Decouples Therapy

May 16, 2012

Has the U.S. decoupled in a good way?

The market has been heading down of late. After peaking on April 2nd, the S&P 500 is off just over 6%, with much of the loss occurring in the first two weeks of May. 

By itself, this is hardly notable as a drop, especially considering that the market is up significantly from its 2009 crash lows (although still off its all-time highs). More noteworthy are foreign markets, now down about 10% over the same period. This continues a now roughly 5-year period in which U.S. stocks have beaten foreign stocks. The underperformance has been so bad that a foreign investment would have to have been made way back in 2004 in order to outperform an investment in U.S. stocks, even though foreign stocks beat U.S. stocks by a wide margin from 2004 to 2007. 

For much of this time period, investors have favored foreign markets, waiting for the U.S. to collapse while other countries somehow magically took off, removed of the burden of the U.S. economy. The belief was that the U.S. was in decline, with no appreciable growth prospects, and nothing left to do but print money in order to push off its inevitable woes. 

The popular term from about a half-decade ago was "decouple" — a scenario in which the global economy and stock market would lose the weight of the United States and no longer be dependent on U.S. demand to spur growth. This would lead to wild riches for those smart enough to focus abroad. 

This strategy, of course, is reminiscent of another popular investment concept, the “New Economy” versus the “Old Economy," because in 1999, tech stocks were leaving value stocks in the dust, and the smart move was to own a bunch of tech and growth funds.

Today, it's pretty clear that the decoupling that took place wasn’t the world leaving the U.S., but the U.S., relatively speaking, leaving the world. While we're in no way problem-free, most major economies have even bigger problems – in debt and deficits, in unemployment rates, growth, and even real estate, which was supposed to be the United States' signature problem.

Even the debt problem – the area in which we're the undisputed leader in screw-ups – is better here than just about anywhere. Our government can borrow at under 2% for 10 years (likely below inflation, so the U.S. is literally getting paid to borrow) while some euro-area countries can only borrow from each other at this point and Greek 10 year bonds yield 30%. Even our supposedly bankrupt states are getting back to balance after reducing spending and seeing tax revenues climb. 

This last point represents a key difference between America and most of Europe. Our biggest and "worst" state, California, still in debt trouble, but not nearly as bad as it was a few years ago, represented all that was wrong with America. But as The Economist just noted, Facebook's pending IPO could generate a windfall of $2 billion-plus (and possibly more) for California in taxes alone. This, on top of all of the newly minted millionaires and billionaires spending money and paying sales taxes in the Golden State. 

The cash generated by the Facebook IPO could be enough to wipe out a good chunk of the budget shortfall in the state. The best part: it’s not really a once in a lifetime windfall. It’s not even once in a decade. California saw $7 billion from the 2004 Google IPO. And this, in the decade following the dot com crash. 

Europe doesn’t have a Facebook economy. Greece and Spain will never see big IPO windfalls. They have to cut spending and raise taxes to balance a budget. That practice causes recessions and social unrest. That's not to say America isn’t long overdue for spending cuts and tax hikes, just that we have the wind at our backs in the form of an economy that wins in spite of the government. We don’t just grow out of a problem, we IPO out of it.

The scary fact for foreign market underperformance is that foreign currencies haven’t even crumbled yet. The U.S. dollar’s slide in the early part of the 2000s was the main reason for outperformance of foreign stock markets. If our dollar rebounds, the  U.S. market won't just be beating foreign markets. It'll kick in to overdrive.

As American declinism slowly turns back to American exceptionalism, we should see two things occur. Mutual fund flows will once again favor U.S. stock funds over foreign funds. The money will head home, tail between its legs, realizing foreign investing ain’t all it’s cracked up to be, much like it eventually began favoring value and smaller cap stocks after the late 1990s tech boom went bust. We should also see gold collapse, as one of the main beneficiaries of U.S. declinism, the appeal of hoarding gold, the most anti-U.S. investment, dwindles.   

When the focus shifts back to the U.S. where it belongs, we'll get back to the levels of foreign stock allocations we had in 2003 in our model portfolios, because then, just as in 2003, the deals will be worth the baggage of Europe. For now, we have about as much as we need, an allocation built up in recent years due to underperformance since we'd cut back years before. It's still too soon for an above-normal foreign stock allocation, because the concept has yet to fall out of favor. If anything we started getting back in to foreign too soon, recently upping our foreign stake to 20% in our aggressive portfolio.

This gets back to our broad investment strategy rules: either buy and hold a U.S. index fund, or have a decent strategy to not  do what's popular with other investors. Otherwise, you'll be chasing Nifty 50, New Economy, hard assets, real estate, decoupled countries, trendy acronyms like “BRIC,” or what have you with your money, at almost precisely the wrong time.