TEUN DRAAISMA WAS THE HEAD OF EUROPEAN EQUITY STRATEGY AT MORGAN STANLEY. VERY WELL KNOWN AND RESPECTED AS A STRATEGIST HE WAS ALWAYS KNOWN TO BE A GREAT STRATEGIST. HE LEFT RECENTLY TO JOIN TT INTERNATIONAL, AN OLD AND QUITE FAMOUS EUROPEAN HEDGE FUND. HE RUNS AN EQUITY FUND UNDER A MACRO STRATEGY.
Below is his commentary for February 2012, he notes that European stocks are extremely cheap and despite decades of underperformance there is a way to find value and make money in Japanese equities. He believes QEIII could be the catalyst which drives Japanese stocks and that stable growth companies should be the best performers.
Three multi-decade extremes
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- We agree with consensus view that developed market economies face a continuation of low growth, deleveraging and shorter cycles;
- Despite this sub-trend outlook, developed market equities will exhibit rallies while policymakers insert liquidity, for instance through quantitative easing programmes;
- The correlation between stocks reached an 85-year high in 2011, which tends to be followed by strong markets unless there is policy failure;
- High dividend yield stocks have reached their most expensive level of the last 60 years (except for a few months in 2008), suggesting that stock pickers would do best looking elsewhere;
- European equities’ valuations have reached record cheapness versus US equities, based on more than 30 years of data, and the risk-reward for their out performance is excellent.
It has now become consensus that the medium-term outlook for economic growth in developed markets will continue to be dominated by deleveraging, low growth and shorter cycles. I always try to challenge consensus views, but in this case, I tend to agree. Of course, Japanese equity markets have been in this type of environment for over two decades now, so one can learn some lessons from their equity market behavior (see chart 1). I found that there are three such lessons:
- There are occasional large rallies lasting several quarters, and the trigger for these rallies is invariably policy action. Recently, QE1 and QE2 have provided such rallies, and we are currently witnessing the LTRO rally, while later this year a QE3 rally may well unfold.
- The best stock picking factor in Japan has been 1 month return reversal – this is a quantitative finding rather than a tradable strategy of course, given the huge turnover involved if applied in practice.
3. Despite the second lesson just mentioned, stocks with the right characteristics can be consistent outperformers and become very expensive, as was the case in Japan for exporters with strong brand names. Of course, Japan’s deleveraging period occurred during a time of prolonged expansion in the rest of the world, which is quite a different context from developed markets’ current predicament. Stable growth names should be the structural outperformers.
Signals from the dashboard
My dashboard is populated with a wide variety of indicators. Frequently these indicators are not at extremes and give no strong message. I get excited, however, when indicators do reach multi-decade extremes, as these are often the basis of good investment ideas, as and when reversion-to-the-mean takes hold.
Reversion to the mean is the most powerful force in finance. The precise timing of the reversion is a tricky and crucial little detail, hence Keynes’ famous quote about markets remaining irrational for longer than you can remain solvent, or equally one of his other quotes that in the long run we are all dead. But still, economic, technical and sentiment factors eventually revert to the mean, and determining where we are with respect to that mean is a crucial starting point in investing.
My approach to investing is to take discretionary decisions based on a disciplined quantitative framework. To make well informed investment decisions, I find it valuable to discuss ideas with colleagues and peers, in order to test hypotheses, learn new insight and gauge where the consensus lies.
At a recent roundtable discussion, organised by a broker and attended by a select group of distinguished investors, one of the distinguished investors felt compelled to state, with some conviction, that reversion to the mean is dead! It made my contrarian alarm bells ring.
So, here are the three extremes that I am excited about.
If one takes all the 15 readings that were above 50, one also finds that markets have always risen in the next 6-12 months, except for in the 1930s. Therefore, history suggests that record high correlation is a bullish sign for equities, unless there is policy failure. But in the absence of policy failure, this evidence suggests that the outlook for equities in the 6-12 months after record correlation is good, for instance if policymakers embark on all kinds of ways to insert more liquidity in the system (however bad the long-term consequences of these actions may be).
In addition, the high correlation suggests that stock pickers should spend time trying to identify the stocks that have become too cheap as a result of the indiscriminate selling across the board. The second and third multi-decade extremes mentioned below make strong suggestions in that respect.
