ETF Archives

The “Great Rotation” and Risk

The FundLogik Application continues to point towards a risk weighting. For most portfolios, that means a shift towards equities and away from fixed income.

Last week, we looked at one of the main currents of money flow which drives global financial markets. This week, we look at the factors which drive the money flows into one of the key asset classes available to investors: Equities.

How Wall Street views Equities

According to the collective judgement of investors on Wall Street, a dollar of earnings this year will cost $15 if you select the average Blue Chip stock from the S&P 500. And, for the optimists in the room, that $15 dollar figure for stocks falls to $12.30 if one looks forward to 2014 earnings rather than backwards to 2012 numbers. That same dollar of earnings will cost you $50 if your tastes run to 10 Year US Treasury Bonds. As bond interest is fixed, there is no need to calculate a rosy scenario.

To Wall Street strategists, this big price difference between equities and fixed income suggests an imminent “Great Rotation” from bonds to stocks as rational investors rebalance between relatively expensive bonds and cheaper equities.

Three Factors

3factors The “Great Rotation” and RiskAre they right? The answer is yes but probably not for the reason usually pushed to the front of the research report (stocks are cheap, bonds are expensive). There are three factors which drive stocks and stock markets: Earnings, Interest Rates and Risk.

Earnings: Supportive of Equities

If you limit your focus to quarterly earnings and consensus forecasts, you will see an exciting jump in expectations at the beginning of this year. The numbers that go into the overall S&P 500 estimate are important because most institutional money is benchmarked to the index or a close derivative thereof. If you are interested in some of the key biases which drive the consensus forecast process, ZeroHedge has an insightful article on the subject.

SPX Earnings The “Great Rotation” and Risk
Source: Bloomberg

Before one gets too excited, let’s step back and view a couple of years at once. The phenomenon highlighted with the small red arrows is known as “earnings roll.” Analysts, who are employed by brokerage firms in the business of selling stocks to clients, push their numbers up in the beginning of the year and then adjust them as quarterly reports come out.

SPX Earnings1 The “Great Rotation” and Risk
Source: Bloomberg

So, if you look at the red line on the second chart (which charts the running 12 month forward forecast), earnings are moving in a positive direction but not dramatically. This is supportive of the market but not enough to make the case for a “Great Rotation” on its own.

Interest Rates: Neutral for Equities

This is an easy call because all the Central Banks are working in concert to keep a lid on interest rates. These generational lows in US dollar interest rates have hardly spurred the borrowing and investment boom that some Keynesians had expected. But with debt levels reaching what some consider dangerous levels relative to GDP, few G-20 countries want to think about servicing their debts at high single digit interest rate levels. Rising rates are bad for stocks, falling rates are good. Interestingly, there are new studies suggesting that low and steady levels of interest rates do not correspond to above average stock market returns while high and steady do not necessarily mean poor performance. With no movement expected up or down, this part of the equation is neutral.

Risk: Positive for Equities

The Chicago Board of Options Exchange has an excellent index for measuring the level of risk in the short term (ie. a matter of a month or two) called the VIX. Although this is often cited as The Fear Index in the market, it is important to remember what it is actually used for on a day-to-day basis: pricing options. A high reading certainly does reveal high anxiety in the market and a low reading, relative calm but the measure is by design a short term one.

The risk we are trying to measure is the certainty of forecasts. To give a simple example, the range of expectations for a consumer products company like Proctor and Gamble are much narrower than they might be for United Continental. While the former may stumble in an emerging market or be subject to margin squeeze, the latter can see profits quickly turn to losses with an adverse move in jet fuel prices. Broadly speaking, the tighter range of expectations command higher Price/Earnings ratios (P/E) while the broader range means the company (or the market) is accorded a lower P/E.

Macro factors can also be measured in a similar fashion. When the range of possibilities are uncertain (think some of the hyperbolic commentary ahead of the “Fiscal Cliff”), investors respond with caution and P/E ratios tend to fall. When uncertainties drop away, investors are willing to bid up asset prices and P/E multiples expand.

