Sell in May and Go Away? Not this Year

Sunday, April 29th, 2012

Sell in May and Go Away? Not this Year

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

One catchy investing maxim that’s popular this time of year is “sell in May and go away,” the notion that investors should cash in their investments and take the summer off. Historically, this hasn’t been a bad strategy. You can see from this chart that June, July, August and September have been the worst four months of the year for the S&P 500 Index since 1988.

Since 2000, the June-September period for the S&P 500 is split. Half of the years saw positive returns, while the other half were negative. Historically, you have only about a fifty-fifty chance for a positive gain during those months while your odds are roughly 10 percent better during the rest of the year.

The trend is less consistent for emerging market stocks. You can see that the median monthly return for the MSCI Emerging Markets Index since 1988 is negative for June and August, but positive for July and September. The frequency of positive returns during the June-September period is roughly 6 percent lower than the rest of the year.

Last year, investors who employed the “sell in May” strategy averted an almost 17 percent drop in the S&P 500 and a nearly 25 percent drop in the MSCI Emerging Markets Index from June-September. Summer of 2010 was a similar experience.

With last year fresh on the minds of investors, should they take the summer off? We don’t think so.

We believe it’s a much better market this year. After following a similar trajectory as the previous year from October to the beginning of March, improving economic data pushed the S&P 500 over 3 percent higher in March 2012 after trending sideways during the same time period last year.

Nominal GDP in the U.S. grew 3.8 percent during the first quarter of 2012 versus 0.4 percent in 2011, and several areas of the economy are much stronger than they were a year ago. Nonfarm payrolls (up 29 percent), ISM Manufacturing (up 2 percent) and auto sales (up 8 percent) have all improved from a year ago, according to J.P. Morgan. In fact, auto sales are currently at a four-year high.

More importantly, the U.S. housing sector continues to improve. The ISI Group’s homebuilders survey is currently at 50.4, nearly 40 percent higher than a year ago.

Building permits are 35 percent higher and the number of housing starts is 3 percent higher than a year ago, according to Credit Suisse. Sales of existing homes are up 5 percent on a year-over-year basis. Credit Suisse says, “The supply of existing one-family homes has fallen from a peak of 11.5 months in July 2010 to 6.3 months in March (in line with the 20-year average).”

ISI Group says an improvement in housing is important because it lifts consumer net worth and employment, which leads to rising consumer confidence. Housing accounts for just over 2 percent of U.S. GDP, but roughly 27 percent of household wealth, according to Credit Suisse.

Earnings Season Off to a Record Start

The improving global economy is reflected in the thirteenth-straight quarter of better-than-expected corporate earnings. As of Thursday, 80 percent of S&P 500 companies have reported earnings above analyst estimates. Earnings for the 260 companies reporting so far were up 11.4 percent year-over-year and beat the consensus estimate by 6.3 percent.

This is good news for shareholders. According to a Bloomberg story this week, “companies are increasing shareholder returns in the form of dividends and buybacks after the 2008 financial crisis led them to hoard cash to a record $1 trillion by the end of 2011.” The number of S&P 500 companies paying out dividends now sits at 401, the largest number since January 2000. Corporations bought back roughly $543 billion worth of shares in 2011 and J.P. Morgan estimates companies will purchase another $679 billion worth in 2012.

U.S. companies aren’t the only ones reporting stronger results. This chart from Credit Suisse shows earnings momentum is strengthening around the world based on 12-month forward earnings per share estimates for the MSCI ACWI (All Company World Index). This is the opposite of what we experienced in 2011.

Buy in May?

May has historically been a strong one for markets. Since 1988, the median return for the S&P 500 and MSCI Emerging Markets during May has been 1.22 percent and 1.28 percent, respectively. In fact, May returns rank in the top half for both indices.

This is also a presidential election year in the U.S., which has historically produced positive returns. Since 1972, the stock market has rallied in 5 of the 8 election years, according to J.P. Morgan, with market gains of 12-26 percent. Only during recession years (2000 and 2008) did the S&P 500 provide negative returns.

Last week, Bank of America-Merrill Lynch suggested “investors position for an economic upturn” by increasing their exposure to equities. The firm’s Global Wave indicator, a compilation of seven global metrics designed to provide a comprehensive assessment of trends in global economic activity, was signaling a trough in the global cycle. According to BofA-ML’s research, the MSCI ACWI (All Country World Index) averages a 14.2 percent increase for the 12 months following a trough in the Global Wave. Historically, the index has experienced a positive return 86 percent of the time.

Instead of “selling in May and going away” for the summer in 2012, we think investors should look to global stock markets and ride the global wave.

Tags: Amp, August And September, Chief Investment Officer, Economic Data, Emerging Market Stocks, First Quarter, Four Months, Frank Holmes, GDP, Maxim, Months Of The Year, Msci Emerging Markets, Msci Emerging Markets Index, Nominal Gdp, Nonfarm Payrolls, Previous Year, Same Time Period, Time Of Year, Trajectory, U S Global Investors
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Accessing Emerging Markets While Keeping Risk in Check

Sunday, February 26th, 2012

by Daniel Morillo, Ph. D, iShares

One of the most common conversations we’ve been having with clients recently relates to the tradeoff between the upside potential of an increased allocation to emerging markets equities and the additional risk that such an investment brings into an overall portfolio. Clients are becoming more interested in emerging markets, yet they remain concerned about risk and how the ongoing European financial crisis and the U.S. political situation will affect equity risk in general.

One potential way to increase your emerging markets exposure while also keeping risk in your comfort zone is by using a minimum-volatility approach to investing in emerging markets.

