A Farewell to Europe? Not So Fast

IN 2008, during the worst of the financial crisis, portfolio diversification was of little help to stock investors as equity markets fell almost in lock step around the world.
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Today, it’s a different story. For the first time since the global credit crisis, spreading one’s bets across different geographic regions is proving worthwhile. For example, while European equities have fallen around 5 percent so far this year — resulting from concerns over the ability of Greece, Portugal and other nations to manage their debt — domestic shares and Japanese stocks have gained more than 2 percent.

But what should investors make of this? Should they continue to diversify their portfolios — or simply reduce exposure to lackluster European equities?

It may be tempting to ditch European stocks. After all, Europe is expected to be one of the slowest-growing areas of the world in the next several years. (Its economy is expected to grow just 1 percent in 2010, compared with 3 percent for that of the United States.)

Moreover, stock markets in that region have become highly correlated with the Standard & Poor’s 500-stock index, thanks to the increasingly interconnected global economy. That means European stocks aren’t likely to zig when domestic stocks zag.

Nevertheless, many market strategists warn that jettisoning stocks from such a big chunk of the world, which represents more than a quarter of global stock market value, would be a big mistake.

For starters, doing so now would simply be locking in losses that have already occurred. “If you have extraordinary predictive capabilities and can see which regions will zig and which will zag, then yes, you don’t have to be fully diversified,” said Greg Schultz, a principal at Asset Allocation Advisors, a financial planning firm in Walnut Creek, Calif.

But without that ability to see into the future, it’s risky to make decisions by looking in the rear-view mirror, he said.

What’s more, as painful as it is to see some portion of your portfolio lose value, it’s actually a good sign when different asset classes move in opposite directions.

“I don’t want everything I own to go up all at once, because it stands to reason that if everything goes up at the same time, then the reverse can be true and everything can lose value at once,” said Mike Scarborough, president of Scarborough Capital Management, an investment advisory service in Annapolis, Md.

Remember that it wasn’t so long ago that European shares helped keep investors’ portfolios above water in a lousy decade for stocks. Between Dec. 31, 2001, and Dec. 31, 2009, when domestic shares were largely flat over all, the Morgan Stanley Capital International Europe index returned around 7 percent annually.

While this trend has reversed this year, there are other ways that European equities can help diversify a portfolio.

Betting on European stocks is a way to hedge one’s currency exposure. To be sure, there’s little appetite to bet on the euro now, after it has lost 6 percent of its value against the dollar since the start of the year.

But Mr. Schultz asks: “Can you tell me that you really know for sure that the euro will be stronger or weaker a year from now? How many people saw this year’s rally in the dollar coming?”

And by diversifying their exposure to Europe, investors can mix up the way they earn their money. European stocks are currently paying among the highest yields in the world — more than 3 percent, versus around 2 percent for the S.& P. 500 — which means they generate a greater percentage of their overall returns through dividends.

“Dividends are as important a driver as price movement,” said Alec B. Young, international equity strategist at Standard & Poor’s.

Indeed, between Dec. 31, 1969, and the end of last year, domestic and European shares appreciated by nearly the same amount, but European stocks enjoyed a total cumulative return, including reinvested dividends, of 6,016 percent, versus 4,258 percent for domestic equities, according to S.& P.

Ben Inker, director of asset allocation at GMO, a money management firm in Boston, added that yet another reason “you need Europe is that the valuation cycles are different.”

In other words, European stocks and American equities are considered cheap at different times. For example, at the beginning of 2001, European equities were trading at a price-to-earnings ratio of 18, versus 25 for the S.& P. 500. Not surprisingly, European shares wound up outgaining domestic stocks, 53 percent to 11 percent, from 2001 through 2007. Similarly, in 1995, the S.& P. 500 was trading at a cheaper level, a P/E ratio of 16 versus 19 for European stocks, and wound up trouncing that region’s market for a six-year stretch.

After this most recent sell-off, Mr. Inker said, “Europe is again cheaper.”

“The reason to have Europe in your portfolio is certainly not because there’s any reason to expect its economy to do better than the U.S. economy,” he added. “It’s because you’re getting things at a discount compared to the U.S. And I like getting deals.”