Markets 1, Conventional Wisdom 0

When markets make substantial moves, it’s always interesting to think about these moves in relationship to market consensus a few years ahead of a particular correction.  More often than not, general market consensus among pundits and serious analysts alike turns out to be significantly off-base.  Unfortunately, money-flows for institutional and individual investors tend to follow these views en masse.

In particular, we want to look at emerging market performance and gold/commodity performance since 2009/2010.  At the time, developed markets including the US and Western Europe were figuratively left for dead relative to the faster growing emerging market block, led by the BRIC nations.  Many market strategists advocated shifting portfolio allocations towards these markets.  Qualitatively, this made sense.  The BRIC nations were all experiencing mid to high single digit real GDP growth (in China’s case low double digit).  Europe was beginning to unravel at the seams as Greece’s governmental financial shenanigans quickly came to light.  US growth was certainly sub-par relative to past post-recession bounces, not to mention the Federal Reserve’s newfangled, untested QE policies introduced some confusion and uncertainty into economic planning and forecasting.  In lock step with these recommendations, many strategists also advocated a continued push into Gold and other commodities.  Talk of global monetary “debasement” via “loose money” policy fueled these discussions.  If the Federal Reserve and the ECB were going to do whatever it takes via monetary stimulus (or if the ECB failed in its mission to preserve the currency and the single currency collapsed), wasn’t it only a matter of time before developed market currencies imploded, producing sky-high inflation and a host of other ills?  And, in a world threatened by hyper-inflation, isn’t the safest place to be in metals and other hard assets?

Well, a funny thing happened over the past few years.  Buying developed market equities since the end of 2009 turned out to be a much better plan than buying emerging market equities and gold/other commodities, even though some of the dire predictions did come true.  For instance, US growth has remained somewhat spotty and below trend.  Developed Europe experienced two straight summers of economic turmoil and uncertainty.  Japan’s earthquake/tsunami and subsequent nuclear crisis significantly disrupted economic and energy policy in the world’s third biggest economy.  

From the end of 2009 through yesterday, June 20th, the MSCI World is up approximately 35% (total return).  Over that same stretch, the MSCI Emerging Market is essentially flat, up 1.2%.  The broader Goldman Sachs Commodity Index is up approximately 17%.  Gold is up 18.7%.  Digging deeper into the MSCI World, the EAFE Index, which includes developed nations outside of the US, is up 18.2% while the S&P 500 in the US is up 53%.  Amazingly, with all of the turmoil experienced within Europe and Japan over the past three and a half years, a portfolio solely allocated to the EAFE and ignoring the US still would have beat a portfolio allocated equally between emerging markets and commodities, or emerging markets and gold specifically.  That is an amazing result.  

What could possibly account for the fact that market consensus was completely turned on its head?  Obviously, there are many factors that affect performance over time.  Long-term valuation ratios perhaps provide one of the easier ways to see market psychology in real time. Market multiple expansion above mean usually reflects a general build-up of optimism and a rise in perception that risks, economic and otherwise, are declining.   In this case, using Bloomberg index earnings numbers, the S&P 500 was trading at approximately 17.5x on a 10-year normalized basis at the end of 2009 while the EAFE was trading at approximately 19.5x.  Meanwhile, the MSCI Emerging Market index was trading at approximately 22x.  Granted, the differential wasn’t huge, but the long-term P/E ratios do show that a bit more expectation was built into emerging market equity prices at the end of 2009 than developed markets. 

What about Gold valuation?  Arguments over the fair value of gold have been around as long as there have been markets in the metal.  We’ll use the ratio of gold to the dollar index to give us some sense of valuation perspective.  At the end of 2009, gold was trading at approximately 14x the value of the US dollar index.  That put the gold/dollar ratio at nearly 2 standard deviations above the historical mean.  Gold did continue to spike, eventually passing the 3 standard deviation mark.  It’s now come back to earth, and as pointed out above, isn’t valued significantly above its late 2009 level.  At 2 standard deviations above the mean a case can certainly be made that gold was overvalued (overloved) at the end of 2009 (and remains so today).

Fast forward to today and the situation has changed markedly in equity markets.  Investors are fleeing emerging markets en masse and pessimism has increased substantially about the prospects for future growth in the BRIC nations.  US equities are viewed as a safe-haven of sorts.  In many ways market consensus has flipped from the position observed at the end of 2009.  Does this sentiment flip show up in valuation metrics?  Certainly.  The MSCI Emerging Market Index is now trading at approximately 14x on a 10-year normalized basis, while the US is trading at approximately 21x.  EAFE stocks at 17x are trading slightly cheaper than they were in 2009.  

