Liquidity made me do it

The rationale for the market rally since March 09 has been liquidity pumped by the Fed. The interesting point is that the market decline from summer 2008 to March 2009 has been also explained by the disappearance of liquidity. The disappearance of liquidity was caused by over levered banks.

I am not going to agree or disagree about the causes of the market rally because I can't. I distinguish between causation and correlation. The latter is easy to detect by statistical methods, however the former is almost impossible to prove. So arguing that point is irrelevant. One suffice to note is liquidity can disappear overnight but can't appear in same speed. It takes time.

Most investors, as evident by the decline and rally of the market, value liquidity. They attach a premium to it making liquid assets somewhat expensive to illiquid ones. I am agnostic to liquidity therefore I am not willing to bid more for it. However price is more important. I was a willing buyer from October till May, although in retrospect, regrettably, not enough. Now I am not. Back then the cyclically adjusted PE was around 10, now it is 19, above the long term average of 17. See chart courtesy of Dr. Robert Schiller.

At these levels I am more risk averse. I have sold several positions over the past few weeks for a summary see here and here. I have also wrote calls in American Express (AXP) at $40 which should take out of that position by it expiration next week. Moreover, Burlington BNI have been taken over by Berkshire which should close by early next year. So my cash position is rising so what to do.

In an fair valued or overvalued market I concentrate exclusively on event driven positions, like takeovers, spinoffs, bankruptcies and reorganization and liquidations. My favorite is spin-offs. Some of the opportunities I am looking at:

• AOL spinoff from Time Warner
• Madison Square Garden (MSG) spinoff from Cablevision
• Cloud Peak Energy coal spinoff from metals giant Rio Tinto
• Pharmaceutical Product Development, Inc. (PPDI) Spinoff of Compound Partnering Business.
• SixFlags post bankruptcy equity
• Lear Corp post bankruptcy equity

In an over valued market where you look can be different than an undervalued one, where businesses sell far below their normal earning power value.

Changes to portfolio

Reducing EEM stake by more than half. I have been holder of Emerging Market index for a while in an effort to diversify internationally. The call was to hold the index for the long term but as my style of investing changes, more focus on event driven investing, I find my emotions rule how I view this position. I get swayed by economic analysis from various sources. I do not have any insight or edge.

Also, I have bought in the EEM when all were selling in Sep of last year. Valuation then made sense. Now emerging market funds are loaded with capital as money flow into them like crazy. Valuation has increased from 10 x earning to 20 time earnings now. People have high expectation of emerging market due to growth potential. I think it is a likely scenario that economic dominance will shift to some emerging economies like China and India but the odds that the market gives me for returns are not favorable. So I am taking my profits here and I will set tight.

I am also selling out of FirstService(FSV). I am existing this position with a small loss of 7%. I have made this call based on valuation alone. the value of the sum of the parts were higher than the market cap of the company. However as I started to look at the business details, a step I should have done before buying, I started to change my mind and cheap valuation does not cut it alone. I sold because:

• high compensation to CEO and management compared to peers and level of earnings growth.
• rollup strategy that is empirically destroys value
• ROIC is on par with the cost of capital
• bulk of the growth is attributed to acquisitions. what will happen if they can't acquire anymore?

Another sell decision TSX index: too much concentration in Natural resources and financials. Actually between the two sectors it makes up to 75% of the index. And those two areas where I do not have a lot of insight. Another small loss of 4%.

PE Valuation Cycles

I tend to view markets in PE cycles rather than most widely used price cycles of bear and bull markets. This means I follow PE expansion and compression cycles. Why? As investor and I look at valuation to allocate capital rather than price. Moreover, capital appreciation or return is made up from two sources: PE expansion and earning growth. So it follows that PE trends should determine bear and bull markets rather than price action. 

For the purpose of this post there are two cycles an PE expansion cycle and PE compression cycle. There has been 8 secular cycles, including this one, measured from PE trough to peak, throughout the period from late 1800. There were 4 PE expansion cycles and 4 compression cycles, including this one from 2000 to date. 

I used Prof. Robert Shiller data for my analysis and the most interesting findings are in the following table:

Here are few observations:

• There are secular cycles lasting many years from PE trough to PE peak and vice versa.
• 10 yr Yield peak and trough coincide with PE cycles; rising yields does impact valuation. So the prospect of rising yields in today's market will negatively impact equity valuation.
• Average PE compression cycles is some 13 years; we are 9 years in this cycle.
• Average annualized returns associated with PE compression cycles is almost double the upside move in the PE expansion cycle, -17% vs 10%.

