We believe that the starting point for evaluating the allocation weight to be given US equities within the overall equity allocation in a portfolio should begin from the world weight of US equities.

It may well be that US equities should be overweighted or underweighted for any number of reasons, but we believe the world weight is the appropriate starting point.  It’s a bit like “zero based budgeting”.

We believe it is inappropriate to begin with old rules of thumb such as “80% to 90% US and up to 10% to 20% in foreign equities”.  At best, such rules were formed a long time ago, before the extensive globalization of commerce we have today. At worst, they were just narrow insular thinking.   You can arrive at an 80% US allocation, but you should not start at an 80% US allocation.

Currency Issues:

We are not overly concerned about the currency risk argument often posed against non-US equities.  You have currency risk with all Dollars, and you have currency risk with foreign equities.  Which is better varies over time.  We have confidence in the ability of the management of hundreds or thousands of companies to effectively optimize currency exposures directly related to their businesses.

If we should become concerned about an existing currency exposure within an equity allocation, we can apply a currency overlay to deal with that.

The fact is that large-cap companies dominate most equity portfolios.  Large-cap companies tend to have a diverse set of currency exposures within their balance sheets and operating statements — often rather opaque as well.

Today, investors can deal directly with currency exposure through futures, spot foreign exchange accounts, and exchange traded products.

World Market-Cap Charts:

The charts below show the Dollar size of the US stock market and the total world stock markets, as well as the percent weight of the US stock market within the total world markets.

Note three things:

1. the non-US stock markets are larger than the US market.
2. the US world weight has been in decline in recent years (not because the US got smaller, but because the rest of the world grew larger faster).
3. the US weight has risen from 33% at the end of 2007 to 38% by September 2008 (not because the US rose — it fell massively — but because it fell less massively than the balance of the world’s markets).

From 1990 to 2000, the US stock market rose from 35% and 52% of world market-cap at the height of the dot.com bubble.

The data for the charts come from the World Federation of Stock Exchanges, and is for total market-cap, as opposed to free-float market-cap, which is used by index companies.

The FTSE All World index, a free-float index which is rebalanced semi-annually, is tracked by the Vanguard ETF symbol VT.  As of 10/31/2008 the US weight in that fund was 45.6%.

Summing Up:

Whether you would reference total market-cap or free-float market-cap, it is fair to say that the US represents somewhere between approximately 38% and 46% of world weight.

We recommend beginning the thinking and discussion process about portfolio target weights within the overall equity allocation with a US weight of perhaps 40% and a non-US weight of 60%.  Then consciously and logically stay at those weights, or deviate according to your predictions and projections about the future.

Note: The weights in the table above are within the equity allocation alone, and not the entire portfolio.  For example, if the portfolio were 50% equity and 50% bonds, the equity weights shown in the table would be 1/2 of that within the entire portfolio.

In the design process you could use a single fund such as VT for all equities, or VTI for the US and VEU for the non-US.  Or, you could use a collection of funds such as SPY, MDY and IWM for the US, and EFA, EWC and EEM for the non-US portion.  You could become yet more elaborate with US sector or style funds, and with non-US sector, style, region and country funds.

Securities mentioned in this article: VT, VTI, VEU, SPY, MDY, IWM, EFA, EWC, EEM,

Our Current Recommendations:

We have recommended high cash positions since the summer, and we continue to do so.  The current market unpleasantness if not yet over.  We are keeping powder dry for a demonstrated trend reversal and will not be participating in risky attempts to catch the absolute bottom.

When we do return to the equity market, we will be doing so with US and non-US weights representing logical deviations from world weights based on judgement.

Most likely we will split the decision and put one-half to two-thirds of equity assets in a simple array of funds at world weights, with the remainder in an array of tactically selected funds to emphasize this or that sector, style, region or country.

Richard Shaw
QVM Group LLC

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