Markets for the most part have held up. There are a couple of weak areas. The NQ has lagged both the...
Time to start planning how to rotate out of U.S. stocks and back into emerging market stocks
03/08/2011 8:30 am EST
The U.S. Standard & Poor’s 500 stock index was up 5.4% for 2011.
In more recent weeks, I’ve also warned that while I think the outperformance of the U.S. market is likely to continue for a while, it’s no time to get complacent. See my post from February 8 http://jubakpicks.com/2011/02/08/u-s-stocks-will-outperform-the-rest-of-the-world-in-my-opinion-for-the-first-half-of-2011-but-dont-forget-that-first-half-part/ .
And today I’d like to go one step farther and say that it’s time to think about strategies for rotating out of U.S. stocks and into emerging markets again. It’s absolutely too early to execute them—May would be about right, I think, for small exploratory moves. But it is absolutely time to plan this rotation and think about what to buy and what to sell.
What’s pushed me to this next step recently?
Evidence that expectations for the U.S. economy—and hence for U.S. stocks—are starting to run ahead of reality. When that happens, a stock market is setting itself up for a fallow period or even a correction as economic fundamentals catch up with stock prices. In other words, the result is likely to be a period of U.S, underperformance.
And evidence that expectations for at least some emerging economies—and hence for stocks in those emerging markets—are sinking like a stone. When that happens, a stock market is getting ready to build a base from that low level of expectations prior to moving up as expectations improve. In other words, these markets are looking at a future period of outperformance.
The reaction to Friday’s jobs number is a good indication of the way that expectations are starting to run ahead of actual economic performance in the United States.
First, here’s what the data said about the economy. According to the Bureau of Labor Statistics the U.S. economy added 192,000 jobs in February. Economists had forecast an increase to 185,000 in February, according to Briefing.com. The private sector actually did even better, adding 220,000 jobs in February. All this was enough to bring the unemployment rate down to 8.9% from 9.0% in January. The full unemployment rate, which includes discouraged workers who have stopped looking for work and workers in temporary jobs who would like permanent jobs declined to 15.9% from 16.1%.
But that was the extent of the good news. Layoffs from the state and local government budget crisis cut 30,000 jobs from the gains in February and a 30,000 monthly drop in government jobs seems baked into the U.S. economy through June when many states end their fiscal years. Adding jobs at a monthly rate of 192,000 or so isn’t enough to reduce the unemployment rate by more than a tiny margin. For that we need job growth north of 250,000 a month. With governments shedding 30,000 jobs a month it’s going to be really tough to get to 250,000 new jobs a month.
The news about incomes was also discouraging. Income growth was non-existent for the month. The average workweek was unchanged at 34.2 hours and average hourly earnings rose just 1 cent in February. (For the last 12 months average hourly earnings are up just 1.7%.) Unchanged workweek times unchanged hourly earnings equals? The math is easy—stagnant incomes. And that’s bad news for the economy at a time when the cost of gasoline and food are on the rise. The price of gasoline, for example, climbed 8.8% in February to a national average of $3.17 a gallon, according to the AAA. If incomes are stagnant and the cost of food and gasoline are rising, consumers have that much less to spend on everything else. And that’s not a recipe for faster economic growth.
And the headline in the Financial Times the next day? “Strong US employment figures raise hopes for sustainable job creation.”
Huh? You see that in Friday’s data? I don’t.
But Wall Street apparently does. And that view is at least partially priced into stocks.
U.S. stocks have almost doubled to 1321 on the S&P 500 (as of the close on March 4) from their Great Recession low in March 2009 at 676. That surge has been built on the recovery in the U.S. economy and in corporate earnings. Earnings have grown fast enough that the price-to-earnings ratio for U.S. stocks has actually fallen during most of the rally. From a price-to-earnings ratio of 18.6 in 2009, the P/E for the S&P 500 fell to 15.5 in 2010, according to Morningstar. Despite their huge rally starting in 2009, U.S. stocks were actually cheaper in 2010—on the basis of trailing earnings per share—than they were in 2009.
That may—and I stress “may”—have started to change. The most recent trailing 12-month price to earnings ratio—which includes January and February 2011 as a replacement for those months in 2010—has crept slightly upward. And, in the process, it has passed an important milestone: The trailing 12-month P/E at 16.1 is actually a bigger number than the current Wall Street consensus on earnings growth for 2011. On the good ol’ rule of thumb, the PEG ratio (PE to earnings growth rate), U.S. stocks aren’t a ripping good bargain anymore.
Not that they’re terribly expensive either, mind you. The Wall Street consensus calls for 14.8% earnings growth on the S&P 500 in 2011 and with a trailing 12-month PE of 16.1, the market’s current PEG ratio is just slightly over the level—at 1—that separates the bargains from the not so bargains for many growth-at-a-reasonable-price investors. And, of course, that slight premium to a PEG ratio of 1 disappears if you think that U.S. economic growth and U.S. stock market earnings will be higher than expected.