Here are some valuation implications, if I use typical cycles averages to the current PE compression cycle:

• According to the data, the long term average of PE of 16.34x, it seems that at the current market levels the S&P is fairly valued at 15x.
  
• Given the size of the credit event occurred in 2008 and the disruption to world economy also the succession of various bubbles: Internet, housing and credit, a retrenchment in PE by 80% is realistic. So far PE compression is 65% from its 2000 peak. In the secular PE compression seems that a move of 80% down is typical. Therefore another 15% compression is highly likely. 
• The current compression cycle should end around 8-9 times 10 years real earnings, as most compression cycles ended in single digits. If we use the current S&P 10 yr earnings of $57.67 per share then that puts the price target of the S&P at 519, some 40% decline from the current level.
  
• There is an expected Bear market in treasuries due to high supply of paper as governments to try to finance deficits, thereby increasing yield, another sign of secular PE compression, as any PE. 

Although history does not repeat itself but it rhymes. History can rewrite the averages here, but events that transpired are not unique to history and has occurred in the past, so we will work them out. And equities will experience another bull market, but I doubt it is going to be now.

Credit and PE Cycles

Credit availability, not leverage, underpins equity valuation. Actually it underpins a lot of economic output but for the purpose of this post I will stick to equity valuation.

Having lower yields on treasury bills affect stock valuation positively, as you discount future dividends, cash flow or earnings streams by lower discount rate, thereby increasing valuation. The opposite have negative affects on valuations; higher rates mean lower value. The concern is for equity valuation going forward is the rapid increase in treasuries yield. 

The massive debt being accumulated in the US and elsewhere is what will cause yields to rise quickly. Here is an excerpt from John Mauldin letter, which can explain why  yields will have to go up very quickly:

The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year.  US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn't do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let's be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less. It also assumes massive tax increases from carbon credits.

I am not concerned about where the money will come from, it will come, as supply creates its own demand at the right price. What price may that be, you ask? I bet you it is going to be at much higher yields. I suspect somewhere around 6%. Yields have already began to move upwards in a hurry. Look at the the 10 yr Treasury from Yahoo:

So here some observations: 

• The yield rise is not a good sign for a sustainable PE expansion in equity. Given that cyclically adjusted PE, Data from Prof. Robert Shiller, have not dipped under single digit, as historically no sustainable bull market have began from double digit PE. Please look at the second graph.
• Bull markets or PE expansions have been associated with low yields and the prospect of bear market in treasuries do not give me confidence in any PE expansion for the next few years. Observe the 70s era in the second graph.
•  PE compression takes awhile. PE have been compressing since the burst of the Internet bubble in early 2000. That is 9 years only and that is not long enough period. If history holds we can be looking for another 5-10 years of range bound market prices.
  

Bond vs Equity

We are at economic inflection point; when business as usual returns and what is usual is being figured out as we go. How quickly the world economy returns to normal—and indeed, what “normal” is going to be—will depend on hard-to-predict factors such as the fluctuations of consumer and business confidence, the actions of governments, and the volatility of global capital markets.

Credit normalization is the key to equity performance over the next little while. Without access to financing equity prices will remain under pressure. If you believe that bond professionals are better than equity analysts, which I do, then yield behavior of credit instruments should provide some clues. In addition, cost of debt is an important metric for equity valuation, the higher the cost of capital the lower equity value should be. 

The bond and equity markets have diverged over the last few months. One was priced for hooverville and the other for normal recession. Then, the reverse occurred, equities woke up to the realities of the economy while the bond markets recovered some bit. Now with the market rallying some 25% since its lows, the question is does the bond market agree with equities?  

Well the answer this time is somewhat difficult than in the past. Debt markets have been mostly flat during the recent equity rally. Actually you can argue that the treasury yield rise is positive for equity, as investors shift money from non yielding assets to equities. Another point is the elevated spreads on corporate and other instruments are now pricing risks appropriately, as historical low spreads leading to the credit crises were an aberration.

The credit environment is much better than last November on all fronts:  

 

• Corporate spreads have seen improvement since Dec 08 but did not participate in the recent equity rally and stayed mute for the most time.
• High Yield spreads remain high as evidence of defaults and low recoveries are starting to appear in bankrupt company data. However the market is far better for Q4 2008 and deal are being done even for the riskiest companies, see here. 
  
