THE most fascinating graph I saw this past week showed the correlation between different asset classes dating back to 1976.
The range included gold (yes, that perennial safe haven), other commodities, bonds, emerging markets (from 1992), and the euro. It would be a reasonable expectation that you should be able to construct a bullet-proof portfolio with that mix of assets.
Not so.
In the 1970s, the correlation was negative. For most of the 1990s it was pretty low – almost zero. Over the entire period, it was 2%. At the moment it is 40%. That means that they are increasingly moving in tandem. No wonder quant and solution funds, and even stock pickers, are calling 2010 “the 2008 without the credit crunch”.
The investment decision seems again to have become one of either taking or reducing risk – a rather binary approach.
Movement in the overall market is more muted than in 2008, but we are seeing short-term moves of significant magnitude in individual shares.
Over time, it simply does not make sense that all emerging market shares or the S&P are treated largely the same as gold when it comes to repositioning a portfolio.
One should bear in mind that the correlation analysis is a rather long-term one, and it is a blunt statistical tool at best, but this phenomenon is definitely having an impact on the already limited rationality that exists in the market.
In the short term, this is painful and stock pickers are left scratching their heads (more so than usual) when investors sell off any asset they perceive to be adding risk to their portfolio, with little regard for what is actually happening in the company and even in its operating environment.
If you pick shares, and can catch your breath for a moment, this must be setting us up for the most fantastic stock picking opportunity, because on an individual basis undervalued shares that continue generating good returns will ultimately be recognised by investors with a rerating.
An excellent example of a stock that was sold down by 50% leading up to early 2009, only to appreciate by over 300%, is Adira, a two-wheeler finance company in Indonesia.
The company has generated an excellent return on equity (RoE) over time, over 40% at times, managed its cost base, and never had a problem with its own financing.
But it is a small emerging market company, and was tarred with the “risk off” brush. We are likely to see many more of these in 2010.
As for the operating environment, data releases seem to add to the confusion, even more so than usual. There seems to be a staring contest between higher growth in emerging economies and emerging value in developed economies. No one wants to blink.
For the optimists out there, the last quarter’s numbers from the US show that demand was the strongest on a quarterly basis since the recession began, and it has accelerated at the fastest pace since 1983.
The sceptics put this down to rebuilding of inventories and nothing more. However, while inventories in some sectors are being built up, they are being run down rapidly in the housing market. The US has depleted about $50bn of new home inventories since the beginning of last year.
One could say that at this rate there will not be a single new house in the US by the end of next year!
Picking shares
I have not managed to find an optimist about Europe yet. Ireland has just been downrated and, unlike the US, it still has a huge housing overhang with many developments standing empty.
It feels as if there really is nowhere to hide at the moment – even if you choose offshore cash as your safe haven, you still have to select a currency.
Despite the full valuations, one cannot ignore emerging countries, because as Guy Monson from Sarasin wrote recently, “we’re all emerging investors now and the term emerging economies will in time disappear, just like e-commerce did, when we came to realise we are all consumers on the web”.
The portion of earnings from emerging countries for multinationals is significant, and increasing. China is now the largest vehicle market in the world, and for the past five years China, India and Indonesia made up a whopping 25% of world growth.
Yet their representation in global equity portfolios has been much lower. But that is old news now, and EM has been discovered, and no longer cheap – but more important to the developed world than ever.
This is the ultimate environment for picking shares, both in emerging countries and in the slower growing areas. No region is without its issues, but discernment will return and perhaps the only bit of safety you can have is to focus on stocks, not themes, and to do your best to understand what you’re investing in.
And that statement is being severely tested at the moment.
Fin24.com
Ahern is with SIM Global, a division of Sanlam Investments which travels the world researching listed companies with potential unlocked value.