The
stock market, as defined by the S&P 500, was up over 7% in July.
By month-end, it was up nearly 50% off the lows from March, back to
its highest levels since last November.
As usual, gains were propelled by a variety of reasons, but
one of the leading factors was the surprise of a strong earnings
season. Halfway through the earnings season, over 70% of companies
that have reported quarterly earnings "beat" expectations.
On this measure, it is among the best quarters of the last ten
years.
Simply beating earnings expectations is not the whole story
-- raising guidance for future quarters is an important part
of the plot as well. Roughly one in ten companies have raised
guidance thus far, making this the best quarter for companies
raising guidance in roughly four years. In addition, this is
the third quarter in a row that more companies raised guidance
than the prior quarter.
Nonetheless, our current stock market outlook, despite the
strong price gains and an improving earnings picture, is shifting
back to a more neutral level. Valuations are up 50% since early
March, and while they still look fairly inexpensive compared
to longer-term averages and compared to the level of government
interest rates, they are simply not as attractive as they were
in previous months. In addition, individual investor sentiment
is finally starting to shake its stubborn skepticism and become
bullish. While not necessarily at an optimistic extreme, which
would clearly concern us, it is interesting to note that various
investor sentiment levels are ominously back at levels associated
with the market peaks of June 2009, January 2009, and May 2008.
Our less positive tone, however, is not due to the common sentiment "the
market has gone too far, too fast" since the March lows.
While we agree with this notion that the market went too far,
too fast, we still prefer to apply that statement to the panic
sell-off from last fall, which pounded stock market prices far
in excess of the losses that we have actually seen so far in
the broad economy or compared to normalized corporate earnings.
At this point, while we have seen many fixed income markets
-- where many of the capital market problems originated -- return
to pre-Lehman Brothers bankruptcy levels, the S&P is still
nearly 25% off its September highs.
All in all, we see a mixed bag for the market outlook. The
outlook for important economic topics such as the shape of the
eventual recovery is also mixed, as we see a plausible scenario
for a V-shaped, L-shaped, or W-shaped recovery. The same goes
for our outlook on inflation; there are powerful reasons that
indicate how deflationary forces or inflationary factors could
dominate. In sum, we currently do not anticipate making any
significant portfolio changes in the near term.
However, neutrality in the over-all market outlook does not
mean there isn't opportunity in the markets. In this month's
report, we will discuss two areas that have generated a fair
amount of investor interest this year. First, we will review
our current outlook on emerging markets, focusing on China,
and second, we will update our outlook on one of the better
performing areas of the bond market this year -- Treasury Inflation
Protected Securities (TIPS).
Emerging Markets
We believe that emerging market ("EM") securities
deserve a dedicated role in long-term investor portfolios. When
we say "emerging markets", we are describing a country
with an economy that is considered to be in the process of rapid
growth. Currently, there are 28 countries considered to be emerging,
with countries such as China, Russia, Brazil and India being
the most prominent ones.
The simple logic for adding emerging markets to a diversified
portfolio - or any asset class for that matter -- is that over
time they have the potential to increase returns, and may even
reduce over-all portfolio volatility. Emerging markets also
make up 45% of the world's economy (a 37% increase from the
start of the decade), just under 10% of the global stock markets
(or just over 15% of non-U.S. stock markets), and it is widely
expected that these market shares will continue to grow in the
years and decades ahead.
A common question is how much should an U.S. based investor
hold in emerging market stocks? We think that a reasonable long-term
weight for emerging market equity exposure is approximately
5%. This number is built off of two factors. The first factor
is how much investors should have in non-U.S. securities, including
both developed and emerging markets. We believe that number
should be about 20%, given that the typical U.S. consumer spends
about 20% of their over-all consumption on non-dollar goods.
The second factor, as mentioned above, is that emerging markets
make up just over 15% of the international market. So, 20% times
15% equals 3%. This is our initial frame of reference regarding
a long-term portfolio weight. We are then comfortable increasing
that position because of our belief that the emerging markets
will continue to grow their global market share in the years
ahead. Nonetheless, weights significantly above 5% - such as
10% or more - would qualify as aggressive.
However, this does not appear to be a good time to get aggressive
on emerging markets. In short, emerging market equities are
now trading back at relative valuation levels last seen in late
2007. This was just before the significant sell-off in these
markets, both in absolute and relative performance terms.
Another concern we have is that investor sentiment is overwhelmingly
positive on emerging markets. Fund flows into emerging market
funds have been very heavy this year; one article in late July
reported that flows were 34 times larger into emerging market
funds than they were into U.S. stock funds. There are many studies
on fund flows, including one by Frazzini and Lamont titled "Dumb
Money: Mutual Fund Flows and the Cross-Section of Stock Returns" (thanks
to the website, Econompicdata, that reminded us of this study)
which states: "…on average, retail investors direct
their money to funds which invest in stocks that have low future
returns. To achieve high returns, it is best to do the opposite
of these investors."
China
One market that has attracted a lot of attention of late, especially
given that its returns have been so strong in 2009, is China.