Minimum-volatility portfolios, as I explain in this video, are designed to provide exposure to a particular market with lower risk than a traditional capitalization-weighted portfolio. As might be expected, minimum volatility strategies may sacrifice some upside during strong market rallies. What’s surprising, though, is that over longer time periods minimum volatility portfolios have generally been shown to deliver similar return to their cap-weighted counterparts but do so with lower risk[1].

How can an investor take advantage of this feature of minimum volatility portfolios in the case of emerging markets?

Consider, as a starting point, a portfolio constructed with a typical 60%/40% allocation split between stocks and bonds. Assume, in addition, that the allocation to emerging markets within the equity portion of the portfolio is 10%, using a broad emerging markets benchmark like the MSCI Emerging Markets Index. Over the last 10 years this 60/40 portfolio would have delivered an average annualized return of 6.3% and annualized risk of 10.6%[2].

Baseline Portfolio with 6.3% annualized return and 10.6% annualized risk

Now imagine swapping out the traditional cap-weighted emerging market exposure for a minimum-volatility emerging markets strategy, for example the MSCI Emerging Markets Minimum Volatility Index[3]. How would the swap affect your portfolio? Because the minimum-volatility exposure to emerging markets is less risky than the traditional cap-weighted exposure (19.3% vs. 24.4% over the last 10 years), this means that it is possible to increase the allocation to emerging markets while keeping the same total risk of the portfolio.

Portfolio using minimum volatility emerging markets exposure with 9% annualized return and 10.6% annualized risk

In particular, within the equity portfolio it would be possible to go from 10% cap-weighted exposure to emerging markets to about 40% minimum-volatility exposure to emerging markets while keeping to the same 10.6% total risk of the portfolio over the last 10 years.

To compare, a 40% exposure to emerging markets within equities in the form of a cap-weighted exposure such as the broad MSCI Emerging Markets Index would have resulted in annualized risk of about 12% over the same time period. That’s a significant increase over the original risk budget — 10.6% — of the baseline portfolio.

Accessing equity exposure via minimum-volatility alternatives can allow investors to take on more exposure to risky assets, including equities, while keeping to a stable risk budget.  A minimum volatility strategy could be compelling in the current environment, where equity risk remains a concern for many investors.

Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Asset allocation may not protect against market risk.

Tags: Annualized Return, Capitalization, Comfort Zone, Emerging Market, Equity Risk, Financial Crisis, Investing In Emerging Markets, Ishares, Market Exposure, Morillo, Msci Emerging Markets, Msci Emerging Markets Index, Political Situation, Portfolios, Stocks And Bonds, Strong Market, Time Periods, Tradeoff, Volatility, Weighted Portfolio
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Global Stock Market Review: Europe Spoils the Party

Tuesday, January 17th, 2012

Investors last week faced a tug of war between signs of an improving U.S. economy and lingering concerns about Europe’s debt malaise. The Euroland worries moved to center stage on Friday when Standard & Poor’s downgraded the credit ratings of France, Austria, Italy, Spain, Portugal and four other European countries. Also denting sentiment were rumblings out of Greece, suggesting that the recently agreed bailout terms were now in doubt.

After starting off the year better than any other since 2006, the S&P 500 Index had its worst day of the year on Friday, but nevertheless remained in positive territory for the week as a whole.

Trading on stock markets during the second week of 2012 was again characterized by light volume, but it was nevertheless a good week for most risky assets such as stocks, corporate bonds, and precious and industrial metals.

Equities gained ground for the second consecutive week as shown by the performance of the two principal global equity benchmarks: the MSCI World Index closed 0.8% higher and the MSCI Emerging Markets Index surged by 2.8%. In a clear reversal of last year’s pattern, emerging markets have so far this year outperformed developed markets by a factor of 2.5.

Click on the table below for a larger image.

On the issue of mature versus emerging markets, well-known investor Marc Faber said: “What we had in 2008 was the outperformance of the U.S. and emerging economies’ stock markets and commodity markets got hit very hard, but it lead to a major low in emerging stock markets that bottomed out between October 2008 and March 2009. After that emerging stock markets outperformed the U.S. until the end of 2010. So I think we may get a similar picture. I read all the strategies that say we should invest in the U.S. I say maybe that’s correct for the next three months or so but I would rather be looking at an entry point in emerging markets over the next six to nine months.”

As far as the U.S. is concerned, all the benchmark indices ended the week in positive territory, with the S&P 500 and the Dow Jones Industrial Average gaining 0.9% and 0.5% respectively. But the real star was the Russell 2000 Index that improved by 1.9%. This is a good sign for the overall market as outperformance by small caps is normally associated with rising markets.

Al the U.S. indices are also higher for the year to date, ranging from +1.7% to +4.1% – in the case of the tech-heavy Nasdaq Composite Index.

When one considers the 10 economic sectors of the S&P 500 Index, it is clear that the cyclical sectors were the stronger ones over the past few days. These are sectors such as Materials (+3.9%), Financials (+3.1%) and Industrials (+2.6%). Not shown, Homebuilders (+7.5) surged on the back of Lennar reporting a solid increase in new orders. The lagging sectors were the defensive ones such as Utilities (-0.4%) and Consumer Staples (-0.3%). Energy also fared badly and was down by 1.4%. This pattern of cyclical sectors outperforming defensive sectors is what one would expect in the bull phase of a stock market.

Source: U.S. Global Investors – Investor Alert

Moving beyond the U.S., most stock markets ended the second week of the year in the black. Among mature markets, strong performers included Singapore (+2.8%), Australia (+2.2%), France (+1.9% – notwithstanding the country’s credit rating cut) and, surprisingly, Spain (+1.9%). In the emerging markets category China at long last rebounded, closing 3.7% higher. Also performing well were Hong Kong (+3.3%) and Brazil (+2.3%). The notable downmarkets included Portugal, New Zealand, Holland and the U.K.

