Tom Lydon Positions For 2012: Emerging Market Stocks And Bonds Trump Developed Ones

by: Tom Lydon

This is the 14th piece in our Positioning for 2012 series. Readers can find the entire Positioning For 2012 series here.

Tom Lydon is President of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net worth individuals. Tom is also editor and publisher of ETF Trends. He began his career with Fidelity Investments and was a founding member of Charles Schwab's Institutional Advisory Board. He serves on the Board of Directors for U.S. Global Investors, Inc. and Guggenheim-owned Rydex | SGI and is also on the Pacific Investment Management Co., LLC (PIMCO) Advisory Board for RIAs. He is the author of The ETF Trend Following Playbook, as well as iMoney: Profitable Exchange-Traded Fund Strategies for Every Investor. He has been involved in money management for more than 25 years.

Seeking Alpha's Jonathan Liss recently spoke with Tom to find out how he planned to position clients in 2012 in light of his understanding of how a range of macro-economic and geopolitical trends were likely to unfold in the coming year.

Seeking Alpha (SA): How would you generally describe your investing style/philosophy?

Tom Lydon (TL): We use technical trading strategies based around the 200 day-moving-average and other indicators, which help mitigate risk. Specifically, we keep an eye on the moving averages, both 50-day and the 200-day and never chase after under-performing markets.

Trend following is a long-term and dependable strategy that helps eliminate the emotions that cause erratic investment decisions. By following a pre-defined strategy before jumping into any investment, an investor is more likely to keep a focused attitude toward investing, instead of trading sporadically or placing bets on gut feelings.

SA: There are numerous ETFs that are likely to be ‘buys’ based on the trend-following strategy you follow at any given time. What sort of analysis are you using to drill down on the names you actually end up buying? What does your screening process look like beyond simple moving averages?

TL: While there are general buy indicators out there, we also look for momentum off lows. For instance, the S&P 600 Small Cap Index has outperformed the S&P 500 coming off the most recent low in mid-December. Additionally, small-cap ETFs, like the iShares Russell 2000 ETF (NYSEARCA:IWM) or the iShares S&P SmallCap 600 Index ETF (NYSEARCA:IJR), have generally been outperforming large-caps since the Oct. 3rd low. Now, with most major domestic indices moving above their 200-day moving averages, small-cap stocks seem like a more attractive pick, especially given their penchant to rebound much quicker than their larger counterparts.

Down on the sector levels, healthcare, consumer staples and consumer discretionary ETFs have held onto their 200-day moving averages, including the SPDR Health Care Select Sector Fund (NYSEARCA:XLV), SPDR Consumer Staples Select Sector Fund (NYSEARCA:XLP) and SPDR Consumer Discretionary Select Sector Fund ETF (NYSEARCA:XLY).

It should be noted that these trend-following strategies are not signals for buy-and-forget type investments. If investments begin to dip below their trend lines, investors should not stubbornly hold onto them but instead should make sure to have a stop-loss order in place to provide a suitable exit point.

SA: Which asset classes are you overweight? Which are you underweight? Why?

TL: High-yield bonds, including corporate debt and international sovereign debt, hold an overweight position in client portfolios. Market swings have been influenced by any hint of Eurozone woes, but Corporate America has held on. American companies have reported strong quarterly earnings and growth.

U.S. firms are also sitting on a ton of cash which will help lower the risk of defaults. Corporate bond ETFs also offer attractive yields for those income-seeking investors who are reluctant to jump into the low yields in Treasuries. For instance, the iShares iBoxx $ Invest Grade Corp Bond (NYSEARCA:LQD) and iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG) are both high-yield ETFs that sport yields over 4%.

Emerging market debt is also an attractive alternative. Developing countries have low debt-to-GDP ratios, most below 50%, compared to a U.S. debt-to-GDP level of nearly 100%. Despite their lower credit ratings, emerging market debt may have a more favorable credit risk compared to the sovereign debt of developed countries because of their low debt levels. Additionally, these countries are showing robust growth, whereas growth in the developed world has slowed to a crawl. Still, investors need to be mindful of the inflation rates over the long-term since they can eat away at returns.

The iShares JPMorgan USD Emerging Markets Bond Fund (NYSEARCA:EMB) offers a yield close to 5%. This fund holds U.S.-dollar denominated bonds, which removes the currency risk that investors would have otherwise been exposed to if the fund held local currency denominated bonds. Or, investors may take a look at the WisdomTree Emerging Markets Local Debt Fund ETF (NYSEARCA:ELD), which tracks emerging market debt denominated in local currencies. ELD also provides a yield of around 5%.

