Research Watch

Amid all the cheer about the ASX punching back through 5,000 points and the Dow climbing towards new all-time highs, there’s a certain sense of deja vu. Indeed, the Fed has now pushed Warren Buffett’s preferred valuation metric to levels not seen since the frothiest years of the tech and housing bubbles, which reminds Jeremy Grantham of Einstein’s workable definition of madness: constantly repeating the same actions but expecting a different outcome. While Grantham still sees value in certain markets, Goldman Sachs has gone so far as to downgrade equities the world over. Watch out below. On the other hand, Macquarie argues Australian earnings are beginning to justify the domestic rally, and shareholders are finally pressuring companies to invest for growth. Meanwhile, Charles Schwab unveils its portfolio pyramid, Morgan Stanley details its currency war strategy and, in the spirit of Alan’s weekend emails, the latest in the world of pets of finance. In other animal news, ring in the Year of the Snake by applying the ancient Chinese art of feng shui to your portfolio.

Buffett must be worried...

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“For the first time since the recovery began, Warren Buffett’s favourite valuation metric has breached the 100% level. That is, of course, the Wilshire 5,000 total market cap index relative to gross national product (GNP). I point this out because it’s a rather unusual occurrence and the recent move has been fairly sizable. It happened during the stockmarket bubble of the late 90s, then occurred again just briefly during the 2006-2007 period when the valuation broke the 100% range in Q3 2006 and stayed above that range for about a year. We all know what followed the 2007 peak in stock prices.” (Pragmatic Capitalism, February 13)

Grantham’s getting picky...

“Courtesy of … Fed policy, all global assets are once again becoming overpriced. This reminds me of the idea sometimes attributed to Einstein that a workable definition of madness is constantly repeating the same actions but expecting a different outcome! But, as always, asset prices are not uniformly overpriced: emerging markets and, we believe, Japan are only moderately overpriced. European stocks are also only a little expensive, but in today’s world are substantially more risky than normal. The great global franchise companies also seem only moderately overpriced. Forestry and farmland, which is not super-prime Midwestern, is also only moderately overpriced but comes with our nook and cranny sticker attached. But much of everything else is once again brutally overpriced. Notably, US stocks (ex ‘quality’) now sell at a negative seven-year imputed return on our numbers and most global growth stocks are close to zero expected return. As for fixed income – fugetaboutit! Most of it has negative estimated returns on our data, and longer debt, as always, carries that risk that may be slight in any period, but is horrific if it occurs – accelerating inflation. When one combines the apparent determination and influence of those who do the bullying with the career risk and short-termism of the bullied and the desire of the general public to believe unbelievable good news, these overpricings can go much further and the Fed can win another round or two. That’s the problem. A clue to timing would be when we begin to hear more passionate new era arguments: profit margins will always be higher; growth will snap back to 3% for the developed world; and new ones I can’t think of… maybe ‘when the discount rate is this low the Dow should sell at, perhaps, 36,000.’ In the meantime, prudent managers should be increasingly careful. Same ole, same ole.” (Jeremy Grantham, chief investment strategist at GMO, February 2013)

And Goldman just downgraded the world...

“World stock markets have rallied to levels not seen since the collapse of Lehman Brothers, but the bull market has screeched to a halt and now one of the world’s largest investment banks has downgraded its outlook for global equities. The resolution of the ‘fiscal cliff’ and the passing of a bill to extend the United States’ debt limit in January had consolidated the risk-on trade in recent weeks, with the S&P 500 and Dow Jones Industrial Average both up over 6% in January. But markets have been treading water in February and Goldman Sachs says that any risk that existed at the end of last year is now split between a number of different events. ‘We think the equity market will need time to digest the recent gains,’ Goldman said in a research note, although its long-term view is still pro-risk ‘Asset prices have moved a long way and are now very close to our 3-months targets.’ … ‘We believe that investors are now much more relaxed about European risks, and though we agree that risks have diminished, we are still far from a solution, and market focus on the remaining risks could flare up again,’ it said. Any sell-off in equities is set to be short lived, according to Goldman Sachs, and it has downgraded its outlook from overweight to neutral for three months, but is still overweight over 12 months.” (CNBC, February 12).

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But upgrades could justify the upswing...

