Jordan: Hello again everyone and welcome back to the Atlas Investor podcast with Tiho Brkan. Thank you so much for joining us today for episode number eight. Tiho, my friend, how are you doing today?Tiho Brkan: Jordan, I’m doing very, very well. Thank you for asking me that every single episode, but I’ve always forgotten to ask you back so this time I’m going to do that. How are you?Jordan: Oh, I’m great. Thank you so much for asking. I’ve been waiting, each podcast, each and every podcast, for you to ask me that. But anyway, Tiho, more importantly, tell us what you’re going to be covering today in this episode.Tiho Brkan: I’m on the final leg of my European tour as I was traveling through southern and eastern Europe, visiting Berlin, Germany. So we’ll discuss investing in Germany. We’ll
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Jordan: Hello again everyone and welcome back to the Atlas Investor podcast with Tiho Brkan. Thank you so much for joining us today for episode number eight. Tiho, my friend, how are you doing today?
Tiho Brkan: Jordan, I’m doing very, very well. Thank you for asking me that every single episode, but I’ve always forgotten to ask you back so this time I’m going to do that. How are you?
Jordan: Oh, I’m great. Thank you so much for asking. I’ve been waiting, each podcast, each and every podcast, for you to ask me that. But anyway, Tiho, more importantly, tell us what you’re going to be covering today in this episode.
Tiho Brkan: I’m on the final leg of my European tour as I was traveling through southern and eastern Europe, visiting Berlin, Germany. So we’ll discuss investing in Germany. We’ll discuss the economy and the taxes of the German economy. And we’ll look into equity prices and real estate prices, as we always do, Jordan.
And then in the global macro section, we’ll be discussing recent developments in global stock markets. In particular, US stocks over the last few weeks as well as emerging market stocks. And what’s been happening throughout 2017. So shall we get back into it?
Jordan: Sounds good.
Okay, Tiho. So Germany. Now, the first thing I want to know, while you were over there did you quaff a few beers for me?
Tiho Brkan: Well, Jordan, that’s a very interesting word. As you know, English is my second language so I’m not very familiar with that word. Can you please explain?
Jordan: Well, I wasn’t familiar with this word until recently but the definition is to drink a beverage, especially an intoxicating one, copiously and with hearty enjoyment.
Tiho Brkan: Well, that sounds definitely like something somebody should do with German beer. Or even better, as most of the German people would agree, going across the border on the east side towards the Czech Republic and drinking beer because I think it’s even better there. But yes, to answer your question, I did quaff a few beers and I had a couple of German sausages. I was there in November. It was the last leg of my European tour, as I said before, and it was getting cold and it was a perfect time to be enjoying some beer and some heavy food. I really enjoyed my time in Berlin.
Jordan: Okay, well, I’m glad to hear that, Tiho. Now, getting back to Germany and Berlin, please share some general information.
Tiho Brkan: Of course. So, Germany’s very well known. It’s a key player in the European continent, of the Eurozone economy and it’s an export powerhouse. On my overall European tour, which spanned five months, visiting over 15 countries, it’s (Germany) the wealthiest of all the countries that I visited. GDP per capita is at $44,000 US dollars, which is higher than the $38,000 even in France, Paris, where I was for episode six. 82 million people live in Germany and, of course, just like France, Germany has its own ETF for stock market exposure, as well as quite interesting real estate prices, Jordan. So all in all, it was a very eye-opening trip when it comes to investment perspectives and opportunities.
Jordan: Okay, Tiho. Now, would you like to cover the stock market or real estate next?
Tiho Brkan: Well I think the most important thing is that people at home and people who live far away from Germany, the easiest way to expose themselves to an economy like this that has been in boom stages, actually, is via an ETF or a stock market. So we should probably start with that. Most people are not going to jump on a plane, as I do, and cover 15 or 20 countries on some continent very far away from where they live and look for undervalued assets and real estate assets that take a long time to find. So shall we start with the stock market first?
Jordan: Yeah, that sounds good. And, Tiho, I’ll just say, with this podcast and with the information that you’re giving out, they don’t even have to jump on a plane and go to those places. I mean, if they’re interested in finding out more about what you do and possibly working with you in the future, they should definitely contact you, right?
Tiho Brkan: Definitely. Visit TheAtlasInvestor.com. So TheAtlasInvestor.com is the website. Get in contact with us and, you know, I work with some great clients already. We’ve had very solid returns over the last many years and we don’t just invest in the stock market and the bond market which we cover here in the podcast. We also consider quite a few alternative assets because there’s opportunity everywhere. We discussed alternative assets in episode 5. That was a great episode when I was in Prague.
