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What Rising Correlations Mean for Market Returns

Yesterday, we saw that fears regarding rising correlations were overblown. Today, we'll look at how the markets have performed while we've been experiencing these higher correlations.

While many in the financial media have cited globalization as the reason for the rising correlations, it seems more likely that the increase is due to the series of crises we have had during this period.

Consider the following. From 2000 through 2010, the annual correlation of the S&P 500 Index to the MSCI EAFE Index rose to 0.97, and the correlation of the S&P 500 to the MSCI Emerging Markets Index was 0.91. Yet, the S&P 500 returned 0.4 percent while the MSCI Emerging Markets Index and the MSCI Emerging Markets Value Index returned 10.9 percent and 13.1 percent, respectively. Also note that the MSCI EAFE Small Cap Index returned 8.2 percent.

Let's take another lesson from history. We have seen similar episodes of rising and very high correlations. For example, for the five-year period from 1972 through 1976 the annual correlation of the S&P 500 to the MSCI EAFE rose to 0.874. That period probably produced similar cries about how global diversification was no longer working, and thus it wasn't needed. However, over the following five years the annual correlation fell all the way to 0.258.

Unfortunately, we can't know what the future will hold -- there are no clear crystal balls. However, there's nothing new in the data to suggest that over the long term the benefits of international diversification are any less than they have been.

Let's suppose that for whatever reason global equity markets do in fact become more closely correlated. Would that make global diversification unappealing? It's hard to see why that would be the case. Would it make sense for U.S. citizens to restrict their ownership of auto industry stocks to Ford and eliminate firms such as Toyota from consideration? And how would Japanese investors, who have experienced a 21-year bear market in Japanese stocks, answer this question about the benefits of global diversification? Do you think they believe international diversification doesn't make sense in this "new era"? And how do we know the U.S. won't turn out to be the next Japan?

The bottom line is that international diversification is as important as ever. In fact, it has been said that diversification is the closest thing there is to a free lunch -- so you might as well eat a lot of it. And, remember that the greatest diversification benefits with equity investments come from the asset classes of international small-cap stocks and emerging market stocks.

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