Emotional Rescue

In last week’s “Interesting Articles” email, we linked a post entitled “Mr. Market Doesn’t Care What You Think.”  That article focused on the link, or lack thereof in many cases, between market performance and consumer sentiment.  As markets move deeper into earnings season, we couldn’t help but think of that title again when it comes to the stories and sentiment surrounding three particular companies: Apple, Amazon, and Research in Motion, soon to change its name to Blackberry.  Each of them has either reported earnings or made a big product announcement over recent days and weeks.  All three have made stock moves in recent months that have confounded a wide range of pundits, bloggers, and analysts.  We can’t think of many other names in the marketplace of late that have inspired as much debate. All are prominent brands with relatively long histories and, in the case of Apple and Amazon at least, very large market caps.  In that respect, one would expect an intense spotlight.  However, the intensity of recent moves in the stocks has ignited debates about fundamental stock picking and the efficiency of markets.  When it comes to picking individual stocks (and thinking about broader market moves), there are lessons we can all learn from recent action.

First, let’s quickly recap the stories and recent moves.  

• Apple, of course, rallied relentlessly for the past three years, moving from a low of near $100 per share in early 2009 and hitting $700 per share in late 2012.  This past fall, Apple became the most valuable company in the world measured by market cap.  Astronomical increases in revenue, profit, and cash flow fueled those gains.  The company started paying a dividend under Tim Cook’s leadership.  Even with the massive appreciation in share price, the incredible growth in revenue and income has kept multiples at what many consider to be “value stock” levels.  Currently, the trailing 12-mo P/E is 10x, and trailing EV/EBITDA is approximately 5x.  Of late, the stock has been under pressure; it’s fallen 36% percent since late September.  This downward move has inspired an enormous volume of debate, with many incredulous that a company with such a strong fundamental backdrop can act so poorly, especially relative to the broader market advance we’ve witnessed over the past four months.  This “frustrated” side represents the majority with many of its representatives citing the continued top-line growth, additional opportunities to return cash to shareholders, strong brand awareness, and, of course, the compressed multiples (“It’s a growth stock with value stock characteristics.  How can this stock not go back up!”).  The skeptics point to declining margins, increased competition, and the fact that year over year earnings increases have shrunk considerable over recent quarters.
• Research in Motion, the maker of Blackberry smartphones occupies the other end of the spectrum.  The stock and the company’s prospects have been in relentless decline since the introduction and proliferation of the iPhone and Android mobile ecosystems in 2007 and 2008.  Blackberry at one time was the dominant force in the mobile smartphone space with market share levels solidly north of 50%.  Market share over recent years has fallen to approximately 2%.  The stock price followed the trajectory of the business, declining from a peak near $140 to a low of $6.22 in late September.  While revenue is still above levels seen in late 2008, owing to the strong growth in overall smartphone sales in recent years, EBITDA has been halved and net income has actually crept into negative territory.  Since September, however, the stock price has doubled, even taking into the account declines this week after the announcement of their new smartphone operating system.  Like Apple above, this move over recent months has generated massive debates over the nature of the move, especially from those looking at the fundamentals and pulling their hair out strand by strand.  The frustrated, representing a majority, tend to believe the company will remain in a death spiral.  This group has been absolutely incredulous when it comes to the recent stock move (“This company is old news!  They’ll never catch up to Apple and Android! Nothing else matters!”).  Of course, judging by the short interest in the stock, this group probably represents a good number caught up in a short squeeze.  To those on the other side, the company still appears cheap; these folks believe that if Blackberry can just hold the line with the new operating system and maintain a number three position in the cell phone pecking order, that the stock could continue to rebound dramatically due to the large cash position, debt-free balance sheet, and compressed multiples/expectations.
• Amazon straddles the line.  Without a doubt, Amazon has become a phenomenal brand and success story.  Over the past several years, the company has moved away from the core book and music categories to deliver a wide range of goods from food to household items.  They’ve established digital video and music stores to provide serious competition to Apple iTunes, Netflix, and other entertainment companies.  Amazon Prime, which allows users to pay a yearly fee for free shipping and access to digital video streaming, has been an enormous help in building brand loyalty.  Even though Amazon faces increasing pressure to pay sales taxes in various locales, they’re working to significantly enhance their distribution network. In some areas, rumors suggest Amazon wants to move decisively into same-day delivery.  Revenue has more than doubled since the end of 2009.  The stock price has moved in lockstep, from just below $50 in late 2008 to $265 currently.  There’s been one little problem, however.  EBITDA and Net Income growth have been lagging to put it mildly.  Amazon continues to trade at very high multiples.  Estimated P/E for the coming year is 85x.  P/B is nearly 15x.  EV/EBITDA is a very high 40x.  An earnings report over the past week has reignited the controversy over the future trajectory over the stock.  Similar to RIMM, a solid number of observers are extremely frustrated that the stock has continued to march higher even though the company consistently fails to deliver solid bottom line growth.  This group cites increased sales tax collection initiatives, potentially better online competition, and, of course, extremely high valuation ratios as reasons the stock should decline.  Proponents of the stock point to the massive top-line growth and Amazon’s increasingly dominant market share position in online shopping, not to mention its increasing mindshare in the overall marketplace.  Likewise they point out that Amazon is wisely investing in the future and that profits will come in spades once the management vision is completely executed.  The earnings report generated one of the better lines this week from one of those incredulous about its new 52-week highs.  Blogger Matt Yglesias stated, “…Amazon, as best I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers.  The shareholders put up the equity, and instead of owning a claim on a steady stream of fat profits, they get a claim on a mighty engine of consumer surplus.  Amazon sells things to people at prices that seem impossible because it actually is impossible to make money that way.”  

