Going Ever More Global

More of the S&P 500's revenues are coming from overseas. But international diversification still pays

Thanks to increasing globalization, roughly 44% of the S&P 500's 2006 revenues came from international sources. This compares to only 32% in 2001. The energy sector has the largest international exposure with 55.9%, followed closely by information technology with 55.2%. Interestingly, the exposure for the influential financials sector is a mere 30.9%.

Despite the housing-driven slowdown in the United States, overall global growth is surprisingly robust, as European and Asian economic momentum continues unabated. According to data from the International Monetary Fund (IMF), the U.S. represented only 12% of 2006 global GDP growth - highlighting the importance of global revenue diversification for U.S. multinationals.

As S&P 500 sales become increasingly internationally diversified, U.S. companies are better able to capitalize on overseas strength. At the same time, they can minimize the negative impact of the downturn in new housing demand at home.

We saw this dynamic at work in the first quarter. S&P 500 earnings growth of 8% significantly exceeded the 3% analysts expected heading into the earnings season. For the second quarter, S&P analysts expect earnings growth of 5.7%, dropping to 2.4% in the third quarter. S&P Equity Strategy believes rising foreign sales exposure, amid continued international economic momentum and a weakening U.S. dollar, will continue to act as a support to earnings.

Even so, S&P Equity Strategy does not believe the S&P 500's increased international sales are a substitute for international equity portfolio diversification, for three reasons.

First, foreign companies are valued based on local political, economic, and regulatory conditions that do not impact the valuations of U.S. multinationals to nearly the same degree.

Second, we think currency diversification represents a major reason for owning foreign stocks. Many U.S. multinationals dilute this opportunity for diversification by hedging the currency risk associated with their overseas revenue, undermining their ability to leverage a weakening greenback.

Third, S&P believes foreign companies tend to reinvest locally for growth, thereby boosting their long-term prospects, whereas U.S. multinationals repatriate much of their overseas revenue to fund domestic share buybacks and dividends. After spending a record $431.8 billion on buybacks last year, S&P 500 companies spent an additional $117.7 billion on buybacks in the first quarter, putting 2007 on a pace for another record. Similarly, S&P 500 companies spent $58.3 billion on first-quarter dividend payouts. This means 2007 could eclipse the 2006 dividend record of $224.25 billion.

S&P Equity Research maintains its 65% equity allocation, divided between 40% U.S. stocks and 25% foreign issues. Our U.S. allocation includes 34% in large caps (SPY), 4% in mid-caps (MDY), and 2% in small-caps (IJR). The international allocation includes a 17% weighting in developed overseas markets like Europe, Australia, and Hong Kong (EFA); a 5% emerging market weighting (EEM), which includes China, India, South Korea, Taiwan, Latin America, Eastern Europe, Africa, and the Middle East; and a 3% allocation to Japan (EWJ), reflecting its low 0.28 correlation to the S&P 500.

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