Stock prices will continue to rise, if U.S. growth remains in the range of 3.1%-3.3%, says Janney, Montgomery, Scott. Barclays is bullish on Chinese stocks and emerging markets as a whole in the near future. Federated recommends Danish and Norwegian stocks. Behavioral finance expert Shlomo Benartzi explains why stock prices change with the weather, plane crashes and soccer victories and how to help clients stick to rational decisions.
Mark Luschini, Janney, Montgomery, Scott.
A barrage of earnings announcements hit the financial airwaves last week. The news was mostly better than consensus expectations. So far more than 1,000 companies have reported on their businesses for the first quarter and about two-thirds beat earnings estimates, while almost three-quarters exceeded revenue estimates. The latter of the two is important because top line growth will ultimately facilitate the job creation that has been sorely lacking in the post-recession recovery. Encouragingly, revenue growth is a reflection of increasing economic activity both here and abroad – and comes despite the lingering worries of high oil prices and creeping input costs.
For the week, the Dow Jones Industrial Average finished ahead by 305 points, or 2.5%, at 12,811. That was the Dow’s fifth positive week in the last six weeks. For the month of April, the Dow rose 4%, putting it ahead by 10.65% year-to-date and just 10% below its peak level in October 2007. Aiding stocks, besides terrific news on the profit front, are low interest rates, global growth, unencumbered balance sheets and little competition for investors’ attention given the paltry rates offered by fixed income securities. And yet, even as stock prices have powered higher, valuations remain undemanding. It is expected that profits this year will exceed those of the previous high which occurred in 2007 – a time when, concurrently, the stock market reached its all-time high of 14,164. So today’s stock market multiple of 13-14 times 2011 earnings seems attractive. Importantly, a reasonable valuation helps to provide a cushion against an unwelcome event which could disrupt the pleasant backdrop for equities.
Slowing growth, if it were to occur, could derail the equity express. Last week’s reading on GDP for the first quarter was somewhat weak, although it was widely expected. GDP advanced at a 1.8% annualized pace, well below the 3% rate coming out of the end of last year. While far too soon to declare a threat, and with most pundits looking for the growth rate to quicken, it does give pause in the event the weakening in spending and investment should persist. Last Wednesday, Federal Reserve Chairman Ben Bernanke shared the Fed’s forecast for 2011 – stating the first quarter’s numbers would be a drag – but still proclaimed growth to be in the range of 3.1%-3.3% for this year. If that holds, equities should continue their advance, even if some of the easier gains may already be in for the year.
Barclays Wealth, May Compass.
Is China “overheating”?
The primary concern facing the Chinese economy, currently, is one of overheating – as reflected in the tight employment situation, high urban real estate prices, and rising inflation. The latter is largely a result of high commodity and food prices. If left unchecked, however, pessimists argue that rising inflation could lead to price instability, economic boom-and-bust cycles, and, potentially, social unrest. As a result, capital and property markets have witnessed significant corrections since 2010, although year-to-date,the equity market has registered a tentative rebound.
Increasingly, consensus has started to shift from a central scenario of an economic “hard landing” for
China to one of a “soft landing”. But to address residual pessimism, we need to tackle several key
issues, namely:
1. Will China indeed experience a “hard landing” on the back of recent credit tightening measures and
continued expected increases in interest rates?
2. Is the sustained Chinese growth of the last two decades about to end abruptly? That is, is China a
“bubble”?
3. Are current concerns over growth and inflation a recent and new phenomenon?
4. What has been driving growth in China in the last 20 years? Is it different this time around?
Five-Year Plans: road maps for growth
We believe that answering these questions requires an understanding of the role of Five-Year Plans in China’s recent economic history. The economic proposals of the Communist Party of China (CPC) are encapsulated in these Five-Year Plans, the first of which started in 1953.
From 1991-1995, the 8th Five-Year Plan focused on the reform of China’s economic system. As a result,
China registered an average annual growth rate of 11%, which was 4% higher than the period of the previous Five-Year Plan. However, in the mid-1990s, Chinese inflation hit more than 25% and credit and monetary tightening measures were introduced. The markets experienced similar sharp corrections to what we are seeing now.
