ROGER MUNS

Country bias refers to the common tendency among investors to overweight stocks and bonds based in their home country. This is true for U.S. and non-U.S investors. One of my clients with a balanced portfolio has a target allocation of 45 percent to U.S. stocks, while a pension fund manager in Denmark allocates 15 percent. Depending on their allocations to bonds and other asset classes, at least one and probably both are investing with home bias.

Global marketable stocks. Morgan Stanley’s “Comparison of Selected Asset Markets as of January 2007,” reports U.S. marketable stocks total $12.9 trillion (45 percent) and non-U.S marketable stocks total $15.8 trillion (55 percent).

There have been extended periods when U.S. stocks outperformed non-U.S. stocks (and vice versa). During the periods that stocks outperformed, their currencies appreciated. What are 5- and 15-year historical returns for U.S. and non-U.S. stocks as of September 30? Returns for the S&P500 (U.S. large-cap index) and MSCI-EAFE (non-U.S. stock index) were 15.4 percent and 24.1 percent (5-year index) and 11.1 percent and 9.1 percent (15-year index), respectively.

Interest, dividends and gains on U.S. stocks and bonds are distributed in U.S. dollars — the same currency you use to buy most goods and services. But if you invest abroad, earnings will normally be paid in another currency. This exposes you to currency risk. Ideally, you want to overweight stocks in countries with higher returns and strengthening currencies. From 2000 to Oct. 15, 2007, most foreign currencies appreciated against the U.S. dollar. The British pound appreciated 34 percent, Europe’s Euro 54 percent, Canadian dollar 53 percent and the Swiss franc 43 percent. However, during the 1995 through 2001 period, foreign currencies depreciated against the U.S. dollar. Currency exchange rates tend to rise and fall over time (mean reversion). Hence, the effect of currency risks tend to diminish as the investment time horizon lengthens.

Allocation to Non-U.S. stocks. Owning a significant amount of non-U.S. stocks has two important benefits. First, it still provides meaningful diversification benefits (especially with emerging markets) despite the growing integration of the global economies. Second, it has provided higher returns during certain extended periods of time. You want to overweight non-U.S equities during these periods and underweight them when they are weak.

No one knows when to overweight or underweight non-U.S. stocks, but there are ways to improve your odds of being right. First, analyze and compare price ratios of U.S. and non-U.S. stocks. Price ratios include the price divided by (1) earning, (2) book value, (3) cash flow and (4) sales. Also, look at forecasted long-term growth rates and PEG ratio - it is the price to earnings (P/E) ratio divided by the growth rate. Currently, non-U.S. stock price ratios continue to be more attractive.

Second, look at the flow of funds. Based on the Investment Company Institute’s monthly surveys of the U.S. mutual fund industry for the year ending August 2007, investors contributed $130 billion (net) into non-U.S. stock funds and withdrew $15 billion (net) from U.S. stock funds. Capital inflows tend to drive stock prices and currencies up while outflows tend to drive them down.

Third, evaluate the relative strengths of the U.S. or non-U.S. currencies. The value of the U.S dollar is based on the economic law of supply and demand, which is theoretically impacted by our trade balance, government deficits, interest rates and inflation. The trade deficits for the U.S. totaled $471 billion through Aug. 31 (annualized for 2007, it is $706 billion), $758 billion for 2006 and $714 billion for 2005. In 1980, the United States owned more foreign bonds than any other country. In 2000, the United States became the largest debtor country in the world. Since 2000, the growth of our debts to foreign countries has accelerated. Increases in federal government debt for fiscal years ending Sept. 30 were $501 billion (2007), $574 billion (2006) and $554 billion (2005). In September, the Federal Reserve lowered its federal funds rate and another cut is expected. China, Japan, India, South Korea and others are starting to diversify their foreign currency risks, which could reduce the demand for U.S. dollars. None of this is good news for the U.S. dollar.

Conclusion. Based on the above, I continue to believe investors should not have a home country bias and should make a significant allocation to non-U.S. stocks and bonds.



December 2007