Shaping a portfolio for 2013 (iv): Europe

 The Eurozone, which comprises most of the EU, is in recession.  Not only that, but it’s suffering a crisis of trust that threatens to tear it apart.  But you wouldn’t know it from the recent performance of EU stock markets.ward

a quick look back

In over-simple terms, the Eurozone was formed solely as a monetary union, without any fiscal checks and balances.  It was like a partnership where everyone got to use the common credit card.   On the tacit assumption that gentlemen always pay their debts, the EZ never checked to see if users could, or did, pay their bills–even though the group as a whole was responsible for any charges.  The chief lenders were government-controlled banks run by bureaucrats with no notion of how to analyze creditworthiness or detect fraud.  If all else failed, the “parent,” Germany, would presumably pick up the tab.

Not a great real-world concept.

The fantasy balloon was popped in October 2009 when a newly-installed government in Athens discovered the previous administration had been faking the national balance sheets and income statements for many years.  Greece was broke, much more heavily in debt than it had previously revealed, unable to repay.  The new guys made the bad news public, but have been unwilling (my view) to do much, other than ask for debt forgiveness, to remedy the situation.

Members have been fighting about how to proceed since then.  Until very recently, no one has been willing to lend to economically weak nations like Italy and Spain, forcing them into crisis.

Pretty awful stuff.

2012 stock market performance

Last year, the S&P 500 was up by a stellar 13%+,  on a capital changes basis.  Despite the ugly picture I painted above, EU stocks outperformed the US by about five percentage points last year, in dollar terms.  That’s the result of a huge rally since July.  EU stocks, which I pointed out back then were yielding 5.5%, still have a 200 basis point yield preference over the S&P–meaning holders made close to eight percentage points more than the S&P on a total return basis.

A dollar-based investor who bought in late July (something I would have thought to be too risky for just about everyone) would have made over a third on his money in five months.


Some people talk about a four-stage process in problem solving:

Stage 1:  deny the problem exists

Stage 2:  blame someone else

Stage 3:  blame yourself

Stage 4:  begin to fix the problem.

I think the Eurozone reached Stage 4 last July   …and the markets picked up on this very quickly.

where to from here?

I read the positive market reaction so far as being basically an anticipatory rally, in the expectation of change that’s yet to come.  In other words, I think it’s far from a sure thing that the parties involved have the political will to create the closer fiscal union that is needed.

still, some positives

a 4%+ dividend yield indicates there is still considerable skepticism still in the markets–implying further upside for stocks if good news continues to flow from Brussels and Berlin

–it’s now much less probable that the EU will come apart at the seams (if anything, there’s likely only to be a slow unraveling)

–the end of the scorched-earth “austerity” policy and its replacement with a more accommodative monetary regime means eps growth in 2013 might surprise skeptics on the upside.  For what it’s worth, the OECD is projecting that Europe as a whole will begin to see (admittedly meager) positive year on year comparisons in the second half.

my bottom line

An EU that’s at least not falling apart and where overall GDP is stable or better is a plus for the rest of the world.

Any value investor, I’m sure, will have a field day poring over the financials of the many companies that are trading at under net equity value–the risk, of course, being that there may be legal and cultural barriers to asset value ever being realized.

But there are better places in the world to invest, to my mind, for the moment at least.  If I were forced to have actively managed money in Europe, I’d certainly be significantly underweight.  I’d be emphasizing Germany, Scandinavia and the UK.  I’d also be trying to find well-managed companies with unique products/services, especially ones with the ability to sell outside the EU.

Since I’m not compelled to be in Europe, I’m content await further political developments and to hold only a few names, concentrating on firms listed in the EU but doing most of their business elsewhere.  Personally, I own small positions in a couple of Vanguard Europe funds, plus IHG.  I’d be happy to add a couple more individual stocks, once I have time to do the research.