Jordan: Okay, Tiho. Now back to Germany and the German stock market. Tell us how it’s been performing and tell us what the current valuation looks like.
Tiho Brkan: Sure. Well, let’s start with the performance first and then we should get into the valuation. We’ll compare it to the French market where I was recently, as well as the US stock market. So performance-wise, German stock market is up almost five times in the past 20 years. So four and a half times over the last two decades.
Having said that, while the returns sound wonderful, a majority of those gains came from the bull market in 2003 until 2007, precisely because the US dollar was weak and the global equities, excluding the United States, outperformed during that period. Over the last, let’s say, 10 years from 2007 to 2017, while German equities have made some new record highs, it has been a steady but not sharp increase.
And if you look at the chart, (for those watching YouTube right now), you’ll notice that it looks like a bit of a lost decade in some ways. One other thing I would like to say about performance is despite the fact that it has been pretty strong over the last two decades, Germany has endured five bear markets of more than 20%. During the Asian financial crisis, German stocks went down by almost 30%. Then during the dot-com bust, together with September 11, was a 60% drawdown. That was a huge crash during which German stocks declined for three consecutive years.
Then during the subprime crash and the global financial crisis, which eventually led to the bankruptcy of Lehman Brothers, German stocks decline by some 65% from peak to trough. That was within less than 18 months. Finally, we also had the eurozone debt crisis and we had the emerging market slowdown with an oil crash. Those events affected German stocks and pushed them into another bear market.
So it’s been an extremely volatile time for those investing in Germany. The German market has some great, quality companies but it’s an extremely volatile economy and therefore the stock market is too. That is because it’s highly cyclical and dependent on exports, Jordan.
Jordan: That’s true. And why don’t we get into the valuations and what kind of potential returns you think this market can deliver over the years ahead?
Tiho Brkan: Sure thing. Well, this market is priced quite similar to the French market. And I did say in episode 6 while I was in France that instead of just playing one of the European countries, whether it’s Germany or Switzerland or UK or Sweden or France, for that matter, you could buy a basket of all of them and therefore hold exposure to the higher quality European economies. They all seem to track each other to a degree. Some do better at one time and others do better during other times.
Germany’s price to book valuation, compared to the United States is quite cheap. We are looking at 1.9 times price to book. And in the United States, I think we’re edging toward 3.4 times. So the United States is quite expensive. We covered that in the previous podcast.
Price to sales in the United States is reaching 2.2 towards a 2.3 reading, which was last seen in the year 2000 prior to the tech crash. Meanwhile, price to sales in Germany is 0.9. So quite attractive relative to the United States. The low valuation is because revenues have been increasing since 2007 for the German economy and specifically German corporations. The German stock market has moved sideways over the past decade while revenues have been rising.
The CAPE ratio for Germany is 21 compared to 32 and a half for the United States. So the CAPE ratio of the United States is at a level similar to the 1929 peak. Meanwhile, Germany is quite moderately priced. It is not expensive but not cheap.
By the way Jordan, one interesting thing about Germany is its weighting in the world index is at 3.7% which is a fraction of the United States which has a weighting of 44%.
So I want my readers to understand that whenever they buy developed markets, they are not getting proper exposure to Germany. Majority of the developed markets index is still predominantly the United States. So if you would like to have proper exposure to countries like Germany you really have to go out and buy the ETF itself.
In regards to forward returns, I would answer the same way I did for France. We have had a lost decade in German stocks. We also have a lost decade in French stocks and they seem to be breaking out now. And technically it’s a pretty good picture. But having said that, we’re late in the economic cycle, momentum is very much overbought, bullish sentiment is very, very high at this point. And, finally, valuations for US stocks, as I’ve just discussed, are extreme.
So if we have a setback or a bump along the way, for United States stocks, in particular, my fear is that it could drag down markets such as France or Germany quite easily, as correlations tend to rise whenever selling pressure starts.
Jordan: Okay, so let’s shift gears and talk about real estate. Can you give us a basic overview of the German real estate market and maybe the prices in various cities within Germany?
