Many Markets, Few Values
By JACK ABLIN
JUST BECAUSE MARKETS get out of whack -- and trust me, they always do -- doesn't mean investment portfolios must also be out of whack. In volatile times smart investors strive to diversify as a means of reducing risk. History has shown the wisdom of such efforts: Allocating more funds to undervalued asset classes or markets, and avoiding expensive ones, not only can reduce risk but enhance long-term returns.
What's more, the opportunity to add value can be enormous, as the return differential between top- and bottom-performing markets can range from 25% to 75% in any calendar year. Over the 12 months ended Sept. 30, for instance, an investor who shifted 5% out of the Lehman Aggregate Bond Index, which delivered a 2.68% return, and allocated these funds to the MSCI Emerging Free Index, which gained 45.58%, would have picked up 2.15% in portfolio performance.
Shoulda, woulda, coulda? Identifying undervalued and overvalued markets is not as difficult as it sounds -- if you use the proper metrics. Take the so-called Fed model, thought to be favored by Alan Greenspan's Federal Reserve, which compares the earnings yield on the Standard & Poor's 500 stock index (12-month forward earnings divided by price) with the 10-year Treasury yield. Based on the difference between the two, the S&P was 70% overvalued as of January 2000, the market's peak.
I evaluate most markets from five perspectives, starting with fundamentals, which I gauge by comparing earnings and bond yields, or the market's price/earnings ratio relative to other markets' P/Es. Second, I study the general direction of the economy, which helps me determine whether or not we're in a conducive investment environment. The slope of the yield curve is a handy measure of investor expectations of economic growth.
Liquidity, the measure of ready cash available to propel a market, helps predict the market's capacity to advance. Comparing the year-over-year growth rate in the M3 money supply to the year-over-year growth rate of gross domestic product (GDP) is a good liquidity measure.
I also study investor psychology, or perceptions of the market, which has proven a good contrary indicator. There are many useful sentiment gauges, including the Consensus Index and Market Vane, which you'll find in the Market Laboratory. If bearish sentiment has climbed to levels indicating investors wouldn't touch the market with a proverbial ten-foot pole, it's likely there is nobody left to sell. Conversely, if bulls abound, there may be no one left to buy.
Lastly, I analyze momentum. It is not enough for a market to be cheap, as cheap markets, like cheap stocks, often remain so, creating what is commonly referred to as a value trap. Momentum measures confirm that a market is moving in the right direction. If a market (or stock) moves above its 50-day or 200-day moving average, that's one good indicator of positive momentum.
I take a 12-to-18-month view of markets. Trying to predict the behavior of one market versus another on a quarterly basis is one step away from reading entrails. Short-term market moves are driven by investor psychology, which is often irrational. Beyond a year, market movements tend to respond more favorably to fundamentals and other measurable inputs.
So, where can an investor add value today?
I'm neutral on U.S. equities, as valuations are reasonable but the backdrop is dimming. The Fed model suggests the market could be as much as 20% undervalued, although subbing riskier BBB-rated corporate-bond yields for the 10-year Treasury yield suggests it's fairly priced. At the same time, future earnings -- the model's numerator -- are set to slow. The economic outlook isn't encouraging either. The Fed's moves to raise interest rates eventually will crimp growth, restrain retail spending and trim corporate profits.
The stock market thrives when the yield curve is steep and short-term rates are trending lower. At the moment, the opposite is true. Short rates are expected to more than quadruple to 4.25% by the end of this year from their low of 1% in June 2003. Meanwhile, on the longer end, the difference in yield between two-year and 10-year Treasuries has declined from 1.55% to 0.15% over the past 12 months.
Typically, the Fed takes rates too high, precipitating a financial crisis and a flight from risky assets. It is precisely when the crowd has given up that valuation and economic measures begin to turn attractive. The time to buy stocks aggressively will be when momentum turns positive. For now, valuations are reasonable enough to support my agnostic view of the asset class. But if interest rates rise substantially or profit expectations falter, I would scale back my equity exposure.
Within the equity market, small-capitalization stocks, as represented by the Russell 2000, have outpaced large stocks (the Russell 1000) by more than 43% over the past five years. While large-caps' underperformance was justified from a valuation perspective, the scales are tipping toward the big guys again. At the outset of the small-cap rally, the P/E of the Russell 2000 was a full eight points below that of the Russell 1000; now, small stocks trade at a 15% premium to their larger brethren.
