US stocks, based on long term valuation techniques, are the most expensive in the world. Expected returns over the next decade, again based on long term valuation techniques, are somewhere south of 5% real and with inflation very low, nominal returns won’t be much better. At Alhambra, we believe that, at best, the S&P 500 is uninteresting and at worst is in bubble territory. That doesn’t mean we can’t find anything to buy in the US market, but it does mean that we find it very difficult to maintain exposure to US stocks through a broad based index fund. It is probably not coincidence that a surge in popularity for indexing has resulted in highly valued indexes. And anyone who has been reading these weekly commentaries for any length of time knows how hard I find it to do anything that is overly popular. If everyone is doing it, I lose interest.
For investors, this presents a dilemma since the US is also the largest, most liquid market in the world. Global investing almost requires that one have at least some exposure to the US stock market. We are addressing this need for US stock exposure by returning to our deep value roots and including more individual equities in our portfolios. We are not so naive as to expect that if the US market takes a big hit that we will be completely spared but we do believe that a value approach may limit the damage.
The other alternative for global investors is to reduce exposure to the US market and concentrate on markets where valuations are more reasonable. To us, investing is no more complicated than buying what’s cheap and avoiding what is very dear. Right now, that means our focus is almost entirely on foreign markets although investing outside the US still requires that we track the US economy. Why?
Return = Dividend Yield + Growth + Change in valuation
When we look at this equation and apply it to the US, we are concerned about all three factors. Dividend yield on the S&P 500 is just 2%; growth, despite some decent news this week (more on that later) is weak and valuations are very high, meaning that it is likely that the change in valuation over a reasonable investment time frame is likely to be negative. If we take a 2% dividend yield and add GDP growth it is obvious that even a minor negative change in valuation would lead to losses.
When we look at this equation in relation to foreign markets, we still have to focus on the US economy because GDP growth in most of the rest of the world, to at least some degree, is dependent on US growth. And we still see that as a problem. The economic news recently has trended better but as Jeff Snider and a lot of others have pointed out, a lot of the recent growth has been from adding inventories. We saw a similar phenomenon last year where inventories grew in the second half of the year in anticipation of higher growth that never materialized. The result was a slowdown in the first half of this year as last year’s inventory rise was worked down. The upward revision to 3rd quarter GDP last week was almost entirely from a revision of the inventory numbers. 3.6% growth in the quarter sounds great but if, as we suspect, it means much lower numbers in the 4th and 1st quarters, it doesn’t mean much.
The employment numbers were also an upside surprise last week and I don’t want to minimize it but the 200k payroll gain, assuming it is accurate (a very big if), barely keeps up with population growth. Jobless claims are hitting new lows and that is certainly good news for those with jobs, but there are also millions facing an end to benefits come January 1. Long term unemployment is a huge problem and based on the economic idiocy I’ve seen out of DC recently, isn’t likely to change anytime soon. My guess is that we’ll see some kind of budget deal soon that makes only some minor changes in current spending and taxes. I guess that is better than a deal that includes much higher taxes but if the economy could stand on its own with current policy we wouldn’t see the Fed engaged in extraordinary policies. Which by the way, I expect the Fed to start ending fairly soon.
It seems fairly obvious, at least to me, that the Fed wants to end quantitative easing. I think they may have finally realized that the policy is not only ineffective but also increasingly a political lightning rod. President Obama last week gave a major speech on inequality and while he didn’t mention monetary policy specifically, anyone with a pulse knows it is contributing to the problem (assuming there is a problem). I’ve written about the issue many times in the past and it isn’t a new idea that inflation leads to greater inequality. Anyway, the Fed seems likely to use the recent strength in economic data (as iffy as it is) to justify the beginning of the end of QE. It won’t hurt that hawks such as Richard Fisher and Charles Plosser will be voting members of the FOMC starting in January.