Shaping a portfolio for 2013(lll): China


Like the US, China is a complex topic with lots of moving parts.  I’ve also been investing in China-related stocks for over 25 years (hard to believe it’s been that long), so there’s an increased risk of my being distracted by details.  So, like my views on the US, I’m down to bullet points:

1.  In the late 1970s, China decided it had to embrace Western economics (not politics), because central planning wasn’t working and it didn’t want to end up like the old Soviet Union.  Like Japan before it, China pegged its currency to the US dollar and concentrated on growth through export-oriented manufacturing.

Two factors separate China from run-of-the-mill emerging countries using the Japan blueprint:

— the huge size of its population, and

–the single-mindedness with which it has pursued economic expansion.

Thirty-plus years later, China is now the second-largest economy in the world.  It’s three times the size of #3 Japan, and 80% as big as the US (using Purchasing Power Parity GDP figures).  In a handful of years, China stands to become #1.

2.  The financial meltdown in the US and the € crisis in the EU depressed demand in China’s two major markets.  China’s (very competent) economic mandarins initially added temporary extra stimulus to domestic activity to counter the effects.  But even while China was doing this, it was clear that the currency peg would, quickly enough, transmit enormous (and unneeded/unwanted) monetary oomph to the mainland economy.

Like other emerging economies, China has been spending the past couple of years trying to cool down an overheating economy.

That task has already been accomplished.

3.  In November, China completed its once a decade Communist Party leadership transition.  In the runup to this event, high-level decision-making grinds to a halt, since bureaucrats don’t know the identities, let alone the intentions, of their new bosses.  That drag on the economy is in the past, as well.

4.  Because of #2 and #2, it seems to me that the year of the Snake will be a strong one for China.  Growth may come in at “only” 8%, but that will certainly be better than most other places on the planet.  The Chinese PMI is already signalling acceleration.

how to invest

You can get some exposure by finding stocks in, say, the US or Europe, that have significant operations in China.

You can get more direct exposure by buying the stocks of Chinese companies.  As with any other equity investment, the basic choice here is whether to pick an index fund/ETF, or to actively manage–either by selecting an actively-managed mutual fund or picking the stocks yourself.

Personally, I own three funds in the Matthews family of China-related offerings.  I also have international accounts with Fidelity and Charles Schwab so I can buy Hong Kong-listed names in the local market.  Many are also available for trade on the pink sheets, although usually at considerably less favorable prices.

I’ve never been a big fan of ADRs.  In general, a foreign company only comes to the US when it thinks it can get a better price for its equity than it can from investors in its home market, who presumably know the firm and its business practices much better than foreigners.  The only exception I see to this rule is the case of EU-based tech companies, where local investors are mostly clueless.

Shaping a portfolio for 2013 (ll): the US

I’ve been having a horrible time organizing this post.  I keep going off on tangents.  So I’ve decided to stick to making assertions.

Here goes:


 The long-term growth rate for real (i.e., adjusted for inflation) GDP in the US is around 2%.  We’ve been growing at that rate for the past few years.

I don’t see any reason why 2013 should be any higher.  Arguably, the withdrawal of government stimulus could shade that figure downward a bit.

If we assume inflation at 2%, this means nominal GDP growth of 4% for 2013.  That probably translates into 7%-8% profit growth for the domestic operations of US-listed companies.

changing growth patterns

The pattern of this recovery has been far different from the norm for the US during my working career.  Industry, tourists and the affluent–not the usual suspects (housing, autos and widespread consumer spending)–were the hot spots during the earlier years.

In mid 2011, focus shifted.   Recovery broadened to include more ordinary Americans.   Early 2012 gave the first signs that the domestic housing market was bottoming, suggesting an uptick in activity was in the offing.   At around the same time, slowdown in China called into question the durability of the luxury goods/tourism boom.

2013?  I think housing and consumer durables (like cars) will be the stars.  Reacceleration of the Chinese economy after the recent change in Communist Party leadership will also boost businesses that cater to Pacific Basin demand.

pent-up demand, anyone?  …anywhere?

