Our last investment update was published shortly after the November elections. At the time, we suggested that historically, markets don't care very much about election results and noted that year-end rallies were quite typical in election years. Since then, stocks have rallied in the double digits and three months later, investors are confronted with yet another set of uncertainties. So we figured this was a decent time for an update on portfolio strategy and our investment outlook for capital markets in an environment now naively classified as The Great Rotation. This article serves to share a few of the points we've discussed internally during the past week. The bottom line can be expressed as follows: Too much optimism in the short term; better value abroad in the long term.
Three years in a row, the market has launched out of the starting gate in January, and last month was the best in almost two decades. But the pattern in the past two years has been for the market to go limp after a strong start. This year is setting up to prove Mark Twain right again, as the weight of the evidence points to rough waters ahead. We are sitting on higher than normal cash levels across our portfolios, waiting to buy at lower prices. After putting some of our dry powder to work around the November elections last year, we now believe investors should consider positioning more defensively and hold off on additional equity purchases. Importantly, there is a big difference in the set-up today vs. the set-up pre-cliff. Back in November, markets were oversold and sentiment was washed out. Accordingly, we made a case for a tactical rally in stocks. But today, we are confronting much more challenging conditions. The chart below shows that economic activity is likely to roll over soon and markets are likely to be disappointed given inflated expectations. This has been a great indicator post crisis and just flashed its fourth sell signal since the 2009 lows. Each of the prior signals preceded a cyclical top in risk assets. We are not expecting a different result this time around.
Pointing to a Pullback
Furthermore, investor sentiment has reached euphoric levels, the market is overbought and the VIX recently hit its lowest levels since 2007. Capitulation is everywhere and the bears are running for cover. A correction is overdue and the cycles we monitor warn of a soft patch ahead. According to our friends at Hussman Funds, present market conditions are not exactly welcoming and now match only six other instances in history: August 1929 (followed by the 85% market decline of the Great Depression), November 1972 (followed by a market plunge in excess of 50%), August 1987 (followed by a market crash in excess of 30%), March 2000 (followed by a market plunge in excess of 50%), May 2007 (followed by a market plunge in excess of 50%), and January 2011 (followed by a market decline limited to just under 20% as a result of central bank intervention). "These conditions represent a syndrome of overvalued, overbought, overbullish, rising yield conditions that has emerged near the most significant market peaks - and preceded the most severe market declines - in history."
We are not ringing the '87 alarm just yet, but we do believe that a run-of-the-mill 10% correction in stocks should not come as a surprise here, particularly considering that the first quarter of the presidential cycle has historically been the weakest, January's performance notwithstanding. A pullback of this magnitude would be just enough to relieve overbought conditions and excess optimism and give the SPY one last run toward all-time highs before facing the long term realities of record high profit margins and uncomfortably high valuations.
Looking for a Catalyst
Last week, markets reacted swiftly to the Federal Reserve's growing discomfort with easy-money policies as some suggested the Fed might tighten policy sooner than expected. While we believe the chances of an early end to QE are somewhere between slim and none, what we believe isn't worth a whole lot. Rather, the market will be driven by consensus expectations, and given the likelihood of rising inflation pressures over the next couple quarters, those expectations will begin to shift their focus toward policy tightening, creating a large headwind for the market in the second half of the year. Granted, this headwind may arrive sooner than expected given the relentless spike in gasoline prices, as shown in the chart below.
Putting all this together, we see a number of catalysts on the immediate horizon which could spark a sell-off in risk assets. In addition to the growing risk of central bank policy mistakes, the debt ceiling deadline is looming in May, and in the near term, we have to monitor the event risk posed by Italian elections and the U.S. sequester. We believe keeping some dry powder on the sidelines to scoop up cheap assets is prudent here. We are also selling call options on the stocks we own to take in some premium and sell off some upside beyond what we believe is a fair price.
Better Value Abroad
With a number of major markets approaching record highs, some investors are suffering from nasty flashbacks. While the current advance is similarly overextended as the last major market peak, there are enough differences to warrant a more constructive stance today. Many market internals remain healthy, global economic momentum is likely to improve, and most importantly, long term valuation measures point to value in international equities. Bottom Line: The median correction in post-election years has been 9.6% so our eyes are open for buying opportunities into an expected decline and focused on companies domiciled outside the states, which are more attractively priced today.
Although the recent rally has left European stocks slightly more expensive than where they stood last fall, valuations remain much more compelling than those in the states and we expect this gap to close over time. Furthermore, dividend yields are much higher in the EU providing investors with an opportunity to focus on high quality companies distributing healthy cash flow.
Despite the obvious and long-running macroeconomic concerns in Europe, we actually think the decision to overweight European equities is increasingly obvious today. Normalized valuations are roughly half the levels of U.S. stocks. Dividend yields provide almost twice the cash flow to investors. And earnings risk is significantly lower than in the U.S. as margins are quite depressed in Europe, while they remain at record highs at home. As a result, we are looking for volatility created by recent elections in "the old country" as an opportunity to increase allocations.
A similar case can now be made for emerging market equities, which have de-rated relative to developed markets and now trade at a discount to slower growing western markets on a price-to-book basis. Following a multi-year downward adjustment to growth expectations, emerging market equities now trade at a discount to both historical levels and to global equities on an earnings basis as well.
Contrary to the downturn in U.S. Economic Surprises, our work on emerging market leading indicators continues to point to a short term acceleration in economic activity, albeit with significant risk of a long-term hangover. We are seeing some early signs of "improvement" in recent economic data out of China and consequently, emerging market equities are poised to benefit from a low starting point in terms of valuations and expectations. But don't worry. We'll revisit our structurally bearish thesis on China again soon. In the interim, be sure to read Ed Chancellor's most recent piece on the subject, available here, so as not to get too excited about our cyclical call amidst the secular risks.
As for bonds, there are still plenty of opportunities to earn a decent spread over government securities. For our part, we continue to focus on select areas of structured credit markets along with short duration, high-yield "orphan" corporates.
Shame on Me
That's it for now. I just couldn't work up the strength to discuss precious metals and mining companies today. For two years in a row, the price of gold has risen while the price of gold stocks has declined, a lot. The sector now trades at an extremely depressed multiple of cash flow and the stocks are significantly depressed relative to the price of gold, offering a relative margin of safety even if gold prices were to fall substantially from here, which is not our expectation. It would seem that, contrary to equity market ecstasy, the state of morale in the gold mining universe has hit rock bottom, and then sunk a bit further. We couldn't imagine a better setting for a tremendous rebound in the price of these stocks. Then again, we made this same argument last year, which is why I'm not bringing it up today. Fool me once, shame on you; fool me twice, shame on me.