Wednesday, January 25, 2012

It's Never Been More Expensive to be Defensive

As regular readers of Random Glenings are aware, I have been very cautious in my approach to the financial sector for the past year or so.
I have also been cautious on global market, believing for most of 2011 that the best markets were to be found in the US.

But now perhaps the time has come to reconsider my position.

Ah, ha! you say.  I thought you were saying that the underlying fundamentals were terrible for the banks and insurance companies.  Low interest rates, meager loan growth, and massive debt overhangs - aren't they still weighing on the group?

Oh, and the euro issues are still very much with us, aren't they?

Well, yes.  But as famed economist John Maynard Keynes is reported to have once said:  "When the facts change, so do my opinions.  What do you do, sir?"

There are several factors that have evolved in the past few weeks to have caused me to seriously reconsider my bearish stance on the financial group and international investments.

The biggest one occurred last month, in Europe. As you no doubt read, the European Central Bank (ECB) pumped nearly 1 trillion euro in the large eurozone money center banks. These loans were made for a three year term, which essentially protects the banks until 2014.

Meanwhile, the Fed pumped hundreds of billions of dollars into the interbank lending market in Europe, averting a certain credit collapse.

While most of this money now sits on deposit - the euro banks remain determined to shrink their balance sheets, and improve their capital ratios - the truth of the matter is that the ECB and the Fed have apparently staved off financial Armageddon.

So disaster is off the table, for now, at least. Greece may yet default, but it seems more likely that the euro zone will limp along for at least for the next couple of years or so.

But a recovery is not yet being priced into the financial stocks, or in many markets across the globe. Sentiment is just too bearish.

Merrill Lynch's chief global strategist Michael Hartnett was in town yesterday, and I had a chance to hear his thoughts.  The story he told goes something like this:

Everyone across the global seems to share the same sentiment.  Stocks in the US will be in a trading range, and further upside from current levels seems limited. The euro zone is in free fall, and it is only a matter of time before Europe falls apart.  China is heading for a major slowdown, as are many other emerging markets. The only safe areas to invest are US Treasurys and dividend-paying US stocks.

Michael's perceptions are confirmed by valuations in the bond and stock markets.

Investors are still piling into Treasury notes, despite the fact record low interest rates.  The Fed is apparently going to keep its target funds rate at near 0% until 2014, yet corporations and individuals continue to pile into money market funds.

In the stock market, dividend-paying "safe" stocks are commanding a huge premium to every other sector, despite the fact that growth prospects in these sectors are every bit as turgid as those found in the financial sector.

For example, here are the forward price/earnings ratios of some of the sectors in the S&P 500 (figures provided by Merrill Lynch):

Telecom        16.4x
Utilities         14.4x
C. Staples      14.3x
Tech              11.7x
Energy           10.8x
Finance         10.4x

The reason, I would argue, that telecom and utility stocks are commanding the highest P/E ratios boils down to the fact that the sector offers high dividend yields.

But can you really argue that telecom should trade at a 50% premium to technology?

Now let's take a look at the world markets:

North America        12.0x
Asia Pacific             11.4x
Europe                      9.9x
Emerging Markets    9.4x

See the pattern?  A year ago it was an article of faith that investors should have a large portion of their investable assets in the fastest growing parts of the world - namely, the emerging markets.  However, investor sentiment has turned so cautious and bearish that only the most defensive stocks and bonds are favored.

The title of this piece says it all.

Being defensive may feel comfortable, but I suspect a few years from now we'll look back in wonder at investors happily locking in meager returns, and shunning opportunities that are staring them in the face.