Global Stock Market BLOG - Mike Burnick

International Stock Market Gains Getting a Big Boost from the Beleaguered Buck

In yesterday’s blog post, I discussed the fact that your U.S.-based brokerage accounts may not be performing as well as the blue-chip averages might lead you to believe.

While both the Dow and the S&P 500 Index hit new all-time highs this year, the falling value of the U.S. dollar has severely sapped these gains, when viewed from a global perspective. In fact, the S&P 500 is still almost 40% below its 2000 peak, when you price this index in euro instead of dollars.

This Same Trend Remains an Ongoing Theme in 2007, at Least So Far…

The Brazilian real is another currency that is surging higher against the dollar.  Investors in Brazil’s Bovespa Index are enjoying spectacular year to date gains of 28% in U.S. dollar terms. 

Meanwhile, an investor based in Rio would still be happy with his stock investment returns this year, but it’s a more restrained gain of about 18%

Or take Australia. In the land down under, investors have enjoyed stock market gains of about 9% in the benchmark ASX 200 Index this year – similar to the return of the Dow. 

But for U.S. based investors, Australia’s market is up nearly 18% in dollar terms.

Taking a look at a leading stock market much closer to home, the Toronto Stock Exchange 300 Composite is up a rather modest 7% this year for local investors living in the great white north.

But for U.S. stock accounts, Canada has been a profit bonanza with gains of 17% this year – mostly courtesy of the strong Canuck-buck – which continues to surge towards par with the U.S. dollar.

Currency Return: Another Key Factor in Global Investing

These are just a few examples that I think illustrate the point that when it comes to investing overseas, there are at least two key dynamics at work influencing your returns. The first is what’s going on in the home-market of the country or region you’re considering for investment.

What’s happening with the local economy, interest rates, deficits, trade balances, corporate profits, etc, etc. – these factors are the driving influence behind how well a market performs on a nominal basis – that is, in its own local currency.

But as a global investor, you must also carefully consider what’s happening with international currencies, in relation to your own home currency. That’s where you can earn a potential double-play on your global market gains.

As the dollar has bounced a bit in recent weeks, it’s now more important than ever to have a look at the strength or weakness of the local currency in any offshore market you consider for investment.

Just How Well Have Your U.S. Blue-Chips Performed?

Stock indexes in the U.S. have (mostly) surged to new highs in recent weeks. The venerable S&P 500 index – everyone’s favorite scorecard of U.S. blue-chip shares – finally made it a few weeks ago.

And the old sentimental favorite, but a much narrower measure of just 30 stocks, the Dow Jones Industrial Average made it new fresh record highs a few months ago.

The tech-heavy Nasdaq Composite Index, it should be mentioned, is still about 50% below its dot.com-bubble peak.

But for the most part, investors that stuck with U.S. blue chip shares – through thick and thin – have finally been rewarded. Painful memories of the post-bubble bear market in America’s blue-chips have at long-last been erased. Well, not exactly.

From the Outside Looking in – U.S. Stock Gains Don’t Look so Hot

If you look instead at the U.S. stock market’s performance from the point of view of an overseas investor, the returns look pretty poor indeed.

And in a world-wide investment marketplace that’s growing more tightly integrated by the day, how else would you view market performance?

As I’m fond of saying, there’s a big world of investment opportunities out there, so you shouldn’t limit yourself to just domestic stocks, ETFs, or mutual funds.

International markets today make up about 55% of the world’s total stock market capitalization, and this percentage is growing fast. The point is, even for the domestic portion of your equity assets; don’t use the S&P 500 or the Dow as your only benchmarks to judge how well you’re doing.

From the point of view of a European investor for instance, U.S. share prices are performing miserably – still languishing far below their previous peaks.

The S&P 500 Index for instance, priced in euros, is still almost 40% off its 2000 high. And the Nasdaq when priced in euro, is some 65% below it’s previous peak – yikes!

Sinking Dollar Saps Stock Returns in Global Terms

Or course the sinking U.S. dollar plays a big role in this dichotomy of performance, depending on which side of the “pond” your stock account is located. The euro has gained about 60% in value vs. the buck since 2000, which means that many U.S. dollar denominated asset classes look as if they’ve been standing still for the past few years!

But this trend isn’t just confined to the euro, and it isn’t just an historical issue; it continues to impact U.S. stock performance today in 2007, and in many other currencies as well.

But here’s the potential upside; as this trend continues, it can give you a double-dose of gains for your U.S. based global investment portfolio.

Tune in tomorrow, when take a closer look at how this trend is playing out in global markets so far this year...

A Rough Week in Global Markets

Last week, Chinese shares fell on the first day of the week, but most markets shrugged that off to post early gains. However, worries about rising global interest rates and inflation sparked a more meaningful sell off on Wall Street later in the week, which may carry over for increased volatility over the next several sessions.