The CPC then introduced the 9th Five-Year Plan for 1996-2000, which focused on the establishment of a modern enterprise system – especially the development of capital markets. After several interest rate hikes, real interest rates subsequently turned positive again, and asset prices resumed their upward trend. It was a classic case of an economic boom-bust cycle. Post-2000 Five-Year Plans have consistently aimed to tame such cycles. China's 10th (2001-2005) and 11th (2006-2010) Five-Year Plans have targeted urbanisation and infrastructure spending. Economic growth accelerated again until inflation reared its ugly head in 2004-2005, and then again in 2008 (at almost 9%), resulting in a series of rate hikes.
Anticipate a soft landing for China
In the aftermath of the global credit crisis in 2009, inflation enjoyed a brief reprieve before creeping up to its current level of 5%. Once again, “hard landing” stories were circulating in the marketplace for the whole of 2010, in the face of several real estate tightening measures announced by the government.
This time around, the central bank has tried proactively to rein-in inflation and an overheated economy.
China’s GDP in the first quarter of 2011 grew at a real year-on-year rate of 9.7%, marginally down from 9.8% in the fourth quarter of 2010. The numbers suggest a “soft landing” scenario, in line with Barclays Capital forecasts of 9.3% GDP growth for 2011 as a whole.
For the second half of the year, we expect further moderation in both growth and consumer price inflation, which bodes well for the medium-term economic outlook. Unsurprisingly, the Chinese equity market was one of the worst market performers last year. However, year to-date, Chinese equities have managed to stage a mild recovery, in anticipation of the 12th Five-Year plan (2011-2015).
The 12th Plan: strategic industries
This plan seeks to address rising inequality by targeting sustainable economic growth, with an emphasis on domestic demand, and the seven announced key strategic industries.
We believe that these two factors – the emphasis on domestic demand, and the seven key industries –could spur the medium-term GDP outlook for the Chinese economy. In selecting the seven strategic industries, the CPC is trying to target a more sustainable growth strategy by setting the following objectives:
1. It aims to address issues that could limit growth potential, such as pollution.
2. It seeks to create new growth opportunities, such as in aircraft manufacturing;
3. It endeavours to develop critical technologies, which could result in sustainable export dollars
(such as biotechnology)
4. It aims to capitalise on China’s absolute and comparative advantages (such as rare earth elements), and
5. It aims to improve national security by focusing on alternative energy, potentially reducing its reliance on oil imports.
The government expects the seven strategic industries to contribute approximately 8% and 15% of GDP by 2015 and 2020, respectively. These targets will be supported by favorable policies such as tax concessions, research subsidies, preferential pricing, and availability of cheap financing.
However, this may not necessarily translate into success for every company within the strategic sector/industry. Investors will still need to be selective in stock-picking by identifying firms with core competencies, and business/strategy execution capabilities driven by some competitive edge. In so doing, investors can build a portfolio of corporate champions that provides an effective exposure to the growth of these strategic industries.
Chinese equities: valuations are attractive
In summary, we believe the 12th Five-Year Plan could serve as a clear and reliable road map of developments in the Chinese economy over the next few years. Meanwhile, Chinese equities remain attractive based on a multiple of 11.6 times prospective earnings for the MSCI China. This is below the 5-year historic average of 13.5 times, and is also attractive relative to the Asia ex-Japan regional PE of 13.0 times. The attractive valuation is, moreover, backed by the improving corporate earnings outlook for Chinese firms.
In conclusion, in anticipation of lower inflation rates and a successful Five-Year Plan, we maintain a constructive view of the Chinese equity market. We recommend that both short- and long-term investors accumulate Chinese stocks, especially on any market weakness.
Koon Chow and George Christou, Barclays Emerging Markets Weekly.
De-risked but not distressed
The agreement on Portugal’s bailout package and a generally healthy set of PMI data this week should encourage investors to view EM assets positively. The de-risking we have seen this week was probably more technical in nature, namely profit-taking ahead of the ECB/BoE and payrolls data.