With the European Central Bank commitment to support the Euro at almost all costs, the passing of the “Fiscal Cliff” and the realization that the trajectory of US Government Debt issuance is likely to pursue a more sedate upward trajectory while the underlying economy continues to grow at a lower but sustained pace, some of the big worries in the market are being calmed.

If one wants a proxy (rather than anecdotal assurances), a reasonable measure of longer term anxiety is the spot gold price. With the arrivals of ETFs, gold is certainly cheaper to hold but the shiny metal still provides no income. Investors buy gold because they are willing to forego income to hedge against the risks they perceive in other asset classes. The FundLogik application and just a cursory look at the charts show that the upward trajectory of gold has cooled dramatically.

Conclusion

The FundLogik application has been flashing “Buy Riskier Assets” since November last year. Now we are starting to see that the market has been a good leading indicator as the conditions for better earnings and a less volatile environment shape up.

Keep holding onto the riskier end of your watch lists…and as they say on the airplane, “sit back, relax and enjoy the ride.”

Home Builders Still Strong

The US property bust was ground zero of the Global Financial crisis. Now, five years later, the business cycle is alive and well and property has turned around. Despite the fact that home ownership is still below peak levels and there is still unsold foreclosure inventory hanging over several real estate markets, the companies in two homebuilding ETFs continue to see improved revenues and margins.

KB Homes announcement of earnings is further confirmation that the sector rebound has legs.

XHB vs. ITB

 Home Builders Still Strong
Source: Yahoo Finance

The biggest difference between the two is the index. XHB’s index is equal weighted and includes more companies in the homebuilding supply chain. ITB is market capitalization weighted and while it also has supply chain companies, it gives greater weight to the actual builders. That weighting difference accounts for most of ITB‘s relative outperformance. XHB, part of State Street’s SPDR range, is slightly larger than ITB, from Blackrocks iShares range, but both have more than $2bn in assets each.

Top 10 Holdings

XHB % of Total
Standard Pacific Corp 3.650%
PulteGroup Inc 3.619%
Mohawk Industries Inc 3.598%
Toll Brothers Inc 3.553%
Ryland Group Inc/The 3.547%
Tempur-Pedic International Inc 3.529%
Owens Corning 3.496%
Select Comfort Corp 3.480%
Lumber Liquidators Holdings Inc 3.477%
DR Horton Inc 3.472%
ITB % of Total
PulteGroup Inc 10.403%
Lennar Corp 10.158%
DR Horton Inc 9.131%
Toll Brothers Inc 8.486%
NVR Inc 7.088%
Home Depot Inc/The 4.176%
Ryland Group Inc/The 3.927%
Lowe’s Cos Inc 3.550%
MDC Holdings Inc 3.443%
KB Home 3.067%

Source: Bloomberg

Reaching Along the Risk Curve

As we break for the MLK holiday, it is a good time to look at where “January Effect” has taken us. In the case of individual stocks, there have been some good performances but the core US indices have largely consolidated the “Fiscal Cliff Deal” gains. We were up just over 4% in the S&P 500 index, same as this time last year. Because of AAPL, the Q’s are only up 3%, against 6% last year. Earnings season has started and although companies are expected to beat their well whispered numbers on the whole, the overall growth in earnings in not expected to crack much above the 3% mark. So, with unemployment still high, developed market economic growth anemic and most of the problems of the last few years being kicked down the road, it is perhaps not surprising that the markets are pausing at these levels.

But the market looks forward and we should see some New Year optimism in the form of boosted earnings expectations and aspirations. So far, most of the enthusiasm appears to be in the emerging markets with East Asia, led by China, taking point. In last week’s issue, we looked at some of the options available there. FXI and HAO look promising.

This week, we sneak a peek at two reasonable sized funds in the emerging markets that are often overlooked by investors (EPI at $1.3bn in assets and TUR at $900m in assets).

India

India is an emerging market but it can hardly be described as a new one. The BSE (Bombay Stock Exchange) started up in 1875, making it Asia’s first exchange. As a result of the markets relative maturity, EPI is a well balanced fund with only a quarter of its assets in financials and a good spread of Energy (21%), Information Technology (12%), Materials (11%) and Industrials (10%). Although the growth rates have cooled in the past few years, the years of strong growth and economic reform have lifted a huge segment of the population into the middle class. This has led to a huge consumption boom of everything from gold to apartments to laundry powder. India’s politics are messy and its relations with its neighbors are a work in progress, but it would be foolish to overlook the huge population and very favorable demographics (especially vis-à-vis China’s).