Developed market equities hold an underweight position. For instance, a comprehensive European equities ETF, the Vanguard MSCI Europe ETF (NYSEARCA:VGK), is well below its 200-day moving average, and even back at home, the S&P 500, along with related ETFs such as the iShares S&P 500 Index Fund ETF (NYSEARCA:IVV), have all struggled to remain above their 200-day moving averages.

Both the E.U. and the U.S. are weighed down by high debt levels, which have led to greater uncertainty in the market. Along with the ever looming Eurozone problems, we are still suffering through high unemployment levels and a general lack of confidence in the marketplace.

SA: Name one investment that exceeded your expectations in 2011, and one you had high hopes for that didn’t’ pan out. Do you see any particular investment surprising investors over the next year?

TL: Before the year started, equity markets looked like they were in reasonable shape to have a good year. Investors were becoming more risk-tolerant after the financial crash of 2008 and Treasury yields were beginning to stabilize around pre-crisis levels. With yields basically in a downtrend since the 1980s and already at historic lows, we expected Treasury prices would begin to fall, and conversely, yields rise. I’m sure I wasn’t alone in this line of thought -- even PIMCO’s Bill Gross notably, or notoriously, made the bet away from Treasuries earlier this year. Who would have thought that Treasury yields would move below levels seen during the 2008 downturn?

Even the downgrade from Standard & Poor’s this year on U.S. debt wasn’t enough to seriously diminish investors’ appetite for Treasuries. The U.S. has clear deficit challenges but Europe’s debt crisis continues to buy time for Washington amid solid demand for Treasuries. The 'bond vigilantes' are quiet on the U.S., for now at least.

Equity markets were regaining their ground, and small-cap stock ETFs should have been leading the market rebound. Historically, small-caps have outperformed large-caps coming out of an economic recession. However, this year was bad for all equity classes, with small-cap ETFs such as iShares Russell 2000 (IWM) falling short of large-caps.

SA: 2010-11 saw a notable rush for the exits from equities and equity vehicles. Is this a cyclical, or secular shift? What would it take to bring them back?

TL: The rush for the exits looks like a cyclical shift. Investors are reacting to the news and headlines of the day and seeking shelter away from riskier assets during the bouts of market volatility. These knee-jerk swings will not last forever and investors will eventually come back to riskier bets. It is human nature to avoid risk and shy away from the markets during times of uncertainty.

If this were a secular shift, where would the money go? Investors would not be content to let money sit on the sidelines, unless the economy falls into a deflationary spiral. Investors can’t turn to the Treasuries market forever and watch yields run closer to zero.

Most of the problems in equity markets may be traced back to uncertainty in the Eurozone. However, we are stuck with the European problem, whether we like it or not.

SA: How are you protecting clients from the risk of Eurozone contagion? Are you avoiding European equities? European debt? Are there considerations (like the situation in the Eurozone for example) that will cause you to ignore buying into a fund even if the trend indicates something is a ‘buy’?

TL: The Eurozone financial crisis has kept [U.S.] markets suppressed. Their own markets are stuck in a downtrend. While there are those who believe it may be a good time buy into 'cheap' Eurozone assets, most of those investments are still speculations without any meaningful moves to back up what are essentially gambles. Investors need to be cognizant of the fundamentals, and with poor fundamentals, the technicals tend to follow.

SA: Global macro considerations dominated the headlines in 2011. Do you see 2012 unfolding differently? If so, how?

TL: Macroeconomic problems will continue to weigh on stocks going into the New Year. Europe will remain a hot topic and any perceived negativity or weakness in the stability of the European Union will put downward pressure on the overall market. The tighter federal budget in the U.S. will also constrain growth. Additionally, natural disasters in the Asia region have disrupted the global supply chain.

All things considered, the U.S. and other markets have shown some resiliency in the face of mounting pressures, and the global economy will keep improving, albeit muddling along at a slower-than-expected pace.

Stocks are moving almost in lockstep and correlations among assets are at some of their highest historical levels, underscoring the elevated sense of uncertainty. It will take a while before the investor mindset moves away from the herd mentality. In the meantime, expect the frequency of 'all-or-nothing' type market movements to stick around. There are even new ETFs such as the PowerShares S&P 500 Low Volatility Portfolio Fund (NYSEARCA:SPLV) that attempt to smooth the market’s bumpy ride.