Having said all that, I think probably the most likely outcome for US growth in the near future is for it to continue at its current feeble pace. There are plenty of reasons to worry that the outcome is worse than that and we’ll be watching them closely, but for now, if we make that assumption, foreign markets are offering much greater value than the US stock market. We even find some markets where a worse outcome for US growth doesn’t seriously dent the case for investment. So to answer the question at the top, what’s cheap?
Well, Japan for one. We made our initial investment in Japan well over a year ago and it has performed even better than we expected. The Japanese market, even after a large rally, still trades for just 1.5 times book value and P/Es, because of rapid earnings growth in Yen are actually falling. Japanese economic growth has picked up, growing at a nearly 4% annualized rate in the first half of this year although it slowed in the 3rd quarter to about half that pace. Of course, there are questions about whether growth can be maintained with a sales tax hike planned for early next year but low valuations are not usually found in places with no problems. I said when we made the investment that the Japanese were out of options and they would do two things – devalue the Yen and make some significant structural changes. They’ve done the first part and we’re waiting on the second. If they follow through, I think Japan could be at the beginning of a major, multiple year bull market. If they don’t, well, this rally will end like all the others of the last 25 years.
And Europe for two. We also made our initial investment in Europe two summers ago and it has performed well so far if a bit less than the US recently. Obviously there are still major problems in Europe and all markets there are not cheap. Germany, for instance, does not appear attractive to us at current levels. Most of the bargains on the continent are to be found in, not surprisingly, the economies that have suffered the most. Spain, Italy and the Netherlands are the most attractive while Switzerland and Germany are the least. For the more adventurous, Greece and Ireland still look cheap. Back to our equation, we have dividend yields in Spain and Italy of 4% and 3.5% respectively, a return to growth and the potential for rising valuations.
And last but not least are the emerging markets but here we think you need to be very selective, at least for now. Two of the original BRIC countries look particularly cheap – Russia and China. Dividend yields in these countries are not that high – around 2% – but growth is much higher (at least in China; Russia is more about potential) and valuations are much cheaper with room to expand. As we see with many of the countries with cheap markets, these two are not without their problems. Russia gets a cheap valuation for just being the mob state it is but also because of its reliance on commodities. In many ways the problems in Russia mirror those in China. Both countries have a great need for reforms that strengthen the rule of law, privatize state companies and reduce corruption. And in both countries there is an elite with a vested interest in maintaining the current state of things. Of the two, China seems more serious about reform and their recently announced 3rd plenum, if fully implemented, would be a very positive development.
Other emerging markets are not as interesting. Brazil is facing serious problems that are primarily a result of the hangover from the credit boom they had during the China double digit growth years. Selling commodities to China was great business while it lasted but as usual Brazil did not take the opportunity to reform their economy while things were going well. Now they’ve got a shrinking GDP and a capital flight problem. Indonesia has similar problems with growth slowing, inflation rising, the current account moving into deficit and the Rupiah falling. India’s problems are too extensive to list here but suffice it to say that the market there is not cheap enough to provide any comfort in our opinion.
One thing that worries us about making large allocations to foreign markets is the currency risk. There are ETFs that hedge the currency and we’ve used one for Japan where we were nearly certain the Yen would fall. We haven’t done the same in Europe because we didn’t have the same confidence that the Euro would fall. While that looks like a good bet so far, further easing by the ECB could change that equation. In addition, when we purchase individual equities there is no way to cheaply hedge the currency risk. If the US dollar rises significantly, our returns in dollars will be negatively affected and the risk of that is not insignificant. We are encouraged, from a contrarian standpoint, that there are so many longs in the Dollar right now but if several trillion dollars of QE didn’t weaken the dollar, ending it seems unlikely to do the trick.
With most everyone enthralled by the US stock market, we think a focus on other markets is likely to pay off in the next few years. Investing is often about doing the thing that makes you the most uncomfortable and certainly investing in Russia, China, Japan and Europe fits the bill. It also fits our mantra to buy what’s cheap.
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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773. You can also book an appointment using our contact form.