Research Watch

Japan’s Asian threat, the China syndrome, emerging markets pressures, Dow dynamics, a Buffett battle looms, and conversations in Goldman’s elevator.

Summary: This week’s Research Watch covers a range of investment snippets, including Japan’s Asian threat, the China syndrome, emerging markets pressures, Dow dynamics, a Buffett battle looms, and conversations in Goldman’s elevator.
Key take-out: There are fears Japan could lose control of its money printing presses, spurring a replay of the 1997 Asian crisis.
Key beneficiaries: General investors. Category: Portfolio management.

As equity investors cheer the Bank of Japan’s latest reflation efforts, there are niggling fears the central bank might yet lose control: Societe Generale notes some worrying similarities with the beginning of the Asian financial crisis. Meanwhile Goldman Sachs, which has just covered its timely gold short, sees value in China despite headwinds that continue to batter emerging markets. In the US, Barron’s latest “Big Money” survey sets new records for bullishness — although John Hussman and Mark Hulbert see things differently — as asset managers mourn the death of the 60-40 portfolio model. Doug Kass prepares to go one-on-one with Warren Buffett and, on video, puppets act out secrets leaked from the Wall Street elevators.

Could Japan trigger another Asian financial crisis?...

“We have just returned from a marketing trip to Hong Kong and Singapore and had some very fruitful conversations with clients. Much of the discussion centred on the likelihood that the Bank of Japan (BoJ) would lose control of the printing press and how a rapidly declining yen would lead to a replay of the 1997 Asian currency debacle. It seems investors may have forgotten that yen weakness was one of the immediate causes of the 1997 Asian currency crisis and Asia’s subsequent economic collapse. We discussed how that scenario might mirror what is happening today. We have noted previously that China has seen a pronounced rise in its real exchange rate in recent years — mirroring events in Thailand, Malaysia and South Korea in the run-up to the 1997 crisis (and indeed the GIPS prior to the Eurozone crisis). In addition, China, and many other key EMs have seen a trend deterioration in their balance of payments, partly as a result of the repatriation of foreign direct investment — again echoes of 1997. Hence despite a $128 billion rise in China’s first quarter foreign exchange reserves to a record $3.44 trillion, we note the yoy growth rate is still only a paltry 4%. And although 4% is an improvement on recent data, it is a far cry from the rapid growth rates of recent years and represents a huge monetary tightening that may help explain recent poor Chinese data.” (Albert Edwards of Societe Generale via Pragmatic Capitalism, April 18)

Stop shorting gold...

“We have closed our recommendation to short COMEX Gold, as prices moved above the stop at $1,400/toz. We have exited the trade significantly below our original target of $1,450/toz, for a potential gain of 10.4%. The move since initiation was surprisingly rapid, likely exacerbated by the break of well-flagged technical support levels. Our bias is to expect further declines in gold prices on the combination of continued ETF outflows as conviction in holding gold continues to wane as well as our economists’ forecast for a reacceleration in US growth later this year.” (Goldman Sachs, April 23)

And start buying Chinese stocks...

“Chinese stocks are becoming attractive with the decline in equity valuations and corporate profit growth poised to level out, according to Goldman Sachs Asset Management. ‘We are probably at the trough of the earnings and valuation cycle,’ Alina Chiew, head of Greater China equity at the New York-based bank’s asset management arm, told reporters in the city yesterday. ‘It’s a very interesting time to get into it.’ While the Hang Seng China Enterprises Index, which tracks stocks trading in Hong Kong, slumped 7% this year to yesterday, member company earnings rose 1.7% in the three months through March 29, the first uptick since June, data compiled by Bloomberg show. The Bloomberg China-US Equity Index of 55 Chinese stocks in the US has dropped to 12 times estimated earnings, almost 50% below its valuation in March 2012. … ‘The market needs to wean itself off expectations of double-digit growth out of China,’ Chiew said. ‘Investors should adjust the fair valuation that they are willing to pay. The key to investing in China is being able to ride out the cycle over the medium term and forget the bumpy ride in between.’” (Bloomberg, April 24)

Although emerging markets are still under pressure...

“What’s behind this underperformance in emerging markets stocks? It seems that a number of simultaneous developments has contributed to the sell-off:

  1. The spectacular decline in shares of Apple has put downward pressure on some of its Asian suppliers and related technology firms.
  2. Weaker than expected growth in China is contributing to the sell-off.
  3. The emerging strength of Japan’s exporters due to rapid yen devaluation is hurting the regional competitors, particularly in South Korea. The KOSPI index is down over 6% year-to-date.
  4. The recent violent commodity sell-off especially in metals and energy is pressuring commodity producers such as Russia. Russia’s export sector is a one-trick pony, except for some arms sales and a sprinkle of IT services. That’s why with oil sharply lower, the Russian stock market is down 13% year-to-date. Other commodity exporters, from Brazil to South Africa, got hit as well.
  5. Negative economic surprises in the US are not helping.”

