Look for Opportunity in Uncertainty

Aug. 13, 2014 | By Rick Golod

Executive Summary

Geopolitical tensions and concerns about Europe's economy appeared to be causes of global equity weakness in July. I believe further declines are likely in the short term, as market corrections are a normal part of bull markets. However, my long-term view, which is positive, remains intact. Developed market equities remain attractive, while emerging market equities are not likely to sustain their recent rally.

  • Overweight US. The US market has encountered a period of seasonal weakness — where low trading volumes during the summer months have tended to contribute to lackluster returns. Despite July's market decline, economic data continued to look stronger, which could provide a positive backdrop for stocks heading into year end, especially deep value stocks. I don't see any evidence that the bull market is ending any time soon.
  • Neutral weight Europe. With the economic recovery still fragile, the European Central Bank (ECB) is likely to enact further stimulus, just as the US Federal Reserve (Fed) did during the US recovery. Also mimicking the US, I believe central bank accommodation is likely to bolster equity prices ahead of economic improvements. Economic uncertainty is likely to favor stocks that pay a high-dividend yield or have a history of raising dividends.
  • Overweight Japan. The risk-reward profile of Japanese equities looks attractive, as the group is under-owned and cheap relative to developed market equities. What's more, Japan's central bank is committed to quantitative easing (QE), which may weaken the yen and bolster equity prices.
  • Underweight emerging markets. I believe headwinds from China's economy, weakness in commodity prices, technical factors and other influences will dampen the recent upward momentum. The rally is an opportunity to reduce positions, in my opinion.
August Quick Take

Stay invested, corrections are normal

Escalating violence in the Russia-Ukraine and Israel-Gaza conflicts motivated global equity investors to take profits in most regions in July. Europe, excluding the UK, declined 5%, the US was down 1.5% and Japanese equities increased 0.6%. Emerging markets were up 1.4%, driven by a 2.8% advance in emerging Asia. (Regional performance is represented by the MSCI Europe ex UK Index, MSCI USA Index, MSCI Japan Index, MSCI Emerging Markets Index and MSCI EM Asia Index, respectively.)

Many asset class declines in late July and early August violated important technical levels, increasing the probability that more painful price declines could happen. Expectations for US equity volatility also increased, as the VIX volatility index spiked 65% in July.

The spread between the best- and worst-performing asset classes and sectors is likely to widen as uncertainty rises and investors focus more on valuations.

While this would be a good time to review asset allocation overweights and underweights, I still believe that developed markets offer appreciation potential, while emerging market equities continue to merit caution despite their recent gains.

US: Overweight

July was a difficult month for US equities. For example, in its last week, the S&P 500 Index suffered its worst weekly decline (-2.7%) in two years.

Market weakness in late July was not a surprise, and the trend is likely to continue in August. There are several trends worth highlighting:

  • A technical analysis trend, the Presidential Cycle Pattern, which is based on past price movements, suggests that typically during the middle of an incumbent's term markets peak in June, followed by a 6% correction through September, and then a year-end rally of 8.8%. Of course, past performance is no guarantee of future results.
  • Since 1928, above-average June returns, similar to the returns we experienced this year, have been followed by negative returns in July 51% of the time.
  • The number of stocks trading above their 20-day and 50-day moving averages was declining, indicating a loss of market momentum.
  • When July has been down, returns in August have been up 59% of the time since 1928, with an average gain of 0.25%.

In my opinion, the markets may continue to be turbulent in the short run. But my longer-term outlook remains positive. After all, there aren't many strategists labeling this correction as the end of the US bull market yet.

In fact, I think investors may want to use any market weakness as an opportunity to add to existing equity positions. My experience has been that the greater the uncertainty, the greater the investment opportunity.

This year, the equity market has been driven by both expanding price-earnings ratios (P/Es) and rising earnings — a somewhat infrequent occurrence called a "dual rally" by Cornerstone Macro, an independent macro research provider. According to Cornerstone, since 1985, dual rallies have tended to exhibit less market volatility (as measured by standard deviation) and the least-painful corrections, declining 3.9% on average. At the same time, returns were positive 100% of the time and averaged 11% over the following six months.

I believe the market's dual rally could continue as both earnings and P/E multiples improve further. Analysts' earnings revisions ratio is above 1, denoting more upgrades than downgrades, and has continued to increase on both a one- and three-month basis. Second-quarter profits are set to increase 7.7%, and 70% of companies are beating analysts' forecasts for both revenues and profits. An improvement in leading indicators is a great sign of stronger earnings ahead.

P/E multiples tend to expand when the dollar is rising and commodity prices are falling. The trade-weighted dollar has appreciated almost 14% since July 2011 and is up almost 2% last month. Commodities, as measured by the Thomson Reuters/Jefferies CRB Index, recently broke below their 200-day moving average, which is a sign of further declines ahead. As of Aug. 11, Brent crude has declined $10 a barrel since June 22, which means lower gas prices ahead.

