Every U.S. institutional investor investing internationally has to address three sad facts. First, neither Japan nor continental Europe - which together make up almost 80% of the Morgan Stanley Capital International EAFE index of stocks in Europe, Australia and the Far East - will be fundamentally attractive for the foreseeable future.
Second, the most attractive foreign markets are small; Southeast Asia or other emerging markets just can't replace Japan and continental Europe for institutional investors. Third, the weak dollar that propelled big currency gains to investors in recent years seems more likely to reverse, threatening currency losses.
As a result, this situation appears to leave big funds with nowhere to place meaningful bets but at home. Bye-bye diversification? Is modern portfolio theory wrong?
Not so fast. Maybe we just have to take some new and less traveled ways. If Japan and continental Europe are fundamentally unattractive, then they might be good shorts. And because these markets are big, large amounts can be invested.
If foreign investment in this way continues to be a meaningful diversifier, then positions in emerging markets, like those of Latin America, Indonesia and the Philippines, and in developing countries, like Portugal and Malaysia, can be built up - to an even higher percentage of the total fund than if they were not balanced by the short positions. Of course, currency management has to be added to the portfolio. Good morning, real diversification.
The euphoria for international
This course was never how international investing was envisioned or promoted.
Back in 1976, the Amos Tuck Business School at Dartmouth had organized a seminar on international investments. This was the first time I heard the good news: international diversification was the ultimate panacea - you can drink your sweet wine of higher performance and have it, too, in the form of lower risk. Modern portfolio theory does work.
Of course, then as now, it was one thing to have an academic argument and another thing to make changes happen. But with the help of several farsighted consultants, both investment managers and clients increasingly were willing to go along. Investments in Europe and in the Far East, mostly of course in Japan, became commonplace.
At first the recommended asset mix was 5% EAFE and 95% U.S., then 10% EAFE and 90% U.S., and so on. The results were wonderful. The gains in performance were indeed quite spectacular, even for relatively small percentages of international investments.
As a consequence, as we all know, international investing became more popular. Public funds increasingly joined the fray, and even individual retail investors poured money into mutual funds investing overseas. Not coincidentally, the dollar fell steadily as this outflow of money went on.
The phenomenon of Japanese success
When you went to a bookstore in New York from the early 1980s on, you found a lot of books on the supremacy of Japanese technology and Japanese management systems. You also found a lot of books on why everything in the United States was bad.
I don't think the pro-Japan books were wrong. It was the time when their manufacturing prowess was key, and the U.S. lagged badly. All of the important computer chips were mass-produced cheaper and better in Japan and Korea, and they were ahead in high-definition TV and fiber optics and faxes and lasers.
So why worry about price-earnings ratios of 100 and more? There were excellent arguments explaining these huge ratios largely as accounting differences. Besides, we all knew the Japanese go for market share rather than short-term profits. So we paid for market share and bought Japanese stocks.
In 1989, Japanese valuations had reached bubble characteristics, not just for stocks but for everything. The real estate of all of Japan was valued at two times that of the United States plus all stocks listed on the New York Stock Exchange thrown in as a bonus.
European unity enthusiasm
As to Europe, the second part of these wonderful 1980s was equally good. After a lot of commiserating about Eurosclerosis, the chairman of the European Union, Jacques Delors, had the vision of proclaiming "Europe 1992" when all frontiers within the European Community would fall and one united market would be created. This would help business, create jobs and profits. My colleagues from Europe, like me, were out in force to sell the concept to American investors. To their benefit, investors bought it.
In the 1980s, Japan and continental Europe grew rapidly, overtaking the United States in many dimensions and becoming world leaders. But now they are overshooting and there is no correction in sight.
The Europeans and the Japanese continue to revere high export surpluses (which erode domestic stockpiles) and they hold back their own consumers with rigid market controls and high prices. They let the cost of doing business at home go up in spite of increasing global competition.
