May Turn Up in Stocks Likely to Last

After a very volatile correction lasting just over 4 months, May 3 marked a turn up in markets.   During the correction some indices made consecutively lower highs, and either higher lows (creating a triangle formation, small cap indices) or held at support multiple times (large cap stocks).    May 3 saw a price reversal and only a few days later many indices were making higher highs, breaking up through the downtrend.  During the rest of May stock price marched higher, despite on going geopolitical concerns and a disruptive Italian bond market.

International stocks also turned up early May, but were thwarted by the ongoing difficulties, politically and regarding the US Dollar strength.   Ex-US stocks appear to have retested correction lows at the end of May but have yet to catch up to US markets in exceeding high-water marks during the January-April correction.

Drivers of the renewed bullishness in prices are both fundamental and sentiment driven.  Fundamentally, earnings in Q1 grew by more than 25% year over year, with upwards of half that coming from tax reform.  After hitting a 7-year bullish extreme in January at 59%, sentiment towards stocks became quite negative after the correction took hold, bottoming at 26% bulls in early March.  Recently bullish sentiment was back up to 35%, and I expect bullish sentiment to increase to very high levels again prior to any significant declines in stock prices.

Additionally, the record earnings (and Q2 forecasts) have driven down the market Price to Earnings ratio from nearly 25x in January into the mid 22x range, based on trailing 12 months as-reported earnings.  Furthermore, according to FactSet analysts have been raising Q2 forecasts, contrary to history where estimates steadily decline into earnings season (setting up easy ‘beats’).   The decline in prices and increase in earnings, past and forecast, has pushed the ratio down, and essentially removed the discussion of how expensive the market is.   Sentiment moving up from lows, and earnings (be they tax driven or economic) climbing should make it easy for investors to push money into stocks over the coming weeks or months.

This Correction Was Different

The dive in stocks in February came on the heels of a rise in interest rates.  The yield on the 10-year Treasury went from 2.38% December 29, 2017 to 2.85% on January 29.  This significant rise is akin to the rise in rates after Trump’s election and the ‘Taper Tantrum’ when Fed Chair Bernanke stated that the Fed will raise rates ‘sometime in the future’ in the summer of 2013.  Both post-election and in the summer of 2013 stock prices rose as bond prices fell (bond prices and rates move inversely to each other).    This time however rates were ‘too high’ and would either effect corporations’ profits or the relative attractiveness of stocks vs bonds, causing (or at least giving a reason) for both stocks and bonds to fall at the same time.

The significant prior declines in stock prices late 2015/early 2016, as well as 2nd half of 2011 (US credit rating downgrade) were accompanied by a decline in interest rates, pushing up bond prices.  The past several large moves in either rates or stock prices were met with opposite reactions from the other asset class.  This behavior is the root of Modern Portfolio Theory, investing across asset classes to reduce volatility.   This natural diversification that has been at the root of finance academia for over 30 years, but may be coming to an end.

The result is that investors who are more conservative, seeking a traditional 60/40 stock and bond split may encounter fluctuations like those more aggressive investors who are much more exposed to stocks.   And the worst-case scenario of a bear market in stocks may be accompanied by rising rates/falling bond prices.   Investors who are not aware of this and who do not have a plan on how to reduce volatility in both asset classes will have a very difficult time when the current bull market ends.  It will be important going forward to have a strategy in place if both assets decline in price and not rely on traditional diversification concepts.

Adam Waszkowski, CFA

Observations and Outlook April 2018

First quarter of 2018 turned out much differently than investors had been expecting at the turn of the New Year.  In January’s note, there were many sentiment indicators that had eclipsed their all-time highs. The highest percentage of investors expecting higher prices in twelve months was recorded.  Equity markets peaked on January 26 and fell 12%, followed by a large bounce into mid-March then subsequent decline that left us at quarter end about 4% above intraday lows from February.  We may be seeing the first stages of the end of the 9-year-old bull market.  Looking back at 2007 and 2000, the topping process can be choppy with market gyrations of +/-10%.   This is a complete 180 degree turn from the past two years where volatility was non-existent and equity markets went the longest period ever without a 5% decline.  Expect continued choppiness as the impact of Tax Reform filters through the economy and if corporations can continue the blistering pace of earnings growth going forward.  At the same time for mostly the same reasons, interest rates are likely to be range-bound.  Very recently the price of oil climbed on a news release that the Saudis would like to see $80/bbl oil.  Rising oil prices would be akin to a tax on consumers and hamper US growth.

