Zaks Investment Advisory Service

About Current Events, Emerging Markets and Brazil in Particular

Last Tuesday (February 5), the market fell by about 3.2 percent. One is getting the impression that the market has been remarkably volatile over the past 12 months. Let us take a look at whether this is really the case. A one-day market loss of one percent is quite substantial. There were 43 such cases over the past 12 months (just for the reference, there were 252 trading sessions during that period). Is that a little or a lot? In the 12 months preceding that, for example, the market fell by more than one percent in a day on only 13 occasions. In other words, it is quite clear that the past 12 moths were far more volatile than the 12 preceding ones. Let us compare this with a 30-year data span – as we know, one year is but a drop in the bucket on the stock exchange. On average, there were 28 days when the market fell by at least one percent (compared to 43 days over the past 12 months). So if one follows this criterion, the market really was more volatile in past year than average. There were 15 days over the past 12 months when the market dropped by more than two percent. In comparison, on average, there were six such days in the past 30 years. And what about a decline of more than three percent, as happened on February 5? For today’s Dow Jones index, three percent represents a drop of more than 360 points. There were two such events in the past year: it last happened on February 27, 2007, in other words almost a year ago. On average, though, there have been 1.3 such falls a year. So did we just have a record 12 months? No. For example, between February 4, 2002 and February 4, 2003, the market had seven drops of three percent or more (compared to the two for the past 12 months).

If one tackles this problem using a slightly more scientific approach, one can evaluate daily price fluctuation using standard deviation. In one of our previous programs, we said that standard deviation of the price is a basic criterion of risk: the higher the standard deviation, the higher the risk. Usually, however, risk is evaluated using monthly or annual price fluctuations, not daily ones, even though these are all obviously interrelated. Measuring daily price fluctuations using standard deviation, one finds that over the last 30 years, market prices were more volatile than in the past 12 months eight times.

What conclusions may we draw from this? Yes, the market really was quite volatile in the past 12 months. But we are far from setting any negative records. We can only continue to hope that the next 12 months will look more like 1995, when prices gradually grew without major fluctuations.

And now, let us return to our main subject: emerging markets. Why am I talking about them so much? There are two reasons: first of all, their stock prices have recently experienced strong growth and there are many reasons to believe they will continue to do so, if a bit more slowly. The second reason is related to those very price fluctuations we just discussed: although in and of themselves, emerging market exchanges are more volatile than ours, their prices are not strongly correlated with the US indices. On the other hand, prices on European exchanges are significantly more correlated to our own: they follow one another through the ups and downs. It’s true that some relationship exists between the movement of stock prices on the exchanges of developing countries and those on the US exchanges, but these are not as strong. This is very important to us: we can diversify our investment portfolios using developing countries’ stocks. Even though we add a riskier asset class to our portfolio, because this asset class is not strongly correlated to the core of the portfolio, the resulting mix may be less risky than the original portfolio. I’ll talk about this phenomenon some more in one of the future programs.

In our previous programs, we talked about the economies and financial markets of two nations that form the BRIC group – China and Russia. But although both have a right to brag about the pace of their stock markets’ growth over the past five years, they are not the record-holders, from the American investor’s point of view. For us, the most profitable stocks were found in Brazil. This is a pretty surprising fact: Brazil’s economy is far from the fastest developing, bowing to both China and Russia in this respect. China’s economy grew by about 11.5 percent in 2007, and Russia’s – by 7.5 percent. Brazil, meanwhile, only gained about five percent. And most importantly, if one looks at Brazil’s main Bovespa index on the Sao Paulo exchange, one finds that it gained less in the past five years than Russia’s RTS index. So why was Brazil’s index the most profitable for us?

The whole secret rests in currency exchange rates. We invest in dollars while Brazilian stocks are, of course, quoted in Brazilian reals. And the real exchange rate has shot up over the past five years: one could buy 3.7 reals for one dollar at the start of 2003, but now – only 1.8. In other words, the real has just about doubled in value against the dollar. In the meantime, the Bovespa index has gone up by a factor of more than five. Yet it grew substantially more for American investors – for us, the Bovespa experienced more than tenfold growth!

It is interesting to note that the currencies of China and Russia both strengthened in the past five years, but to a lesser extent. Trying to preserve the competitiveness of China’s export industry, the Chinese central bank has been allowing the yuan to very slowly creep up against the dollar: it has gained just 15 percent in five years. The Russian ruble grew more, but also less than Brazil – by about 30 percent. Higher exchange rates have helped foreign investors in the Chinese and Russian markets, but they helped those investing in Brazil a lot more.

The Brazilian stock exchange is an example of what I just mentioned: its prices are not strongly correlated to those on our exchanges. More specifically, the correlation coefficient between the Bovespa index and the S&P 500 stands at about 60 percent. I will remind you that 100-percent correlation means that prices are moving in unison, a zero correlation means that prices are independent of one other, and a negative 100-percent correlation indicates that prices move in opposite directions: when one goes up, the other goes down.

We will continue our analysis of the Brazilian economy and financial market in our next program. This was Sergey Zaks. Thank you for your attention and until next time.