From the April 2007 issue of Wealth Manager Web • Subscribe!

April 1, 2007

Mr. Market Speaks

When it comes to analyzing the capital markets, performance is king. But while returns are often the first number under scrutiny, veteran wealth managers know that it shouldn't be the last.

Mindful that there's more than one way to quantitatively slice an investment, we ran the major asset classes through number-crunching prisms other than performance. The intended quarry: Noteworthy trends that aren't already overexposed by the usual suspects in the financial media. Our hunt turned up several items deserving further inspection, including the three detailed below: The global distribution of equity capitalization, volatility trends and the changing correlations among the broad asset classes.

Let's start with Mr. Market's allocation of equity market cap. As always, the distribution ebbs and flows with economic cycles, the shifting sands of global competition, etc. Does the division of this world's publicly traded capital pie have any bearing on portfolio design? Yes and no.

Modern portfolio theory suggests that market-cap-based allocations are optimal, albeit for the average global investor with an infinite time horizon. Such allocations are therefore suitable for everybody in the aggregate and nobody in particular. In practice, asset allocation should reflect an investor's goals, risk tolerance, time horizon and so on. But while the distribution of market cap alone shouldn't dictate equity allocation for anyone in particular, surveying its evolving mix offers perspective on what's passed, what may be coming, and how investors value the competing equity markets.

Consider that U.S. stocks represented 44 percent of global equity capitalization at the start of 2007, based on S&P/Citigroup Global Equity Indices (see "Capital Flows," below left). That's down from 53 percent in 2000. In other words, most of the planet's equity capitalization resides beyond America's shores.

Where has the capital gone? Emerging markets have been a popular destination. At the beginning of this year, developing nations claimed 7.5 percent of global equity capitalization--up from 3.8 percent in 2000. Some fared better than others. The Asia-Pacific region (excluding Japan) continued to hold the lion's share of capital among emerging markets.

In the developed world, Europe also has been taking a larger relative share from the U.S. At this year's open, European equity cap claimed 30 percent of the world's total, up slightly from 2000.

Meanwhile, equity markets around the world have generally become kinder, gentler mediums of exchange. Falling volatility in stock markets, in other words, has been a recurring theme.

The waning of volatility has been especially pronounced since 2004, when developed markets joined the downward momentum already in progress in emerging markets. As illustrated in "Volatility Stumbles" on the next page, the U.S. stock market and MSCI EAFE were each about half as volatile at last year's close as they were at the end of 2004, based on annualized standard deviations calculated from 36-month trailing total returns.

The bond market, too, has become calmer with time. The Lehman Brothers Aggregate Bond Index was about three-quarters as volatile at last year's close compared to two years previous.

"There are an awful lot of people out there who are simply ignoring that we're in a downswing in volatility," says Geoff Considine, president of Quantext Inc., a Boulder, Colo. consulting boutique that designs investment risk-management software. He warns against assuming that lower volatility is here to stay. "Volatility has cycled forever," Considine notes. "If you make very long-term plans based on [the recent low volatility], and volatility reverts to historical levels, people could end up with far riskier positions than they thought they'd had, especially for retirees or near-retirees."

Considine says that the longer-term outlook calls for more of what presently is in short supply--namely, higher volatility. "Long-dated S&P 500 options have much higher volatility than we've seen in the last several years," he adds.

Considine concludes that the short-memory syndrome seems to have infected investor sentiment once again. "You should be assessing portfolios based upon realistic, long-term measures of volatility, and not just looking at how your portfolio's done in the last three years," he advises. "In very quiescent markets when volatility is low, people get more and more aggressive because they haven't been hit."

If volatility rises in the future, investors should exploit the trend by more frequent or perhaps more aggressive rebalancing techniques, Liz Ann Sonders, chief investment strategist at Charles Schwab & Co., tells Wealth Manager.

If relatively higher volatility suggests rebalancing opportunities, some asset classes have been riper than others on that front. In contrast to stocks and bonds, the Wilshire REIT index's trailing three-year standard deviation was, at 2006's close, at a peak since 1990, when our data starts. Meanwhile, the Dow Jones-AIG Commodity index at the end of last year was within shouting distance of its former crest in trailing standard deviation posted back in 2001.

Fluctuating volatility and a lengthy stretch of gains inevitably alter the strategic relationship among the asset classes. The correlation between the Russell 3000 and Lehman Brothers Aggregate Bond indices, for instance, has been climbing in recent years (see "Correlation Evolution," above right). While still low, the correlation reached a seven-year high in 2006, based on rolling 36-month measures of trailing returns.

Bonds are still a strong diversifying agent relative to stocks, but less so than in the recent past. In fact, diversification benefits in general are harder to come by. For a more dramatic example, consider the correlation between REITs and U.S. stocks. For about two years through early 2003, REITs and domestic stocks posted a low correlation in the range of zero to roughly 0.2, pushing above 0.5 in late 2006.

Rising correlations in recent years can also be found between:

o small- and large-cap U.S. stocks

o U.S. bonds and TIPS (inflation-indexed Treasuries)

o U.S. stocks and foreign developed-market bonds

o Domestic high-yield bonds and investment grade bonds

One notable exception is the correlation between U.S. stocks and commodities. Starting in the second half of 2005, some strategists warned that the historically low and negative correlation that commodities shared with traditional financial assets was fading. But the warning looks premature, based on last year's downturn in correlation between stocks and commodities (see "Correlation Evolution," above).

In a similar vein, the correlation between domestic and foreign stocks has been trending down for the last two years. Pundits have been arguing that international equity diversification has become relatively weaker, based on rising correlation in recent years. Perhaps that trend is in the process of changing, too.

In fact, correlation, volatility and the distribution of market cap are never constant. Looking at a one-number reading suggests otherwise, but the world is more complicated, as the charts above remind us. Markets, in sum, are dynamic, evolving entities, as are the associated risks and returns. Portfolio construction, as a result, should be no less.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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