This exercise isn’t meant as a prediction that emerging market equities are ready to fly to the moon and the US equity markets are ready to crash in a matter of days or months.  Instead, use it as another reminder that valuation and other quantitative, objective metrics can be much better tools to guide long-term portfolio thinking than the qualitative “story-based” consensus put out by the recognized market intelligentsia.  Again, as we’ve stated many times in the past, oftentimes “What Wall Street knows ain’t worth knowing.”

All Volatility Isn’t Equal

If you’ve read any of our posts over the past several months, or perused the linked articles, you’ll know we often return in some form or fashion to the over-wrought media market coverage you’ll find out there in both the mainstream press and on widely followed blogs.  A few months ago, for instance, everyone was gaga over the Cyprus bailout and how Cyprus’ troubles meant the end of western civilization as we know it.  In recent days, every time we open the paper or scan through the news screens, we’re confronted with headlines about amazing market volatility, and wreckage, and amazing market moves over recent sessions.  Most of the articles attribute all moves, up, down, or sideways, to Bernanke’s “tapering” talk, or some variation.  

Don’t get us wrong, there have been some interesting moves in markets over recent weeks.  Since the beginning of May, the US 10-year treasury yield has risen a whopping 50 bps—from 1.65% to 2.14%, still among the lowest yield prints in history and back to basically the same spot observed last May.  The Nikkei, Lord forbid, has fallen from an intraweek high approaching 16000 at the end of May to the current level of 12686.  There’ve been enough headlines about a Japanese bear market this week to make one sick to his/her stomach.  Never mind that the Nikkei is up approximately 50% in local currency terms since November, even after the recent correction!  Is that truly a bear market?  Maybe if you chased at the recent top.  The Nikkei and Japanese yen both got caught up in parabolic frenzy, and market participants are rightfully deflating some of that balloon.  

One particular Bloomberg Radio headline caught my attention in the car the other day, saying that recent market moves had eliminated $2.5 trillion in stock market value globally since May 21^st.  Pretty scary, no?  A quick look at the various indices, however, shows a rather mild, perhaps healthy correction since the end of May.  The MSCI World is down less than 5% peak to current trough, entirely unexceptional when it comes to market corrections historically.  The S&P is off a more benign 3.7% from its intraday high set several weeks ago.  After all, markets had risen relentlessly for months and were showing some classic short-term technical overbought signals. 

Returning to the notion of volatility, one would think reading the headlines that volatility in equity markets had reached levels not seen since the scary days surrounding the European debt crisis in late 2011.  Checking the 20-day volatility numbers for both the S&P 500 and MSCI EAFE indices this morning shows that volatility for both indices is exactly in line with the long-term historical average, and below the average for 20-day volatility observed over the past five years.  Perhaps, we’ve all been spoiled by the relentlessly calm move higher in global and domestic equity markets.  

The point here isn’t to call out the media or even make a call that markets are going to immediately begin a dramatic move higher.  In reality, we wouldn’t be surprised if global equity markets had a little correction left in them.  The S&P 500 is still about 125 points above its 200 day moving average and hasn’t touched that trend line since last fall.  Markets back and fill and that’s ok.  The broader point is to point out again how dangerous it can be for individual and institutional investors to get caught up in dramatic news flow to the detriment of their portfolio performance (and sanity).  All of us, from those that casually follow business and market news to those like us that spend all day watching screens and doing this for a living, are bombarded by an ever-increasing array of news sources, analytical tools, and other ways to keep up.  Much of it is noise, and oftentimes the headlines are overtly negative to grab one’s attention and lacking a sense of perspective or context, as seen above.  We’ve pointed out in past notes on market sentiment that several sentiment indicators have been tracking in decently negative territory, despite the fact that markets have been grinding higher and higher.  Hence, we’ve seen classic “climbing the wall of worry” behavior.  With headlines and talk of volatility and tapering, the sentiment indicators we follow have fallen deeper into negative territory (potentially a positive contrarian signal).  The CBOE put/call ratio is the highest it’s been since May of 2012, when the market was experiencing a deeper short-term correction (and there were proclamations about the end of Europe and the world as we know it).  The Farrell Sentiment Indicator, based upon the AAII bull/bear numbers, is low by historical standards.

Again, it’s never time to be complacent when investing in equity markets.  At the same time, we become much more concerned when investor sentiment is trafficking in extreme positive territory, not when some investors and pundits are acting like a 3% correction is the beginning of a 2008 repeat.  As a final note, in the face of ever increasing noise, it’s good to point out again that having a plan or system to add objectivity to the investment process can make a significant difference when buffeted by loads of conflicting information.  Furthermore, applying the “keep it simple stupid” principle when approaching markets is often more productive than creating overly complex systems and analytical tools.