2012: Politics Versus Fundamentals
Richard Bernstein Advisors
By Richard Bernstein
December 9, 2011
Assessing the prospects for a coming twelve-month period is always a challenge. We rely on our broad arsenal of fundamental barometers for profits, sentiment, momentum, and our cyclical indicators to help us identify whether markets are correctly aligned relative to their economic and profits cycles.
Fundamentals, contrary to popular perception, generally change quite slowly. Although investors may disagree regarding the ultimate investment implications, fundamentals tend to follow a somewhat predictable path. Our research primarily focuses on these fundamental paths.
However, fundamentals might not determine 2012’s investment results. With governments intervening in many economies, it certainly seems like global politics, rather than fundamentals, might determine 2012 outcomes. We’ve seen politicians questionably intervene not only in the US, but also in Europe, in Brazil, in China, and in other countries. Political decisions can be capricious, and the resulting investment paths can be considerably more fickle than they might be if based primarily on fundamentals.
Forecasts for 2012 are complicated even more by the apparent tug-of-war between markets and politicians. Identifying and timing the ebb and flow of this tug-of-war during 2012 is likely to be investors’ biggest challenge. Fundamentals suggest avoiding credit-related investments. Politics argue the opposite.
The decade of continually increasingly leverage ended in 2008. Asset classes in which outperformance were fueled, either directly or indirectly, by the credit bubble have accordingly been underperforming. Hedge funds, housing, financials, commodities, and emerging markets immediately come to mind.
However, politicians around the world are attempting (fruitlessly in our opinion) to counteract that transition. In the emerging world, credit bubbles and the fastest rates of money growth in the world have led to lose/lose political choices between inflation and unemployment. In the developed world, politicians are actually fighting the much needed consolidation of the global financial sector. Despite that history clearly demonstrates that economic healing after an economic or financial bubble is largely dependent on the quick rationalization of excess capacity, politicians are actually creating policies designed to curb the shrinkage of bank balance sheets and maintain excess banking capacity.
If fundamentals rule, then we think 2012 will be another year of US asset outperformance. This remains a very out-of-consensus view but, as we have repeatedly pointed out, the US dollar index (DXY) troughed in April of 2008, and the S&P 500 has been outperforming the MSCI BRIC Index for four years. Investors still consistently flock to the highest quality asset in the world, US Treasuries, when market volatility increases.
Politicians will likely skew fundamentals from time to time to buck the consolidating, post-bubble trends. One should not be surprised to see our themes underperform during such periods of political attempts to re-inflate the bubble and maintain status quo.
Within this backdrop, some of our favorite investment themes for 2012 include (in no particular order):
Overweight US/Underweight EM
The US stock market has now outperformed the BRIC markets for four years. Surprisingly few investors seem to know this fact. Chart 1 shows the performance of the S&P 500 and the MSCI BRIC index beginning December 31, 2007. The US stock market not only provided protection relative to the BRIC markets during the bear market (whatever happened to those stories of emerging market economies “de-coupling” from the developed world?), it has maintained that outperformance during the bull phase.
This is similar to the performance between emerging markets and NASDAQ when the technology bubble was deflating. Investors during the early-2000s waited for Technology stocks to outperform, and were generally unaware of the superior performance of the emerging markets. The second chart shows the performances of the NASDAQ Composite and the MSCI Emerging Markets Index indexed from the end of 2000. The unexpected reversal of performance subsequent to the peak in the Technology bubble was more dramatic than is that of the current cycle. Nonetheless, leadership changed in both cases, and investors were generally unaware.
US valuations remain quite compelling relative to those in the emerging markets, according to our work. Chart 3 shows a comparison of free cash flow yields between the US and the emerging markets. In 1998, when emerging market equities troughed, EM free cash flow yields were roughly 7%, whereas they were about 3-4% in the US. Today, the roles are reversed. US free cash flow yields are between 7% and 8%, and EM free cash flow yields are less than 3%.
In addition, US earnings statistics remain the strongest in the world. Chart 4 shows the percentage of companies within each region that reported positive earnings surprises during each quarter of 2011. Note that the US was best during each quarter. Because earnings surprises tend to propagate, the US’s lead seems to still be a very bullish signal for the relative performance of the US corporate sector.
