First off, the U.S. market is simply looking “toppy” to me. That doesn’t mean there is a crash or a bear market in the future (although that is a real possibility), but the outsized returns of the last four or five years are unlikely to be repeated. Will Denyer and Tan Kai Xian of Gavekal have made the case that it no longer makes sense to overweight U.S. equities, which had been the firm’s position for many years:
Our issue is that three key drivers of U.S. equity outperformance are going into reverse:
1) In recent years the Federal Reserve was the most aggressive liquidity provider in the world — this is no longer the case. In fact, the Fed is making moves toward tightening, while everyone else is easing.
2) In recent years the U.S. benefited from an extraordinarily competitive currency — this is no longer the case. In a very short period, the U.S. dollar has gone from being significantly undervalued against almost all currencies, to being fairly valued against most, to now being overvalued against the likes of the euro and the yen.
3)In recent years U.S. equities were attractively priced — this is no longer the case. On a number of measures the market is stretched.
Even though the Federal Reserve rate hike has probably been pushed off into the third quarter, it will soon be priced into the market. Fed rate hikes usually lead to price-to-earnings (P/E) compression, whether or not there are strong earnings. But since almost half of S&P 500 earnings come from outside the U.S., a strong dollar is going to weigh heavily on those earnings. Procter & Gamble has said currency costs will reduce its earnings by $1.4 billion after-tax this year. It is not alone.
Further, more than half of S&P 500 companies have P/Es over 20; and, to put it bluntly, bull markets do not begin from valuations at this level. The Russell small-company index is down for the last year, quarter, month, week, and day. Small companies in general are in a bear market (though numerous small companies, typically ones that are tech-focused in some way, are having a banner year).
So, where do you go if you are taking money off the table from the U.S.? Counterintuitively, the coming Greek crisis suggests that we might want to look to Europe. To understand why, let’s review what’s going on in Greece.
The euro-positive Greek crisis?
As we read the headlines, it would appear that Europe is heading for a major confrontation over Greece. The Germans and other Europeans have made it very clear that there will be no haircut on Greece’s debt. Tsipras and his left-leaning coalition party, Syriza, were elected on the basis that there would have to be major haircuts in the Greek debt, as well as relief from the austerity requirements imposed by the Troika (the ECB, IMF, and European Commission) in the wake of the last Greek bailout.
Within a few weeks, Greece will need significant loans to make its debt payments and to pay its bills. The requirement for getting those loans is that Greece must adhere to the regime that was agreed to by the previous government. Tsipras and company have made it quite clear that they do not intend to do so. If they don’t, it is highly unlikely that they will get the Emergency Lending Assistance (ELA) from the European Central Bank that would be needed to bail out their banks. Money appears to be leaving Greece, and deposits are at their lowest levels since 2012.
A Greek exit from the Eurozone has the potential to precipitate a crisis. An excessively permissive compromise by the Eurozone might also create a crisis. Deutsche Bank gives us the following chart (hat tip to my friend Barry Ritholtz at The Big Picture):
Everybody, and I mean everybody (not just the Germans), recognizes that Greece cannot actually pay its debts. A 175% debt-to-GDP ratio is simply unsustainable at an interest rate of 4%, let alone at the level to which rates have risen in the last few months. While Greece is running a primary surplus, which means they are taking in more revenue than they’re spending (if you don’t count interest and loan repayment costs), they are nowhere close to actually covering the interest-rate expenses they are accumulating. They are digging themselves an ever-deeper hole, and the austerity measures are keeping the country mired in a state of depression.
However, if Europe does the seemingly humane thing and forgives the bulk of the debt, then parties on both the far left and the far right throughout Europe may demand the same deal that Greece gets. You can almost guarantee that far-left coalitions in Italy and Spain and the far-right party in France would come to power as a result. That would eventually blow up the Eurozone and potentially even the European Union — not exactly what European leaders want.
This is not a situation that is going to fester for a long time, as the clock is ticking and debt payments will have to be made in the very near future. So what will happen? I think it might help us to look at who actually owns that Greek debt.
There are restrictions on what the ECB and the IMF can do in regards to debt relief, and private investors are not going to be thrilled with any solution that does not fulfill the terms of their bonds. Coming up with a compromise is going to be very complex.
That said, my sources tell me that a tentative deal has already been reached that will look like the balanced compromise scenario in the chart above. Tsipras, so I am led to believe, has tentatively agreed to a deal by which the bulk of Greek debt will be extended to 40 or 50 years at 0% interest, or something in that range. That is not the debt forgiveness that he promised his followers, but it is the next best thing.
continue reading: https://www.mauldineconomics.com/frontlinethoughts/portfolio-strategies-2015-investing-in-an-age-of-divergence
