Your 2016 Investment Strategy Guide: 10 Best ETF Buys

|
Includes: DBEU, EEM, FEZ, FPE, FTGC, IPF, PICK, VWO, XLY, XME
by: Ky Trang Ho

Summary

Emerging markets are cheap, trading at 42% below their median P/E.

Developed market financials, particularly in the U.S. and U.K., having de-levered since 2009, are better positioned to participate in a growth upturn in their economies.

Valuations in Europe are cheaper and dividends higher than in the U.S.

Nasdaq (Wikimedia commons) https://upload.wikimedia.org/wikipedia/commons/1/18/NASDAQ_studio.jpg

How should you invest your money in 2016? I asked a group of investment strategists to weigh with their top recommendations and their outlook on the stock market. Some of the issues I asked them to address were:

  • Do you think we're headed for a bear market? Why? or Why not?
  • What do you make of the stock market's valuations?
  • What impact will a Federal Reserve Rate hike have on the stock market?
  • What are the best investing opportunities now given the state of the stock market?

1. iShares MSCI Emerging Markets ETF (NYSEARCA:EEM)

by Zachary Abrams, manager of wealth management and portfolio analysis at Capital Advisors, Ltd. in Cleveland, Ohio with about $600 million under management.

The sentiment is so poor that emerging markets are oversold. In the short-term it's hard to find the positives other than a possible a reversal in the dollar, which tends to depreciate after the first rate hike and could reverse capital flight.

From a trend standpoint, assets that move down tend to keep moving down until they don't and assets that outperform now are likely to outperform moving forward until they don't. Emerging markets stocks are currently moving down and their relative performance versus U.S. Stocks is poor. It's hard to say when this will stop.

My longer-term view is constructive given the forward return projections over the next decade versus U.S. large, U.S. small, and developed market stocks. For example, we project U.S. large at 2% real returns over the next 10 years. We then use Research Affiliates (NYSE:RA) for other asset classes, which project 0% for U.S. small, 5% for developed markets, and 8% for emerging markets.

For the longer-term projections Research Affiliates uses Shiller P/E (price divided by the average of 10 years of earnings (moving average), adjusted for inflation). Here is the table:

Asset Class

Current P/E

Median P/E

% +/- Valued

10 Year Real Return Projections

U.S. Large

25

16

56%

1%

U.S. Small

47

40

18%

0%

Developed Markets

14

22

-36%

5%

Emerging Markets

11

19

-42%

8%

Emerging markets are cheap, trading at 42% below their median P/E. Further, this is also true relative to U.S. large where U.S. large has a P/E of 25 and emerging markets is at 11. The caveat to this, and what I alluded to in the first bullet, is that what is cheap now can continue to get cheaper (i.e. emerging markets could fall in value more).

I could make this same argument over the last few years and yet emerging markets continue to fall. Further, the sample size is small I believe relative to U.S. large and thus perhaps the median is actually inflated and thus the current valuation isn't as undervalued as indicated. I should also note that U.S. large average valuations have been trending up and thus perhaps are not as overvalued as indicated.

This would mean that emerging markets are not as relatively undervalued to U.S. Large. Additionally, I believe the projections are based on growth constants and could thus be off if growth is higher or lower than the mean. In spite of all those caveats, the probability still favors Emerging Markets outperformance over the next decade.

As you can see, when emerging markets have outperformed it tends to be for a prolonged period of time. The same on the flip side. Thus, from a relative performance standpoint even if you don't time the bottom of emerging markets you can still have a good probability of generating higher returns by waiting for them to turn around.

From a fundamental standpoint I would look for the following: 1) clear route to Fed tightening, 2) reversal in U.S. dollar or at least the expectation it will stop rising, and faster and growing growth than the developed markets. I got these from Mark Dow and they seem to fit the narrative. None of these appear to be on the horizon at this point, which is why it's hard to be bullish currently as noted in the first bullet.