The US appears to have the strongest corporate sector in the world right now, and US corporations have produced their strong earnings while actually de-levering their balance sheets. Charts 5 and 6 show the trends in the US and Chinese corporate sectors’ debt/equity ratios. Whereas US companies have been reducing during the past decade their reliance on debt to boost profitability, Chinese companies have increasing debt. Chinese debt/equity ratios are now on par with those in the US, but Chinese earnings dynamics have been weaker. It seems particularly odd to us that Chinese companies would have to increase leverage given the supposed strong growth in the Chinese economy.
Smaller capitalization stocks
We continue to believe that the best secular investment theme in the global equity markets is US small cap stocks. Smaller US companies are starved for capital much the way that emerging markets, energy, and commodities were ten years ago. By definition, capital starved companies’ higher cost of capital translates to higher expected returns for investors.
Investors appear to be overlooking smaller US companies’ fundamentals. As shown previously in Chart 4, companies in the Russell 2000 have been producing positive earnings surprises at a better rate than most other regions of the world. Although smaller US companies’ earnings fundamentals are not yet superior to their larger US counterparts, we believe that relationship is likely to reverse.
Some investors are concerned about the valuations of smaller capitalization stocks, but we think those views ignore smaller companies’ earnings potential. Chart 7 shows that US small caps remain one of the fastest growing segments of the global equity markets. In fact, the 2012 projected earnings growth rate for the Russell 2000 is presently three times that of China’s and nearly four times that of emerging markets in general.
The caveat to investing in smaller companies is their stocks’ typical volatility. Smaller companies are extremely sensitive to changes in the macro-economy. In the “risk on/risk off” world, smaller companies tend to significantly outperform when risk is “on”, and significantly underperform when risk is “off”. However, despite the volatility during 2011, the Russell 2000 has nonetheless outperformed the MSCI Emerging Market Index by about 10% so far during 2011.
Commodities and Gold
Wampum was the shells and beads that the Native Americans traded in return for goods and services. We think investors in gold should realize that gold and wampum are identical. They are both real assets to which society affords a romantic notion that is supposed to make them more valuable than are other real assets. The idea that “gold is a currency” only further reinforces its similarities to wampum.
Real assets, in general, tend to perform well during periods when a currency is depreciating and inflation expectations are rising. Critically, this is not happening within US dollar markets, and actually has not been happening for quite some time. It is, however, starting to happen in other currencies.
Chart 8 shows the Thomson Reuters/Jeffries CRB Index. Most investors still do not appreciate that commodities (when priced in US dollars) peaked in 2008. One could point to individual commodities that have performed well, but the asset class as a whole has not met many investors’ return expectations.
This underperformance makes sense to us for two reasons. First, commodities are an inflation hedge and excessive credit typically generates excessive inflation. The credit bubble did indeed lead to the highest inflation rate in the US in nearly 18 years (5.6% in July 2008). However, as credit has been curtailed, so have inflation rates, and so have the prices of commodities and other real assets.
Second, the dollar index (DXY) began to appreciate about the same time. Although there is much talk about the US “de-basing” its currency, the fact is that the tradable dollar index hit a bottom in early-2008 (see Chart 9).
Gold has, to some extent, bucked the negative trend in other commodity prices. This makes little sense to us because the dollar is not depreciating nor are inflation expectations rising. Real asset prices such as housing and commodities have depreciated, but not gold prices. It is our feeling that gold prices will not be far behind.
Some gold enthusiasts have suggested that investors should reduce their exposure to gold only when it reaches its 1980 peak “real” price (i.e., inflation-adjusted price). Why then have few observers mentioned that gold hit that 1980 peak several months ago? Chart 10 shows the spot price of gold deflated by the CPI. Gold is as overvalued today as it was in 1980. In fact, we would argue it is more overvalued today because inflation rates are less than half of what they were in 1980.
Perhaps most important, the last time gold got this overvalued, it was followed by a twenty-year bull market in financial, and not real, assets. We continue to believe that the investors’ sentiment is quite favorable for financial asset outperformance.