On the positive side, if there is a solution to the Eurozone debt issue in 2012 while U.S. corporate profits maintain their high level, expect markets to improve along with investor sentiment. When investors feel it’s safe to get back into this market, we could experience a market 'melt-up', as there is so much cash on the sidelines.

SA: How much cash are you currently holding in client accounts?

TL: We currently have about half of assets in cash positions ready for when up-trends return. The large market oscillations in the late summer months triggered sell signals and most advisors and investors are loathe to dive into volatile market conditions with frequent hundred point swings in either direction.

SA: Where are the real growth stories overseas right now?

TL: The foreign economies that are moving away from their export-oriented industries will be the next growth stories. While exports contribute to a significant chunk of growth in most emerging countries, the global slowdown will contribute less to export demand, and the slowdown won’t miraculously change overnight, either. Consequently, developing countries that are turning inward for growth will show remarkable improvements ahead. Middle classes are rising in China and India, for instance.

Countries like Malaysia, Philippines, Singapore and Southeast Asian economies are beginning to implement economic reforms, develop their own economies from within and expand their workforces.

SA: How much exposure to emerging markets do you have both in terms of stocks and bonds? Are China, India or other major emerging markets better positioned to withstand a serious global economic downturn than the U.S.?

TL: As the emerging markets rapidly develop and industrialize, these economies will begin to advance to a point where they will be able to stand on their own, becoming less affected by developed economies and capital flows from overseas. The emerging markets have already begun to show greater self-reliance, seeing greater domestic consumption and moving away from their reliance on exports. As developing countries begin to further 'decouple' from their developed counterparts, adverse financial conditions in Europe and the U.S. will have a smaller impact. However, the decoupling effect will likely take decades before emerging countries become more self-sufficient.

In the meantime, emerging market investments have been pummeled by the risk-off environment that has stemmed from the Eurozone debt crisis. Any doubts in the fiscal well-being of such a large chunk of the global financial world will inevitably touch upon all corners of the world. Emerging markets are usually hit hardest in liquidity crises.

Additionally, growth in the emerging markets, especially in the BRIC nations, has begun to show signs of slowing down. Recently, China revealed disappointing year-over-year numbers on both its Consumer Price Index and Producer Price Index. The Indian, Russian and Brazilian stock markets are already trading in bear territory.

Still, if you are a contrarian investor, these low emerging market valuations may be a good entry point to bet on the eventual reversal in their equities markets. While the tide of market sentiment has remained predominately bearish, the emerging markets have the potential to bounce back at a far stronger pace than developed markets.

Emerging market bonds have been trading above their trend lines. Emerging market equities, on the other hand, have yet to breach their 200-day moving averages. Exposure to these markets should be based on when they are trading above their long-term trend line.

SA: We are coming up on an election year. Will this be good or bad for markets? Are you positioning for different potential outcomes?

TL: If the S&P 500 closes 2011 in the red, it would only be the third time in over 80 years that stocks failed to rise in the third year of a presidential cycle. That doesn’t bode well for stocks in Obama’s fourth year. Historically, the stock markets perform at their best during the third year of a president’s four-year term. During the honeymoon period, the newly appointed president would enact all his promised changes, and after a couple of years, the changes should begin to show some effect and positively affect the markets.

The stock markets hate uncertainty and the new presidential election season is just that. The election year will likely be stuck in choppy trading as the markets prepare for the new president, along with the administration’s new economic plan.

Still, the S&P 500 has historically done better in the fourth year when a Democrat was in office – this is only a correlation and should not be confused with causation. Additionally, re-election is also associated with a better performing stock market, which is usually determined by a positive view on the economy and the approval of the administration being re-elected. There is a chance Obama could be saved if employment and housing numbers improve, but don’t count on it.

SA: Inflation or deflation? Growth or recession? Which way is the U.S. economy headed and how will you be positioning clients?

TL: After the financial crisis and weak economic growth, the Federal Reserve has kept monetary policy loose and aggressively bought bonds. Conventional wisdom dictates that a rise in M1 and M2 should cause a surge in inflation; however, the market has been hoarding money in place of risky securities, which has led to a relatively subdued inflation rate. When it comes down to it, inflation will coincide with the bet on risk appetite, and investors will eventually step out of their safe-haven Treasury mindset and return to riskier markets, which in turn will help fuel a rise in inflation.

