By: Peter Schiff, CEO and Chief Global Strategist
Jim Nelson, Portfolio Manager, Euro Pacific Asset Management
Going into 2015, the economic outlook held by the U.S. investment establishment could not have been much more positive and unified. Pundits saw all the variables aligning to create the best of all investment worlds, a virtual "no-brainer" of optimism. Panels on financial television, which had been a venue for sharp debate, seemed more like exercises in mutual agreement.
Despite a host of lackluster economic data points that came in at the end of 2014, the sunny forecasts about the economy came fast and thick: "The Forecast for the U.S. Economy in 2015 is positively rosy" said MSNBC on December 27, 2014. On December 30, the Associated Press said, "The United States is back, and ready to drive global growth in 2015". On February 10, 2015, Andrew Stoltmann said on CNBC, "Is U.S. growth, this engine that really is going in the right direction, is that going to be able to take us out of all the economic malaise we are seeing in other countries...will the U.S. get us out of this mess, or will every other country weigh us down?" The belief that the U.S. is the only growing economy in the world was unchallenged by the many other panelists on the segment.
The certainty has remained strong in the New Year. On February 11, Moody's projected a 3.2% annual GDP growth over the year, which, if achieved, would be the first 3%+ result since 2005. President Obama approached his January State of the Union address as an economic "mission accomplished" moment, stating that the American economy had finally returned to full health, after six years of disappointment. The idea that the economy had reached "escape velocity," and would no longer need Fed support, was widely accepted.
The optimism was fed by popular forecasts that:
- Strong growth in the 3rd and 4th Quarter 2014 would be a precursor to continued strength in 2015, a year that many believed would be the best (in economic and financial terms) since the crash of 2008.
- The U.S. stock market would continue to outpace foreign markets in 2015, as it had in the second half of 2014, thereby sucking in capital from abroad.
- The Federal Reserve would finally begin to raise interest rates from zero, sometime around spring or summer of 2015.
- The European Central Bank, The Bank of Japan and many other central banks around the world would begin to ease monetary policy just as the Fed was expected to begin tightening, thereby pushing up the dollar to new heights.
- Higher interest rates from the Fed would not slow the American economy but would strengthen the U.S. dollar and knock out any remaining support for gold.
A herd mentality takes hold when unanimity is high, and markets can often tilt beneath the stampede. Investors chase returns en masse and pile into positions that may already be overvalued. This can create opportunities for those brave few who can run against the crowd to find areas that the herd has overlooked. In a recent poll by investment firm Legg Mason, 85% of "affluent U.S. investors" indicated that the U.S. markets "offer the best opportunities over the next 12 months" compared to other global options. That's up from the 74% in 2014. (CNBC, Jeff Cox, 2/12/15)
Of course, the unpopular trade may be a losing trade, and those rational investors may pay the price for clear thinking in a time of irrationality. But herds can be spooked, most often by unexpected developments which can catch the herd wrong-footed and spark major movements when the masses scatter at the same time. When that occurs, those who resisted the herd may find themselves rewarded. We believe that we are approaching such a point.
The Herd Gets It Wrong
Not so surprisingly the actual trajectory of the economic and financial news in 2015 has veered considerably from the script that was so confidently sketched out just a few months ago. The first big surprise was the drop in the price of oil, which fell by more than 55% between September 2014 and January 2015. Then Switzerland shocked markets in January by abandoning its three year old Euro currency peg, sending the Swiss Franc up almost 30% against the Euro in intraday trading. Closer to home, we saw both a "surprise" January sell-off in stocks and a large increase in volatility. Then there is gold, an asset class that had been virtually given up for dead by nearly all the large investment firms at the end of 2014. However, gold was up nearly 8% in January, and the index of gold mining stocks (another sector with virtually no mainstream support at the end of 2014) was up nearly 19%.
Although the employment reports bathe the economy in the diffuse light of recovery, many of the less followed economic indicators have further diverged from expectations in the opening months of 2015. Many economists had initially believed that GDP in the 4th quarter 2014 would come in at an annualized pace north of 3.0% (after having expanded at a blistering 5.0% in Q3). But in January the actual number came in at a lackluster 2.6% (to even get there the government had to rely on a hard-to-believe 0.0% inflation rate estimate). That number was subsequently revised down to 2.2%.
The early weeks of 2015 also provided a series of dramatic "misses" in a broad spectrum of less followed economic data points:
- December consumer spending declined .3% (the largest monthly drop since 2009). In January, spending slipped another .2%, for the first consecutive monthly decline since 2009.
- New U.S. factory goods orders declined 3.4% in December, the fifth straight month of declines, and the largest month over month drop since mid-2009.
- December retail sales declined .9% when estimates were for a much shallower .1% drop. The next month missed again, when retail sales declined .8% in January, doubling the predicted .4% decline. The back-to-back misses represent the worst two-month drop in retail sales since October 2009.