This is a gross domestic product growth table from the IMF:

Projections

2013

2014

2015

2016

Emerging

5.0%

4.6%

4.2%

4.7%

Advanced

1.4%

1.8%

2.1%

2.4%

Difference

3.6%

2.8%

2.1%

2.3%

As you can see, emerging growth has decreased and it's growth differential from the advanced world has also decreased. This would be evident even more so going back before 2013. Further, while the projections show improvement, they are just that - projections. The growth trend is still against them and this was from July 2015. I suspect that would be weaker right now.

The only major risks investors face in my view is not meeting their long-term financial goals and/or permanent catastrophic loss of capital. This happens by not having a financial blueprint and subsequent investment plan. Without those, investors are more prone to panic and thus facing those risks. If we are only talking emerging markets, the big risk is obvious: they continue to fall in value and you're trying to catch a falling knife. The cheap asset gets cheaper. Further, emerging markets are very volatile.

2. SPDR S&P International Financial Sector ETF (NYSEARCA:IPF)

by Daniel Waldman, Themos Fiotakis and Yianos Kontopoulos, strategists at UBS Securities

We think of emerging market financials as entering the late stage of the credit cycle, while developed market financials, particularly in the U.S. and U.K., having de-levered since 2009, are better positioned to participate in a growth upturn in their economies.

Emerging markets, having levered up steadily since the crisis, is likely to face a weak growth profile, negative credit impulse, and more severe asset quality problems moving forward. So far there has been no major increase in local currency money and bond market rates despite currencies having sold off for the last four years, but with credit spreads also slowly losing their mooring, the risk of rising cost of equity becomes much more real.

Our analysts believe implied cost of equity for emerging market banks has already increased from about 11.7% to 13.8% during the last six months. Credit growth is slowing, and nominal gross domestic growth is slowing even faster, implying leverage is still rising. This compromises both the ability to accumulate incremental assets, and also suppresses return on current assets.

Some 56% of UBS analysts covering emerging market financials now expect downside risks to net interest margins, compared to 40% in the previous quarter. The equivalent number for developed market is 31%, unchanged from third quarter.

Although emerging market financials trade below developed market financials on a price-to-book basis, we believe that trends in return on equity are worse in emerging market as well. emerging market financials' return on equity has dropped from 19% in 2012 to 15.6% today, and is likely to slip further.

Also, if nominal gross domestic product continues to fall at a faster pace than credit, we would expect emerging market financials to de-rate further. Already, valuations in emerging market financials seem high in this context. We see developed market financials not so much as a cheap play poised for a serious re-rating, as a defensive play that happens to be much better positioned than emerging market financials.

We take the view that a slowdown in the emerging world is unlikely to substantially impact growth in the developed world. This is because a) developed market economies are much less open than emerging market economies, so a hit from developed market to emerging market cuts much deeper into emerging market than vice versa, and b) global liabilities are written in developed market currencies, not emerging market currencies, so a tightening of liquidity in the latter owing to local banking or credit problems will not have nearly the same impact on global growth as a banking crisis in developed market (as we saw in 2009).

The risks: emerging market growth (particularly China/Asia) surprises to the upside, alleviating asset quality concerns and supporting credit demand.

3, 4, 5. Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO),
Deutsche X-trackers MSCI Europe Hedged Equity ETF (NYSEARCA:DBEU) and First Trust Global Tactical Commodity Strategy ETF (NASDAQ:FTGC)

by Herb Morgan, founder, CEO and chief investment officer of Efficient Market Advisors, LLC (NYSEMKT:EMA) in San Diego, Calif. with $692 million assets under management.

We're not headed for a bear market. But I do think a correction is a possibility. If we define a bear market as a decline in equity prices as measured by the S&P 500 of 20% or more, than no. To be sure stocks aren't cheap, nor are they particularly expensive. At 18.5 times current earnings the S&P 500 is only slightly above its 15-year average price-to-earnings multiple.