Prior to last week’s improvement, the Shanghai Stock Exchange Index dropped by more than 30% from its high of August 2010. The trigger for the turnaround was Chinese bank loans and M2 money supply both rising more than expected as Chinese officials started taking action to stimulate the economy. Chinese equities look attractive from a valuation point of view and it would seem that investor concerns about slowing economic growth and a further shake-out in the property market have already been discounted by stock prices.

Tags: Bailout, Commodity Markets, Corporate Bonds, Day Of The Year, Emerging Economies, Emerging Stock Markets, Global Equity, Global Stock Market, Industrial Metals, Light Volume, Marc Faber, Msci Emerging Markets, Msci Emerging Markets Index, Msci World Index, Outperformance, Risky Assets, Rumblings, Second Consecutive Week, Spain Portugal, Tug Of War
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Opportunities in Asia and an Update on Volatility (Koesterich)

Tuesday, October 18th, 2011

by Russ Koesterich, iShares

Call #1: Neutral on Indonesia

I first advocated an overweight view of Indonesia back in early February. Since then, the market has bucked the negative global trend. Since February, the iShares MSCI Indonesia Investable Market Index Fund (EIDO) has gained roughly 9% and has outperformed the MSCI Emerging Markets Index by 25%. Indonesian equities currently trade at 3.6x book value, more than twice the emerging market average. Past performance does not guarantee future results.  For standardized performance for EIDO, please click here.

Given the magnitude of this outperformance, Indonesia no longer looks that cheap relative to other emerging markets. As such, I’m closing out my overweight view on the country, and I am moving to a neutral stance.

Call #2: Overweight on Taiwan

I’m seeing better opportunities in other parts of Southeast Asia, particularly in Taiwan.

Equities in Taiwan are also trading at a premium to other emerging markets, but the premium is modest and is justified given Taiwan’s above average growth prospects. Taiwan’s gross domestic product is expected to grow by 5% in both 2011 and 2012. Among other reasons to like Taiwan, the country’s corporate sector is profitable with a return on assets of 11.2%, well above the global average. Taiwan’s dividend yield of roughly 4.5% is also well above the global average.

But the Taiwanese market is not without risks. Its biggest risk: Taiwan is an export driven economy.  If the global economy experiences a double dip, Taiwan will suffer. Still, I believe investors are being compensated for the risk (possible iShares solution: EWT).

Call #3: Market Volatility Level is Closer to Fair Value

Finally, I want to provide an update on my view of market volatility. In mid-August, I suggested that market volatility levels appeared extreme. At the time, the VIX — or volatility index — was trading in the mid 40s, more than double its long-term average.

While I expected a difficult and volatile market environment, my analysis suggested that investors were overreacting. Volatility was higher than it should be and was likely to fall. Since then, the average level of the VIX Index has been in the mid 30s. It closed Thursday at around 30. This level is still elevated relative to the index’s long-term average, but it’s closer to fair value. As such, I’m no longer a seller of market volatility. Going forward, assuming that Europe can address its immediate problem and that there is no disorderly default by Greece, I expect equity market volatility to remain in the mid 20s to low 30s for the foreseeable future.

Source: Bloomberg

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

Copyright © Russ Koesterich, iShares

Tags: Dividend Yield, Double Dip, Driven Economy, Eido, Global Average, Global Economy, Global Trend, Growth Prospects, Investable, Ishares Msci, Market Volatility, Mid 40s, Msci Emerging Markets, Msci Emerging Markets Index, Neutral Stance, Outperformance, Return On Assets, Taiwanese Market, Volatility Index, Volatility Levels
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Global stock market moving averages – a mixed picture

Wednesday, October 12th, 2011

A quick whizz around the moving averages of global stock markets makes for interesting reading. Specifically, I have considered the standard deviation from the 50- and 200-day moving averages for both mature and emerging stock market indices.

As shown in the tables below, the key conclusions are as follows:

• Most developed markets are again trading above their 50-day moving averages (indicating the secondary trend), including the MSCI World Index and all the major U.S. indices. It is not surprising to see markets such as Greece and Portugal bucking the trend, with Japan also an underperformer.

• The recovery of emerging markets is lagging that of the developed ones, and most of these markets are still below their 50-day averages. Pakistan, South Africa, Turkey and Venezuela are notable exceptions.

• Considering the 200-day moving averages (an indicator of the primary trend), all the developed markets with the exception of New Zealand are below their averages, with Austria, Greece and Singapore more than two standard deviations in the red.

• As far as emerging markets go, only two – Pakistan and Venezuela – are above their 200-day averages. The MSCI Emerging Markets Index, as well as three of the BRIC countries – China, Brazil and Russia – is more than two standard deviations under water.

I would not be surprised to see a further recovery in stock markets over the next few weeks, with those markets most deeply oversold relative to their 200-day moving averages offering the strongest recovery potential. But until we see the majority of the indices (as well as the majority of individual stocks) breaching their 200-day lines, one would be hard-pressed to talk of a resumption of the bull market.

Developed markets – ranked by standard deviation from 50-day moving average

Emerging markets – ranked by standard deviation from 50-day moving average

Developed markets – ranked by standard deviation from 200-day moving average

Developed markets – ranked by standard deviation from 50-day moving averages

Tags: Brazil, Bric Countries, Conclusions, Emerging Stock Market, Exceptions, Global Stock Market, Global Stock Markets, Greece, Moving Averages, Msci Emerging Markets, Msci Emerging Markets Index, Msci World Index, Pakistan, Resumption, South Africa, Standard Deviation, Standard Deviations, Stock Market Indices, Stocks, Venezuela, Whizz
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Extreme Moves Leave Markets in Rare Territory

Saturday, September 24th, 2011

Extreme Moves Leave Markets in Rare Territory

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

If you haven’t paid much attention to global markets this week, here’s what you missed…fears that the global economy is dangerously close to a recession due to the financial crisis in the eurozone and flatlining growth in the U.S. sent assets of all shapes and sizes into a tailspin.

