A reader passed along a missive from S&P noting that correlations between domestic stocks and foreign stocks have been going up. Specifically the correlation between the S&P 500 and MSCI EAFE has gone up to 0.89. If memory serves I seem to recall those two correlating close to 0.80 for a quite a while but I may have that wrong.

The reader used the word deworsification to describe what has happened to the tenets of diversification and what it is supposed to do for a portfolio during adverse market conditions.

This hits a few points I have tried to make over the last few years. The broader you go, so something like MSCI EAFE, the more that you blend away any positive attributes that might exist. The EAFE index is heaviest in Japan and the UK. Japan has had a whole bunch of problems while the UK looks very similar to the US. The heavy countries in EAFE are heavy due to size. Big is not necessarily better. How long do want to be be in countries with a headline-making banking crisis, deflationary issues and any other problems you want to throw in?

I’m not sure how many times I’ve talked about foreign investing at the country level. There are countries whose economies are much healthier than that of the US. There are countries whose economies run on different inputs than that of the US. There are countries whose economies are at different ends of the economic spectrum than that of the US (meaning surplus countries).

Of course all of those markets are down a lot. Other than cash, a couple of absolute return vehicles and inverse funds there hasn’t been any place to hide in this bear market. However most of these kinds of markets hit their peaks at different points than the US. Brazil kept going up for nine months after the SPX peaked. Exposure to these sorts of countries combined with a clearly defined defensive strategy is a much better idea than buying the EFA ETF and thinking you are diversified. By the way the EAFE index peaked a couple of weeks after the SPX did.

The bigger idea is simple and you either buy into it or you don’t. A country that has surpluses or is an exporter or a commodity based economy or all of the above has a good chance of being at a different point in the economic cycle and by extension a different point in the stock market cycle. Making them potentially better candidates for diversification.

None of this has to be difficult. If you buy into the idea that countries with different economic attributes off a chance for better diversification over the long term then the next step is learning about different countries and then making small investments to spread out the risk.

This won’t be right for everyone of course but I have been making this same point about EAFE for ages, it does not provide as good a diversification as going to the country level.

Last 5 posts by Roger Nusbaum

• The Big Picture for the Week of November 15, 2009 - November 14th, 2009
• Process Drilldown - October 23rd, 2009
• Sunday Morning Coffee 10-18-09 - October 18th, 2009
• A Little Followup From This Morning - October 8th, 2009
• Wednesday Roundup - October 7th, 2009