BULLS & BEARS: Foreign stocks aren’t shield against bearish U.S. market

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A client of mine recently expressed concern her portfolio didn’t have foreign stock-market exposure.

Because of this lack of diversification, she said, her account had just been “muddling along” for the 22 months we had been working together.

Her concluding statement: “You haven’t bought me any foreign stocks to protect my portfolio in case the U.S. market suffers a calamity!”

You know how a dog’s head quizzically tilts to the side when you talk to it? I think my head did the same thing while I was listening to her concerns.

First of all, my firm does not manage foreign stocks, which she knew 22 months ago.

Second, her account had performed about 50 percent better than the market over the time we had been working together, which seems to me is better than “muddling along.”

And finally: No, contrary to conventional wisdom, foreign stocks probably won’t protect a portfolio if we suffer a domestic bear market.

In the most recent negative years here at home, from 2000 through 2003, $100,000 placed in the U.S.’ S&P 500 dropped to $62,410.

During that recession- and 9/11-fueled decline, it would have been prudent to have funds abroad, right?

Well, in that same period, the $100,000 placed in the proxy for foreign markets, the EAFE (Europe, Australia, and Far East) index, dropped to $56,680.

No protection there. Before that calamity, the U.S. market dropped about 3 percent in 1990, and the EAFE dropped more than 23 percent.

You have to go back to 1977 to find a year in which the U.S. market lost value while the foreign index gained.

In the last 31 years, the S&P 500 has suffered negative returns six times while the EAFE has sunk into negative territory seven times.

Because the world’s economies are interconnected, if you are looking for downside-risk protection, you won’t find it across the pond.

In addition, the outperformance by foreign stocks is a cyclical phenomenon.

Historically, foreign stocks do better for a few years, then the domestic market will turn and dominate for a few years.

Leadership swings back and forth like an erratic pendulum.

For four years in a row now, the EAFE index has been the beauty pageant winner.

This strong run is why foreign stock mutual funds have been raking in the lion’s share of money the last few years.

But four years of dominance is a long pendulum swing and at some point the momentum will shift back to the United States.

Can foreign funds increase returns? Yes, absolutely, but don’t expect them to protect your portfolio.

Spreading your portfolio over many, many securities, funds and markets is not prudent diversification.

Peter Lynch, the legendary manager of the Magellan Fund, created a great word that I think describes it: “deworsification.”

Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.

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