What are American investors doing?

That may be changing. According to research by ING, global markets tracked the U.S. with a correlation coefficient of 0.93 between 2003 and 2005. In the most recent two years ending in February, though, the correlation has dropped to 0.63. If we assume stock valuations will track growth, and if we also assume the long-term decline in the dollar that started in 2000 is not going to end any time soon, the sensible thing to do is to invest internationally. And that is exactly what American investors are doing.

According to the most recent capital flow report from the Treasury, foreigners bought $13.5 billion in U.S. equities in February, the latest reporting month, down from $22.8 billion in January. At the same time, though, U.S. investors bought a net $15.3 billion in foreign equities, up from $13.2 billion in January. Americans have been steadily increasing the amount of foreign equities bought since 2004. Stock market indices are not correlated with currencies, at least not consistently, with the one great exception of the yen and the Nikkei.

This, too, has some fundamental logic. Most of the Nikkei 225 companies are exporters such as Sony, Canon, the car companies, and the chip-makers. When the yen falls, these companies can sell more goods abroad, and sometimes cut prices. If the yen has just fallen, you can fairly reliably expect the Nikkei to rise the next day, and vice versa. Usually the correlation (which is an inverse one) is more than 0.95, depending on what period you are looking at (Figure 4).

Note that foreigners are an important component of the Japanese stock market, holding upwards of 40 percent of total equities while holding only about 4 percent of Japanese bonds.