It Finally Happenned

It took until the final day of the quarter, but the S&P 500 put in a new all time high closing at 1,569 on March 28th. 



Source: StockCharts



It has taken a while for the S&P 500 to reach these levels again.  This chart from JPMorgan should help put things in perspective.

When the S&P 500 first reached these levels thirteen years ago, it was trading at a forward P/E of 25.6 and competing with a ten year Treasury yield of 6.2%.  Now, the forward P/E is 13.8 and the ten year yield is 1.9%.  So as we have worked through the excesses of the tech, real estate and finance bubbles, overall corporate earnings have continued to grow.  This has made valuations more reasonable and therefore stocks relatively less risky.  At the same time, yields have come down lessening their attractiveness.  With the Fed committed to its current low interest rate policies (think liquidity wave) until unemployment reaches 6.5%, there is no reason to think this relative attractiveness should change any time soon (baring some geopolitical black swan). 

Since making new highs, the S&P500 has since pulled back a little.   While a weaker than expected gain in jobs from the ADP report today was the reason cited for the pullback, a consolidation after reaching new highs is not too surprising.  In addition, investors are anticipating announcements from the Bank of Japan and the European Central Bank Thursday and US employment data on Friday morning.   All potentially market moving events. 

While forecasts of EPS growth have been shrinking, the forward P/E of under 14 does not scream overvalued.  On a positive note, Markit and JPMorgan announced that the JP Morgan Global PMI increased to 51.2 for March from 50.9.

Source Markit JPMorgan

 

Given its large international exposure, the S&P 500 is highly correlated to global growth.  The increase in global PMI is a good sign for better earnings in the future.  While Europe remained a drag, the US continued its growth, the rate of expansion accelerated in China and Japan saw the first growth in ten months. 

Source: StockCharts

While Japanese manufacturing might have seen growth in March, the Nikkei has been consolidating after a large run up since mid November.  Some of this is a function of a short term strengthening of the yen due to increased tensions with North Korea.  In any case, a weaker yen is critical for an export led economy such as Japan's.

New Central Bank Governor Haruhiko Kuroda will lead his first meeting on Thursday.  With the Nikkei approaching its 50 Day moving average the markets will be watching closely for signs of continued commitment from the BOJ to bringing the yen down and bringing inflation up.  A perceived lack of commitment would probably be seen as a time to take profits in the Japanese markets.

Meanwhile in Europe, the resolution of the Cyprus banking crisis, has led to continued talk of contagion by pundits.  So far calm seems to be prevailing as both Italian (4.62%) and Spanish (4.94%) ten year yields closed below five percent.  The pressure seems to be releasing through the decline in the Euro (and drops in the Italian and Spanish stock markets). 

The ECB meeting tomorrow may help shed some light on the situation.

Still Risk On

Risky assets have been on the move lately.  This can be seen in multiple asset classes.  The first sign that we are in a Risk On environment is the widening of spreads on US Treasury Debt versus other governments' debt.  US Treasuries are considered by many the ultimate safe haven and so tend to enjoy a premium when investors are worried.  The premium shrinks or disappears when the worries go away.  

Source: Wall Street Journal

The second sign is the S&P 500 Index's relentless move towards new highs.  The last high was 1,565 in 2007.  We are less than one percent away.



Source: StockCharts.com

With earning's growth expected to be minimal, this has brought up Price Earnings ratio, but not to exorbitant levels. 

Source: Dr. Ed's Blog

On the economic front, while the 'fiscal cliff' and 'sequester' would appear to have taken away much of our margin for error on the growth front, there are positive signs coming from the private sector.  Construction employment, which tends to pay well, is coming back, along with the housing market.  And both would appear to be still early in the game.

On a more global and esoteric note, South Korean exports, which tend to be a leading indicator of global exports, are growing.  This is despite the increased geopolitical tensions on the Korean Peninsula.  North Korea recently cancelled the Korean War ceasefire and cut off the hotline to South Korea.

Source: Humble Student of the Markets

Other signs of healing include Ireland's first successful ten year debt auction since 2010, Spanish and Italian ten year yields both nicely under 5%, and yields on 'junk' bonds hitting a record low of 5.56%.  Overall, investors seem to be taking a positive view of things.  With things relatively calm on the investment front, I would urge you to make sure you know what your goals are for your investments, what the time frames for those goals are and have a plan in place and know what you will do given different scenarios.  It is much easier and better to do this without the influence of sharp emotions and media hype.

In Japan meanwhile, the Nikkei continues to move up.

Source:StockCharts.com

With the Yen moving down at the same time, the currency affect needs to be hedged out.  While it does not track the Nikkei, the Wisdom Tree Japan Hedged Equity Fund (DXJ)* does hedge out the currency risk and has been a good way to play this rise. 

