October 29, 2008

Economic Scene - Are Stocks the Bargain You Think? - NYTimes.com

Economic Scene - Are Stocks the Bargain You Think? - NYTimes.com

NY Times take similar theme as my post last week. It is a good read.

The point of my post and the NY times article that the markets is always about valuation and nothing else. Economics and the credit crises future impact matter less than you think. If you buy at an attractive enough valuation you will be rewarded.

US dollar: Why is it going up

There could be a case to be made for higher inflation and a weak US dollar. The trade deficit and the enormous debt on the balance sheet of the US will lead to higher inflation and lower value of US financial assets. So the US dollar SHOULD slide, but markets have a mind of their own. This is more of a long term outlook once the economy has some legs under it.

What is obvious right now is the economy continues to slow and credit creation continues to contract, it's going to be very hard to get sustained inflation. I think prices are going to respond to the slower global economy. If that's true, then demand for commodities, demand for everything, goes down and some inflation subsides, as inflation is a lagging indicator and credit is a leading indicator. There's not a lot of credit being issued these days.

As for the US dollar, it generally appreciate when the global economy is slowing and in the time of financial uncertainty investor typically flock to US treasuries which means dollar appreciation. Moreover, leading central banks will pursue aggressive rate cuts, which only the US Fed was doing lately, to stimulate their economies. Lower rates abroad are positive for the US dollar.

You can certainly see this in the surge of the dollar lately. The dollar index surged 18% to 92 this month. For the week on the downside, the Brazilian real declined 9.8%, the Australian dollar 6.9%, the Norwegian krone 6.2%, the Swedish krona 6.1%, the Euro 5.7%, the Danish Krone 5.7%, the South Korean won 5.6%, the South African rand 4.8%, the Canadian dollar 4.5%, the Mexican peso 4.3%, and the British pound 3.9%. Examining this week's rout in some of the "emerging" currencies, the Iceland krona declined 16.3%, the Romanian leu 10.6%, the Hungarian forint 8.2%, the Czech koruna 7.3%, the Polish zloty 6.9%, the Turkish lira 6.3%, the South Korean won 5.6%, and the Chilean peso 5.4%.

The dollar have no legs to stand on; there is no fundamental reason for it to be higher. So I would not alter any investment strategy based on the recent trend. Some began to sell multinational corporation as they will hurt by higher US dollar. The rationale goes as those tail winds that elevated their earnings in the past will become head winds depressing their earnings.
The US election will not alter a weak dollar as both candidates are powerless to do anything about the deficit and government spending.

In my investment selection I will take advantage of this and pick those multinational, energy and metals as they will provide the greatest appreciation once the eventual decline in the dollar resumes.

October 18, 2008

Is the market under valued? yes but....

It is time to value this market and look at real adjusted Price/ Earnings ratio (PE). As discussed before I use this ratio to determine if the market is fairly value or not. The ratio adjusts for inflation by calculating real earnings and real prices by adjusting them to the CPI index, as published by the government. The ratio also adjusts for economic cycles by averaging the last 10 years of earnings. This way it adjusts for abnormal economic activities, whether it is a peak or trough. Whenever I refer to PE ratio in this post, I reference the real-adjusted PE ratio.

There are good news and bad news. The good news is the market is trading under its long term PE average. The bad news is markets always have to overshoot the average on the downside. Look at chart attached.

The long term adjusted PE ratio is 17 and we are trading at an adjusted PE of 15. Real earnings have grown by 15% from the burst of the tech bubble in April 2001, while real prices have declined by 42% in the same period. Also real dividends have increased by 47% over the same period. Off course the market was over valued at that point with an adjusted PE ratio of 34x and as a result the PE ratio have contracted by 56%.

The decline in equity prices have made valuation look attractive. The contraction in prices and PE ratios have outpaced the real increase in earning and dividends. This makes the market attractive for meaningful equity investment.

However, there were no significant bull market in history that began with a double digit adjusted PE ratio. The bull market of 1880s, 1920s, 1950s and 1980-1990s all have started with an adjusted PE in single digits. The bull market of the 1920s started with PE ratio of 5x and ended at 35. The bull market of the 1980-1990s began its run with an adjusted PE ratio of 8.7x and ended with a staggering ratio of 45x.

So until we get to an adjusted PE ratio of under 10x do not buy all at once. Pace your purchases. And because I do not want to time the market I will buy some at the present, which I did by taking advantage of these prices, and allocate funds for later time if markets decline further. At this pace of decline we will get there very quickly.

Economic headlines are always bad and factor in worst case scenarios entering a recession. There is nothing new in this recession that will make it any different from the others. It may be longer but there is no question that businesses will adjust and grow their earnings. As a result investors who buy at attractive valuation will make good returns in the long run.

