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Jim Sloan Positions For 2020: A Pivot Toward Emerging Markets But Keep An Eye On The Dollar

About: SPDR S&P 500 Trust ETF (SPY), EEM, Includes: BRK.A, BRK.B, DEM, DGS, JPM, OGZPY, RSXJ, SBRCY
by: Jim Sloan
Jim Sloan
Long only, value, growth at reasonable price

It's a year for hoping to get solid, ordinary returns but taking care to consider risks; the U.S. market is somewhat expensive and calls for a good defense.

My major action late last year involved a pivot toward emerging markets, which grow faster than the developed world and are historically cheap, thus reducing their level of risk.

The default estimate often used for annual return in the U.S. market is 10%, but the numbers that historically generated that estimate now sum to 5.5% at best.

Specific risks in 2020 include a possible downturn in the economy and/or corporate profits and an election outcome unfriendly to business.

Berkshire Hathaway is a good defensive core holding, diversified emerging markets value should outperform over ten years, and Russia deserves a special look by the venturesome.

What do you expect to be the key driver of stock market performance over the course of 2020?

This is a year for hoping to get solid, ordinary returns and taking care to consider risks. The trouble is that risk is sometimes counterintuitive. Diversification is often described as one way to reduce risk, but diversification is a concept with its own counterintuitive twists. Cap-weighted index funds provide a form of diversification but might not serve well in the next bear market. My goal for the year is just to get those solid ordinary returns if they eventuate and avoid catastrophe if they don't.

The major risks for 2020 are a downturn in the economy, a downturn in corporate profits, and an election outcome unfriendly to business. None of these risks appear particularly likely based on current data, although corporate profits are a bit soft and employment data needs to be watched carefully. Above average valuation continues to hang over both the equity and bond markets but reversion to the mean does not necessarily have to happen in any particular year. I'm not an enthusiast for hedging because it's so expensive. Owning value and some carefully chosen fixed income are my primary defenses.

I am a value investor. I buy value where I find it. My major action over the past six months has been a pivot toward emerging markets value. I have used ETFs for the most part. There has been a good argument for emerging markets value for the last couple of years - an asset class that is almost forgotten as it has underperformed all other asset classes for a decade. This has been long enough for most investors to forget that a decade of poor performance by emerging markets is cyclical rather than permanent. Emerging markets have a number of particular problems including poor corporate governance and transparency, government intervention, and squirrelly currencies, but they have stronger growth than the developed world and far better demographics. Over the decade in which their markets have stalled, economic progress and corporate profits have continued at a reasonably good pace.

In August of last year the case for buying emerging markets value finally came together. I had owned nothing international for a decade but I have some familiarity with the EM space. From 2002 to 2004 I owned Brazilian and Indian country funds getting a triple as the markets doubled and the funds swung from discounts to premiums. Owning Brazil and India felt great while NASDAQ and the dot-coms went to Hades in a bucket. Emerging market investing is like parachute jumping - it looks and feels more risky than it is.

There are real risks. A strong dollar can be a major headwind for emerging markets stocks and could delay their movement back to the top of the performance list. A global bear market might also hit them hard because they are a historically volatile asset class, but there is a fairly good chance that they would outperform the rest of the world in both the decline and the recovery. Emerging market performance often correlates to a degree with gold and commodities, asset classes I won't buy but which tend to confirm a positive environment for EM investing.

By last August the dollar appeared to be topping and emerging markets stocks were beginning to perk up. All in all, my shift toward putting new equity money into emerging markets had an intuitive element similar to a large move I made in early December 2018 (and wrote about here) to extend fixed income maturities using long-term munis and CDs. Intuition, to me, is knowing and digesting a lot of facts, sorting them for importance, and taking a step back to let the whole picture sink in.

As we begin 2020, are you bullish or bearish on U.S. stocks?

The terms bullish and bearish are too broad and insufficiently nuanced to fit my more probabilistic approach. The central questions involve what average return one should expect from stocks and over what period of time one can reasonably expect to receive it. A single year, to me, is not long enough for important tendencies to assert themselves and predicting the one year S&P 500 return is like putting down a bet on an NFL playoff game. The sweet spot for forecasting is probably 7 to 10 years. I undertake a rolling reassessment on an annual basis so that my portfolio has come to be a laddered version of my thinking. More than ten years is too far in the future with too many unforeseen events and unexpected new trends developing.

I feel uncomfortable telling young people in my family to just throw money regularly into the S&P 500 and let time in the market make you rich. This piece of conventional wisdom back-studies well - as in the oft-cited Ibbotson/Chen study using data starting in 1926 and also Jeremy Siegel's Stocks For the Long Run - but it's hard to be sure that even that long a period is not just an outlier of sorts. On that subject I recommend a demanding but wonderful 2002 article which is easy to get on the internet: "What Risk Premium Is 'Normal'?" by Robert Arnott and Peter Bernstein. The years from 1926 to 2000 contained many unrepeatable events and trends, all of which were positive for the U.S. stock market.

