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VOL. 129 | NO. 65 | Thursday, April 3, 2014

David Waddell

Now Tack!

By David Waddell

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In sailing, when the wind shifts direction, you must move your sails or risk losing the wind. The first indication of a shifting breeze comes from the telltales, strips of lightweight material attached to the sails that foreshadow a change in conditions. Recently, the market telltales have been active.

The Strong and Steady Breeze

For the last five years, “growth” stock indices have outperformed “value” stock indices. Additionally, U.S. stock indices have dominated the global indicies. Within the strong and steady U.S. growth indices, internet and biotechnology stocks provided the largest gains. While the MSCI All World stock index has appreciated 14.38 percent annually for the last 5 years, the Nasdaq Biotech index (ETF: IBB) returned 28.92 percent annually and the Nasdaq Internet index (ETF: PNQI)returned 33.90 percent annually. Filling your sails with those tailwinds would have brought home the America’s Cup!

Unfortunately, after gains of this magnitude, opposing natural forces come into play. Valuations become stretched and buyers lack vigilance, leading to lower quality shareholder offerings and fundamental excuse making. Unfortunately, sea changes in momentum only become obvious in hindsight. But with the fast money crowd growing in size and influence, these shifts have become more recognizable. Over the last month, the two indices collapsed 13.23 percent and 10.63 percent, respectively, while he S&P 500 has been flat. Clearly, the winds have changed.

Which Way Did It Go?

We mentioned last week that some defensive sectors like utilities and energy have recently caught a bid. However, these sectors resemble heading to port more than seeking new gusts. Those intent on winning the race need to pursue a more rapid wisp. Over the last month, the most substantial gains have occurred in the heretofore least favored locations. The emerging market indices have experienced significant turmoil and outflows over the last few years. However, in the trailing month, momentum has appeared. The Brazilian market (ETF: EWZ) has advanced 9.84 percent, the Indian market (ETF: PIN) has advanced 8.81 percent and the Chinese mainland market has bounced 3 percent above its March 20 low. The Emerging Market index, has taken the performance lead from the S&P 500.

Do these telltales indicate a more durable change in market momentum? It’s too early to judge. However, this is how shifts occur. Fast money departs a momentum trade that has overrun and relocates to another, historically volatile, under-appreciated market address. The most attentive market observers take note and begin reporting on the rotation, alerting more mainstream media. As word spreads that a new profit source has appeared, larger and larger money players will investigate.

However, for slow money to follow fast money, the fundamental factors must support the case. As we have discussed, emerging market valuations are far lower than developed market valuations and well below the stretched valuations in the U.S. Money has poured out of emerging market funds with sentiment readings decidedly negative. Negative money flows, bearish sentiment and historically low valuations paired with higher growth rates will entice investors should the winds accumulate. With the fundamental case compelling, a turn in momentum could revive broad investor interest in investment tourism.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.

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