Don’t Sell In May?
MCLEAN, VA–Last week’s discussion prompted many questions about the strength and sustainability of emerging markets in general and Asia in particular.
In other words, when will the rally end?
For starters, the main point of the previous issue was that the overall economic environment remains hospitable for stocks. As I noted, “Markets could, however, decline for a number of other reasons (e.g., high valuations, loss of momentum, external shocks). But a decline attributable to economic weakness or corporate performance doesn’t seem likely, at least not yet.” (See SRI, 3 March 2006, Still Going.)
The straightforward and quick answer to the above question is, “Whenever people stop asking.”
This is usually the case with bull markets; once everyone starts getting comfortable with the prevailing market action (in this case extreme outperformance of emerging markets), the market turns decisively down.
The view here remains that a selloff will definitely be harmful to Asian stocks, but the region’s markets–including Japan–will recover nicely and much faster than many observers expect. I’ve offered a rationale for this assessment on many occasions; it’s based on the view that 1998 marked both a bottom for Asian markets and the commencement of a new multiyear bull market. This new bull market is supported by superior Asian growth prospects and the consequent, though gradual, return of local investors to their home stock markets (see SRI, 15 February 2006, The Rules Of Engagement, and 22 March 2006, Until It Melts).
As summer approaches the old adage “sell in May and go away” is starting to circulate again. Investors seem to be especially nervous with regard to Asia, as the market is up 20 percent since the beginning of the year. And after looking at markets around the world, I have to admit the possibility for a correction has increased dramatically. At the same time, valuations in Asia remain low at 13.7 times the long-term price-to-earnings ratio, while dividend yields are solid. Both factors would be very helpful in a down market. In addition, in 2004 and 2005 May was, technically speaking, a great time to buy Asia. See the chart below.
Source: Bloomberg
The SRI Portfolio is balanced and, as indicated by a beta of 0.86, has low volatility. Hence, I expect the portfolio to hold up well in a turbulent market.
The biggest risk for global markets continues to be the wild action in commodities. I was a member of the editorial team of another newsletter, and we were fortunate enough to identify this bull market in commodities three years ago. And I still think this bull market is genuine and can go on for a long time. But the fact that prices have gone parabolic–copper is trading at $8,000 a ton–could prove very disruptive.
As I noted in early March, “The main fear in the commodities market is that China might need to take a breather. The wild speculation–there are so many new funds that have been created for the sole purpose of investing in hard commodities that it’s easy to lose count–built into the metals will therefore cool off.
“A selloff in commodities is more likely than not. And given that no one knows at what level it will stop, although some people claim they do, investors should be prepared. Take profits off the table and reduce your exposure to mining stocks and the like. There will be better entry points ahead.” (See SRI, 8 March 2006, Hedge Your Bets). Unfortunately, in the same issue, I suggested a short in BHP Billiton; the trade didn’t work out and I subsequently recommended closing the position.
Nevertheless, the view here remains that commodities will correct because indications are that China wants them to. Reports out of China point to a profit squeeze for domestic manufacturers, much of which is attributed to high commodity prices (although other issues are also at work). Add to this the obvious efforts by the Chinese to cool down their economy–two weeks ago the People’s Bank of China raised the 1-year lending rate by 27 basis points to 5.85 percent–and it’s not difficult to see that if the Chinese successfully slow down their economy commodity prices will drop.
Of course, things don’t work instantly in the markets; one can therefore only hope that the parabolic rise of commodities price won’t result in a dramatic bust that painfully distorts the commodity bull. See chart below for commodities index.
Source: Bloomberg
Currency issues remain atop everyone’s agenda. The Chinese have indicated that the renminbi (RMB) will continue to appreciate, and quite a few analysts expect a faster appreciation than we’ve seen to date. I anticipate that Asian currencies will continue to gain against the US dollar (USD) as economic growth leadership continues to gradually shift from the West to the East (see SRI, 1 March 2006, The Butterfly Effect). The US Dept of the Treasury is aware of this, and will refrain from naming China as a currency manipulator in a report on exchange rate policies to be released today. If the US Treasury is silent on the matter, the Chinese will certainly be eager to show good behavior and would probably expedite RMB appreciation.
The USD is also losing value against the euro (EUR). For the time being, the European Central Bank (ECB) has held its irritation to itself, because Asian currencies are shouldering the weight. In other words, the EUR doesn’t have to appreciate against the USD and Asian currencies at the same time.
The following chart is revealing. It depicts the EUR-South Korean won (KRW) relationship (KRW per EUR) and clearly shows the rise in EUR-KRW (i.e., depreciation of the KRW) during the last dollar selloff. But the recent move demonstrates that the EUR has been able to mitigate some of the burden of the current dollar fall, as the right side of the chart demonstrates (i.e., KRW appreciate against the EUR).