 The recovery is pretty long in the tooth, both in business cycle and stock market terms.

Typically, when the economy is under stress, individuals stop buying and companies defer investment.  This creates “pent-up” demand that begins to be satisfied as soon as economic circumstances look brighter.  Spending surges for a while and then tails off to trend.

More than four years in, there’s not much that hasn’t had a chance to experience this cyclical surge.  Exceptions:  Housing is one area.  Autos are another.  We’ll be getting fresh data in a couple of weeks, but a year ago the average car on the road in the US was 11 years old.

As they see that pent-up demand is increasingly satisfied in the economy, stock market investors always increasingly shift their focus away from economically sensitive names and more toward niche companies with a history of strong profit growth in both good times and bad.  In other words, they shift from value to growth.  I think this will be another important feature of 2013.

Washington, a force for PE multiple expansion?

Over twenty years ago, a former colleague helped me to the conclusion that neither major political party in the US had an economic agenda appropriate for the modern world.  I think this is truer now.

Back then, the possibility that Washington craziness was clipping 1% a year off real GDP didn’t seem that important (I’ve just made up the 1% number, but I don’t think having an exact figure is critical). Inflation was higher; real growth was better, too.  So if the political status quo meant nominal GDP growth came out at 6% instead of the 7% it might have been were economically sensible policies in effect, did it really matter that much?

Today, in contrast, those extra 1%s would come in mighty handy.  Growth is slower.  International competition is fiercer.  And we’re in the earliest stages of national belt-tightening needed to pay the gigantic bills Washington has run up.  But everyone knows that Washington is dysfunctional and is steering us along the initial leg of the same trip Japan has taken from world dominance to irrelevance.

An investment point?  I think that the worst that we can reasonably expect from the White House and Congress is already pretty much factored into today’s S&P price earnings multiple.

Yes, this may unfortunately be the most probable case…

…but if I’m right, it would be hard for Washington to create a negative surprise.  Even a mild positive one could create multiple expansion.   Not anything to act on today, but something to keep in mind.

US economy vs. US stock market

It’s important to keep in mind that the course that US GDP takes and the one the US stock market takes are two separate things.  For one thing, half the profits of the S&P 500 come from non-US operations (split roughly equally between the EU and emerging markets).  For another, some important sectors of the economy, like autos, construction or real estate, have little representation in the index.

For 2013, a key question will be how to arrange the mix of domestics and foreign-earners in the portfolio.

Shaping a portfolio for 2013(l): general

I’m going to be writing about my equity strategy for 2013 over the next week or so.  I’ll be doing so from the perspective of a US-based investor, although the conclusions should apply–with some adjustment–for investors based elsewhere.

I’m going to use the same format as a year ago.  Today, some general observations.  Then, my take on the US, the EU and China (the last as a proxy for emerging markets in general).  After that, my thoughts on how the S&P 500 will perform this year.  Finally, what I think an actively managed equity portfolio should look like.

If I were still a working professional I would have done this all a month ago. I assume all my former peers began to adjust their portfolios in November or December, as well. But as an individual, I can turn on a dime.  So I really don’t need to be as early as I used to.  More importantly, though, two new issues have come up in recent weeks that call into question what I probably would have written a month ago.  More about this below.

thematic questions

I see three big themes for world equity markets in 2013.  They are:

out of intensive care?

The housing market in the US peaked and began its lengthy swoon in early 2007–six years ago!

The wheels began to come off the financial system in the US a year later–five years ago.

We can now see that the domestic housing market began its recovery nine months or so ago (one sign was how analysts were hooted down by talking heads whenever they said anything positive about housing).  Last week, newly released minutes of the last Fed meeting show the monetary authority thinks the US will no longer need further extraordinary life support measures (that is, continuing QE) within at most 12 months, maybe half that.  This is partly because the Fed judges the cure to be worse than the disease.  It’s also partly because the US economy is developing a pulse of its own, although not the youthful, vigorous one we might have hoped for.