• Sovereign debt is stable and bodes well for Emerging Markets. Actually sovereign debt has been on a tear since Dec 2008.
  
• Commercial mortgages spreads remain elevated except for AAA rated paper.  
• Bank loan markets improved since last Dec 2008. Deals are being done, see here.

The consensus right now is we are going to have to revisit the lows and equity to head down. However, credit has improved so much form November of last year. Although I do not see any sustainable rally we may just languish in range bound market. Yet again who knows?? 

Investment Paralysis

On Investment paralysis by GMO's Jeremy Grantham

those who were over-invested will be catatonic and just sit and pray. Those few who look brilliant, oozing cash, will not want to easily give up their brilliance. So almost everyone is watching and waiting with their inertia beginning to set like concrete.

What to do?

You absolutely must have a battle plan for reinvestment and stick to it.

Bond Vs Equity Market Action

The divergence between equities and debt is still striking. The disconnect between the two markets is astonishing. One of them is right and the other is wrong. My money is always on the debt market as it is run by professionals while the equities markets are run by armatures.

Debt markets in the last quarter of 2008 were shut and yields skyrocketed for any debt instrument expect for US treasuries while equities still reflected recovery in earnings in 2009. Debt prices correctly priced the deleveraging occurring in the world since beginning of 2008 while equities did not. Now it is almost the reverse. Debt has recovered and High yield and high quality deals are being made, in relative terms to no deals in late 2008. In addition yields on US treasuries have increased to above 3% recently from the lows of 2% in late 2008. Bond investors are beginning to look for buy more risk while equity investors are running from it.

There is a possible conclusion to draw from this is the bond investor is beginning to allocate funds to riskier assets classes as they are looking for things to normalize somewhat. The willingness to take risk by bond investors may indicate the sell offs in stock markets are overdone.

On equity valuation basis the market PE (adjusted for 10 year earnings and inflation) is around 12 now, far below the historical long term averages. However as noted before is some of my posts this can go to the single digit as market overshoot on the upside and the downside as well. From these levels it will not take much for the S&P PE ratio to be in the single digit territory, maybe another 20% from current levels.

The investing environment for the long term is looking better and better. Although there are many challenges, serious ones, I think selling or shorting now is a terrible risk/ reward proposition. I think it will take time for a return to a bull market but the market prices is setting the base line for favorable action for the long run.

The 10 year yield has gone up considerable from it lows in late December.

Please observe action of of the S&P 500 and the LQD, ETF for high grade corporate bonds. Equities have declined by more than20% while debt rallied by 7% over the same period. The same story can be found in high yield and bank loans.

Hidden Liabilities: Pension Plans

The recent market decline along with population demographics posts huge liabilities to corporate America. The defined benefit pension plans will face severe underfunding due to the decline in financial assets coupled with the fast approaching retirement of baby boomers. These hidden liabilities will pose serious issues to valuations and must be accounted for when valuing a potential investment.

Consider this, as the baby boomers start to retire en masse, beginning in 2010, you could see combined pension and health-care costs representing a huge percentage of total gross domestic product. In 2008, companies and their employees have seen their pension assets plummet by some 40-50%. The pension deficits in the S&P 1500 companies have reached $409 Billion by the end of 2008, down from some $100 Billion in mid 2007. And most plans are underfunded by 25% (Source: Washington post).

In a bull markets the problem of pension plans are forgotten due to high rate of return will ensure that companies do not have to contribute to their plans. However, in a declining markets such as this one and in the prospect of deflation in financial assets, corporations who will underfund these plans significantly introducing large debt onto their balance sheets.

Corporate America used aggressive assumptions in its pension plan calculation (aggressive assumptions like high rate of return and high discount rates tend to reduce liabilities and cash contribution by corporations). I dislike seeing assumed rate of returns around 9-10% but many corporations used these figures in good times and was supported by their actuaries, Now these assumptions will be tough to pass the mustard sort of speak.

Moreover corporations used favourable market conditions to be aggressive in their assets allocations. Many have increased equity exposure to more than 50% of the plan assets. No doubt to lessen their expenses and boost earnings. Now these with larger exposure to equities will have pay dearly.

The problem gets worse for corporate America. The increasing life expectancy of people will compound its liabilities. In the old economy, the average employee would work for the same
company for 35 years. In their pension calculations, actuaries of pension plans would make the assumptions that male and female workers would retire at 65, and the majority would die by 68 and 72. Now actuaries of these same plans need to factor in that today a minimum of 10% of all
male pensioners will live beyond 91, and female pensioners beyond 94.