Among the E7 and G7 countries, only two markets increased for the week—Pakistan (up 2.2 percent) and Japan (up 0.5 percent). Russia (down 12.2 percent) and Indonesia (down 10.7 percent) were the leaders in the opposite direction. The average return for the 14 countries was a 5.7 percent decline.

Many investors have used gold and other commodities as a haven from recent volatility, buoying prices while equities sunk, but even those investments weren’t immune to the wave of selling. Silver was hit the hardest, falling nearly 24 percent, with copper (down 16.5 percent) and platinum (down 11.2 percent) not far behind. Gold and oil were down roughly 9 percent and the yellow metal was down more than $100 during intraday trading on Friday.

The U.S. dollar, in contrast, was up 2.2 percent. Much of the dollar’s rally came after the Federal Reserve announced the creatively named “Operation Twist” on Wednesday. The Fed will sell $400 billion of short-term securities and buy an equal amount of long-term debt. The goal is to push down long-term interest rates, which would spur economic activity.

As a result of this week’s actions, the S&P 500 Index is just slightly below two standard deviations from its mean over the past 60 trading days. The MSCI Emerging Markets Index is at a similar position, just greater than two standard deviations from its mean over the same time period.

The two charts above illustrate how rare two standard deviation events are for these markets. Over the past ten years, 60-day percentage changes to the downside of this magnitude have only occurred just over 5.4 percent of the time for the S&P 500 and 4.8 percent of the time for MSCI Emerging Markets.

This rare territory is often called “oversold” by traders and portfolio managers. That simply means too many investors have sold their holdings in a condensed timeframe, driving the price down more than its historical average.

Take a look at the gold/U.S. dollar relationship, for example. Over the past 20 trading days, gold has dropped 8.7 percent while the U.S. dollar appreciated by 6 percent.

This week’s moves are even rarer for gold and the U.S. dollar. The U.S. dollar has experienced similar upward moves only 3.5 percent of the time over the past decade, while similar declines in the price of gold have happened roughly 4 percent of the time.

I point this out because markets have historically reverted back to their mean after crossing into extreme territory, creating a “buy” or “sell” signal for the asset. This gauge has proven a reliable indicator for our investment team as it seeks to limit downside risk and take profits when assets have experienced a big run.

Since mid summer, our investment team has sought to limit exposure to downside risks by raising cash levels, selling mid-caps to buy large-cap companies and downsizing positions in cyclical areas such as industrials while increasing those in more stable areas such as consumer staples. This week’s market volatility provides an opportunity to selectively invest cash and redeploy capital.

The market’s reaction to the Fed announcement is indicative of how little confidence investors have in policymakers in controlling what appears to be an escalating situation. More than half of investors and analysts surveyed believe a global recession is imminent.

While we certainly recognize the current downside risks for the global economy, we think it’s worth noting that investor sentiment and emotions can be significant market drivers, but the math of the market indicates we are probably at an extreme and a price reversal is likely.

One of these is the Conference Board Index of Leading Economic Indicators (LEI), which our director of research John Derrick highlighted for you in last week’s alert. The LEI, has historically been a good predictor of economic growth as it measures peaks and troughs in the business cycle. Despite it being one of the most volatile months for equity markets in recent memory, the LEI increased more than expected during August. In addition, initial July figures were revised upward. ISI Group said in a report on Thursday that “the LEI is not flashing any sign of an impending recession.” In addition, the firm also expects a modest gain for the September jobs report. ISI calls America’s jobs outlook “capital market’s most important economic statistic.”

These are positive developments, but we’re not out of the woods yet. The U.S. economy will continue to inch its way forward over the next one to two years and U.S. companies and consumers must adjust to this low-growth environment. It’s critical investors identify the companies that will successfully compete in this environment.

We believe America is up to the challenge.

John Derrick, director of research, contributed to this commentary.

Tags: Chief Investment Officer, Commodities, E7, Economic Activity, Eurozone, Extreme Moves, Frank Holmes, G7 Countries, Global Economy, Global Markets, Gold, Intraday Trading, Msci Emerging Markets, Msci Emerging Markets Index, Outlook, Percentage Changes, Same Time Period, Shapes And Sizes, Standard Deviation, Standard Deviations, Tailspin, Term Interest, U S Global Investors
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What’s Driving Russia’s Outperformance?

Sunday, March 27th, 2011

What’s Driving Russia’s Outperformance?

By Frank Holmes, John Derrick and Tim Steinle, Co-managers of the U.S. Global Investors Eastern European Fund (EUROX)

The Russian MICEX Index, which increased 22.5 percent in 2010, has jumped 15 percent so far in 2011, significantly outperforming many other markets.

China is the second-best performer of the BRICs, rising more than 5 percent, while India (down over 10 percent) and Brazil (down over 2 percent) have lagged. Overall, the MSCI Emerging Markets Index has dropped just over 1 percent.

This has effectively recoupled Russia with the other BRIC countries. The Russian economy lagged out-of-the-gate once the global recovery began, leading some to question whether it belonged in the same category as Brazil, China and India. Those sentiments seemed premature and symptomatic of an anti-Russia mindset.

Russian’s outperformance has been driven by several factors. First, the Russian ruble has appreciated 7 percent against the U.S. dollar, boosting stock market performance for U.S. investors.  This development also has a long-term benefit as a strong ruble benefits the country’s domestic sectors, something we’ll discuss later.

