Beat the market doldrums

PORTFOLIO POINT: As markets remain balanced between positive and negative forces, it’s harder to be bullish, but still difficult to be completely bearish. Investors need to think outside the square.

As Alan Kohler wrote on the weekend, any prediction of a market rally was snuffed last week by warnings of contagion spreading not just to Spain, but to Italy – the Eurozone’s third-largest economy – and by the continued intransigence of getting a Republican House to agree with a Democrat President on the US government’s debt ceiling.

Add to that the latest news of eight banks failing the European Banking Authority’s stress test and continued signs that US Fed chairman Ben Bernanke won’t come to the rescue with a third round of quantitative easing, as briefly thought last week.

All in all, it doesn’t look good for a sustained rebound on the macroeconomic front then. But is it really so bad?

While things have been volatile in Washington, Wall Street has recorded a brilliant start to the second-quarter earnings season, with 74% of the companies reporting so far exceeding analysts’ estimates. Amid downgrades for key stocks here in Australia, US profits are up, on average, by 6.5% over the corresponding period last year. It makes one wonder who’s supposed to be enjoying the strong economy.

In Europe, meanwhile, Germany continues to grow unabated, without the typical asset class bubbles that you see in so-called “Anglo-Saxon” markets like ours. And it’s more than just a case of a weak euro, thanks to Greece et al. Germany’s economic miracle is also down to productivity improvements, sustained internal demand, an absence of deleveraging and low borrowing costs, despite the recent rate rise from the European Central Bank. And just think: all this has been possible with a green economy as well.

The only problem though, as always, is Germany’s Weltschmerz. Despite latest forecasts of 3.4% GDP growth in 2011, economists are tipping that Tuesday's ZEW economic sentiment index will fall to a very bearish –11 on the continual problems at the Eurozone's periphery.

But all this angst belies the reality. And while I wouldn’t be bullish in the face of skittish investors and depressed Germans, the Eurozone still has plenty of ammunition left in its policy arsenal, a point admirably made by Polish Prime Minister Donald Tusk, whose country has recently begun its rotating six-month presidency of the EU and which, after all, has faced far greater historical hurdles in the past 100 years than Greece likely ever will (see Continental drift).

The US also has far greater options at its disposal than many commentators or ratings agencies would suggest. As Winston Churchill said, the Americans can always be counted on to do the right thing once they have exhausted all the other possibilities. When the debt ceiling is finally lifted – and a policy combining tax increases and spending cuts is made to ensure a more sustainable fiscal deficit – expect the Greenback to rally (see Greenback in fashion).

Having said all that, we shouldn’t discount the time-tested ability for policy makers – European and American – to stuff things up in the face of compelling logic. The strong possibility of an eventual solution to the developed world’s debt debacle shouldn’t (and doesn’t) discount the tail risk of a collapse, which is why markets continue to range-trade, rather than recover. If a fortune teller told you, for instance, that there was a 10% chance of dying in car crash today, many would probably stay home, or catch the train. Same with the market: the risks may be small in probability, but they’re big in consequence.

So what can you do? By going long equities at the present, it is possible you will be vindicated on a short-term horizon, but the small risk of catastrophe (which always exists, but nevertheless seems to be more apparent these days) more than justifies caution on a risk-adjusted basis, if you believe in the efficiency and intelligence of the market that is.

By going long equities you also open yourself to the risk of continued outperformance by “safe-haven” asset classes such as gold or the US dollar. And on that topic, the yellow metal breached the $1600 during today's session which makes my call to sell gold on May 2 (see Gold is looking overdone) appear a little premature

Beyond the simplistic risk-on/risk-off trade that the market seems to be employing as a whole, a more nuanced approach I believe is to stay exposed to stocks, but to be highly selective in the stocks you own on both a bottom-up and on a thematic basis.

At the risk of sounding like a broken record (see Look beyond the ASX 200), I think investors should be brutal with their portfolio and reconsider many blue-chips that have performed well in the past but won’t necessarily perform well in the coming years (see The dirty dozen).

Investors should also ask themselves whether their stocks justify themselves in terms of capital growth, safety or yield. I’d say most don’t and those that do tend to be either small in market cap or heavily discounted (see The diminutive dozen and The discounted dozen).

