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The market correlations are a changin': Could this be the end (in the short term) of U.S. outperformance?
10/23/2012 8:30 am EST
But what I find oddest about these predictions is not that they’re necessarily wrong but that they ignore the facts of life in the financial markets for the last two-plus years. The predictions that I’ve seen talk about prospects for earnings growth of 7% to 11% in the fourth quarter of 2012, which after a decline in earnings in the third quarter of 2012 would set the market up to move ahead in 2013. Or the predictions point to continued low interest rates from the Federal Reserve and the extra liquidity being pumped into the economy and market by the Fed’s most recent program of quantitative easing. Or they argue that although the price to earnings multiple on the S&P 500 has climbed to 13.3 from 12 at the beginning of 2012, there’s still room for further advances since the multiple at the peak in 2007 was 15.2.
All those observations are true, but they’ve been beside the point recently. What’s oddest to me about these predictions is that so few take into account the peculiar macro-driven nature of the financial markets over the last couple of years. For the two years or more—pretty much since the spring of 2010 when investors around the world started to focus on the possibility that Greece, Ireland, Portugal and more were facing default—financial markets have been dominated by big macro trends. And that has meant that they’ve moved in startling lockstep.
Which means that the most important question for you right now as you build you portfolio isn’t whether the U.S. market might move up 9.2% by the end of 2013, but whether that lockstep period might be coming to an end. And whether in 2013 other markets might be able to rise even when the U.S. market doesn’t or at least outperform the U.S. market.
You’ll recognize the pattern I’m about to describe. After all we’ve lived with it for roughly two years.
When fears about the EuroZone flared, global assets moved toward “safe” havens in the U.S. and Japan. The effects could be disconcertingly—to investors trying to hedge their risks—widespread. A stronger dollar, for example, could lead a drop in the price of commodities (and commodity stocks) and even produce a retreat in the price of gold. Gold, an asset purchased to hedge against financial turmoil, falling because of financial turmoil? Go figure.
When it looked like one plan or the other might succeed in heading off the EuroZone crisis—for the moment—European stocks and bonds would rally. And so would other risk-on assets such as stocks in emerging markets.
Add in such macro drivers as fears of hard landing in China or a slowdown in U.S. economic growth and you don’t change the story—the price of assets is still determined by macro trends—even if you make it more complicated.
I don’t see how any analyst can make a prediction for 2013 without taking the macro driven nature of the past, current, and, I’d argue, near-term future market into account. Global cash flows, a major driver of asset prices, are nervously trying to figure out the risk and reward of stakes in specific markets and asset classes. The money that flowed into U.S. markets as investors sought a safe haven during the EuroZone debt crisis has been a major factor in driving up the prices of U.S. stocks and bonds in 2011 and 2012. A reversal of those flows would act as a brake on U.S. asset prices and encourage the appreciation of assets in the markets receiving those flows. Macro trends won’t be the only determinant of asset prices in 2013, but decisions about allocations among markets and asset classes need to take our best projections of those macro trends into account.
To unravel those trends, and to get some insight into how correlated markets are likely to be in the rest of 2012 and in 2013 I think the looming fiscal cliff in the United States is place to start.
One of the most striking things about recent predictions for 2013 has been the assumption that the U.S. just won’t drive off a fiscal cliff at the end of 2012 or at the beginning of 2013. Politicians in Washington, Wall Street assumes, won’t be so stupid, self-destructive, and short-sighted as to let a combination of the expiration of the Bush tax cuts, the end of the reduction in Social Security taxes, and the imposition of automatic budget cuts send the U.S. economy back into recession.
I think the most likely outcome is indeed some kind of a deal that prevents the U.S. from pulling a Thelma and Louise. But we can be assured that the process won’t be easy, smooth, or quick. There will be moments when a deal looks just around the corner and moments when it seems impossible. We know from the long-running cliffhanger that is the EuroZone debt crisis that the cumulative effect of this kind of melodrama is a gradual increase in nervousness and fear. Throw in, as I think we should a coupe of warnings from Standard & Poor’s and Moody’s Investors Service about possible downgrades to the U.S. AA credit rating and some posturing by the partisans on the Democratic and Republican side (extremely likely if President Obama wins re-election and some Republicans decide it’s their job to make sure his second term doesn’t succeed) and it’s hard to see why investors would be willing to award the United States automatic “safe-haven” status.
How big any gradual diminution of the “safe-haven” premium will be over the next two quarters or so will depend not just on what does or doesn’t happen in the United States, but also on how macro trends unwind in both Europe and China. Remember the market’s vote of confidence in the United States hasn’t been a vote for the absolute quality of U.S. fundamentals but a judgment on the relative in the quality of those fundamentals versus the EuroZone and China.
So if the squabbling in the U.S. over a solution to the fiscal cliff rises in volume at the same time as the EuroZone and China look relatively less risky, we could see a fairly high flow of investment cash into European and Chinese financial assets.
How likely is it that Europe and China will seem less risky over the next few months? Notice the exactly wording of my question. I’m not looking for an actual solution to the deep-seated problems of the European currency union or a rebalancing of the Chinese economy and reform if the Chinese banking system. Instead I’m trying to gage whether we’ll see temporarily convincing short-term moves that raise confidence in those two economies.
