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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

XHB vs. ITB
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 [ppopup id="3860"]S&P 500 index[/ppopup], same as this time last year. Because of [ppopup id="3914"]AAPL[/ppopup], the [ppopup id="3862"]Q’s[/ppopup] 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. [ppopup id="3915"]FXI[/ppopup] and [ppopup id="3916"]HAO[/ppopup] look promising.

This week, we sneak a peek at two reasonable sized funds in the emerging markets that are often overlooked by investors ([ppopup id="3917"]EPI[/ppopup] at $1.3bn in assets and [ppopup id="3918"]TUR[/ppopup] 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, [ppopup id="3917"]EPI[/ppopup] 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 [ppopup id="3918"]TUR[/ppopup]. 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

China's Electricity Production - Monthly
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

Imported Iron Ore - Monthly
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.

Regime Uncertainty – Why We Are Still Waiting

As my eldest daughter approaches her final year of high school, I am constantly reminded (and proud) that she is starting to take in a larger view of the world. Most of the time, this takes the form of the typical issues which energize people her age. We don’t always agree but it is nice to have a civilized debate from time to time. And I like to think that we have both learned from the interaction.

But the other day, she asked me how things were going in the market over the dinner table. When I responded with a short (my wife occasionally makes wild claims that I can go on a bit), pithy response, she crinkled up her nose and declared: “Well, it sounds like nothing much has changed!”

I really couldn’t find fault with her statement. Europe is still becalmed (some people would use a stronger adjective), the US government is still spending several percentage points of GDP more than it is taking in, sovereign debts are piling up and interest rates are being held aggressively low.

The resolution to Europe’s issues will continue to suffer from the lack of a Federal political structure to match the monetary union. Given the history and recent election results, US politicians will raise taxes and make only token cuts to spending, giving us neither a balanced budget nor a pathway to revived economic growth. And, because the FED’s actions are transmitted globally through the US dollar, the artificially low interest rates (for some) will continue to clog up the global economic arteries.

The interest rate issue bothers me in particular because the FED’s well intentioned QE and Twist programs play havoc with the pricing signals that individuals, corporations and governments use to make decisions. Corporations are sitting on piles of cash because their investment yardsticks are sending very conflicting messages about the cost of capital and hurdle rates. Knowing that the interest rate regime could change overnight by bureaucratic fiat does not engender great confidence when planning for a multi-year, multi-billion dollar investment strategy.

Just when I was looking for a way to simplify it down for myself and others, the Mises Institute dropped an article into my email called “Regime Uncertainty”.

The crux of the Mises article is that we are experiencing a slow recovery because net new private investment has stalled. This is the private investment over and above what is required to keep our capital stock in shape (considering depreciation and obsolescence). In past recessions, the drop off in private investment reverses within a year or two of the economic trough. The only two times this has not occurred in the past 100 years: “during the Great Depression and during the past five years.”

The author determines the core problem to be Regime Uncertainty. In the 30’s, the future of property rights did not look bright given the global trends towards Fascism and Communism which were really two different versions of state directed economies. Nowadays, the risk to property rights seems to be more a question of slow erosion through higher taxation, a larger public sector and government regulation rather than outright expropriation of assets.

That explanation goes a long way towards fitting the “fact pattern” that we see playing out in the developed economies today. Corporations are not only facing the usual uncertainties of the marketplace but they have the added uncertainty of the operating regime in these markets. The interest rate manipulation which vexes me can be seen within this framework as just another government encroachment on the normal workings of the private market.

And, if we need more evidence that the markets are being led around by the politicians, look no further than today’s 2% rally on the news that maybe the politicians will get their act together in time to avert the overhyped “Fiscal Cliff.” Given that the Fiscal Cliff is the artificial construct of the same politicians who are now being compelled to solve it, is it really that hard to see why private capital feels reluctant to mobilize?

After all, everything is on the table according to these politicians. If you are the CEO of a major corporation or bank, do you want to place any serious bets before the end of the year? Hmmm…it seems that “Regime Uncertainty” is not such a radical title for an article after all.

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