Economy
-Consumer credit surged in March up 10.2%. It was the largest jump in borrowing in more than 10 years. 5/8
-Jobless claims dropped for the week beating expectations, and the 4 week moving average fell to 379,000. 5/11
-Spain is requiring banks to set aside $38.8 billion to meet potential loan losses and quicken the sale of troubled assets. 5/12
-China’s growth slowed in April, resulting in analysts dropping GDP expectations for the quarter and increasingly the likely hood that Chinese officials implement stimulus measures. 5/12
-Wholesale prices in the U.S. fell for the first time in 2012 dropping 0.2%. The fall was a result of reduced energy prices. 5/12
Corporate
-HSBC’s profit rose 25% in the first quarter excluding onetime charges on its investment banking and emerging markets operations, but its costs remain high. 5/9
-Disney’s fiscal second quarter saw earnings gains of 21% led by its theme parks and cable channels offsetting weakness in its movie division. 5/9
-News Corp earnings rose 47% due to growth from its cable networks. 5/10
-Cisco’s earnings gained 20%, but had a cautious outlook. 5/10
-Fannie Mae had a $2.7 billion profit for the quarter, its best quarter since it was bailed out nearly 4 years ago, and will be repaying $2.8 billion it owes the government. 5/10
-Spain announced it will take a stake in troubled Spanish bank Bankia SA to rescue the weak bank. 5/10
-J.P. Morgan admitted to a $2 billion trading loss as a result of a complex trade of its own capital that depended upon a continued economic recovery. 5/11
Market
-Gas price continue to fall and are down for the 5th straight week. The average price for a gallon is down to $3.79 from $3.94 at the beginning of April. 5/8
-The U.S. Stock market showed little concern over the election results in France and Greece with the S&P 500 up 0.04%. Both countries saw changes in top leaders which are not as friendly to the austerity cuts the countries have undertaken to fight their sovereign debt issues. 5/8
-The price of oil has continued to fall as it dropped to $97.01 a barrel on Tuesday. It is down $9 for the month. 5/9
-Markets continued to fall as jitters over Europe, and specifically Greece’s change in government, were more pronounced. The Dow dropped for the 5th straight day falling 0.6% and the S&P fell 0.4% to 1363.7, its lowest close in close to a month. European markets fell more abruptly with concerns the Greece may reject the austerity plan that had been developed for them. Europe as a whole fell 1.7%. 5/9
-U.S. markets continued to fall as worries over Greece and Spain weighed on markets. The Dow fell 0.8%, the S&P fell 0.7%. Europe as a whole hit its lowest level in three months and Spain’s stock market reached an 8 and a half year low. In response to growing global concerns a 10 year U.S. treasury auction resulted in the lowest yield on record of 1.855% and in the secondary market the 10 year U.S. Treasury yield dropped to 1.835% a three month low. 5/10
-Europe agreed to release a portion of a bailout payment to Greece, but held back $1.3 billion as a warning to the country to get its government in order. 5/10
-On European concerns and the trading loss for J.P. Morgan U.S. markets had a down week. The Dow has its worst week in 5 months falling 1.7%. The S&P 500 fell 1.1% for the week. Internationally, Japan was down 4.6% and Europe fell 0.4%. Commodities continued to retreat with Oil falling 1% to $96.123 a barrel and gold dropped to $1,583.60 a troy ounce. The 10 year rallied over the course of the week finishing at 1.841%. 5/12
What is the Appropriate International Equity Allocation for Your Portfolio?
Diversification has long been espoused as an important virtue of a successful equity allocation. But to what degree should a U.S. investor’s portfolio be diversified between U.S. stocks and international stocks? We have reviewed this issue to seek to identify an optimal asset allocation.
International equity provides a portfolio exposure to market influences that expand beyond the U.S. market. These factors bring about differing returns in foreign countries and therefore reduced correlation with the U.S. International currencies add another layer of diversification as they do not move in line with equity prices and therefore help to reduce the correlation between U.S. and foreign stocks. As a result of the reduced correlation, historically, the volatility of a portfolio that holds international stocks as well as U.S. stocks is lower than a U.S. only portfolio. While over the past 40 years U.S stocks have offered a slightly higher return than international stocks, when a portfolio is created with a combination of the two it results in a portfolio with less volatility, but similar returns. Thus, a globally diversified portfolio has offered better risk adjusted returns than a U.S. only portfolio.
More recently we have seen the diversification benefits of including an international equity allocation decrease. Correlations between the U.S. and international stock markets have moved more closely together since 2000 and including an international equity allocation has not provided any benefits over the past three years. However, correlations have changed throughout the past 40 years. There have been other historical periods where having a very low allocation to foreign stock has been the optimal portfolio allocation followed by periods where having a higher level of international stock would be preferable. While correlations between the U.S. stock market and international markets will likely be higher going forward than they were in the 1970s through 1990s, we believe that they will return to a reduced level as they have done in the past. Thus, they will continue to be an important part of a diversified investment portfolio.
With the benefits of investing globally established, the next step is to determine to what degree an investor should incorporate international equity in their portfolio. A starting point is to invest based on a market neutral approach. Under this scenario an investor would hold the global market weight of equities in their portfolio. This scenario would result in a portfolio that has slightly less than 50% allocated to U.S. stock and slightly more than 50% allocated to international stock.
While the resulting expected portfolio volatility would be lower than that of a 100% U.S. equity portfolio, it would have the equivalent volatility of only a 15% allocation to international equity. Thus, it can be fine tuned. By reviewing the historical volatility of international equity it shows that an investor would receive the full benefit of international diversification by holding roughly 40% of their equity portfolio in foreign stock.
However, correlations have differed over time and as a result the ideal combination of U.S. and foreign stock has varied. Reviewing international diversification over 10 year time frames, an investor would have realized the majority of the diversification benefit of international equity investing by maintaining between a 30% to 40% allocation to foreign stocks.
Another factor to consider is that inefficiencies exist when investing outside of the U.S. The average expense ratio according to Morningstar in 2011 for international equity index funds was 0.30%, whereas it was 0.19% for U.S. stock index funds. We use index funds here as they provide the most efficient allocation to each investment space and provide an apple to apples comparison. In addition, transaction and investment costs typically remain higher internationally than in the U.S. These issues reduce the benefit of a maintaining a higher level international allocation.
While we seek to maintain investment portfolios that are broadly diversified we also want to diversify efficiently and limit costs. Based on the above findings, a fully diversified portfolio would maintain a 40% allocation to international equities, but given the increased costs of foreign stock, likely higher future correlation, and similar levels of diversification that can be derived with a lower allocation we feel that a 35% allocation can deliver the exposure in a more efficient way. Although this is our general recommendation, individual investor circumstances can lead to different allocations being the right fit.
Index Performance April YTD Trailing 1 Yr
US Stock (Russell 3000) -0.66% 12.13% 3.40%
Foreign Stock (FTSE AW ex US) -1.52% 9.84% -12.64%
Total US Bond Mkt. (BarCap Aggregate) 1.11% 1.41% 7.54%
Short US Gov. Bonds (BarCap Gov 1-5 Yr) 0.45% 0.34% 2.78%
Municipal Bonds (BarCap 1-10yr Muni) 0.92% 1.46% 7.08%
Cash (ML 3Month T-Bill) 0.00% 0.01% 0.05%