The US No Longer Concerned with Europe?

Crossing Wall Street has an interesting set of graphs that show the S&P 500 versus the Euro.  At least for the end of the year it shows what most market observers probably thought – the US equity market was correlated to the Eurozone.

In October and November the Euro and the S&P 500 were highly correlated.    So as the Euro got stronger the S&P 500 increased in value.  If this seems contradictory, remember as the crisis in Europe grew the appetite for risk would fall and the flight to quality would grow.  Thus, investors would sell stocks and the Euro and move into Treasuries, for example.

What has happened in January?  The correlation has essentially stopped.  What does this all tell me?

• Could be nothing, very small sample size
• If it is something, the big drag from Europe wasn’t so much a slowing economy but a financial system collapse
• The risk of the latter has been reduced, at least for now
• The former was already priced in
• Thus, assuming the correlation means something, negative economic news from the Eurozone will probably have minimal impact on US markets (assuming US data stays positive)
• If however the risk in financial markets comes back, the correlation could come back

The Further They Fall the More They Come Back?

The iShares Emerging Markets Markets Index ETF (EEM) was down about 19% last year per Morningstar.  The SPDR S&P 500 (SPY) was roughly flat or up around 2% if you count dividends.  Obviously being heavy in Emerging Markets in 2011 would have dragged down returns.

2012 on the other hand is a different story.  Through last Friday’s close, EEM’s YTD return is around 16% while SPY is around 7%.  That amount is even larger if you are weighted towards certain economies (Brazil, India).

There was a similar story in bonds; WisdomTree Emerging Markets Local Debt (ELD) was down around 2% in 2011.  Certainly not catastrophic, but the iShares Barclays Aggregate Bond (AGG) was up almost 8%.   This year?  Through Friday’s close, ELD’s YTD return is around 8% while AGG is around flat.

The FT sites 3 big reasons: better than expected US economy, progress in the Eurozone, and evidence that China may have a soft landing.

Will this continue?  I am not sure.  I tend to think that if the Eurozone doesn’t spiral out of control the rest of the world could surprise nicely.  Emerging Markets, being high beta, would probably be in the best spot for one of the larger gains.  Further, Emerging Markets may still be undervalued relative to both historical norms and developed markets.

I am NOT trying to say Emerging Markets will for sure be the place to be in 2012, as any global disruption could send emerging market shares tumbling (they have exhibited a higher volatility).  You need to be careful before selling and diversification still an important driver.   However, yesterday’s trash might be tomorrow’s treasure.

Not All Government Debt is the Same

I have mentioned before why US government spending is different than Eurozone government spending.  Recently I read an article by Satyajit Das that highlights some of these, as well as touches on some other government spending issues:

• Since debt rarely gets repaid, the markets focus on the ability to pay the interest and whether or not the debt can be refinanced.
• When borrowing in its own currency (e.g. the US), “a sovereign’s capacity to borrow is only constrained by the willingness of investors to purchase its securities and the cost of that borrowing.”
• When used as the major reserve currency (again, the US) the ability to borrow is increased.
• If there is a large amount of domestic savings (e.g. Japan) the ability to fund is easier.
• A country that can’t print its own money and has high foreign liabilities (weaker Eurozone states) will have a harder time convincing the market it will be able to service the debt and then refinance it.
• This results in higher interest rates, which further constricts the ability to borrow.  This is why the US can borrow more than countries like Greece.
• The more diverse and dynamic the economy, the more diverse the tax revenue streams; thus, the greater the ability to borrow will be.
• Current and expected GDP are huge factors in determining how much a country can borrow.  

So putting this all together, you can see why Europe is fiscally struggling right now – a high % of foreign liabilities in a currency they don’t print and economies with anemic growth outlooks that aren’t diverse.  Further, the resulting higher interest rates creates a vicious circle.

I am not saying the US fiscal situation is in great shape, but from the above comparison you can see why our interest rates remain so low and why we can continue to expand our debt to GDP ratio.  In short, we ain’t Greece.

Thoughts on 2012 Consensus

My last post dug into what the “experts” are predicting for this year.  Here are my thoughts on that consensus: 

• I tend to think if we avoid those “tail risks” we could have a very good year on the S&P, higher than consensus. 
• At the same time I think the chances of one of those “tail risks” popping up is probably higher than the bulls believe. 
• This makes the market hard to handicap.
• So my conclusion reflects this discrepancy, that by year end we will end up in the poles – either up nicely or down poorly. 
• I really think the US economy could surprise here if it doesn't get derailed, despite the secular deleveraging trend. 
• Here are some general strategies on how to play divergent conclusion:

• Avoid the riskiest assets

• Regardless of asset class, move up the quality chain

• Focus on investments that benefit from monetary/fiscal policy

• Think about investments that are less economically cyclical

• Avoid illiquid investments

Please keep in mind that I am just sharing some general strategies on how to navigate the current environment.  If you implement the above successfully, you can hopefully still get some upside while limiting your downside.

2012 Consensus

In my last post, I pointed to some evidence, which demonstrated how far off the 2011 consensus was. Despite that, I will provide the 2012 consensus below:

• Projections range from very bearish to very bullish.  I expected this given the broad range of opinions I read.
• Even among sell side analysts there seems to be more divergence with S&P 500 performance projections ranging from -9% to 20%.
• The average S&P 500 performance projection was about 7%; however, this is usually the case.
• The S&P 500 EPS earnings projections range from $96 to $110.
• The average S&P 500 EPS earnings projection is about $102.
• Those who are bullish tend to think many of the “tail risks” out there (European collapse, Israel-Iran, China hard landing, etc.), while present, and are unlikely to happen. 
• Those who are bearish tend to think these risks are possible and at the very least will drag on the market.
• The ultra bulls think that we could see some large upside surprises in the US economy – GDP, unemployment.
• The ultra bears think the “tail risks” are probable (especially Europe).

There you have it, the 2012 consensus opinions from my readings.  My next post will outline my thoughts regarding these projections and I will provide you with a few portfolio ideas on how to play this.