Too Many Pessimists

This week: Vanguard MSCI Emerging Markets ( Ticker: VWO )

At an investment conference the other day the mood in the room was optimistic, despite the recent thrashing the market has suffered. Of course, nibbling on oh so delicate pastries in a swanky hotel can have that effect. But really, many of the portfolio managers there, responsible for hundreds of billions, were cautiously bullish on equities because they believed everyone else – individual investors, doom-and-gloom economists – was just too pessimistic.

To be sure, there are problems. Worries over Euro-zone debt, slow growth and a credit downgrade in the United States and signs of slowing growth in emerging markets drove the awful August sell-off and those problems remain today. Yet the market has discounted each of these problems and while they are significant, they are manageable.

Equities in developed market – Canada, the United States, Europe – are down between 12 to 20% from their April highs but have recovered somewhat from their mid-August lows. The price to earnings ratio of the S&P 500 is at about 12 to 13 on trailing earnings, a level not seen since March 2009. Some European equity indices – Germany’s DAX and France’s CAC 40 – are at long-term price-to-earnings ratios of around 10 times, well below their historic average.

These cheap valuations suggest investors fear a double-dip, a recession following recession with tepid growth in between. True, in the absence of action, we likely would fall into a recession. But is that realistic?

When my novice 8-year old and I play chess (on a non-virtual wooden board if you can believe that!) his moves do not yet anticipate my reactions. Similarly, many investors do not anticipate how governments and central bankers will react to fear of an economic slowdown.

President Obama unveiled a fiscal stimulus plan on Thursday worth nearly US$450-billion, much bigger than the US$300-billion flagged. Skewed largely towards tax cuts for workers and business, the package could boost gross domestic product by about 1% and jobs by about a million, according to economists’ estimates. While the plan still must pass Congress, it is expected a good deal of it will be approved.

Federal Reserve Chairman Ben Bernanke, worried about his mandate to maximize employment, (and not just his own), is sending signals of further stimulus to be announced in two weeks. Unlike the last round of Quantitative Easing, this anticipated next round, called “Operation Twist” should bring down longer-term interest rates and that may encourage further investment and spending.

European central bankers are following the same script, buying their sovereign members’ bonds and considering cutting interest rates to spur economic growth. For now, the Euro zone looks like it will work out of its debt crisis though more drastic measures may come in future.

Nor are emerging market actors sitting idle. In contrast to developed markets, emerging markets faced high inflation 10 months ago and began aggressively raising interest rates. They have largely succeeded and have now softened their tone on monetary policy, indicating that further rate increases are unlikely. Brazil has gone a step further by actually cutting rates two weeks ago.

Other indicators agree that we are not recession-bound. Prices for copper, a key industrial metal and a strong leading indicator of economic growth, have remained robust at above $4 a pound. Supply disruptions have helped the price but demand remains firm too.

One of the best economic indicators, the yield curve or the spread between short and long-term bonds remains in positive territory, with the long-term much higher than the short. The curve often inverts with short rates higher than long rates as speculative activity becomes excessive, followed soon after by a recession. There is a question as to how accurate the yield curve would be in forecasting a double-dip recession but the jury is still out on that.

For beaten down markets such as these, buying the most unloved assets can be the best. In this case, emerging markets have suffered the most as investors fled risky assets for the safety of U.S. government treasuries.

Our preferred ETF for broad emerging market exposure is the Vanguard MSCI Emerging Markets ETF (VWO-NY). It holds 910 stocks and China, Korea, Brazil, Taiwan and India make up 65% of the ETF. The fee of 0.22% ($22 per $10,000 per year) is less than a third of its nearest competitor.

Disclosure: We may hold positions in any securities mentioned in this report.