ValueTrend’s Keith Richards says emerging markets, Europe and Asia should be on your radar for portfolio diversification. This, along with some commodity plays.
Readers of The MoneyLetter know that I’ve harped on the hype surrounding tech and ‘stay at home’ stocks since the late summer. And I’ve made it clear that opportunity presents itself in what the market is NOT paying attention to. That is, value stocks are where the opportunity lies. Here’s a quote from Morgan Stanley’s research that backs this outlook:
“In that post-vaccine world, people will be able to spend the $1.8 trillion in excess savings deposits they’ve built since February, equivalent to 9 per cent of annual GDP. People have never had excess savings on anything like this scale in the modern era. Accordingly, we’re expecting an unprecedented wave of spending on discretionary services like leisure, travel and entertainment, just as soon as people feel safe and the sector fully re-opens.”
My take—as I have been pounding the table on—is to continue to focus on value and ‘go outside’ stocks for our portfolio.
‘Stay at home’ stocks like the FAANGs, Zoom, Peloton, etc. are overvalued, and overbought. Market indices like the S&P 500 and NASDAQ are overweight these ‘stay at home’ names. This, in my opinion, is about to change. I believe that the market will become a rotational, stock pickers market, rather than an index-player’s market or growth-focused market. Money is likely to find a home in value stocks like industrials, utilities, staples, infrastructure and even select financials as markets rotate.
Fed influence has driven rally
Again from Morgan Stanley: “We think 10-year yields are about to rise significantly and a 100 bps move cannot be ruled out. . . . the driver of the next leg in this bull market will likely be earnings, not valuations.”
Much of the rally seen since the 2009 lows, particularly the returns seen since Trump’s inauguration in January 2017, have come from a steady stream of monetary stimulation (rates) courtesy of the Federal Reserve. The potential for similar Fed-driven stock market performance over the next few years is diminishing. Here is a quote from Bill Dudley, former president of the Federal Reserve Bank of New York, from a Bloomberg article (courtesy Bear Traps):
“No central bank wants to admit that it’s out of firepower. Unfortunately, the US Federal Reserve is very near that point. When interest rates stay low for long enough, the policy can even become counterproductive. In the US, monetary stimulus has already pushed bond and stock prices to such high levels that future returns will necessarily be lower. Assuming stable valuations, expected equity returns over the next decade are probably no greater than 5% or 6%. The 0.7% yield on the 10-year Treasury note doesn’t even cover expected inflation. As a result, people will have to save more to reach their objectives, be they a secure retirement or sending their kids to college. That leaves less money to spend.”
In addition to easing monetary policy by the Fed over that past 10 years, we’ve had additional firepower injected into the market via fiscal stimulation. COVID cheques for unemployed workers, corporate subsidization (airlines, etc.) for hard-hit sectors in the economy and infrastructure spending to stimulate growth. A percentage of this cash gets injected into the market. Robin Hood investors have piled into the overweight tech & ‘stay home’ stocks in the S&P 500 and NASDAQ indices using this cash. But, like all good things, fiscal stimulation will come to an end. A reduction in ‘free money’ will have an impact on stock market performance.
Regression to the mean
There’s another factor, beyond the ineffectiveness of Fed monetary policy and government fiscal stimulation, that may contain returns on broad stock indices over the coming years. It is the mathematical tendency for averages to ‘regress to the mean’ when they rise above or below their average returns.
The average (15+ year) returns for stock markets tend to be around 7 per cent for the broad world market index (MSCI World Index), 8 per cent for the broad US indexes (S&P 500) and about 6 per cent for the TSX 300. The last ten years have seen the US market (S&P 500 in particular) outperform those returns. The S&P 500 is approaching a doubling of its average returns. Its annualized rate has been well over 13 per cent vs. its 8 per cent average! Meanwhile, the MSCI Equal-Weighted Index has compounded at about 1 per cent a year since 2007 vs. its 7 per cent average.
Will returns come back to their averages?
To illustrate what this means to us as investors, let’s look at historic price trends during the two greatest bull markets of all time for the S&P 500. They were: 1982—1999, and 2009—present. You’ll notice that prices contained themselves within a high range, and a low range. This is known as a ‘channel’. When the market nears or exceeds the top channel line, it tends to decline to the bottom channel. And vice versa. This up/down price pattern illustrates the principle of ‘regression to the mean’ insofar as maintaining the market’s average rate of return over time.
I probably don’t need to point out that we are near the top of the recent bull market’s trend channel. This implies that prices will either flatten, or decline. And that’s if we anticipate a continuation of the 13 per cent average returns of the S&P 500. If we were to draw a longer trend channel that included the 2001 and 2008 market crashes, you’d see that we could experience a much bigger decline or period of under-performance in order to bring the average back to the historic average return of 8 per cent a year. In either case, there is evidence of some slowing for the S&P in the next little while. And that’s not so good for buy and hold investors right now. But it may be good for you and me. We don’t have to be invested like the index.
Don’t count on fiscal and monetary policy to continue pumping the market’s overvalued growth stocks to produce similar returns on the markets. For now, rates remain low. But the fiscal stimulus packages being injected into the system will eventually influence inflation. Rates will rise eventually. Markets could return to their long-term average returns as some of the leading overvalued stocks slow down.
I think investors should slowly add commodity plays, including producers, producing countries (and their currencies) and the commodities themselves to their portfolios. Inflation hedges can include precious metals, base metals, agriculture, and yes, even energy. Further, by owning some international exposure in your portfolio, you might have regression to the mean working in your favor. If world indices return to their average performance numbers from the current 1 per cent a year returns, this implies greater potential in markets outside of the USA.
Meanwhile, US markets might return from their 13 per cent average performance by experiencing lower numbers. In a nutshell: emerging markets, Europe and Asia should be on your radar for portfolio diversification. This, along with some commodity plays. This is a longer termed strategy that won’t necessarily profit in the short term. As such, we at ValueTrend are legging into inflation-sensitive stocks (commodities) and international markets a bit at a time—not all at once. Meanwhile, the ValueTrend Equity Platform remains focused on value names.
Keith Richards is Chief Portfolio Manager & President of ValueTrend Wealth Mgmt. He can be contacted at email@example.com. He may hold positions in the securities mentioned. The information provided is general in nature and does not represent investment advice. It is subject to change without notice and is based on the perspectives and opinions of the writer only. It may also contain projections or other “forward-looking statements”. There is significant risk that forward looking statements will not prove to be accurate and actual results, performance, or achievements could differ materially from any future results, performance, or achievements that may be expressed or implied by such forward-looking statements and you will not unduly rely on such forward-looking statements. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please consult an appropriate professional regarding your particular circumstances.
This is an edited version of an article that was originally published for subscribers in the November 2020/Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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