They continue to close their eyes to the mounting pile of public debt in the face of shrinking and rapidly aging populations - not to speak of the promises made for pensions and health care. Banks continue to be too mighty, stifling markets and entrepreneurs. Shareholders come last on the feeding line, as management prefers cash compensation over stock options (they know why!). In this environment, the hollowing out of the industrial infrastructure will go on as far as the eye can see. And the young talents will try to evade the huge tax bills by moving abroad.
Yes, all of that may change and eventually will. But by the time these snails reach satisfactory milestones, the rest of the world also will have moved; and the United States and the emerging and developing nations are most likely already out of sight. If a miracle happens and Japan and continental Europe get their Thatchers, Reagans and Milkens, I would rather be late in getting in than having run up further losses while just hoping.
10 years of EAFE underperformance
As of the end of September, we have witnessed a full decade where EAFE is underperforming the U.S. market and is increasing the overall portfolio risk at the same time. The exact reverse of what was hoped for and what had been the big argument for going overseas in the first place.
What is now the recommended asset mix? Certainly not the current 30% international. Once this underperformance becomes more apparent, Americans will begin to repatriate their foreign investments and foreigners will invest in the United States to make currency gains. But the rising dollar is of course bad for U.S. equities, which will fall and disappoint investors.
So why not go on with international, as things supposedly tend to equal out over time? (IBM Corp. was 110, and then 45, and is now at more than 100 again, right? And so the Nikkei 225 will go back to 39000, right?)
First of all, investors cannot afford to stay invested in a losing strategy too long - particularly pension fund officers whose career achievements are measured in short time spans. But more importantly, it only makes sense to hold on to a losing strategy if the potential for a turnaround can be clearly demonstrated. That is definitely not the case.
If the dollar was quite apparently overvalued today, investors could at least expect big currency gains from an eventual fall in the dollar as in 1985 when the deutsche mark was above 3.40 and the yen at 270. But the dollar is at or very close to all-time lows.
The currency valuation excesses have reached sort of the same proportions that occurred in the 1980s in Japanese real estate. At recent exchange rates, Salomon Brothers calculates the Japanese gross national product, expressed in dollars, is 84% of that of the United States. Because there are fewer than half as many Japanese as Americans, this equates to every Japanese producing 172% of every American.
More big currency gains unlikely
No chauvinism here, but that number is unreasonable and therefore, it's safe to suggest the dollar will not continue to fall at the rate it did. More likely, it will reverse. Whether that will come this year or next doesn't matter when we talk about long-term investment strategy.
In this scenario, institutional investors have several options.
First, they can cash in the currency gains and withdraw from foreign investments. But where to go with the money? The U.S. equity market, as noted, will not benefit at all if the dollar should rise.
Second, they can invest in emerging and developing markets only. These markets continue to be very attractive. But these markets are volatile and small. The big funds would be unable to establish meaningful exposure.
Third, they can combine a long position in emerging and developing markets with a short position in continental Europe and Japan indexes (with full cash cover, without using leverage). Since 1988, when emerging markets indexes became available, that portfolio would have continued to deliver magnificently what diversification should accomplish, namely, reduced risk (in spite of the Japanese bubble) and significantly increased returns.
I know that to make a bet that something is going down is contrary to the American spirit. It is also against the American experience that stocks don't go up over time. But the Nikkei is today where it was nine years ago (the Standard & Poor's 500 Stock Index was at the lofty level of 230 at that time versus 584 today), and the Deutsche Aktien Index, popularly called the DAX 30, rose just 7% in the last five years.
We are dealing here with overmature economies that are clearly beyond their prime. We have to realize that while our population grows, theirs is on the decline. We want to invest where our capital contributes to growth - the emerging and developing markets - and we can justify doing that only by selling short the overmature foreign markets. In the end, this helps everybody because necessary adjustments will be forced to happen sooner than later. Let's go to work.
Ullrich S. Moser is president of Moser Advisors Inc., Stamford, Conn.