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Friday, July 25, 2014

European Stock Selloff: Noise and Opportunity…or Signal of Worse Times Ahead

European stocks have fallen sharply over the past month. Based on ETFs total returns between June 20 and July 22 the selloff looks like this:
FEZ (Eurozone) -4.5%
EWG (Germany) -3.7%
EWI (Italy) -6.1%
EWP (Spain) -5.3
Over the same period the S+P 500 is up 1.2%

When looking at short term moves of this magnitude it is useful to review the fundamentals and to judge whether a move of this type is “noise” a movement based on short term news but not something that changes the long term picture or a major signal. Markets overshoot and in my view it isn’t often that a large move like this is justified by fundamentals.
Bloomberg gives a good overview of what is going on in the European markets.
Sections in italics are quotations from the article

Germany was the first of the European stock markets to recover from the Euro crisis of 2011. German stocks sold off along with the rest of the Euro zone  during the crisis despite the fact that the largest German companies are world class multinationals( Siemens, BASF, Daimler Benz for example) and not dependent on the Euro zone for their success. The valuation discount of these stocks vs US competitors created an opportunity for investors and the German market recovered as price returned to value.
As Bloomberg notes:
The DAX (German Stock Index)rallied as investors sought safer stocks during the euro area’s sovereign-debt crisis and bet that Germany’s export-oriented companies would benefit from global growth. While the index surged more than 25 percent in each of the past two years, it’s gained only 1.9 percent in 2014, lagging behind the 10 percent jump for Italy’s FTSE MIB Index and the 7.4 percent increase in Spain’s IBEX 35 Index. (IBEX) The Stoxx Europe 600 Index has climbed 4.3 percent this year.
Not surprising there has been a bit of performance chasing as seen in ETF flows:
Traders have pulled almost $817 million in the past six weeks from a U.S. exchange-traded fund holding German companies, while investing $270 million in an ETF of broader European equities, according to data compiled by Bloomberg…. The number of shares outstanding on the Vanguard FTSE Europe ETF (VGK) climbed to arecord 289 million this month, while it fell to 161 million for the iShares MSCI Germany ETF, the least in more than a year, data compiled by Bloomberg show. Traders have pulled almost $1.2 billion from the German fund in 2014, after investing in it for the past five years, according to the data. They’ve added or kept money in the European ETF every week but two since April 2013
There is some logic to investors spreading their assets beyond Germany and elsewhere in Europe. The valuations are more compelling in Italy and Spain and the data particularly from Spain are more encouraging. Both the Italian and Spanish indices include world class multinationals not dependent solely on domestic markets. There is one crucial difference: financials have a significant weighting in the Italian and Spanish indices and there are concerns about financial stability. Nonetheless the aggressive low interest rate and other policies of the European Central Bank (ECB) stands behind those financial institutions.
As the Bloomberg article notes:
Even after this year’s advance, the Spanish equity gauge is 50 percent away from its 2007 peak, while the Italian measure and Portugal’s PSI 20 Index (PSI20) would each have to more than double to recover their highs of that year. Greece’s ASE Index would have to more than quadruple to match its 2007 top.
American investors are willing to gamble on riskier assets in the euro region as they seek better valuations outside their home markets and expect the European Central Bank to continue supporting the economy, according to Raiffeisen Capital Management’s Herbert Perus.
The ECB introduced a negative deposit rate in June as it announced new long-term refinancing operations and said officials will start work on an asset-purchase plan. President Mario Draghialso indicated the central bank’s willingness to do more if necessary.
The fundamental positives for earnings growth seem in place and German and other European stocks are still at a valuation discount to the US:
At the same time, analysts estimate earnings growth for U.S. companies will be smaller than for European ones. Profit will climb 11 percent for those on the S&P 500 in 2015, compared with a 14 percent gain for the DAX, according to the average projection compiled by Bloomberg. Those listed on the PSI 20 will see a 43 percent jump in earnings next year, while they will rise 21 percent for the IBEX 35 and 25 percent for the FTSE MIB, the data show
Against the backdrop of positive fundamentals for Europe what explains the large one month selloff?
The major explanation is the heightened tensions between Russia and the Ukraine. Germany has the largest trade relations among European countries with Russia and the Ukraine. This has been the apparent reason for the weak performance of German stocks over all of 2014 but it has been even more pronounced recently.  In fact in the 3 days since the downing of the airliner over the Ukraine the DAX German index fell 2.5%.
A bit earlier in July the prospect of a renewed European debt crisis spooked investors for a brief period due to fears about the financial status of Portugal’s Espirito Santo Financial Group SA. Was it noise? As of the the market close in the US on July 24 both the Italy(EWI) is 3.8%  above its recent low closes on July 17.. Spain(EWP)is 3.6% above its low on that date