A second factor driving Russia has been the geopolitical and natural disaster events that have transpired during the past few weeks. Russia is relatively safe from the type of political uprisings seen in the Middle East and North Africa. Its government is decidedly popular with the public and the one-two punch of President Medvedev and Prime Minister Putin give the government clout on both international and domestic fronts.

The price of oil has risen roughly 25 percent since the unrest and turmoil began in the Middle East and North Africa.  As an energy exporter of crude oil and natural gas, Russia is one of the few large economies in the world that directly benefits from higher energy prices.

Russia is the world’s largest oil producer and it’s estimated that for every $10 increase in the average annual price of oil, Russia’s revenues rise by $20 billion, according to the Financial Times.  Since Russia is not a member of OPEC, it is not bound by production caps and can increase production as it sees fit while prices are at elevated levels.

Russia is also the world’s top exporter of natural gas and Stratfor Intelligence points out the situation in Libya has shut down 11 billion cubic-meters of natural gas flow to Italy. As Europe’s third-largest consumer of natural gas, Italy has turned to Russia for gas supplies. In addition, a shutdown of several Japanese nuclear facilities could mean as much as a 14 percent increase in natural gas consumption to meet the Japan’s energy demands.

In the energy sector, the Eastern European Fund (EUROX) portfolio emphasizes companies that show strong growth in production, reserves and cash flow, relative to their peers. Specifically, Novatek, Rosneft and TNK-BP fit this profile.

Russian energy equities, which carry the largest weighting in the MICEX, have gained 25 percent this year. This is higher than non-oil Russian equities, which have risen only 7.7 percent. However, as oil and gas taxes swell the government’s revenue, these funds are increasingly allocated to social and public works programs which are likely to create an opportunity for non-energy related equities. These sectors appear poised to benefit from the current macroeconomic environment.

This table from Merrill Lynch shows the performance of the different sectors of the Russian market following a sustained rise in oil prices. Merrill Lynch compiled research on the seven instances where oil prices rose 20 percent in a two-month span and maintained at least half those gains over the following six month period.

Historically, the average gain for Russian equities is more than 34 percent. While energy generally jumps out ahead when oil prices move higher, you can see that it lags other sectors as the rally progresses. We have long been positive on both Russian financials and the consumer sector and these sectors appear well positioned going forward.

Consumer-oriented equities such as retailers have historically been the best performers, netting an 85 percent gain on average and triple the gain of energy equities. Retailers X5 and Magnit should be able to capitalize on these trends. Russian financials are next with an average 83 percent gain. Sberbank, Russia’s largest bank, is the largest holding in EUROX.

Another area that could directly benefit from the Kremlin’s cash-filled pockets is infrastructure. Russia is in dire need of a significant revamping of its infrastructure. Similar to the American Society of Civil Engineers report that rates America’s  infrastructure a “D,” the World Economic Forum says the quality of Russia’s infrastructure lags that of other emerging countries such as South Africa, Turkey, China and Mexico.

The areas most in need of upgrading are Russia’s transportation and electrical power grid. The quality of Russia’s roads ranks in the bottom-third in the world, according to Merrill Lynch, and it’s estimated that Russia loses 6 percent of GDP each year due to underdeveloped roads. In fact, the combined length of Russia’s roadways declined 6 percent between 2002 and 2010 despite a 60 percent increase in car penetration, Merrill-Lynch says.

It’s a similar story for Russia’s airports and rail network. Russia currently has roughly 300 operational airports but just 40 percent of them have paved runways and 30 percent do not have an airfield lighting system, Merrill Lynch says. The rail network, almost entirely constructed during the Soviet era, is highly concentrated in the Western region of the country and is estimated to require more than $70 billion in investment for upgrades and repairs by 2020, according to Merrill Lynch.

Russia’s aging power grid is unreliable and accident prone. Merrill Lynch projects that significant investment by 2020 is required to update and modernize the grid. With industrial consumers accounting for 85 percent of electrical consumption, keeping the power up and running is essential to maintaining Russia’s industrial production levels.

To finance the much needed infrastructure improvements, the Russian government created the $420 billion Federal Target Program (FTP). The FTP focuses on key transportation areas such as rails, autos, marine and civil aviation.

The FTP has specific goals to meet by 2015 such as increasing the percentage of roads that meet federal standards by 23 percent. The plan also calls for a 47 percent increase in the shipment of goods and a 40 percent increase in airline penetration through improvements of aviation infrastructure.

In addition to the FTP, three special events will help drive Russia’s infrastructure spending: The 2012 Asia-Pacific Economic Cooperation (APEC) Summit, 2014 Winter Olympics in Sochi and the 2018 World Cup. Merrill Lynch estimates that total spending for the World Cup will reach $50 billion. Construction for the Games in Sochi includes 161 miles of roads and 65 miles of rails, and the APEC calls for 48 new objects to be constructed for a total of $83 million.

While higher energy prices are in danger of slowing down consumers in the U.S., Western Europe and certain emerging market countries, it has the opposite effect for the Russian economy. With increased cash flow from its natural gas and crude oil exports, the Russian government has the much needed capital to invest in the country’s aging infrastructure and to support domestic consumption.

This should drive outperformance of Russian markets throughout 2011 and stimulate demand for infrastructure-related commodities such as crude oil, copper, cement and iron ore.

Tags: Brazil, BRIC, Bric Countries, BRICs, China, Commodities, Disaster Events, Domestic Sectors, Emerging Markets, energy, Frank Holmes, Global Recovery, Holmes John, India, Infrastructure, John Derrick, Micex, Msci Emerging Markets, Msci Emerging Markets Index, Natural Disaster, oil, Oil Producer, Outperformance, Russia, Russian Economy, Russian Ruble, Steinle, Stock Market Performance, Term Benefit, U S Global Investors
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How the VAR Model and Japan’s Tragedy Affect Investors

Monday, March 21st, 2011

Our thoughts and prayers are with the people of Japan. The videos, images and stories of the devastation caused by last week’s earthquake and tsunami have touched our hearts and rattled investor psyches around the world.

