Friday, July 11, 2014

Scattershot Summer Thoughts:

EAFE: Waiting for Godot

As we’ve discussed in the past, since the beginnings of the 2007 to 2009 financial crisis, the MSCI EAFE, an index comprised of developed market companies from Europe to Australia to the rest of Asia, has significantly trailed the performance of US markets.  Of course, the sovereign debt crises spreading across southern Europe from 2010 to 2012 hurt European equity markets and held back performance.  And, Japan has been a multi-year economic mess, though Abe’s moves since late 2012 have ignited strong recent upward moves in Japanese equities.  Looking over the first six or so months of 2014 though presents a similar relative performance picture despite the fact that attitudes towards international equities, and Europe in particular, seem to have perked up considerably.  Through yesterday (7/10), the EAFE total return is 3.79% vs. 7.44% for the S&P 500. 

Long-term relative performance analysis shows that the back and forth battle between US and International stocks has been cyclical in nature, with long periods of EAFE outperformance followed by long-periods of US outperformance.  In the past, major turns in relative performance have occurred when the relative strength ratio between the EAFE and S&P 500 has reached extreme levels, generally either +1 or -1 standard deviations from the average.  We’ve passed that threshold recently, with the EAFE performance relative to the S&P 500 falling below -1 standard deviation from the average in recent weeks for the first time since late 2001 and early 2002.  Here’s a chart of long-term relative strength.
The last time the EAFE crossed this threshold to the downside, the EAFE index outperformed the S&P 500 significantly over subsequent years.  From 12/31/2001 to 12/31/2007, the period roughly corresponding with the minor uptrend in the chart coming after the last threshold breach, the EAFE was up 132% (total) vs. 42% (total) for the S&P 500.  Interestingly, even with all of the economic and political troubles outside the US over the past 13 years, the EAFE has matched S&P 500 performance on a simple basis and actually outperformed the US when taking dividends into account.

Investors like us have been waiting for our international developed brethren to re-take the performance mantle from the US for a few years now.  The above suggests that the winds may shift in coming quarters and that the EAFE may soon become a strong relative performer.

Emerging Markets Emerging?

Speaking of relative performance and downtrends, there’s no denying Emerging Market equities have been performance dogs when compared to the US and even developed Europe and Asia over the past several years, defying all sorts of conventional wisdom coming out of the Great Recession.

Year-to-date, the MSCI Emerging Markets Index has shown some vigor, matching the performance of the S&P 500 for the first time in what feels like ages.  Is this the beginning of another long period of outperformance or another short-term reversal?  The evidence seems mixed at this point.

Like the EAFE/S&P 500 comparison above, Emerging Markets performance relative to US stocks has been just as cyclical.  The recent underperformance comes after a long period of outperformance following extremes similar to extremes observed above in the EAFE chart.  Even with underperformance over the past 3 or 4 years, relative strength is stuck in the middle of the 2 ½ decade range as seen below:
Using relative valuation, Emerging Markets are clearly undervalued on a long-term basis, with various CAPE P/E ratios hovering in the low-teens versus the low-20s for US equities.  At some point, those wide valuation differentials will converge.  When though?  We also look at the 200-day moving average for the relative strength ratio between the S&P 500 ETF, the SPY, and its Emerging Market counterpart, the EEM.

At this point, the downtrend remains in place as shown below:
At IronHorse, we’re seeing more and more emerging-market stocks pop-up as targets for consideration; we’ve even added a small amount of single-stock emerging markets exposure in recent months.  We’ll become more comfortable, however, with large amounts of emerging markets exposure when the above trend starts moving the other way.

Sentiment:  The Song Remains the Same

The past few years, we haven’t ceased to be amazed by the quickness with which broader market sentiment deteriorates at the first hint of correction.  This is a very good thing in our estimation.  Take recent market action.  Granted, the S&P 500 and global markets have pulled back in recent sessions.  Nonetheless, the S&P 500 is still slightly up for the month of July at this writing and the MSCI World is down less than 1% for the month.

What’s happened to various sentiment indicators?  Fear has jumped.  It’s not extreme, but the jumps higher for fear gauges seem disproportional relative to the magnitude of actual equity market moves, a condition that’s persisted for much of this equity market cycle.  For example, the put/call ratio has jumped from a roughly neutral level to approximately 0.6 standard deviations above the long-term average.  The 10-day average for the ISES option indicator has fallen from an extended level over 1 standard deviation above the norm to a neutral level over the past two weeks.  Meanwhile, individual investor sentiment as represented by the AAII bull/bear/neutral survey remains below long-term averages.

As we mentioned a few weeks ago, there seem to be several pockets of serious complacency out there, but nothing that warrants deep pessimism.  Corrections, minor or not-so-minor, are healthy recalibration agents for up markets.  Investors broadly seem to still think, though, that every little hiccup is the beginning of the end of days.  Until this behavior changes significantly, we’ll remain encouraged.

Inflation: Little Sound, Little Fury

This week, the back and forth continued among various Fed officials, Fed watchers, and market gurus about the future path of inflation, and hence Fed rates.  Some of this back and forth has contributed to some of the recent market hiccups.  James Bullard, St. Louis Fed President, suggested this week that the Fed Funds rate could increase sooner than the markets expect. 

Of course, there remain a number of pundits and analysts out there sounding the inflation warning signals, as they’ve been doing for five years now.  To this, we say, “Where’s the Beef?”  Looking at 5-year and 10-year TIPS/Treasury spreads, a way to gauge the broader market’s expectations for future inflation, inflation expectations remain well grounded at this point and have barely budged in recent months, even with improving labor market numbers and other indications that economic growth has regained its footing.  The following charts provide a visual representation of this benign pattern:
 
Furthermore, it seems to us that the biggest driver of sustained inflation problems in the past (take the mid to late 1970s for instance) has been strong increases in unit labor costs.  At this point, there’s no sustainable evidence that unit labor costs are increasing materially in the US.

Look at the below chart showing year over year unit labor cost moves.  As you can see, the green line, the 24-month moving average for year-over-year unit labor costs, began increasing in 1967 and didn’t stop until Volcker broke inflation’s back over a decade later.  Of course during this time period, Americans experienced the infamous double-digit inflation that affects attitudes to this day.  What’s happening now?  Actually not much.  There’s always statistical noise in this series.  Focus on the 24-month moving average which remains in a downtrend.  Wage data in the recent strong employment reports remains unremarkable.  We’ll begin to worry about long-term inflation trends when labor costs begin to uptick in a meaningful and sustained way.  

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