Turkey

Turkey is a more typical emerging market when one looks at the make-up of TUR. The fund is heavily weighted (52%) to financials. Industrials (12%), Consumer Staples (11%), Telecoms (8%) and Materials (6%) round out the top five sectors. Turkey is exciting because its geographic and cultural positions look very promising in the medium and longer term. As a secular Islamic state, it is well accepted in the Middle East both diplomatically and commercially. As a NATO ally, it demands a seat at the EU table (although France resists). And culturally, the Turkic people of the oil rich ex-Soviet republics along Russia’s southern border are promising consumers and business partners. Like India, Turkey has a few domestic and diplomatic issues that are far from sorted. The only cautionary note for an investor is the local currency, the Lira. Because the ETF is so heavily weighted towards financials, weakness in the currency can drag performance down.

Stick With Risk

January Effect still looks to be alive and well as developed markets hold onto gains and emerging markets show continued strength. Stay exposed to risk assets for the time being.

China: Taking the Temperature

Continuing on from last week’s topic, we look East for signs of a stronger or weaker January effect for riskier assets.

Washington Beltway antics have not gone away (eg. the new Treasury Secretary’s loopy signature). But we think investors should focus on the Global Economy, where companies big, medium and small struggle for sales and profits.

One interesting corner of the Global Economy is China. While there are over 100 ETFs with China exposure (courtesy of ETFdb.com), by screening out sub-$100m funds, one can limit oneself to just 6 ETFs for consideration. FXI is by far the largest (with similarly profiled GXC and MCHI taking #2 and #3 slots) while HAO, PGJ and CHIQ offer exposure to different and smaller segments of the Chinese economy.

What is interesting about the structure of the equities available in China is that they primarily offer exposure to the domestic economy. Exports may have been the important driver of the “China Miracle” but for fund managers and regular investors alike it has always been hard to pick up meaningful direct exposure.

Therefore, when looking at China going forward, it is important to look at indicators for the domestic economy. Two reliable indicators are the imported Iron Ore Price and Electricity Production.

Electricity

ChinaElec China: Taking the Temperature
Source: Bloomberg

Electricity Production is a well-followed index because it has proven to be a very clean and useful data set over the years. While GDP numbers and CPI figures have drawn sideways glances from time to time, the jumpy electricity figures (note the regular Chinese New Year drop every year in Jan-Feb) are not considered politically sensitive. What the figures show this year is pretty consistent growth at around the 9%-10% level.

Iron Ore

IronOre China: Taking the Temperature
Source: Bloomberg

The other price to watch is the Iron Ore import price. China imports bulk iron ore from Australia, Brazil and other countries to feed the domestic and export production machines. From September 2011 to September 2012, the price of sea-borne Iron Ore almost halved as the Chinese economy softened. Part of that was due to the petering out of stimulus programs launched in 2008 and 2009 but the leadership change of 2012 also played a part in the overall bearishness.

Without much fanfare, the price has rebounded sharply, first to the 120 level and now into the 150’s. While most Australia exporters are still keeping $120 in their cashflow projections for the year, it is clear that Chinese demand for Iron Ore has returned.

Conclusion – Cautiously Optimistic

The Chinese Economy looks like it is stabilizing at high single digit growth rates. It is clearly not following the path of fellow BRIC members Russia and Brazil which have experienced sharp deceleration in growth rates over the last few years. The China ETFs are exposed primarily to the domestic market which our two indices above suggest will see some strength. But remember that most of the component stocks in the S&P 500 (SPY), EAFE (EFA) and the DAX (EWG) also have big stakes in China’s economic fortunes. With low expectations for the G8 economies, the global multinationals are looking at the massive middle class spending power forming in China and India to drive growth in the medium term.

FXI ranks well in our Balanced ETF Portfolio, which is the default portfolio in slot #7. It also comes out on top of our large ETF rankings.

How long will “January Effect” last?