Downplay the de-risking
Notwithstanding the results of the US payrolls data due for release later today, the key developments this week should result in investors looking positively towards EM assets. The agreement on Portugal’s bailout package was reached quickly and in line with political consensus (in Lisbon). The size of the package (EUR78bn, the equivalent of 45% of the country’s 2010 GDP), in our European economists’ view, reflects the determination of the EU authorities to ring-fence problems in the periphery. On the data front, this week has seen a generally healthy set of PMI data releases both in developed markets (DM) and in EM. Also, even though EEMEA PMI saw a slight setback and US non-manufacturing ISM surprised to the downside, our economists see little to worry about in either of these regions, for now.
The de-risking that we have seen in global equities and, to some degree, in currency space in EM has been rightly modest and we think, mainly technical in nature (eg, profit-taking ahead of ECB/BoE and payrolls data). We believe overall EM positioning by real money investors is helpful, and with trading in recent weeks punctuated by public holidays, it seems unlikely that speculative positions in EM local or external markets are extensive.
We think key beta factors for EM assets are still pointing in a positive direction: US rates and Treasury yields remain contained; and our FX analysts believe that EUR/USD, in spite of a recent correction, is likely to head higher. The uptrend on EUR/USD should offer some positive pull for EM currencies.
With the exception of RUB and MXN, EM currencies have not overstretched themselves given where EUR/USD has already moved to. If there is a common ‘restraint’ on EM FX, it is probably the temporary break for payers that we currently see, with lower carry providing a little less appeal for yield-focused currency longs.
Payers can take a break but should be vigilant on commodity prices
Global oil and food prices have recently moderated, which may contribute to some erosion in the amount of hikes priced in the near term and therefore, the potential for payers to perform. However, we believe this is unlikely to last long for several reasons. First, our EM inflation surprise index (updated for the March inflation prints) was still positive; that is, inflation has still been surprising to the upside (though the index has recently come down off its highs). In addition, policy surprises are still occurring (India surprised with a larger hike than we and the market expected this week). This is generally symptomatic of narrowing output gaps in EM as a whole (certainly when compared with DM) which should continue to support our long FX and payer recommendations in the medium term. Second, our commodity research colleagues still strongly emphasize the role of both demand and supply fundamentals in keeping commodity prices high and skewing the risk outlook, The correlation coefficient between commodity prices and EM equities has returned to positive territory since March, suggesting a ‘good scenario’ for risk taking. To put another way, commodity prices and equities confirm the same thing - strong global demand. We note, however, that while demand-driven commodity price increases are less worrying for EM (as it is likely to be supplying most of the demand), our commodities team does not rule out the return of supplyside concerns in the coming months, particularly for oil given the potential for a further deterioration in Yemen and Bahrain. On the food side, supply shocks have already taken their toll on grain prices and should continue to pressure food prices higher. The risk is that if supply-side pressure re-asserts itself, EM assets may see a repeat of February’s price action.
We believe that a positive message should be conveyed on EM assets and that, despite our concerns on EM inflation, it should also encompass some relief for EM fixed income in the near term. The latter should not last, hence our characterisation of a ‘break’ for payers.
More seriously, we remain sensitive to an inflection point in terms of EM assets’ reactions to rising commodity prices. Specifically, we are sensitive to the point where rises are not viewed as confirmed strong global demand, but a challenge to it. We do not see the market being at that inflection point in the next few weeks but it joins our list of tail risks that we highlighted in our recent publications.
Nichola Noreiga, Federated Investors
Although several peripheral European countries are struggling to regain their economic footing, Scandinavian nations Norway and Denmark appear to have turned the corner. Nichola Noriega, Federated's International Equity Strategist, explains what distinguishes their strong comeback and whether it's sustainable over the longer term.
Q: How have Norway and Denmark distinguished themselves from many other European economies coming out of the recession? The Norwegian and Danish economies had different experiences during the Great Recession, but both have made strong recoveries.
