Trivia Question:

Between 1970 and 2015 the U.S. stock market provided a hypothetical annualized return of 10.2%. During the same period the MSCI developed-market index, which includes 26 countries including the U.S., returned 9.5%. Over this span, in how many calendar years was the U.S. stock market the top annual performer among all countries in the MSCI index?

A. 0        B. 3        C. 8        D. 17

The answer is A. Many find it surprising that during the past 45 years there was no year when the U.S. stock market was the top performer. This illustrates the benefit of diversifying broadly across many different markets. The U.S. stock market is worth roughly $22 trillion, or 53% of the world market capitalization. A well-diversified portfolio will include equities that account for the remaining 47% that trade in non-U.S. developed and emerging markets. 

Many investors vary their exposure to foreign equities based on forecasts of global growth or exchange rates. But most would be better served by targeting a level of foreign equity exposure suited to their circumstances, and sticking to it through periodic rebalancing (we provide sample portfolio allocations on page 27).

Exchange rate fluctuations can have a heavy impact on foreign equity returns. For example, emerging market stocks returned 2.8% during the first quarter in local currency terms but 5.8% in U.S. dollars. Non-U.S. developed markets lost 6.4% in local currency, but fell by only 4.8% in dollar terms. These differentials were attributable to a weakening dollar during the quarter, depicted in the red circle in the chart on the previous page. For example, a dollar cost 0.92 euro when 2016 began (in orange, measured on the left axis), but had fallen to 0.88 euro by the end of the quarter.

A weakening dollar simply means that more dollars are required to purchase a foreign asset. So as time passes the dollar value of foreign securities increases as the dollar weakens. This is what happened during the first quarter, as the returns of both emerging market and developed market shares were boosted by the falling dollar.

Exchange rate fluctuations are highly volatile and notoriously unpredictable. The chart demonstrates that the dollar’s first quarter decline ran counter to the trend since 2014. Other things equal, foreign investors avoid U.S. securities when U.S. interest rates fall, and the resulting decrease in demand for dollars puts downward pressure on the dollar. During the first quarter the dollar fell as consensus grew that the Fed’s enthusiasm for further increases in the fed funds rate was weakening.

It would be folly to try to predict what might come next. The narrative presented describes just one variable (relative global interest rates) that drive exchange rates. In a global fiat currency regime exchange rates will change based on news of all types, though the sentiments of central bankers weigh heavily. Wise investors will avoid the temptation to time these fluctuations.

Also in This Issue:

Quarterly Review of Capital Markets
Can You Double Your Money in 10 Years?
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles