Today, Bloomberg ran an article that provided comprehensive data indicating what is surely a global bear market. The good news is the attractive valuations that are developing. The bad news is that if you had all your money in stocks before the decline, you won’t be able to take advantage of those attractive valuations. Well allocated investors who keep some powder dry in cash or diversified into high quality debt will have the resources to buy new stocks as this bear market runs its course and eventually bottoms.

Long-term investors with 3-5 year perspective to evaluate returns will probably do fine even if they are being battered by today’s markets. Short-term investors need to be out of the way.

The most difficult decision is for retirees who depend on their portfolios to live. If they have been relying on dividends from their portfolio, fluctuations in price are not all that important in the short-term (unless, of course, they owned mostly mortgage REITS and banks that are cutting dividends). Retirees or others who need to utilize capital to live or to fund near-term uses, should not have had all of their money in stock — but if they do have more in stocks than they can afford to have eroded by a bear market, it may not be too late to take some off the table for recommitment later.

A major risk of taking money out of the market when things are bad is taking it out too late and then putting it back in too late with a consequent permanent loss of return. It is late, but perhaps not too late to take some equity money out of the market. The direction and momentum suggests that there may be enough additional damage to come that some advantage could be gained by raising some cash even at this late date.

For our own account, we went sold 1/2 of our stock positions in mid-December and have sold 90% of our stock positions by mid-last week. We hope to be able to gauge future bottoming behavior to recommit in time to capture well discounted values. REITS and banks which we have written about as sectors to avoid during 2007 will probably be ones to overweight during the next up cycle — possibly in 2008.

Here are key facts from the Jan. 22 Bloomberg article (http://www.Bloomberg.com):

“Stock Drop Pulls 38 Indexes Into Bear Market; Banks Lead Plunge … Almost half of world’s biggest stock indexes fell into a bear market …

The MSCI World Index’s 3 percent decline yesterday, the steepest since 2002 … MSCI World valuations at the cheapest since at least 1995 …

… a bear market, commonly defined as a drop of more than 20 percent in a 12-month period….

The MSCI World Index of 23 developed markets is down 17 percent from its Oct. 31 record. The MSCI gauge of developing nations also reached a bear market yesterday …

Among 80 equity national equity benchmarks tracked by Bloomberg, indexes in Argentina, Australia, Austria, Belgium, Bulgaria, Chile, Colombia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Hong Kong, Hungary, Iceland, Ireland, Italy, Latvia, Lithuania, Luxembourg, Mexico, Namibia, the Netherlands, Norway, Peru, Poland, Portugal, Romania, Singapore, Spain, Sweden, Switzerland, Sri Lanka, Turkey, Venezuela and Vietnam also have dropped at least 20 percent from recent highs.

… The S&P 500 has fallen 9.8 percent so far this year, while declines in the U.K. and Germany yesterday left those countries’ benchmark indexes down 14 percent and 16 percent respectively. …

… The slump has made stocks cheap by historical standards. The 1,953-member MSCI World is now valued at 14.1 times its companies’ profits, the lowest since at least 1995, according to data compiled by Bloomberg. Europe’s Stoxx 600 has a price-to- earnings ratio of 10.7, the smallest since at least 2002. …”

Here are some Yahoo Finance (http://finance.yahoo.com) price charts for key indices that graphically demonstrate the point made in the Bloomberg article.

ETFs related to the charts above are:

EWJ = Japan
EWG = Germany
EWU = United Kingdom
EWZ = Brazil
SPY = United States
EWH = Hong Kong

Richard Shaw
QVM Group LLC

One approach to asset allocation among equities is to follow world market capitalization.  Rather than investing heavily in domestic securities simply because they are familiar, the world market cap approach allocates stock assets according the relative size of the stock markets around the world. 

Centuries ago, investors in smaller countries such as Holland and Scotland learned  to invest abroad, because their wealth exceeded the domestic opportunities.  Americans on the other hand have had access to large domestic markets and have been quite insular as investors until recently, but even with the major shift toward international investing of the past several years, U.S. investors are far from allocated by world market cap.

