Acting on Incomplete Information There's More to Dollar, Interest-Rate Decisions By Ernie Ankrim, Chief Investment Strategist Russell Investment Group Global Leaders in Multi-Manager Investing December 15, 2004 This article has been provided by our parent company, and any references to rates or returns are based in $US and specifically relate to US markets. The investing world is filled with observations from participants and pundits that have some element of truth. As interesting as these nuggets may be, they often don't tell the complete story. This year, there have been two clear cases where incomplete information has allowed assumptions to reign over reality. Interest-rate and dollar-value influences have led many investors to take action based on incomplete information. Back in April, when the US Federal Reserve looked to increase the short-term interest rate, people began making assumptions. The usual refrain was something like this: "it's obvious that interest rates are going to rise, and that means that bonds are going to go down, so shouldn't I be moving out of bonds into money markets?" While people were looking for a yes or no answer, the only correct response should have been "it depends." That's because knowing only the direction rates are headed isn't enough information to make a decision. Comparing Alternatives What you really must know as well as direction is magnitude: just how much are rates going to go up? In mid-April, yields on bonds were about 4%. Money market funds were yielding about 0.8%. While it's true, a rise in interest rates generally damages the prices of bonds but not money market funds, comparing the two comes down to returns. The US Fed raised rates, and indeed the yields on money-market funds rose to about 1.4% in the second half of the year. In addition, as expected, bond prices declined. Yet through Dec. 9, the year-to-date return on the Lehman Brothers Aggregate Bond Index, the general measure for intermediate-term bond portfolios, was 4.32%. While this figure is lower than the yields on bonds, it's clear the yield differential bonds continued to enjoy over money markets offset the decline in the value of bonds. The US Dollar Dilemma With the current focus on the US dollar's depreciation, investors are facing the same sort of problem in decisions about U.S. vs. non-U.S. equity allocations. It's true that when the dollar depreciates, a U.S. dollar-based investor holding securities abroad in some other currency will enjoy a tailwind. If the dollar depreciates by 3% and you own euro-based mutual funds, your funds will increase in value by 3% plus or minus the actual return in the locally based currency. Again, while knowing the value of the dollar is declining is helpful information, it's not enough to tell you whether non-U.S. equities are a good opportunity. The following table, based on data from May 1971 through October 2004, shows how the size of the decline can affect the decision. Using the S&P 500 Index to represent U.S. equities, and the MSCI EAFE Index to represent non U.S. equities, we tallied the differential between the two indexes for each 12-month period where the value of the dollar had fallen. We then grouped these periods into four categories:   Dramatic falls in value: between 25% and 35% Significant falls in value: between 15% and 25% Modest falls in value: between 5% and 15% Insignificant falls in value: between 0% and 5% Differential between the MSCI EAFE and S&P 500 during 12-month periods of US dollar declines from May 1971 through October 2004 % of total observations   Foreign currency appreciates by   Difference in EAFE (in $US) and S&P 500 returns         Average   Maximum   Minimum 2%   25% - 35%   42%   63%   20% 7%   15% - 25%   25%   54%   -15% 25%   5% - 15%   8%   37%   -26% 18%   0% - 5%   -0.3%   31%   -29% When the dollar fell between 25% and 35%, the average differential between the S&P 500 and the EAFE was 42%. So it's obvious that at such times, increasing your exposure to non-U.S. equities can be wise. However, over this almost 33-year period, such dramatic falls represented only 2% of all the 12-month observations. And as the magnitude of the fall lessens, so does the average differential between the S&P 500 and the EAFE:   When the dollar fell between 15% and 25% — only 7% of 12-month observations — the average differential was 25%. When the dollar fell between 5% and 15% — 25% of observations — the average differential was 8.2%. When the dollar fell between 0% and 5% — 18% of observations — the effect was negligible as the average differential was 0.3%. While these are the average impacts, the range of how good or bad the impact may be varies widely — into both positive and negative territories. For the dramatic falls, the range varied from 63% on the high (meaning dollar-based investors were 63% better off tracking the EAFE than the S&P 500) to 20% on the low. For significant falls, the range differed from 54% on the high to -15% on the low (indeed, there were 12-month periods where even with the dollar's decline, the EAFE underperformed the S&P 500). And with modest falls, the range varied from 37% on the high to -26% on the low. For current comparisons sake, the euro has appreciated approximately 12% vs. the dollar since September. The dollar recently has traded at an all-time low compared to the euro. Fusion Wins Out What to make from outcomes that are this varied? It all goes back to the wisdom of holding some of everything. Sometimes dollar depreciation rewards investors in non-U.S. equities, sometimes it doesn't, and uncertain propositions are no reason to overweight your portfolio in one direction. That's why my refrain has always been to have some portion of your holdings in non-U.S. equities, in times of both currency weakness and strength. But be careful: knowing that the dollar is depreciating is only an indication that non-U.S. equities may be a little better buy, and having too much of a good thing can work against you if you guess wrong about magnitude. Copyright© Frank Russell Company 2004. All rights reserved. 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