Sentiment as seen by the AAII % bullish rolling 8-week average has declined from its euphoric high at 49% in January, down to 33%.  At the bottom of the last correction in early 2016 this average was 23%.  The current correction may be over and a lot of selling pressure has been exhausted there is room to the downside still. A reading in the mid 20% has been a good area to mark a low in the markets.  Sentiment is often a lagging indicator.  Investors are most enthusiastic after large price gains.  The opposite is true too in that sentiment numbers go low after a price decline.   It can be helpful to take a contrarian view as sentiment measures move to extremes.

aaii rolling bulls 4 2018

Blame for the downturn in January was due to a slightly hotter than expected print of Average Hourly Earnings (AHE), and the resulting concern over how quickly the Fed will raise interest rates.  The rapid change in AHE has not followed through into February and March, yet stocks remain well off their highs.  Analysts have been looking for wage pressures due to very low unemployment numbers for a long time.  The lack of wage growth is likely to the re-entrance of discouraged workers back into the labor force.  As a discouraged worker, who ‘hasn’t looked for work in the past month’, they are removed from the workforce.  When the number of unemployed decreases (the numerator) along with the total workforce (the denominator), the unemployment percentage rate goes down.  A low unemployment rate at the same time there is little wage pressure is due to the workforce participation rate being very low.  Focusing on the total number of people employed, which is still growing on a year over year basis, may give us a better read on employment situation without looking at the unemployment rate.  Any impact from Tax Reform should show up in an acceleration of year over year Total Employees growth.

total employed 4 2018

A more telling chart, and perhaps the real reason behind President Trump’s fiscal stimulus is the following chart. Using the same raw data that created the above chart, the chart below tracks the monthly, year over year percentage change in total nonfarm employees in the United States.  There are no seasonal adjustments etc.  While we are growing, the rate of increase in the total number of people working, is slowing.

% change in total employed 4 2018

Forward guidance from companies will be critical.  Expectations are still quite high regarding full year earnings and end of year price target for the S&P500, currently about 3000, 15% higher than todays price level.  During the first quarter, when earnings from Q4 2017 were reported, companies beating earnings estimates were rewarded only slightly, while companies missing earnings had their stock prices pushed down.  It seems there is still a ‘priced to perfection’ hurdle that companies must overcome.

 

The largest macroeconomic driver for the remainder of the year is the now global shift from QE (quantitative easing) to QT (quantitative tightening).   This global liquidity spigot the Central Banks have been running on full blast for the past 9 years has begun to end.  The US Federal Reserve stopped buying bonds (adding dollars to markets) and began raising rates.  These are tightening liquidity.  While in 2017 the European and Japanese central banks more than made up for the Federal Reserves actions, both have been broadcasting plans to temper their liquidity injections.  China is tightening as now in preparation for increased stimulus to coincide with the Communist Party’s 100th anniversary in power in 2021.

Over the past 9 years global liquidity additions has been the key driver to global asset prices.  As these additions slow and become subtractions, one must assume it will impact financial markets.  Most importantly global US Dollar-liquidity is the most important as the Dollar is the global reserve currency.  Recently the LIBOR-OIS has been in the news, having risen dramatically over the past few months.  This index is a rate that compares the overnight cost of interbank dollar borrowing in the US vs Europe.  The cost to borrow US Dollars in Europe has gone up dramatically.  A low cost would reflect ample Dollars for those who need them, a higher cost reflects a shortage of dollar-liquidity.  The TED Spread compares the interest rate on 90-day treasury bills and the 90-day LIBOR rate.  The TED spread is 90-day rates and the LIBOR OIS is overnight rates, and they follow each other closely.    The crux of it that they both measure the availability of funds in the money markets.  If these rates go up, it is seen as a decrease in available funds.

