Emerging Markets Equities Get No Love: Pics, Charts, Graphs

Chances are you haven’t liked investing in Emerging Markets for the last 5 years:

As the red-headed equity step-child, Emerging Markets have been extraordinarily disappointing.  Global Fund Managers haven’t taken too kindly to this performance, and have decided to put less and less dollars there:

The good news is since Emerging Market equities have been loathed nearly as much as A-Rod they are now attractively priced:

JP Morgan

In fact, the case can be made Emerging Market equities offer better forward return prospects than any other equity asset class.

GMO

So is now the time to buy?  It could be.  But I want to see the markets validate this before I make any overweight recommendations.  Market trends can persist for a long-time, both on the way up and on the way down.  Thus, my current Emerging Markets Equity Strategy:

Current Market Scorn + Attractive Valuations = Wait for Trend Reversal + Then Start to Build an Overweight Position.

This way (in theory) I can insulate myself from the “falling knife” and still capture a decent chunk of the upside.  That could be next month or next year, but whenever it is the returns of that asset class should be attractive on a risk/reward basis.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Perspective on the Recent Bull Move: Just Where Are We in This Cycle?

Almost everyone is happy as Diamond Dave when stocks go up.  Luckily, that has been mainly the case since 2009, despite the fact that it has felt better looking back, and investors have been nervous the entire time.   It’s helpful to look at similar past moves, not necessarily as a guide, but to see where we currently stack up in terms of duration and size and maybe see if a chart pattern stacks up. 

The former lets me know there is juice left in the squeeze.  While past moves don’t provide absolute certainty, historical precedent provides trends and perspective.  The latter is a guide to how investor emotions tend to move throughout a cycle.

For instance, while the current bull market run is large in both size and duration there have been moves in the past that have lasted longer.  This tells me that despite some clamoring the current market run is due for a reversal (and it may be), past moves have indicated that such a move can go on for quite some time. 

Here is a chart from Merrill Lynch and noted by Barry Ritholtz:

So here is how I see it:

• In terms of duration and length, the current bull market is roughly in the middle.  Thus, while long in the tooth, history suggests the market still can run more.
• Twice after a similar rally we have started a new secular bull market after a 20% pullback. (Merrill Lynch note)
• However, twice we have had large time periods of range bound markets after the 20% pullback. (Merrill Lynch note)
• In short, a pullback while inevitable doesn’t have to happen tomorrow and once it does happen it could either be a nice long uptrend for equities or the start of a more range bound market. 
• So what this really tells us is that are a still wide range of outcomes, even after our large bull market run.

Thus, I still think the prudent move is to let the market run, while staying up the quality chain and looking for signs of deterioration, something I will cover in a future blog.  At that point, pairing back risk exposure will be the sensible move.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Why Everyone is Worried About Fixed Income Risks And How To Address It

Client questions present the best blog post opportunities.  There is no better sample of what is going on in the minds of high net worth investors.

Recently, a client asked us to comment on the latest piece from PIMCO’s Bill Gross, which he read in a national publication.  Below is an abridged version of my response, which outlines various themes, risks, and subsequent strategies to fixed income moving forward: 

• The initial theme of the August Outlook is “there will always be a need for fixed income”.  I totally agree.  In fact, I would say the demand on the private individual side will increase over time.  This is due to the demographic change we will be going through, e.g. an aging population.
• Also, Treasury supply may fall as the budget deficit falls.
• I explained that it would be helpful to look at this client’s own situation.  In this case, we are managing the portfolio to withstand a large loss of capital.  Of course we can’t protect against any or all loss, but we can build the portfolio to try and avoid the big losses: in effect, win by not losing big.  Bonds are still the best way to do that, and the chart below provides historical evidence:

• One could retort that yields have been falling for almost this entire period; thus, bond prices rise. This is true; however, from 1976 to late 1981 bond yields on the 10 year treasury doubled (thus bond prices fall), going from roughly 8% to 16%. 
• Further, the max drawdown over a rolling 12 month period was -9.20% for bonds and if you held them for 5 years the low return would be 11%.  Thus, even over a 5 year period where interest rates on the 10 Year Treasury doubled, aggregate returns for the asset class were positive. 
• Even with the recent spike in interest rates, the largest on record for a similar time frame, most of our bond managers range from down 3% to up 1%.  This is hardly the big loss I mentioned earlier.
• I also contend high quality bonds will still offer the greatest hedge against falling risky assets.  Thus, the small loss we experienced on the bond side was still worth it given the protection it provides if equity markets reverse course.
• The reason aggregate bond returns can still be positive even as Treasury rates rise (aside from coupon payments) is due to the other major theme of the Gross piece – carry (another way to say yield, but more than a fixed coupon payment).  He lists 5, but I will focus on two:   