Considering the earnings yield of the S&P is 5.4% and the risk free yield of the 10 year U.S. Treasury 2.23% there is a large premium to be earned by owning stocks. Further, U.S. companies can be expected to have earnings growth in excess of the mediocre GDP growth due to the operational leverage granted them by the low cost debt issued during this era of ultra-low interest rates.

In order to see a bear market, we'd first have to expect and envision a major recession. This is not in the cards due to massive monetary stimulus taking place globally. Even though the Fed is likely to raise short-term interest rates on Dec. 16, investors should not equate this with tightening. This is simply less-loose monetary policy and move towards normalization. The risk to my scenario would be a surprise uptick in inflation, which would have to be met with aggressive Fed tightening.

There is a large gap between the earnings yield of the S&P 500 and the risk-free yield of the 10-year U.S. Treasuries rendering either stocks cheap, or bonds expensive. It's a little of both. While the returns on bonds over the last 30 years have been coupon plus appreciation, we see coupon minus appreciation going forward. So the valuations on bonds are expensive.

Valuation is always and everywhere a "relative" metric. So, while stocks aren't cheap by historical P/E, they are cheap relative to bonds.

Barring any major developments between now and Dec. 16 the Fed will raise its target for the Federal Funds rate. (The rate banks borrow at from each other). This rate will still be extremely low. The Fed is still being very loose. The question for investors is really how many more hikes to expect and over what period of time. We believe the plan is for a slow return to normalization.

In the old days of the past 60 years a normal Fed Funds rate was 5%. Today, I think a more normal rate will be 2.5%. Further, I don't see us getting to 2.5% for at least a couple of years.

Investors will have lower returns on fixed income for a very long time. Fixed income will remain an important part of a portfolio. But the interest earned will stay paltry. Income oriented investors need to identify managers who can be creative (without adding too much complexity or risk) in creating total return so investors can increase their portfolio income with inflation.

It means income oriented investors need to carefully include non-bond sources of income in their portfolios. Such non-bond sources could include master limited partnerships (MLPS), real estate investment trusts (REITs), common stocks and alternative investments.

Given the state of the stock market, we see good opportunity in stocks. The strength of the U.S. dollar has left many foreign investments cheap for U.S. investors. International developed markets as measured by the MSCI EAFA index are flat for the year. But the valuations are below that of the U.S. This is not without reason, as the big players Japan and Europe have lagged significantly behind the U.S. in the recovery cycle.

Also, emerging markets as measured by the MSCI Emerging Markets Index have been decimated by the strong dollar, plummeting commodity prices and concern over the Chinese economy. We think all the concerns are justified but have been fully priced into the market, so we have begun to accumulate shares in the Vanguard Emerging Markets ETF.

We also like Europe. Europe is about five years behind the U.S. in recovery but has been expanding for all of 2015. European unemployment while high is declining and the European Central Bank, led by Mario Draghi, is committed to doing whatever it takes to return to growth.

We favor the Deutsche MSCI Hedged European ETF. Valuations in Europe are cheaper and dividends higher than in the U.S., plus hedging out the likely rise in the dollar are taken care of within the ETF.

Finally we like commodities. Many commodities are trading below their marginal production costs. We see demand coming back in 2016 and the impact of the rising U.S. dollar fading somewhat. We have been buying First Trust Global Tactical Commodity Fund . We like it because its active and doesn't have as much oil exposure as other commodity ETFs, and its unique structure cause it to issue a 1099 at tax time rather than a burdensome K-1.

6, 7. iShares MSCI Global Metals & Mining Producers ETF (BATS:PICK) and SPDR S&P Metals and Mining ETF (NYSEARCA:XME)

by Mike Chadwick, CEO of Chadwick Financial Advisors in Unionville, Conn. with $150 million under management.