The threat of disaster from the damaged Fukushima nuclear power plant unleashed a ferocious sell-off of Japanese equities, but the damage to other major markets has been limited. Already experiencing a slight pullback prior to the events on March 11, U.S. equities and emerging markets have held up quite well. The MSCI Emerging Markets Index has only pulled back 2 percent since the earthquake and the S&P 500 Index only 3 percent.

Japan has experienced similar disasters before on a smaller scale. In 1995, the Great Hanshin Earthquake severely damaged the port city of Kobe, killing more than 6,000 people. Japanese industrial production (IP) fell by 2.6 percent during the January following the earthquake, according to Societe Generale analyst Takuji Okubo. However, that drop-off was short lived. Okubo reports that IP sprang up 2.2 percent the following month and 1 percent during March.

Goldman Sachs estimates that the total cost of damage from the March 11 earthquake will be $198 billion—roughly 1.6 times that of the Great Hanshin earthquake. That works out to roughly 4 percent of GDP. However, Martin Wolf from the Financial Times points out that as of March 17, Japan has lost $344 billion worth of market cap since March 11, equaling nearly 7 percent of the country’s GDP.

Why have investors reacted this way? Investor anxiety and the selloff have been exacerbated by two trends which have plagued Wall Street over the past few years: The excessive use of Value-at-Risk (VAR) models and a risk-averse herd mentality.

The VAR Model is used by investment firms and others to measure the market risk of their asset portfolios by calculating the probability of maximum loss given a certain time period, i.e. “how much could I lose in a really bad day (month)?”

VAR models have three different components: A time period (generally a day or a month), a level of confidence (generally 95 or 99 percent confidence level) and an estimate of investment loss. There are three mathematical models used to calculate VARs: Variance-Covariance, historical simulation and Monte Carlo Simulation. (Editor’s note: For an in-depth explanation of these concepts, see Investopedia and HedgeFund-Index.)

All of the major investment firms have a risk management officer who uses some form of a VAR model. Their biggest concern is the daily, weekly, and monthly volatility. There’s a certain level of volatility that financial institutions can’t stomach because they are leveraged themselves.

It’s similar to the freezing point when water turns to ice. Once this level is reached, the risk management officers give portfolio and money managers a “tap on the shoulder” to reduce risk and raise cash levels. Since risk managers all over the world are using very similar models, it creates a herd mentality and stock sales all get triggered at the same time. Similar herd mentalities and groupthink have led to some of history’s most infamous financial calamities such as the crash of 1987 and 2008 after the fall of Lehman Brothers.

The VAR herd mentality shows up in the volatility index, or VIX, which is a measure of stress in the system. Currently, it’s a combination of forces (the ongoing turmoil in the Middle East and North Africa and Japan’s natural disaster) that is injecting stress into the system. The VIX pushed toward the 30 level last week, a level that has historically been associated with “extreme market turbulence.” As of mid-week, the two-week change in the VIX represented the sixth largest move in the past 20 years, according to Greg Weldon.

Once stability returns and a new equilibrium is found, the VIX then falls and the risk management officer allows the money managers to invest again.

Periods of high volatility and uncertainty generally cause investors to head for cover and liquidate assets but we think investors should do the opposite—classic contrarian thinking.

A prime example occurred two years ago. On March 18, 2009, we highlighted for investors in a special alert that a shift in government policy—an amended FASB-157 “mark to market” rule, a change to the short sell (uptick) rule and a $300 billion liquidity injection from the Federal Reserve—meant a strong wind was hitting the market’s sails and was likely to cause a massive price reversal. We were confident of this shift because these events fit into one of our core tenants of our investment process—that government policies are precursors to change.

Two years later, large growth funds, large value funds and world stock funds have all risen 40 percent or more, according to Morningstar. Some asset classes such as midcaps and natural resources stocks have doubled off of their lows but are still working to regain previous highs.

Unfortunately, instead of buying into the opportunity, more than $25 billion was pulled out of domestic and international stock funds while $22 billion flowed into bond funds, such as intermediate-term, short-term and intermediate government bond funds. The returns on those asset classes over the same March 2009 to March 2011 period were 11.9, 6.8 and 5 percent, respectively.

Another example is last year’s explosion of the Macondo Well in the Gulf of Mexico. Many investors dumped their investments in British Petroleum because of the regulatory uncertainty and growing costs of the cleanup, but BP’s stock has recovered more than 67 percent since its June 2010 lows.
The key difference between the events of two years ago and today is that natural disasters tend to cause great short-term anxiety but have minimal lasting effect, while shifts in government policy are generally precursors to significant change. BCA says that “natural disasters rarely change an economy’s growth trajectory and this earthquake should be no exception.” They continue to say that “the earnings picture of the Japanese corporate sector is unlikely to be significantly affected by this natural disaster.”

In fact, the total impact of the earthquake on Japan’s economy is likely to amount to 0.5 percent of GDP, not even comparable to the global credit crisis that reduced Japan’s GDP by 10 percent between the first quarters of 2008 and 2009, according to the Financial Times.

In America, following Hurricane Katrina, we saw that there are basically six to 15 weeks of misery before the rebuilding begins. Estimates show Japan will spend $500 billion to rebuild its economy and given the government’s long history of investing in the country’s infrastructure, we expect they will waste no time in rebuilding and repairing. Reconstruction spending will probably kick in some time during the second quarter, supporting the country’s growth rate, according to BCA.

