Invesco DB Dollar Index Bullish ETF (UUP) has been in an uptrend and currently trades above its rising 200-day moving average.
While the uptrend in the dollar is clear to me as a technician, some have made the case that there is likely to be a persistence bid to the dollar due to the nearly $12 trillion in dollar denominated debt held by non-banks outside the United States according to BIS. Here is what my friend Michael Gayed had to say about it. The key take-away here is that servicing this debt will create strong demand for US dollars.*
So the technical trend lines up with a bullish narrative for the US Dollar. What does this have to do with diversification at the equity level? If the bullish dollar thesis plays out, the case can be made that foreign equities will continue to lag their US peers. Looking at the 252-day (one-year) correlation between different global regions and UUP, we can see that there has been an inverse relationship. While the SPY also shares this trait, its correlation is the weakest of the group.
Additionally, the more global nature of trade actually increases the exposure of US companies to foreign markets in some cases. According to Morningstar, Large Cap Growth equities derive more revenue from outside the US than the other style buckets. This implies that there is actually a level of international diversification to be had simply by tilting US holdings toward Large Cap Growth.
The iShares Russell 1000 Growth ETF has been leading the SPY fairly consistently since early 2017.
While I may always feel that trading/owning foreign equities is more glamorous than owning US equities, I am not going to let my early career bias prevent me from making sound investment decisions. For now it makes sense to keep the portfolio US centric until the weight of the evidence points abroad.
*As of this writing, I am long call options on UUP in a personal account.