(Sober Look, April 18)

Dow 16,000!...

“The stockmarket isn’t the only thing that has set records this spring. Barron’s semiannual Big Money poll of professional investors also is setting a record — for bullishness, that is. In our latest survey, 74% of money managers identify themselves as bullish or very bullish about the prospects for U.S. stocks — an all-time high for Big Money, going back more than 20 years. What’s more, about a third of managers expect the Dow Jones industrials to scale the 16,000 level by the middle of next year, notwithstanding a dismal week of selling that left the blue-chip index at 14,547.51 on Friday. (Barron’s, April 20)

Or not...

(John Hussman of Hussman Funds, April 22)

In fact, Wall Street is unlikely to be much higher in four years time...

“That sobering forecast comes from a simple stock-market timing model that has turned in the best performance of any in forecasting the market’s four-year return. … [It’s] based on a single number that appears each week in the Value Line Investment Survey, the flagship publication of Value Line, a New York-based research firm. The number represents the median of the percentage gains that Value Line’s analysts estimate the 1,700 widely followed stocks they monitor will produce over the next three to five years. Over the past five years, for example, this number … has been as low as 45% and as high as 185%. It currently stands at 50%. … Those who do follow the VLMAP for market-timing purposes use it to project where the market will be in four years, the midpoint of the analysts’ three- to five-year horizon. Because Value Line’s analysts — like most of Wall Street — are on average too optimistic, followers of the VLMAP often adjust it downward when translating it into a specific four-year forecast. For example, Dan Seiver, an emeritus economics professor at Miami University of Ohio and chief economist at Reilly Financial Advisors in La Mesa, California, told me that he advises clients to use any VLMAP reading below 55% as the occasion to build up cash. Noting that the current reading of 50% is only marginally higher than the 35% level registered in the weeks leading up to the bull-market high in October 2007, Mr. Seiver currently advises … to allocate 40% to 50% of their equity portfolios to cash.” (Mark Hulbert via The Wall Street Journal, April 19)

The 60-40 model is dying...

“The 60-40 strategy is rooted in modern portfolio theory, first popularized in the late 1950s, which holds that diversification among asset classes helps boost returns. The problem, in a nutshell, is that low bond yields — driven by the Federal Reserve’s policy of keeping borrowing affordable — combined with historically low stock dividends have thrown the model out of whack. … A 2012 study by Chris Brightman, head of investment management at Research Affiliates … predicts that a 60-40 portfolio will yield a 4.4% annual return from 2011 to 2020. If that turns out to be true, it would mark one of the worst decades ever for the strategy. In the periods 1981-1990 and 1991-2000, in contrast, the strategy yielded annual returns of 14.3% and 14.4%, respectively. Such a slowdown could cause problems for adherents, especially when it comes to retirement planning. ‘You should not plug in an assumption that [a 60-40 portfolio is] going to return 7% or 8%,’ Mr. Brightman says. To replace the strategy, some financial professionals are turning to alternative investments — like commodities, foreign currencies, real estate or even private equity — that weren’t easily accessible or widely used when 60-40 method became popular.” (Market Watch, April 23)

And Kass is preparing to battle Buffett...

“Douglas Kass, the investment manager selected by billionaire Warren Buffett to ask questions at Berkshire Hathaway’s annual meeting next week, has hit the books in preparation for the challenge. The fund manager said in an interview yesterday that he’s reading Alice Schroeder’s more-than-800-page biography of Buffett and other titles to get ready for the May 4 gathering in Omaha, Nebraska. It’s taken about 10 hours on average for each question, he said by phone. ‘We can’t lose sight that this company, and Mr Buffett as a person, has been combed over with questions,’ said Kass. ‘It’s not like this is a breeze. I think he expects something of me, and I don’t want to disappoint him.’  Buffett, 82, has sought to refocus attention at the meeting on Berkshire by allowing journalists and analysts to alternate with the audience in asking questions of him and Vice Chairman Charles Munger. Kass, founder of Seabreeze Partners Management, answered Buffett’s call to change the panel by adding an investment professional who’s betting on the stock’s decline.  … ‘I do know Mr Munger is going to call me a chump for being short his stock,’ Kass said. ‘I’m ready for the put-down. I have thick skin.’” (Bloomberg, April 23)

Video of the Week: Overheard in the Goldman Sachs elevator...

“In a video homage to the popular twitter feed, @GSElevator, puppets bring to life verbatim comments that did not stay in a Wall Street elevator.”
Graph for Research Watch

Click here to watch the video.

(CNBC, April 19)