Consider the 2006 Investment Company Institute annual report which reported that U.S. mutual fund stock assets were 77.2% in U.S. domestic stock funds and 22.8% in international stock funds.   That’s way up from 10 to 20 years ago, but not close to the actual world market cap by country and region.

Now consider the report by the World Federation of Exchanges (”WFE”) for the period ending April 2007 (excludes investment funds and some markets such as Russia).  Their data indicates that the market cap of the U.S. stock markets account for only 36.4% of the world market cap of $56.4 trillion.

Looking at the three major regions as typically reported, their data indicates this allocation:

• Americas - 42.4%
• Asia/Pacific - 25.8%
• Europe, Africa & Mid-East - 31.8%

Reformating to align with the MSCI U.S., developed markets of EAFE and emerging market indices, the WFE data indicate this world market capitalization:

• United States - 36.3% (etf proxy: IWV)
• EAFE - 44.0% (etf proxy: EFA)
• Emerging - 19.7% (etf proxy: EEM or VWO)

The emerging markets were less than 10% just a few years ago, but their explosive growth has dramatically changed the picture.  Reasonable extrapolation of current relative earnings growth rates will see those allocations tilt even more to the emerging markets.  We’ll probably have to stop calling some of them emerging in the not too distant future.

The EAFE complex is substantially as follows:

• traditional Europe - 29.4% (etf proxy IEV)
• Japan - 8.3% (etf proxy EWJ)
• Australia - 2.3% (etf proxy EWA)
• Canada - 3.2% (etf proxy EWC)
• Singapore - 0.8% (etf proxy EWS)

The emerging market complex is substantially as follows:

• China - 6.9% (etf proxy FXI)
• India - 3.2% (etn proxy INP)
• Korea - 1.6% (etf proxy EWY)
• Brazil - 1.5% (etf proxy EWZ)
• South Africa - 1.4% (etf proxy EZA)
• Mexico - 0.5% (etf proxy EWW)
• all others - 4.6%

Unfortunately, these country percentages within the emerging markets category don’t line up very well with the allocation among emerging countries in the MSCI emerging markets index (see a prior article: Tilting Your Emerging Market Exposure published at Seeking Alpha). 

The MSCI index is free-float adjusted and the WFE figures are not.  That may be the explanation of the differences — that one measures total market wealth and the other measures the investable opportunity.  It may also be due in part to measurements at different points in time, or perhaps something else.  However, the major point about regional market caps is, we believe, intact in spite of the data discrepancies. 

For our own account, we seek to invest as much toward where the market cap is, subject to limits as to the degree of volatility we can accept in our portfolio. 

Regardless of the percentages, we recommend ”core” portfolio holdings of a broad market U.S. equities fund, a developed countries international fund and an emerging markets fund.  From that core it is then appropriate to tilt any or each of those three key categories toward a style or market cap or sector weights in the domestic market, and toward sub-regions or countries in the developed international and emerging markets, by adding specialist “satellite” funds.. 

The Latin American exchange traded fund, ILF, and the Asia/Pacific Rim excluding Japan exchange traded fund, EPP, are examples of ways to create a regional tilt.  Individual country funds provide the other satellite funds to create tilt toward where you think the most value growth may be. However, we do not recommend abandoning the core holdings. Remain diversified and ready for the twists and turns that inevitably occur in markets.

You will want/need to review your satellite fund choices at least yearly, because they may move in and out of your favor, but you should maintain diversified core positions.  You should also set (write down) an allocation policy decision for each position and rebalance to the policy allocation periodically to keep the balance of assets you selected in the first place.  This also allows you to “harvest” gains instead of riding positions up and then back down again. 

While there is opportunity to enhance returns by making good market cap, style (value or growth) or sector allocation decisions in the domestic market, we think that to the extent that your physical and mental time is limited, you will fare better making region and country allocation decisions most of the time.  And, while correlations are converging worldwide, there is still probably lower correlation of returns between regions and countries than between domestic market caps, styles and sectors.

Tread carefully overseas, but do go there.

Richard Shaw
QVM Group LLC
Registered Investment Advisor 

disclosure: author owns IWV, EFA, VWO, EWY, EWS, EWA, EWW among the securities mentioned.