Again, all three above have tended over recent months or years to confound a significant number of critics and analysts, many of them well-respected practitioners of fundamental stock analysis.  We’re not here in this particular blog post to make a judgment about the future direction of the above companies or the direction of their market prices.  Instead, we’re here to again point out the fundamental truth at hand: no matter how logical the argument, no matter how obvious over or undervaluation, no matter how obvious it seems that a particular business model is the greatest or worst of all time, the market at large could care less.  In the cases above, and in many other cases in the current market, prices have made moves that upend the apple carts for a majority of investors.  Several famous market clichés tend to capture this truth:  “Don’t catch a falling knife;”  John Maynard Keynes famous line, “The market can stay irrational longer than you can stay solvent;”  and, “What Wall St. knows ain’t worth knowing.” 

As campy as some of the statements are, there’s a lot of truth here.  Watching the stocks above run against the consensus logic, which in many cases is sound, leads us to several conclusions that investors need to keep in the back pocket.  

1. Momentum is a powerful force in the marketplace.  
1. The above may sound obvious, but there are some interesting observations about market structure behind this statement.  The overall market is heavily influenced by the activity of large institutional investors, from mutual funds to hedge funds.  Most of the people managing funds are incredibly capable and logical analysts with many years of experience investing in public equities.  Nonetheless, the professionals driving much of the market movement (and even a good number of the “machines” increasingly engaging in investment activity) are just as subject to the same biases and psychological errors witnessed across a wide range of human activity.  There’s no need to talk about all the behavioral quirks here, but there are some that stand out.  Prominently, managers are subject to herding behavior.  As a stock moves higher, for instance, and generates positive performance, it’s easy for investors, individual and professional alike, to justify jumping on the bandwagon.  Upside performance, such as that seen over recent years in Apple and Amazon, generates numerous positive articles in the mainstream press pointing out the performance and in many cases providing reasons why performance can only continue to improve.  In the earlier phases, valuations are usually reasonable providing cover.  Managers are cognizant of the public press and of the fact that their individual investors are attuned to the performance of these particular companies.  It becomes important to have the high-flyers in the portfolio to show investors that one is clued into “what’s hot” in the marketplace and business community.  Or, simply, the “missing out” component in the brain ignites pushing investors into the stock.  Either way, massive flows of capital move in that direction.  Confirmation bias creeps in.  Managers and individuals begin to ignore any evidence that runs contrary to their position and focus entirely on evidence that confirms the thesis.  As price continues to climb, and this became an issue with Apple, the stock becomes a bigger and bigger piece of a benchmark index leading other investors to add to the allocation simply to keep up with benchmark performance.  Price/performance takes on a life of its own.  In general, this is referred to as a stock under “accumulation.”  
2. Of course the same thing happens in reverse, leading to institutional “distribution.”  The story changes, usually due to some sort of catalyst (unexpectedly bad earnings report, corporate action, etc.) leading institutions to begin selling the stock and taking profits.  In Apple’s case, the Q3 earnings report and the maps debacle changed sentiment.  As witnessed during the buy phase, the initial move is most likely justified by the fundamentals, but price movement takes on a life of its own.  It doesn’t help that the stock is often trading at lofty multiples and resting on a weak market foundation.  Managers only see the negative stories from this point forward.  Unlimited prosperity becomes “death spiral.”  News coverage becomes unrelentingly bad and managers don’t want investors to see any traces of the position in their portfolios.  Stock performance becomes dreadful, in many cases exceeding anything logical relative to the true business prospects.  Once again, it takes a catalyst to arrest the decline.  For RIMM, this was a better than expected earnings report for Q3 followed by news that the new operating system would be unveiled on time.  
3. To close with the RIMM/AAPL example and show how quickly momentum can change, within a few short months in late 2012, the AAPL story changed from a company that could do no wrong to a company that couldn’t get anything right, even though nothing had fundamentally changed at the product level.  Snafus like the maps issue became prominent whereas during the up phase snafus like “antenna-gate” were largely ignored by investors.  RIMM, on the other hand, went from a company with a relatively small user base, poor technology and execution, and no prospects whatsoever in the press and analyst community, to one with a contender on its hands, “innovative” operating system, and a “solid base” of users to upgrade.  Again, like Apple within weeks headlines that would have been framed in a negative context were written with positive overtones.  
2. Following from the above, markets are definitely not truly “efficient” in the short or even intermediate term.  Market efficiency debates have been a prominent part of the discourse in finance disciplines for quite some time and there’s no way to even begin to hash out the research on this.  Watching companies and markets trade on a daily basis, however, it’s quite apparent that asset prices can become quite unhinged from intrinsic value to the up and downside and (as the above bullet implies) emotional investing impulses can significantly override logic and good sense.  In the late 1990s, many technology stocks traded at multiples that could never have been justified by any rational model, yet they continued rising for months and months.  Moving away from stocks, we witnessed this disconnect in the housing market in the mid-2000s; there were many analysts screaming from the rooftops that the assumptions justifying high price ratios relative to historical mean were bunk and completely unrealistic.  That didn’t stop people from lining up as far as the eye could see to buy unfinished condos.  In any case, placing too much faith in market efficiency and logic can lead to very poor investment outcomes.  Perhaps you though Amazon was extremely overvalued in 2010 (it was by many traditional conventions) and shorted the stock or sold a position.  This would have cost the investor a pretty penny.  Similarly, buying RIMM in early 2011 when it was near $50 may have seemed like a decent prospect trading with the stock trading at 12x earnings and an EV/EBITDA of 7x; this would have cost you 80% of your capital over two years.  Over the intermediate to long-run, the fundamentals tend to work themselves out and markets seem to demonstrate efficiency.  Many of the individual stocks trading at astronomical multiples during the tech boom fell dramatically in price, many never having reclaimed prior peaks.  Looking at a broad market, the Nasdaq still trades approximately 40% below its early 2000 peak.  Housing prices eventually collapsed, but are now much closer to median multiples witnessed over the historical record.  The time it takes, however, for the market to come to its senses can be long indeed.
3. If markets and stock prices can be inefficient momentum machines, chewing up logical analysis like a dog bone, what’s an investor to do?  Knowing that momentum and price inefficiency can combine to create harrowing outcomes for investors, it’s important for investors to develop some semblance of a rules-based approach when investing.  Some fundamentally-oriented investors still incorporate technical trading rules into the investment process to impose discipline, for instance.  As we’ve seen a cheap stock can become demonstrably cheaper; perhaps a technical rules based approach can orient an investor to exit a position until more favorable momentum climes develop.  Some investors incorporate rules such as stop-loss tactics.  These types of rules aren’t guarantees that frustrating outcomes won’t occur, of course.  There’s nothing more frustrating than getting stopped out of a position, only to watch prices reverse course and shoot to the moon.  Rules can work in reverse as well.  Technical trading rules can help investors maintain discipline, keep winners in a portfolio, and capture upside.  For those investors not inclined to incorporate these tactics, simply observing certain portfolio management conventions can prevent poor outcomes.  For instance, one could adjust position sizing to fit relative risk tolerances.  For the more risk averse, smaller positions sizes and higher diversification levels lead to less anxiety if the forces above push heavily against the investor’s tip-top analysis in a particular stock.  On the flip side, setting explicit price or multiple targets can help maintain discipline and define exit points for winners.  Whatever the case, the ultimate idea is to suppress the behavioral biases and emotional responses that contribute to bad outcomes. 