The volatile Shanghai Composite index plunged 8.3% in overnight trading one week ago today, the biggest fall for the Chinese A-share index since a nearly 9% sell off spooked global markets back in February.

Other Asian markets suffered some collateral damage as a result of China’s swoon; most notably Japan and Hong Kong, markets stabalized later in the week, but still finished with modest losses.

Wall Street Shrugs off China, but is Wary of Inflation and Interest Rates

On Wall Street, investors largely ignored the selling in China, as the S&P 500 Index rallied to yet another record high last Monday. But the good times didn’t last. U.S. stocks headed south on Tuesday, after stronger than expected economic data on the service sector, and manufacturing activity.

It didn’t help matters that Federal Reserve chief Ben Bernanke was on the stump talking about the ongoing housing debacle; he also reminded investors that inflation was still the Fed’s #1 concern.

Against this backdrop, global markets slipped again, led lower by U.S. stock markets, which fell three straight days. In Europe, the ECB again hiked benchmark lending rates to 4%, which was widely expected. But the ECB continues to talk tough about inflation, as central banks typically do, which nevertheless spooked investors.

Are Bonds in a Bear Market?

The perception in the market is shifting to higher inflation expectations perhaps extending the upward trend in global interest rates. Previously, many investors thought the U.S. Fed was finished with its monetary tightening, and that other central banks would soon follow suit.

The yield on the benchmark 10-year U.S. Treasury bond surged to a high of 5.14% last week for the first time in almost a year. Treasuries are still one of the most widely held securities on the planet – a favorite investment for all those countries with bulging trade surpluses seeking to recycle their dollars. When bond yields rise, as they have now for five weeks straight, bond prices move in the opposite direction falling in value.

Bill Gross, the celebrity fixed-income manager at Pacific Investment Management in California, one of the world’s biggest bond investment firms, says that bonds are now in a bear market – following the end of a 25 year bull run. 

If that is in fact the case, then investors around the world may have more to fear from higher inflation expectations and higher interest rates going forward. And as I have pointed out before, higher rates have the potential to stop the growth of global liquidity and credit expansion dead in its tracks.

The Rising Cost of Asset Appreciation Part II

In an article yesterday, I pointed out how a relatively benign interest rate environment in the U.S., Japan and many other nations around the world is helping to fuel global asset appreciation.

The red-hot performance in emerging markets, strong global trade, share buy-back activity, the M&A boom, and the staggering growth in derivatives – are all highly dependent on low rates – and abundant liquidity. But rates have been quietly creeping higher.

In fact this week, yields on 10-year U.S. Treasury bonds broke above the 5% barrier, triggering a torrent of selling on Wall Street, and in many international markets too.

In an apparently unrelated bit of news, which is actually more relevant that many investors realize, Morgan Stanley said in a report that the global derivatives trade rose to $415 trillion at the end of last year.

The Derivatives “Time-Bomb” Ticks Away

My colleague Jack Crooks, who keeps track of these seemingly esoteric stats, points out that: “the global pool of structured financial products [derivatives in all forms] ballooned from 8.7% of global GDP in 1987 to 246.1% in 2000 and then to 789.2% last year.”

The staggering growth in derivatives, which is now nearly nine-times the size of the entire world economy, parallels the appreciation of global assets and the expansion of cheap credit worldwide because these events are all closely intertwined – you can’t have one without the other.

In fact, the value of derivatives is like a scoreboard for global liquidity and asset appreciation. As the big Wall Street firms, hedge funds, and private equity players around the world push asset prices higher, they use ever increasing amounts of leverage (borrowing) to do so. And the way they “manage their risk” (or attempt to anyway) is through the derivatives trade.

The thing that alarms people the most about derivatives is the fact that it’s a largely unregulated over the counter market where big banks, brokerage firms, hedge funds, and private equity investors all come together in an attempt to slice and dice their risk exposure, peddling pieces to various “counterparties.”

Wall Street’s “Smartest Guys” Engaged in a Pants-off Dance-off

This dizzying system of derivatives high finance works well, so long as the global liquidity boom plays on, and money (like Wall Street talk) is cheap. All these newly-minted masters of the universe think that THEY are the smartest guys in the room, and are convinced they can always find some “greater fool” to lay off their risk.

It’s like a game of musical chairs, only so far the music has played on too long, and nobody really knows how many derivative players will desperately fight for the few remaining seats – when the sweet strains of music finally fade away.

Of course somebody (quite possibly several of them) will inevitably fall flat on his/her rear-end, as is always the case. But for the time being, everybody thinks their seat is safe, it’s the other guy who’s got to worry, not me!

So What's All This Got to do with Unsettled Financial Markets?

One area of high finance that’s certainly been inflated by cheap liquidity, is the current craze in merger and acquisition (M&A) activity.

