As I noted in Part 1 of this series it seems reasonable to expect that even after a U.S. economic recovery, it will be difficult for long term U.S. GDP to grow at the rate that has been seen in the postwar era. Long term real GDP growth is likely to struggle to exceed 3%. That would put a long term expectation for U.S. equities to produce real returns more in the area of 4 -6% rather than the 6-8% of the past.
Which U.S. Stocks To Own?
The evidence is fairly clear that stock picking either by an individual or an “active” mutual fund manager is not a path to investing success. Passive investing through low cost diversified investment vehicles is the preferred path. But that does not necessarily mean that the best path is to own an S&P 500 index fund (which is actually a portfolio of large-cap stocks chosen by a committee) or a broad based capitalization weighted index through an ETF such as VTI is the way to go.
The evidence is quite strong that over the long term “value” stocks and small stocks provide superior risk/return characteristics. There are many passive vehicles to implement for a “value tilted” portfolio. ETFs and low cost index funds are available using varying methodologies based on P/E, P/B and a range of other factors. Among these are the more interesting such as the fundamental index products PRF (large cap) and PRFZ (small and mid cap) and those based on the MSCI indices VTV (large value) and VBR (small value) as well as the funds from Dimensional Fund Advisors, a pioneer in this approach.
Dividend weighted ETFs are one subset of these value weighted passive portfolios. Portfolios of large-cap dividend and dividend growth stocks either through ETFs, actively managed mutual funds or individual concentrated portfolios of “dividend growth stocks” chosen by bloggers have become the near unanimous pick as the U.S. stock strategy for 2012. Not surprisingly part of that reason has been the great performance of this strategy over the last two years. For example, DVY - the dividend ETF, has produced total returns of 17.8% in 2010 and 11.8% in 2011, far outperforming the broader U.S. market.
The various advocates of this strategy argue that one can pick up a dividend yield in excess of treasury bonds and still have the opportunity to gain from dividend increases and capital appreciation. In a world of low interest rates and slow economic growth, it seems a no brainer to own a large-cap high dividend payer. Certainly the argument is compelling particularly since the Fed has given signs it has no plans to raise rates until 2013.
But given what we know about placing too much weight on recent performance and the tendency to extrapolate a short time series as evidence of a new investing paradigm (some now argue dividend stocks are a substitute for bonds), perhaps some diversification away from this strategy makes sense.
It is disconcerting that this trade has become so “crowded." And some of those dividend growth favorites are no longer value stocks.
By contrast the large value ETF has a P/E of 11, the VTV a P/E 12.2.
Perhaps it’s time to use a more comprehensive approach to accessing the long term return advantage of value stocks by purchasing stocks at lower valuations through ETFs such as PRF or VTV in the large cap space or VBR or PRFZ in the small cap space.You can read more about fundamental indexation here from Robert Arnott whose index is used by the Powershares ETFs, and here on the new website of Joel Greenblatt, a longtime value stock picker who favors indexing for most investors You can catch his great little book on the subject too.
That 4%-plus dividend is enticing but a decline in valuation back to the market multiple would mean a loss in stock value that would wipe out the dividend income. In other words, negative total return. Since most people measure their investment performance by total return i.e. the account value on the statement, purchasing a large-cap dividend stock in an industry like consumer staples at a P/E premium to the overall market should raise some yellow flags.
Furthermore it is well known that during periods of stock market recoveries small-cap stocks outperform large caps. In 2009 the small-cap fundamental value ETF PRFZ returned 58.7% vs. 11.1% for the high dividend DVY. Because of that the total three-year return for PRFZ is nearly twice that of DVY, 89% vs. 45%. Below is the growth of $100,000 over that period with PRFZ in blue, DVY in green.
Should the market rally in 2012, those with concentrated portfolios of large cap dividend payers might well find themselves missing out on much of the markets returns.
Could it be the case that once again in 2012 large-cap high dividend paying stocks produce returns well in excess to other sectors of the market? Absolutely yes.
But I would view it as unlikely that utilities will repeat as the top performing industry sector again in 2012 (XLU utilities up 19.6% in 2011 followed by XLP consumer staples up 14.1%). Here is a chart comparing three-year returns for XLU, XLP, PRF and PRFZ and VTI total U.S. stock market (three-year returns top volatility bottom).
A bit more diversification with small-cap value stocks and large-cap value stocks beyond the high dividend universe might be a better way to position a U.S. stock portfolio in 2012.
I won’t hazard a guess on how the European crisis will turn out. But I view it as extremely unlikely that the German economy or the profitability of German companies will go into a long-term secular decline. Germany still has a budget and trade surplus, relatively low unemployment a highly skilled labor force and some of the highest quality companies in the world producing state of the art products.
Here is a list of the top 10 holdings in EWG, the Germany ETF.