We all know the difficulties of short-term thinking, but I got an interesting insight into the difficulties of long-term prognostication while reading physicist Lee Smolin on developments in quantum gravity. He predicted that by the end of this century quantum gravity would be so fully understood that it would be taught to high-school students all around the world. I have no quarrel with the prediction that by 2100 we will have quantum gravity down pat. What I'm less sure of is whether there will still be high schools.

The Ibbotson/Chen and Siegel studies established an expected annualized return of the total stock market as being about 10%. The composition of this return was dividend yield plus corporate earnings growth (summing to real return) with inflation added to get nominal return. The late Jack Bogle estimated it that way, and Warren Buffett, in his farewell message to his partners in 1969 (which I wrote about here), used the same formula plugging in 3% for dividends, 3% for earnings growth, and 3% for inflation.

There is nothing wrong with this approach except for the fact that in 2020 the numbers you would have to plug are very different. You would have to use 1.5% for dividends, 2% for earnings growth (which in the longer run tracks GDP growth), and 2% for inflation. That's about 3.5% for real return and 5.5% for nominal return. That's before taxes and also before any adjustment in valuations - a factor included in Bogle's model.

If you think valuations can go meaningfully higher, raise your hand. If you think they may revert to the mean or, God forbid, overshoot on the downside, you may wish to take shelter under your desk. For lack of anything better, I guess you might use that 5.5% as the year's default probability. Just remember that one-year returns aren't really predictable.

My own major U.S. holdings are Berkshire Hathaway (BRK.A)(BRK.B), banks, property and casualty insurance companies, and industrials. In all cases they date back several years and the embedded capital gains are well over 50%. All seem cheap or reasonably priced at the present moment and I am happy to continue holding them no matter what the overall market does. As you can see I follow the Buffett/Munger rule on diversification: I don't bother with it.

Berkshire Hathaway is my number one domestic stock pick for 2020. You get best of breed diversification for a single click. It is also dirt cheap on look-through earnings, is shareholder-friendly, and has sterling management. I recently discovered that I have written over 250 pages of articles on it for SA. Many stocks will outperform Berkshire in 2020, but I don't happen to know which stocks they are. For combined offense and defense and great risk-adjusted returns, Berkshire is hard to beat.

Which domestic/global issue is most likely to adversely affect U.S. markets in the coming year?

Well, just to set everybody's mind at ease, I don't think it's Iran. You can be confident that anything they could do to harm U.S. interests they are already doing, and they are a highly vulnerable country with a terrible economy which just had a major military strategist taken off the board. In the U.S. the biggest risk is probably the election, although we may get an unprecedented test of just how far it is possible to push the market and the economy by pure monetary action. In global markets it's probably whether we have genuinely made a reversal to dollar weakness for the next few years. There is one key thing to remember about the U.S. Nothing global is likely to hurt us on a scale anything close to the harmful impact it will have on everybody else. Any serious harm to us is likely to be something we do to ourselves.

How does the political climate affect the risks and opportunities for next year?

Generally the market does not have strong political preferences, and neither do I. I make every effort to ignore personalities and take a cold and analytical view of politics, hoping to align myself with the markets. This year there are a handful of policy areas that might actually matter. The majority of business leaders probably feel some personal distaste for Trump, but they appear to be reasonably happy with the major Trump policies. Most would probably also be satisfied with the most probable Biden policies.

This year the risk would be the emergence of either Warren or Sanders who would be certain to push hard for reversal of the 2017 corporate tax cut. This would generate an immediate structural reduction of after-tax corporate earnings and thus reverse the large upward bump which occurred in 2018. A large drop in corporate earnings across the board would almost certainly produce a sharp one-time adjustment of stock prices. On a smaller scale, any of various proposals to pay for medical care in part by an increase in FICA/SECA (payroll) taxes would likely have a modestly negative impact on both employment and consumption.

I'm paying particular attention to the threat both Warren and Sanders pose to the large banks. For one thing, I own a ton of them, mainly JPMorgan (JPM) and Bank of America (BAC). Punishing banks would be a case of fighting the last war. It would do damage both to large banks and to the intermediation of capital in general. That's the lifeblood of the economy. Banks are currently well-capitalized and well-supervised. They are doing their job splendidly. None of that matters to politicians, of course.