We are also seeing nuclear projects being pushed back until engineers from around the globe can learn from this tragedy. This makes coal, natural gas and crude oil more attractive in terms of near-term demand.

A final variable to consider is the immense patriotism and pride inherent in Japanese culture. In his Financial Times column, Martin Wolf says “if any civilization is inured to such tragedies it is Japan’s. Its people will cope. This seems certain.” Japanese culture has a very strong family unit with high savings rates. If the picture of the family above is any indication, this strong culture of family will help them endure, adapt and move forward.

Director of Research John Derrick contributed to this commentary.

Tags: Asset Portfolios, Emerging Markets, Financial Times, Gold, Goldman Sachs, Great Hanshin Earthquake, Herd Mentality, Infrastructure, Investment Firms, Japanese Equities, Market Risk, Martin Wolf, Maximum Loss, Msci Emerging Markets, Msci Emerging Markets Index, Nuclear Power Plant, oil, Psyches, Pullback, Selloff, Societe Generale, Thoughts And Prayers, Value At Risk, Videos Images
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How the VAR Model and Japan’s Tragedy Affect Investors

Saturday, March 19th, 2011

How the VAR Model and Japan’s Tragedy Affect Investors

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

Our thoughts and prayers are with the people of Japan. The videos, images and stories of the devastation caused by last week’s earthquake and tsunami have touched our hearts and rattled investor psyches around the world.

The threat of disaster from the damaged Fukushima nuclear power plant unleashed a ferocious sell-off of Japanese equities, but the damage to other major markets has been limited. Already experiencing a slight pullback prior to the events on March 11, U.S. equities and emerging markets have held up quite well. The MSCI Emerging Markets Index has only pulled back 2 percent since the earthquake and the S&P 500 Index only 3 percent.

Japan has experienced similar disasters before on a smaller scale. In 1995, the Great Hanshin Earthquake severely damaged the port city of Kobe, killing more than 6,000 people. Japanese industrial production (IP) fell by 2.6 percent during the January following the earthquake, according to Societe Generale analyst Takuji Okubo. However, that drop-off was short lived. Okubo reports that IP sprang up 2.2 percent the following month and 1 percent during March.

Goldman Sachs estimates that the total cost of damage from the March 11 earthquake will be $198 billion—roughly 1.6 times that of the Great Hanshin earthquake. That works out to roughly 4 percent of GDP. However, Martin Wolf from the Financial Times points out that as of March 17, Japan has lost $344 billion worth of market cap since March 11, equaling nearly 7 percent of the country’s GDP.

Why have investors reacted this way? Investor anxiety and the selloff have been exacerbated by two trends which have plagued Wall Street over the past few years: The excessive use of Value-at-Risk (VAR) models and a risk-averse herd mentality.

The VAR Model is used by investment firms and others to measure the market risk of their asset portfolios by calculating the probability of maximum loss given a certain time period, i.e. “how much could I lose in a really bad day (month)?”

VAR models have three different components: A time period (generally a day or a month), a level of confidence (generally 95 or 99 percent confidence level) and an estimate of investment loss. There are three mathematical models used to calculate VARs: Variance-Covariance, historical simulation and Monte Carlo Simulation. (Editor’s note: For an in-depth explanation of these concepts, see Investopedia and HedgeFund-Index.)

All of the major investment firms have a risk management officer who uses some form of a VAR model. Their biggest concern is the daily, weekly, and monthly volatility. There’s a certain level of volatility that financial institutions can’t stomach because they are leveraged themselves.

It’s similar to the freezing point when water turns to ice. Once this level is reached, the risk management officers give portfolio and money managers a “tap on the shoulder” to reduce risk and raise cash levels. Since risk managers all over the world are using very similar models, it creates a herd mentality and stock sales all get triggered at the same time. Similar herd mentalities and groupthink have led to some of history’s most infamous financial calamities such as the crash of 1987 and 2008 after the fall of Lehman Brothers.

The VAR herd mentality shows up in the volatility index, or VIX, which is a measure of stress in the system. Currently, it’s a combination of forces (the ongoing turmoil in the Middle East and North Africa and Japan’s natural disaster) that is injecting stress into the system. The VIX pushed toward the 30 level this week, a level that has historically been associated with “extreme market turbulence.” As of mid-week, the two-week change in the VIX represented the sixth largest move in the past 20 years, according to Greg Weldon.

Once stability returns and a new equilibrium is found, the VIX then falls and the risk management officer allows the money managers to invest again.

Periods of high volatility and uncertainty generally cause investors to head for cover and liquidate assets but we think investors should do the opposite—classic contrarian thinking.

A prime example occurred two years ago. On March 18, 2009, we highlighted for investors in a special alert that a shift in government policy—an amended FASB-157 “mark to market” rule, a change to the short sell (uptick) rule and a $300 billion liquidity injection from the Federal Reserve—meant a strong wind was hitting the market’s sails and was likely to cause a massive price reversal. We were confident of this shift because these events fit into one of our core tenants of our investment process—that government policies are precursors to change.

Two years later, large growth funds, large value funds and world stock funds have all risen 40 percent or more, according to Morningstar. Some asset classes such as midcaps and natural resources stocks have doubled off of their lows but are still working to regain previous highs.

Unfortunately, instead of buying into the opportunity, more than $25 billion was pulled out of domestic and international stock funds while $22 billion flowed into bond funds, such as intermediate-term, short-term and intermediate government bond funds. The returns on those asset classes over the same March 2009 to March 2011 period were 11.9, 6.8 and 5 percent, respectively.

Another example is last year’s explosion of the Macondo Well in the Gulf of Mexico. Many investors dumped their investments in British Petroleum because of the regulatory uncertainty and growing costs of the cleanup, but BP’s stock has recovered more than 67 percent since its June 2010 lows.

