There’s a strange disconnect today between some investors’ trepidation about U.S. stocks and the soothing signals coming from the equity market.
As my Bloomberg colleague Barry Ritholtz recently noted, a whole bunch of high-profile money mavens — Stan Druckenmiller, George Soros and Bill Gross included — are kvetching about the dangers lurking in U.S. shares (among other places).
I wrote a column yesterday about how our highly-valued U.S. stock market, and the importance of earnings estimates in generating price-to-earnings ratios — which are one of the most pivotal valuation gauges for investors. And a P/E ratio, after all, is only as good as the earnings assumptions baked into it.
I looked at three ways that investors might try to forecast current-year earnings: 1) Use analysts’ estimates; 2) Assume results will approximate last year’s earnings, and 3) Calculate an average of the last several years’ worth of earnings.
The time has come to talk about U.S. stock valuations because we now have some unsettling metrics in our hands.
On Friday, the U.S. Commerce Department said that U.S. gross domestic product grew by just 1.2 percent in the second quarter, far lower than the 2.5 percent growth that analysts expected. This is the third consecutive quarter of disappointing GDP growth – the U.S. economy grew by 0.8 percent in the first quarter and by 0.9 percent in the fourth quarter of 2015.
Just as troubling is the growing reluctance by companies to invest in capital and inventory (investments that lay the groundwork for future growth). Gross private domestic investment (which includes residential investment by landlords) declined by 9.7 percent in the second quarter. This also follows declines in the first quarter and in the fourth quarter of last year of 3.3 percent and 2.3 percent, respectively.
Guess what? For the first time in six years, value stocks are on track to edge out momentum stocks.
As my Bloomberg News colleague Oliver Renick put it, “It’s been a great year for catching falling knives.” Renick is alluding to value investors’ fear of grabbing a plummeting stock, only to watch its price plummet further.
Europe’s economies — hence, Europe’s markets — have had a tough go-of-it over the last several years, despite central bankers making historic efforts to revivify the region. The U.S., by comparison, has been a raging success (despite the fact that, for investors at least, the post-financial-crisis U.S. recovery is much untrusted and much unloved).
Let’s look at U.S. and European stock performances over several years. The S&P 500 Index returned 12.6 percent annually during the five-year period from January 2011 to December 2015 (including dividends), while the MSCI Europe Index returned just 4.5 percent annually over the same period.
When investors talk about stock investing, they mostly talk about the small questions. Which way is the market trending? Where are we in the market cycle? (Insert your favorite piece of financial punditry here.)
Those questions may be entertaining, and a prescient investor might even profit from the right answers, but investors are probably no worse off — and may even be better off — if they tune out those conversations entirely.
The recent coup attempt in Turkey, however, raises a pivotal question that every stock investor must confront: Will Turkey continue to respect a rule of law that bolsters free enterprise and vibrant markets?
Early signs aren’t encouraging. President Erdogan has imposeda state of emergency, and Turkey’s parliament handed the government emergency oversight yesterday, effectively allowing Erdogan to impose martial rule. Mass imprisonments and a civil service purge have followed.
The state of emergency is expected to last several months, and Deputy Prime Minister Mehmet Simsek has tried to reassure nervous investors that “business will be as usual” and that Turkey remains “committed to the market economy.”
But investors don’t seem reassured. The Borsa Istanbul 100 Index has dropped 14 percent on heavy volume since last Friday. More telling, the Index has declined every day this week despite the fact that the coup was squashed last weekend and well before Turkish stocks began trading on Monday.
Investors, in other words, aren’t bothered so much by a failed coup as about what comes next. Their concerns are well placed — there’s good reason to believe that weak rule of law is associated with greater risk for stock investors.
Turkey is one of eleven emerging market countries – along with Brazil, Mexico, Philippines, Indonesia, Thailand, Malaysia, Greece, Taiwan, Korea and Chile — with an MSCI stock index that stretches back to 1988 (other emerging market locales have later inception dates).
So I compared the historical return and standard deviation of each legacy MSCI country stock index with that same country’s average rule of law score from 1996 to 2014 (as compiled by the independent research firm The PRS Group). Rule of law scores are given on a scale from zero to one, with one representing the strongest rule of law. (Standard deviation is a common market proxy for risk that measures the volatility, or bumpiness, of investment returns).
What I found was that the correlation between the countries’ rule of law scores and the standard deviations of their stock indices was a negative 0.24. In other words, weaker rule of law is correlated with greater stock market volatility, and vice versa.
Brazil, for example, had the lowest rule of law score (0.35) of the eleven countries, and the MSCI Brazil Index had the second highest standard deviation (50 percent). Chile, on the other hand, had the highest rule of law score (0.81), and the MSCI Chile Index had the lowest standard deviation (24 percent). (To put this in perspective, the S&P 500 and long-term U.S. government bonds have had a standard deviation of 19 percent and 8 percent, respectively, since 1926.)