The stock market is very dangerous at this time. Prices are inflated across the board pushed higher by seven years of zero interest rates and unconventional monetary policy across the globe. People are searching for yield, and in doing so have pushed asset prices to insane levels in many asset classes, completely unaware of the risks they're taking. This could be a who's who of horrible times to invest.

We are going to have a bear market and I believe it's close, very close to happening. We're actually likely in the topping process right now, markets are high but participation is dwindling, fewer and fewer stocks are driving prices higher in the major indices. I think the likelihood of a rate increase is only 50/50, the underlying economy isn't supportive of record high asset prices it's simply a product of chasing returns and monetary policy.

Never before has so much been dependent upon what central bankers and politicians promise. Valuations make little economic sense in many categories such as biotech, some technology and many ordinary businesses, people are chasing momentum and technical indicators without regard to fundamental economic principles.

Not only are stocks in a bubble, but so are many categories of bonds, real estate and other typically uncorrelated asset classes. The market isn't currently linked to the economy at all, it is being held hostage by central banks and political promises, neither of which are reliable for the preservation or creation of wealth.

At some point the faith of market participants in these antics will cease, and then we'll see a shift in the tide and behavior will require earnings and relative valuations, not just a better alternative than 0% in the bank. Simple metrics such as corporate earnings as a percentage of Gross Domestic Product is at record levels.

The Schiller P/E is pushing levels we've only seen before in 1999 and 1929. Many companies are trading at 100, 200+ times estimated earnings, some have no earnings and trade at 10 or 20 times sales. There are many similarities in todays markets and the market in 1999. This is a debt fueled bubble that when pops, will be painful for the majority.

The best investment opportunities I see today are in the miners and the energy complex. This isn't likely an all-in now opportunity but rather an easing in overtime strategy. Valuation is the thesis plain and simple, the miners especially are grossly undervalued, many trading at 20% of book, never mind any other metric.

Miners remind me of the banks in 2009, when everyone thought a lot of them were going under. Some did so one needs to be careful but most will rebound and those who survive will take market share from those who fail. Miners also act as a leveraged play on metals, which will at some point do well when people lose faith in central bank policies and wake up to the reality of the over indebted world with no easy way out.

We cannot fix our debt problem with more debt. Oil not as good of a value, but relative to the rest of the market my second choice. Both industries are under pressure, companies are cutting dividends, laying off workers and getting lean. This is when to really buy companies safely and make serious gains. The concept of buying what is hot doesn't work for value investors and this has been a go go growth market for seven years now.

These categories can certainly go lower from here. But at these levels the majority of the downside risk has been taken off the table.

8. First Trust Preferred Securities and Income ETF (NYSEARCA:FPE)

by Brock Moseley, managing partner of Miracle Mile Advisors in Los Angeles with $500 million under management

2015 has been a lost year for U.S. equity markets and current valuations point to a similar result in 2016 as the current average price-earnings ratio of the S&P 500 is 18.5, higher than its historical average of 17.1. While valuations may be stretched, the macroeconomic indicators still suggest that the U.S. economy is growing at a solid rate so a bear market remains unlikely.

Compared to the U.S., valuations overseas remain attractive (current price-warnings of MSCI EAFE is 15.4) paving the way for 2016 to be the first time since 2012 that international developed markets will outpace those of the United States. This divergence is already occurring in Japan as the MSCI Japan Index is up 6.2% over the past trailing year whereas the S&P 500 is only up 2.2%.

Continued stimulus by the European Central Bank and the Bank of Japan will provide a boost to the regions' exporters who will be the drivers of double digit growth in the international developed markets in 2016.

Converse to the accommodative stances of central banks abroad, November's solid job report increased the probability that in December the Fed will initiate an interest rate hike for the first time in seven years. If the Fed embarks on a series of hikes in 2016, traditional fixed income investments will face continued downward pressure from rising interest rates.