Now that the politicians on both sides of the aisle have decided to take a bit more of the private economy in taxes and keep piling up debts for future generations, it is time for markets to return to normal seasonality and resume weighing up the prospects for different investment classes without constant reference to the hot political winds gusting out of Washington.

The question most investors should be contemplating is whether we will see a repeat of last year when the equity markets extended the “January Effect” through the entire first quarter of the year.

The FundLogik application indicates that now is the time allocate a larger portion of your assets towards the “risk” end of the spectrum. Whether that momentum peters our in February or steams on until the beginning of April remains to be seen.

In the 6 ETF FundLogik Portfolio, Non-US large cap equities (represented by EFA) and the Emerging Market Equities (represented by EEM) are ahead of SPY, TLT and DBC with QQQ bringing up the rear. However, if the January Effect does stretch further into the first quarter, it would be logical to expect QQQ to move up smartly in the rankings.

In the sample bond portfolio, Convertibles and Emerging Market debt funds are leading the pack. This suggests an appetite for more risk and a reach for yield.

In the sample equity portfolio, European Equities ranks at the top while Emerging Markets replaces Developed Markets, largely mirroring the FundLogik Portfolio ranking.

In the Blended ETF Portfolio, China (FXI) and International Real Estate (RWX) come out at the top of the list. China was volatile for most of last year but picked up steam after the leadership transition was completed. Real Estate is both a yield play and a capital gains play.

Political Risks will resurface

There are still a few more “political crises” to come, all of them just as manufactured as the one that was “narrowly averted” in the wee hours of the New Year. Whatever one’s political leanings, most can agree that the resolutions are of the “kick the can down the road” variety. Despite the promises to do better next time, the bottom line is that the new political line up in Washington looks the same as the old line up. There is little reason to expect a different outcome next time.

So, what does this mean for investors?

“January effect” should be fairly well pronounced this year. A combination of tax loss harvesting from a volatile 2012, the rehashing of the Euro crisis, leadership change in China and the political drama in the US means that institutions entered 2013 with a bias towards safe assets. Don’t be surprised to see money flowing back into QQQ and SPY favorites as fund managers rebalance for first quarter optimism.

Last year, the “risk off” trade was US Treasuries, the US dollar and, at times, precious metals. But these asset classes have rallied hard in recent years. It is hard to see how there is much upside left in these assets, particularly US Treasuries. The conditions which support the high prices will persist: a still massive US current account deficit, FED purchases of Treasuries and the fact that many other major currencies, particularly the Euro, don’t look very promising relative to the US dollar. Since none of those conditions appear ripe for change in the near term, one can expect continued fund flows towards two of the largest asset classes. There will continue to be “worry pieces” in the financial media about China, Japan or Middle East sovereign wealth funds looking to “dump” their Treasuries. The outcome will be no different; these large holders can shift at the margin but cannot dump. US dollars flowing out through the Current Account will flow back into US Treasuries and other similarly overpriced assets for the foreseeable future.

That does not mean there will be no volatility. Given the fact that both the household and government sectors are still massively in debt, even small shock events will continue to be magnified by the excessive leverage that remains in the system.

The real question is that of rebalancing. Will institutions remain happy to add to their piles of low yielding US Treasuries and cash as well as their non-yielding hoards of Gold? Or will we see more shifting towards riskier assets? At the margin, it is not the foreign sovereign wealth fund that drives the asset allocation but the large US institutions. If a consensus forms that equities and real estate assets are a better value than US Treasuries (ie. not just lip service but actual shifts in asset allocations), then we could see a rise in interest rates combined with a strong surge of liquidity into the stock and property markets. The stock markets will react positively while the US real estate market would probably just accelerate the digestion of the inventory hangover of the last 5 years.

At this point it is hard to say which way the balance will swing. Low growth in the G-8 economies could give comfort to asset allocators that the lofty values at the long end of the Treasury market will be supported by the FED’s commitment to “twisting” the yield curve. A change to the delicate balance however could send investors scrambling. The bloated FED balance sheet plus Bernanke’s commitment to keep interest rates low for as long as possible may not be enough to stem the rush for the exits.

For now, the FundLogik application is pointing towards a healthy “January Effect”. Position yourself accordingly.

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