Platforms like the blogosphere and Twitter provide an interesting real-time observation deck to view the frustrations and emotional responses of investors in companies like Apple, RIMM, and Amazon when stock price movements aren’t following the consensus logic.  As described throughout, price movements can cause a considerable amount of intense, emotional debate about “who’s right” and “who’s wrong” in particular situations.  This shows up sometimes in raw emotional outbursts on the various social platforms.  To borrow the phrase again, Mr. Market doesn’t care.  As an investor, throwing up one’s hands in frustrating and shouting at the market-at-large only exacerbates negative outcomes.  Investors need to enter every position with a clear plan as to the justifications for the position (valuation etc.), potential outcomes and targets, and plans for exit under various circumstances, positive or negative.  This type of action plan helps cut through the considerable noise out there, impose discipline, and keep reasonable losses from becoming much larger losses.

Rally-Ho!

Last week we discussed the magnitude and duration of corrections in secular bull and bear markets.  As we discussed, corrections in secular bear markets tend to be bigger than those observed during secular bulls, and tend to last longer.  This week, we’ll turn last week’s analysis on its head and discuss the nature of the rallies, often referred to as “cyclical bull markets”, that occur between the major corrections.  Currently, this side of the bull/bear ledger is more germane considering markets in the US and around the globe have been on a tear higher over the past several months.  Like last week, we’ll review the period from roughly 1950 to the present, picking up with the end of the secular bear market in 1949.  Again, as we discuss differences in performance during secular bull markets and secular bear markets, keep in mind that there have been five secular market cycles since the market peak in 1929: the bear period from 1929 to 1949, encompassing the Great Depression; the secular bull period from 1949 to 1968, which peaked in the wake of the Nifty 50 craze; the bear period from 1968 to 1982, which was marked by political upheaval and “stagflation”; the secular bull from 1982 to 2000, which culminated with the tech craze and the highest valuation levels recorded in modern times; and the current secular bear period, which began in 2000, marked by the tech bust, subdued economic growth, the “Great Recession” and sovereign debt crises.