ted spread and us dollar 4 2018

The chart above tracks the TED spread and the US dollar.  The relationship is loose but fits well over multiple quarters.  If this relationship is correct, the US dollar should dramatically increase in value in the coming months.  An increase in the US Dollar will push the prices of non-US assets lower, make dollar denominated debt widely used in emerging markets more difficult to pay back and have further repercussions in debt markets.  A weak US Dollar is the underpin of global asset prices, and a stronger dollar, along with Quantitative tightening will be a strong headwind to asset prices in the second half of 2018.  If earnings can continue to growth strongly and more workers can be added at a strong pace, both leading to more credit growth, this headwind may be able to be offset.

In addition to international money market rates, the slowing velocity of money has been a constant impediment to economic growth.  Or, rather, the low velocity of money is indicative of an economy that continues to languish despite massive amounts of new money put into the system.  If the pace of money flowing through the economy slows, GDP can be increased by putting more money into the system.  More money moving slowly can be like a small amount of money moving quickly.   If money is removed from the system via tightening measure from central banks, and we do not see an increase in the velocity of money, GDP will decline.  The slowing of VoM has been a problem since 2000 and is likely directly related to ‘why’ the Fed keeps rates extremely low for very long periods of time.  Of course, if VoM were to return to 1960’s levels, interest rates would be substantially higher, causing a re-pricing of all assets—which is a topic for another day.

fredgraph

Adam Waszkowski, CFA

awaszkowski@namcoa.com    239.410.6555

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

“Good” Inflation: Rising rates and falling stocks

Over the past week, the Dow fell by 4%, more than halving its ytd gains through Friday 1/19 (all time high).   Bonds continued the decline started in mid-December, bringing losses during the current ‘bond rout’ to -5.7% year to date.  That is a one week decline in the Dow of 4% and a four-week decline in long-bond prices of 5.7%.  Balanced investors have seen stocks gain and bonds lose, putting most investors (moderately conservative to moderately aggressive) at a mild gain or loss so far this year.  Generally, diversification across asset classes reduces volatility when bonds go up, stocks generally are weaker and vice versa.    When the classes move together differentiation across risk profiles diminishes.  Stocks remain in a strong uptrend and given the substantial gains over the past few months, equity centric investors should be able to take this in stride (or they shouldn’t be equity-centric) as 4% is a small blip in a strong multi-quarter uptrend awash in investor optimism, all-time low cash levels, all-time high exposure to stocks and financial assets and expectations of higher wages, earnings and GDP growth.   In this light, a rebound, or ‘buy the dip’ would not be surprising.  The new feature though is that volatility has returned.

The ‘bond rout spilling into equities’ explaination has to do with relative attractiveness.  If rates keep rising, bond prices are hurt, while becoming more attractive (due to higher yields) to equity investors, putting pressure on equity prices.  At some point, earning safe interest attracts enough investors from stocks to weaken stock prices.  The S&P 500 dividend yield is now 1.8%, similar to what can be found offered on 18 month CD.

Rate have climbed due to rising inflation expectations.  Inflation is expected to, finally, exceed the 2% goal set by the Federal Reserve ‘in the coming months’.  Current thinking is that a tight labor market is pushing AHE (average hourly earnings, +2.9% Jan ’18 vs Jan ’17), combined with more take home pay (via tax reform), will result in more spending from consumers and investment from business.  This will take time but markets have already priced it all in.  Just like the stock market has priced in exceptional earnings growth to match its exceptional valuations.  The chart below shows us that we’ve been in a tightening labor market for years without being able to hold above 2.0% inflation but briefly.

infl vs unemplmnt

Given the new feedback loop between stocks and bonds, perhaps we shouldn’t be so excited about inflation, even if its ‘good’.  On the bright side, the past few years has seen 3.25% as a top in 30yr bond yields and perhaps a decline in rates near term may help both bond holders and stock investors alike.