- December pending home sales declined 3.7%, almost four times larger than the consensus increase of .9%.
- The December U.S. trade deficit rose by 17% over November, posting the largest monthly gap since November 2012 and the largest monthly increase since July 2009.
But the biggest storyline in the accepted narrative is that the Federal Reserve will finally raise interest rates for the first time in six years, sometime around midyear. On that point Wall Street's once monolithic resolve is starting to fracture. Some are now questioning the need for the Fed to actually follow through on its stated intentions. Many cite the surging U.S. dollar as the key development that will convince the Fed to delay once again the first interest rate hike in six years. If the Fed grabs that excuse to hold fire, investors may come closer to understanding just how dependent U.S. markets have become on near zero percent interest rates. This is a surprise that could scatter the herd.
What's Really Up with the Markets?
In the six years since the Great Recession began in 2008, the economy has been boosted by both monetary and fiscal stimuli. The Federal Reserve has held its overnight rate at 0% while expanding its balance sheet by almost $4 trillion (from 7% of GDP in 2008 to 25% of GDP in 2014). On a parallel track, the Federal government ran four consecutive $1 trillion plus budget deficits (before pulling back to less than half a trillion annually more recently). Lower borrowing costs are supposed to juice the economy, encouraging business and consumers to take out loans and spend. Fiscal deficits are supposed to replace the consumer demand lost through recession. But despite these unprecedented levels of stimulus, real GDP growth in the U.S. averaged just 2.2% from 2010 through 2014, which compares with an average of almost 3.5% in the post-WWII period. If this substandard growth is all we could achieve with the floodgates wide open, why should we expect that the economy will improve in 2015 if the stimulus doesn't return? The herd may be loud and powerful, but it can also be blind.
Despite the the current records being set almost daily on Wall Street, (the NASDAQ just eclipsed 5,000 for the first time in almost 15 years), optimists claim that the market is not overvalued because the current S&P 500 price-to-earnings ratio, of about 19 times trailing 12 months earnings, is not too far above the historical norm of about 14. But this doesn't tell the whole story. The "earnings" divisor of the equation is not nearly as bankable as many would like to believe. Most investors have not considered the extraordinary factors that helped push up earnings, artificially we believe, in 2014.
According to Bloomberg, in 2014 S&P 500 companies spent an estimated $565 billion (or 58% of corporate earnings) on share buybacks, a figure that is extremely high by historical standards. Buybacks increase earnings per share by reducing the number of shares outstanding. Cutting the pie into fewer slices makes earnings appear to rise, even when they haven't. But such accounting moves do little to increase real growth or help a company prepare for future success. Money spent on buybacks is not available to purchase new plant and equipment, to fund research and development, or to spend on marketing and logistics. In that sense, buyback spending generates current earnings at the expense of future earnings.
We believe that the buyback surge results from the likelihood that corporations have seen little evidence that their businesses are growing organically and that buyback purchases are perceived to be better uses of free cash than investments in capacity expansion. This is a strong reason to believe that the economy is not as resurgent as we have been led to believe. Interestingly, the last significantly upward surge in buybacks culminated in 2007, which turned out to be the year before the crash of 2008.
Earnings have also been boosted in the past few years by zero percent interest rates, which allowed corporations to borrow for next to nothing, thereby reducing one of corporate America's biggest cost centers. Falling debt payments allow corporations to increase profitability without increasing top line earnings. But such a boon is a two-edged sword. Rising rates can just as easily sap profitability. Low rates have also enticed many companies to borrow just to buy back shares and pay dividends to shareholders (the two activities accounted for 95% of corporate earnings in 2014 according to data compiled by Bloomberg). This mechanism makes it very clear how ultra-low interest rates benefit stockholders but do very little for Main Street consumers.
As a result of the low rates and the recent buyback frenzy, we suggest that investors should look past current P/E ratios and instead look at Cyclically-Adjusted-Price-to-
Earnings (CAPE), which is also known as the Shiller Ratio (named after its developer, the Nobel prize-winning economist Robert Shiller). Shiller argued that a single year provides too narrow a window to get a true view of a corporation's ongoing ability to generate profits over time. To adjust for that, he recommended looking at earnings over a 10-year period to smooth out cyclical and economic anomalies. We think this is a very good idea.
Looked through a lens of CAPE ratios, the U.S. markets begin to look very expensive in comparison to other global markets. The graph below tells the tale:
With a CAPE ratio of well over 27, the S&P 500 Index is valued at least 75% higher than the MSCI world Index CAPE of around 15. (High valuations are also on evidence in Japan, where similar monetary stimulus programs are underway). On a country by country basis, the U.S. has a CAPE that is at least 40% higher than Canada, 58% higher than Germany, 68% higher than Australia, 90% higher than New Zealand, Finland and Singapore, and well over 100% higher than South Korea and Norway. Yet these markets, despite the strong domestic economic fundamentals that we feel exist, are rarely mentioned as priority investment targets by the mainstream asset management firms.
