Other Equities: Global CAPE Valuations (and Positions)

Our Man’s performance last year was disappointing, and one of the major sources of the disappointment stemmed from failing to capture some profits when positions moved significantly in OM’s favour before later reversing.  This was particularly the case with some long-term positions, such as EUO, which went was being a positive 50bps+ contributor to one that cost the portfolio over 30bps on the year.  Thus one of Our Man’s aims for 2013 is to show greater flexibility around his longer-term positions, especially by using technicals more to help with when to resize positions by taking profits or adding to positions.

Those who read this blog regularly know that Our Man likes discussing the CAPE, or the Cyclically-Adjusted PE (it’s can also be known as the ‘Shiller PE’), ratio quite a lot (such as way back when).   While the ratio is not very good at telling you what will happen with markets in the short or even medium term, it’s very helpful as a long-term guide to value or anchor.  Over the last couple of years, there has also been some great work and research done on CAPE’s globally and also using empirical data to test whether the ratio does indeed prove a good guide to long-term value.  The most interesting (and easily understood) stuff comes from Mebane Faber (Cambria Investments); and this recent paper provides a short and simple read that you don’t need to be an egg-head to understand.  Among the things that Faber’s work (and others) empirically shows is that when CAPE’s are low (i.e. the market is cheap) expected future returns are typically higher (especially over longer time periods, 5-10yrs.  See Figs 3A & 3B on page 5).  This also holds true outside of the US, where Faber looked at CAPE’s and returns for 32 markets (Fig 7 on page 10).

Why bring this up now?   Well, the crisis in Europe has seen markets fall and looking at the CAPEs, some are starting to reach valuations that are very attractive both absolutely and relative to the respective country’s history.  While getting good data outside the US is difficult (or expensive) for an individual investor, data back to the mid-90’s is very easily accessible and Our Man used it to create his own CAPE mini-database to get a sense of the valuations in Europe.  (NB.  You may notice that Spain is a glaring omission from the below.  Rather oddly, OM has misplaced his Spanish data…)

What should be reasonably clear is that valuations are clearly cheaper today than at any time in the last 7-10yrs in almost all of the countries.  While the US’ longer data set (see first graph in this post) suggests that the last 7-10yrs have not been particularly cheap in a historical context, it’s noticeably that in Italy (CAPE of just over 8) and especially Greece (CAPE of c2) valuations are at an attractive level on an absolute basis. 

Given these valuations and the longer-term nature of CAPEs, it makes sense that OM is going to try and apply some of the aforementioned flexibility by using technicals to help him get into and size positions driven by CAPE valuations.   Interestingly, both Greece and Italy appear to have formed potential bottoms during 2012.  While it’s not clear that the long-term pain in those economies and markets is over, it seems to make an interesting entry point. 

Given that CAPEs are a good guide to long-term valuation and Faber’s work which suggests the benefits are better felt through long-term holdings (i.e. 5yrs+), you should expect to see EWI and GREK in the portfolio for some time though their size will vary.  While the positions have been started in Italy (EWI) and Greece (GREK), given the sharper run-up in GREK since the summer, the position there is smaller (c1%) with Our Man looking to add to it if there’s a pull-back of note.

As a final note, neither EWI nor GREK hedge their currency exposure hence both would fall if the indices they track were flat (or rose), but the Euro weakened (more).  As such, at some point, Our Man may add some EUO as a short-term hedge specifically against these positions.

2013: Fingers of Instability

Our Man recently looked at some of the things that could help the economy and markets in the upcoming year, now for some of the things that offer more concerning thoughts. 

- European debt problems (and recession?) 

While Draghi’s efforts have enabled Europe’s weaker countries to have continued access to the debt markets, they haven’t prevented a number of European companies from having tepid growth or falling back into recession.  The risk in Europe continues to be further political breakdown driven by the weak growth (or negative growth), especially if it persists in the stronger European core.  During 2013, some things to watch will be the elections in a number of countries (especially whether we see an anti-reform government in Italy, and what happens in Germany) and whether there will further unrest in the austerity countries (especially Spain and Greece). 

