Prateek Mehrotra, MBA, CFA®, CAIA®, Chief Investment Officer of Endowment Wealth Management, and its affiliate, ETF Model Solutions, is featured in an exclusive cover interview in the most recent issue of Trusted Insight Magazine. In the article, Prateek discusses his career path, along with the vision that lead to his co-founding of the two firms’ of which he serves as Chief Investment Officer, serving clients through a multi-family service model, and the firms’ investment approach. You can read the article at Trusted Insight website (requires free registration to access).
The Labor Dept. reported that headline inflation fell 0.2% in September from August and was flat or zero on a year over year basis. However, the core CPI which excludes volatile food and energy was up 0.2% over the previous month and increased 1.9% year over year, marking its biggest gain in a year.
Majority of the gain in the core CPI was driven by shelter costs which increased 3.2%. However, the inflation measure preferred by the Federal Reserve, core PCE has a 20% weighting to shelter costs vs. the core CPI which has 40%. Estimates are that the core PCE increased just 1.3% year over year, which is below the Fed’s 2% comfort level.
While inflation is not a worry yet, improving labor markets and wages could subsequently add more fuel to fire in the future. Something we are keeping an eye on.
(Source: WSJ, BLS)
The wealth of American households climbed to a new peak in the second quarter, bolstered by rising real-estate values that more than compensated for a flat stock market.
The net worth of U.S. households and nonprofit organizations—the value of homes, stocks, bonds and other assets minus all mortgages, debts and other liabilities—climbed by $695 billion to $85.7 trillion, according to a Federal Reserve report released Friday.
The report provides a snapshot of the robustness of American balance sheets before the turmoil that struck stock markets in August. Households lost close to $13 trillion in the recession, but a soaring stock market and resurgent home prices have boosted American wealth by $30 trillion over the past five years—gains fueled in part by a campaign of ultra-low interest rates and large-scale asset purchases by the Fed.
This week saw one of the more widely anticipated Fed announcements of recent years as investors looked to see if the “zero” interest rate environment was going to be put behind us. As was widely publicized yesterday, the Fed elected to do nothing, based upon concerns of an economic slowdown, pushing off the prospect of a rate hike. First Trust’s economic team put out a report that provides the text of the Fed’s statement, along with their perspective of what we can expect moving forward. Learn more.
The difficult market environment in August reminded us about the three other Augusts – August 1997 (Asian crisis), August 1998 (Russian crisis) and August 2011 (European debt crisis). In each of those episodes, there were some type of global risk events, and as a result, US market suffered significantly.
In 1997, Asian financial crisis started in Thailand with the collapse of the Thai baht after the Thai government was forced to cut the Thai baht’s peg to US dollar after exhausting its foreign reserve. As the crisis spread to Indonesia, South Korea and Malaysia, most of Southeast Asia and Japan experienced declining currencies, stock markets crashes and a jump in private debt. The crisis raised the fears of global economic meltdown. As a result, the US equity market dropped by 5.6% in August. However, the US market recovered quickly with a 5.5% rally in September.
In 1998, the Asian financial crisis and the following reduced demand for crude oil and nonferrous metals, negatively impacted the Russian exports and foreign reserves. A series of political missteps and inability to implement a set of economic reforms severely erased investor confidence and led to capital flight. Without enough foreign reserve to support its currency, on 17 August 1998, the Russian government devalued the ruble and defaulted on domestic debt. The Russian default caused global liquidity dry up and credit spreads widen, which brought down the then-known hedge fund, Long Term Capital Management. US equity markets tumbled 14.4% in August, but again recovered nicely in September and October.
In 2011, the European debt crisis intensified after it started in the wake of the Great Recession around late 2009. In August, the government bond yields in Italy and Spain breached 6% level as the European leaders struggled to reach an agreement to expand the bailout fund. The US equity market dropped by 12.4% during the months of August and September. However, once again, it recovered in October, gaining 10.9%.
This year, the stock market rout started in China when the Chinese government unexpectedly devalued its currency, which triggered concerns over global economic slowdown. The US equity market declined by 6.1%.
| Event | S&P 500 Index
(August) |
S&P 500 Index
(whole year) |
Valuation (current PE) | Short Term Interest Rate | ISM Manufacturing Index |
| 1997 -Asian Crisis | -5.6% | 33.4% | 21.9 | 5.2% | 56.3 |
| 1998 – Russian Crisis | -14.4% | 28.6% | 22.0 | 4.8% | 49.3 |
| 2011- European Debt crisis | -12.4% (Aug and Sept) | 2.1% | 13.6 | 0.0% | 50.6 |
| 2015 – Chinese Slowdown | -6.1% | ?? | 18.6 | 0.0%
|
51.1 |
The equity market drops in the first three crises all recovered nicely and quickly. Will this time be the same? We believe it is quite likely though we still recommend caution.
- There is no crisis this time so far. The Chinese economy will definitely or has already slowed down from double digit to 7% or lower. But everyone tends to agree that it will grow at a reasonable pace. The Chinese stock market rout started after a dramatic run-up and a bubble-level valuation. The sell-off, though painful, was a necessary correction. As a word of caution, the bad news from China may not be over, we may see more market volatility going forward.
- The US equity valuation is not cheap, but not at an extreme (see table above). During the crises in 1997 and 1998, the equities are much more expensive.
- The US monetary policy is ultra-loose. Even if the Fed may raise interest rates this year, the monetary policy is still very accommodative. The interest rates in 1997 and 1998 were much higher.
- The US economy is solid. In Q2, the US economy grew at 3.7% annual pace. ISM Manufacturing Index is still in expansion territory and unemployment rate is close to 5%. The slowdown in China will have limited impact on the US growth as the exports to China only account for 1% of the GDP in the US. However, the slowdown in China will have significant impacts on the US companies that are doing businesses there.
