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While the recent stock market rally may seem to signal that the worst is past, a look at the big picture tells us otherwise. Look at the following obstacles, and you will know what I mean.

  1. The economy is deleveraging. Not long ago, we were leveraging up. Growth was fueled by debt and was further boosted by the multiplier effect. For every dollar borrowed, the economy expanded by several dollars. Economic expansion thus went on steroids. Now, the reverse is happening. Consumers and businesses are reducing debt. And for every dollar of debt reduction, a few dollars are withdrawn from the economy. Therefore, we are now in a hangover state in which activities will shrink, putting pressure on revenues.
  2. Leverage magnified profit margins in the recent past. Now that leverage is in reverse, profit margins and the bottom-line will contract.
  3. The cost of borrowing is going up. So again, profit margins and the bottom-line will be under pressure.
  4. It took the world about the last 20 to 30 years to leverage up. It will take much longer than a year or two to unwind the leverage.
  5. Taxes in the U.S. are going up. Higher taxes will further impede economic growth and will also erode profit margins.
  6. As borrowing costs rise, investors will begin to discount stocks at higher rates, meaning that stock PE ratio, and therefore stock valuation, will fall.
So you see, three important stock drivers, namely top-line, bottle-line, and PE ratios, are all fighting an uphill battle at least for the foreseeable future. Given these challenges, it is hard to be overly optimistic about stocks. More importantly, after the recent surge, broad markets in the developed world appear to be at or close to fair value. To find attractive stocks, I believe Asia is a better place to look because the fundamentals there are stronger than those in the developed world. These fundamentals are outlined here:
  1. The banks in Asia are not as exposed to the bad debts as U.S. and European banks are. As a result, Asian banks will able to resume normal lending much faster than their developed world counterparts.
  2. Asian economy is growing faster than the developed economies.
  3. The balance sheet of Asian consumers is healthier than those in the U.S. and in Europe. Therefore, consumer deleveraging, and its effects, in the former market will be less pronounced than in the latter markets.
  4. China has US$2 trillion of foreign reserve, a budget surplus, and a trade surplus. So China has the firepower to spend itself out of trouble and lift Asia along. The U.S. is opposite. It has large national debt, budget deficits, and trade deficits. It is having trouble borrowing from overseas, so it is printing huge sums of money to save itself. Common sense tells us that governments cannot print money indefinitely. If they keep doing it, sooner or later, the dollar will crash and the consequences will be tragic.
  5. Asian stocks have fallen harder than the developed markets have. And even after the recent run-up, many Asian markets remain cheap. For example, the Singapore Straits Times Index and the Hong Kong Hang Seng Index are at levels close to their levels in the early 1990’s, before the Asian financial crisis.

In summary, I believe that a recovery of the world economy and stock markets will be slow and bumpy. However, I believe that Asia economies and stocks will lead the developed markets for the next few years.

Disclosure: Long TDF, no positions in IVV, EFA, EWH, EWJ, EWS, EWT.

Source: Asia Will Lead the Developed Markets Over the Next Few Years