We understand the desire for gold as part of a non-dollar portfolio, but we don’t understand the interest in gold among US dollar-based investors. Chart 11 shows gold’s return this year in US dollars, in Brazilian Reais, and in Indian Rupees. Although gold returns in US dollars peaked earlier this year, returns in several emerging market currencies have continued to rise.
Treasuries for diversification
Perhaps the most misunderstood asset class today is US treasuries. It is unfortunate that some politicians in the US have attempted to tarnish the potential creditworthiness of treasuries and have scared many investors because treasuries continue to behave as the world’s highest quality asset class. As we have emphasized for many years, treasuries are the only major asset class that currently provides diversification to a multi-asset portfolio. In fact, long-term treasuries (as measured by the BofA Merrill Lynch 15+ Year US Treasury Index) returned over 25% and 30-year zero-coupon treasuries returned over 60% from June to September this year when most other asset classes decreased in value.
Chart 12 shows the correlation between the S&P 500 and a broad sample of asset classes. The reality is that treasuries, regardless of maturity, are the only asset class that today has a negative correlation to equities. Virtually every other asset class is positively correlated. This means that a portfolio that contains five or ten asset classes, but does not contain treasuries, is probably not a diversified portfolio.
It is also unfortunate that investors have been put off by treasuries’ low yields. Treasuries always have low relative yields (remember that bonds are priced by basis points “over” treasuries). Income-oriented investors can always find superior yielding bonds. Today’s situation is nothing new.
Treasuries’ lower yields have actually increased their diversification potential. As yields fall, treasuries’ duration increases (they become more interest rate sensitive). Thus, smaller amounts of treasuries can be used to diversify portfolios without losing effectiveness.
What if rates go up? In that situation, treasuries would likely underperform. However, most other asset classes would probably appreciate in that economic backdrop, and their outperformance would likely more than offset the negative return in treasuries. We find it somewhat startling that investors are willing to invest in assets that are traditionally quite risky like gold, commodities, hedge funds, or private equity, but they refuse to invest in treasuries, which continue to show safe-haven properties.
Increasingly avoid alternatives
Few investors realize that most alternative assets’ returns are credit-dependent, and that these asset classes’ outperformance was largely driven by the bubbles’ increasing availability of credit. Because the global credit bubble continues to deflate, we feel investors’ expected returns for alternative asset classes may be too optimistic.
Chart 13 demonstrates that traditional asset allocation is not dead. The chart compares the returns over the past four years for hedge funds, hedge fund fund-of-funds, and treasuries (as measured by the iShares Barclays TLT ETF). Treasury bond returns have been quite superior to those of hedge funds or funds-of-funds. In addition, traditional asset allocation has much cheaper fees than do hedge funds and fund-of-funds.
The treasury bond market is the deepest and most liquid market in the world, but hedge funds and fund-of-funds limit their investors’ liquidity. Often, investors actually have to ask permission to liquidate their holdings.
In our minds, the comparison between alternatives and traditional asset allocation is quite simple. Traditional asset allocation has provided diversification, superior returns, liquidity, and cheaper fees, yet investors continue to shun the traditional approach. Alternatives have underperformed, are highly correlated to other asset classes, hinder liquidity, and charge high fees, yet investors continue to flock to such assets. This seems to be a comparison of a superior, less expensive product to an inferior, more expensive product. We continue to prefer traditional asset allocation.
2012: Politics continues to influence returns
We expect 2012 to be another year of political intervention as the global credit bubble continues to deflate. Investors have already seen such intervention in the US and in Europe, and have been victims of the inconsistency of the political process leading to market volatility. We expect political issues will increasingly surface in the emerging markets as 2012 progresses.
Many of our investment themes for 2012 mimic our 2011 themes. However, these themes have generally played out well, but investors have not gravitated to them. Valuation, sentiment, and earnings fundamentals still seem to support our on-going themes.
The decade of the 2010s, we think, will be remembered as one which reversed many of the trends of the 2000s. Leverage aided performance during the 2000s, but it has hindered performance so far during the 2010s.
Although market leadership is likely to gyrate as politicians argue, the fundamentals ultimately seem to favor our themes.
(c) Richard Bernstein Advisors