Steven Leuthold, who actually IS one of the smart guys in the room when it comes to investments, recently commented in Barron’s: “the price private-equity firms are paying to buy out companies is 33% to 40% higher than a year ago,” indicating that too much cheap money may be chasing too few high-quality companies in today’s equity markets.

Leuthold hastens to add that he doesn’t believe private equity alone will sink the market.  But in the current lull of slower economic growth and higher rates, liquidity may begin to dry up somewhat at the margins.

And when that happens, players in the global asset appreciation party must carefully keep an eye on the nearest chair. And any wrong-move: from the M&A world, in emerging markets, or among derivative soaked hedge funds – could easily trigger a mad-dash for the exits.

So, are the DJs of global liquidity done playing music for the night, or just changing their tune? Well this week at least, Wall Street didn’t seem too pleased with the lack of music.

The Rising Cost of Asset Appreciation

Inflation is everywhere.

It’s certainly in energy and food prices, regardless of what the questionable “official statistics” tell you. And inflation is also threatening to push up the cost of keeping the global liquidity boom alive and well.

As I have commented previously, cheap credit (or debt) represents the rocket-fuel that continues to propel global asset appreciation. But interest rates are also on the rise around the world, which is effectively raising the cost of the fuel required to propel this asset boom ever higher.

This begs the question: are we fast approaching an inflection point in asset markets?

Stocks & Bonds on Divergent Paths

Typically, low or at least stable interest rates help fuel stocks, and other asset prices higher, but since the spring of this year, while the S&P 500 index has marched to new record highs (along with many other asset classes), prices of benchmark 10-year U.S. Treasuries have moved in the opposite direction.

Since yields (or interest rates rise as bond prices fall, this divergent move has led 10-year Treasury yields back above 5%, up from about 4.5% early this year.

Longer-term 30-year Treasury bond yields are nearly 5.2%, perhaps on the way to 5.6% and beyond within the next 6-months, according to some commentators.

It’s an interesting development: seeing higher rates amid a U.S. economy that expanded just 0.6% last quarter, according to the most recent data, the slowest growth since the last recession. Many still belive the odds of recession in the U.S. are still pretty good, in fact we may already be there once all the “official data” gets revised.

As I mentioned, low global rates have produced the abundant liquidity needed to keep the whole game in motion.

Low Rates that Fuel the Boom, are Now on the Rise

The easy money fuels emerging market investment, global trade, the commodity boom, share buy-back activity, the current global M&A boom, and the staggering growth in derivatives – it all depends on low rates – and abundant liquidity.

However, interest rates are stubbornly on the rise at present – perhaps fixed income markets are simply looking past the valley of slower U.S. economic growth, to more asset appreciation ahead – let the good times roll!

But I’m beginning to see some signs of potential excess around the edges of this global liquidity boom.

Corporate M&A activity has reached a frenzied pace, with more buyout offers announced nearly every day. Meanwhile, the secret currency that helps support leveraged asset appreciation, the global derivatives trade, is growing to ridiculous levels.

It seems like sooner of later (probably sooner), something’s got to give... tune in tomorrow for my take on the buyout and derivatives boom – and how it’s likely to impact financial markets.

Argentine Subsidies Lead to Energy Crunch as Mother Nature Turns Ugly

The financial times recently reported that Argentina suffered a severe cold snap last week (yes, its winter in the Sothern Hemisphere). Further, the country’s energy sector was caught of guard by the unexpectedly inclement weather, which “pushed the national energy system to the brink of collapse” as a result.

With sub-zero temperatures in the capital of Buenos Aires - producing the coldest month of May in 45 years - Argentina’s power grid was pushed to the breaking point. This resulted in “schools without heating and residents suffering power cuts” throughout the city as citizens were subjected to curbs on their fuel supplies, which got diverted to power plants instead.

Energy Subsidies lead to Under-Investment in Sector

The root cause of Argentina’s electrical woes however, is due to a heavily subsidized energy sector in the country, which has led to misallocation of resources, and under-investment in Argentina’s energy infrastructure.

In fact, Buenos Aires residents pay “some of the world’s cheapest utilities rates” with monthly bills for natural gas routinely running just $10 for an average sized apartment. Government tariffs have been frozen at these artificially low levels for five years. Oil prices in Argentina are also heavily subsidized.

As a result, Argentine energy companies suffer from a “double whammy: domestic prices for oil and gas that are well below international prices, plus high tariffs on exports.” These socialist energy policies lead to shortages of diesel fuel, due to limited domestic oil refining capacity. Companies must then purchase much more expensive fuel on global markets, only to sell it at a loss again to Argentine customers.

Straightening out Argentina’s Energy Sector May be Too Late

With profit margins crimped by this dilemma, Argentine energy companies have been unable to invest in new refining capacity and pipelines, while utilities have under-invested in new power-plants and transmission networks.