When inflation does rear its ugly head, investors may hedge their portfolios with Treasury Inflation Protected Securities (TIPs) related ETFs such as iShares Barclays TIPS Bond Fund (NYSEARCA:TIP). Gold is also another traditional store of wealth and refuge in uncertain times. But during times of high inflation and economic expansion, equity markets and stock ETFs would most likely be in the midst of a bull run. We held some indirect exposure to gold through the gold miners ETF (NYSEARCA:GDX) earlier this year, but we have since liquidated that position as the fund fell below its long-term trend line. Currently, we are not allocated to physically-backed gold ETFs, as gold has fallen below both its 200-day and 50-day moving averages since the beginning of December.

However, wary investors who fear a deflationary period much like what the Japanese experienced in their 'lost decade' may want to stick to cash or other assets closely tied to cash holdings. ETFs that track short-term government debt such as SPDR Barclays Capital 1-3 Month T-Bill ETF (NYSEARCA:BIL) would be ideal. Additionally, dividend ETFs such as iShares Dow Jones Select Dividend (NYSEARCA:DVY) also offer investors the possibility of additional income during the bleak times, although investors are taking on equity risks with a fund like this.

SA: Where do you see Treasury yields in 12 months? Are Treasuries worth buying at current (low) yields? For clients requiring income, where have you been turning in this low yield environment?

TL: Over the short-term, cutbacks and austerity measures in both the Eurozone and the U.S., weaker global growth and the bouts of worsening Eurozone risk will contribute to suppressed Treasury yields. Once risk appetite returns, yields should then begin to rise. By the end of 2012, expect yields on 10-year Treasury notes to bounce back to the 2.5% levels.

Currently, with Treasury yields at their historic lows, investors will not generate too much value if they decide to jump onto the Treasuries bandwagon now. Instead, if you are worried about your low fixed-income stream, other investments are offering higher income payouts. For instance, corporate bond ETFs such as iShares iBoxx InvesTop Investment Grade Corporate Bond Fund (LQD) and emerging market debt funds including iShares JP Morgan USD Emerging Markets Bond Fund (EMB) offer great yields, with good capital appreciation prospects as well.

SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the ‘lost decade’ we just experienced?

TL: Investors can still follow the traditional 60/40 split, but the allocations within the 60/40 are much different than the past.

For instance, long-term U.S. government debt allocations need special consideration. Long-term investors should not take on Treasuries with long maturities since it is almost certain that rates will begin to rise. Instead, investors can start to move toward short-term Treasuries, which should help diminish the hit from rising rates, and take a more balanced approach in allocating to corporate bonds and international sovereign debt holdings.

ETFs have brought the availability of the international debt market to more retail investors. This relatively new ETF category is attracting billions of dollars in inflows and is one of the most popular asset classes of the year. With the tremendous growth potential of the emerging countries, especially compared to the developed economies, investors will find great value in emerging market debt. While emerging markets have lower credit ratings, they may show better credit risks since developing countries are sitting on low debt levels of close to 50% of GDP. In comparison, the U.S. is at around 90% of debt-to-GDP.

Corporate America continues to recover from the financial crisis. Companies are reporting strong quarterly earnings, showing reduced debt and sitting on loads of cash, which will help promote future growth and protect against bond defaults. Corporate bond securities are looking like a much more valuable source of debt, with yields at very respectable levels. iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) offers investors exposure to investment grade corporate debt, with decent yields around 4.6%.

Until a new long-term trend develops, we remain underweight equities. The S&P 500 needs to maintain levels above 1300 for a sustainable period and current economic uncertainties may prevent that in early 2012.

SA: And where do other asset classes like commodities and REITs fit into the picture at present time?

TL: Alternative asset classes should have a smaller weighting in an overall portfolio. Currently, the overall commodities markets have not been performing well – the PowerShares DB Commodity Index Fund (NYSEARCA:DBC) is struggling to regain ground, but the asset class as a whole is considered a good diversifier. For instance, commodities have historically maintained a low correlation to equities and bonds. Additionally, they have been shown to correlate with higher inflation levels. After the copious amount of cash thrown into the world economies, inflation could begin to kick in over the next few years, and commodities should trend higher.

Real Estate Investment Trusts, or REITs, have attracted attention as a source for dividend yield. The asset class has proven to provide stable prices and low correlation with the equities markets, making it another portfolio diversifier. Furthermore, with potential inflation in the future, REITs can serve as an inflationary hedge, providing asset appreciation and rising rents during periods of economic expansion, which usually preclude inflation.

Full Disclosure: Tom Lydon’s clients own EMB, LQD.

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