The first quarter was a very strong one for US equity markets
with far weaker performance outside the US:
US total stock market (ETF
VTI) 11%
Developed International Markets (EFA) 3.7%
Emerging Markets (VWO) +
3.7%
If the US market
rally continues at this rate for the entire year it would mean increase would represent a 40% + gain for 2013
which Is to say the least highly unlikely.
We remain skeptical of the recent price increases and within
the discipline of our long term strategy have reduced our exposure to US
stocks.
What are the common explanations for the market rally?
Here is a rundown of
the “conventional wisdom” and my skeptical response
·
Because
of low interest rates and uncertainty outside of the US investors have “no
place else” to put their money.
True,
US interest rates are at record lows and the high valuation of many high
dividend stocks that considered stable but low growth indicates many investors
are ---erroneously in my view—looking at dividend stocks as a substitute for
bonds. Indicative of this is that
consumer defensive stocks considered slower growing, but higher dividend stocks
and utilities are top performing sectors year to date. These stocks generally
trade at a valuation discount to the SP 500 but are now trading at premium of
over 10%.
The
curious part of this explanation is that the bond market as reflected in market
prices —and the conventional wisdom of the bond market analysts—is that the end
of the Feds aggressive easing policy is nearing. So if the equity rally is
because of low interest rates and bonds are
highly risky due to the prospect of higher interest rates it seems that low interest
rates are a thin reed upon which to base a 10%+ rally over 3 months…the message
of the bond market that the major declines in interest rates are behind us.
·
A “great
rotation” is occurring in which investors are returning to stocks after missing
most of the markets recovery
Great rotation is too strong a term
particularly if it represents the beginning of a long term major return of
individual investors into the stock market. Anecdotal and fund flow data
definitely do show movement of individual investors back into stock funds and
ETFs. But individual investors (and the fund managers who try to “catch up”
with the market to avoid outflows and attract inflows) can be a fickle lot and
many of them will likely flee from the market at the first sign of a selloff.
·
Price
Momentum: Markets definitely have a momentum factor in which short term
trends are self-reinforcing. That makes market timing –trying to pick tops and
bottoms—virtually impossible. But high returns make markets more risky, price
can deviate from value in the short term and markets tend to revert to the mean.
High current returns and valuations portend lower returns in the future. All
this means that rebalancing makes sense
in response to large market moves (in this case selling stocks and readjusting
allocations) but moving all in or all out is
not a path for long term investing success
·
Improved
economic outlook in the US. At the end of the 2012 all the conventional
wisdom was forecasting a reversal of the modest of the emerging economic
recovery due to the sequester, payroll tax increases and assorted other woes.
None of this has changed since the turn of the year , yet the market has shown
the strong performance. Macro-economic data particularly in housing show the
economy has likely bottomed. But the growth prospects are still modest at best,
the employment data and consumer spending and confidence data don’t point to
anything close to economic growth above 2.5 -3% with the potential for negative
surprises larger than those for unexpectedly
good news. The anemic employment figures
released on April 5 are a good sign of how fragile the recovery is.
Furthermore, the stronger the economic data
the greater the prospects for a change in Fed policy….and higher rates are
unlikely to be good for stocks.
·
Improved
corporate profitability: corporate
profitability has improved led largely by the recovery of the devastated
housing and financial sectors. Consumer spending has not shown a major upturn.
Furthermore,
investors have been bidding up the prices of stocks of large cap high dividend
payers many of which are major multinationals with large portions of their
revenues coming from outside the US. If the message of the European and
Emerging economy equity markets is for slow growth and profitability among
those companies there has to be a limit to the prospective profit growth of US
multinationals like Procter and Gamble, Ford and McDonalds who depend on
foreign markets for a large portion of their profits.
·
US
markets attractive vs. the rest of the world: The
situation in Europe and slower growth in emerging economies certainly raise the
risk levels in these markets…but in a global economy does that mean that equity
holdings in non US economies justify the divergent performance and valuations are
likely to continue?
·
Valuations
are reasonable: At the
end of the day stock prices can go up one of two ways: increased profits or
higher valuations (i.e. one dollar invested buying a smaller portion of future
earnings because of optimism about the future).
The
best long term measure of valuation is the CAPE or Schiller P/E ratio which is
based on the average of 10 years of earnings.
Markets with high valuations as measured by CAPE have shown to have poor
investment returns going forward. The current US S+P 500 P/E are 23.18 well above
the historical mean of 16.47. The Price earnings P/E ratio based on 12 month
trailing earnings is 17.93 vs. a long term mean of 15.49. In other words the
market is anticipating a sustained recovery in earnings….despite economic
uncertainty around the world. It is hard for to see the US market as
undervalued.
Based
on most valuation measures the US market is highly valued although certainly
not at “bubble” levels Despite
appearances …the higher the market returns the higher risk and the lower
the prospective returns indicating
caution is in order and the prospects of a “correction” in the near term is high.
Will
the pattern of recent years with a selloff after a first quarter (see below) repeat itself?
With the large price indices of the past quarter….it seems a reasonable
scenario.
.
Investment
implications my general investment
approach makes use of portfolio rebalancing, but large scale
market timing and believes that “price and value” can deviate in the short term
but revert to the mean in the long term. My current outlook and strategy is based upon: Rebalancing between asset classes has been
shown to increase return modestly and at lower risk (volatility)
Rebalancing
portfolios A rebalancing strategy would take some profits on equity
positions and moving to fixed income
(more on fixed income strategy in my next email) in order to keep portfolios
slightly underinvested in equities vs. target allocations. Of course investing
this way goes the opposite of the tendency to buy into momentum. That strategy
runs the risk of buying high and selling low. Although rebalancing certainly
runs the risk of missing out on some of the moves due to momentum…as has likely
been the case for rebalances that have missed the most recent part of the
market’s strong rally.
Global
Allocations
With global valuations as follows (relevant
ETF listed in parentheses) price/prospective earnings
US S+P 500 (SPY) 13.5
Europe (VGK) 11.3
Germany (EWG) 12.8
Emerging Markets (IEMG) 10.95
Emerging Asia (11.38)
It is hard to find a rationale for favoring
US over non US stocks for the medium to longer term.
The major US and European indices are
heavily weighted with global multinationals that compete with each other around
the world; it is hard to rationalize European multinationals trading at a 15%
valuation discount to the US peers.
Emerging market economies have slowed from
their very rapid growth of previous years but still have stronger long term
growth prospects than the US. These
indices include both major multinationals such as Samsung as well as domestically
oriented companies like China mobile. Growth has slowed significantly in China, India,
South Korea and Brazil but longer term growth prospects and demographic trends
remain positive.
Ironically one of the hot “new ideas” for
investing is to invest in merging market corporate government and corporate
bonds because of the better economic fundamentals vs. the US. If that is the
case and if the major growth market for US multinationals is in the emerging
economies then a longer term perspective would see emerging market stocks
trading at a 20% discount to US stocks as a buying opportunity.
A valuation based investor looking to
initiate new equity positions would likely look outside the US and rebalancers
might wind up selling US stocks and adding to their international allocation.
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