Furthermore, since 1985, when the S&P 500 P/E was between 16x and18x trailing 12-month earnings, positive equity returns followed over the next 12 months 76% of the time. Currently, the trailing 12-month P/E is 17.5.

Despite the market's decline, positive economic announcements were made during the market sell-off, including:

  • Positive figures in July for the first six Purchasing Managers Indexes (PMI). This has happened only 6% of the time in the past 10 years.
  • At 57.1, the Institute for Supply Management (ISM) Manufacturing Index was at its highest level in three years. Gross Domestic Product (GDP) is currently 100% correlated to the ISM index. At this level, historically, we were two to three years away from recession. The ISM Non-Manufacturing Index came in at a nine-year high at 58.7.
  • It's been eight years since we've seen unemployment claims (four-week moving average) come in under 300,000 or payroll growth averaging 200,000 over a six-month period.

Investors should focus on sectors and asset classes that have tended to outperform when the economy is strong.
The increase in The Conference Board Leading Economic Index (LEI), the rise in the Philadelphia Fed Index and the improvement in economic growth all suggest overweighting value over growth. I would add to existing positions in or overweight deep value managers who are overweight in the "hyper cyclicals," (financials, technology, consumer discretionary, energy) which have tended to outperform in this environment. If interest rates remain low, I believe dividend-oriented value funds could also perform well.

Europe: Neutral weight

European equities were the worst-performing region in July. Disappointing economic announcements, another round of sanctions on Russia and credit concerns, including the fear of a Portuguese bank default, took their toll. In fact, the Citi Economic Surprise Index for Europe has been negative since April 28, as more economic data announcements have disappointed than beat consensus expectations.

That being said, I continue to believe Europe is an opportunity to replay the US investing experience over the past couple of years. As in the US, disappointing European economic growth is likely to prompt further stimulus from the ECB. In the US and Japan, it didn't pay to fight the Fed or Bank of Japan (BOJ), respectively. QE weakened the dollar and yen, and US and Japanese equities rallied despite underwhelming economic growth. I think the same outcome could happen in Europe.

For now, European economic growth continues to be fragile. Although lower interest rates are likely to provide a better yield spread for banks to repair their balance sheets, credit growth has yet to improve. Euro-weakening policy by the ECB will likely benefit export-led countries (Germany, Norway) directly and consumer-driven countries (Greece, Italy and Portugal) indirectly, as tourism becomes more attractive with a weaker euro.

Nevertheless, European equities are gaining appeal with the yield on 10-year German Bunds (government bonds) near 1%, versus the average dividend yield for MSCI Europe Index of 3.64%.

A backdrop of economic uncertainty is likely to favor companies with predictable earnings and/or a high current dividend yield. Large-cap, multinational companies that are paying a high dividend yield or have a history of raising dividends look most attractive to me.

Japan: Overweight

The yen/dollar exchange rate weakened slightly in July, and stocks ended the month somewhat flat but still in positive territory. However, late in the month through early August, the yen/dollar exchange rate strengthened, hurting Japanese equity prices. With the Nikkei 225 Index 84% correlated to the yen/dollar exchange rate over the past 10 years, these market movements are fairly expected. The strength of the yen was likely the result of investors seeking investments perceived as "safe havens," such as the US bonds and the yen.

In my opinion, investing in Japan isn't about the economy or fundamentals. Rather, I like the country's risk/reward profile. Japanese equities are under-owned and oversold. They haven't been this cheap relative to developed market equities in 20 years. Until recently, Japan had the highest upward earnings revision ratio among the major global regions (the US now holds the top spot). Finally, the BOJ remains fully committed to weakening the currency, and its stock market has historically reacted positively to a weak currency.

Emerging markets: Underweight

Emerging markets have generated positive returns the past two months, prompting investors to move back into the asset class. Equity inflows, at $5.3 billion, are at an 18-month high.

Recent gains are largely attributable to improving economic data in China. During the second quarter, its economy accelerated for the first time in nine months. Increased fiscal spending on transportation infrastructure, reduced taxes and lower reserve requirements for banks helped keep the economy on track for the government's targeted 7.5% GDP growth rate.

However, the recent strength looks unsustainable to me for the following reasons:

  • Headwinds in China — Corporations have higher debt levels and lower earnings quality, and overdue loans have risen. The housing market remains troubled with a slowdown in property transactions and rising vacancies in sold homes. Until real estate prices bottom, consumer spending is likely to be restrained. Real estate investment trusts (REITs) may not be able to pay investors the record-high volume coming due in 2015.
  • Monetary stimulus on hold — China's central bank has indicated that further easing remains on hold through the second half of the year. The rest of emerging Asia is likely to hold rates steady or tighten.
  • Commodity price weakness — Over the past 10 years, the MSCI Emerging Market Index has been 83% correlated to the Thomson Reuters/Jefferies CRB Index (see chart below). The commodities index has just broken below its 200-day moving average, suggesting further weakness.
  • Lack of confirmation — The relationship between emerging market equity prices and credit default swaps, a derivative instrument that serves as insurance against loan nonpayment, has not confirmed the recent rally. Additionally, on a technical basis, the sustainability of the current rally is still in question. In my view, a move above 1085 in the MSCI Emerging Markets Index would confirm a long-term uptrend.
  • China shares seem overbought — Currently, the percentage of stocks trading above their 50-day moving average is at the same extreme levels seen in 2011, 2012 and prior to the market rollover in 2013. Rather than signaling the beginning of a lasting uptrend, to me, such trading looks like short-covering, wherein traders with short positions buy back the stocks they borrowed against.
  • Signs of financial system stress in Asia ex-Japan — The Bloomberg Financial Conditions Index for non-Japan Asia is beginning to weaken.
  • Potential for a "value trap" — While current valuations could be supportive of equity prices, sometimes stocks are cheap and stay cheap for a reason, known as a value trap.
Commodities Suggest Emerging Market Weakness Ahead