(Source: Julex Capital)
With the market in flux, it’s important to think rationally and practice patience. To accomplish that, here are 10 phrases you should NOT be telling yourself:
- I got a great stock tip from a friend of a friend.” – Herding
- “This time is different.” – New Era Thinking
- “I should have seen the crisis coming.” – Hindsight Bias
- “I check my account on the hour.” – Myopic Loss Aversion
- “This is can’t miss!” – Overconfidence
- “It just feels right.” – Affect Heuristic
- “…but Jim Cramer said…” – Appeal to Authority
- “Rebalance? Why bother?” – Status Quo Bias
- “I’m on a hot streak right now!” – Gambler’s Fallacy
- “I can always start saving later.” – Hyperbolic Discounting
(Note: The above is a re-post from the Brinker Capital Blog)
China Large and Small Cap Indices seem to be approaching longer term valuation levels. Also:
- China’s margin debt is substantially lower. Outstanding margin debt on the Shanghai and Shenzhen stock exchanges fell to 1.25 Trillion Yuan on Monday from a record high of 2.27 Trillion Yuan on June 18th. Stock market peaked on June 12th.
- Large Cap Stocks estimated P/E ratio is approx. 10 which represents 2013 P/E 5 Year lows.
- While valuation multiples have contracted globally, the Chinese P/E multiple has contracted more. Chinese Large Cap Stocks are now cheaper than the S&P 500 and the Dow Jones Industrials.
- Chinese Small Cap Stocks are still trading at a higher P/E relative to US Small Cap Stocks.
We continue to maintain an allocation to China A Shares in the Endowment Index.
Bob Doll’s comments on recent equity market volatility share many of our same viewpoints:
Possible reasons for recent market decline:
- Multi-month decline in earnings
- Widening credit spreads
- Economic weakness from China/devaluation of the Yuan
- Slowing growth and commodity price weakness (deflation fears)
- Fed Policy uncertainty
- Market technicals
- Investor nervousness, skepticism, and uncertainty
Near term thoughts-
- China’s economy is slowing, but not enough to cause a global recession
- US economy continues to perform well
- He doesn’t see this correction as indication of recession, since he see’s no inflation/Fed tightening
Market dynamics- The belief that this swing is likely caused by technical factors and not fundamental weakness in the economy, when combined with the fact that previous declines during this bull market have been buying opportunities, there is belief that this is one as well.
Of course, past performance is no guarantee of future results.
There are various ways to measure inflation including the headline CPI, as below:
- CPI or Headline Inflation=0%
- Core CPI=1.8%
- Cleveland Median CPI=2.3%
- Sticky Price CPI by Atlanta Fed=2.2%
- Dallas Fed Trimmed Mean Personal Consumption Expenditures (PCE) preferred by FOMC=1.7%
These are year over year numbers. Hence, despite the decline in commodity prices the Fed believes that inflation is heading towards its 2% target.
When we talk about emerging market equities today, we find that people are disappointed: there has been under-performance of late. Additionally, there remain key risks:
• The U.S. Federal Reserve (Fed) raises short-term interest rates
• Commodity prices decline
While each of these well-publicized risks can contribute to further volatility, it’s also quite possible that they are already reflected in emerging market equity valuations today.
Dividend Yield as a Barometer for Valuation Opportunities
There are many ways to measure equity valuation, and in this case we look at dividend yields. Specifically, we break the available history (starting in 1988) of the MSCI Emerging Markets Index into high- and low-dividend-yield years.
• High-Dividend-Yield Years: Years that began with a dividend yield above the median dividend yield for all calendar years.
• Low-Dividend-Yield Years: Years that began with a dividend yield below the median dividend yield for all calendar years.
• Squarely High Dividend Yields: The median dividend yield was about 2.3% for the full period. 2015 began with a dividend yield of 3.1%1. As of June 30, 2015, the MSCI Emerging Markets Index had a dividend yield of about 3.0%.
The Bottom Line: Since high-dividend-yield years indicate lower prices relative to dividends, the key question is whether they exhibited different returns, on average, than the low-dividend-yield years, when price levels relative to dividends were higher.
Dividend Yield is a Potential Measure of Relative Valuation in Emerging Markets
(12/31/1987 to 6/30/2015)
- High-Dividend-Yield Years: When a year began with a high dividend yield, the average return for that year was over 28%. In fact, such values were followed by negative years in only five instances, the worst of which was a negative 25% return in 1998.
• Low-Dividend-Yield Years: When a year began with a low dividend yield, the average return for that year was below 4%. Such values were followed by negative years seven times, the worst of which was 2008’s negative 53% return.
• Years That Started with Dividend Yields above 3.0%: Actually, we started 2015 not only with a high dividend yield but with one above 3.0%. There have been only five such years before, and although past performance can never predict future returns, the returns were strong in those years, averaging 58%. The lowest return of any of these years was 2012, when the MSCI Emerging Markets Index was up over 18%.
Is It Time for the Turnaround?
While we strongly believe that emerging markets will come back into favor, it is extremely difficult to predict when this turnaround will occur. There remain very real risks, but the more critical question regards whether the higher dividend yield reflects these risks.
Some things that we’re being particularly watchful of:
- Stabilization and/or rebound in commodity prices.
- Further stimulus in China or other activity relating to China’s currency.
- U.S. Federal Reserve raising short-term interest rates to help people put this in the rear view mirror so that other things can move back into focus. There is concern as to how emerging market currencies might react.
1Refers to 12/31/2014.
Important Risks Related to this Article
Dividends are not guaranteed, and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.
Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.