It’s A Small World After All

If there is one ubiquitous piece of financial advice, it is this: invest in different markets. Each month, the major private wealth banks in the world publish their recommended allocations. They might suggest putting 60 percent in stocks, and in turn breaking that down into U.S., European and emerging-market stocks, and an additional 40 percent in bonds, varying from U.S. Treasuries to municipal notes. In the past, these "asset allocation" formulas have been the bedrock of global investing, and many of them have done quite well, with the underlying principle being that it is possible to predict how various types of investments will perform relative to one another, based on historical patterns. Unfortunately, the bedrock assumptions of these formulas are now wrong.

Asset allocation models are hardly ancient. Until the 1960s, most pensions were managed with little or no exposure to equities, which were considered too risky. Few people or institutions invested in stocks or bonds outside their own country. It was simply too costly and too complicated to conduct transactions abroad. But in the past 30 years, the scale of investing globally has increased greatly, with approximately $45 trillion in global stocks alone. The global bond market is only slightly smaller, and the combined amount is substantially larger than all global GDP.

Almost all that money is now invested according to models that predict that some markets will rise as others fall, some will be more costly, some less, some riskier and some safer. A model might say, for instance, that if Hong Kong equities are 25 percent more expensive than stocks in New York, then U.S. stocks have x probability of generating a certain return greater than stocks in Hong Kong, and therefore portfolios should have a higher concentration in New York. That is then extrapolated across multiple markets and types of assets, to come up with the recommendation to "buy New York, sell Hong Kong," or overweight European stocks and bonds at the expense of Latin American or Asia, and so on.

The glaring problem with these models is that they assume that assets in one market are not correlated to assets in another. Again, until very recently, that was true. And it was true because most markets were, at least to some extent, a closed loop. Capital flowed globally, but not freely. Whether because of incompatible technology that made it more time-consuming to trade in dozens of markets simultaneously, or because of legal restrictions in various countries, each national market had its own, independent dynamics, and often these moved in opposite directions. The result was that when Hong Kong soared, Japan sank, or when Frankfurt was up, New York was down.

But in the past few years, markets have been moving more in sync, largely because legal barriers are disappearing and technology has created global electronic exchanges. No longer is there a "risk premium" for emerging stocks, which used to be seen as less liquid and more exposed to political risk. Today, markets in Dubai, Brazil, Hong Kong, South Korea, Mexico and the like are almost as liquid as the New York Stock Exchange or NASDAQ because the same $100 trillion flows through all of them.

As a result, global markets have converged. Both the fundamentals of individual stocks and markets as a whole are more in sync, especially with the adoption of cross-border common accounting and reporting standards. Today, with the exception of several European bourses, all equities are trading in a very narrow range—plus or minus a point around a price-to-earnings ratio of 15. Most bonds are also in a compressed range of interest rates, plus or minus a point around 4.5 percent. While it is possible to make a lot of money if you actively trade billions of dollars a day and are content with pennies here and there (which on billions add up), most money is invested on long-term assumptions according to those allocations models. And with valuations compressed, there is no way that those models—which assume divergence and difference—will perform as expected.

This may not yet be a problem on the scale of the subprime debacle in the United States, but it could have serious ramifications. For example, if the fund managers expected 7 percent based on the models and got only 5 percent based on the fact that everything is converging, then they may feel pressure to take more risks to make up the difference. That pressure will force them to look for riskier investments. And if the vast majority of stocks and bonds have converged, the only place to look for atypical returns is on the margins and at the extremes, which is precisely what happened recently with the run on esoteric mortgage derivatives that led to the subprime crisis.

It's ironic that the synchronization in movement of global stocks could actually become a risk factor, rather than a force for greater market stability. Unlike the sharp collapse of the mortgage market, asset allocation investing models will probably remain in vogue for some time, with fund managers muddling along until a critical mass realizes that there is now one global capital market, not dozens of regional ones. Until then, most investors will confront chronic disappointment, while a lucky few manage to profit.

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