Source: Thomson Reuters Datastream, Aug. 6, 2014

I would use current emerging market strength to reduce positions in this asset class and remain underweight, except in certain best-of-breed stocks and countries.

Final thoughts

History suggests that current equity market weakness in the S&P 500 Index is more of a "healthy" correction than something more ominous. Investors should consider using any market weakness to add to large-cap value positions using deep value managers.

Europe is not a regional equity play but more of an asset class, sector and stock opportunity, as some areas of the market should benefit from further ongoing currency weakness.

Japan has a plan in motion that will take time to materialize. I'm not one to fight against a central bank with unlimited resources to weaken its currency and an equity market that has tended to respond positively to such weakness.

Emerging markets had its decade of outperformance and could likely offer tactical trading opportunities for the nimble investor. For the trader, enjoy. For the investor, beware. Deleveraging will likely be a painful process for many emerging markets, but a positive for developed markets as inflation pressures remains subdued.


Sources: Invesco; All data and information provided by Invesco as of Aug. 13, 2014, unless otherwise noted. Additional sources include: Bank of America/Merril Lynch, July 1-Aug. 6, 2014; Bloomberg LP, June 30-Aug. 13, 2014; Gluskin Sheff, Aug. 5-6, 2014; Cornerstone Macro LP, April 8-July 30, 2014; Thomson Reuters Datastream, July 9-Aug. 12, 2014; Renaissance Macro Research, July 28-30, 2014; Morgan Stanley, June 9, 2014; Bloomberg News, July 17, 2014; Boenning & Scattergood, July 28, 2014.

The opinions referenced above are those of Rick Golod as of August 13, 2014, and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of other Invesco investment professionals. The comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from expectations. Past performance is no guarantee of future results.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
   In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
   The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
   Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.
   A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
   There can be no guarantee or assurance that companies will declare dividends in the future or that if declared, they will remain at current levels or increase over time.
   Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound.
   Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
   Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.

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The S&P 500® Index is an unmanaged index considered representative of the US stock market. The MSCI Europe ex-UK Index is free-float-adjusted market-capitalization weighted index designed to measure the equity market performance of the developed markets in Europe, excluding the UK. The MSCI USA Index measures the performance of the US equity market. The MSCI Japan Index measures the performance of Japan's equity market. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index designed to measure equity market performance of emerging markets. The MSCI EM (Emerging Markets) Asia Index is a free-float-adjusted market-capitalization weighted index designed to measure the equity market performance of emerging markets in Asia. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, shows the equity market's expectation of 30-day volatility, used to measure equity market risk and commonly called the "investor fear gauge." Price-earnings (P/E) ratio, also called multiple, is a common valuation metric for stocks that compares a stock's share price to its per-share earnings. Earnings revision ratio is a ratio of analysts' earnings upgrades to earnings downgrades used to gauge analysts' sentiment about the stock market. The Thomson Reuters/Jefferies CRB Index is a widely recognized index measuring the performance of global commodities, with exposure to the energy, agriculture, industrial metals and precious metals markets. PMI (formerly Purchasing Managers Index) is a commonly cited indicator of the manufacturing sector's economic health calculated by the Institute of Supply Management. The Institute for Supply Management (ISM) Manufacturing Index is a commonly cited gauge of manufacturing conditions based on surveys of more than 300 manufacturing firms conducted by the ISM. The Conference Board Leading Economic Index (LEI) is an economic indicator used to forecast changes in the business cycle based on a composite of 10 underlying components (including data on employment, manufacturing, consumer expectations, stock prices, money supply, interest rates, among others). The Federal Reserve Bank of Philadelphia Business Outlook Survey is a regional survey of the health of the manufacturing sectors in eastern Pennsylvania, southern New Jersey and Delaware. The Citi Economic Surprise Index measures how a variety of macro indicators "surprise" relative to expectations. The Nikkei 225 Index (or Nikkei Index) is a price-weighted index measuring the top 225 blue chip companies on the Tokyo Stock Exchange and is commonly considered representative of Japan's stock market. Deep value investing style uses the traditional Graham and Dodd approach whereby managers buy the cheapest stocks and hold them for long periods in anticipation of a market upswing. Dividend yield shows how much a company pays out in dividends each year relative to its share price.