This last result is of particular note. Using historical data, an in-
crease in correlation between U.S. and EAFE returns lowers the attrac-
tiveness of foreign investing. And there is evidence that the short-run
correlations between U.S. and foreign markets have been increasing. A
two-year moving average of the correlation coefficient between the
United States and the EAFE is shown in Figure 10-3. The correlation rose
dramatically in the early 2000s, and it has dropped a bit since. Critics of
foreign investing often cite high correlations as a reason to keep foreign
stock exposure low.
But this is not necessarily so. The impact of increased correlation on
the allocation can be reversed with only a slight change in assumptions.
If EAFE returns are expected to be only 60 basis points higher than their
historical average, or the expected risk of foreign stocks slightly lower,
then an increased correlation will actually raiseyour foreign allocation.
This occurs because under these altered assumptions, investors would
be receiving a better risk-return trade-off in foreign stocks than they re-
ceive in U.S. stocks. Hence, the more correlated foreign and U.S. mar-
kets, the less attractive U.S. stocks are.
172 PART 2 Valuation, Style Investing, and Global Markets
FIGURE10–3
The Correlation between U.S. and EAFE Stock ReturnsTwo-Year Correlation Windows-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Correlation Coefficient197219741976197819801982198419861988199019921994199619982000200220042006