For yield seeking investors looking to reduce their interest rate sensitivity, one ETF to consider is the First Trust Preferred Securities and Income ETF. FPE has muted interest rate sensitivity because 65% of its holdings are fixed to floating rate preferred securities. Furthermore, FPE is up over 6% year-to-date and offers a healthy yield of 6.2%.

After years of record low volatility, the average VIX reading increased to 16.5 in 2015. The uptick in volatility was driven by uncertainty regarding the Fed's first hike, sluggish demand in the global economy, and plummeting energy prices. These factors as well as heightened geopolitical tensions in the Middle East are still grabbing headlines meaning that 2016 could be an even more volatile year than 2015.

9. Consumer Discretionary Select Sector SPDR ETF (NYSEARCA:XLY)

by Ryder Taff, CFA, portfolio Manager at New Perspectives in Ridgeland, Miss. with roughly $85 million.

We are looking at a very interesting time in the market. On the whole, valuations are very high as interest rates are low. There is a lot of anticipation of the valuations declining, which would mean that stock prices have to decline unless earnings rose dramatically. Two large expenses of companies, interest and labor cost, are almost certain to start rising next year. This will limit earnings growth. I anticipate little earnings growth and some decline in valuation ratios across the board.

The American consumer is benefiting greatly from the rising economy and rising wages. All sorts of things can benefit here but I am very interested in consumer discretionary stocks. The SPDR Consumer Discretionary ETF will likely benefit from people having extra money to work:

  • On home projects: Home Depot (NYSE:HD) and Lowes (NYSE:LOW)
  • Shop online: Amazon (NASDAQ:AMZN)
  • Keep or upgrade cable packages: Comcast (NASDAQ:CMCSA), Disney (NYSE:DIS) and Time Warner (TWC)
  • Buy a cup of coffee on the way to work: Starbucks (NASDAQ:SBUX)

The sales of these companies should rise faster than the average which will benefit them even as some expenses increase.

10. SPDR EURO STOXX 50 ETF (NYSEARCA:FEZ)

by Daniel Waldman, Themos Fiotakis and Yianos Kontopoulos, strategists at UBS Securities

European equity valuations are favorable, and markets should benefit from a combination of improving credit growth, monetary stimulus, low energy prices, and a slightly positive fiscal impulse in 2016.

After remaining stalled for years, credit growth has begun to recover in the Eurozone. Our leading credit indicator for Europe, constructed from components of the European Central Bank lending survey, has historically led both credit and gross domestic product growth, as well as equity performance (see link). This leading indicator is pointing to a further acceleration in credit growth, yet markets are significantly underpricing the possibility (Figure 6).

The improvement in credit growth, combined with supportive monetary and fiscal policy, and lower energy prices, should lead to an acceleration in 2016 growth.

Our European Economics team forecasts growth rising from 1.5% in 2015 to 1.8% next year. In particular, they see a pickup in nominal gross domestic product growth as inflation turns - a key support for corporates' revenue growth. Policy in Europe is supportive, with both fiscal and monetary policy set to ease, and the ongoing easing in credit conditions is pointing to acceleration in private sector demand.

Against a backdrop of accelerating growth, continuing low inflation should allow accommodative policy to remain in place and enable credit reflation. This should be particularly positive for equities, and our European strategists have a 13% earnings growth forecast for 2016. This would be the first earnings growth in five years, driven by improving nominal GDP, rising margins, and high operational leverage as wage and material costs remain low.

They also stress that actual lending to corporates by banks, which is the principal source of funding for European corporates, has turned positive for the first time in over three years. Finally, it is worth noting that on a cyclically-adjusted basis, the European valuation gap to the U.S. is at recessionary levels (Figure 7).

The risks: Some degree of European recovery is likely priced. Earnings disappointment due to European growth weakness or a rise in fears regarding the emerging market backdrop would be negative. Euro-to-U.S. dollar strength would be a drag on earnings, though we are likely far from levels where it would be an issue, and would expect the ECB to lean against euro/U.S. dollar strength above 1.15 in the near term.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.