Risk and return go hand in hand, of course, so it’s also true that weaker rule of law is correlated with higher returns, and vice versa. The correlation between the countries’ rule of law scores and the annual returns of their stock indices was a negative 0.5.
Mexico, for example, had the second lowest rule of law score (0.38) of the eleven countries. The MSCI Mexico Index returned 17.1 percent annually from January 1988 to June 2016 (including dividends), handily beating the return on the MSCI Emerging Markets Index of 10.6 percent annually over the same period. But risk cuts both ways. The Philippines had the third lowest rule of law score (0.43), and the MSCI Philippines Index returned only 8.6 percent annually over the same period.
All of this brings us back to Turkey, which at first glance looks like an outlier. Turkey’s rule of law score (0.67) puts it near the middle of the pack, but the MSCI Turkey Index had the highest standard deviation (54 percent!) of the eleven countries. What gives?
It turns out that Turkey hasn’t been a model of stability when it comes to rule of law. Turkey’s rule of law was weak in the 1990s, and the rolling ten-year standard deviation of the MSCI Turkey Index was upward of 60 percent back then. In the 2000s, however, Turkey’s rule of law strengthened, and the Index’s standard deviation drifted down to just below 40 percent, where it remains today.
But here’s the most important thing to note, I think: Turkey’s rule of law has been weakening since 2010, and its annual rule of law score was lower in 2014 than at any point since 1996. It’s hard to imagine that Turkey’s rule of law scores won’t continue to weaken even further following this week’s developments.
The upside for investors is that Turkish stocks will have to extend the carrot of higher expected returns to investors to attract them — and investors will have to decide whether the risk is worth it.
If 2015 was the year that nothing worked, then 2016 is shaping up to be the year that everything worked. Bonds are up. Stocks are up. Real assets are up. Gold is up. Go ahead – pick your favorite asset — it’s likely to be up as well.
Markets aren’t supposed to work this way. Every asset is meant to have its season. If investors are feeling peppy, for example, they’re supposed to buy stocks. If they’re feeling blue, they’re supposed to buy bonds. And those gold bars buried in the backyard, of course, are a security blanket for those occasional freak outs.
No one knows, of course, what awaits the U.K. in the aftermath of Brexit. But investors and analysts are already anticipating one fallout: a steep drop in U.K. real estate prices.
The fear of a correction in U.K. real estate is wreaking havoc on open-ended U.K. property funds. Investors want out of those funds, but there’s only so much liquidity to go around. For one thing, fund managers can’t just snap their fingers and turn real estate into cash.
More problematically, if property funds sold real estate portfolios at the same time to satisfy redemptions, then property values would tank and investors would be handed deep declines. (This quandary reminds me of an old Steve Martin joke about an investing book called, “How I Turned a Million in Real Estate into Twenty Five Dollars Cash.”)
U.K. property funds caught in a liquidity crunch are doing the only thing they can — temporarily suspending redemptions — and seven funds so far have locked up for some period of time since the Brexit vote.
Fidelity announced its less-than-groundbreaking entry into the booming world of smart beta in April with the launch of a large-cap, value ETF. Now the mutual fund giant is back in the news with another me-too move: It recently cut prices on 27 passive index funds in order to beat or match the already low, low fees that its largest competitor, Vanguard, charges for similar funds.
Jim Lowell, editor of the Fidelity Investor newsletter and website, called the move “hugely significant” — but perhaps that’s a slight exaggeration. The Fidelity Small Cap Index Fund, for example, cut fees from 0.23 percent to 0.19 percent, and the Fidelity 500 Index Fund cut fees — wait for it — from 0.095 percent to 0.09 percent.
Still, it’s easy to see why Fidelity felt like it had to do something. Investors are increasingly demanding lower fees, which is somewhat problematic for a fund family like Fidelity that is widely associated with expensive, actively-managed funds. According to Fidelity, investors yanked close to $19 billion (net) last year from its actively-managed stock funds. At the same time, investors poured a record-breaking $236 billion into Vanguard, a bastion of low-cost, passively-managed funds.
Fidelity no doubt wants to get on the right side of fund flows, but let’s get real — some modest fee cuts to Fidelity’s index funds aren’t likely to transform Fidelity into a go-to passive manager. Fidelity can, however, do something truly significant: It can slash prices on its actively-managed funds.
Steven Major, HSBC Holdings’ head of fixed-income research, calls Brexit a mere “sideshow.” Howard Marks says Brexit isn’t likely to have a meaningful effect on the economies of the U.K. or the European Union. George Soros thinks Brexit has unleashed a 2008-sized debacle. Larry Summers views Brexit as the worst shock to Europe since World War II. Paul Krugman predicts that Brexit will make Britain substantially poorer.
I don’t belong on the same list as the worthies noted above, but last week — before Brexit happened — I questioned how much EU membership actually boosted the U.K.’s GDP or productivity after joining the group in 1973. I thought dismal currency and market outcomes had already been baked into the U.K.’s performance going back years. How much worse could it really get, I wondered?