Over the past 60 or so years, the major corrections (15%+) we discussed last week have been followed without exception by moderate to furious rallies that oftentimes push markets past prior peak levels.  Like market corrections, the nature of the rallies is related to the overall market environment, secular bull or secular bear.  In a mirror image of last week’s data, post-correction cyclical bull market rallies tend to last much longer and achieve much stronger performance outcomes during secular bull markets than the rallies that occur during secular bears.  Let’s look at the S&P 500 data pertaining to the rallies:

* Highlighted Areas represent Secular Bear market periods. 

We’ve witnessed 17 rallies post-correction since 1949, including the present rally.  As you can see above, the median post-15%+-correction rally across all markets has lasted a little more than two and a half years and generated nearly 75% in returns (simple return, not including dividends).  The longest and best performing rally without a 15% intervening decline was the rally from 1990 to 1998, which lasted nearly 8 years and produced a return trough to peak exceeding 300%.  Wow!  The shortest post-correction rally occurred in 1980 as the US grappled with a double dip recession.  Lasting about two-thirds of a year, the rally still managed to produce trough to peak returns of 43%.  This was closely followed in shortness of duration by the short rally between round one of the European sovereign debt crisis in 2010 and round two in 2011.  This relatively short-lived rally also produced the smallest overall return in the data series at 36%.  

Breaking the data down in to secular bull and secular bear periods provides some interesting contrasts.  Median performance for cyclical rallies during secular bulls exceeds performance during secular bears by approximately 30 percentage points, 86% to 58%.  Furthermore, median rally duration is two years longer.  There’s more variance/volatility in the secular bull numbers owing to the fact there are a few significant outliers to the upside, notably the 300%+ return during the ‘90s.  Secular bear market rallies tend to be more consistent statistically in terms of performance and duration.  

Similar to the data last week, there’s no major statistical relationship between starting normalized P/E ratios and subsequent rally performance.  The R-squared, a statistical measure of how well starting P/E levels in this case influence performance, is a mere 0.04.  Correlation is -0.2.  P/E ratios tend to have a much stronger statistical relationship to long-term annualized returns and tend to display little correlation to short-term moves.  Hence, more often than not, it’s not a very good idea to rely on P/E ratios for market timing purposes!  The lowest starting P/E for a post-correction rally was 6.64x in 1982.  This also happened to mark the switch from secular bear market to secular bull market.  The highest starting P/E for a rally was 33.77x in 1998.  Of course, the P/E at the end of the 1998-2000 rally was an astronomical 43x; this happened to mark the end of the 18 year secular bull market.

Where do we stand today?  Since the absolute trough associated with the late 2011 swoon, the S&P 500 has rallied approximately 40%.  The duration of this rally is 1.3 years.  Most market observers believe we’re still enmeshed in the secular bear market that began in 2000.  Using past rallies within secular bears as a guide, this rally is still under the median in terms of duration and overall performance.  There is one thing to consider.  To paraphrase Mark Twain, history doesn’t necessarily repeat, but it certainly rhymes.  During the last secular bear market from 1968 to 1982, the first major post-correction rally from 1970 to 1973 proved to be the longest duration-wise as well as the best performing.  The pattern could be repeating itself here, which bears watching.  While the sample set is small, each secular bear over the past century has ended with normalized valuations in the single digits.  Currently, normalized P/E sits at approximately 23x.  This doesn’t preclude the market from rallying furiously, as seen in some past episodes.  However, there are probably decent odds that investors will witness another round of major market turmoil in coming years.  The good news: time-wise, we are probably in the later innings of the secular bear.  At some point in the not too distant future, investors should see another 15 to 20 year period of outsized global equity returns.

Corrective Action

With markets having rallied significantly over the past several months, both in the US and around the globe, we thought it might be interesting to take a look at the frequency, duration, and depth of market corrections over the past 60 or so years.  We’re not undertaking the exercise in anticipation of major upcoming market turmoil.  Instead, it’s a reminder that investors’ expectations for equity market performance are often romanticized on some level.  Memories can be very short.  Investors often underestimate the frequency of corrective episodes.  In reality, it’s a normal part of the process of investing in equity markets.  Over time, equity market returns have been solid.  Investors just have to endure some bumps and volatility along the way.  Of course, some of the bumps are a lot worse than others.  As we’ve discussed in the past, the severity of corrective action is best viewed within the broader context of “secular bear market” or “secular bull market” action.  These cycles generally have lasted 15 to 20 years over the past century and are generally bookended by valuation extremes; “secular bull markets” end when valuations are severely stretched, while “secular bear markets” have usually ended with long-term valuation indicators at severely compressed levels, such as single-digit P/Es.