Investors should allocate a greater portion of their portfolio to cash as well. Rachel Williamson on Friday wrote a review of retail cash accounts (see Are bonus savers worth the trouble?). Some of the yields on these products more than give most blue-chips a run for their money in terms of risk-adjusted returns.

And conversely, while I’ve been saying the Australian dollar looks overbought, and it is indeed still quite below its May 2 peak, investors needn’t hedge this risk by buying cash in US dollars. Instead, by gaining US exposure via equities, investors can enjoy the strong yield of the Aussie dollar with the attractiveness of an undervalued greenback in stocks. Such a strategy would have indeed performed well over the past year, judging from the chart below, which tracks the performance of America’s S&P 500 index, versus the Australian dollar and the ASX 200.

US equity exposure can be had through US stocks and US dollar-denominated index products directly if your brokerage costs are reasonable enough, or via a range of exchange traded funds on the ASX.

Vanguard, one ETF provider, offers the US Total Market Shares Index ETF (Code: VTS), while iShares offers an S&P500 ETF (Code: IVV), a Russell 2000 index of small cap US stocks (Code: IRU) and several global indices, which contain US companies, including the mega-cap Global 100 (Code IOO), which includes Exxon Mobil, IBM, Chevron, General Electric and Microsoft among its biggest holdings.

Finally, US exposure can be had via Australian equities themselves. It’s often said that blue-chip plasma company CSL Limited (CSL) is an Australian investor’s typical US dollar exposure, considering that most of that company’s revenue is earned in the currency, but investors need not restrict themselves to this. The same could be said for other major healthcare stocks such as ResMed (RMD) and Cochlear (COH), and non-healthcare stocks such as Wotif.com (WTF), which is based on the fortunes of domestic holiday making would rebound on a stronger US dollar (see Online's sleeping beauty and Now boarding). Investors will nevertheless need to assess the merits of these stocks as individual companies as well.

At the smaller end of the market, healthcare minnows such as Sirtex Medical (SRX – see Health sector's sleeper) hold appeal. While they tend to get ignored by the market, deep value is eventually realised, as holders of Cellestis Limited discovered. Cellestis was profiled by us last year [LINK] when it traded at $2.39. In April this year Dutch group Qiagen NV made an offer for $3.55 per share. On Monday last week, this offer was increased to $3.80 per share.

With a bit of creativity, common sense and research, retail investors can do quite well out of a sideways trading market when institutional investors – hampered by low liquidity and restrictive mandates – cannot make up their minds as to whether the market is going to perform or collapse.

There are certainly significant risks on the horizon, but there are also significant opportunities. To my mind, the biggest risk always has been and remains in China, which I believe is far more exposed to structural weakness than most Australian investors realise. Having said that, my own bearishness on China’s fixed asset overhang was somewhat assuaged last week when I attended a presentation by eminent Chinese economist Xiaolu Wang.

While the topic – his controversial “grey income” thesis, that Chinese households are massively understating their wealth by between 5 trillion and 9.3 trillion renminbi ($A727 billion to $A1.351 trillion) – has caused much teeth-gnashing in Beijing, it also presents a far rosier picture than official statistics suggest should China’s government find itself in a debt debacle of its own making – this time due to dodgy construction and infrastructure projects financed by the billion through local government off-balance sheet vehicles (sound familiar?).

And when one considers that China has faced non-performing debt crises in the past and survived – as was pointed out to me by Westpac economist Huw McKay at the same conference – even a collapse in property prices there need not end China’s growing economic miracle. But while this illustrates that there’s a silver lining to any dark cloud, I’m still not convinced that Australian resource export growth would survive any type of crisis in Chinese housing or fixed asset investment.

And now with more data coming out that inflation is getting worse and China is in a bona fide property bubble (see also Property boom’s Chinese foundations for China’s link to our own frothy real estate market), I wouldn’t want to be too cavalier with investing in mining or mining services companies.

Overall, upside and downside risks are finely balanced in the big picture, but investors who are small and nimble enough can still enjoy good returns if they look hard enough. Increasing your cash exposure on one side while looking for counter-cyclical, deep-value and US dollar-exposed stocks in your equities exposure, would be a good start.