I always looked at reasonable assumptions from the companies I own. What are reasonable assumptions? The most important one is the assumed long-term annual rate of return to be around 5.5-6.5%. That is the big one. Then you go down the line to the discount rate used to calculate net present value of the benefits, in this case the lower the better. Other assumptions to pay attention to is the salary and benefit increases is an important one.

The implication is to look for companies with conservative assumptions about their plans. Look also for their asset allocations. Plans that have larges percentage of its assets in debt are much better than those with more tilt towards equities. Conservative assumptions about their pension plans will translate into lower cost of debt and more capital structure flexibility.
_______________________________________________
PS. for good overview of the subject see this primer.

A new era...but ??

In euphoric or pessimistic markets always create the same type of proclamations of new era.

In the recent Tech bubble investors have piled on Warren Buffett and claimed that his old valuation metrics does not work in the Internet era and he is a "has been", as evidenced by Barron's cover "what's wrong Warren?". Also I submit to you the decoupling theorist and their new era for the Chinese stocks as it can maintain itself without the rest of the world.

Today is no different. Although the market conditions now is terrible and has not been witnessed by many investors, similar proclamations are being made. Lets review some of these claims:

• Buy and Hold is dead. Many strategist and money managers have been repeating and promoting this mantra. It is very convenience that they do the self promotion is very obvious.
• Index funds are dead.
  
• Buffett strategy is stale. Similar to the Internet bubble many including Barron's are claiming the death of the Oracle of Omaha. Time will tell, yet again, if he will stand the test of this market.
• Fear turns everyone into an economist. Many investors have diverted from what they do of finding investable businesses to making macro calls. Many investors are allocating their funds to gold, as the expectation that hyperinflation due to US spending will drop the dollar. For example, Einhorn's recent letter that has been making the rounds in the blog-sphere. He is good money manager analysing companies and picks loser from the winners. In his recent letter he made a bet on gold as fear from currency debasement. The gold trade is popular now as fear grips investors. Again you divert your energy from what you do best into something unrelated because of emotions. This is similar to the euphoria of investing in the internet money losing companies because you do not want to miss the boat.

In the extreme of market conditions emotions and claims like this surface in earnest. Maybe it is a sign that we are overdoing it on the downside. I will stick with what is tried and true there is never a new investing paradigm; It is always about business fundamentals and long term earning power.

What does well in slow economy?

I have two ideas for slow economic times: prisons and schools.

If you think about it you have two choices when you are out of a job:

1. go to school to upgrade your skills and get a better job, or
2. commit crime

I hope the majority will pick the first choice. But the reality is both are growth industries in this economic climate.

Enrollments in both are growing. Schools like ITT and Devry are doing very well and recording record growth in revenues. The market seems to reward their shareholders as most of school companies are hitting 52 week highs. The performance of schools industry is on fire and the market does not seem to care that some are over leveraged.

As for prisons, it is also a growth industry. The government is running out of space in the federal prison system so they are contracting out this to companies like Prisons of America. That segment should see growth in its revenue as well.

I have better business proposition. Convert many of the hotel projects that have flooded the markets lately into prisons. The hotel industry have seen a flood of new hotels and over capacity in new rooms. What to do with them? Convert them into prisons. If you think about it prisons are just like hotels but you do not have the luxury of checking out when you want.

Are you feeling lucky?

The divergence of opinions of economists and strategists about market and economic issues is truly amazing. It is the first time that I have witnessed such an opposing camps on all issues from market direction, inflation situation, recovery prospects, and market valuation. There are extreme opposing camps with nothing in between; lets recap some of these issues:

• inflation: there is the prospect of hyperinflation due to the unprecedented spending of governments or deflation as the complete collapse of all types of demand.
  


• economy: some believe that recovery will be after 2009 others say it will take few years to recover out of a depression.
  


• markets: some say very cheap other say very expensive as earnings will collapse completely.
  


• emerging markets: is the future as it recovers due to increase consumption by its citizens while other expecting complete collapse of paper economies.
  


• US dollar: some forecast its collapse others say it will hold up as all currencies are in no better shape.
  
  
• gold: some think it worth $6000 while others think it will be worth 500 in few months.
• 
  
• Treasuries: it is a bubble while money still pours into it. This indication alone is very intriguing to me. The treasury market is worth trillions of dollars so capital owners are institutional and large. These investors, and it seems a lot of them, are saying that 2.3% is the best return they can find for the next few years, then you should listen up.
  