In addition, U.S. stocks currently offer some of the lowest dividend yields to compensate investors for the higher valuations (see chart above). The current estimated
1.87% annual dividend yield for the S&P 500 is far below the current annual dividend yields of Australia, New Zealand, Finland and Norway.
If there were strong reasons to believe that U.S. earnings will expand in the near term, then high valuations, in either current or CAPE terms, would not be a major issue. If earnings can catch up to prices, then normalized valuations can be re-established. But given the current economic drift in the United States, where exactly are the catalysts that are supposed to spark an earnings increase?
The consensus still expects that the Federal Reserve will start raising interest rates from zero sometime around mid-year, which means that many investors believe rising "short" rates are a certainty. And although the surging dollar and widespread confidence in the U.S. economy helped push down 10-year yields to as low as 167 basis points in late January 2015, there should be little confidence that long yields can fall much further, if at all. In fact, 10-year yields spiked up to 2.14% just 15 days after reaching a low of 1.68% on February 2. Few expect more doses of quantitative easing from the Fed to keep down rates on the long end of the curve.
If the economy could only grow at 2.4% in 2014, when overnight rates were at zero and 10-year rates fell more than 28% over the course of the year (from 3.0% to 2.17%), should we expect the economy to grow briskly, and domestic earnings to increase, if both short and long rates are rising? In addition, the rising dollar has depressed the value of overseas earnings generated by large U.S. multinationals.
These growing concerns may explain why as U.S. markets loudly hit record highs, analysts are quietly revising down their optimism. A February article in Barron's cites a report from Societe Generale that compiled forecasts for U.S. corporate earnings to reveal the steepest drop since 2009 (during the depths of the financial crisis). The report suggests that rising valuations and declining earnings may be exposing U.S. investors to more risk than they care to acknowledge.
Ultra low rates will also prevent the Fed from cutting rates to boost stocks if the economy falters. When markets crashed in 2008, interest rates were almost 6 percent, allowing the Fed tremendous room to slash rates to support share prices. But with rates now at zero, or close to zero, the Fed has no such capacity. It will have to resort to a new round of quantitative easing to stimulate. More QE from the Fed could be the surprise that finally wakens the slumbering foreign exchange herd and leads to reversals of 2014 dollar gains. A falling dollar would counter any nominal equity gains resulting from QE.
On Wall Street, investors generally chase returns. The big moves in U.S. stocks combined with the fast flowing rhetoric about American financial exceptionalism has further entrenched the herd mentality. Data from Thomson Reuters Lipper service indicates weekly inflows into "U.S. Only" equity funds surged to a record $39 billion for the week ending December 24. At the same time, non-U.S. focused funds saw outflows of $2.5 billion.
After six consecutive years of positive gains in the S&P 500 (and more than 200% return since March of 2009), few forecasters have loudly voiced concerns that the upward run of U.S. stocks will end anytime soon. In 2014 the S&P 500 outperformed stocks in the rest of the world (as represented by the MSCI Index of non-U.S. global markets) by an astounding 20%. This was by far the largest gap in the past 13 years (see chart below).
But should we really expect another year of such results? Would it not be more logical to suggest that the over-performance of U.S. markets in 2014 will revert to trend this year. Given that the S&P 500 stands where it does over a 10-year timeframe (see chart below), would we not at least expect the index to begin moving back to trend, and perhaps underperform world markets in coming years?
Have the Courage to Buck the Trend
Don't be fooled by the madness of the crowd. The U.S. is not "the sole remaining engine of world growth" as the talking heads would seem to have you believe. Both China and Germany recently announced record trade surpluses, despite increasing imports. We are the world's biggest debtor nation, and I believe we will continue to rely on monetary stimulus and international support to limp by with mediocre growth. Quantitative easing will not solve Europe's problems and it is more than likely that the Fed will not only fail to raise rates in 2015, but will join Brussels and Tokyo in the international printing party. But what will be accomplished by more QE is the perpetuation of substandard performance and unsustainable debt.
We believe it would be far better to invest based on these overlooked fundamentals. The good news is that unloved assets may be attractively priced. At a time when energy and labor costs are at multi-year lows, and gold priced in some non-dollar currencies is approaching all-time highs, there are overseas gold mining stocks trading at levels consistent with much lower gold prices. The fall in oil has pushed many energy stocks down by 50% or more. In addition, there are currencies issued by fiscally solvent nations at fresh multi-year lows. If the currency wars intensify further, it's possible these countries might follow the lead of Switzerland and retreat from the field of battle. This means that investment in those countries may go up in dollar terms even if the stocks in those markets stay flat. In addition, the already rich dividend yields sourced in foreign currencies can become even richer if the underlying currencies appreciate against the dollar. Of course the reverse scenario is also a possibility, where yields in USD terms will fall if the dollar rallies and the dividends become worth less in dollar terms.
