Hedging Against The Fed Telling The Truth

by: Lloyd Clucas

Investors are reportedly fleeing US equities for European equities.

European equities are more overvalued than anywhere else in the developed world.

Those who ignore the effect of QE seem to be ignoring reality.

The US FRB says it is finished with QE and is only wondering when in 2015 to hike short rates; remarkable that anyone believes them.

Top performance is going to wildly overvalued small cap stocks and to those following the trail of global QE.

Hedging Against the Fed Telling the Truth

LONDON (Reuters) - International investors slashed their exposure to U.S. equities in May to its lowest in over seven years, while maintaining the euro zone as their leading stock market destination, a closely watched survey said on Tuesday.

Nuts! The U.S. is ostensibly done with QE. The tinder is still there in terms of excess reserves in the banking system (reduced very little and then only by temporary measures). But the FRB now continues to threaten rate hikes. (They should do it, but that is another article.) If they do it this year, they will do one face-saver and nothing more.

The USD has rallied some; US multinationals have recently had export earnings curbed. The FRB talk about rate hikes distracts from concerns they will have to go to QE4 if the rest of the developed world continues their currency war behavior.

We have European equity O-V by 62-73%, the US by 25-41%, Japan by 10-11%, but China 18-19% undervalued. I wonder how the fundamentals-rule-all crowd explain the equity shifts described above? It sure as hell isn't on valuation! Nor on prospects.

Generally, I'd expect their politics are fogging their windshields. Maybe they are, but the QE-is-irrelevant crowd includes sensible people from both sides of the US political aisle. (For example, Scott Grannis and Jeff Miller, both here on SA.)

We have US, Chinese (and much of the EMs') prospects remaining globally the best over coming quarters. We could, of course, be wrong.

Europe is an 18th century wagon filled with the EZ peripherals' unemployed, pulled by stoic Germans and a few other "Scandinavian"-like countries. At some point, in some way, the peripherals are going to have another, hopefully milder, but still severe, "German Experience" that they won't enjoy. I expect it will serve them right.

The investor rush to Europe is driven by one thing: The knowledge that the ECB's pumping will enrich investors, marginally improving EU demand, and producing little else. Investors care about little else. In terms of investing, that is the only reason we are there - and profiting more than in the US - at least in recent months. Perhaps skin color is driving some of it, too. It sure isn't anything real.

Europe's printing/pumping is fresher and probably has longer to go, and more urgency, than elsewhere.

There's one big exception: East Asian markets. China looks like they may decide to turn on the pumps. They hate sticking with the Dollar. They do it so they may gain a position in the IMF's SDRs. Translated: They want their currency to become a globally accepted reserve currency. When that happens (August?), they may feel free to do more "stimulative" things monetarily. They don't now.

So, we hold onto European equities, have much more in Japan, and even more in East Asia, including China. So far, so good. But speculation is rampant. It drives the world today. The IMF warns, the FRB scorns.

To be clear, we aren't advocating plunging into QE-driven markets. The QE-driven portion of our portfolios are about 6%. They are exclusively in currency-hedged ETFs (e.g., the WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ) and the WisdomTree Japan Hedged SmallCap Equity ETF (NASDAQ:DXJS) in Japan and WisdomTree Europe Hedged Equity ETF (NYSEARCA:HEDJ) in Europe). If you are looking at total returns in DXJ and DXJS, please remember to add in the very substantial December 2014 distributions to shareholders.

Other Far East holdings, including China-related and other EM equities, are primarily through ETFs, but are not currency-hedged (e.g., iShares China Large-Cap ETF (NYSEARCA:FXI), iShares MSCI Hong Kong ETF (NYSEARCA:EWH), Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO), iShares MSCI Singapore ETF (NYSEARCA:EWS), iShares MSCI Philippines ETF (NYSEARCA:EPHE), and regrettably, so far, Market Vectors Vietnam ETF (NYSEARCA:VNM)). We are guessing China is likely to try to maintain its "peg" to the USD through much of this year.

Nevertheless, the bulk of our holdings remain in dominant, global, mostly US, dividend growers with high corporate profitability. These are all individual equity holdings. Our big problem with that: even our well-selected and very-profitable holdings in such equities stand at 36% overvaluation today. Appalling!

The big gains in these latter stocks were a function of more than fundamentals, though the latter surely played their part. U.S. QE, ostensibly dead, delivered the overvaluation and may well still deliver lots more. But that will not happen with the FRB's current attitude. QE 4 would blow the doors off. I do not expect it, but it could happen. The strong Dollar tortures the Fed and the other politicians.

High performance from the like of the Russell 2000 (RUT) is in the face of a WSJ-reported ttm P/E of 79.3x... if you believe those numbers. Incidentally, we do not. But the small-caps being overvalued case remains true.

As a consequence, on April 27 and 28, we raised Cash from 0-2% (vs. 93-95% equities) to 20-36% Cash for all portfolios. Even a 20+% "Crash" would not likely generate undervaluation as we see it. There'd be no margin of safety. As a result, one cannot responsibly deploy leverage for any material period. Instead, one needs Cash to deploy. Hence the seemingly deleterious additions to Cash of recent.

It is our hedge against the FRB telling the truth (i.e., the FRB raises rates in 2015), or the EZ confronting a moment of truth, or serious shooting commencing between countries that matter - i.e., in the Far East.

(The Failed State Belt remains a total waste of our blood and treasure - as it has been since 2003. That is 12 years for those of you who can remember how long WWII lasted - and the conditions described in Orwell's satirical world of 1984.)

Disclosure: The author is long ALL SHARES MENTIONED IN THE ARTICLE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Nothing in the article should be taken as investment advice or solicitation to purchase any securities mentioned.