Oberservations and Outlook July 2017

Selected Index Returns 2nd Quarter/ Year to Date
Dow Jones Industrials    3.95%/ 9.35%          S&P 500   3.09%/9.34%         MSCI Europe   7.37%/15.36%

Small Cap (Russell 2000)   2.46%/4.99%     Emerging Mkts  6.27%/18.43%     High Yld Bonds   1.37%/15.3%

US Aggregate Bond 1.45%/2.27%   US Treasury 20+Yr   4.18%/5.66%    DJ/UBS Commodity -3%/-5.26%

2017 and its second quarter continue to be kind to financial assets, with both stocks, bonds and gold all climbing year to date.    European and Emerging Market equities have been the strongest this year, rising smartly after falling by 10% during the second half of 2016.  Emerging Market equity funds are back to a price area that stretches back to 2009!

Bonds continue to vacillate in an upward trend since mid-December. The commodity index is down primarily due to oil, as agriculture and base metals are essentially flat on the year after a recent climb.

Correlations between stocks and bonds have increased recently, with equities being flat over the past 6 weeks as bond prices have declined over the last two weeks.   While this phenomenon is negative for investors, equities appear to remain well inside their uptrend while bonds (and gold) appear to be near medium-term support levels.  We may see both stocks, bonds, and gold again climb concurrently reflecting a continuation of the year to date behavior.

What has been driving stock prices?  Growing earnings, low interest rates, lack of inflation, and ‘moderate’ GDP growth are the most common reasons to explain how prices have gotten to these levels.  Earnings have been on the rise since the end of the ‘earnings recession’ that lasted from June 2014 through March 2016.   After a decline of some 14% we’re now growing again, even robustly, given the low base from the previous year.  Earnings are still one or two quarters away from hitting new all-time highs, yet the S&P500 is roughly 20% higher than in early 2015.  The chart below gives us a visual of what prices rising faster than earnings looks like. Anytime the ratio is moving up indicates prices climbing faster than earnings.

shiller cape 6 30 2017Source: www.multpl.com

By this metric (and there are many others) stocks are valued at a level only exceeded by the roaring ‘20s and the dot-com era.  Can earnings continue to grow to support valuations?  The continued lack of wage growth and continued generationally low labor participation rate are headwinds to growth in consumer spending.  Consumer credit growth has slowed dramatically over the past six months and without wage or credit growth it’s difficult to see how the consumer will spend more to support ‘moderate’ GDP growth.  Low interest rates, or the comparison of low rates to dividend and earnings yield have provided much support over the past several years to the reasoning behind bidding up stocks faster than their earnings growth.

Interest rates bottomed one year ago at 1.3% (10-year treasury) and then ran up to 2.6%, mid-range since 2010 and the upper range of rates since late 2013.  The jury is out still on whether this marks the end of the bond bull market that has lasted since 1981.  The problem is that if consumers and businesses must increase their interest expense, there is that much less left to expand their consumption and investment.   Low rates had been a key enabler of more borrowing, leading to more consumption, and higher profits.  Now, in some areas, analysts are saying that higher rates are ALSO good for stocks because it represents growth expectations.  Frankly we’ve been ‘expecting’ growth now for several years, and the only positive representation of growth (GDP) we have seen is due to a willful under-reporting of inflation.   Gains in expenses in housing, healthcare, and education have far outstripped the general inflation rate.  At the same time, official statisticians tell us our TVs, cell phones, and other tech devices are far cheaper, because we ‘get more’ for our money.  This is called hedonic adjustments.  Look this up and you will understand why one’s personal experience with the cost of living doesn’t mesh with the official inflation statistics.

It seems the main reasons we are given for buoyant stock prices appear tapped out or stretched.  The thing is, it’s been like this for a few years now.  So then, what really is driving prices?  Some of it has to do with FOMO, Fear Of Missing Out.  No one wants to get left behind as prices rise, even if said prices already appear expensive.   As fundamentals have deteriorated over the past few years what is causing or who could be that marginal buyer who always seems to have more money to put towards financial assets? Perhaps this chart has something to do with it.

