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Opportunities despite high valuations
WITH just a few months to the end of the year, financial markets are in one of those deceptively calm periods.
US stockmarket indices are inching up to new all-time highs. Sentiment is buoyed by strong employment numbers, high profitability and expectations that interest rates will be kept low in the foreseeable future.
The benchmark S&P 500 Index is valued at more than 20 times earnings, with cyclically adjusted ratios even higher at 26 to 27 times.
High US valuations are a troubling development for investors who have not benefited from the post-2009 rally and are looking for a safe place to park their money.
The US is the world's biggest and broadest market, with a large number of profitable, cash-rich companies for investors to sink their teeth into. Yet at these valuations, one cannot easily make the case for investors to buy a low-cost exchange-traded fund (ETF) tracking the S&P 500 to get exposed to stocks.
The world's biggest funds are turning cautious. BlackRock, for example, downgraded US equities to "neutral" in a June report, citing stock valuations being in the 70th percentile of their long-term historical range.
Even in Europe, the strongest, most stable stocks, many of them consumer-related blue chips listed in the UK's FTSE 100, are running at historically high valuations.
The world of bonds is no different. Bond yields globally have continued to fall as investors rushed for safety following events such as Britain's exit from the European Union at the end of June.
In Europe, it is rare to find a 10-year government bond trading at above one per cent. Bond prices are now so high that yields are even negative in Switzerland, Germany, Japan and the Netherlands.
Low long-term yields typically signal that markets think a recession is coming. But yields worldwide are also being distorted by extraordinary levels of bond purchases by major developed market central banks in Europe and Japan.
Another reason is the surfeit of savings and the relative lack of investment opportunities in a slow growth world, where populations continue to age.
Meanwhile, debt levels continue to rise in some parts of the world, notably China. The interconnectedness of the global financial system means that a shock in one area can rapidly spread to other parts, as we saw from China's stockmarket crash a year ago.
And thus one potential trading idea comes from buying insurance against the current combination of low volatility and high valuations. Insurance like index put options can be purchased for one's stock portfolio. These will gain in value should stocks take a tumble, and expire worthless if they do not.
Gold is also a hedge against economic turmoil, though its price can often be speculative.
One can also bet on rising volatility through complicated ETFs structured to track the Chicago Board Options Exchange's (CBOE) widely-followed volatility index, or VIX.
Invest in the expensive or the cheap?
A second point needs to be made: Sometimes it pays to invest in expensive stocks and steer clear of cheap stocks. The answer is never clear cut. Some markets or stocks are justifiably expensive because they are fundamentally strong and likely to outperform. Likewise, some stocks are cheap because they are expected to do badly.
The art of investing is to gauge which stocks are more expensive than what is justified, and which are cheaper than justified.
One good example is food stock Nestle, which has traded at an average of 20 times earnings over the last 15 years, and continues to get more and more expensive as its underlying earnings continue to grow.
Facebook looked expensive when it first listed in 2012, but its rapid growth in generating revenue from advertisements now makes its initial valuations look cheap.
On the flip side, indebted companies operating in cyclical businesses can trade at low earnings ratios or high yields because investors expect some of these companies to go bankrupt - which does happen.
The difficulties in judging the growth potential of a company is one key reason why investing is much harder than it looks. It is not just about comparing ratios.
Recognising that crystal ball gazing into whether a company will grow 20 per cent or 30 per cent in the next five years is close to impossible, some investors decide to stay away from such "growth stocks" trading at price to earnings multiples of 20 to 30 times or more. Rather, they focus on so-called "value stocks", which are often more stable companies that have temporarily taken a hit due to one reason or another.
They come up with a guess of how much the company is worth, based on its historical earnings. Some projection into the future still has to be done, but value investors are often conservative about growth rates.
Some of these stocks operate in cyclical industries, and might make losses in bad times. But if they are stable enough, goes the thinking, they will survive to benefit when the good times roll around again.
Thus value investors come up with a guess of how much these stocks are worth, and call it intrinsic value. They make the move when the company is trading at a sizeable discount, say, 30 per cent, to its intrinsic value. They call this the margin of safety.
Value stocks in Asia
To value investors, Asian stocks are a decent hunting ground.
Fundamentally speaking, the region still has a sizeable working-age population and will continue to grow.
A major problem is high debt levels, especially in Chinese companies and less so in Japanese ones.
Another issue is poor corporate governance, especially at firms where the CEO wields sizeable influence over the board.
Nevertheless, across stock market indices around the world, the cheapest ones in terms of absolute forecasted price to earnings ratios and price to book ratios include those nearer home: Singapore, Hong Kong, China and Russia. Stockpickers sifting through companies in these markets might be able to find some gems.
In bonds, valuations are generally at year-to-date highs across the board even for emerging markets (EM), after a strong inflow this year that pushed down yields and caused currencies to appreciate. But in relative terms, the difference between a number of EM yields has widened relative to US Treasuries.
The extra yield cushion one gets from investing in EM bonds might suggest opportunities, despite the higher volatility that can come with investing in these countries.
Many Asian countries are considered emerging ones, and there will also be opportunities to lend money to fundamentally strong Asian companies in the year ahead.
The US presidential election
Apart from putting in short trades and considering investments in the region, investors have to be aware of known risks. These include the continuing debt worries over Chinese banks, along with the depreciation of the Chinese yuan.
Meanwhile, as the end of the year approaches, the biggest event on the calendar, not just for the US but for the world, is its presidential elections on Nov 8.
As at mid-August, polls show Hillary Clinton - seen to maintain the status quo - with a comfortable lead. However, there is still some time before November and politics is unpredictable.
A win for Donald Trump would create more uncertainty for global financial markets, though the effects would not be as immediate as what would happen if, for example, the US fails to raise its debt ceiling.
Nevertheless, markets will react in the short term, and investors have to draw up a trading plan accordingly.
Analysts have said that the rise of protectionism, which Mr Trump symbolises, will slow growth around the world.
Economists have always told us that higher trade barriers will make domestic exporters less competitive while potentially hurting employment and economic growth. But tariffs can protect local workers from losing their jobs. Hence they will be popular.
In the US, higher tariffs imposed on imported goods from Mexico and China, as Mr Trump suggests, will be inflationary in nature. This will lead to faster hikes in interest rates and a stronger US dollar - a negative for emerging markets.
The prospect of higher interest rates will also mean investors should stay wary of bonds, particularly those that yield very little.
However, Mr Trump has also promised to drastically lower the top rate of taxes that US businesses pay to 15 per cent, from 35 per cent. This will boost the economy, but make it more indebted.
As such, some analysts have suggested that a Trump victory will lead to a short-term boost in stocks, but less so over the medium term.
All in all, financial markets never get boring, and always provide investors with an opportunity to make money.
They just need to have the cash to do so, the confidence to enter based on logic and data, and the temperament to stay invested in turbulent times.