VOL. 130 | NO. 166 | Wednesday, August 26, 2015
The Worldly Investor
Playing the Pullback
By David S. Waddell
After four years of up, markets have quickly entered correction territory. Unfortunately, since most investors operate with short memories, the current pullback feels major since recent comparisons have been minor. However, markets corrections don’t presage negative annual returns.
In fact, on average over the last 35 years, markets have pulled back 14 percent from intra-year highs while still finishing positive in 27 of those years. Absent strong recession signals, which we are not seeing, we view the current air pocket as an opportunity.
This week, I thought you might enjoy some inside access into W&A’s investment war room.
The sell: Recently we eliminated our position in a dedicated Asian strategy as the quasi-decoupling of the Chinese yuan from the U.S. dollar led us to reweight our regional concerns.
Debt deceleration in China has translated into growth deceleration, causing the Chinese to lower interest rates and reserve ratios to support growth.
Typically, when a nation eases monetary policy in recognition of softening economics, its currency depreciates in sympathy. While the Chinese intervened to maintain the currency reference rate, real market forces have been tugging the yuan lower. By de-pegging on Aug. 10, the yuan should gravitate toward its market determined equilibrium point.
We believe that the market based value of the yuan may actually be 10 to 15 percent below the current level. A revaluation of that magnitude will impact China’s neighbors and create investment jitters across the region.
To be clear, the world has been lobbying China to free float its currency for ages. However, the world also must adjust to the new regime, and as with any change, there will be winners and losers largely identifiable only in hindsight.
In light of these developments, we felt compelled to reduce our Asian currency exposure and more directly, our emerging Asian currency exposure.
The buy: With our Asian proceeds, we added an active management strategy weighted 80 percent towards Europe and Japan as both regions host supportive quantitative easing programs.
International equities still hold a valuation advantage over U.S. equities.
Comparing normalized 5-year trailing P/E’s, the USA trades for 22 times earnings while the rest of the world trades for 17 times. In addition to offering over more compelling valuations, offshore central banks are in “stimulus” mode while the U.S. central bank is in “normalization” mode.
If investors have learned anything since 2008, it’s that quantitative easing programs boost asset prices. Both Europe and Japan initiated QE programs post QE in the U.S. Europe announced their program in February, while Japan boosted their program in October 2014.
A quick survey of post-announcement returns confirms our QE = higher stocks hypothesis. Year-to-date, in local currency, the MSCI Euro index has appreciated 1.52 percent, while the MSCI Japan index has appreciated 5.12 percent. Correspondingly, the MSCI USA index has depreciated 6.53 percent. With world growth concerns rising, embedded pro-growth monetary policies offer comfort.
Bottom Line: The bull hasn’t ended but it may change direction. Look for opportunities to add or reposition exposures toward more predictable themes. At least that’s what we are doing!
David Waddell is president and CEO of Memphis-based Waddell & Associates.