Central-Bank-Balance-Sheets-Versus-MSCI-World-Index

As central banks have purchased outstanding bonds (and equities in the cases of Japan, Switzerland and Israel among others) the cash or liquidity provided has found its way back into the equity markets.  Additional effects have been to put a bid under bonds, increasing prices and lowering rates.  What many investors in the U.S. don’t realize is that the European and Japanese central banks continue to this day putting approximately $400 billion per month into the financial markets.  If this is the true reason behind stock and bond price levels today, any cessation, slowing or even anticipation of slowing will likely have negative effects on asset prices.  The chart below shows where the U.S. Fed ended its QE efforts while Japan and Europe picked up all the slack and then some.  The astute observer can see where the Fed tapered, while the ECB was not adding liquidity, from 2014 to 2015.  From mid-2014 to early 2016, the Vanguard FTSE Europe ETF dropped by 29%.

central bank buying 4 2017

Beyond central bank liquidity creation there is also the concept of growth in the private sector.  Here too we see that a phenomenal amount of debt must be created to sustain growth.   New debt creation in China dwarfs the rest of the world.  China has put up high growth numbers the past several years, more than 7% annually.

private sector debt creation qe

Going forward it will be crucial to watch for central banks’ behavior as to ending current ‘QE’ policies.  Japan is still committed to a 0% 10yr bond rate, yet the ECB has begun to state that its bond buying won’t last forever, and is likely to slow by mid-2018.  The U.S. Fed has indicated continued tightening via rate hikes (likely one more this year) and to begin to let ‘roll off’ maturing bonds.  The roll-off will take liquidity from the markets.  It will start small and gradually increase in 2019 and thereafter.  These cessation tactics are done under the current understanding that financial conditions are ‘easy’.  Put another way, the banks will start to slow new liquidity and then drain liquidity as long as financial conditions, which include stock market levels, don’t get to difficult.   What exactly is the Fed’s downside tolerance is unknown.  What is knowable, is that the decision-making process takes months to be put into effect and by that time, markets could move down and growth could halt.

Near Term vs Long Term

The concepts of credit creation and central bank balance sheets and their respective monetary policies are will have impacts on asset prices over the longer term.   Year over year earnings growth forecasts, specific companies’ ‘beats’ or ‘misses’ and monthly data on inflation, job growth, and wages all have short term impacts on the stock market.  Currently, earnings are expected to grow robustly, official inflation is subdued and official unemployment are all in the “very good” range.  Combine that with the Fear Of Missing Out concept and that should help keep the markets up and even higher for a while longer.  The problem is that simply because we want markets to move higher doesn’t mean they will.  At some point paying 30x earnings will seem too expensive and the markets will lose some marginal buyers and some will become sellers, for whatever reason.   Based on current valuation metrics and the business cycle, we know that equity returns over the next several years will be very low.  If rates go up, and/or credit (the ability to pay) worsens for individuals and businesses bond funds will likely suffer as well.  Over the long term, avoiding large losses or drawdowns, even while lagging the market on the upside, can have a dramatic positive impact over a full market cycle.

What Can Be Done

If one suspects returns will be lackluster, and prices volatile, should one endure it?  The solution is at once simple and difficult at the same time given our cultural of equity ownership and the media’s constant focus on one asset class: equities.

Diversifying amongst the other 6 asset classes is a start.  Most advice revolves around two classes, stocks and bonds.  If one truly wants to buy low and sell high, one must identify the other areas that are “low”, increase exposure there, and reduce exposure to “high” asset classes.  Not only does this smooth out volatility but can increase long term returns.   Given the outlook for more volatility in stock and bond prices; very low prices (historically and relative to other assets) in precious metals, agriculture and oil; there should be many opportunities to take advantage of short term swings to benefit and move some ‘eggs’ from the equity side into other, non- and lower-correlated asset classes that are currently much lower in price.

Easier said than done, yes.  This is exactly why investors should seek out Investment Advisors willing to do this difficult work and that have a strategy to deal with changing markets.  For more information on how I am doing this for my clients, please contact me.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

International Investing – Looking Abroad for Better Returns

With the upcoming Memorial Day kicking off the start of summertime, and 1st quarter earnings season wrapping up, it appears all is well and good, at least outside of the political kabuki theater in Washington. There’s a chorus of animal spirits driving optimism by corporate leaders and consumers alike, which is in turn driving business investment and household consumption and savings.

And it’s not only happening in the U.S. as we’ve seen strong earnings growth and positive surprises across industries and geography – evidence that we are experiencing a bout of synchronized global expansion.