Source: Bloomberg
The above picture fits well with SRI’s call for a global currency realignment where the dollar will remain the reserve currency, but from a lower base. Diversification in other currencies is therefore recommended, especially on a longer-term basis.
Investment Themes
One of SRI’s investment themes regarding Asia is the return of local investors to their home stock markets. This is happening for the simple reason that they’re optimistic about their futures and thus more willing and eager to participate in the changes that are taking place. Given the scale of the socioeconomic evolution in Asia, now local investors are coming back “institutionalized.”
What I refer to are changes in the pension systems across Asia; pension funds in India and China, for example, can buy equities for their portfolios for the first time. In addition, investing schemes like US-style 401-K plans have been implemented (in South Korea and Taiwan) and are planned for other countries, including Thailand.
What’s underway in Asia will have long-lasting positive consequences for the markets, as countries have realized they need to do more to be able to pay for pensions as people retire. So they’re creating mandatory defined contribution schemes within which individuals will have more choices in investment styles. They’ll be able to generate better returns than prevailing extremely conservative pension schemes.
The main idea is to allow a little more exposure to equities. In Taiwan, for example, the equity ceiling for the labor pension fund was raised from 30 percent to 40 percent. In Thailand, the government pension fund’s ceiling for domestic equity investment is expected to be raised to 30 percent; the fund has also begun investing in foreign markets. In India, private sector pension plans are now permitted to invest up to 5 percent in equities.
Although the implementation of these proposals takes time, it’s important to note the concentrated effort to cultivate and institutionalize an equities culture in Asia, following the American prototype. At the same time, individual investors are starting to feel more comfortable allocating a bigger part of their assets to the equity markets, thus providing additional leverage to the effort.
This is undoubtedly bullish for Asia’s markets, as the move is being coordinated by governments and is therefore more difficult to reverse. As institutional assets increase, Asian markets will gradually exhibit characteristics of more mature markets.
South Korea was one of the first to allow its national pension fund to increase it allocation to equities, and investors have been buying into the market via monthly installment payments to equity funds. The Korean market has responded extremely positively–it’s up 75 percent since the beginning of last year.
Banks and other financial institutions in the region will continue to benefit, and should form the core of an Asia-focused portfolio.
Although we already have a couple of banks in the SRI Portfolio, I’m adding one more, Korea-based Shinhan Financial Group (NYSE: SHG). Shinhan is involved in all aspects of the financial industry. The stock has performed quite well and we might see some short-term weakness, but a diversified portfolio should be able to absorb the commotion.
Source: Bloomberg
In other words, when will the rally end?
For starters, the main point of the previous issue was that the overall economic environment remains hospitable for stocks. As I noted, “Markets could, however, decline for a number of other reasons (e.g., high valuations, loss of momentum, external shocks). But a decline attributable to economic weakness or corporate performance doesn’t seem likely, at least not yet.” (See SRI, 3 March 2006, Still Going.)
The straightforward and quick answer to the above question is, “Whenever people stop asking.”
This is usually the case with bull markets; once everyone starts getting comfortable with the prevailing market action (in this case extreme outperformance of emerging markets), the market turns decisively down.
The view here remains that a selloff will definitely be harmful to Asian stocks, but the region’s markets–including Japan–will recover nicely and much faster than many observers expect. I’ve offered a rationale for this assessment on many occasions; it’s based on the view that 1998 marked both a bottom for Asian markets and the commencement of a new multiyear bull market. This new bull market is supported by superior Asian growth prospects and the consequent, though gradual, return of local investors to their home stock markets (see SRI, 15 February 2006, The Rules Of Engagement, and 22 March 2006, Until It Melts).
As summer approaches the old adage “sell in May and go away” is starting to circulate again. Investors seem to be especially nervous with regard to Asia, as the market is up 20 percent since the beginning of the year. And after looking at markets around the world, I have to admit the possibility for a correction has increased dramatically. At the same time, valuations in Asia remain low at 13.7 times the long-term price-to-earnings ratio, while dividend yields are solid. Both factors would be very helpful in a down market. In addition, in 2004 and 2005 May was, technically speaking, a great time to buy Asia. See the chart below.
Source: Bloomberg
The SRI Portfolio is balanced and, as indicated by a beta of 0.86, has low volatility. Hence, I expect the portfolio to hold up well in a turbulent market.
The biggest risk for global markets continues to be the wild action in commodities. I was a member of the editorial team of another newsletter, and we were fortunate enough to identify this bull market in commodities three years ago. And I still think this bull market is genuine and can go on for a long time. But the fact that prices have gone parabolic–copper is trading at $8,000 a ton–could prove very disruptive.
As I noted in early March, “The main fear in the commodities market is that China might need to take a breather. The wild speculation–there are so many new funds that have been created for the sole purpose of investing in hard commodities that it’s easy to lose count–built into the metals will therefore cool off.