- China (and the rest of the BRICs)  

While China appears not to be a concern in the short-term, after growth picked up in Q4, there continue to remain question marks over the veracity of the data.  The other major concern over China’s growth is the aggressive government-sponsored/encouraged expansion of credit, and whether the sharp increases will feed through to higher NPLs.

  

- Japan  

As Our Man remarked last year, Japan is fascinating as they were the first country into a debt-deflationary spiral and there’s a reasonable chance that they may be the first country out of it.  Both of the key pillars of Japan’s strength, its savings rate and trade surplus, continue to wane and the new government appears very inclined to pressure the BoJ into further QE by setting a specific inflation target.

- US Political Intransigence (or Incompetence)  

Over the last few years, one sad truth has been that we shouldn’t underestimate the incompetence of politicians in Washington.  While 2013 seems to have started on a positive trend, with a fiscal cliff deal and an agree to increase the debt ceiling in the short-term, there’s ample opportunity for the sequester and budget hijinks to result in no deal and a government shut-down, or one that has imposes much austerity too quickly and only succeeds in pushing the economy back into recession.

- Negative Contagion  

One of the great positives of 2012 was that we arguably saw positive contagion, where positive developments spilled over from one area to the next.  The risk in 2013 is of negative contagion, where negative events in one region impact the others; such as a slowing Europe exacerbate the problems in China and Japan, which combined with a budget stand-off helps pull the US towards recession.

- Global Trade & Protectionism  

A holdover from previous years!  For those who are historically minded, the steady decline of Global Trade and the rise of protectionism was one of the noticeable features of the 1930's depression in the US.  With so many countries facing growth headwinds, and attempting to encourage exports, the temptation for domestic politicians will continue to be to blame foreigners and the rhetoric about punishing “cheating” (i.e. trade surplus) countries will remain.  Let’s hope we don’t see an equivalent of the Kindleberger spiral for 2010’s!

- Demographics  

A long-term concern for Our Man is the weak demographics of the Western world.  While this is a major problem in Japan, China and many European countries, it’s also starting to impact the US.  In 2011, the US Birth Rate hit a historic low (it’s now about ½ the peak rate of the baby boom years) and the US fertility rate (1.9 children/woman) is now below the rate needed to maintain the current population.  Furthermore, the aging of the baby boomers will continue to have significant impacts on housing, employment and unemployment and investing.

- Corporate Margins & Valuation  

Another holdover from previous years!  While all the other ‘fingers of instability’ suggest risks to the global economies, it’s corporate margins and valuations that make the market particularly vulnerable.  While short-term measures (such as trailing P/E or the awful forward Operating P/E) suggest that the market is cheap/fairly valued they require the belief that the current level of margins (near all-time highs) is sustainable ad infinitum.  Perhaps they are, and we’re in a new paradigm but Our Man suspects that reality is that the elevated levels of margins offers more potential for downside surprise than upside opportunity.  While long-term measures of valuation are a terrible guide to any given year’s market performance, they do offer a valuable guide or map for real cheapness or value and they don’t suggest that the broad equity markets offer much in the way of absolute value.

2013: Glimmers of Hope

Traditionally, at the start of each year, Our Man looks at some of the major things that could help or hinder the economy and markets during the upcoming year.  As such, here are this year’s Glimmers of Hope (see here for an explanation of the thinking behind Fingers of Instability and Glimmers of Hope), which looks at some of the things that could help drive markets higher.

