Reduce Portfolio Risk Through Global Diversification.

• Author: Simms, Robert A.

While the U.S. stock market has performed superbly in recent years, 2000 has been a year of flux -- making it a good time to revisit the argument that allocating investment dollars to overseas markets is prudent.

As domestic markets continue their seemingly aimless meandering, where do investors look for fresh equity growth? Perhaps the Old Continent holds some new opportunities. Certainly the U.S. stock market seems to be struggling. Even with the Nasdaq market rebounding from its ugly spring slide, the fabulous returns of recent years aren't likely to reappear.

The current U.S. economic cycle is now approaching its ninth year. How much longer can it continue? Domestic equity markets appear to be fully valued, given the elevated price/earnings ratios of the cap-weighted S&P 500 Index. If they haven't done so already, CFOs and their investment managers should be thinking about rotating funds into other sectors.

Meanwhile, one index that has been overlooked by some investors due to lagging performance in recent years is the EAFE (Europe, Australasia and the Far East). The EAFE has lately accelerated -- and in fact, topped the S&P 500 in 1999 (27% to 21% average returns) for the first time in several years. It now seems likely that the EAFE will outperform the S&P 500 for at least the first three to five years of this century.

Between 1994 and 1998, the average annual return of the EAFE index was about 10%, which lagged behind the S&P 500's 23%. But during the 1980s, the EAFE outperformed the S&P by an average of 5.5% per year (+21.8% to +16.3%). The cyclical nature of the relationship between these two indices is apparent.

Based on quantitative valuation measurements done by our organization, which include price/earnings, price/book ratios, return on equity, and earnings growth rates, we have concluded that the developed international (EAFE index) markets are currently undervalued compared to the S&P 500.

Converging Market Forces

One of the underlying factors of the equity performance shift has been the unification of the European economies, which has triggered a movement towards American-style capitalism. The main catalyst has been increasing economic deregulation, leading Europe into a free market which increasingly resembles that of the U.S.

Europe has created a free flow of people, capital, goods and services within its collective borders. The elimination of tariffs and non-tariff barriers indicates that Europe's old defense mechanisms...