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Will Global Stock Markets Take Their Lead From The U.S.?

The markets peaked together - will they trough together?

William Hester, CFAJanuary 2009All rights reserved and actively enforced.Reprint Policy

Last week the Bank of England cut its benchmark rate to its lowest level since the Bank's creation in 1694. Itsaid that the availability of credit to both households and businesses had tightened further and the output inthe UK was likely to fall sharply this year. Japan's economy is currently in recession using similar standardsused to determine US recessions. The recent Tankan Survey there showed the worst change in outlook bymanufactures in 34 years. The ECB is likely to cut its benchmark rate this week in an attempt to offsetslowing Euro-area data.

All of this suggests that the global economy is likely now entering into its worst recession since the early1980's, when the rate of growth slid from double digit growth to contraction. The duration of the recessionsin individual countries could also end up mirroring that period, where, for example, the UK was in recessionfor two years and Germany's contraction lasted almost three years.

The graph below plots recent growth trends along with the expectations for GDP growth in the majoreconomies over the next two years. Economists are expecting US economic growth to drop sharply in thejust-ended 4 th quarter, rebounding through the first half of the year until it begins to expand in the 3 rdquarter of this year. The pattern for other developed economies is marked by shallower declines in output,but that are more drawn out. Economists expect the UK economy to contract all of this year, eventuallyrecovering in 2010. The Euro area faces similar prospects, according to forecasts.

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So if the recoveries of other major developed countries lag the US, will the eventual rebound in thosecountries stock markets also lag? Or would these countries be likely to recover along with the US if itseconomic prospects were to improve? So far, the major markets have rallied impressively off their respectivelows. The EAFE index is up about 20 percent from its late November closing low. The Dow Jones IndustrialAverage is about 14 percent. Interestingly, the outperformance of the EAFE versus the DJIA is at about thesame ratio that occurred during the previous cyclical bull market lasting from 2003 to 2007. So far, it lookslike global investors are taking their cue from broadly rising markets and less so than on individual economicoutlooks.

One way we can examine this question is to look at the performance of individual developed markets duringperiods where the US and each non-US developed country shared economic prospects, and compare thoseresults to when they differed. To do this I received permission from ECRI , an economic forecasting service,to use a set of recession dates they've created for 20 countries. ECRI applied the same standards used todetermine US recessions to these individual countries, noting where recessions occurred. Our sample willbe nine countries for which ECRI has business cycle dates and that are are included in MSCI's developedmarket index with sufficient price history.

Since 1970, four important global recessions have occurred: from 1973 1975, 1980 - 1982, and somewhatlesser global retrenchments in the early 1990's, and in 2001 through early 2003 (a fifth occurred in 1998, butwas experienced mostly by developing countries). The early 1970's recession might well turn out to be ablueprint for the current global retrenchment. The United States economy troughed in March of 1975 whilemost European countries troughed later that year in July and August. Japan's recession matched the USeconomy's slowdown nearly identically through that period. The early 1980's showed more divergence in theoutcomes. The US economy experienced back to back recessions, the last one ending in November 1982.Germany's economy recovered at about the same time, but the economies in France and Italy didn't recoveruntil well into 1984. The recessions in Europe in the early 1990's generally began later and also lasted laterthan the brief slowdown experienced by the US economy.

I've created three graphs below which attempt to provide clues as to whether global markets will continue tooutpace the US market even if their economies are not expanding. The first graph shows the performance ofeach developed market during periods where both the US and that country's own economy were inexpansion. This is the largest block of time, which includes the late 1970's, the late 1980's, and during mostof the 1990's. The vertical axis measures the correlation of returns between the US and each country. The

higher the country is on the axis, the higher the correlation. Not surprisingly, this is determined partly bygeography. Canada and the UK have a higher correlation of returns when compared with Australia. Thehorizontal axis measures the average monthly return net of the US return over the same periods. Countrieslying to the right of the zero line have outperformed the US market, on average, during these periods.Countries to the left of the zero line have underperformed.