Observations and Outlook January 2018

Investors have not been as fully invested in the stock market since 2000.  Does this mean anything?

Maybe.  It is a reflection of investor expectations though.  One can infer this by assuming investors own what they think will go up in price and therefore is investors are very long, then they expect prices to rise.  The American Association of Individual Investors (AAII) recorded the highest level of optimism in 7 years, since December 2010.  The historical average is 38.5%.   In an article from AAII, dated January 4, 2018 they review how markets performed after unusually high bullish and usually low bearish sentiment readings.

From AAII:    “There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of 0.5% following those previous readings, up slightly more times than it has been down.   Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings. The magnitude of underperformance has been greater when optimism is unusually high than when pessimism has been unusually low.”

This does not necessarily mean that our current market will decline rapidly.  Actually, AAII finds that while returns are below-median, they are positive.  Positive as in ‘above zero’.   Sentiment drives markets and when sentiment gets too extreme, either in bullish for stocks or bearishness for bonds or any other financial asset, returns going forward are likely to disappoint.  If everyone has bought (or sold) who is left to drive prices up (or down)?   What we need to recognize is that investors become optimistic after  large advances in the stock market, and pessimistic after declines.  UM-Probability-of-Stock-Mkt-Rise-Oct-2017-1024x705_thumb1

Again, this chart above does not mean we are about to enter a bear market.  It only shows the markets progress at points of extreme optimism.  We can see in 2013 into 2015 rising expectations and a rising market as well as from 2003 to 2007.   Now that we can visualize the mood of the market, lets review some other metrics from 2017 and what is in store for 2018.

2017 was interesting in several areas.  It was the first time in history the S&P500 had a ‘perfect year’ where every month showed gains in stock prices.  We are also in record territory for the longest length of time without a 5% pullback, almost 2 years.   Historically, 5% drawdowns have occurred on average 3-4 times each year.  In addition to price records, there are several valuation metrics at or near all-time records.    The ‘Buffet Indicator’ (market capitalization to GDP) just hit 1.4, a level not seen since Q4 1999.  “Highest ever” records are exceeded well into mature bull markets, not the early stages.  Stock markets generally spend most of the time trying to recover to previous highs and far less of the time exceeding them.    Momentum and priced-to-perfection expectations regarding tax policy are driving investors to be all-in this market, as reflected by Investors Intelligence Advisors’ (IIA) and American Assoc. of Individual Investors (AAII) stock allocation and sentiment surveys each at 18 and 40-year extremes.  Combined with the Rydex Assets Bull/Bear Ratio, at its all-time extreme bullish reading, it’s difficult to argue who else there is to come into the market and buy at these levels.

However, bullish extremes and extreme valuations can persist.  Their current levels do likely indicate that we are well into a mature bull market.   The bull was mature in 1998 too and went on to get even more extreme.  This is the case many perma-bulls trot out, that since were not as extreme as 1999, there is plenty of room to run, and ‘dont worry’.

The US Dollar and Quantitative Tightening

The current ‘conundrum’ is why is the US dollar so weak?  We have a Fed that is raising interest rates growth likely to exceed 3% in the fourth quarter.  Usually a rising currency would accompany these conditions.    The dollar declined throughout 2017.  This was a tailwind for assets outside the U.S. whose value in dollar terms increases as the dollar declines vs foreign currencies.   If the dollar begins to move back up this will be a headwind for ex-US assets and for sales/profits to large companies in the S&P 500 who do almost half their business outside the U.S.

In addition, central banks have given notice that, while the Fed ended QE in late 2015, other central banks are beginning to end their programs with the European Central Bank reducing its bond purchases from 60 billion euros per month to the current 30 billion, and down to 0 in September 2018.   The Bank of Japan (and the Japanese Pension Fund) have declared they are reducing their purchase of stocks, bonds, and ETFs.  Only China hasn’t formally announced and end to market interventions.   Most pundits are pointing to the bond market as the area that will be most affected.  Possibly, but to claim that bonds will get hurt and stocks will be fine is ignoring how global equities have performed hand-in-glove with banks’ liquidity injections over the past 10 years.  Both stocks and bonds will likely be affected.

