Smaller Stocks Hold the Leadership Position So Far This Year

Chart of the Week for November 3-9, 2000

The major domestic equity indexes have outperformed the MSCI EAFE Index of other developed market stocks since January 1999. As the chart on the right depicts, the Wilshire 5000 and the S&P 500 indexes rose 17.8% and 16.4%, respectively, while the MSCI EAFE Index returned only 4.5% for the same period. There are two main explanations for the unassuming performance of the international index.

First, as the chart on the left shows, most major foreign currencies have been depreciating against the dollar. Except for the Japanese yen which showed some resilience by appreciating 2.7%, most currencies lost ground to the greenback since January 1999. The euro lagged 27.0%; the British pound fell 12.6%, and the Australian dollar declined 15.9%. As a result, even overseas companies who did well in local currencies for the period saw their profits severely trimmed when converted to U.S. dollars.

The second reason — which derives from the first one — relates to the influx of foreign capital to U.S. assets. Not only does such a capital outflow from these countries put further pressure on local currencies, it also contributes to strenghtening the U.S equity markets. (A substantial part of this foreign capital is channeled to the equity markets, as U.S. stocks continue to be attractive.) Absent widespread carnage in U.S. equity makets, U.S. investors are not highly inclined to move assets overseas, which might help reverse the downward pressure on both foreign stocks and currency trends. As long as foreign investors continue to have confidence in the strength of the U.S. economy, they may continue to pour resources into the domestic financial markets.

However, discarding foreign stocks because of unfavorable market conditions would be a mistake. Historically, there is a low correlation between foreign and domestic stocks; that is, they tend not to move in lockstep. A well-diversified portfolio with foreign assets can take advantage of these performance trends. Despite a challenging 2000, the MSCI EAFE Index rose 352.0% over the last 15 years (though the domestic indexes performed strongly as well). Moreover, who knows when there will be a reversal of fortune for the dollar!?

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