The Disconnect Continues Richard Bernstein June 3, 2011 Our strategies focus on finding disconnects between investor sentiment and the reality of improvement or deterioration in fundamentals. The current disconnect regarding the United States and the emerging markets still appears to us to be quite significant. We continue to significantly underweight the emerging markets in our funds. Through the end of May, the emerging markets have lagged the United States (see Chart 1), and emerging market fundamentals continue to erode, yet investors remain generally quite bullish regarding emerging market debt and equities. Investors, in our opinion, continue to underestimate the opportunities in the United States and underestimate the potential risks in the emerging markets. Chart 1: 15% 10% 5% 0% -5% -10% -15% 9.7% 8.7% 7.8% Russia US vs. BRIC & Emerging Markets* Year-to-Date Total Returns as of 5/31/11 US Small-caps 2.4% -2.2% -2.2% -10.2% US EM Brazil China India * Total returns, dividends reinvested, in local currency. For index descriptors, see Index Descriptions at end of document. Yield curves don t lie One of our favorite indicators is the slope of the yield curve. Yield curves have historically been very good predictors of future profits growth and of future trends in equity market volatility. Steep curves (i.e., a wide, positive spread between 10-year and 2-year notes) have generally been followed by periods of stronger growth and lower volatility, whereas inverted yield curves (i.e., the 2-year rate is higher than the 10-year rate) have generally been followed by profits recessions (i.e., periods with negative year-over-year trailing EPS growth) and higher volatility. The United States currently has the steepest yield curve in the world. As Chart 2 shows, the spread between US 10-year and 2-year notes was about 259 basis points at the end of May. Interestingly, this is not only the steepest yield curve in the world at present, but the US yield curve is close to its steepest since the mid-70s (the steepest was the 291 basis-point spread on February 4, 2011).
US Peru UK New Zealand Czech Reb Colombia Singapore Philippines Spain Hong Kong Finland Italy Netherlands Poland Belgium Denmark Russia Mexico Austria France Canada Germany South Africa Switzerland Israel Hungary Japan Norway Indonesia Malaysia China South Korea Taiwan Thailand Australia Sweden Chile Turkey India Brazil Ireland Portugal Greece If history is any guide, the very steep US yield curve argues that current expectations regarding future US corporate profits growth and equity market volatility trends are too bearish. However, some yield curves around the world are starting to suggest increased caution may be warranted. Chart 2 also reflects that yield curves are inverted or very flat in a number of countries, including some of the BRICs. Most investors are probably not surprised that Greece, Portugal and Ireland currently have the world s most inverted yield curves, but our guess is that investors have no idea that Brazil s yield curve is a mere 1 basis point from inversion, or that India s is only 2 basis points from inversion. Chart 2: 300 200 100 0-100 -200-300 Global 10-Year to 2-Year Sovereign Bond Spreads* as of 5/31/11-897 Source:, Bloomberg * Current 10-Year Sovereign Bond minus Current 2-Year Sovereign Bond or Current 9-Year Sovereign minus Current 1-Year Sovereign Bond for countries with 10-Year or 2-Year data unavailable, in local currency. Many US investors are very concerned about the Fed s future monetary policy and the looming end of QE2, but aren t the least bit aware that yield curves in the BRIC countries might soon invert. This seems critically important to us because history shows well that bull markets typically end not at the beginning of a central bank s tightening cycle, but rather when the central bank has tightened too much, and inverted yield curves typically indicate that a central bank has tightened too much. The US currently has the steepest yield curve in the world, and investors are very concerned about the longevity of the US bull market. BRIC yield curves are close to inverting, but investors don t seem the least bit concerned. This is a whopping disconnect, in our view, and presents a significant, actionable investment opportunity. 2
Earnings Fundamentals Continue to Favor US Companies By our reckoning, the US currently has the world s best corporate fundamentals. As charts 3 and 4 demonstrate, the US currently leads the world in the percentage of companies reporting positive earnings and positive revenue surprises. BRIC and emerging markets are lagging well behind. Chart 3: 70% Percentage of Companies Reporting Positive EPS Surprises by Region (1Q 2011) 60% 50% 40% 30% 20% US Europe US Smallcaps World BRIC Emerging Markets * For index descriptors, see Index Descriptions at end of document. Japan Chart 4: 60% Percentage of Companies Reporting Positive Revenue Surprises by Region (1Q 2011) 50% 40% 30% 20% US Europe US Smallcaps World BRIC Emerging Markets *For index descriptors, see Index Descriptions at end of document. Japan 3
