Europe's Loss, America's Gain?

Investment returns for Q3 2014 range from mediocre to abysmal. Large cap U.S. stocks turned in the best results, rising an uninspiring 1.1 percent. Com­mo­dities, on the other hand, fell a jarring 12.5 percent, their worst quarterly showing since 2008. International stocks dropped 6.4 percent. Even real estate investment trusts, the best performing asset class so far this year, fell 2.5 percent in the quar­ter.

The market’s recent poor performance has many investors wondering if we are sliding into a new bear market or if the rally resume. Of course, no one really knows, but the evidence suggests brighter days ahead. We expect that corporate earn­ings growth and a strong dollar will con­tinue to draw investors toward U.S. equities.

CAPE Fear

Bearish investors often point to CAPE as the reason to expect a major market decline. CAPE stands for Cyclically Adjusted Price Earnings ratio and is calcu­lated by dividing the market’s current price by the trailing ten-year moving average of real earnings. Ten years of earnings history is used in order to smooth the impact of the economic cycle on the overall price/earnings ratio. CAPE was popularized by Robert Schiller, a Nobel prize-winning economist from Yale University. Schiller has credibility among many investors because he is one of the few who warned against both the 2000 dot.com bubble and the 2007 real estate bubble.

Currently, CAPE is 25.8—significantly higher than the long-term average of 16.57. However, the world has changed a lot since 1881 when Schiller’s data set begins, so it may make more sense to compare today’s CAPE with more recent history. For example, the 20-year average CAPE is 27.01, slightly higher than today’s level, and the 30-year average is 23.72, slightly below today’s level. As I read CAPE, the market is certainly not cheap, but it is also not exorbitantly priced.

Bearish investors also worry about flagging global economic growth and its effect on cor­porate profits. A good measure of cor­porate activity is the Purchasing Mana­ger’s Index. As this chart illustrates, the U.S. is currently enjoy­ing greater strength in manu­facturing than most other countries. Perhaps most troub­ling of all is the growing diver­gence between the U.S. and Germany. Germany’s sagging economy is a widely cited reason for the market’s recent sell off. But perhaps the concern is overdone. What if Europe’s problems actually help the U.S.?

Euroglut

An article published this past week by George Saravelo of Deutsche Bank offers insight into what may be happen­ing in the world economy and where we might be heading. In Saravelo’s mind, the culprit is weak domestic demand in Europe, leading to a condition he calls “Euroglut”, or too many euros chasing too few European investment opportunities. Saravelo writes:

Euroglut is a global imbalances problem. It refers to the lack of European domestic demand caused by the Eurozone crisis. The clearest evidence of Euroglut is Europe’s high unemployment rate combined with a record current account surplus. Both are a reflection of the same problem: an excess of savings over investment opportunities. Euroglut is special for one reason: it is very, very big. At around 400bn USD each year, Europe’s current account surplus is bigger than China’s in the 2000s. If sustained, it would be the largest surplus ever generated in the history of global financial markets.

The problem is compounded by the European Central Bank. Saravelo continues:

The ECB plays a fundamental role here: by pushing down real yields and creating a domestic “asset shortage”, it is incentivizing European reach for yield abroad….Think about policy over the next few years: at least 500bn-1 trillion of excess cash will be sitting in European bank accounts “earning” a negative rate of 20bps. In the meantime, asset-purchases will drive yields down across the board – there will be nothing with yield left to buy.

If Saravelo is correct, we need to ask ourselves what will happen as this glut of euros grows. The answer is simple: euros will pour out of Europe in search of better investment opportunities elsewhere. And where will those opportunities most likely be? In the United States, where economic growth is driving higher corporate earnings, and in other dollar-based economies (Latin America and Asia), where interest rates and returns are higher. In short, Europe’s plight could work to our advantage. Remember, liquidity flows always affect financial assets first.

Diversification matters

Of course, any talk of Euroglut and massive liquid­ity flows is still mostly prognostication. Nobody knows how this will really play out in the months ahead. So instead of trying to select the winning invest­ment, inves­tors are best served by main­taining proper diversification. The importance of diver­­sifi­cation can be seen by com­par­ing the risk and returns on bonds, U.S. stocks and inter­na­tional stocks over the past 10 years with a balanced portfolio invested one-third in each.

The balanced portfolio captures 90 percent of the S&P 500’s return, but cuts the investor’s risk by over one-third. Looking at it another way, an investor in the balanced fund could have picked up an additional 0.7% of annual return by moving to the S&P 500, but portfolio risk would have increased by 50 percent. Paying such a high price in added risk for such a modest gain in performance seems like a bad trade in our eyes. As we manage client portfolios, we evaluate these kinds of tradeoffs on an ongoing basis. Though there may be periods of time when one particular asset class outshines all others, the evidence clearly shows that it pays to diversify.