In a nation enjoying robust economic expansion of 8%-plus annually over the last several years – something’s got to give.

Finally, Argentina’s government has conceded the need to modify its restrictive tariff structure, which should finally provide incentives for private firms to invest in modernizing the nation’s energy sector.

But building new power plants, transmission lines, and oil refineries doesn’t happen overnight. So Argentineans may soon face a tough choice: between the reality of high global oil and gas prices – or risking a severe economic slowdown as a result of the country’s inadequate infrastructure. Tough choice!

You Should Hear what Bonds are Saying about Stocks

U.S. stocks aren’t the only assets rising to new highs recently – so are U.S. Treasury bond yields – and that fact may soon have investors running for cover.

The financial press has been busy reporting new record highs in the S&P 500 index of blue-chip U.S. stocks. In fact, many global equity lists are surging higher. But less well noticed is the fact that interest rates have also been moving higher in recent months.

Two-year U.S. government bond yields recently reached 4.97%, and the still inverted yield curve (when short-term interest rates rise above long-term) now prices the benchmark 10-year Treasury to yield 4.95%. In fact, yields on the 10-year have jumped nearly half a percent since mid-March, to the highest level in nine-months.

Also, a Bloomberg news story (Fed Faces Pressure to Raise Rates, Options Show) yesterday reveals that options contracts tied to the expected Fed funds rate (the overnight lending rates targets established by the Federal Open Market Committee) indicate a growing probability that the Fed’s next interest rate move might be to hike rates to 5.5%, rather than cutting interest rates to counteract anemic economic growth.

What the bond market may be telling us is that inflation pressures continue to grow, as a result of abundant liquidity around the world. And if this is a legitimate signal, it may have very negative implications for U.S. stocks – and perhaps equity markets around the world.

That’s because one of the key factors supporting stock market gains has been low global interest rates. Cheap interest and abundant liquidity is fueling the boom in merger and acquisition activity, boosting share buy-back activity, and is funding the yen-carry trade in global markets.

Should interest rates surprise investors by moving higher in the near term – as opposed to the market’s current outlook that calls for steady or falling rates – then it may finally provide the catalyst for a long-overdue correction in stock markets.

And as I noted in my last article Are Global Markets Moving in Lock-Step? (June 3, 2007), when markets fall, they tend to all go down together. Be careful out there!

Are Global Markets Moving in Lock-Step?

As I pointed out in my last article, the S&P 500 index finally made it “over the hump” last week to a new all time closing high. But it’s not much reason to celebrate given the dismal relative performance of this blue-chip U.S. stock index.

While the S&P 500 index gained about 9.5% annually over the past five years (through May 7, according to data from Standard & Poor’s), the MSCI EAFE index of developed foreign stock markets surged 17% a year – nearly twice the annual rate of U.S. stocks.

But you ain’t seen nothing yet...

The MSCI Emerging Market Index – which includes red-hot developing economies like China, India , Russia and Brazil – soared nearly 26% a year over the last five-years. Even in the U.S., several smaller stock indexes have shown clearly superior performance. For instance, the S&P MidCap 400 Index is up about 12.5% per year over this same period.

Investors Piling-On Best Performing Markets

Given these facts, it’s no wonder that investors are piling into overseas markets in record numbers. In fact, mutual fund flow data from the U.S. Investment Company Institute shows that in 2006, $10 billion of fresh cash moved into international equity funds, while funds that track the S&P 500 index suffered a net OUTFLOW of more than $8 billion.

But if you’re considering a headlong rush into foreign markets, keep the word “correlation” in mind.

Correlation, as it’s applied to investment returns is a measure of how much alike two different markets perform. A correlation of 1 means two markets are said to move in perfectly lock-step with each other, falling and raising the same magnitude at the same time. The lower the correlation, the less “alike” two markets are.

Global investors seeking to diversify their investments should seek out markets that ARE NOT too closely correlated – thus when one market zigs the other zags – producing a much smoother ride along the way.

For Diversification, Look for Low Correlation

Looking at global stock market returns over the past 5-years shows the S&P 500 and MSCI EAFE index have a correlation of 85% (pretty close to perfectly in lock-step). And Emerging Markets are 78% correlated with the “500 over the same period. These correlations grow even stronger during global market sell offs – as occurred in February and early March. When markets fall, they all fall together.

But there are several interesting markets around the world, which look undervalued to me on a fundamental basis, and ALSO have a very low correlation to U.S. market returns.

For example, Japan (as measured by the iShares MSCI Japan index ETF (symbol: EWJ) has a correlation of less than 30% with the S&P 500 index, according to S&P data, one of the lowest in the world.

Global investors in search of greater profit opportunity AND diversification for their holdings, should be taking a very close look at these markets right now.