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Taggart wrote:From page 11 of "Irrational Optimism" by Dimson, Staunton and Marsh.
Thank you Taggart, this is exactly the kind of argument I hoped to see in this thread; quantifyable data. Even though I decided to retire from this thread, your post indeed deserves to be addressed.
In fact, your article fills a few missing pieces of historical data that I was missing in a Yearbook I referred to. For instance, now we can say that World returns were positive every and each 21 year period (expressed in US dollars - I'll address this later). It also provided lower volatility than US for 20-year returns.
As Table 1 shows, over the past 103 years, global diversification via our world index would have lowered the returns earned by a U.S. investor because overseas equities underperformed U.S. stocks and the dollar was strong against most other currencies. At the same time, however, global diversification would have lowered risk.
The bar for the world index in Figure 3 shows the net impact of these factors for our notional U.S.-based global investor. Despite incorporating many countries where investors historically needed horizons much longer than 20 years to avoid losses, the world index nearly met the 20-year test. Although the worst 20-year return was –0.2 percent a year, the annualized real returns were consistently positive over all intervals of at least 21 years.
Now, to address the issue of currencies:
Furthermore, our findings for the world index are dependent on being U.S. based. When world index returns are expressed in German Marks (now Euros) from the perspective of a German citizen, they reveal that a German global investor would have needed to wait 57 years to be assured of a positive return. Similarly, global investors in the world index from Italy and Japan would have needed horizons of 33 and 34 years. These extended horizons are the result of the historical volatility of exchange rates.
Actually, I was expecting that someone in this thread will point to this, so thanks again Taggart. Now, looking at these numbers we can assume that these were the worst performers, currency-wise. I.e. just about everyone else actually turned up profits in their local currency over the course of 30 years (remember, the article looks at 20 year intervals, and we were talking about 30). Now, a minor point is that investors do not need 100% in their local currency, rather they are interested in a basket of currencies to match their liabilities. Surely this will be heavily tilted to the domestic currency, but it won't be 100%. It is reasonable to assume that such a basket will pull Japan and Italy under 30-years. But this is speculation as I don't have data for this, and there is a more important reason why it is not relevant.
Let's look at the countries in question. Germany, Italy, Japan. Do you see a connection here? Now we're are going back to my argument that if you were born at a certain time in Germany, you were screwed and you could do nothing about it. Destruction of value happened across the board, and now I can show that diversified all-stock still provided the best possible results.
The recommended risk-mitigation strategy for a portfolio is a diversification across assets (as stipulated in Taggart's article), and I suspect this means domestic bonds (also martingale's suggestion). Now I'll tell you what these 3 countries in question share in common (except the obvious): these are 3 countries where bonds pulled out unprecedented feat of yielding non-trivial negative real return averaged over the last 100 years (-1.8%, -1.3%, -1.8%). No other country in the list, and certainly no stocks in any listed country, can boast such a claim.
I can add even more - look at the equity over bond premium. For Germany and Japan these values are higher than world average and are higher than for US. This means that asset that is supposed to protect me from the nasties of the stock market not only actively destroyed value, but it underperformed even more than in the countries that were not affected.
Are these assets that you want me to diversify into? Thanks, but I'll pass.
Now, there is a second part of the article that deals with prediction of the future. I won't address all the points there, but I will note that there were quite a few changes in US and World economies since 2002 - the last year that they considered. Trivial example would be balooning P/E ratios - I did address it before, but just for the record, in 2002 P/E ratios in US were ~45, and now they're ~17, which is just about average value. The same is true for other markets. US market cap is down from 54% in 2003 to less than 40%. US dollar is at the all-time lows. Guess how World index was doing all this time?
Which brings us to the last point - declining dividend ratios as a predictor of declining future returns. You see, on each analysis that spells imminent doom and gloom (very convincingly), it is easy to provide an analysis that provides equally opposite perspective, equally convincingly. Analysis of the first category tend to concentrate on the problems of US economy (which are debatable); but more importantly, they fail to notice that the more problems US have, the less important it becomes for the world economy (notice declining market cap); and even more importantly, they fail to notice that there are a lot of other countries around the world (as surprisinig as it may seem). Just as research of the second kind may overemphasize emerging markets, globalization, low-interest rates/inflation and reducing volatility.
This is nothing new, and both kinds of outlooks were there countless times in the past.
As an example of the rosy outlook for the world, see Why We Remain Bullish?. It is no less (and no more) convincing to me than other research.
At GaveKal, we believe that there are five great secular trends which essentially account for the remarkable strength of the world economy and financial markets:
1. Globalisation is leading to much greater economic stability.
2. Emerging markets are finally emerging.
3. A financial revolution has created a democracy of credit and changed the risk profiles of many asset classes.
4. Low inflation has become established as a worldwide norm.
5. Monetary policy has gone through a counter-counter-revolution.
They also address (in detail) concerns of overvaluation:
...let us consider the four reasons why risk assets could in principle be dangerously overvalued:
1. Growth and profitability could decline
2. Inflation and interest rates could rise
3. Valuations could be unreasonably expensive
4. Liquidity/leverage could be dangerously high
Reviewing our recent History further convinces us that something deeply structural is happening in our markets. To illustrate this, we will make an honest confession: if someone had come to us five years ago and told us that we would experience:
a) A 75% wipeout on the Nasdaq,
b) 9/11 and the anthrax attack, terrorist attacks in Madrid, London, Mumbai…,
c) Wars in Afghanistan and Iraq and oil at US$75/bl,
d) Enron, MCI, Worldcom…,
e) SARS & bird flu,
f) GM debt downgraded to junk (GM is the fourth largest bond issuer in the World)
g) Katrina,
h) Refco (the biggest commodity broker) and Amaranth (the biggest hedge fund blow-up),
i) A big conflict between Israel and Hezbollah that Israel would not win,
j) A nuclear bomb detonation in North Korea…, and
k) The first year-on-year fall in US house prices in ten years and a blow-out of the US subprime lending space…,
we would have likely concluded that the best thing to do was to head to our lake house in Oklahoma, load up on guns, cartridges and bottled water and wait it out. If that same person had told us that in the US, and in most other countries, corporate profits would be reaching record highs, that the World MSCI would be hitting all-time highs and that the VIX index would hit all-time lows, we would definitely have called for the men in white coats with the van and the padded room. Yet, here we are. And the only people in need of a padded room are the doom and gloomers who are spinning themselves in circle trying to come up with new potential nightmare scenarios for the global economy.
...
The fact that these shocks faded away so quickly, doing so little damage to the markets, suggests to us that most investors, far from being overexposed and overleveraged are still not committed or leveraged enough.
for someone. Who knows. 