Norway had a very shallow recession, with GDP down only 1.4% in 2009, which was one of the best outcomes in Europe. This result was probably helped by the fact that oil prices started recovering in 2009, and oil is a major contributor to Norway's economy. In addition, Norway's solid fiscal position enabled the government to pump a sizeable amount of stimulus into the system. In fact, among developed countries, Norway is one of the few 'creditor nations.' A budget surplus, a current account surplus and a relative low-debt-to-GDP level allowed the government to aggressively tackle the slowdown. As a result, the Norwegian economy was back on a growth path as early as the second quarter of 2009.
Denmark's recession experience was more severe than Norway's. Its GDP was down 5.2%, which was a bit more in line with the experiences of other European countries. But similar to Norway, Denmark remained in a relatively sound fiscal position. This allowed the government to support the economy in the downturn and, we believe, contributed to the very strong market performance over the past couple years.
Q: How has the recovery evolved in those economies? In Norway, the private economy recovered quickly and is taking the baton from the government's fiscal stimulus in driving economic growth. Scandinavia dealt with its own banking crisis back in the 1990s and, as a result, Norwegian banks are run relatively conservatively. They had limited exposure to the subprime mortgages and structured products at the heart of this recent crisis and were in reasonably good shape coming out of it. Additionally, financial authorities introduced several measures to ease liquidity concerns which proved successful and helped stabilize the banking system. We subsequently saw credit standards ease in 2009 and credit growth pick up, lending support to the recovering economy.
Norwegian exports have been very strong, helped early on by a decline in the currency back in 2008. The currency has strengthened, but Norway is still running a very large current account surplus. Close to 50% of Norway's exports are in the oil and gas industries which have clearly rebounded over the past couple years. However, they are also gaining share in manufacturing and other exports.
The Norwegian consumer is also in good shape. Unemployment has stabilized at just 3.5%, residential property prices have rebounded and interest rates are still pretty accommodative. Consumers are feeling confident and they are spending.
Similarly, we've seen signs in Denmark that the private sector is replacing the government as the main engine of growth. Denmark has a very open economy and exports have grown as the global recovery progressed and that has been a boost to the domestic economy. It thrived because of its trade links with strong countries like Germany and other key growth economies. Exports also have benefited from the country's history of innovative product development and superior manufacturing. Additionally, income tax cuts and a stabilized housing market have boosted consumer confidence and supported increased personal consumption.
Q: Can you tell us what you particularly like about the prospects for Danish and Norwegian companies? We believe the prospects for many Danish companies are still very strong. Companies domiciled in Denmark are among the highest quality corporations due to their above-average profitability and below-average leverage. Denmark is home to industry-leading shippers, food product manufacturers, brewers and pharmaceutical companies. These companies not only have strong positions within their domestic markets but are growing and taking market share internationally.
There are several companies in Norway, particularly in the energy and financial industries, that are beneficiaries of ongoing strength in that economy and globally. These companies are benefitting from steady earnings growth, strong cash generation and are able to reward investors with substantial dividend yields.
Q: What about a longer-term view for these countries? Norway and Denmark's high-quality, low-risk economies have created an environment for continued growth. Additionally, given their exposure to the global recovery, which we expect to remain on track, their export markets should do well.
That said, while we expect that GDP in Denmark will continue to expand, growth is likely to slow down a bit in 2011. The government is now focused on lowering budget deficits through austerity programs in the next few years, which will result in lower spending and potentially higher taxes and these will have an impact. Nonetheless, companies in Denmark are set to produce above average earnings growth and the stock market should be rewarded.
GDP growth in Norway is expected to accelerate a bit in 2011 and 2012 given the country's strong position in the oil and gas industries. Companies in Norway are also producing above-average growth and are trading at very attractive valuations.
Both of these markets have several characteristics that make them attractive investment opportunities and they are both well-positioned to continue to outperform.
Shlomo Benartzi, Center for Behavioral Finance, Allianz Global Investors
In characteristically provocative manner, Warren Buffett had this advice for investors in his 2004 Chairman’s Letter: “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”
According to standard economic theory, people make investment decisions based on a rational analysis of the present value and future prospects of equities. It is clear from his advice to investors, however, that the Oracle of Omaha recognizes that factors other than rational analysis are sometimes at play.
