How do stock market benchmarks pop 1% out of the blue? Check your Twitter news feed. Crimea voted to join Russia as everyone anticipated. Industrial production rose more than expected in February. And the second largest e-commerce site in the world, China-based Alibaba, is getting increasingly close to an IPO date. In essence, buying the previous week’s pullback seems reasonable to the masses.
On the other hand, broader stock benchmarks have not made much progress in 2014 and the rallies have occurred on remarkably low volume. In contrast, long-dated Treasuries and precious metals have been runaway underdog success stories. Can the SPDR Gold Trust (GLD) and/or the iShares 20+ Treasury Fund (TLT) continue to defy critics? Perhaps. After all, few predicted the surprising season for the NCAA Tournament-bound Shockers from Wichita State.
Gurus assured investors that rising interest rates were a huge risk this year. They’ve been wrong so far. Similarly, prominent commentators laughed at the idea that gold would go anywhere but south of the $1000 per ounce level. Wrong again. Meanwhile, stocks were supposed to be the smartest asset class for the money.
There are several problems with the simplistic assessments on the asset classes. For one thing, they ignored the benefit of diversification; in most years, diversification is valuable to a portfolio. Additionally, safe haven seeking tends to increase when a single asset class stretches the boundaries of reasonable risk. Consider what the folks at Goldman Sachs are saying. Not only do they acknowledge that stocks are expensive across nearly all of their valuation metrics, but some of those metrics are downright scary. Specifically, the median stock in the S&P 500 trades at roughly 16.7 times forward earnings — guidance that most expect will be lowered even further in the coming months. The median stock in the S&P 500 has traded higher than 16.7 less than 10% of the time since 1976.
These observations are not meant to suggest that a crash is imminent; rather, it is important to be realistic about the current environment. In fact, one might even use the current circumstances to his/her advantage by considering big time trends that may be highlighting the strongest risk-reward opportunities.
1. Utilities. You could not find anyone with a hankering for highly regulated, high yielding, slow growers in 2013. Since signs of wear-n-tear first appeared in the domestic and global economies this year, however, interest rates have stabilized; they’ve even moved lower. Modest interest rates are serving high-dividend yielding utility companies quite well. What’s more, the non-cyclical nature of the sector is desirable in times of economic uncertainty. Equally worthy of note, it is the only major sector that is hitting fresh 52-week highs on Monday, 3/17 (St. Patrick’s Day.)
|Utilities ETFs Electrify The Competition|
|1 Month %||3 Months %|
|iShares Global Utilities (JXI)||3.7%||10.3%|
|Vanguard Utilities (VPU)||2.8%||10.5%|
|SPDR Utilities (XLU)||2.7%||10.5%|
|SPDR S&P 500 (SPY)||1.8%||5.1%|
2. Foreign Small Caps. On the surface, foreign stocks may seem like riskier prospects than U.S. stocks. Yet what happens when valuations for U.S. equities reach questionable levels of sustainability? For example, according to WSJ.com, the Russell 2000 is trading at a price-to-earnings ratio that is 42% above its long-term (200-day) average. The last time it traded at these levels? March of 2000. Equally disturbing, the price-to-book ratio for iShares Small Cap Russell 2000 (IWM) is 4.5. Historically speaking, investors in U.S. small cap blend stocks are paying a hefty price-to-book premium.
Circumstances change dramatically when investors look abroad. Both the Vanguard FTSE All World Small Cap (VSS) and WisdomTree Europe Small Cap (DFE) boast more modest price-to-book ratios of 1.7. Similarly, iShares MSCI EAFE Small CAP (SCZ) trades at a 25% trailing 12-month price-to-earnings discount relative to the iShares Russell 2000 (IWM). While U.S. small-caps are still holding their own performance-wise, inflows into foreign small caps as well as a perception of value are likely to show up in performance gains as the year progresses.
3. Stealth Health. Most readers know that SPDR Select Health Care (XLV), PowerShares Pharmaceuticals (PJP) and/or Market Vectors Pharmaceuticals (PPH) have been mainstays in my client portfolios for years. Over the same period, I have advised aggressive traders to board the biotech bandwagon through funds like SPDR Biotech (XBI) and First Trust Biotech (FBI). Yet the boom has been riding fast and furious for quite some time; the premium for drug ownership is getting a bit rich.
Nevertheless, non-cyclical sectors with limited rate sensitivity still make sense. Relative strength and modest drawdown percentages continue to favor sub-segments in the health care arena like iShares Medical Devices (IHI) and iShares DJ Health Providers (IHF). Equally worthy of consideration are global funds like iShares Global Health (IXJ), equal-weight offerings like Guggenheim Equal Weight (RYH), as well as stealth health assets like iShares MSCI Denmark (EDEN). The latter has nearly a 40% weighting in health care corporations.