To me, a more broad-based recovery is welcomed as it eases worries of a maturing U.S. business cycle that may not be able to do as much heavy lifting for the global economy as it has recently. And, given such a constructive global backdrop, stock markets around the world may have further to run.

For a U.S. investor, there are 47 individual country-specific exchange traded products (ETFs and ETNs — https://seekingalpha.com/etfs-and-funds/etf-tables/countries) that one could purchase to garner exposure to a basket of stocks in each of these countries.

Post the global recession of 2008 to early 2009, you could have easily ignored 46 of those specific countries and focused on one – the U.S.

You could use the S&P 500 as a gauge or a broader stock market benchmark that includes broader exposure to mid- and small-capitalization companies like the Vanguard Total Stock Market ETF (ticker symbol “VTI”), providing a more complete view of the U.S market than the S&P 500.

It is remarkable how the U.S. stock market has outperformed the rest of the world over the past decade. Among these 47 individual country stock markets at the close of 2016, VTI ranked # 1 over 10 years, # 2 over 5 years (behind Ireland) and # 1 over 3 years. Until last year, investing outside the United States had been a fool’s errand for an entire decade!

But 2017 may mark a turning point. So far this year, the U.S. stock market sits at a lowly 39 out of 47 with a gain of ~ 7.0% year to date (through May 23rd) for the Vanguard Total Stock Market ETF. Of the other investable markets, 29 of the 47 country-specific funds are up double-digit percentages nearly 5 months into the year.

Home Country Bias

If you are a U.S. investor sticking with the U.S. stock market over the past decade has been easy to do; it also has been a winning bet. But the real reason it has been easy is that most investors suffer from a home country bias – the preference to invest in one’s own country’s stocks.

So what? Today, the U.S. stock market currently accounts for 36% of the world’s stock market capitalization; that’s down from 45% in 2003. So, if you truly want a balanced stock portfolio, you should have 64% (nearly 2/3) of your stock investments outside of the U.S. markets.

Does the idea of investing most of your hard-earned wealth in global stocks make you feel queasy? Of course it does. However, you should invest abroad for the same reason John Dillinger gave when the police asked him why he robs banks: “Because that’s where the money is.”

Global Investing Back in Fashion?

Timing the market is more for the lucky than the smart, but still reversion to the mean is the one rule of investing that, given time, always rings true.

Here’s really simple reasons why I think global stock markets have started just such a reversion.

#1 – U.S. investors despise global stock markets. Chances are you have no interest in investing outside the U.S. in either developed or emerging market stocks. After all, international stock markets have gone essentially nowhere in the past decade. If negative sentiment is a necessary contrarian indicator, you could hardly ask for a better setup.

#2 – International stock markets are very cheap. It is no secret that the U.S. stock market is expensive, valuation-wise, compared to the rest of the world. According to Star Capital Research, the U.S stock market is the 3rd most expensive in the world. Only Denmark and Ireland have richer valuations based on future earnings expectations.

As I mentioned earlier, reversion to the mean. Few things are predictable in investing, but given enough time, cheap stocks will get more expensive and expensive stocks will get cheaper.

#3 – International stock markets have turned up and you probably didn’t notice. Chances are you’ve been focused on U.S. stocks more than ever or the political scene in Washington. After all, the Trump Bump gave many U.S. investors a renewed appetite for risk taking, one that harkens back to the 1990s.

However, solid returns in the U.S. stock market year-to-date tell you nothing about how much money you could have made investing outside our country’s borders.

Is 2017 the year that international stocks begin to make their long-awaited comeback? The signs are as good as they have been for a long time. And, who knows, after a few years of leaving the U.S. stock market in the dust, international investing could cease to be a pariah for U.S. investors.

I suspect more U.S. investors will turn to looking outside the U.S. for superior market returns be it in emerging markets or in developed markets like European bourses where a combination of diminished political risks, cheap valuations, years of underperformance, and a European Central Bank (ECB) that is in no rush to hike rates make the region attractive.

The graphic below from Jonathan Krinsky of MKM Partners LLC and Bloomberg points out that a simple comparison of the Vanguard FTSE All-World ex-U.S. ETF (ticker symbol, “VEU”) versus the S&P 500 ETF (ticker symbol “SPY”) showing massive turnaround potential for the rest of the world to catch up.