• and the list goes on.

One camp is right and the other got extremely wrong. So are you feeling lucky?

So what to do?

Well I have few things I am doing right now:

1. I am adjusting my time horizon to at least 10-15 years to see recovery in equity prices to the July 2007 peak. So you have to make sure that you do not need the capital for that long.
   
2. Yes equities are becoming cheap but it will be cheaper, see my post here, so I will buy in small increments and not over-commit. I will commit fully when PE ratio becomes in single digits.
   
3. Fixed income offers great value and great returns right now so I will take advantage of it before I overweight equities.
   

In the end all these strategists and analysts are purely guessing with no idea what is going on. Investing following their advice is a quick way to losing your capital.

Distress Investing

Please consider reading Third Avenue Funds shareholders letter about investing in the distressed assets and investing in this new era.

He details a case for investing in debt instruments of the financially distressed companies. Distressed investing is highly rewarding but you have to consider its fit for your own competence and abilities. Distress investing needs sophistication and expertise in areas of law, accounting and negotiation, or access to talented resources that can provide you with the help needed. Investors need to understand their abilities before buying these issues. In my opinion distressed security investing is best left for those who specialize in it. In such markets where information is scarce, those who are informed will take advantage of those who are not.

Please consider chapter 12 of Seth Klarman's Margin of Safety for a premier on the subject. You can read the whole book as it is a good summary of how an investing process should run.

Pimco Will Postpone Some Dividends - WSJ.com

Pimco Will Postpone Some Dividends - WSJ.com

Several closed end funds have suspended distribution to shareholders. The operational risks from closed end funds have surfaced due to the severe decline in assets and credit crises. I have noted to this when I have talked about investing high yield closed end funds. The problem is

... closed-end funds must maintain asset coverage of at least 200% with respect to senior securities, such as auction-rate preferred securities. That means for each $1 of preferred stock issued, a fund must have at least $2 in assets. A fund is prohibited from declaring or paying a dividend that would put it below the 200% asset-coverage ratio.

As a result of the market's declines, the Pimco funds' asset-coverage ratios have fallen below the required 200% level, the firm said.

However, most of these dividends are postponed and will resume once asset prices correct.

FT.com / Columnists / Martin Wolf - Why fairly valued stock markets are an opportunity

FT.com / Columnists / Martin Wolf - Why fairly valued stock markets are an opportunity:

Great article about the valuation of today's market. I have been using the modified PE described in the article as my guide in valuing the market and as the article details the valuation of this market has not been seen in a long time.

Since the end of last month, I have been buying more of the market indices, like Emerging Markets index (EEM) and Russell 2000 (IWM). I have also bought Brookfield Asset Management (BAM) preferred shares, which I made the case for here.

There are great bargains especially in fixed income markets. I can say that in the fixed income universe you can find compelling risk/ reward propositions than in the equity markets, the BAM preferreds are such an example. I will have a future post talking about these opportunities.

Expert prediction: flipping a coin is better

Let me begin this post by two endearing quotes about economists:

An economist is expert who will know tomorrow why the things he predicted yesterday didn't happen today

Lawrence J. Peter

Economics is an extremely useful form of employment for economists

John Kenneth Galbraith

Media has reported on economists and investors who called the crises and profited from it. Some of those people are John Paulson the famed hedge fund manager who made multi billion dollar in 2007 betting against sub prime. Another is Prof. Roubini who "predicted" the crises and continue to give sound bites to the media.

I always enjoy reading about the newly minted expert of a crises or an episode of the economy. Before Paulson and Roubini there was Abby Joseph Cohen, the famed Goldman Sachs strategist, who called the S&P during its bull run in the 1990s and was hailed by media as the market genius. Internet companies had their prophets as well. There are a host of so called "experts" who came and gone. Those experts rode their once in a life time call on economic or market matters but disappeared into the sunset when they tried to do it again. I reckon that Roubini and Paulsn will face the same fate.

Lets look at these experts in another light. If there are 20,000 experts, why does only one guy have this figured out? What is special about them?

Walk into some big arena filled with 20,000 people each standing and holding a quarter. Ask them to flip it one time: heads you remain standing, tails you sit down. Repeat the trial 14 times among the people who remain standing only. A normal distribution of outcomes would say after fourteen trials you would reasonably expect one person to be standing up, actually 1.22 to be exact. Ladies and gentlemen, I give you Professor Nouriel Roubini, Andrew Lahde Capital, who saw his accomplishment for what it is and called it quits, andPaulson.