That’s, of course, the crux of the issue at the moment. The stock market, which is still in rally mode despite the turmoil in Egypt and Libya, seems convinced that, as in quarters since the economic bottom, U.S. earnings will beat the consensus projections. If that’s so, then U.S. stocks should continue to climb. They aren’t incredibly expensive at the moment, after all.
But I think there’s reason to question the expectation of above consensus earnings growth. The U.S. economy—and U.S. corporate earnings face a number of headwinds that were blowing less strongly when analysts compiled their projections.
- Oil has climbed to more than $100 a barrel—higher oil prices mean higher costs for companies (eating into profit margins) and absent rising consumer incomes (and rising incomes were absent from Friday’s jobs numbers) higher oil prices also mean that consumers have less money to spend on things other than oil.
- Commodity prices for things other than oil—from copper to sugar—continue to climb. That not only means higher costs for many companies but increasing difficulties in delivering the kind of cost reductions that have helped earnings to grow faster than the economy during the recovery. Those companies still unable to fully pass on higher costs to their customers, and there are many—face the possibility of a classic margin squeeze.
- A falling dollar works to raise costs for U.S. companies. The message from the European Central Bank last week that it will most likely raise interest rates in April has led to a euro rally and a dollar retreat. (Currencies rally when interest rates rise and we’re now looking at a situation where interest rates in the Eurozone are likely to rise months before any increase from the Federal Reserve in dollar interest rates.) A weaker dollar contributes to the increase in prices for commodities—an oil producer will want more dollars for a barrel of oil, for example, because each dollar is worth less.
I don’t think these headwinds add up to a collapse in U.S. economic growth or in U.S. stocks. But they are reasons to think that expectations for earnings growth above the 14.8% now projected for 2011 could be disappointed.
Now contrast these perhaps overly sunny expectations for the U.S. economy and U.S. earnings in 2011 with expectations for an emerging economy and market such as Brazil.
Economists and analysts are engaged in a race to see who can cut projections for growth most quickly.
The Brazilian central bank is in the midst of an aggressive series of interest rate increases. It raised benchmark interest rates by 0.5 percentage points last week to 11.25% and signaled that it will raise rates again, most probably to 11.75% next month. The goal is to fight inflation by slowing the economy. So far the effect on inflation has been hardly noticeable—not surprising—but the economy, which grew by 7.3% in 2010 has slowed significantly.
How low will growth go? Initial projections for 6%, for 5.5%, and for 5% have been published and then abandoned. A new consensus seemed to be forming about 4.5%, but recent projections have pushed well below that. For example, Nomura Securities recently cut its estimate for the growth rate of Brazil’s economy in 2011 to 3.9%. Nomura’s projection before that had been 4.4%. (Nomura projects that interest rates will hit 12.5% by the end of 2011.)
I think that higher interest rates are a good reason to lower growth forecasts for Brazil. But at some point I think those lower forecasts will have discounted all the actual bad news for the Brazilian economy—and some projected bad news that’s not likely to happen. In other words, at some point, expectations for Brazil will have swung too far to the downside.
If you were to chart some kind of index of expectations versus likely outcomes, what you would see right now is a line for the U.S. that showed an increasing likelihood that expectations were too optimistic, that they were outrunning likely real outcomes. For Brazil, you’d see a line that showed an increasing likelihood that expectations were too pessimistic, that they were under-estimating real outcomes.
And at some point you would decide to start to switch from the overly optimistic U.S. market to the overly pessimistic Brazilian market.
I don’t think we’re at that point quite yet. Another 0.5 percentage point increase in interest rates in Brazil in April will ratchet up the pessimism quotient on the Brazilian economy. U.S. stocks are running ahead of the U.S. economy now, in my opinion, but we aren’t likely to see much concrete evidence of any problems in earnings performance due to the headwinds that I mention above until earnings reports for the June quarter (although some might show up in earnings guidance for the March quarter released in April.)
Sometime in May then, I’d start to look to sell not the entire U.S. market but a few U.S. stocks that look especially over-extended and to rotate that money into Brazilian stocks that look especially undervalued. I’d do the same with other emerging markets on an individual calendar that took into account where each market is on its path to excessive pessimism. (Some markets seem to have a long way to go—India’s troubles, for example, I think are still underestimated. Some markets I think are not that far behind Brazil—Indonesia, for example.)
What I advocate is a kind of dollar cost averaging that begins with an initial position in an emerging market stock or country ETF (exchange traded fund) and that then gradually puts more money into that position month by month. Put a fixed amount in so that you buy more shares when they’re cheap and fewer when they’re expensive. Fund these buys by selling U.S. positions that look over-extended. (You aren’t trying to eliminate your U.S. exposure but to shift from overweighting U.S. stocks to a neutral or perhaps underweight exposure to U.S. markets.) Think about beginning this shift in May and carrying it out over three to six months. The big challenges to the U.S. market come in the second half of the year, in my opinion.
It would be good to be in front of those challenges rather than behind them.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of January see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/ I will have the fund’s portfolio holdings as of the end of February posted by the end of this week.
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