While recent equity strength appears to be climbing a wall of worry, Bob Savage argues that it will ...
Prepare for a Stock Market Curveball
03/07/2011 5:41 pm EST
Expectations for domestic growth could soon get a reality check, so it's time to plan investment moves to dodge a possible correction. Start with emerging markets.
For months, I've been saying that I think the US stock market will be the best-performing stock market in the world for the first half of 2011. And so far the US stock market has obliged.
- On March 4, the iShares MSCI Emerging Markets index (NYSE: EEM), for example, was down 1.2% for 2011.
- Brazil's market, as measured by the iShares MSCI Brazil index (NYSE: EWZ), was down 2.18% for 2011.
- The iShares FTSE China 25 index (NYSE: FXI)—among the best-performing China indexes—was up only 0.81%.
By contrast, the S&P 500 was up 5.4% for 2011.
More recently, I've also warned that, while I think the outperformance of the US market is likely to continue for a while, it's no time to get complacent. (See my February 8 post for more on this topic.)
Today, I'd like to go one step further, and say it's time to think about strategies for rotating out of US 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 has pushed me to this next step?
There's evidence that expectations for the US economy and US 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 underperformance in the United States.
There's also evidence that expectations for (at least some) emerging economies, and for stocks in those emerging markets, are sinking like a stone. When that happens, a stock market begins building a base from that low level of expectations, before moving up as expectations improve.
In other words, these markets are looking at a future period of outperformance.
The reaction to the March 4 US jobs numbers is a good indication of how expectations are starting to run ahead of actual economic performance in the United States.
First, let's look at what the data said about the economy:
- According to the Bureau of Labor Statistics, the US economy added 192,000 jobs in February.
- Economists had forecast an increase of 185,000, 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% in January. The full unemployment rate—which includes potential workers who have stopped looking for employment, and workers in temporary jobs who would rather have permanent jobs—declined to 15.9% from 16.1%.
That was the extent of the good news. Layoffs from state- and local-government budget crises cut 30,000 jobs from the gains in February, and a monthly drop of 30,000 government jobs seems baked into the US 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 growth north of 250,000 jobs a month. With governments shedding 30,000 workers a month, it's going to be really tough to get to that 250,000 figure.
The news about incomes was also discouraging. Income growth was nonexistent for the month. The average workweek was unchanged at 34.2 hours, and average hourly earnings rose just 1 cent in February. (For the past 12 months, average hourly earnings are up just 1.7%.)
An unchanged workweek plus unchanged hourly earnings? That math is easy—it equals stagnant incomes.
And that's bad news for the economy, at a time when the costs of gasoline and food are rising. The price of gasoline climbed 8.8% in February to a national average of $3.17 a gallon, according to AAA.
If incomes are stagnant and food and gas costs are rising, consumers have that much less to spend on everything else. That's not a recipe for faster economic growth.
The headline in the March 5 Financial Times? "Strong US employment figures raise hopes for sustainable job creation."
Huh? Do you see that in the March 4 data? I don't.
But Wall Street apparently does. And that view is at least partially priced into stocks.
NEXT: Why We Should Question US Growth Figures|pagebreak|
What the Numbers Show
US stocks, as measured by the S&P 500, have almost doubled—to 1,321, as of the March 4 close—from their Great Recession low of 676 in March 2009. That surge has been built on the recovery in the US economy and in corporate earnings.
Earnings have grown fast enough that the price-to-earnings ratio for US stocks has actually fallen for 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, US 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 known as the PEG ratio (P/E to earnings-growth rate), US 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—so with a trailing 12-month P/E of 16.1, the market's current PEG ratio is just slightly over the level (1) that separates the bargains from everything else, for many growth-at-a-reasonable-price investors.
And, of course, that slight premium to a PEG ratio of 1 disappears if you think US economic growth and US stock-market earnings will be higher than expected.
That is, 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—still seems convinced that, as in quarters since the economic bottom, US earnings will beat the consensus projections.
If that's so, US stocks should continue to climb. They aren't incredibly expensive at the moment, after all.
Reason for Doubt
But I think there's reason to question the expectation of consensus earnings growth. The US economy and US 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. A jump in oil prices means higher costs for companies (eating into profit margins). Absent rising consumer incomes (and rising incomes were absent from those March 4 jobs numbers), higher fuel costs also mean that consumers have less money to spend on other things.
- Commodity prices for things other than oil, such as copper and sugar, continue to climb. That means not only higher costs for many companies, but also increasing difficulties in delivering the kinds of cost reductions that have helped earnings grow faster than economies during the recovery. Companies that are 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 US 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 in which interest rates in the Eurozone are likely to rise months before any increase by 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 US economic growth or in US stocks. But they are reasons to think that those expecting earnings growth above the 14.8% now projected for 2011 could be disappointed.
NEXT: How to Take Advantage of the Changing Tides|pagebreak|
The Emerging-Markets Advantage
Now, contrast these perhaps overly sunny expectations for the US economy and US earnings in 2011 with expectations for an emerging economy and market, such as those of Brazil.
Economists and analysts are engaged in a race to see who can most quickly cut projections for growth.
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, then abandoned. A new consensus seemed to be forming around 4.5%, but recent projections have pushed well below that.
For example, Nomura Securities recently cut its estimate for Brazil’s growth rate in 2011 to 3.9%. Nomura's previous projection had been 4.4%. (Nomura projects that interest rates will hit 12.5% by the end of 2011.)
I think 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, as well as 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 US showing an increasing likelihood that expectations are too optimistic and outrunning likely real outcomes. For Brazil, you'd see a line showing an increasing likelihood that expectations are too pessimistic and underestimating real outcomes.
And at some point you would decide to start switching from the overly optimistic US market to the overly pessimistic Brazilian market.
What to Do Next?
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.
US stocks are running ahead of the US economy now, in my opinion, but we aren't likely to see much concrete evidence of any problems in earnings performance until reports for the June quarter (although some might show up in earnings guidance for the March quarter, to be released in April).
Sometime in May, then, I'd start to look at selling—not the entire US market, just a few US stocks that look especially overextended—and rotating that money into Brazilian stocks that look especially undervalued. I'd do the same with other emerging markets, on an individual calendar that takes into account where each market is on its path to excessive pessimism.
(Some markets seem to have a long way to go. I think India's troubles, for example, are still underestimated. Some markets—such as Indonesia's, for instance—are not that far behind Brazil's.)
What I'm advocating is a kind of dollar-cost averaging that begins with an initial position in an emerging-market stock or country-focused exchange-traded fund, and then gradually moves 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 US positions that look overextended. You are not trying to eliminate your US exposure, but instead to shift from overweighting US stocks to a neutral or perhaps underweight exposure. Think about beginning this shift in May and carrying it out over three to six months.
The big challenges to the US market will 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 (JUBAX ), 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 here.
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