October 5, 2008

Value Idea: Emerging Markets- Part 2

Previous corrections have seen emerging markets lag behind developed markets by 50 per cent or more, so far it has only down by 30%. So there may be a further decline for EM index. As I argued in my earlier post this represent opportunity. But Emerging economies are not created equally: different countries pose significant inflation and credit risk. Some have trade deficits that weight heavily on their currencies and economies. Moreover, as an asset class there are several risks associated with such an investment. Lets look at the major risks:

Credit risk and downgrade

Emerging market credit conditions have peaked after five years of improving fundamentals, and a "pronounced downside" is becoming apparent to some of those economies, Standard & Poor's
said in a recent report.They argue that credit has more downside risk and very limited upside as developing economies slow and enter a rescission.

The ratings agency warned that less benign credit conditions in industrialized nations have clouded prospects for the growth of world trade, with a negative impact for emerging markets. Although the credit crises is a developed economy problem but the prospect of spillage to EM economies is a real risk from the following mechanisms:
• Counterparties. There is a direct impact through counterparty channels. The list of financial institutions liable to be affected includes all but the most isolated and remote financial service
institutions of the world.

• Risk perception. The second channel is indirect, through risk perception. The problem is that many global relationships evolve day-by-day, resulting in significant uncertainty about the way risk spreads in the global economy.

• Cost of capital. The price of risk rises substantially. This affects all asset classes that are categorized as high risk.

Out of 43 emerging market central governments rated by S&P, 33 have stable outlooks, eight have negative outlooks and only two --Poland and Slovak Republic-- have positive ones.

Countries with negative outlooks are the Dominican Republic, El Salvador, Hungary, Kazakhstan, Pakistan, Serbia, Sri Lanka and Vietnam. In the last six months, S&P upgraded six emerging market sovereign credits, most of them in the Western hemisphere -- Brazil, Peru, Trinidad and Tobago and Uruguay. During the same period, four emerging market sovereign credits were downgraded -- Pakistan, Ukraine, Georgia and Argentina -- the highest percentage of downgrades since 2003.
Here are some country thoughts on the credit risk of specific countries:
While the usual weak spots of emerging markets (eg, Thailand, The Philippines, South Africa, Argentina, Hungary) could suffer substantially in the wake of what is essentially a mature economy financial crisis, those with more robust structures — although with chequered pasts — may also be tested (eg, Turkey, Indonesia, Mexico).

At the same time, the successful new global powers are either still not strong enough (China, the Gulf states), still too isolated (India, Brazil), or happen to be in the midst of ongoing turmoil
(Russia), such that no significant global impetus can be expected to come from their direction.

Capitol outflows from EM

Capital flows to emerging economies could drop to around $550 billion in 2009 from an estimated $730 billion this year, sapping a major source of growth in countries such as Brazil and China, as per estimates: source Financial Times.

Most of the capital that flows into emerging economies has been in the form of loans, not portfolio investments, which only make up 8 percent of the total. Loans from banks and other institutions altogether make up 57 percent of total net private sector flows, while foreign direct investment accounts for 35 percent.

Moreover, in 1997-98, more debt was sovereign. Now, much of it is corporate, taken out by Indian, Chinese and other emerging-market companies. That implies a global credit tightening could have as big an impact on emerging markets as slowing import demand in the rich world.

This means the shockwaves from Wall Street's implosion over the last few weeks that have accelerated a process of risk reduction and froze money markets will likely have a direct impact on emerging market capital inflows. This will almost certainly hurt growth in emerging economies, one of the main drivers of global growth over the last year. This could slow growth in global gross domestic product below 3 percent -- a level the International Monetary Fund considers a recession.

How to invest:

I prefer ETFs to invest in this asset class; this way I avoid analysing individual companies and diversify company specific risk by holding index.


MSCI Emerging Market Index (EEM) is an obvious one and easy to gain exposure to this assets class. I hold this one and I will continue to buy it as my equity exposure to EM. Most equities in this ETF are Brazilian and Chinese, making up to 30% of the fund. Those are very favorable countries with strong growth prospects going forward.

Specific Country ETF. You can hold individual country ETFs, however you need to do your homework on which counties have solid fundamentals. If you are going to go this route look for countries with large exports relative to their imports. These counties will see their currencies appreciate against the dollar. In this category I prefer to look at: China, Brazil, Korea and most Asian countries excluding Japan. I would avoid Turkey, south Africa and most Latin countries due to weak fiscal policies and large national debt.

EM Debt
To get exposure to EM debt is a tougher task. As a lot of the products out there are hedged and own mostly US dollar denominated debt. This obviously negate part of the reason to invest in EM, to hedge against the dollar depreciation. Local bond investments in Brazil, Mexico, and Poland remain attractive given relatively high nominal and real interest rates. I still did not find a product that would satisfy my criteria in this category, so I would rather accumulate EEM at this time than invest in suboptimal asset.