Please read the Disclaimer before reading this article.
Please note that this is a big picture think piece. I won't go into detail about the short term timing aspect as I usually do.
I currently hold a position in Emerging Market stocks.
Emerging Markets and the US Dollar
The next 10 years won’t look like the past 10 years. It seems obvious, but most investors buy the things that have done well in the past, instead of the things that will do good in the future.
A lot of times, buying the things that have done well is not a bad idea because markets trend. This is the reason why there is a huge academic writing on momentum being the “premier market anomaly”, according to Fama and French.
As legendary investor George Soros put it: “Most of the time I am a trend follower, but all the time I am aware that I am a member of a herd and I am on the lookout for inflection points.”
So, following the trend is not bad. We know for example that growth has been outperforming value for year after year (and by a huge margin). A lot of people have tried to call the rotation, where value would start to outperform again, in these last few years. As we all know, growth has continued to outperform.
So, once you have a trend, it continues longer than most market participants think, and as Soros states, it is best to ride the trend as long as possible.
On the other hand, markets are cyclical and investors herd. In the beginning of 2000, 62% of Americans thought it was a good idea to buy stocks. The dot-com bubble burst and the market lost 50% of its value. In the middle of 2002, when the market was at its lows, only 34% of Americans thought stocks were interesting. As you can see, investors do the opposite of what they should do.
Why were they so bullish at the end of the 1990’s? Well, the S&P had just quadrupled in 10 years time and this performance was extrapolated into the future. Interesting to note is that in 1990, only 26% of people thought it was a good time to buy stocks. Again, the masses were wrong.
Source: Gallup
Extrapolating the past into the future is one of the worst things an investor can do. Markets are both trending, and cyclical. As Howard Marks put it: “I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.”
There are short term cycles and long term cycles. In this article, I want to have a look at these longer term cycles.
Imagine a passive investor that invested in the US equity market for the last 10 years. This investor would have an annualized return of more than 13% (including dividends) during this period. That’s a great performance (for retail and institutional investors, we of course want much higher returns :-) ).
The problem comes when this passive investor needs to decide what he will do for the next 10 years.
The following chart shows that between 2008 and now, the US stock market increased significantly (despite declining 50% during the financial crisis) while emerging markets did absolutely nothing.
However, between 2000 and 2008, the US stock market did absolutely nothing while the emerging markets increased significantly.
What if the passive investor we are talking about wasn’t invested in the US for these past 10 years but in emerging markets? His performance would have been terrible.
The herding we just talked about and the fact that investors are most positive about an asset class when it’s recent history is good, indicates that probably a lot of investors were very bullish emerging markets right before and right after the financial crisis because it did so well in the years leading up to the gfc. This extrapolation of past performance was detrimental to their investment returns.
So, the big lesson of the chart above is that markets move in big trends. The last 10 years, emerging markets did absolutely nothing while the 10 years before, they were on of the best asset classes you could invest in.
The next chart from GMO shows the performance of a traditional 60/40 portfolio. Again, you see that there are long multi-year periods when your returns are almost zero.
In the year 2000, when we had just experienced an 18-year secular bull market in stocks, more than 60% of Americans thought buying stocks was a good idea because they extrapolated past performance into the future. This was a huge mistake and the next 10 years didn’t resemble anything what they expected.
Source: GMO, Tonight, we leave the party like it’s 1999
So, we know from Soros that it is best to stay invested in a trend but these previous two charts also show that there are big secular trends when markets either do nothing, or they do an awful lot, for multi-year periods. Markets are thus cyclical as pointed out by Howard Marks.
A lot of famous investors and big asset management firms have been bullish on emerging markets for several years because their valuations are low. Since valuations are a great predictor of long term returns, I understand (and agree with) their reasoning.
However, how can we time these things? Did you want to be in emerging markets these last few years when they stayed flat and you saw a huge outperformance by other asset classes? I certainly wouldn’t.
The missing link between valuations and the timing of when these low valuations start to work (resulting in outperformance,) is global macro.
I’ll use our example of the US vs emerging markets as a case in point.