Consider the circumstances, such as easy credit and a strong dollar, that long favored small-caps. Credit is tightening, and investors are beginning to require a higher yield premium to lend to lesser-quality issuers. Large-cap companies usually enjoy easy access to the credit markets, so they would gain a relative advantage here.
Too, large companies tend to be exporters, while smaller ones generally stay home. Dollar strength has hurt the market's largest issues, but it's likely the buck will reverse course as the Fed's rate-raising regimen ends. Momentum is beginning to confirm the sectors' reversal in fortune; since the start of August, small stocks have underperformed by more than 3%.
S&P Depositary Receipt (ticker: SPY), is an exchange-traded fund representing the S&P 500. iShares S&P 100 (OEF) represents about 57% of the market cap of the S&P 500. Both ETFs afford a low-cost way to play the large-cap market.
Looking abroad, developed international markets, as represented by the MSCI EAFE index, are reasonably valued relative to the S&P 500. The broad foreign index trades at 16.7 times trailing earnings, a 7% discount to our market, and at 2.3 times book value, a 21% discount to the S&P. EAFE earnings are expected to grow by 10%, S&P earnings by 12%.
On the economic front, global central banks are somewhat more accommodative than our ever-tightening Fed. Since monetary accommodation is more conducive to an equity advance, score one for the foreign marts. That the EAFE has gained close to 6% in a year in which the dollar has rallied against most major currencies further signifies the strength of international markets. Should the dollar weaken, as it's likely to do, the EAFE markets would enjoy a tailwind. iShares MSCI EAFE (EFA), a widely traded ETF, is a good way to play these markets.
Emerging-market equities remain attractive on an absolute and relative basis, in spite of their impressive gains over the past three years. They trade at a 25% discount to their U.S. counterparts on a price-to-earnings basis, and at a 26% discount on a price-to-book basis. While current emerging-market valuations are higher than historical trends, the underlying credit quality of economically emergent nations has improved markedly. Considering more than half of emerging-market economies have attained an investment-grade credit rating, current valuations are well within reason.
Liquidity firmly supports these stocks. Cash flows into emerging-market mutual funds have been largely positive since early 2003. Too much hot money can be a cause of concern, however, so this is a condition worth monitoring.
The moves we've seen in emerging markets likely are part of a multi-year revaluation relative to the U.S. market, and are apt to continue as investors search for incremental value and return. Exposure to this sector can be attained through iShares MSCI Emerging Markets Index (EEM).
THE BOTTOM LINE:
While rising rates and slower profit growth suggest trouble ahead for U.S. stocks, foreign markets are likely to keep gaining ground. Commodities' upcycle could end this year.Leaving stocks, I continue to hold commodities, a position I added two years ago. But I expect we're in the eighth or ninth inning of the commodity cycle. Unlike all of the other markets I track, commodities possess no fundamental value. Since coffee doesn't offer investors dividends or earnings, there's nothing to discount to determine its current market value. Therefore, we need to rely more heavily on the economic environment for clues.
The real rate of Treasury bills is a valuable metric for commodities, as short-term investors have a choice: they can invest in real assets (commodities) or financial assets (Treasury bills) to protect their purchasing power over time. When T-bills yields are offered sufficiently above the rate of inflation, financial assets will adequately protect purchasing power. But, when T-bill rates are set below the rate of inflation, as they were at the end of 2001, real assets will do a better job.
From the fourth quarter of 2001 through September of this year, T-bill yields were below the rate of inflation and the Dow Jones AIG Commodity Index advanced more than 90%. By year end, however, short rates are likely to top inflation, creating an advantage for financial assets. Our bet: the commodity cycle will end at the close of 2005. There is no ETF that tracks the Dow Jones AIG Index, but the Pimco CommodityRealReturn Strategy Fund (PCRDX), which combines inflation-indexed Treasuries and derivatives, is a decent proxy.
Investors can hold expensive assets as long as their value keeps growing. The minute a market loses momentum, however, it's time to pare your position. Think of a market cycle as a clock, where six o'clock is the bottom and 12 o'clock is the peak. Using metrics will help you get in at 7:00 and out at 1:00.