1. One way to add carry is through credit spreads, which is the difference between what one type of bond yields and a Treasury bond yields (note: they both have the same duration, or to make it easier, maturity date).  In this instance, even when Treasury yields rise if spreads don’t rise (and they typically don’t) the investor still has a positive return.  Given the large amount of bond asset classes, there are usually opportunities in one asset class or another to add carry via the credit spread.  And at various points some bond asset classes or more advantageous than others.
1. A good example is a high yield bond, because the risk of default is substantially higher than that of a Treasury investors receive a higher yield.  Assuming the risk of default is low (e.g. when the economy is good), even when Treasury rates rise these bonds can generate a positive return as their interest rates may stay the same or fall (i.e. you collect the interest payment while the value of the bond stays even or rises).
2. Another is through maturity extension.  Which is to say adding carry by going longer out on the yield curve (e.g. 30 year bond yields more than a 3 month T-Bill).

• Both strategies of adding carry have risk.  If the economy picks up and Treasury interest rates rise, then portfolios more geared toward maturity extension will lag.  If the economy falters and Treasury rates fall, then portfolios more geared toward credit spread narrowing will lag.  Further, there are times when both could move down together, like in May and June and to a lesser extent even now. 
• As Gross notes, there are times when it is advantageous to be positive total carry or negative total carry.  Further, there are times when certain type of carry is more in vogue than others (e.g. maturity extension when the economy looks shaky).  Thus, as opposed to be more passive in our bond portfolios we are being more active. 
• Our analysis indicates that skilled active bond traders can find the best places to get carry depending on the environment.  But in the event one manager can’t, we are building around a few different ones to smooth out the returns.  We are blending these managers based on how much leeway they have in constructing their portfolios, some will favor adding carry through credit spreads and some through maturity extension.  The ultimate goal will be a bond portfolio that can stay afloat as interest rise, but provide support to the total portfolio when riskier assets pull back.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Notes on Commentary

I realize at times some of what I write is difficult to comprehend, and I do my best to try and simplify things.  While that is a concern, what worries is reader misinterpretation, and feel it may minimize the chance of that happening, by explaining how I write the 10 or so paragraphs a week:

1. From amongst the enormous amount of reading I do every week, I try to find some things of interest in the wealth management arena, typically investment related.
2. Try to simplify those concepts into an easy read, and shine a light on them, which provides a perspective, which may be of interest to the reader.
3. Have a colleague review what I write so I don’t sound like the follow when trying to simply things:  
• .
4. Give it a third look to make sure the points are clear and concise.
5. Submit to our Compliance Department according to SEC regulation, so I don’t get into trouble.
6. Post online, usually the week after I write it, but at times a few weeks after I write the original.

Remember, nothing I write is static.  For instance, this post on utilities being overvalued was written in early May, but since then Utilities are down roughly 5%.  They are still overvalued relative to their historical norm, but less so than previously. 

The dynamic nature of markets and my opinions on those markets is important to consider when reading these blogs, especially in regard to the equity market, where I am currently bullish but have a more bearish intermediate term view. 

Circumstances change so will my views will be fluid.  Further, momentum, which I believe is a good risk control indicator, can change quickly.  My views on shorter term outlooks one week could begin to diminish a few weeks later.  In other words, these blogs are time sensitive, as is most commentary, and this must be considered when reading not just my opinions, but those of others. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Fast Forward Earnings

Forward earnings projections for the S&P 500 are at record highs.  Glass half full – earnings should continue to improve.  Glass half empty – high earnings means high expectations.

Rather than project where earnings will be, I will give my interpretation of how to read the consensus.  This chart from Dr. Ed’s blog helps:

While difficult to read (so see the notes), some things stick out:

• The bulk of the time forward projections are too high start too high (see the blue lines trending down)
• Forward earnings projections tend to be reliable (notice slope of blue line is small) most of the time…
• Unless there is a recession (see the slope of the blue line is massively negative 2001, 2008, 2009)
• Even if forward earnings projections move down, sideways, or slow in growth, equities can still advance due to multiple expansion, i.e. stocks become more expensive relative to the earnings they produce (see the red line in 2012 and 2013)
• Though there is certainly a limit on this expansion, for instance a forward PE in the mid 20s in 2000 was certainly an alarm signal when the long-term average is around 15

And my subsequent takeaways:

• We are below the longer-term average on forward PE, thus even if forward earnings come down the equity markets can move higher
• An exception to this would be if we hit a recession, in which case all bets are off
• Another would be if the multiple gets too high, where falling earnings would yield a falling equity market as multiple expansion can’t offset the decrease in earnings
• We are currently around 14 P/E.  In 2007 at the peak we were around 15 and 25 in 2000.
• Thus given we appear to be at a reasonable valuation level on this metric, the risk to stocks lies in the risk of a recession
• So far the data doesn’t seem to indicate a recession is coming
• Still, since equity markets tend to lead the recession (even ones that don’t come to be) it’s important to gauge the momentum of the market for any possible hint 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.