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The graph shows that developed international markets typically outperform the US market when the globaleconomy is expanding. The data is surprisingly consistent through our list of countries. Australia, Swedenand Germany have outperformed more than the others, on average. The performance of the Canadian andUK markets has been closer to the average return of the US market, with higher correlation.

The next graph shows the same mix of correlation and net performance but only looks at the periods where

both the US and each country have been in recession. These periods capture the bulk of the globalrecessionary periods I mentioned above.The graph demonstrates that the trends we've seen in this bearmarket where most international benchmarks are performing worse than the US market - are not unique tothis bear market. Since 1970, international markets have tended to underperform the US market duringglobal recessions. (The UK market's high average return can almost be entirely explained by a couple ofmonths following the 1973-1974 bear market where the MSCI UK index rocketed higher as investorsanticipated the end of that period's recession.)




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The chart also shows that the correlation of returns across various markets increases during recessionaryperiods. As I noted in November 2007 in International Markets Show Important Divergences , global diversificationis least useful when it's needed most. And this data shows that not only does the correlation between USand international markets rise during recessions, but that global returns trail US returns during theseperiods. Lower returns with higher correlation. This data implies that the benefits of international investingand diversification come predominantly during periods of global expansion, and not during bear marketsinduced by recessions.

The third graph shows the performance of international markets during periods where each country is inrecession but the US economy is in expansion. Whether or not this actually occurs, this is the outlookcurrently embedded in economist's forecasts this year. The expectations are that the Euro countries and theUK will be in recession at least 6 months longer than the US.




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The graph shows that international markets typically trail the US market during periods where that market'seconomy is in recession and the US economy is expanding (across the nine countries these periods makeup roughly 15 percent of the data). On average, the monthly returns for these periods are 40 basis pointsless than US returns. But notice that because of the differing economic performances, the averagecorrelation of returns across various countries also drops noticeably.

These results aren't surprising. US markets have reliably rallied only between two and three months prior tothe end of US recessions. It's very much the same in international markets. Their performance is moremixed until closer to the end of recession. On average, international markets trail US markets through theseperiods. There's little evidence to show that individual global stock markets ignore dimming prospects fortheir own economies simply because prospects for the US economy improve.

Valuation

An equalizer in the current environment may turn out to be the valuation of international markets. Globalmarkets fell further during this bear market and they've been left with valuations that are better than thelevels on US stocks. The graph below shows the ranges of valuation of a selection of markets in the MSCIdeveloped market index. The blue lines denote the range in P/E multiples for each country since the early1970's. I created them using monthly prices and the peak earnings series for each country. Because each

series including the data for the US market - begins in the early 1970's, it doesn't capture the longertrading histories that some of these markets have. But it does include the early 1973-1974 global bearmarket where many global markets traded at single-digit P/E multiples.




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The graph shows that average valuations are generally better globally than they are in the US on a pureprice-to-peak earnings basis. Even taking into account the recovery through the end of the year, many ofMSCI's country indexes are trading at a single-digit multiples on peak earnings. But there's a caveat to thevaluation argument. The boom in global growth that occurred up through the middle of last year was morebeneficial to EAFE members than US companies. While the growth in US earnings was impressive,earnings growth in the bulk of EAFE countries was more so. Earnings growth was in some cases was oneand half to two times faster for individual EAFE countries than US companies the last few years. This waspartly fueled by an even great expansion in profit margins above longer-term averages than what was

realized in the US. Therefore, the earnings of these companies could be at a greater risk of falling furtherand for a longer period of time. And if recent peak earnings don't represent the true current earnings powerof the index, the price to earnings figures may be overstating the attractiveness of their valuations.

Taken together, the data suggests that investors should not rely on outperformance from global markets inevent that the US recovers first. In 1974 global markets bottomed within a month or two of each other, eventhough a number of the recoveries in European economies lagged the US recovery. In general, the stockmarkets of economies that are in recession tend to lag the returns of the US market when the US economyis expanding.


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