As seen from the one year charts below for EWI (Italy) EWP (Spain) EWG (Germany) and FEZ (Euro zone) all are still significantly below their recent highs.I have added the 200 day moving average to the charts. This is a widely used indicator as a buy sell signal. Those interested in a discussion of the use of moving averages as a meand of trend following/capturing the momentum factor might be interested in looking at the work of Mebane Faber here




Monday, July 7, 2014

Time for Earnings Season Will Disappointments Come...And Would it Even Matter For the Markets

As the WSJ reports in an article with the headline 

Time for U.S. Firms to Earn Stock Investors' Faith

Some Say Revenues and Profits Must Accelerate to Sustain Rally

...we are entering “earnings season” for reports of second quarter earnings of corporations with projected earnings at very high levels:
The Dow Jones Industrial Average broke through 17000 for the first time ever last week, powered by an upbeat jobs report that was the latest in a string of strong U.S. economic indicators. That helped cement investors' view that the weakness caused by severe weather in the first quarter was behind them.
Now, with stocks trading at their highest levels in seven years when compared with expected earnings, some investors say corporate revenue and profits need to accelerate to sustain the rally, especially as the Federal Reserve continues to pare back stimulus measures
To be sure, some investors still consider valuations to be stretched despite selloffs in some corners of the stock market in recent months. The S&P 500 is trading at 15.7 times its expected earnings for the next 12 months, the highest since July
The article cites some favorites among fund managers
Mr. Luttrell is holding on to so-called growth stocks such as Facebook Inc., FB -1.46% PCLN +0.23%  and Google Inc. GOOGL -0.32%  that sold off steeply in March and April amid concerns that the shares were overvalued. Valuations of these stocks have fallen to reasonable levels, and they could start to look more attractive if those companies report strong earnings, he said.
Another manager in the article  cites Kroger and Netflix as his top holdings,
Kroger's second-quarter profits are expected to rise 1.7%, and Netflix's are forecast to more than triple
Tough to consider most of the above as deep value stocks...and their earnings are certainly subject to a fair amount of variance vs expectatons/forecasts.
Good earnings reports are needed to justify current valuations…and the Fed is at the end of its easing cycle….does that equal a positive outlook for a further rally??
Price may eventually return to value, high current returns historically are followed by historically low returns…but also research indicates there is a momentum factor to financial markets….
That is why forecasts of near term market performance is near impossible

Friday, July 4, 2014

Mid-Year Review of the Markets June 30, 2014

The first half of the year ended with virtually all markets around the world --both stocks and bonds showing strong performance. The explanation for most of these moves centered on the “no one else to put your money” rationale with interest rates low around the world.  In early June the European Central Bank began an aggressive policy of unprecedented low interest rates . In the US sentiment in the markets is that the Federal Reserve won’t be raising rates for an extended period of time. As a consequence money flowed into stocks and riskier portions of the bond market.

US Stocks.
·         The broad US stock market once again put in a strong performance the US total market index (ETF ticker VTI) is up 7% ytd. Large cap value stocks and small cap value outperformed the overall market.
·         By virtually all measures the US stock market is highly valued vs historical levels.
The continued strength of the market can be attributed to:
·         Current low interest rates and little indication the Federal Reserve will raise rates in the near future. This is seen as a positive for us stocks.  The low rates also produce a “nowhere else to put your money  movement. The large moves in high dividend stocks such as utilities drawing investor interest and high valuations indicates investors looking for alternatives to low yielding bonds
·         Paradoxically stock prices seem to reflect optimism on the US economy.  But clear signs of a recovery would lead to higher interest rates…a negative for stocks.
·         Momentum: momentum is certainly a factor affecting market returns in the short term. At this point the US market shows strong upward momentum including flows into the market who have missed much of the stock market’s gains by avoiding stocks.
·         The combination of high valuations and a momentum driven market creates the conditions that could easily lead to a market selloff even if only short term. In the long term price reflects value and US stocks carry high valuations.

International Stock Markets
Emerging Markets:
·         After an extended period of underperformance vs the US, emerging markets have had a sharp rebound this year. Emerging Asia (etf GMF) is up a bit more than the US this year although the overall emerging markets still lag (etf IEMG).
  •            With interest rates low around the world the fears associated with the negative impact of higher interest rates has dissipated.
  •          Sentiment towards economic fundamentals in many parts of the emerging economies has turned more positive.
  •          Emerging markets show the most attractive valuations globally trading at a valuation discount of around 25% vs the US and 20% vs the broader European market

Emerging markets are characterized by large “hot money flows” quick to sell in down markets and quick to buy in when performance turns positive. Judging by data on inflows into emerging market stock funds and ETFs this buying cycle seems to be in place. But investors should make sure they understand the volatility of these markets and have a long term commitment to their allocation in these stocks.
European Markets
·         In early June the European Central Bank (ECB) initiated an unprecedented program of low interest rates and other policies for monetary easing. There is every indication that low European rates will continue well after the US enters into any reversal of low interest rate policies.