It currently seems unlikely that either Warren or Sanders will emerge as the Democratic nominee. Both gain their support from a minority faction of a divided Democratic Party - a faction whose passionate supporters have nowhere to go except to support the Democratic nominee. Feeling strongly about the outcome doesn't give you an extra vote except occasionally in the river wards of Chicago. Historically political parties don't nominate highly ideological candidates because it's necessary to move to the center in the general election, the two exceptions in my lifetime being the nominations of Republican Barry Goldwater and Democrat George McGovern. Both were crushed in the general election. Barring an unexpected turn of events, the nominees will be Trump and Biden. If history teaches anything, however, it's that anything can happen.

If worried about Sanders or Warren you can console yourself with the likelihood that within a few years you will get the buying opportunity of a lifetime.

Conviction of an impeached Trump? Highly unlikely at this point but it would be catastrophic, not least because Trump would not likely go quietly into oblivion as Nixon did. A Constitutional crisis might ensue.

What do you expect out of the yield curve in 2020, and what impacts will that have on the equity market and the economy in general?

While I look at the 2-10 yield curve every day and occasionally at several of its variants (e.g., 3 months to 30 years), I don't think of it as a single indicator that locks in a particular economic outcome. A steep curve tells me something positive about the bank stocks I own, but a very steep curve may prompt the Fed to hit the brakes. A strongly negative yield curve is usually accompanied by other data suggesting recession. A flattish but modestly positive curve like the current one says the economy is steady as she goes. I also pay attention to the absolute level of rates which seems okay for now. Negative rates would be a disaster. Rates rising to 3-4% would be positive if it happened over several years but very bad if it happened suddenly. I don't think the yield curve is something one can really predict. The yield curve is supposedly the thing that does the predicting.

In terms of asset allocation, how are you positioned as we begin the New Year?

My overall portfolio is a bit over 50% stocks. My fixed positions reflect the fact that I lengthened maturities in December 2018 using CDs out to 5 years and long term munis. All of the fixed positions could be rolled off quickly, however, if a major bear market created an opportunity to buy stocks which were suddenly cheap.

The big change during 2019 is that I went from zero to 18% in emerging markets in my own account and somewhat less in my wife's account, writing about it here. I used ETFs for the most part because of the difficulty in evaluating individual emerging market stocks, especially in the case of small cap and value stocks. I did not use the popular Vanguard FTSE Emerging Markets ETF (VWO) because it is cap-weighted and thus owns a portfolio more expensive than alternative choices which are better as measured by aggregate average price to book value (1.9 for the Vanguard ETF) and average P/E (13.3 for Vanguard). It is also heavily tilted toward mega-cap growth and contains about 36% China. That's more China than I want.

My largest positions are in two Wisdom Tree ETFs, Emerging Market High Dividend (DEM) and Emerging Market Small Cap Dividend Growth (DGS). The Wisdom Tree ETFs are based on fundamental indexes which select value by using dividends as the primary screen and adjusting for quality factors particularly in small caps. Both ETFs had an aggregate P/E of well under 10 and a yield well over 4% at the time of purchase. I would be perfectly happy to own internal compounders without the tax consequences of a dividend, but dividends have the undeniable argument that they demonstrate a company's ability to pump out actual cash. The current yields available in emerging market value are coincidentally about the same as the yield in the U.S. market during the glory days of dividends (before 1990), and the risks in a diversified portfolio do not seem to me as great as they are perceived to be. I do not, however, feel comfortable recommending them on that basis to investors who are primarily interested in safe income. To me they are simply a key marker of a cheap asset class.

The stocks in both WisdomTree portfolios, and all emerging value ETFs I considered (I bought several) had significantly faster expected growth than the S&P 500 and also better growth than the Vanguard FTSE Emerging Markets ETF despite its Chinese tech/media high flyers. The aggregate P/E well under 10 matters because its inverse, earnings yield, provides a rough estimate of expected long term return. (See the Siegel data.) That 10-11% prospective return compares to about 4.4% earnings yield for the S&P 500. For aspiring EM investors who would like to dip a toe into the pool, these or other diversified value-oriented ETFs might be a good place to start. BlackRock's (NYSE:BLK) iShares also include a few good EM candidates. I don't actively dislike the Vanguard ETF, as long as you are happy with 30% higher valuation (still far cheaper than the S&P 500) and a lot of China. It has Vanguard's usual very low cost.

I should add that I took a somewhat speculative position in one country: Russia. I bought two individual stocks, Gazprom (OTCPK:OGZPY) and Sberbank (OTCPK:SBRCY), as well as the VanEck Vectors Small-Cap Russia Index (RSXJ). Here's what I initially wrote about it and here's an important revision. Russia is wonderfully hated and unpopular with investors, Putin strikes most Americans as a demon, the U.S. has sanctions in force specifically against Gazprom, the government and the oligarchs have their hands in everything, there is no corporate transparency and weak rule of law, and the economy is unbalanced. It's obviously a buy. At the time I bought it, Russia was the cheapest market in the world at less than 6 times earnings, offered yield around 7-8%, and yet it has been the best-performing market on the planet over all intervals up to a year, providing some assurance that it isn't Greece, Venezuela, or Zimbabwe. Don't you go out and buy it, though. I probably bought it the day after a full moon.