Buffett understands from his years of experience that investors often buy high and sell low. They also often buy the wrong stocks, sell the wrong stocks and, in normal times, do far too much buying and selling. Academic insights from Behavioral Finance help explain why people behave the way they do, and they offer practical solutions to financial advisors to help their clients make better investment decisions. The idea is that people are not being stupid, they are just human.
Here, we introduce The Ulysses Strategy, which engages the reflective mind for rational short- and long-term investment strategies, thereby avoiding the errors that the intuitive mind is otherwise prone to make.
Financial advisors are well aware of the herd mentality of humans, which sometimes leads individual investors to buy high and sell low, by plunging into rising markets and fleeing when markets fall (Bikhchandani et al., 1992; Galbraith, 1993). But there are other psychological issues at play in the behavior of individual investors, beyond fear and greed, impulses that flow from the intuitive mind.
Overconfidence is as strong an urge in humans as the herd instinct. It leads people to believe they can outperform the market, and seduces them to trade stocks at an irrationally high rate. It’s a costly path to follow. One study of 66,465 individual investors over a six-year period in the United States found that the average investor turned over 75 percent of his/her portfolio each year. Transaction costs associated with this excessive trading reduced net performance by 3.7 percent compared with the market as a whole. Investors who traded most (in the top quintile) did even worse: these people turned over their portfolios more than twice each year, and as a result suffered a 10.3 percent reduction in net performance (Barber and Odean, 2000; see also Daniel et al.,1998). This is the expenses trap that Buffett mentioned in his letter.
A separate study of transactions in 19 major international stock markets produced equally salutary warnings against the urge to beat the market by too frequently buying and selling securities. Between 1973 and 2004, the average “penalty” for repeated buying and selling as opposed to a buy-and-hold strategy in these markets was 1.5 percent (Dichev, 2007).
Faced with thousands of possibilities, individual investors are ill-equipped to make rational decisions about which stocks to buy. Most people simply don’t have the time or expertise to find fairly valued stocks or under-valued stocks. As a substitute for appropriate analysis, many people unconsciously fall back on a simple rule of thumb, or heuristic: What stocks are in the news? Buy them.
Apparently, it matters not at all why a company happens to be in the news – the launch of a new product, large one-day moves on the market (up or down), even a scandal involving the CEO – these stocks are bought disproportionately by individual investors (Barber and Odean, 2008). This is the intuitive mind taking the easy way to making a choice, one that, if fully engaged, the reflective mind might reject.
Inevitably, attention-driven buying pushes prices beyond true value, and investors once again do less well than they expect.
The intuitive mind is at work in the very common mistakes people make in selling stocks they already own. The rational investor would sell losers and hold on to winners. But this is not what individual investors commonly do: They sell winners too early and losers too late. This error is called the disposition effect.
This is how it works for investors. An individual who owns a stock that has appreciated significantly faces a choice: hold or sell. If they sell, they lock in a gain, and they feel good about that. But by selling they forfeit any possibility of further price appreciation and accept the certainty of paying taxes on their profit. If a stock has lost value, however, the investor faces the prospect of admitting a loss if they sell, and that feels very bad. Loss aversion kicks in and most investors choose instead to hold on to the stock.
They now face the possibility of further deterioration in price, and the certainty of passing up tax advantages if they were to sell, which is what they perhaps should do.
The disposition effect is the result of mental accounting. The rational investor would be interested in the overall return of their portfolio, and be content to say, “You win some, you lose some, but overall it’s doing well.” Instead, the typical investor treats the portfolio as a series of investing “episodes.” A winning stock offers the opportunity to sell, and so lock in a gain, and the investor experiences the pleasure of that gain. They sell. This is a positive investing episode. A losing stock offers the prospect of incurring a loss, and experiencing the pain that goes with it. They hold, and in so doing avoid a negative investing episode (Barberis and Xiong, 2010).