Yield Curve Inversion (or not)

I102YTYS_IEFFRND_I30YTR_chart

The chart above shows in red the persistent decline in 30-year treasury rates.  This week Bill Gross called the bottom (in rates, the top in prices).  This may be premature as one can see dips and climbs over the past few years, all of which have been accompanied by calls of the end of the 35 year bond bull market.

What is more interesting is that in the past 3 recessions, the yield curve as seen through the 10-2 Year Treasury Yield Spread declines, through the zero level (aka inversion, 10yr bonds paying less than 2 year notes) before a recession.   Our current level of .5% is not far from zero.   Most people are waiting to see it invert before saying a recession in on the way, often adding it will be a year beyond that point.    If one looks very closely at the chart we can see said spread actually increase after bottoming out, just prior to a recession starting (which wont be officially recognized until 6-8 months along).   While there are different factors influencing the 2yr and the 10yr rates, a spread widening might be a more important development than continued compression.

Finally, what does all this mean for an investor.   In short, we must all recognize that a 24 month span without a 5% decline is extremely unusual, as there are often 3-4 in a given year.   Also that when investors are most optimistic, returns often lag with the more extreme readings leading to more significant changes.  Mature bull markets eventually end and investors with a longer term horizon need to have a strategy not only for growing their investments, but also protecting the gains one already has.

We all know how to deal with a bull market, but few people have a strategy on how to deal with a bear market.

Adam Waszkowski, CFA

Money for Nothing: from QE to QT

During the crisis, central banks lowered interest rates dramatically during the stock market crash.  The Fed Funds Rate went from 5.25% July 2007 to 3.0% March 2008 (when Bear Stearns failed, most people remember Lehman, which failed in September).   That summer Freddie Mac and Fannie Mae failed and the FFR was lowered to 2% and then 1% in September and finally 0% was the official rate in December 2008.  All the while financial asset prices kept falling and the economy was hemorrhaging.  Soon after hitting 0% as the cost of money to the banking system, the Federal Reserve started Quantitative Easing, where the Federal Reserve would buy mortgage backed securities (as well as other tax-payer insured instruments) to provide ‘liquidity’ to the markets.   The stated goal was to increase the prices of assets (stocks, real estate, bonds) so that the “wealth effect” would spur people to spend money rather than save it.  Given the anemic pace of economic expansion, the primary effect QE has had has been to push up stock prices well beyond normal valuations.

While the US has ceased QE, raised interest rates off the 0% mark, and laid out a plan to shrink its balance sheet (taking liquidity away from the market); the European and Japanese central banks continue to buy assets. The Europeans buy corporate bonds and the Japanese buy everything including equities.  The ECB has expressed a desire to cease its purchases (stopping new liquidity into the market) starting in 2018, but have not committed to a schedule.  The chart above combines all the central bank’s asset purchases and projections into 2019 overlaid with global equities.  On the chart below, notice how the EM (emerging markets withdrew liquidity late 2015 to 2017—emerging market stock indices (EEM) fell 39% from Sept 2014 through Jan 2016).  Additionally we can observe the effect central bank purchases have had on interest rate spreads, giving investors the most meager additional interest for taking on additional risk.

The chart shows the Fed’s net reductions in liquidity and the Swiss, Japanese and Europeans declining levels of new liquidity to the marketplace.   Given that adding liquidity boosted asset prices, as additional liquidity slows and possibly reverses, it is not unreasonable to assume markets will become much more volatile as we approach that time.  We will likely see the effects of Quantitative Tightening (QT) beginning in, and throughout 2018.  One way to counteract this, would be for private investors to save/invest rather than spend this difference (approx. $1.2 trillion), but a reduction in consumer spending would bring its own problems.

central bank purchases 2019

 

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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