Extreme 1: correlation between stocks at an 85-years high in 2011
In 2011, the correlation between stocks reached its highest ever level, based on calculations by Empirical Research, using US data (see chart 2), based on data since 1926. This record high correlation is a result of all stocks having a strong tendency to move up and/or down together, which typically happens when volatility rises. Another reason for higher correlations is that ETF trading and indexing have become more popular in recent times, but in my judgment that is only a very minor element to the high correlation story in 2011. Interestingly we found that high correlations happens in the most extreme way when macro events dominate (recession, depression or other), when stock picking takes a back seat, stocks are being sold or bought together, and the proverbial baby is being thrown out with the bathwater. In fact, extreme levels of correlation are reached towards the end of a bear market, most of all.
Also, note that this phenomenon does not occur at the end of bull markets. Things are quite different at that point, as bull markets have a strong tendency to become more and more narrow, thus resulting in low – and not high! – correlation between stocks. Remember for instance the fact that TMT stocks peaked in 2000, while the rest of the market had gone nowhere since 1998.
What are the investment implications of this first multi-decade extreme observation? I have sliced and diced the data in a few ways. If one identifies peaks with perfect hindsight, markets have always risen in the next 6-12 months, with one exception, which was the period following the peak in Dec-1929.
offer good risk-reward from an absolute return perspective. It is even possible that the valuation of some of these high dividend-yielding stocks mean-reverts through the valuation multiples, not through stock price performance. And there will be quite a few high yielding stocks with depressed share prices that can outperform significantly in tandem with high future earnings growth. But this type of starting point is not great risk-reward for outperformance for the high dividend yield style, as a general statement. Similar pictures can be shown for the valuation of quality and low beta type strategies.
Extreme 2: high dividend yield paying stocks are expensive
High dividend yield paying stocks have only been more expensive once in the last 60 years, which was during a few months in Q4 of 2008. This, too, is based on calculations by Empirical Research, again using US data (see chart 3). This has been a result of the flight to safety and yield during 2011.
Chart 3: Relative valuation of high DY stocks at 60-year high
High-yield stock are now valued at a near-record premium to the market (Large Cap Stocks Highest Quintile of DY Relative Trailing PE Ratios 1951 – Mid-Dec 2011)
What is the investment implication of this second multi-decade extreme observation? I think it means that high dividend yield paying stocks without growth are not very likely to be outperformers from this point onwards. Of course that is not to say that they don’t
A weaker euro will help this position, for instance, but investors should hedge their FX exposure. In addition, it should be pointed out the European equity market is a better play on Emerging Markets, more so than the US equity market is: 29% of European quoted corporate sector’s revenues originates from Emerging Markets, which is much more than the equivalent number for the US equity market of 20%, according to estimates from Morgan Stanley.
The risk-reward of preferring European equities over US equities is excellent. The story is that if Europe gets “solved” by its policymakers Europe obviously outperforms, but equally, if the crisis deepens, it will create a global crisis, which is much more in the price of European equities already. Most investors may assume that European equities can only beat US equities in rising markets. I think, instead, that from these levels Europe can beat US equities in up as well as down markets, given how large the valuation differential has become.
Extreme 3: European equities valuations have reached record cheapness versus US equities
European stocks are record cheap compared to US stocks (see chart 4). We calculate this based on a range of measures, including these three: the Shiller PE, which is based on the average inflation-adjusted earnings from the previous 10 years, the average of three stable metrics (PBV, DY and PCE), as well as a sector-neutral version of the latter. The conclusion is the same each time.
Of course the EU crisis provides a very good reason for Europe to trade cheaply, and it is understandable that global investors were not too keen to buy more European equities last year. However, this has created a significant opportunity.
Chart 4: Europe versus US equities – valuations at 30-year low
The case for Europe in a global context is not only based on valuations. Other, more fundamental factors, are supportive.
It is clear that the structural problem of too much debt will continue to lead to deleveraging, low growth in developed markets and shorter cycles, and this problem is particularly acute in parts of Europe, in line with consensus thinking. But despite this, we believe European equities stand a very good chance of outperforming other regional equity markets, given the starting point in terms of valuations.
Global investors ignore Europe at their peril.