Stock markets often move in response to many factors unrelated to true value. For instance, a commercial plane crash in the United States that kills 75 people or more typically causes the NYSE briefly to shed around $60 billion in value. This reduction in market value contrasts with the actual economic cost of such incidents (incurred by the airline and insurance companies) of around $1 billion (Kaplanski and Levy, 2010). In countries where soccer is a major sport, a loss by the national team leads to a significant decline in that country’s stock market (Edmans et al. 2007). And weather – gloom or shine – has been found variously to affect stock markets, too (Laughran and Schultz, 2004; Hirshleifer and Shumway, 2003).
Investor mood associated with irrational fear of plane crashes or the ignominy of one’s national team losing, is apparently at work here. The resulting dark mood causes investors to view future economic conditions more pessimistically, so they favor selling rather than buying.
As you have seen here, and as Columbia School of Business professor Kent Daniel1 observes, “The evidence that investor emotions are influencing prices of securities is becoming overwhelming.” No less a figure than former Fed chairman Alan Greenspan admitted as much while appearing before the House Committee on Oversight and Government Reform in October 2008. He said of the idea of self-correcting markets: “The whole intellectual edifice …collapsed in the summer last year.” The challenge for behavioral finance is to find ways to help people not go with the crowd, and not be susceptible to the errors of the intuitive mind. Here we offer such a solution.
The phrase “Ulysses contract” refers to a decision made in the present to bind oneself to a particular course of action in the future. It derives from a strategy that Ulysses adopted on his journey home from the Trojan wars, which took him and his ship’s crew close to the Sirenusian islands. The islands were famous for being home to the Sirens, whose songs were so irresistibly seductive that seamen felt impelled to fling themselves into the waters, in an attempt to reach the Sirens. No seaman ever survived, so no living human knew the nature of the Sirens’ songs.
Ulysses wanted to be the first human to hear the songs, and survive. He instructed his crew to fill their ears with beeswax, to block out the sound, and then tie him securely to the mast and to ignore his pleas to be released, should he do so. The plan worked. Ulysses heard the Sirens’ songs, the crewmen ignored his entreaties to be untied and when they were out of earshot, he gave a pre-arranged signal to take out the ear plugs and release him. Ulysses had committed himself to a rational course of action at a neutral time, that is before he could hear the Sirens’ songs, and ensured that he stuck with his decision. This action of pre-commitment is the work of the reflective mind.
In the same way, financial advisors could invite their clients to engage their reflective mind to pre-commit to a rational investment strategy in advance of movements of the market that might otherwise trigger irrational responses of the intuitive mind. This kind of Ulysses Strategy has been shown to work with the Save More Tomorrow program (Thaler and Benartzi, 2004), in a pilot savings product in the Philippines (Ashraf et al., 2006) and in a program to help smokers quit, which involved participants depositing a sum of money in an account that they would forfeit if they relapsed (Giné et al., 2008). Pre-commitment to a rational investment plan is important, because the intuitive impulse to act otherwise is strong.
The first step in the process is to help your clients understand the psychology of trading by individual investors that can lead to poor decisions. Help them understand that these misguided impulses of the intuitive mind are quite natural, but that there is another, better path to follow, one that is guided by the reflective mind.
The second step is to agree on an investment strategy, which would include an acceptable balance between risky and conservative instruments. As financial advisors, you are already very familiar with this. What would be novel for most advisors, however, is to commit to a specific contingency plan. This is an agreement made in advance about what action will be taken should a certain event or condition occur: for example, if the market goes up 25 percent or if the market goes down 25 percent.
The third component of the Ulysses Strategy is to formalize these agreements in a commitment memorandum, to which both the client and the financial advisor are parties. Although research shows that financial professionals are less affected by the impulses of the intuitive mind, they are not completely immune to them (Barber and Odean, 2000).
And by being co-signatories to the memorandum, financial advisors put themselves on the same footing as their clients. This memorandum is not binding, in the sense of a legal contract. But the act of writing down the agreements and putting one’s signature to it helps people resist the siren call of the intuitive mind. It helps clients stick with the plan when changes in market conditions might tempt them to go with the herd, and make unwise decisions. And it helps financial advisors honor the agreement, too.