The key difference between the events of two years ago and today is that natural disasters tend to cause great short-term anxiety but have minimal lasting effect, while shifts in government policy are generally precursors to significant change. BCA says that “natural disasters rarely change an economy’s growth trajectory and this earthquake should be no exception.” They continue to say that “the earnings picture of the Japanese corporate sector is unlikely to be significantly affected by this natural disaster.”

In fact, the total impact of the earthquake on Japan’s economy is likely to amount to 0.5 percent of GDP, not even comparable to the global credit crisis that reduced Japan’s GDP by 10 percent between the first quarters of 2008 and 2009, according to the Financial Times.

In America, following Hurricane Katrina, we saw that there are basically six to 15 weeks of misery before the rebuilding begins. Estimates show Japan will spend $500 billion to rebuild its economy and given the government’s long history of investing in the country’s infrastructure, we expect they will waste no time in rebuilding and repairing. Reconstruction spending will probably kick in some time during the second quarter, supporting the country’s growth rate, according to BCA.

We are also seeing nuclear projects being pushed back until engineers from around the globe can learn from this tragedy. This makes coal, natural gas and crude oil more attractive in terms of near-term demand.

A final variable to consider is the immense patriotism and pride inherent in Japanese culture. In his Financial Times column, Martin Wolf says “if any civilization is inured to such tragedies it is Japan’s. Its people will cope. This seems certain.” Japanese culture has a very strong family unit with high savings rates. If the picture of the family above is any indication, this strong culture of family will help them endure, adapt and move forward.

Director of Research John Derrick contributed to this commentary.

Tags: Chief Investment Officer, Emerging Markets, Financial Times, Frank Holmes, Gold, Goldman Sachs, Great Hanshin Earthquake, Herd Mentality, Infrastructure, Investment Firms, Japanese Equities, Martin Wolf, Msci Emerging Markets, Msci Emerging Markets Index, Nuclear Power Plant, oil, Psyches, Pullback, Selloff, Societe Generale, Thoughts And Prayers, U S Global Investors, Value At Risk, Videos Images
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China in the Year of the Rabbit

Saturday, February 5th, 2011

China in the Year of the Rabbit

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

Happy New Year 4708!

According to the Chinese calendar it’s the Year of the Rabbit. The leading Asian brokerage firm CLSA reports the Rabbit will “wrest the reins from the decidedly unpleasant and erratic Tiger that’s been tossing and turning the markets over the past 12 months.” We all could appreciate a respite from extreme volatility.

Chinese New Year is the longest and most important of the traditional Chinese holidays. It is celebrated around the world wherever there are significant Chinese populations. Customs vary widely but traditionally include an outpouring of gift giving, decorating, feasting, forgiveness and wishing for peace and happiness for everyone.

This is the fourth stage in the seasonally strong period for gold, which began back in August with Ramadan.

In the run-up to Chinese New Year, China’s gold imports are estimated to have more than doubled from a year ago, putting the country on track to overtake India as the world’s largest consumer of the precious metal. The growth in demand is being attributed, in part, to Chinese families giving each other gifts of gold instead of traditional red envelopes filled with cash.

Chinese markets are looking for a rebound in the Year of the Rabbit. In 2010, China’s A-shares market was the only Asian market with negative performance, as fears of inflation and an overheating economy cooled markets.

So far in 2011, China has outperformed the MSCI Emerging Markets Index. The Shanghai Composite Index has decreased only 0.28 percent versus the 1.54 percent drop for the MSCI Emerging Markets Index. By comparison, both Brazil (down 6.07 percent) and India (down 13.87 percent) have experienced declines this year, while Russia has jumped almost 9 percent.

Inflation continues to be the biggest threat to the Chinese economy and could be a headwind for the first half of the year. However, we expect the market to improve as the year progresses.

The Chinese government’s response to the threat of inflation is key. If inflation numbers moderate, then the government won’t be forced to hike interest rates or unleash additional tightening measures, which would be viewed positively by capital markets.

China’s economy is expected to grow about 9.5 percent in 2011, according to CLSA. Roughly 5.5 percent of that will come from investment and the rest from consumption.

One of China’s biggest strengths is that liquidity remains robust and that liquidity is likely to find its way into equity markets.

There is also opportunity through the restructuring of China’s economy with the government’s official policy of encouraging consumption. We believe government policies are precursors to change, so having the correct policies in place is the first ingredient of a consumption-based economy. Mix in rising incomes, only a dash of household debt, healthy consumer sentiment, and China has a recipe for robust consumption. CLSA estimates that consumption will account for 42 percent of GDP growth in 2011.

One sector with a strong upside is the information technology sector. First-rate technology is very important if China wants to move up in the manufacturing hierarchy. Low-cost manufacturing has brought China to where it is today, but advanced manufacturing capabilities are required in order for China to rise to the next level. Additionally, the government will not burden industries it is trying to promote with punitive policies, such as heavy taxes or undue regulatory constraints.

After a disappointing Year of the Tiger for equity markets, the Year of the Rabbit could usher in a change of government policy in the near future that could power markets higher. Or, as CLSA puts it, “hopportunities abound” in the Year of the Rabbit.

John Derrick, director of research, contributed to this commentary.

Tags: Brazil, BRIC, BRICs, Brokerage Firm, Chief Investment Officer, China, Chinese Calendar, Chinese Economy, Chinese Families, Chinese Holidays, Chinese Markets, Chinese New Year, Chinese Populations, Clsa, Emerging Markets, Extreme Volatility, Frank Holmes, Gold, Gold Imports, India, Msci Emerging Markets, Msci Emerging Markets Index, Peace And Happiness, Russia, Shanghai Composite Index, Traditional Chinese Holidays, U S Global Investors, Year Of The Rabbit
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