 

Source: StockCharts.com

While DXJ has moved up significantly since the middle of November, the valuations are just reaching the average for the last five years:

Source:ETF Research Center

Source:ETF Research Center

 

While the speed and size of the move would indicate caution, the valuations would indicate, that there is still more room to go before we get into overvalued territory.  That DXJ has increased  almost 40% in approximately 4 months and has only now reached its average valuations for the last five years, gives an indication of how far sold it was.  Currently, allof this has been based on the election results, statements, intentions and the nominee for Bank of Japan Governor.  We have not seen much hard action.  The situation needs to be watched carefully for continued follow through and success on the part of the Japanese authorities and economy.

*Disclosure: I own DXJ and some vertical call spreads on DXJ in my accounts.

Mid Week topic update

US and the Liquidity Wave

Despite all of the concerns, the S&P 500 Index (1,519 close 2/12/13) continues on its seeming date with destiny at its all time high of 1,576. 

Source: StockCharts.com



The liquidity wave continues to push the market higher.  In addition, there are some signals that there may be a structural shift in risk taking going on.  This would support the wave further than many expect.  On the negative side we have the usual cast of suspects, including slowing earnings growth, higher taxes, higher gasoline prices etc.  To these we should add the austerity risk; that the federal budget deficit has never fallen as fast as it is now without a coincident recession.  We never said riding this big wave would be easy. 

Japan

About a month ago, I mentioned that the Japanese stock market was up about 22% from November 14th.  After a short consolidation period, it has continued its upward trend and is now up about 31% from November 14th.

Source:StockCharts.com

A good part of this gain has been based on the drop in the yen. 

Source: Yahoo Finance

With the yen dropping against the dollar, it is important to hedge this out.  The Wisdom Tree Japan Hedged Equity Fund (DXJ) is one way to do this.  Comparing the returns for the DXJ and the iShares MSCI Japan Index Fund (EWJ) which is unhedged can illustrate how important this is.

Source: StockCharts.com

While the two track different indexes, DXJ was able to approximately double EWJ's return because it hedged out the currency depreciation.  For another way to see the effects of the yen on click here. 

On top of this, the Japanese government is now taking a page out of the Fed's playbook and specifically targeting asset prices.  This past weekend, Japan's Economic Minister Akira Amari said:

“It will be important to show our mettle and see the Nikkei reach the 13,000 mark by the end of the fiscal year (March 31),”
 

This is about another 15% from current levels and a full 50% from it November 14th close.  That would be quite the move in four and a half months.  Yet another fun wave to ride.

Japan?

Even after today's pullback, the Nikkei 225 Index is up over 22% since November 14, 2012. This is due in large part to the election results that brought the Liberal Democratic Party back to power. Since then Prime Minister Shinzo Abe has announced 10.3 trillion yen ($116 billion) in additional stimulus and continues to pressure the Bank of Japan to double its inflation target to 2%. Meanwhile, valuations such as price to book are significantly lower than average and earnings are expected to grow almost 50% this year.

Responding to expectations of more quantitative easing from the Bank of Japan, the yen has declined by approximately 11% over the same time period. This should be a big boost to Japan's export led economy.

In the short term, both the Nikkei and Yen appear overextended and should experience a pullback, which may have started today. While Japan faces both a large debt load and an aging population, the current combination of stimulus, expected quantitative easing, low valuations and earnings growth should allow for a further advance. The 12,000-12,300 area (or approximately 13-15% higher), would appear to be the first target.
 

However, as with all international investments you have to take into account the effect of the currency. In this case, a depreciating yen, while helping Japanese exporters, would hurt international investors as they translate their holdings back to their home currencies cancelling out some if not all of the benefit from the rising market. Therefore it is critical to hedge the currency effect away. Institutional investors can easily do this in the futures markets. Individual investors can do this by purchasing an ETF that tracks a Japanese stock index and then hedges out the currency.

Of the twelve Japanese equity ETF's I quickly found using the screener on www.etfdb.com only two indicate they are hedged, the Wisdom Tree Japan Hedged Equity Fund (DXJ) and the db-x MSCI Japan Currency Hedged Equity Fund (DBJP). Of the two, the DXJ has a lower expense ratio, more assets, and more liquidity. (Full disclosure I own DXJ ).

To illustrate the difference, below is a chart of the non-hedged iShares MSCI Japan Index ETF (EWJ). It is up 12.9% since November 14, 2012. A very nice return for two months, but below that of the Nikkei. Some of this is the difference in indexes, but the majority is due to the 11% drop in the yen.

 

For the same time frame the DXJ is up 22%, or over 9% points more. This is predominately because it has hedged out the effect of a declining yen thus enabling the foreign investor to gain the full benefit of the rising Japanese market.