Euro Pacific Capital relies on a variety of strategies that seek to tap into these unpopular trends to help find real value in overlooked places. Here's a brief selection of some stocks that may benefit from the trends described above. Investors who would like to hear more about these companies and how we are approaching the current market in our Funds and Managed Accounts should call to speak with one of our investment professionals.
South American Footwear Manufacturer
We feel strongly about a leading South American footwear manufacturer that owns a series of well-known proprietary brands and a growing business of private label outsourcing. Although the home country has had a series of economic disappointments and continuing political questions, this company is showing strong growth in international sales, which helps insulate profits somewhat from further falls in the local currency. At present, we believe it has a strong balance sheet and it pays a dividend of close to 4%. And while the company should be considered an aggressive growth stock (it has seen 393% earnings per share growth over the past 10 years), it currently trades below 10x trailing 12-month earnings.
Although the share price is up around 65% since the beginning of 2011, the value per share in dollar terms has barely budged, given the approximately 50% drop in the local currency over that time. The company does have a high leverage ratio, which exposes cash flow to a slowdown in sales. Given its established brands, good revenue growth, and the potential for a turnaround in the currency, we assess the risks as reasonable.
Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future.
In an economy that continues to add millions of new subscribers annually, this major Asia-Pacific wireless service provider continues to impressively grow average revenue per user. The company is at the end of a wireless upgrade cycle, which should help free cash flow and increase customer retention. Its current balance sheet has a good cash cushion, which could finance business and dividend growth. Currently the company has trailing 10-year average earnings per share that implies a CAPE ratio of just 18x earnings. Current P/E is just 15 and dividend yield is 3%. While telecom is considered a defensive sector, country-specific and regional politics is always difficult to predict, which does add risk to the investment.
Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future.
Although the home country of this banking firm does not wind up in many discussions about Asian investing, we feel that it is a vibrant country in the region and is home to some good opportunities. However, its currency has been weak relative to other regional currencies, and the USD, primarily because of the impact of lower oil and natural gas prices. As a result, the currency has fallen with the price of oil. However, we see opportunity for a recovery in the currency with a rebound in energy.
The banking firm we are looking at is among the top in the region and has a large interest in handling Islamic finance. We feel it currently boasts a solid balance sheet, an attractive dividend yield, a CAPE ratio of around 15x, and a trailing 12-month P/E of below 13x.
Although a global macro slowdown could hurt the bank's lending business, we think that the country and the bank, with its strong market position, should be able to bounce back in an overall improvement in the region.
Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future.
Eurozone Sugar Producer
This Northern European company is one of the top producers of sugar in the Eurozone. But in recent years share prices of these providers have been greatly impacted by falling sugar prices due to relaxation of a quota system for European sugar beet farmers that is planned to take effect in 2017, and by increased expectations for competition from high fructose corn syrup providers. However, the sell-off in sugar prices may be overdone given the input costs of creating high fructose corn syrup, and the fact that import quotas on sugar will remain to keep a floor under prices. We believe sugar in the Eurozone could eventually be trading higher next year and that current prices may have bottomed.
This producer is currently trading at levels approximately 40% below levels seen in March of 2014, priced in euros, which itself is down more than 17% against the dollar over the same timeframe. Its current CAPE is now below 10x due to the recent price plunge. But in recent months the share price has stabilized and has moved up.
We see the greatest risk for the company in further intervention from the government (i.e. removing the import quotas that are being left in place), which would allow much cheaper raw/white sugar to enter the European markets. However, despite this risk, we think this leaves the company as a good value prospect and offers exposure to a possible recovery in the euro currency.
Investing in foreign securities involves risks, such as currency fluctuation, political risk, economic changes and market risks. Precious metals are volatile, speculative, and high-risk investments. Physical ownership will not yield income. As with all investments, an investor should carefully consider his investment objectives and risk tolerance as well as any fees and/or expenses associated with such an investment before investing. International investing may not be suitable for all investors.
Euro Pacific Capital, Inc. is a member of FINRA and SIPC. This document has been prepared for the intended recipient only as an example of strategy consistent with our recommendations; it is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investing strategy. Dividend yields change as stock prices change, and companies may change or cancel dividend payments in the future. All securities involve varying amounts of risk, and their values will fluctuate, and the fluctuation of foreign currency exchange rates will also impact your investment returns. Past performance does not guarantee future returns, investments may increase or decrease in value and you may lose money.
Data from various sources was used in the preparation of this document; the information is believed but in no way warranted to be reliable, accurate and appropriate.
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
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