And the answer to the question phrased in that way, is that an increase in short-term confidence is likely in the next two months. November is likely to bring a formal request from Spain for the European Central Bank to start a program of buying of Spanish government debt and a disbursement of the next payment of cash to the Greek government from the European rescue fund. Neither of these acts will solve the EuroZone debt crisis in the longer term. I think Greece will need another write down of its debt sometime in 2013 and this time the European Central Bank will have to swallow the bitter medicine and participate in the write down. And I think bond-buying support for Spanish government debt won’t significantly add to Spanish economic growth or reduce the country’s horrific unemployment rate or safe Spain’s regional governments from bankruptcy (under one name or another) or make the huge amounts of read estate bad debt disappear from the balance sheets of Spanish banks. All these efforts will be is buy time.
But, and this is the crucial aspect, from an investor’s point of view, November’s actions will reduce the fear that the EuroZone is about to blow up and that Greece and/or Spain are about to be thrown out of the club and into international default. That may not bring cash flooding back into European assets—the EuroZone economies will still be near recession levels of growth—but it will be enough to reduce the demand for U.S. assets as a hedge against European disaster.
China is in an analogous position. China’s financial markets have rallied in the last six weeks on a belief that the third quarter marks to bottom for China’s economic growth rate. Recent weeks have brought retail sales, export, and money supply numbers that suggest that August may have been the low and that September has brought a modest recovery. The fear of a hard landing for China’s economy will recede as long as we don’t get data that turn current hopes into disappointment.
What’s the effect of all this on the markets?
- The dollar weakens against the euro. That’s good for the prices of commodities, which are likely to move up on hopes for Chinese economic growth. It also leaves room for gold to advance on a decline in the U.S. currency and fears over the U.S. fiscal cliff.
- Emerging market stocks will look more attractive as fears that the EuroZone debt crisis will blow up move, temporarily, to a simmer from a boil.
- China stocks and emerging market stocks in general should get a boost as fear of a Chinese hard landing diminishes and on the hope that China’s growth rate has bottomed.
- Better than expected economic growth in the United States will, of course, to improve the prospects of U.S. stocks, but to investors who fear the U.S. fiscal cliff, non-U.S. exporters to the United States might be a better way to play this extra growth.
The exact way this plays out across global markets depends, largely on how scary the U.S. fiscal cliff starts to seem.
If it’s very scary, I think we’ll see a continuation of recent trends where most markets and assets move together. If the U.S. looks like it’s headed off a fiscal cliff, I think it will be hard to imagine other markets moving up. The one asset that I’d look for to do well in this scenario is gold, which would rally on fear and the fall in the U.S. dollar.
If, however, the U.S. scenario is only moderately scary, I think we will see some markets move out of strict correlation. A moderately scary crisis is enough to make investors think about whether the potential of a 9.2% gain in U.S. equities (that’s the distance to the 1565 2007 top from the Friday close at 1433 on the Standard & Poor’s 500) is enough to make up for the risk of a credit downgrade, a fiscal logjam in Congress, or a irresponsible compromise that rattles credit markets. When the bullish analysts on Wall Street are offering you only a 9.2% potential gain from current prices, it doesn’t take much fear to make the offer unattractive.
And in this case emerging market stocks would make an attractive alternative—if growth in China looks like it has stopped tumbling. Certainly the potential upside is more attractive. The Shanghai Composite Index is down 38.1% from July 2009 and down 63.2% from the November 2007 high. That’s enough potential, if macro trends don't make any risk too risky to take to make China and other emerging markets attractive in any less-than-really-scary global scenario.
In practical terms what does that suggest that you do?
Check your portfolio’s exposure to gold and other precious metals. Gold has done reasonably well this year with the SPDR Gold Shares ETF (GLD) up 9.86% as of the close on October 19. But that does trail with S&P 500 so far this year (up 15.96%). I think those relative performances could reverse rankings in 2013.
I don’t think you need to move out of all your U.S. positions by any means, but I would concentrate on sectors that show some ability to outgrowth the general U.S. economy right now. Two I’d suggest are housing and housing related stocks, which are a big beneficiary from the Fed’s newest round of quantitative easing, and technology shares, which have been battered by bad earnings news from PC sector leaders Intel (INTC) and Microsoft (MSFT). This week brings a quarterly earnings report from Apple (AAPL), which will go a long way to determining the near-term chances of a technology rally.
A little further down the road, check to see how scary the U.S. fiscal cliff crisis seems to be. The scarier it is, the more you should look for safety in your U.S. stock portfolio. I’d look to dividend payers and consumer stocks, especially if they’ve been crushed lately like McDonald’s (MCD) was this past week.
At the same time I’d be slowly adding positions in China, Brazil, and other emerging markets. My post http://jubakpicks.com/2012/10/19/good-china-stocks-and-bad-china-stocks-and-how-to-use-them/ gives you some suggestions on what stocks to look at and how to stage any buying in that market. I’ll be taking a similar look at Brazil in the next week or so.
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 http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple and McDonald’s as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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