For this exercise, we defined a correction as any peak to trough decline exceeding 15%.  Because there is much more data available, we focused exclusively on the S&P 500.  We took the liberty of adding the correction of 1953 in light of the facts that the peak to trough decline was 14.8%, very close to the 15% threshold, and the correction lasted nearly a full year.  On to the data:

*Highlighted Cells represent periods during Secular Bear Markets

From 1950 through the end of 2012, there have been 16 major corrections.  Nine of those 16 corrections have occurred during secular bear markets.  

This brings some interesting observations to the surface, however.  While the frequency of corrections is nearly equal between secular bear and secular bull markets, the nature of those corrections is markedly different.  During secular bull markets, the last of which occurred between approximately 1982 and 2000, the average length between correction troughs and subsequent market peaks is nearly 4.5 years.  The longest stretch between corrections occurred during the mega-1990s bull; nearly eight years passed between the correction in late 1990 and the correction in 1998 associated with the LTCM and Russian debt default debacles.  During secular bear markets (we’ve been in a secular bear since 2000), the length between corrections falls to approximately 2 years on average.  Furthermore, the duration of the corrections during secular bear markets far exceeds the durations generally observed during solid market up periods.  Average correction duration during a secular bear is approximately 1.25 years, with the longest peak to trough decline occurring over approximately two and a half years from 2000 to late 2002.  Secular bull corrections have lasted on average a little less than half a year.  Interestingly, 6 out of the 16 corrections identified here have lasted a quarter of a year or less.  Finally, and probably most important to investors, the magnitude of correction declines (at least those corrections meeting our criteria) during secular bears exceeds that of secular bulls by a decent margin: 33% on average to 23%.  The most devastating peak to trough decline, of course, occurred between late 2007 and early 2009.  That decline of nearly 58% will remain seared in investors’ memories for quite a while.

If, back of the envelope, we total up all the calendar time from 1950 to 2012 during which investors were mired in correction, it comes out to about 14 years of market time.  This represents about 22.5% of the calendar space over that time frame.  Even with the volatility and deep declines investors have experienced over the past 12 years of this secular bear, it’s probably not a stretch to believe that the typical investor would probably underestimate how much time the market spends in corrective stretches (might make for an interesting survey).  

A few final notes pertaining to the data: 10 of the 16 major corrections have been associated with official US recessions as dated by the National Bureau of Economic Research.  As for the other six, those have generally been associated with a gut-wrenching series of negative headlines, such as the near collapse of LTCM in 1998 or the string of crises associated with the European sovereign debt crisis over the past few years.  There is a statistical relationship between the starting Shiller P/E value at the peak and the subsequent magnitude of the correction, but the connection isn’t rock-solid; the r-squared is approximately 0.23 and the correlation is approximately -0.47.  The average starting normalized P/E was approximately 21x, above the long-term average of 16x.  Notably, four major corrections, 1953, 1976-1978, 1980, and 1980-1982 began with below average normalized P/E ratios.  Matter of fact, the early 1980s corrections began with normalized P/E ratios in the high single digits.  

Again, we’re not trying to scare investors here, but just pointing out that to achieve the solid long-term returns of approximately 6% per annum without dividends/9% with dividends in equity markets, you sometimes have to take a few lumps.  It’s always tempting to try to time every single correction to enhance the return profile.  In practice, timing the shallower corrections has proven quite difficult and even counter productive for investors.  Conversely, the deep-dish declines as witnessed in 2008, 2000-2002, and 1973-1974, were generally preceded by a combination of significantly above average valuations, clear signals of impending economic recession via leading economic indicators and other metrics, and clear technical deterioration and signs of distribution in major market indices.  

As the Months Go By...

Listen to enough talking head chatter every week or month, and you’ll hear a number of calendar-based market clichés.  “Sell in May, go away.”  “Santa Claus Rally.”  “January Effect.”  As we enter a new year, we thought it may be interesting to highlight some statistical data on monthly performance over the past 80 or so years to give you an idea which months and portions of the year have been the most promising for investors, and which months have proven discouraging.

First, let’s present a table with the monthly data (1930 through 2012) for the S&P 500. 

A few things stand out.  First, right now we’re in the middle of the “sweet spot” of the bat when it comes to seasonal performance.  December and January have proven to be the best months performance-wise historically.  Even more interesting, this performance has been among the most consistent of the months in terms of performance.  Three quarters of the time, December has been positive, whereas January has witnessed positive performance approximately 64% of the time.  December and January have two of the lowest standard deviation figures among the months and the two of the lowest spreads between the historical maximum return and the historical minimum return.  Hence, there’s definitely something to the notion of a Santa Claus rally, and a general carryover of the good cheer into the New Year.  

The December-January party has typically led to a February hangover of sorts.  February is the third worst performer behind September and June.  Just as December and January are relatively consistent positive performers, February has been consistent in its dourness with the second lowest standard deviation among all the months.  It isn’t surprising to think that there would be some consolidation after two strong months.  Nonetheless, historically, February consolidation has allowed the market to regroup for solid spring performance.  