  • ·         The June 2012 ECB declaration of “doing all that it takes” to stabilize the European economies set the stage of a strong rebound of European stocks recovering from losses during the 2011 crisis. It remains to be seen what the effect will be on stock markets. But the move immediately led to strong increases in prices drops in yields.
  •        With valuations in Europe lower than US markets and continued low rates it seems the environment is positive towards European stocks.
  •          Although the Euro area index (ETF ticker  FEZ)has underperformed the US year to date it has outperformed the US over the last 12 months
  •        In 2014 both Italy and Spain have rebounded sharply reflecting sentiment that the worst is over in terms of the crisis conditions in the European financial markets of 2011.
  •      T he US central bank is towards the end of its aggressive low interest rate policy and the ECB committed to expanding its monetary stimulus for an extended period into the future. That might set the stage for outperformance of the European markets.

Returns for Selected Stock ETFs
1 yr
3 yr
Total US
Large Value US
Small Value Us
Emerging Asia
Total Emerging Markets
Euro zone

Bond Markets
The “market consensus” of both traders and economists at the turn of the year was that longer term rates would rise in 2014. Perhaps not surprisingly so far this year the market has moved sharply in the other direction.
  • Ten year US Treasury bond rates were at 2.6% at mid-year and reached just under 2.5% during the first half of the year.
  •    Part of the price movement doubtless reflects the reversal of positions by major short term traders unwinding positions aimed at profiting from higher interest rates. The poor performance by hedge funds and others trading in bonds reflects this.
  • While it is difficult to find a rationale for a long term buy and hold investor to buy a ten year treasury bond with a 2.6% yield it does not mean traders might not push yields even lower.
  • The Federal Reserve has indicated that the move to higher short term interest rates will come slower than some may have expected although it will continue “tapering” reversing its purchases of longer term bonds.
  •   In a search for yield investors have moved large sums into riskier assets such as bank loans, high yield bonds and emerging market bonds. As a consequence interest rate differentials between these instruments (spreads) and treasury bonds has narrowed consistently.
  •  Investors adding these assets to their portfolio should be careful to monitor their risk and balance their portfolio with lower risk short duration bonds despite their unattractive current yields.
  •  Investors in emerging market bonds should take into account the high volatility of these bonds including additional currency and political risk.

1 yr
3 yr
Short Term High Yield
Short Term Inv Grade
Short Term Govt
Aggregate US Bond
US Long Tern treasury

Thursday, July 3, 2014

A Not Surprising Result : Active Underprerforms Passive

I like to call it hope springs eternal, Active fund managers constantly insist it is a stock pickers market" and virtually every time active fund managers underperform the market. The argument for "a stock pickers market" is often based on the argument that "correlation between stocks is high therefore more stocks are likely to outperform. The WSJ reports on the first half highlights in red and comments in bold

The SPIVA report from S+P  which is more accurate since in measures performs vs a more specific benchmark (large cap funds vs large cap index etc). The results at the end of 2013 showed under performance in 1, 3 and 5 year performance. Also remember the report studies the percentage of outperformers not persistence of returns thus the active managers that outperform for 3 years may not be the same that outperformed over 5 years.

From the WSJ


Stock Pickers Have Tough Time in 2014


Despite the cry of a "stock pickers" market "dispersion of returns another factor that would increase relative returns of active investors  has been low as well
Correlations between individual shares in the S&P 500, measured over a 60-day period, have fallen to 0.31 this year, according to research firm Axioma. This month, they fell to a three-year low of 0.27. A correlation of 1 means all stocks trade in the same direction. In late 2011, as the euro-zone debt crisis intensified and the U.S. credit rating was downgraded, the measure rose above 0.7.
Still, that hasn't been enough for active managers. Other, more-fundamental missteps have fed into their market-trailing returns: The economy hasn't accelerated as quickly as many had anticipated, and investors overall have gravitated toward larger stocks, rather than the small stocks that many active pickers tend to buy.
As for the future...yes hope springs eternal
Fund managers say that a rebound in smaller stocks would help active-management returns. Others are looking to the resurgence in mergers and acquisitions this year, which allows portfolio managers to make bets on potential buyout targets.