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.

Anecdotes vs. the Fed

As the S&P 500 Index nears its all time high of 1,565, anecdotal evidence of an imminent top keeps piling up.   This past weekend, the front page of the New York Times had an article on small investors getting back into the market.  CNBC has their little bugs in the bottom right of the screen with how many points to go to the all time high.  It is hard to find a bear on the major financial news outlets.  Bill Gross, Dan Fuss and Jeffrey Gundlach are moving into equity management.  (Okay maybe not this last one, since they are all smart guys and after all how much more can you squeeze out of bonds with the ten year Treasury around 2%?  But the others definitely qualify.)

Against this stands the Fed and many of the other central banks of the world.  By nailing short term rates to zero and doing their best to keep the rest of the yield curve as close as possible, they have been trying to force investors out on the risk curve.  As the Ned Davis chart below shows, it appears that they are finally succeeding.  After years of outflows, equity funds have experienced large inflows so far this year.

 

Source: Ned Davis Research

While there are many reasons that the market should not go up, it continues to defy the skeptics.  The main reason appears to be the unrelenting liquidity supplied by the Fed and now supplemented by individual investors.  It is apt that this week surfer Garrett McNamara possibly broke his own record by riding a an approximate 100 foot (30 meter) wave.

Source: Guardian



In many ways, staying invested in this market is similar.  Both are powered by huge amounts of liquidity, can take you a lot further than you think, it is an exhilarating ride, and can end either in glory or disaster. 

"You can't stop the waves, but you can learn to surf"
John Kabat-Zinn

 Learn to surf (investments).

S&P Nears All Time High. What's The Plan?

The markets have been on quite the tear recently.  The S&P 500 Index finished above 1,500 on Friday and is within 5% of its all time high.  Good news abounds and investors seem very optimistic(see Is the Whole World Bullish?).  So what does this mean for your portfolio?  Is it time to dive in with both feet?  Or is it time to take some funds off the table? 

 

There are two opposing possibilities at play here.  The bullish case is that we are only in the early stages of a long run bull market in stocks and is supported by two main pillars.  The first is that the 'Great Rotation', the shift back into equities by the retail investor, has begun.  The big inflows into equity mutual funds and ETF's this January after years of outflows are brought out as evidence of this.  The second pillar is that the secular bear market, that started in 2000 is over.  A good summary of this case was tweeted in early January by noted technician Ralph Acampora,  who continues to be bullish. 

 

The bearish case has multiple pillars.    The Shiller 10 year adjusted P/E is still over 20, Europe's structural problems continue,  the US faces increased regulation and legislative gridlock, Japan is initiating a new currency war, the UK is on the verge of a triple dip recession and S&P 500 earnings, while better than expected are barely growing.  At the same time everyone is getting optimistic, so it must be time for a correction.

 

So what to do?  Remember, it all comes back to you and what works for you and what your goals are.  As in most cases, it is better to have a plan in place in case of emergency than to have to think one up as the world falls apart. The same is true of investments.  If you don't have a plan in place, make sure your advisor does.  And make sure you are both on the same page about it.  If not, get a plan in place. 

 

First I would check to make sure that your portfolio's overall asset allocation is in line with your planned targets.  If not, rebalance back to them.  The next step is where looking at investments through multiple time frames comes in handy.  So as not to miss the potential for a long term advance, I would leave long term core positions in place. This is because while long term stock P/E's are expensive, as the old Wall Street saying goes "Markets can stay irrational longer than you can stay solvent."  Alan Greenspan's 'Irrational Exuberance" speech was in 1996.  The markets continued to go up until 2000.  And you don't want to miss that type of ride.  Also, what if the bulls are right and we are in the beginnings of a secular bull market?  The last one went from 1982 to 2000.  And you definitely don't want to miss that ride. 

 

But what if the bears are right?  For that scenario, any short term, trading, or tactical positions should be reviewed and possibly have their risk management parameters adjusted.  In addition, I would be very careful about initiating new positions at this point.  Particularly any marginal ones.  A 5-10% stock market correction could offer a better entry point.  That does not mean don't buy anything at all, it just means you should be more selective and only initiate positions in those investments with truly compelling reward-to-risk ratios.  Anything close to a previously researched upside exit point, would be on a very, very short leash, so as to preserve the gains.   

 

By having a plan and looking at the markets through multiple time frames, it is much easier to block out alot of the constant noise from the street and achieve your financial goals.  What's your plan?

 

 

 

 

 

 

 

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.