“It is notable that the normal ‘downgrade the near term forecast upgrade the outer year forecast’ trend has not been seen this reporting season to date (although we acknowledge it remains early days). Indeed, both FY13 & FY14 EPSg forecasts for the market have seen upgrades… albeit small. … The strong equity market gain of the last three months has left the Australian equity market trading on an extended valuation (a one-year forward P/E ratio of 14.2x). If, however, this reporting season was to highlight that the long period of downgrades has troughed this we believe would be enough to hold investors hope that the strong FY14 EPSg currently forecasts might indeed be able to be relied upon to justify the recent rise in share prices.” (Tanya Branwhite of Macquarie Group, February 11)

And corporate cash might finally be back in play...

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“Bank of America Merrill Lynch’s Michael Hartnett just published this chart showing investors’ evolving attitudes toward corporate cash. … As you can see from the dotted line, during the financial crisis, investors wanted companies to use their cash flows to slash debt and build up their cash positions. After the crisis, we were left with a global economy in critical condition with limited growth prospects. As you can see from black line trending up, investors wanted their shareholder value returned in the form of dividends and buybacks. But in more recent months, you can see a burst of optimism manifesting in the blue line, which represents the desire for more capital expenditures. In other words, investors want companies to take some risk and invest in growth.” (Money Game, February 12)

How does your portfolio stack up?...

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1. The foundation of the portfolio pyramid is asset allocation. Your asset allocation determines the broad risk level of your portfolio, which should match your risk profile.
2. Market cap denotes the percentage of large versus small companies in the stock portion of your portfolio. Small-cap stocks tend to be riskier than large-caps, but have the potential for more upside. A sound diversification plan includes both, because nobody knows which of these two asset classes will be in favour at any particular time.
3. Next up is style, or the balance between stocks with a greater-than average growth orientation and value- (stocks with a less-than average growth orientation) investing. We recommend a mix of both.
4. Every stock is in an industry, and every industry is in a market sector. Holding too many investments in the same sector can be risky.
5. The 10 sectors comprise 65 industries and 134 sub-industries. Even when a sector’s performance is up, not all industries within that sector will perform identically. For a balanced diet, after you diversify across sectors, diversify across the industries within a given sector.
6. As with sectors and industries, your portfolio should include a mix of different countries. For example, the Morgan Stanley Capital International All Country World Index (MSCI ACWI) includes 45 developed and emerging markets around the globe.
7. It can be risky to have all of your actively managed mutual funds with the same portfolio manager. Suppose the portfolio manager leaves the firm? Or the fund company goes through a disruptive restructuring? How might changes like these affect your portfolio? Hence, it makes sense to diversify across managers, as well.
8. To reduce the risk of portfolio meltdown, diversify your stock holdings so that no more than 20% of your portfolio is represented by any one stock (including stocks held in mutual funds). Generally, you need 40-50 stocks for adequate diversification.

(Charles Schwab, February 8)

How to win the currency wars...

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“First, we’d argue that Japan PM Abe’s initiatives are designed to propel Japan from its 20-year battle with deflationary pressures. A weaker JPY is integral to this policy, but the intention is not to inflict pain directly on Japan’s competitors. Moreover, a stronger Japanese economy would be supportive to global growth. Second, verbal and actual intervention in EM is nothing new, and we still expect some EM currencies to appreciate in 2013, particularly in [Asia excluding Japan]. Still, it’s undeniable that (1) extraordinary monetary stimulus from DM countries has collapsed real interest rates, often leading to currency weakness; and (2) a number of EM and DM policymakers have either raised concerns on domestic currency strength or intervened directly to maintain export competitiveness. Recent price action in [the Korean won] and [New Taiwan dollar], for example, is a powerful reminder of policy-driven trend reversals.” (Evan Brown And Marc Englander of Morgan Stanley, February 7)

And Monti’s new mutt...

“Outgoing Premier Mario Monti on Thursday posted a picture of his newly adopted dog, Empatia (Empathy). Monti was given the small, white dog of no particular breed that was introduced as Trozzy on Italy’s La7 television program ‘Invasioni Barbariche’ during Wednesday evening’s transmission. TV conductor Daria Bignardi first showed Monti a photo of ex-premier Silvio Berlusconi kissing his new puppy named Vittoria and asked if the Premier would be willing to adopt a dog as well. After taking Empatia in his arms, Bignardi asked how it felt to hold the fluffy puppy. ‘Magnificently good,’ Monti said.” (ANSA, February 7)

Video of the Week: Feng shui your finances...

CLSA guides your investment decisions during the Year of the Snake, based on the ancient Chinese art of feng shui.

(CNN, February 8)