At some point, professionals will begin to bet that bonds can’t get more expensive and that yields will begin to go up.  We know the Fed thinks the “normal” level of overnight interest rates is 4%+.  So bond prices have a considerable way to fall as/when a turn occurs.

Could this be happening now?  I don’t have strong conviction, but my guess is that it is.  This is my first December change of heart.  During such periods in the past, stocks have gone sideways to up while bonds have been falling.  If we assume (as I do) that the Fed can control the speed at which rates rise, to thus ensure that economic growth won’t be completely undone by the increasing cost of money, then sideways to up should be  our baseline assumption this time as well.

structural and cyclical

The basic macro problem with the US and the EU:  they’ve both been motoring down the same road to ruin blazed by Japan twenty-some years ago.

That is, in both the US and the EU politicians have responded to declining competitiveness by heavy borrowing.  In itself, that isn’t necessarily bad.  But as far as I can see, the money went to prop up vested interests like real estate rather than to economic restructuring (education, infrastructure, industrial capital investment).  For southern Europe the metaphorical government credit card has been maxed out.  That’s merely a worry right now for the US.

Concern that the forces of the status quo are too strong for either the US or the EU to break a spiral of gradual decline has already been factored into today’s stock prices in both areas.  The main reason for the big rally in EU equities during the second half of 2012, in my opinion, is actions by EU governments that imply they’re shifting out of denial and beginning to address structural issues.

Is it possible that fiscal cliff negotiations in the US show a similar willingness to discard outmoded ideology in favor of economically sound solutions to structural problems?  Maybe.  If so, expect price earnings multiple expansion for the S&P this year.

stock market characteristics

less information

I mean less readily available company analysis done by seasoned professional securities analysts.

Virtually no one I knew as a brokerage house securities analyst during the middle of the last decade is still so employed.  Many have left the industry; others are either self-employed or members of small research cooperatives with limited clout.  I have no insight into what the buy side has done over the past few years, but the shrinkage in funds under management–leading to substantially lower operating income–can scarcely have been an incentive to hire new researchers.

Less efficient markets aren’t all bad.  They mean a greater chance for us as individuals to uncover valuable market or stock-specific information before it becomes generally known.  On the other hand, newer, less skilled players on both the brokerage and money management sides mean that the rules of the game may be changing in weird ways.  In particular, it may take much more time than we might imagine for the light bulb brightly burning in our heads (we hope!) to go on in someone else’s.

more volatility

Individual investors have been shifting increasingly away from actively managed stock mutual funds into index funds and ETFs.  Whatever the balance between short-term traders and long-term investors may be, this action is clearly shifting power toward traders.

The inefficient flow of information may also tend to increase short-term market volatility, as investors have less practical research-based reason to stand counter to the current flow of trading.

Academics use volatility as a synonym for risk.  Other than in their fantasy world, however, it isn’t.  A stock that goes up every day is more volatile than one that never moves–or one that only trades once a week.  But that doesn’t mean it’s riskier, in the way we use that word in normal speech.  There’s no denying, though, that the current stock market I see is more opaque than it was a decade or two ago.  Therefore, it’s harder to predict the timing or effect on the market of better information we may have.

my bottom line

We’re soon going to be entering year five, measured from the market bottom in late March 2009.  And we’re already well into year four of economic recovery from the macro lows later that year.  So there isn’t an awful lot of gas left in the tank to fuel surprisingly strong economic performance–or corporate earnings results, I think.

On the other hand, relatively stimulative money policy around the world suggests that global recession isn’t just around the corner, either.

Absent craziness out of Washington, to me it seems like a flattish year for the S&P, with maybe more short-term ups and downs, and with stock pickers having a chance for much better returns.