Though it makes up less than 2% of the global stock market
(and roughly 20% of the emerging markets), China seems to
have become the "can't lose" investment for many
investors. On one hand, for those investors who are generally
negative on the U.S., the leading view is that China's superior
GDP growth will de-couple its market returns from the U.S.
On the other hand, for those who are generally more upbeat
on the U.S. market's prospects, it is commonly viewed that
China is the high-beta play: If the U.S. is up, China will
be up even more. In short, the consensus seems to be overwhelmingly
positive on China, if not outright giddy. To be fair, by month-end,
there were a crop of research reports starting to suggest
that China was overvalued, frothy, and imbalanced - and the
volatile price action that we saw toward the end of the month
certainly added some credence to those concerns.
Thus, we do not share this enthusiasm for China. While we recognize
that GDP growth is currently running around 8% (the U.S. by
comparison was -1% last quarter) and that the Chinese government
provided massive amounts of stimulus for its economy, the Chinese
markets are seemingly entirely too speculative for our liking.
While stimulus is intended to support domestic spending, there
are many reports that the money is instead stimulating speculation
rather than consumption, resulting in price spikes in real estate,
commodity and equity markets.
In sum, we believe that many investors initiating positions
for the first time (and from 100% gains off the March lows no
less), or even significantly adding to positions, are merely
speculating.
TIPS
Though the darling of the fixed income market this year has
clearly been high yield ("junk") bonds, when it
comes to high-quality bonds, one of the best performing sectors
has been TIPS (Treasury Inflation Protected Securities). The
Barclays Capital US TIPS Index was up 6% through the end of
June.
TIPS are inflation-indexed (to the Consumer Price Index) bonds
issued by the U.S. Treasury. Many consider TIPS to be the ultimate
risk-free asset class as their credit risk is removed due to
backing from the U.S. Government and their inflation risk is
removed by inflation-linkage. Nonetheless, they still have short-term
price volatility, which introduces market risk if the bonds
are not held to maturity.
Like emerging markets, we strongly believe that TIPS deserve
a dedicated allocation in long-term investment portfolios. Unlike
emerging markets, however, we think adding to TIPS makes more
sense in the current environment.
This isn't necessarily because we think that inflation is going
to explode any time soon (it could, but we don't think so, due
to slack in the economy; consumer deleveraging; etc.). Instead,
we like TIPS first and foremost for their high quality -- they
are Treasury bonds -- and secondarily for the fairly cheap inflation
protection they provide.
When it comes to performance expectations for TIPS, there are
some common misconceptions. First, many emphasize that performance
is primarily driven by the inflation linkage. Second, many think
buying TIPS means they are betting that inflation will rise.
We don't exactly agree on either count.
On the first point, TIPS rank as the highest quality bonds
since they are backed by the U.S. Government. Their price movement
is primarily driven by many of the same factors that drive nominal
Treasuries, including economic expectations and investor risk
appetites. In other words, if Treasury yields rise (or drop)
significantly, TIPS will likely do the same.
Second, when looking at either nominal Treasuries or TIPS,
it is not TIPS making the inflation bet. Given that TIPS are
linked to inflation, they are essentially inflation-agnostic.
Rather, it is nominal bonds that are making the bet on inflation
--; and they need inflation to remain stable or go down to provide
the original real return or better.
The difference between the nominal Treasury yields and TIPS
yields is known as the "break-even inflation rate" (BEI).
This number is extremely useful to know for a variety of reasons.
One example is that many consider it -- ourselves included --
a more effective predictor of inflation than consensus expectations
generated by economists. Another key way to use the BEI is to
simplistically determine if one believes that nominals or TIPS
are more attractive. Currently, for instance, the BEI between
10-year TIPS and nominal Treasuries is 1.8%. So, if inflation
averages less than 1.8% over the next 10 years, nominals are
likely to outperform TIPS. However, if inflation averages more
than 1.8% a year, then TIPS should outperform.
While again we are not overly concerned about inflation in
the short-term, the BEI does suggest that inflation will be
less than half of what it has averaged over the last 50 years
(just over 4.1%). Thus, buying TIPS with break-evens at 1.8%
seems like a way to pick up some fairly cheap insurance, just
in case inflation moves back toward long-term averages.
Summary
Shifting back to neutral does not mean that we are negative
on the market. While it would be quite reasonable for the
market to take a step back before the next two steps forward
-- the market is quite extended after the sharp gains of the
last month and since March -- our outlook is still positive
for the next twelve months, and more importantly, the next
ten years. The latter time frame is a more appropriate consideration
for long-term investors. If we do see a correction in the
near-term, that would most likely provide an opportunity to
add to equity positions.
Shifting back into neutral also does not mean that we are coasting.
Given some of the factors listed above, a renewed emphasis on
the quality of assets in the portfolios should be stressed.
For equity investments, that means maintaining an emphasis on
larger, higher quality companies, and not adding to (or possibly
even reducing) riskier areas such as emerging markets and small
caps. In fixed income securities, that means adding to high
quality bonds such as TIPS, and not adding (or possibly even
reducing) positions in low quality bonds.
Sincerely,