Is there something to the “Sell in May, go away” maxim?  Definitely.  September and June are the two worst performance months of the year, with May coming in fourth overall (September is the only month that has produced a negative median return historically).  May, June, July, and September are among the worst months in terms of percentage of positive months.  And, the volatility of the return streams from May through October is higher than witnessed during the period between November and April.  Overall, since 1930, the average May to October return is 1.84% vs. 4.76% for the November to April period.  The median return is 2.76% vs. 5.24%.

As with any bit of statistical analysis, nothing is ever set in stone.  There’s always variance making it very dangerous to make big market gambles in any given year based upon factors such as these.  For all we know, performance during the summer of 2013 could prove to be the best of all time. In any case, there’s clearly been a distinct performance advantage historically for the winter and early spring months in contrast to the summer and fall.  And, when it comes to individual months, December has been a consistent, reliable booster for portfolio managers’ performance.  For those with longer time horizons, understanding and incorporating data such as this could help shape certain decisions, such as tweaking asset allocation processes or deciding on the timing of hedges.

Balancing Acts

China has been the focus for the past several years in terms of the percentage of GDP allocated to consumption, investment, and net exports.  As has been discussed countless times in the business press and academic literature, China’s allocation to investment-related activities and net exports has leaped quite dramatically over the past decade at the expense of consumption, prompting calls from policymakers in the developed world for China to “rebalance” economically, or enact policies to strengthen the currency.  Oftentimes, political actors threaten China with retaliatory action to offset perceived trade balance injustices, as witnessed during the US presidential elections.

Generally, when economists total up GDP using an expenditures method, they derive total GDP from four sources: consumption, investment, government, and net exports.  Let’s take a quick look in the following charts where China stood coming into the year on each of the expenditure measures relative to GDP:

Source: World Bank

Source: World Bank

Source: World Bank

As you can see, the top-down investment driven model in China has pushed investment as a percentage of GDP up approximately 12 percentage points since the start of the new century to 48.4%.  Consumption has dropped approximately 11% points over the same time frame.  The allocation of GDP to net exports has increased by about 1.5%, though the contribution was much higher just ahead of the global economic and financial crisis.  Net exports have moderated as a percentage of GDEP as China’s currency has strengthened and US and European economic problems have stunted trade.  

What’s been worrisome to many in the pundit class, and some in the economics profession, is the fact that China’s numbers for investment as a percentage of GDP have reached levels unseen by other rapidly developing economies at similar stages of economic progress.  Japan, for instance, during its rapid rise juggled similar dynamics as the Chinese, but investment peaked at a level below 40% as a percentage of GDP.  The Economist performed a nice job addressing these concerns earlier this year by noting among other things that capital stock per capita in China still lags the US and other developing countries dramatically (see: http://www.economist.com/node/21552555).  Whether a positive, negative, or neutral condition, we’ll still argue that at some point the mix will need to change; it always has in other countries on a similar development track, and we have no reason to believe it won’t be the case for China.  As for the implications, we’ll handle those in a bit.

Before dealing with potential implications, let’s look at the US mix.  As you see in the charts following, the current composition and the trajectory over the past 10 to 15 years is almost a mirror image of China.

Source: US Bureau of Economic Analysis and Bloomberg

Source: US Bureau of Economic Analysis and Bloomberg

Source: US Bureau of Economic Analysis and Bloomberg

US consumption as a percentage of GDP has risen from the mid 60s during the 1990s to nearly 71% today, though it has recently begun to trail off.  Investment as a percentage of GDP in the US has fallen from near 18% at the turn of the century to approximately 13% today, off the lows of about 10.5% observed in 2009.  Finally, net exports as a percentage of GDP has fallen since the mid-90s, though the figure has improved substantially since the beginning of the financial crisis.  As we discussed last week, heading into the financial crisis the US faced a massive credit bubble and a massive savings deficit.  The deeply negative net exports number above, and the subsequent recovery is a crude visual representation of the dearth of savings heading into the crisis and the subsequent deleveraging/rebuilding of savings in the aftermath.  

Like the China example, it’s probably not too much of a stretch to think that the US will slowly rebalance away from a consumption driven economic model, to one that better balances investment and net exports.  

Perhaps we’re already seeing rebalancing on both fronts.  There’s been much discussion in China as they moved through the recent leadership transition about changing the predominant economic model towards one favoring consumption growth.  Wages in China continue to rise rapidly, narrowing the cost differential, all things considered, between China and the US.  Thus, in the US numerous articles are popping up discussing a new trend towards “insourcing” manufacturing capacity, a resurgence and focus on exporting, and increases in manufacturing employment.

So, now, what are the potential intermediate-term implications if the US and China, the two biggest economies in the world work in tandem to shift the economic mix demonstrated above over the coming years and decades.  Overall, it’s more nuanced than just saying it’s an absolute positive or negative for either country.  If the glide paths are relatively smooth for both countries, the overall impact doesn’t necessarily have to be particularly destructive or disruptive.  On the other hand, a dramatic short-term shift in the mix due to an unforeseen, dramatic political, economic, or market/currency move would be problematic.  Predicting where the countries will fall on the “glide path” is difficult.  Instead, it may be more instructive to focus on what an inevitable mix shift means for certain actors within the respective economies.  