  

- QE-Forever Everywhere and (the lack of) Inflation 

One of the interesting things about crises is that people’s time horizon reduces dramatically.  The aim for folks (almost everyone) becomes to try and limit the impact that they’re feeling (or going to feel) from the crisis, and insulate themselves from the results of the crisis.  For those in power (especially Central Banks and Governments) this results in a string of short-term focused decisions, whose sole aim is to end the crisis as quickly as possible so they can declare their mastery over it.  The downside is that little is done to resolve the underlying problems and it can result in the economy lurching from one crisis to the next, with each ‘successful’ resolution leaving the system more fragile than before.  Some of this can be seen in 2013, which has started with the proponents of Central Banks beginning to declare victory; Mario Draghi has been cheered for saving the Euro, the Fed have publicly committed to continue the QE-experience until either it succeeds (and unemployment falls to an acceptable level) or it fails (and inflation rises to an unacceptable level), and it appears like the BoJ will bow to government pressure and increase QE in an attempt to escape their deflationary trap.  Like 2012, the Central Bankers of the world continue to press the 'sell your bonds, and buy risky assets' line of thinking!  This demand and its impact on the psychology of market participants could well once again prove very supportive to the markets.

  

- Can-kicking Government behavior 

For Government’s the politically optimal way of dealing with crises, is to find a simple quick patch for the problem that pushes the difficult decisions off into the future (and hopefully, onto other folks) even if it means making the long-term issues worse.  This means different things in different countries.  In China, where the ‘crisis’ surrounds the potential slowing of economic growth, the response to any crisis that hints at slower growth (even if it might result in the rebalancing of the economy, which is a longer-term aim) is to increase government-sponsored investment even if the cost is greater overcapacity and a less balance economy.  In Europe, where the crisis revolves around weak government finances, the response is to create ever more complicated and intricate ways to extend, encourage or ease funding to the countries in trouble even if the likelihood of getting a return on that funding is limited, rather than restructuring the debts that are unlikely to be paid.  In the US, with a tax regime that fails to generate sufficient revenues and a spending regime dominated by non-discretionary item (defense, medicare, etc) there’s plenty of scope for short-term fixes (like the fiscal cliff deal) that do little to help resolve the longer-term imbalances.

- Housing Market 

As we mentioned in 2012’s Glimmers of Hope, the housing market was a potential source of upside.  If you look back at historical housing crises, it takes 6-8years (on average) for the housing market to stabilize and start to improve again.  Given that prices peaked in the US back in late-2006, it would suggest that we’re in the neighborhood of seeing (continued) improving prospects here.  While it’s not clear that that Government’s & the Fed’s efforts to reduce the problems in housing are well-thought out, it’s equally clear that any continued stabilization in the housing markets would unquestionably help both socially and economically.

- Global Economic Growth 

Could 2013 be the year that we return more sustainably towards trend economic growth.  There are certainly some positive signs.  In the US, a fiscal deal was agreed and it appears we’re going to have less uncertainty around the debt-ceiling.  In Europe, Draghi has ensured that European government’s will be able to fund themselves and has bought further time for them to see if there are any fruits to the austerity programs they’ve been running.  Finally, in Asia, China has managed to helped stimulate its economy through aggressive bank lending and Japan is discussing a far more aggressive QE program to help try to boost growth.

- State and Local Governments 

One of the consistent drags on the US economy since 2008 has been state and local governments, which have struggled with their own budget woes.  Unlike national governments, they weren’t able to increase deficits as easily and thus were consistent cutters of spending and jobs.  Signs towards the end of 2012 suggested that this trend is approaching its end and while State/Local governments might not be positive drivers of the economy going forwards, they will be likely stop being drags on growth.

- Falling Unemployment (and rising incomes) 

Of all the economic data that's out there, these are the two things that Our Man cares the most about - do people have jobs and do those jobs pay decently.  While there’s many flaws in the data (and its computation), it’s also clear that jobs data in the US is consistently improving, albeit at a slower pace than everyone (I think) would like.   Now perhaps this improvement slows or reverses later in the year and there are seasonal biases benefiting the data currently, but the declining trend in unemployment, positive revisions and increase in hours worked (which will, hopefully, feed through into incomes) is unquestionably good for the economy!  With companies being in a relatively strong position, if demand continues to hold up well, there is potential for this favourable trend to continue. 

