Feb 23rd 2012, 16:46 by Buttonwood
DIVERSIFICATION is always cited as a good thing when investing. Spread your bets, and you will not be exposed to a sudden collapse in a single company, sector of economy. But for equity investors the task is getting harder and harder. International markets seem to be increasingly correlated.
In part, this may be down to the diversification process itself. Investors buy an exchange-traded fund based on the MSCI world index, or US mutual funds venture into more exciting emerging markets. Either way, a loss of confidence among such investors may cause a worldwide sell-off (as research shows).
But it may also be that companies have diversified themselves. The table, from Orrin Sharp-Pierson at BNP Paribas, shows the proportion of corporate revenue that comes from various countries. So, for example, Canadian companies get 11.5% of their revenues from Europe; UK companies get 20% of their revenues from emerging markets.
So let us assume that revenues grow in line with GDP. Combine the mix of revenues, and GDP grwoth forecasts for 2012, and you can figure out how the revenues of national corporate sectors might grow. The result can be surprising. You might assume that the US economy will do better than the UK economy this year. But because of the UK's exposure to emerging markets, UK revenues will actually grow faster.
However, what is striking about the last column is how similar the numbers are; with the exception of non-Japan Asia, they are all in a range of 2.6-4.7%. Diversification does not get you very far.
There is a silver lining to this cloud, for investors at least. The ability of companies to diversify their sources of production means they can control their costs. That may explain why profit margins are so high. Of course, this does not seem quite such a wonderful thing if you are a worker in the West.
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Maybe I'll try diversifying my girlfriends...
There are 2 major factors combining to correlate assets. After Y2K, diversification was touted as the means to prevent the type of losses experienced in tech. People moved into formerly ignored asset classes, converging valuations across asset classes.
High frequency trading is now 80% of trading. They trade by algorithm, since trading is too fast for human intervention. When translated into machine language, diversification means correlation. HFT algorithms chase momentum generated by competing algorithms.
Super charged by loans from the printing press, leveraged HFT now sets prices, as small investors continue to flee equities.
"The ability of companies to diversify their sources of production means they can control their costs. That may explain why profit margins are so high." This may be a dumb question, but I thought that, in efficient markets, pricing pressure would bring down prices and, therefore, move profit margins back to historic norms. Why is this not happening?
Great graph. And, the emerging markets story, for me, is particularly interesting.
In the meantime, the emerging market funds I follow are having a good 2012 thus far, but had a horrible end-of 2011, and have still not recovered from their highs of 2007.
And, those with exposure to Europe have gotten clobbered.
Perhaps diversification here is following the path of diversification in corporate business: rather than smooth out bad results, the conglomerate generates lower overall results and involves management in a bunch of businesses beyond its ken. I remember hearing GE presentations in which they'd say they'd only keep a company if it were 1 or 2 in its field. That was a rational defense of their conglomerate model, but performance proved diversification binds you to losers and spreads precious expertise too far.
In this blog, our Buttonwood columnist grapples with the ever-changing financial markets and the motley crew who earn their living by attempting to master them. The blog is named after the 1792 agreement that regulated the informal brokerage conducted under a buttonwood tree on Wall Street.
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