“A selloff in commodities is more likely than not. And given that no one knows at what level it will stop, although some people claim they do, investors should be prepared. Take profits off the table and reduce your exposure to mining stocks and the like. There will be better entry points ahead.” (See SRI, 8 March 2006, Hedge Your Bets). Unfortunately, in the same issue, I suggested a short in BHP Billiton; the trade didn’t work out and I subsequently recommended closing the position.
Nevertheless, the view here remains that commodities will correct because indications are that China wants them to. Reports out of China point to a profit squeeze for domestic manufacturers, much of which is attributed to high commodity prices (although other issues are also at work). Add to this the obvious efforts by the Chinese to cool down their economy–two weeks ago the People’s Bank of China raised the 1-year lending rate by 27 basis points to 5.85 percent–and it’s not difficult to see that if the Chinese successfully slow down their economy commodity prices will drop.
Of course, things don’t work instantly in the markets; one can therefore only hope that the parabolic rise of commodities price won’t result in a dramatic bust that painfully distorts the commodity bull. See chart below for commodities index.
Source: Bloomberg
Currency issues remain atop everyone’s agenda. The Chinese have indicated that the renminbi (RMB) will continue to appreciate, and quite a few analysts expect a faster appreciation than we’ve seen to date. I anticipate that Asian currencies will continue to gain against the US dollar (USD) as economic growth leadership continues to gradually shift from the West to the East (see SRI, 1 March 2006, The Butterfly Effect). The US Dept of the Treasury is aware of this, and will refrain from naming China as a currency manipulator in a report on exchange rate policies to be released today. If the US Treasury is silent on the matter, the Chinese will certainly be eager to show good behavior and would probably expedite RMB appreciation.
The USD is also losing value against the euro (EUR). For the time being, the European Central Bank (ECB) has held its irritation to itself, because Asian currencies are shouldering the weight. In other words, the EUR doesn’t have to appreciate against the USD and Asian currencies at the same time.
The following chart is revealing. It depicts the EUR-South Korean won (KRW) relationship (KRW per EUR) and clearly shows the rise in EUR-KRW (i.e., depreciation of the KRW) during the last dollar selloff. But the recent move demonstrates that the EUR has been able to mitigate some of the burden of the current dollar fall, as the right side of the chart demonstrates (i.e., KRW appreciate against the EUR).
Source: Bloomberg
The above picture fits well with SRI’s call for a global currency realignment where the dollar will remain the reserve currency, but from a lower base. Diversification in other currencies is therefore recommended, especially on a longer-term basis.
Investment Themes
One of SRI’s investment themes regarding Asia is the return of local investors to their home stock markets. This is happening for the simple reason that they’re optimistic about their futures and thus more willing and eager to participate in the changes that are taking place. Given the scale of the socioeconomic evolution in Asia, now local investors are coming back “institutionalized.”
What I refer to are changes in the pension systems across Asia; pension funds in India and China, for example, can buy equities for their portfolios for the first time. In addition, investing schemes like US-style 401-K plans have been implemented (in South Korea and Taiwan) and are planned for other countries, including Thailand.
What’s underway in Asia will have long-lasting positive consequences for the markets, as countries have realized they need to do more to be able to pay for pensions as people retire. So they’re creating mandatory defined contribution schemes within which individuals will have more choices in investment styles. They’ll be able to generate better returns than prevailing extremely conservative pension schemes.
The main idea is to allow a little more exposure to equities. In Taiwan, for example, the equity ceiling for the labor pension fund was raised from 30 percent to 40 percent. In Thailand, the government pension fund’s ceiling for domestic equity investment is expected to be raised to 30 percent; the fund has also begun investing in foreign markets. In India, private sector pension plans are now permitted to invest up to 5 percent in equities.
Although the implementation of these proposals takes time, it’s important to note the concentrated effort to cultivate and institutionalize an equities culture in Asia, following the American prototype. At the same time, individual investors are starting to feel more comfortable allocating a bigger part of their assets to the equity markets, thus providing additional leverage to the effort.
This is undoubtedly bullish for Asia’s markets, as the move is being coordinated by governments and is therefore more difficult to reverse. As institutional assets increase, Asian markets will gradually exhibit characteristics of more mature markets.
South Korea was one of the first to allow its national pension fund to increase it allocation to equities, and investors have been buying into the market via monthly installment payments to equity funds. The Korean market has responded extremely positively–it’s up 75 percent since the beginning of last year.
Banks and other financial institutions in the region will continue to benefit, and should form the core of an Asia-focused portfolio.
Although we already have a couple of banks in the SRI Portfolio, I’m adding one more, Korea-based Shinhan Financial Group (NYSE: SHG). Shinhan is involved in all aspects of the financial industry. The stock has performed quite well and we might see some short-term weakness, but a diversified portfolio should be able to absorb the commotion.
Source: Bloomberg