- China & an Asian soft landing 
China continues to stimulate their economy whenever there’s the risk of a hard-landing.  While the figures and data coming out of China may be questionable, perhaps they’ve just built a better mouse-trap for managing the economy than the rest of us…

- Valuation
This is a repeat from prior years’ lists!  Our Man continues to mutter that it’s an expensive market (and using longer-term measures it is) but if one only looks at short-term horizons (or uses current year P/E, or mutations of it…such as P/E based on Operating Earnings, or projected forward P/E, etc) then an argument can be made that the market is cheap.

December 2012 Review

Portfolio Update
There was a solitary change to the portfolio during the month:

- Hedges/Put Options:  A put position in XLP (Jan-14, $30 strike) was added to the portfolio.  The position continues the negative exposure to the US consumer (which continues to suffer from the weakness in employment and real disposable income growth).  Additionally, technically, some of the stocks in the ETF (and the ETF itself) are showing weakness having performed very well in 2012 due to the perceived stability of the stocks and their dividends. 

Performance Review 

The portfolio ended the year with a small positive month (+20bps) though this unfortunately left meant the portfolio closed out the year  well behind the S&P (which rose 13%+ even before you take dividends into account) and in negative absolute territory, at -1.4% for 2012.

The largest negative contributors to performance during 2012 were also the negative contributors in December.  The Puts/Hedges was the largest negative contributor during 2012, costing just over 200bps, of which the final 12bps came during December, due to the costs of entering the new position (commission + bid/offer spread) and the existing positions losing the final chunks of their value.  Given the negative carry of the book, it’s one that Our Man will have to be far more tactical with going forwards, especially paying greater attention to technical factors.   The same holds true for the China Thesis (-3bps), which is also expressed through put options.  Finally, the Currencies (-18bps in December) and Precious Metals (-32bps in December) both hampered performance over the course of the year, but to a far more muted degree.

The big gainers in December were the Value Equities (+40bps) and Energy Efficiency (+39bps), on the back of positive sentiment and signs that key positions in those books (DRWI, THRX and XIDE) are showing progress towards their longer-term goals.   These books were mildly (under 50bps each) profitable over the course of the year, and hopefully the fundamental progress in the underlying names will continue in 2013 resulting in greater confidence in the longer-term theses and a re-rating in the stocks. The two largest positive contributions during 2012 came from the Absolute/Bond Funds (-2bps in Dec) and the NCAV (+8bps in Dec) books.  The Absolute/Bond Funds contributed steadily throughout the year, generating a decent return on capital for 2012 (and indeed, since inception).  The NCAV book on the other hand, generated a stellar return on capital (100%+) during 2012, but was constrained by the limited exposure which was a reflection of the small number of positions that met the criteria.

Portfolio (as at 12/31 - all delta and leverage adjusted, as appropriate)
19.6% - Bond/Absolute Return Funds (DLTNX and HSTRX)

12.8% - Precious Metals (GLD)

6.4% - Value Idea Equities (THRX, and DRWI)

2.8% - Energy Efficiency (AXPW, and XIDE)

1.7% - NCAV Equities

0.0% - Other Equities (none) 

-0.0% - China-Related Thesis (under 1bps premium in EWZ Jan-13 puts)

-2.70% - Hedges/Put Options (under 1bps in IWM Jan-13 puts, SPY Jan-13 puts and XLY Jan-13 puts, and 25bps in XLP Jan-14 puts) 

-11.4% - Currencies (EUO – Short Euro) 

50.9% - Cash 

Disclaimer:  For added clarity, Our Man is invested in all of the securities mentioned (DLTNX, HSTRX, GLD, THRX, DRWI, AXPW, XIDE, , EWZ puts, IWM puts, SPY puts, XLY puts, XLP puts and EUO).  He also holds some cash.  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you.