What ‘surprise’ do you see in the market that isn’t currently getting sufficient investor attention?

Putting on my Byron Wien hat, I think that the high flying tech/media companies may struggle a bit. I think Wien may have said that too. Their biggest problem is that capital-lite companies with high ROIC have trouble figuring out what to do with excess cash flow. They are prone to get antsy about so much cash and do stupid and far fetched things - the exception being Apple (AAPL), which has been smart about capital allocation. Facebook (FB) and Alphabet (GOOG) (GOOGL) enjoy the rare distinction of attracting negative political attention from both right and left, and as a result may be forced to disgorge a few of their profitable acquisitions. I also think many "safe" dividend stocks such as utilities and consumer staples are so overpriced for their level of growth that they might surprise in a market hiccup by not being as defensive as many yield-reachers expect. This would be especially likely if the market hiccup involved a modest run-up in rates. The S&P 500 may also underperform most other equity indexes, domestic and international, in the event of a large correction.

What role will the Fed play in the coming year?

The Fed would prefer to do nothing until after the election, and they are very unlikely to raise rates under any conditions. If the economy begins to stumble they will cut rates and pour on liquidity. Election years are funny. Richard Nixon wanted to influence Fed chair Arthur Burns to cut rates in 1960, but his proposal to exert pressure on the reliably Republican Fed chair was vetoed by the Eisenhower Cabinet. In 1972, as a President running for re-election, Nixon personally put pressure on Burns, who capitulated and cut rates, and the ensuing brief boom is blamed for the dreadful inflation that followed. George H.W. Bush similarly pushed for Alan Greenspan to reduce rates in the months before the 1992 election but was rebuffed and went to his grave believing that Greenspan had caused his defeat. Clinton inherited a solid economy, of course, and eventually enjoyed a couple of years of budget surplus. Trump isn't as nice as Bush senior and would be hard to resist.

What issue is receiving too much investor attention and/or is already priced in?

The trade war is probably getting talked about more than it deserves. It's a long-term battle and should be fought mainly over technology and intellectual property as part of a larger strategy to maintain American technological and military preeminence. The trade issues involving exchange of material goods are significant to China and other countries but are a drop in the bucket for the U.S. The only thing to keep an eye on is maintaining enough heavy industry to ramp up military production if needed. American industrial might was behind the thinking of the top German generals who pushed the Kaiser to abdicate in World War I and it was also the point of view of Admiral Yamamoto, who had learned about America as Naval Attache and tried to talk the Japanese generals and the emperor out of attacking Pearl Harbor. That's the kind of history key policy makers should always hold in mind. American military and technological preeminence are central factors in global stability and avoidance of major military conflicts.

Is There An Idea About Investing That Recently Got Your Attention?

Should you stop when you win the game? This is my new question for the year, and my thoughts on it haven't quite come together. The idea was put forth recently by William Bernstein, whose plain vanilla investment advice has been helpful for many investors who don't follow the markets closely. I think the answer to the question may be yes, stop taking any risks at all, for investors near retirement whose assets cut it pretty close to the minimum required. What makes me have some doubt is the fact that risk in your portfolio is not the only risk in your life, and there may be unpredictable twists in the world or your own future for which financial assets could make a difference.

The part of Bernstein's advice I am sure of is that you should reduce risk enough to have a large margin of safety encasing your coverage of basic needs. On the other hand, if you have reason to think you might live a couple of decades, there are some long-term, long-shot risks, including very serious inflation, that are not fully addressed by a very conservative portfolio. And shouldn't we also think a bit about diversifying and laying off risks in our overall lives? Are there any special risks in the place one chooses to live? New Zealand might be optimal - I loved hiking there - but I don't know a single individual in the entire country unless you count the waitress who explained to me why coffee refills weren't free there. There you have it: there's always the unexpected financial angle. The Chicago suburb where I live will probably have to do. The biggest risks probably lie in future events we don't have any inkling of at the present moment, even if it turns out that there are no aliens or menacing interstellar objects hidden just behind the sun (the sort of worry the internet has introduced into our culture). Addressing the future risks we cannot possibly know about may or may not have a financial component, so I'll continue to go after a moderate safe return for a few more years. These are the things you find yourself thinking about in idle moments at the age of 75.

Disclosure: I am/we are long BRK.B, DEM, DGS, JPM, BAC, RSXJ, OGZPY, SBRCY. 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.