Therefore, if there’s a strong likelihood that consumption growth is going to outpace GDP growth in China in coming years, and underwhelm relative to the rest of the economy in the US (and other developing economies) it may be safe to say that US-focused consumer discretionary companies should be shunned in favor of companies focused on selling into China and other emerging markets, as well as nascent consumer companies in China that focus on the urban consumers in their own country.  Similarly, US manufacturers with a strong export model and ability to satisfy Chinese demand could fare well.  Conversely, state-owned enterprises in China focused on the export sector, and the stakeholders there that have been enriched by these dynamics, will face increasing pressures in the future.  These broad conclusions may seem obvious in certain respects.  Looking at the US in particular, though, the consumer discretionary names in the S&P 500 still command a significant portion of investor mindshare.  The ratio of the S&P 500 consumer discretionary index level relative to the broader index is still over two standard deviations above the norm as the consumer index marks new all time highs.  While there’s been plenty of discussion about constrained consumers in the US, it’s not being reflected in market action.  In China, there’s been much talk about reducing the role of massive state-owned exporters in the economy and increasing opportunities for small and medium sized entrepreneurs.  At this point, there hasn’t been significant progress; maybe that will change in short order.  

Anatomy of a Deflating Credit Bubble

Amid a constant barrage of news about fiscal cliffs, and government deficits, and confidence deficits, and European meltdowns, and “muddle through” economies over the past few years, it’s easy to lose sight of an issue that’s played an instrumental part in the massive economic headwinds in the first place.  Ultimately, the severity of the 2008-2009 recession and the subsequent economic malaise, at least in relative terms to the economic rebounds we’ve seen during past post-war episodes, was attributable in major part to the massive reversal of a US consumer credit bubble that was decades in the making.

Look at the first chart below, which represent total household debt relative to disposable income in the US.  The chart is based on data provided by the Federal Reserve Bank from 1965 through Q3, 2012.  Between the mid 1960s until the early 1980s, debt as a percentage of disposable income remained relatively stationary.  From the early 1980s until 2007, households piled on debt at an ever-increasing pace relative to incomes.  Granted, the near parabolic move higher during the last stretches of the credit bubble was mainly attributable to mortgages outstanding, but the point remains the same.  Accelerating debt dynamics provided a turbo boost to economic growth, and probably masked underlying structural issues with US economic growth, especially from 2000, or so, to 2007.  The level of household debt relative to income peaked out at 129.4% in Q3:2007.  Since that time, it’s fallen to approximately 108%.  Further demonstrating the dynamic, below the first chart providing total household debt, we’ve also provided a chart based on data from the New York Fed which breaks debt out into individual consumer components such as auto loan debt, credit card debt, revolving home equity debt, and student loan debt.  As you can see, the ex-mortgage consumer credit categories have been in steady decline for the past several years as well (except for one category: student loans).  

Just as increasing use of credit provided a tailwind to US economic growth for years, the subsequent deleveraging among households has been an albatross. The aftermaths of massive credit bubbles aren’t pretty and are historically marked by years and years of substandard economic growth.  The event unfolding in the US seems to be unfolding according to the template outlined in the Rogoff and Reinhart book, This Time is Different.  Massive private sector credit bubbles prick, creating financial crises.  As governments work to offset the negative effects of the crisis, the debt baton is passed on to sovereigns/governments.  Ultimately, overburdened sovereigns dispense of obligations through various strategies, such as financial repression, monetizing/inflation, or default.  Whatever the trajectory, economic growth usually remains subdued for an extended period as economies adjust, rebalance, and digest; there’s very little policy makers can do.

Source: Federal Reserve

Source: Federal Reserve Bank of New York

Where do we stand in the overall process?  What’s amazing is the fact that the US finished 1999 and entered the 2000s with a household debt to disposable income ratio of approximately 91.5%, nearly 20 percentage points below the current level.  It’s obviously impossible to make definitely predictions on a debt trajectory from here, but it’s not unfathomable to think that total household debt will continue to work lower, especially considering the general aging of US society and other dynamics.  Maybe consumers will dedicate more of their disposable income to debt reduction, or perhaps institutions will write off more debt, such as mortgage balances.  Either way, the headwinds will probably continue.  

Atlanta Fed President Dennis Lockhart’s comments below, made during a speech in late 2011, succinctly describe the deleveraging process and the ongoing ill-economic effects associated with the aftermath of a credit bubble:

"It is necessary that the process of deleveraging plays itself out, which may take several more years. When economies are deleveraging they cannot grow as rapidly as they might otherwise. It is obvious that as consumers reduce spending they divert more of their incomes to paying off debt. This shift in consumer behavior increases the amount of capital available for financing investment. But higher rates of business investment are not likely to fully offset weakness in consumer spending for some time, as businesses continue to grapple with uncertainties about the future.