The following chart shows the performance of the stock market of developed markets versus those of emerging markets (top panel). The bottom panel shows the relative performance between the two. As you can see, there are big multi-year cycles. Emerging markets did great between 2002 and early 2008 but they did absolutely nothing between 2008 and 2020.
Source: MSCI, The future of Emerging Markets
Javier Gonzales writes the following in his book ‘How to make money with global macro’: “If one were to oversimplify the observations in this book into one strategy, it could be called the dollar strategy. It basically invests on the trend of the dollar. If the dollar is appreciating, it invests in the Nasdaq. If the dollar is depreciating, it invests in commodity-exporting markets or commodities.”
If we overlay this relative performance chart (of the US stock market versus those of emerging markets) with the trend of the dollar, we see that they are (almost) the exact same.
For several years, people have been writing about how cheap emerging markets are. However, as the chart above shows, the united states kept outperforming these last few years, even with its much higher valuations. As you can see on the following chart, emerging markets have been cheaper than the US for the last 8 years. Regardless of that, the US kept outperforming.
Valuations are not a timing tool.
Source: Gerard Minack, GMO
The explanatory variable is the us dollar. It’s only when the dollar will start it’s secular declining phase, that emerging markets will structurally outperform developed markets.
(Please note on the chart above that the us dollar also follows multi-year trends. Once the dollar starts to rise, it keeps on going for several years, the same happens when it starts to decline.)
So, what will the us dollar do the next few years?
The following chart shows that from a fundamental perspective, the dollar is overvalued compared to other currencies. So fundamentally speaking, we should be looking for a lower dollar. But, as we already know, valuation is not a timing device. The dollar was wildly overvalued at the end of 2016 but two years later, the dollar stood almost at the same level.
We can also see that is was strongly undervalued in 2005, 2006,… but the dollar only bottomed and started it’s structural rising phase in 2011.
Source: GMO, Quarterly Letter Q2 2018
So, we need something else for the timing than valuations.
The following chart shows the big picture. As you can see, the us dollar follows the trend in the twin deficit (current account balance + government budget balance) very closely (with a 2-year lag). This chart is not up to date and actions by the us government have made the twin deficit explode (even more) in 2020.
I can write a lot more about why I think the us dollar has entered a multi-year bear market but that’s the story for another article.
Let’s recap what we’ve learned in this article:
-Markets trend in very long term cycles and as Soros said, it’s best to ride the trend. Sometimes the us stock market does nothing for 10 years, sometimes it has an incredible run (the same goes for emerging markets).
-At the end of such a cycle, most investors incorrectly extrapolate the past into the future. As we learned from Howard Marks, everything moves in a cycle.
-A lot of people only look at valuations for their investments but as I showed in this article, valuations are a poor timing tool. (Emerging markets have been cheaper than the US for more than 8 years but still the US kept outperforming).
-To explain when an asset class will start to (out)perform, we need to use global macro. The trend in the US dollar is the variable that can explain the relative performance between the stock market of the US and that of emerging markets.
-To know what the us dollar will do, we looked at
1) valuations, to have a long-term fundamental bias
2) the twin deficit, to get a sense of when the move will begin
When the us dollar gets weaker over the next few years, markets that have been dormant for a long time will start to outperform. Most investors will still be in the things that did well, instead of those that will do well. Make sure you are not one of them.
What else will do well when the dollar is declining? The following chart shows that commodities should outperform.
And as we can see below, commodities also move in big multi-year cycles. It’s not because commodities have been a horrendous investment for the last 8 years, that they will be a horrendous investment for the next 8 years.
(The orange line shows the 10 year annualized growth rate for commodities.)
Source: Janus Henderson Investors, Are we entering the next commodities supercycle?
Finally, let’s have a look at the technical picture for emerging markets. It had a huge run since the March lows but as you can see, it’s hasn’t even broken out yet above it’s 10-year base. It’s easy to think that you are late to the party but the party is only just beginning. Make sure you are correctly positioned for the next few years. Don’t assume that things that have done incredibly well in the past (growth, technology, US) will continue to do so. In my opinion, the time has come that dormant markets will start to come alive (emerging markets, commodities, value).