Chart 5 shows the percentage of companies reporting negative earnings surprises. Japan leads the world in disappointing results because of the earthquake s disruption of the Japanese economy. If it were not for that unusual circumstance, BRICs might be leading the world in negative earnings surprises. Chart 5: 60% Percentage of Companies Reporting Negative EPS Surprises by Region (1Q 2011) 50% 40% 30% 20% Japan BRIC Emerging Markets World US Smallcaps * For index descriptors, see Index Descriptions at end of document. Europe US The disconnect continues We have previously pointed out that investors seem unaware that the S&P 500 has outperformed the MSCI BRIC index for almost three-and-a-half years. In addition, we pointed out that, despite the popular view that the US dollar is being de-valued, the tradable dollar index (DXY) has actually appreciated by about 1% per year over the past three years (sources: and Bloomberg; see Index Descriptions at end of document). From our standpoint, it appears as though these facts have largely been ignored. Now, we are trying to draw attention to the fact that BRIC yield curves are on the brink of inversion, while the US has the steepest yield curve in the world. Such signals, while certainly not infallible, have historically been reliable predictors of future equity returns, but investors portfolios nonetheless remain generally overweight emerging markets and underweight the US. Wesee opportunity in this disconnect. 4
INDEX DESCRIPTIONS: The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indices. Anyone interested in such further details is free to consult each such sponsor s or originator s website. Indices are not available for direct investment. US Small-caps: Russell 2000 Index. The Russell 2000 Index is an unmanaged, marketcapitalization-weighted index designed to measure the performance of the small-cap segment of the US equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index. US: Standard & Poor s (S&P) 500 Index. The S&P 500 Index is an unmanaged, marketcapitalization-weighted index designed to measure the performance of the broad US economy through changes in the aggregate market value of 500 stocks representing all major industries. World: MSCI ACWI Index. The MSCI ACWI Index is a widely recognized, free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of developed markets. Emerging Markets: MSCI Emerging Markets (EM) Index. The MSCI EM Index is a free-floatadjusted, market-capitalization-weighted index designed to measure the equity-market performance of emerging markets. BRICs: MSCI BRIC Index. The MSCI BRIC Index is a free-float-adjusted, market-capitalizationweighted index designed to measure the equity-market performance of the following four emerging-market country indices: Brazil, Russia, India and China. Europe: MSCI Europe Index. The MSCI Europe Index is a free-float-adjusted, marketcapitalization-weighted index designed to measure the equity-market performance of developed European markets. Japan: MSCI Japan Index. The MSCI Japan Index is a free-float-adjusted, market-capitalizationweighted index designed to measure the equity-market performance of Japan. DXY Index: InterContinentalExchange (ICE) US Dollar Index. The ICE US Dollar Index, indicating the general international value of the USD, averages the exchange rates between the USD and six major world currencies, using rates supplied by some 500 banks. Brazil: Bovespa Index. The Bovespa Index is a total return index weighted by traded volume and is comprised of the most liquid stocks traded on the Sao Paulo Stock Exchange. Russia: MICEX. The MICEX Index is a real-time, market-capitalization-weighted composite index. It is comprised of the 30 most liquid stocks of Russia s largest and most developed companies from 10 main economic sectors. India: Bombay Stock Exchange Sensitive Index (Sensex). The Sensex is a free-float-adjusted, market-capitalization-weighted index. The selection of the index members has been made on the basis of liquidity, depth, and floating-stock-adjustment depth and industry representation. China: CSI 300 Index. The CSI 300 Index is a free-float-adjusted, market-capitalization-weighted index that consists of 300 A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges. 5
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