…Rebalancing simply takes time. A 2010 report by McKinsey surveyed 32 international periods of deleveraging following financial crises and found that, on average, the duration of these episodes was about six and a half years. U.S. debt to GDP peaked in the first quarter of 2009. By that standard we are much closer to the beginning than the end of our deleveraging process."

If Lockhart is correct, the frustrations we’ve experienced over the past three years with the three steps forward, two steps back recovery will probably remain in place.  

Green Shoots in Global Performance?

Without a doubt, it’s been a frustrating few years for investors with a global orientation.  From the end of 2009 through yesterday (12/6/12), total return for the MSCI World has trailed that of the S&P by about 12.5 percentage points.  Of course, US stocks comprise nearly half of the MSCI World Index.  Isolate the ex-US component as represented by the EAFE, and the story is even more ugly.  EAFE returns have trailed over the past three years by nearly 25%!  In the 11 full quarters since the end of 2009, the MSCI World and EAFE have only outperformed the S&P 500 three times.  Here’s a table of quarterly returns:

	MSCI World	S&P 500	EAFE
Q1:10	3.37%	5.39%	0.98%
Q2:10	-12.47%	-11.43%	-13.69%
Q3:10	13.92%	11.29%	16.57%
Q4:10	9.08%	10.76%	6.67%
Q1:11	4.93%	5.92%	3.50%
Q2:11	0.66%	0.10%	1.80%
Q3:11	-16.50%	-13.87%	-18.92%
Q4:11	7.74%	11.82%	3.40%
Q1:12	11.73%	12.59%	11.00%
Q2:12	-4.85%	-2.75%	-6.93%
Q3:12	6.84%	6.35%	7.00%
Q4:12	1.04%	-1.37%	4.24%

A funny thing has happened of late.  For the first time since the end of ’09, the ex-US markets may outperform US markets for two consecutive quarters.  The EAFE and MSCI World as a whole outperformed slightly in Q3:2012.  Through yesterday, the EAFE has outperformed the S&P 500 by nearly 5.6 percentage points in the 4^th quarter.  Granted, there’s still plenty of time left in the month, but if things hold, this will mark the second biggest differential in performance between the EAFE and the S&P over the past three years (the biggest was an 8.4% point win by the S&P in Q4 of last year while Europe was struggling with most vicious news flow from the debt crisis).  

What factors have started to perk up global performance relative to the US?  Several issues could be at play.  First, from a news flow standpoint, though negative headline flow in Europe continues as the continent struggles with economic weakness and the ongoing political drama surrounding the debt crisis, the intensity has decreased.  Instead, global investors have found it’s the United States’ turn to absorb the brunt of negative headline flow as the President and Congress circle around the fiscal cliff issue.  Plus, the US economy remains sluggish and US earnings growth has been less than inspiring of late.  Second, the “herd” factor may be coming into play; individual and institutional investors entered 2012 with very negative sentiment towards ex-US markets.  Accordingly, equity investors have parked significant capital in US relative to ex-US markets.  As investors have voted with their feet in response to the debt crisis situation overseas, normalized multiples in overseas developed markets have become quite low relative to the United States, as we’ve discussed at several points this year.  Coming into November, the US held the highest multiple among all developed markets around the globe as illustrated by this chart from the World Beta Blog:

Source: World Beta Blog, www.mebanefaber.com

The US trades at approximately 21x.  In contrast, the European or Asian developed market with the highest normalized multiple is Hong Kong at 17x, decently below the US position.  The “Big 3” European markets, the UK, France, and Germany trade at 12.5x, 11.2x, and 13.4x respectively, far below the US.  Most emerging markets remain at low multiples.  Yes, economic/earnings and political conditions have been ugly overseas, especially in Europe.  Using multiples as a guide, it’s apparent that markets have priced in significant pain, meaning that hurdles are low.  When hurdles are low, it’s not particularly difficult to see a spark in performance with just the tiniest shift in news flow.  The opposite is true as well.  Hurdles are relatively high in the US and the tenor of news flow has been shifting, especially in earnings trajectory.  As we discussed recently, earnings news disappointed investors last quarter in the US, which we believe contributed significantly to weak performance.  Expectations are still reasonably optimistic for 2013 S&P 500 earnings.  Another round of earnings misses could result in P/E multiple compression in the US.

Sum it all up, and it could be time for global equities to gain a little bit of the spotlight relative to the US.  Global markets have underperformed US markets for quite some time.  We’ve said it before and it will continue to say it: multiples revert to the mean for various reasons over time.  It doesn’t necessarily happen quickly, and usually doesn’t happen in a neat, straight line.  But it happens.  There’s a wide chasm valuation-wise between US equities and global equities and that differential has developed over a long period of time.  We continue to expect that this course of events will reverse sooner rather than later.  Perhaps, the past two quarters of performance provide some indication that the ship is making its turn.  

We’ll leave you with one final visual representation of the performance differential between the S&P 500 the MSCI EAFE that shows where market currently stand and how the relationship has shifted over time.

Source: IronHorse Capital