In terms of trying to now move that along toward what this is going to mean for equity markets, we just finished an empirical study in our shop that essentially looked at the notion of, in the long term, how closely is real GNP growth related to corporate earnings growth. We all sort of go around with these good notions of boy, you know, you get real GNP growth, right, and obviously it's going to go right into corporate growth. Well, the answer is it does. Not necessarily in the short run, but if you look at periods longer than five years at all the markets in the world, we can find over roughly the last two decades that a 1% growth in real GNP on average translates into about a 5% growth in corporate earnings. So if you have an economy going along at 3% a year, you would expect on average about 15% earnings growth over time.
Of course, the nice thing is if you can find some economy that's growing at, say, 7% or 8% on average, you're going to expect 30%, 40% or 50% earnings growth on average over the long-term.
MR. O'NEILL: Do you look at GNP growth relative to market caps in these emerging countries?
MR. BERGSTROM: Well, this particular study strictly looked at long-term corporate earnings growth vs. GNP growth. We didn't complicate it in this particular analysis with any valuation stuff, which obviously is an important dimension.
Anyway, moving on to talk a little bit about equity markets outside of the U.S. as we see them, it's certainly a mixed bag as we look at 1995. There are some non-U.S. equity markets that we like quite a bit; there are some we think are ahead of themselves on valuation criteria, a little bit overpriced or in some cases quite overpriced. So I think it's going to be an environment in which global investors need to pay quite a bit of attention to what countries they're in as opposed to just having money outside of the U.S. and being floated up on the tide of virtually all the equity markets rising in unison.
I think about once every three days we get the question asked to us, 'Well, gee, aren't really all these equity markets moving a lot more closely together than five years ago or 10 years ago or 20 years ago?' We had the question often enough that we put a lot of effort into an analysis on this question.
Basically what we did is to go back and look at the correlations between the U.S. equity market and the Morgan Stanley Europe Australasia Far East Index sort of standard benchmark. We find, for example, over the period from 1980 through 1994, the correlation between the U.S. equity market and EAFE in U.S. dollar terms has been 0.32, not a huge number by the standards of our business certainly, and from looking at some periods, 1980 through '86, the correlation was 0.42.
MR. STUMPP: That's measured quarterly, monthly?
MR. BERGSTROM: This particular study happens to be measured using weekly data, so we get a little less noise and better estimates. You wouldn't find a dramatically different picture if you used monthly data, although there are some statistical issues I'm not going to get into.
But more recently, from '87 to '94, the correlation between U.S. and EAFE in U.S. dollars is only 0.23. If you take 1994, only the first three quarters, it's been down to 0.10. So it doesn't look like all of a sudden the markets are getting a lot more highly correlated.
Now, of course, what you have to be careful of is there are some very short periods where you get some dramatic shock to the world economic system or the market system where a lot of these markets get more highly correlated, but usually that's a very short-term phenomenon.
MR. STUMPP: One conclusion we came to was if you look at U.S. bear markets and U.S. bull markets, the correlations are relatively stable, which we interpreted to mean foreign stocks did not provide a lot of diversification in U.S. bear markets.
On the other hand, if you were to look at domestic U.S. bonds vs. U.S. stocks, the correlations actually become negative in U.S. stock bear markets, which means bonds provide lots of diversification. So equities around the world tend to be the same animal, but I tend to agree with your trend in the correlation. We saw that as well.
MR. BERGSTROM: Let me talk a little bit about some specific markets here going forward in terms of the 1995 outlook.
There are a number of markets that we do like at these levels. The French market, among the major markets, is a place that has pretty dramatically disappointed equity investors for quite some time now. On the other hand, valuation levels are reasonably attractive. The economy is starting to turn up. There could be some positive surprises in terms of the environment of 1995 - possibly relating to a little less dogmatic linkage with the deutsche mark, possibly some changes on the political side leading to more deregulation of the economy.
I think a lot of the markets that really could provide some big positive gains in 1995 on the equity side fall in the emerging markets camp. These basically are markets not too many people like. They're quite cheap; most of them are small. Some of them that we like include Greece, Indonesia, Portugal, Turkey and the Philippines.
As we look around global equity markets, we find some of the best opportunities at the moment in many of these markets in the smaller, midcap sectors as opposed to the very large, well-known high-cap kinds of companies.
There are quite a number of reasons for this. Certainly on a relative valuation basis, there are a lot better bargains in that sector in many of the developed markets outside of the U.S. Small-cap stocks in Japan, for example, over the last four years have underperformed the index by a substantial margin. The same is the case in Germany, and really only in France have small-cap stocks done fairly well the last few years. Also, there are some quite important diversification benefits in small-cap stocks.
P&I: Are there any international equity markets you would particularly stay away from?
MR. BERGSTROM: Well, we're not too excited about Germany in general. The market has done quite well on most valuation parameters. It's pretty pricey at this juncture in our valuation frameworks.
Japan we were fairly enthusiastic about earlier in the year, and we had a major exposure there. We're now underweighted because we think the market is somewhat ahead of itself on valuation criteria. We don't look for anything that significantly negative to happen, but it's a little hard to see how it's going to outperform, say, the EAFE index from these valuation levels for a while here until the economy perhaps kicks up with some real strong earnings gains.
MS. BRAMWELL: Well, basically two of the big trends in the 1990s are the free markets moving around the world and a rising middle-class at an accelerated rate because of the free markets developing around the world. I think it's a great backdrop.
Generally, I think we are in this synchronized global recovery, and our major trading partners, such as Canada, Mexico, Japan, are surely in this scenario of improvement. I think my problem is that some of the valuations on these international markets are really kind of up there, and although there is this continual movement of people trying to diversify overseas, the U.S. investor still looks underweighted relative to, say, what a U.K. investor or a Japanese investor has invested in other countries. Nevertheless, adjusting for the size of the countries and so forth, we're getting closer to that sort of theoretical max that people want to be. So I think maybe an area of better return would be simply buying U.S. multinationals and looking at those multiples relative to some of those multiples of pay for companies in, say, India and so forth.
Generally, however, I do like Argentina, and I think there are opportunities there.
MR. GREEN: I agree with Elizabeth. I'm a domestic equity manager, but in looking at what I'm seeing in talking to the companies we talk to, the things that are mentioned more often than not are the opening economies in Mexico and South America, Argentina. The NAFTA treaty is looked at very positively from what I'm seeing. On GATT, I think the long-term is positive; short-term, the jury is still out on it, but I'm seeing companies expand into continental Europe and the Pacific Rim and I take those as proxies that the economies in those countries are growing.
Being that I'm a domestic equity manager, I look at the multinationals in terms of kinds of investment in order to participate in those economies.