If you do any reading about capital markets, you've probably come across an article or two saying that people should invest in foreign markets. Overseas markets are supposed to have low correlations to the U.S. market, and these low correlations will smooth out the volatility of your stock portfolio. This makes a lot of sense to me and is what got me interested in the first place.
Unfortunately, this logic is not as accurate as it used to be. A funny thing happened on the way to diversification: the globalization of the world's economy. The world economy is undergoing several events that are causing economic cycles of different countries to synchronize more than they have in the past. One example is the current state of the European Union and the adoption of the euro currency. To be compliant, countries must adhere to certain debt and inflation levels.
This seems to be causing a higher correlation between European stock markets, as evidenced by a two-year chart that compares general French and German indexes. When we add the S&P 500 to the chart, we see that, except for a two-month period at the beginning of 2004, the collective performance looks similar.
China also plays a role in this globalization effect. China has had increased demand for all sorts of products from all sorts of countries. This demand is causing economic prosperity for many of its trade partners. While I still believe investing in China does allow you to get access to a market that has a low correlation to the U.S., these closer ties can be expected to bump that correlation up -- and the diversification benefit down -- as time goes on.
Perhaps the most compelling nugget of anecdotal evidence of increased global correlation is the growth of ADRs. Over the last 10 years, the number of ADRs has more than doubled to almost 500 different companies, not including those on the OTC bulletin board. There are ADRs for the largest companies from most other industrialized nations. While ADRs were taken out of the S&P 500 in 2002, they still participate in up and down trends that occur in U.S. markets. They also can move U.S. stocks -- Nokia's (NYSE: NOK) mid-quarter update lifted domestic analog chip companies.
Sharp-eyed readers will note a practical reason these big multinational companies' stocks may move together: They sell to many of the same markets. Just like our own McDonald's (NYSE: MCD) or Coca-Cola (NYSE: KO), Nokia generates a lot of its sales from abroad.
Does this mean foreign investing is a thing of the past? Certainly not. The growing global economy offers plenty of emerging markets with low correlations to the U.S., albeit with increased risk. And I'd never rule out simply buying stock in a good company, wherever that company might be located. I'm just saying to be careful of the "international diversification" imperative so often touted, as you may not get the same type of diversification that you got 15 years ago.
For more Foolish coverage of overseas investments, read:
Fool contributor Roger Nusbaum is an investment manager and wildland firefighter in Prescott, Ariz. At press time, neither he nor his clients owned any of the stocks mentioned.
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