The Great Divergence

Bill Hester, CFA of Hussman Funds recently wrote a very insightful article about the convergence of the global financial market performance that began in the second half of the 1990s and then the growing divergence seen in recent months:

For a brief period during the last decade the developed economies around the world became one. Countries shared similar fiscal policies, interest rate policies, and spending patterns which resulted in uncharacteristically similar economic performances. Investors took their cues from these trends and sent financial market securities converging in price and yield. The range of bond yields tightened, the level of valuations became closely aligned, and trailing stock returns were remarkably similar. As the developed economies continue to recover from the world-wide credit crisis, and now face new pressures of over-levered sovereign balance sheets and the prospects for below-average economic growth, investors should expect financial market performance among countries to continue to diverge.

(Bold is my emphasis)

Included in his article was the graph below which shows the spread between the highest and lowest 6-month returns of the members of Morgan Stanley’s index of developed countries (the spread is smoothed to highlight the medium-term cyclical fluctuations of the series).

Source: Hussman Funds

The large spread around 1990 highlights the weakness in the Nordic countries during this period as their stock markets collapsed as they battled their domestic banking crises. The peak around 2000 coincides with the peak in the world-wide stock market bubble where a few indexes that were over-weighted in telecommunication and technology stocks fueled strong relative outperformance. But even outside of those peaks, the graph shows that during the 1970’s and 1980’s it was typical for there to be large divergences between the best and worst performing countries – 40 to 50 percentage points difference was typical. More recently through 2007 the divergence in stock market returns among developed countries collapsed. There was very little value in making distinctions at the country level when individual country returns were so tightly centered about broad benchmark return levels.

These trends have shifted the last couple of years and the recent spread between relative performances continues to widen. Year to date, Denmark’s benchmark index is up 20 percent, while the Athens Stock Exchange index has dropped 33 percent. Country selection is beginning to matter again.

This divergence is potentially a very favorable development for global relative strength strategies.  In any universe of securities there is a dispersion or bell curve of returns with the bulk of the returns huddled around the mean and then a number of extreme positive outliers and a number of extreme negative outliers.  The goal of relative strength strategies is to focus the portfolio on the positive outliers and to avoid the extreme negative outliers.  The greater the dispersion in returns, the more likely relative strength is to be able to deliver superior performance over a benchmark index fund. If we do indeed see much greater divergence in country returns going forward, relative strength is well-positioned to capitalize.

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