The 20th century ended with a bang with U.S. equities peaking on March 24th, 2000 with the apex of the tech bubble. Only in the last few years have major market averages such as the Dow Jones Industrial Average and the S&P 500 index significantly surpassed the levels initially reached then. What is more, the real trade-weighted dollar index has more or less completed a cycle of its own, ending last year little changed from where it was in the spring of 2000:
An investor who allocated his money across the global equity spectrum – S&P 500, developed world ex-U.S., and emerging markets – at that time, and who revisited his portfolio only at the end of 2016 would be pleased: returns across the globe and across most sectors, – tech being the obvious exception, – were very healthy:
Yet we know in reality that the performances of the major global equity market segments in general, and sectors in particular, very different over this time frame. To understand this it is necessary to break down the period from March 2000 – December 2016 into two cycles: the “weak dollar” cycle from March 24th, 2000 – October 9th, 2007 (I chose these dates arbitrarily as they mark significant peaks for the S&P 500 index), and the “strong dollar” cycle from October 9th, 2007 until December 31st, 2016. Hopefully, by dissecting these cycles within the cycle can we better gauge where we stand today in terms of equity valuations and how investors might approach the allocation of their portfolios in light of them.
In this article, I will demonstrate the following:
1. Global equity returns, when comparing similar industries and companies, are far more similar than many realize, as the tendency is to focus on big-picture aggregations, such as country and sector indices, which have distorted compositions and thus useless valuation metrics.
2. Currency fluctuations have a dramatic impact on relative global equity returns, particularly between two markets or two sectors that have largely different compositions, and vastly different sensitivities to currency movements.
3. For global investors, due diligence is required in the way of data dis-aggregation or index and sector “unbundling,” to get the clearest picture possible of global equity valuations, and thus identify opportunities.
4. Though currency fluctuations do heavily influence the relative performances of foreign and domestic equities, opportunities abound for those who seek them, regardless of where the market is in terms of currency cycles.
“Weak Dollar Period:” March 24th, 2000 – October 9th, 2007
The long secular bull market for the S&P 500 that began in the early 1980s peaked on March 24th, 2000, marking along with it the peak of the tech bubble that saw the technology sector grow from 6.3% of the index’s weighting in 1990 to more than 20%. It would take several years for the froth of the tech bubble to wear off; from the peak on the 24th of March of 2000 until the next notable top on October 9th of 2007, the tech sector would decline roughly 55% on a cumulative basis. Little wonder, then, that the S&P 500 index cumulatively returned about 16% over this period, certainly a disappointing performance for investors who had grown accustomed to double-digit annual gains in the prior two decades.
While the main U.S. equity market indices languished for most of this period, global investors fared much better, with the MSCI EAFE index (Europe, Australasia, and Far East) crushing the S&P 500, returning a cumulative 67%. Emerging markets did considerably better, returning more than 200%. Investors, – long since trained to think of markets in aggregate terms, and conditioned to view the disparate global equity segments – U.S., foreign developed (ex-USA), and emerging markets (EM) – almost like asset classes wholly distinct from each other, – could not be blamed if they drew the conclusion that the cycle had turned, and investing overseas was the new path to certain prosperity.
A closer look, however, would reveal that much of the difference in gains between U.S. equities and foreign/EM was aided by a steep decline in the real trade-weighted value of the U.S. dollar, which fell about 30% peak-to-trough over the period. The other distinct advantage of the major foreign equity markets over this period was their large exposure, by virtue of much heavier energy and commodity weightings, to the commodities “super cycle,” which saw everything from gold and oil, to uranium and copper explode in value as the dollar plummeted. An investor in foreign energy would have won twice, effectively: he would have benefited from the rise in the price of oil, which would naturally benefit his oil-related shares, and also when his earnings were translated back into weaker dollars. Due to the extreme sensitivity of EM markets to dollar movements, the effect would have been even greater. This ‘double effect’ on the differences in performance across the various market segments can plainly be seen by comparing cumulative returns, particularly in the sectors most sensitive to a weaker dollar and the commodities boom: energy and materials (Note: For S&P 500, I use S&P 500 sector data; all else is MSCI sector data; all returns in USD):
It can be clearly seen that U.S. energy stocks did almost as well as developed foreign energy stocks, the main difference likely being due to currency effects. EM energy dwarfed them both, probably the result of lower starting valuations after the problems in many EM countries in the late 1990s, and also because dollar movements tend to have magnified impacts on EM shares.
What it also reveals is that global information technology and telecom, with the exception of EM telecom, did poorly across the spectrum, as the effects of the global technology bubble had to be worked off with time. The U.S. was not an outlier here; the tech and telecom bubbles were global phenomena, so a period of broad weakness should be expected after so much of the sectors’ future returns were priced into the lofty valuations seen at the bubble’s peak.
Obviously, in the wake of a huge technology bust, an index like the S&P 500, top-heavy with tech names, would fare far worse than an index like the EAFE, which averaged a technology sector weighting about half that of the S&P 500 over the 2000 – 2007 period. Conversely, the S&P had a combined average weighting of only 11% to energy and materials over this same time frame, while the EAFE had much greater exposure to these commodity-related industries, with a combined average annual weighting of about 16%.
Digging deeper, we can take a closer look at differences in the composition of the various materials sectors. At first glance, one would think that the U.S. materials sector would be very similar to that of the rest of the developed world or even the emerging market sphere, yet that is not the case. Indeed, even though each sector is generally classified under ‘materials’ for ease of classification, the components are very, very different.
For example, in the U.S. the MSCI Materials Index, which trailed its EAFE and EM counterparts during the commodities boom,