What is The Market

In order to correctly allocate assets, certain assumptions must be made regarding “The Market.” Often, that term is used within the US to refer to US Large Caps. However, when investing, it is necessary to determine not only an allocation to the S&P 500, but also allocations to US mid and small caps, and international equities as well.

This analysis is focused strictly on publicly traded equities;  no fixed income or other asset classes are included. Additionally, a breakdown of large/mid/small caps is not included.  Although size criteria is generally definitional, it is not trivial, and must also be accounted for in any allocation.

My intent is to examine the global economy from a couple of different perspectives, compare the data to available indices, and understand any differences.

Data is readily available for both GDP and market cap in USD, and these are both relevant measures of economies from an investment standpoint. I have summarized the information from the CIA World Factbook, the IMF, the World Bank, and the World Federation of Exchanges. In order to make comparisons with Morningstar reports, I used Morningstar definitions of Emerging and Developed markets, which means that South Korea and Greece are both classified as Developed Markets.

This is a top down view of the world’s economy:

GDP (IMF, WB) GDP, PPP (IMF, WB, CIA) Market Cap Min – Max
IMF (2015 est) WB (2014) IMF PPP (2015 est) WB GNI PPP (2014) CIA PPP (2014) WFE (2015) WB (2012) CIA (2012)
US 25% 23% 16% 17% 16% 40% 40% 31% 16-40
Europe + Asia Developed 33% 34% 24% 25% 25% 35% 34% 39% 24-39
EM 40% 41% 58% 57% 58% 25% 23% 26% 25-58
Americas 33% 33% 26% 26% 26% 40% 46% 39% 26-46
Greater Asia 34% 31% 41% 41% 40% 37% 31% 35% 31-41
>Asia EM 23% 20% 33% 33% 32% 19% 14% 15% 14-33
Greater Europe 33% 36% 33% 33% 33% 21% 23% 26% 21-36
>Europe EM 5% 6% 7% 8% 8% 0% 1% 3% 0-7
>Africa/Middle East 6% 7% 10% 9% 10% 3% 5% 4% 3-10
China 16% 13% 17% 17% 17% 12% 9% 10% 9-17

For comparison, here are 3 indices for the Global Market.  I have included the economic Min – Max numbers for comparison:

Economic Min – Max FSTE Global All Cap MSCI ACWI All Cap S&P Global BMI Index Min – Max
2016 2016 2016
US 16-40 53% 55% 51% 51-55
Europe + Asia Developed 24-39 38% 37% 38% 37-38
EM 25-58 7% 7% 8% 7-8
Americas 26-46 56% 57% 55% 55-57
Greater Asia 31-41 20% 20% 21% 20-21
>Asia EM 14-33 5% 4% 5% 4-5
Greater Europe 21-36 24% 24% 24% 24%
>Europe EM 0-7 6% 6% 1% 1-6
>Africa/Middle East 3-10 1% 1% 1% 1
China 9-17 3% 3% 3% 3%

These do not match up very well.  The reason for this is that the top down economic look does not include any adjustment for whether or not an outside investor can safely purchase shares of the available stock.

The indices are all constructed similarly, using screening methods.  They all begin by examining every stock market and country in the world.  MSCI has a very detailed look at how they evaluate countries, here, and so does FTSE, here. The criteria are intended to determine if they are allowed to purchase stock there at all, and if so, are the trading rules fair for all participants, and are the investors all equally protected under law.  Once the constituent countries are determined (47 for the S&P, 79 for MSCI, and 46 for FTSE), then a stock screening process begins.  Float adjustments are made, and minimum cap size and trading volume screens are applied.  The end result of equities are then cap weighted within the index.  S&P holds 11,803 stocks, MSCI has over 14,000 and FTSE includes just over 3000.

It’s amazing how similar the three global indices are to one another, and how different they are from the economic data.  The two most obvious issues are the overweighting of the US market, and the underweighting of the Asian EMs (specifically, China).

Is this really a problem?  There is a lot of economic activity taking place that crosses borders.  If you own a stock that does a portion of its business in a foreign country, is that the equivalent of owning some stock from each country?  Currently the US exports approximately 13% of GDP, while China exports 30% of its GDP.    In 2011, 18% of  US workers were employed by US based multinational corporations, and an additional 5% were employed by US affiliates of foreign owned multinational corporations (source).  And it’s not just the US.  According to McKinsey & Company, 36% of global GDP crossed borders in 2012, and thanks to the internet, it isn’t just the big companies.

There are other considerations, as well.  In some European countries (Germany, for one,) many small and medium size businesses do not go public with the same frequency as in the US.  The market cap to GDP metric can be used as an estimate of how fairly valued a market is when compared to itself over time, but it might also give some idea of public versus privately held companies when compared country to country.  Here’s an example:

fredgraph4

What may be happening here is the US has a larger percentage of companies that are public compared to other countries.  So if you want to own the world market, do you want a higher weight of US companies simply because they are more likely to have issued equity?

This is not only an issue with the “Global” indices.  Be sure to examine the details of any index you intend to use.  Emerging market indices, in particular, suffer from these same issues.

Thanks to the many country and region specific indices out there, along with the index funds and ETFs that replicate them, you don’t have to settle for the world market defined by the major index providers.  It is possible to create a portfolio that matches whatever you think is the best representation of the world market.

 

 

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