My point of the post is economists and the "expert" of the day had his/her lucky call, odds are stacked against his next call to be right. Do not chase expert and their performance as predictions are always harder when it is about the future!

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.

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.

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.

Equities:
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.

Value Idea: Emerging Markets

I was working on this post all of last week but Barron's today has published a similar idea you can find it here: "Emerging Markets are cheap and they're the future". It is nice to get a verification of the idea.

Emerging markets (EM) equities and debt look very appealing, debt in particular. Emerging markets index has declined more than 33% this year, while EM debt spread have soared to 300 basis points over treasuries, its spread was 170 BPS in 2007.

Investors over the past few months have scaled down their holdings in emerging market equities and debt considerably. Capital flight from these markets was due to the credit issues faced by the developed world. Investors feared that credit issues will spread eventually to the Emerging Markets. EM funds have seen an outflow of $26 billion, compared with an inflow of $100 billion in the previous five years (source: Financial times, Economist).

I think the changed perception of EM risk is an opportunity. I see that a good risk/ reward proposition is in EM, debt in particular. Although perception of risk has changed, the fundamentals do not support the increased risk due to the following:

1. future growth is much more solid in emerging markets with less structural issues and headwinds to limit its progress.
2. emerging markets currencies will appreciate against the potential collapse in US currency due to current and trade accounts deficits.
3. Developed economies are facing recession and credit risks while EM are facing one headwind in global recession. EM hold surplus foreign reserves as a result their credit situation is
   much better than the US and Europe. Its ability to fulfill its debt
   obligation is not impaired
   

For sure emerging markets will slow down as a result of the rescission in the US; there is no decoupling ever and I am not arguing this. But the upward growth trend is not broken by the current credit crises.

First, Emerging markets economies are growing 4 times as fast as developed nation economies according to IMF. They no longer depend on foreigner to make capital investment; now they are capable of doing that on their own to spur growth.

Second, Emerging markets do not produce only cheap goods, but they have produced multinational companies that compete on the same level with developing nations companies. These companies will expand into developing economies to add markets and spurring growth. This will translate into higher job creation at home and higher wages.

Third, by the numbers emerging markets account for 80% world's population and 50% of GDP growth but only 8% of stock markets capitalization. The imbalance have to be corrected by owning more of the world's assets and occupying more in market capitalization.

Fourth, EM are cash rich and own a large portion in basic resources. As a group, they are in far better shape than ever before.
Many are commodity exporters and many commodities are at record highs.
Recently, crude oil is around $100 a barrel while
other commodities prices have also been increasing, although they came off their recent highs lately. Moreover, over the
past five years, many emerging market governments have taken steps to
insulate themselves from the effects of a global financial crisis.

EM governments are cash rich with reserves at record level. They are sitting at 75% of global cash reserves. Those reserves will support their currencies against the euro and dollar. Although currency appreciation is not the outcome those couturiers want to happen, there is no escaping it. The US dollar faces lots of head winds: ballooning trade deficits and ever increasing debt load. Treasury and the fed are continuing to pump dollars in the system debasing its value; it is astonishing that the dollar has not fell off cliff thus far.

This brings me to what will Sovereign Wealth Funds (SWFs) and cash rich countries do with this capital. The recent credit issues of US have given SWFs and cash rich countries pause and hesitance to invest in the US. These parties want to diversify away from the US to reduce their exposure. EM assets allows them to do just that, particularly EM debt.

My strategy is to be a buyer of EM debt and patient accumulator of equity, as it is highly correlated with global equity markets. I do not know when markets will recover therefore EM equities may languish a bit so I will cost average over the next little while. This strategy will provide me with the following:

1. income as EM debt spread is high for no fundamental reason
2. hedge against US dollar decline
3. appreciation once investors come back to the market
4. improve my asset allocation by increasing debt portion in my portfolio.
   

Valuation
Now, emerging markets are trading once more at a significant discount. There
are some good reasons for this. The turmoil in states bordering Russia
suggests a rise in political risk. For example, stocks in the Ukraine
doubled in barely 18 months, but since January they have halved.

A lot of emerging markets are in the low double digit PE. Falling to single digit PE would provide very attractive entry point.The chart to the left displays that EM equities on PE basis are trading at a discount of 50% to the S&P, while debt has a spread of more than 300 basis points to treasuries. (Charts courtesy of Financial Times)

Next post I will discuss the risk associated with investing in EM also what type of instruments to use to monetize the idea.