Top 10 Holdings (61.62% of Total Assets)
Quite an impressive list. It is hard to see that even a prolonged downturn in the economies of the weaker countries in Europe will hit these companies significantly more than their U.S. competitors. Furthermore many of the large multinationals on this list are significant exporters to the emerging markets and benefit from their growth.
Yet looking at stock market valuations it seems the market is anticipating exactly such a scenario. A widely used measurement of long-term stock valuation is the Shiller P/E (price/earnings) ratio, which is calculated on 10 years of earnings. It gives a good picture of long-term valuations, and gained quite a bit of notoriety after the term “irrational exuberance” was coined, referring to stock valuations at the height of the tech bubble.
And below is the same measure for Germany and France:
The German market is trading at its lowest valuation in 30 years and at a P/E ratio half that of the U.S. It’s hard not to believe that there is long term value in purchasing a portfolio of world class German companies through a vehicle such as EWG. Note that the U.S. market is trading at a valuation 30% higher than the 2008 crisis lows while Germany’s P/E is just about exactly where it was at that time.
In order to justify this disparity it seems to me one would have to believe that a major shock to the European monetary system would massively hit the profits of Germany’s global corporations while U.S. companies would emerge virtually unaffected. Plus one has to factor in the fact that Germany’s public fiscal situation is far healthier than the U.S.
Will this German stock rally begin right now? Have we hit the “bottom” for EWG? Frankly I have no idea. But it does seem that a patient investor looking at relative valuations would seriously consider building an allocation to the German market. And given that the conventional negative wisdom has probably encouraged more than a few leveraged short bets against this market, the rally could be very sharp as the shorts run for cover.
It could very well be that when we look at the bad calls for 2012 that “avoid all European stocks” will be at the top of the list.
Known Unknowns: Emerging Markets
Last year was quite ugly for emerging markets. Investors were jittery and reacted with quick triggers at any hints of slowing growth, particularly in China. Emerging markets are notoriously volatile and often attract hot money that flows in after periods of strong performance and flees on sell-offs, thereby further increasing volatility. Thus it shouldn’t be too surprising to see a double digit decline in 20.11 (-18.8%) after returns of 76.3% in 2009 and 19.5% in 2010.
Given our knowledge of investor behavior and the flow of funds data for ETFs and mutual funds, one can be quite confident that few investors who owned emerging markets stocks during the period 2009 -2011 captured the three year total return of 64% (vs. the U.S. S&P 500 46.5%). Growth of $100,000 below (VWO blue, VTI green).
A thoughtful research paper from Goldman Sachs examines the relationship between GDP growth and equity returns in emerging markets. It concludes there is a strong link between the two although in the short term emerging market prices are very sensitive to changes in forecasts of economic growth. Clearly that explains part of the emerging markets performance in 2011.
Below is a graph of GDP growth and equity returns in emerging markets. One can see that equity returns and GDP growth are linked although at times there is a bit of a lag.
In the longer term it is reasonable to argue that long term equity returns will be tied to long term GDP growth. The Goldman Sachs analysis argues that real (after inflation) return for a stock market should be equal to the real GDP growth plus the dividend yield. With the dividend yields across countries clustered around 2%, the significant driver of the difference in long-term stock returns should be the difference in GDP growth.
It is hard to argue that the long-term growth advantage lies in the emerging markets. The Goldman Sachs researchers for example forecast a long-term real return on Chinese equities of 10.6% based on GDP growth of 8% p.a with the comparable numbers for the U.S. of 3% and 4.8%.
These GDP trends would certainly argue against avoiding emerging markets despite their 2011 decline. In fact for those without a significant weighting it is likely an opportunity to establish a core allocation in emerging markets. Broad based emerging markets ETFs include VWO and EEM.
Burton Malkiel in today’s WSJ makes the case for emerging market outperformance, noting the fundamental factors in their favor, and he writes:
Historically, emerging-market equities had price-earnings multiples 20% above the multiples for the S&P 500. Today, those multiples are 20% lower. And emerging-market bonds have significantly higher yields than those in developed markets.
Will emerging markets produce returns twice that of the U.S. market in 2012? I have no idea. Does it make sense to have a significant weighting in emerging markets as part of one’s equity portfolio? Absolutely yes. Should one eliminate or reduce one’s allocation to emerging markets based on 2011 returns? Absolutely not.
Are the above thoughts forecasts for what will happen in 2012? I would prefer to argue that these are reasonable long-term expectations for market behavior given current market conditions and long term behavior of financial markets.
Could they prove to be way off the mark in the near term? Absolutely yes. But the longer term patterns of financial markets argue that positioning in this manner will prove profitable.
The key to success is not to “bet the house” on these tendencies by not holding a globally diversified portfolio across asset classes. It does make sense not to do so blindly without paying some attention to relative valuations and long-term market behavior.
Additional disclosure: Mr Weinman's clients own PRF PRFZ VTI VTV VBR DVY and EWG.