After several years of underperformance, economic growth in the euro zone has matched that of the U.S. for the past year or so, and appear to be neck-in-neck (as shown in the graphic below).

U.S. vs. Euro Zone, Change in Gross Domestic Product (GDP), Year-over-Year

More than halfway into Europe’s earning season, 69% of companies had beaten earnings per share estimates vs. 75% of S&P 500 companies in the U.S. Overall, this is a fantastic showing.  According to Morgan Stanley, that’s the best showing in over a decade in Europe.

This marked improvement in economic growth is starting to feed through into corporate earnings and revenue. With 1st quarter results in from more than 250 companies, or about a 1/3 of European stocks by market value, the net number beating earnings expectations is on course to be the highest in more than a decade, according to Morgan Stanley. Those companies beating analysts’ estimates for revenue are set for the best performance in at least 14 years, Morgan Stanley added.

Total Returns, including Reinvested Dividends (in euros) of U.S. vs. European Stocks over Past 1 Year

The graphic above shows that over the past year, a recent run by European stocks (as measured by the Euro Stoxx 600 index) has caught up with the S&P 500 over the past month or so.

Total Returns, including Reinvested Dividends (in euros) of U.S. vs. European Stocks over Past 2 Years

On a longer-term basis of 2 years, however, there’s still quite a way to go before European stocks’ previous underperformance relative to their U.S. counterparts is erased.

The Case for Going Global

The combination of an improved outlook for euro zone growth, a benign inflationary environment and a central bank that’s unlikely to echo the Federal Reserve in raising interest rates anytime soon gives European stocks the opportunity to outpace U.S. returns.

Also supporting the case for European equities is the sheer scale of prior underperformance vs. U.S. stocks. However, the same factors also prevail in other major equity regions, especially emerging markets and, to some degree, Japan. However, political risk also remains a negative reality for Europe on a medium- to long-term horizon, even if the most immediate worries seem to have passed.

In many of my multi-asset portfolios, I have followed a geographically diversified approach to my equity positions this year, elevating exposure outside of the U.S. I view my position within the context of diversifying equity exposure across major regions, reflecting a broadening out of economic growth – a synchronization of global growth, if you will – rather than an outsized bet on European outperformance.

While there is a good chance that European earnings growth will come in as the strongest of any region this year, emerging market equities could well give Europe a run for its money in this regard. Japan, too, should see solid earnings growth this year, particularly if the yen remains weak, as I expect it will.

Valuations look significantly cheap for emerging markets as they do for Europe, particularly in comparison to the U.S. stock valuations. Given valuation metrics, the region that looks more challenged than the rest is the U.S. It is clearly the most expensive of any major equity market, and the upside to earnings growth looks somewhat limited unless we can get fiscal stimulus such as tax cuts, infrastructure spending, and regulatory relief passed by Congress.

But for now confidence remains historically high for businesses and households alike, which probably has more to do with expectations for no new anti-business regulations and taxes than actual legislation getting passed that would make it wildly better. With that said, here at home corporate growth (as measured by the S&P 500) is set to accelerate throughout 2017 to a solid 12.3% and 10.8% in 2018, according to Bloomberg Intelligence data. If that comes to fruition, that would be the biggest 2-year advance since 2012 and would help justify rich U.S. market valuations.

In an environment of strong and broadening global economic and earnings growth, I have assigned greater importance this year to being overweight equities relative to bonds, and I am looking to international markets for attractive returns. And while U.S. equities don’t look as compelling as other regions, I’m maintaining exposure a bit of home bias as there are offensive and defensive qualities as well as comfort that U.S. exposure brings to investors’ portfolios.

I wish you and yours an enjoyable summertime ahead and a reflective Memorial Day for those men and women that served and sacrificed to win or preserve our freedom.

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Disclaimer: The opinions expressed herein are those of the author and/or the sources cited. The article is for general education and information about investing and economic matters. Nothing should be construed as advice, nor any of it considered an offer or solicitation of any kind to buy or sell any investment products. We are not responsible for the accuracy or content on third party websites or sources cited; any and all links are offered only for use at your own discretion; and our privacy policies do not apply to linked websites. Eric Linser, CFA is an investment advisory representative of Green Valley Wealth, a dba of Naples Asset Management Company, LLC, a federally registered investment advisor.