Tiho Brkan: Yes, I will. However, before we move to German real estate, one thing that I’d like to add (and we have a chart for this) is to be wary of the current stock market rally relative to German business confidence. Whenever we had business confidence this high amongst German CEOs, decision-makers, and managers, and that was in 1998, in 2000, 2007, 2011, even 2014 and right now, we’ve always seen a bear market or a very nasty correction (in German stocks). And usually by 20, 30 and even up to 50 or more percent.
So here we are now with German business confidence at record highs. The stock market has had a terrific 2017. It’s rallied significantly from the base of January 2016 and also July 2016 which was Brexit. And European stocks have performed tremendously well. They’ve rocketed straight up and now business confidence is very, very high. So I’m wondering if the market has already discounted a majority of the positives and whether a nasty setback lies around the corner or not. Whenever confidence has reached this high, it usually marked a point from which the forward returns were not that terrific, Jordan.
Jordan: Okay, I’m glad you added that final analysis there for the listeners with respect to the German equity market and business confidence there which is very high, as you said. Now let’s talk about real estate and the values or lack thereof in various cities throughout the country.
Tiho Brkan: Sure. So I visited mainly Berlin, even though I did take a train throughout the whole beautiful German countryside. Berlin is, as you know, boosted by its young population over the last few years. And it is enjoying a growing reputation. The city is a European creative and media hub in my opinion. It’s also full of great universities, museums, orchestras and monumental and historical places to visit.
Berlin was always divided between the east and the west until 1989-1990 when the USSR started to fall. So one side of Berlin is a lot more developed than the other side. However, over the last 20 years, there’s been huge tax incentives instituted by the government to build up the other side of Berlin as well as the overall eastern side of Germany.
In regards to real estate, when you do look at the prices in German cities, they’re actually not that expensive at all relative to, let’s say, London, Paris, New York, Tokyo, even Vienna and Geneva and Singapore. I found prices to be very, very attractive. The one that stood out on the high end is Munich, which is priced at USD $6,800 per square meter which is about USD $630 per square foot. That is an average price. Prices, of course, can be much higher for luxury apartments and so forth.
The average price in Berlin was at USD $4,200 per square meter USD $390 per square foot), which is also quite attractive, in my opinion. Dresden was the cheapest city. That’s a very old, historic city, very close the border with the Czech Republic, which I visited as I drove from Prague to Berlin and back while meeting with one of my clients.
Also what I’ve noticed is that Frankfurt and Stuttgart, which happen to be on the south side of Germany, are priced much, much lower than Munich. So generally speaking, German house prices have not risen dramatically over the last several years like we’ve seen in Canada, Australia, Sweden, Stockholm, New York and Las Vegas prior to 2007, as well as Los Angeles and Melbourne. I should also include Hong Kong and Singapore to the list. Some of these global cities enjoyed huge appreciation in real estate prices.
But an interesting point that I would like to make right now is since the ECB has cut interest rates into negative territory, even conservative Germans are starting to speculate in property, Jordan. This is an interesting development. As a result, we’re seeing this upward pressure on real estate prices in some areas of Germany.
Jordan: Yeah. I just want to follow up on that. Are there any opportunities there that a real estate investor could benefit from?
Tiho Brkan: I think so, definitely. In particular, I’ve noticed that Ernst & Young and KPGM and a lot of the other big four accounting firms, as well as property development firms like CBRE and Savills, have all voted Berlin as the most prominent and most interesting investment destination for real estate money in 2018 and ’19.
Now I’m cautious when everybody thinks the same way. And that doesn’t turn out to be correct always because the consensus at times can be right. A majority of the time, when everybody’s on one side of the boat, you want to be on the other side and you want to be a contrarian. Having said that, Berlin is recording very high population growth which is up from its average over the last several years and the fastest since the German reunification.
At the same time, while Berlin is slowly edging towards 3.7 and almost up to four million people that are living in the city, it’s facing severe housing shortages. So I think this is going to put upward pressure on prices. And, finally, Berlin is not an emerging city anymore, Jordan. I have to tell you, Germans kind of viewed Berlin as an emerging city even five or seven years ago from today. But in recent years, companies are moving to Berlin, a lot of the successful people are moving to Berlin, and it has become a very exciting, very youthful, very cultural city that’s coming of age. And it’s a very interesting prospect for investment.
Jordan: That is great information and perspective. With that being said, Tiho, with all that going on there do you think there are new business opportunities there?
Tiho Brkan: Well, business-wise, Germany is an extremely developed country and it’s not as if somebody like me can just pick a handful of opportunities and say, yes, this is what should be done. I think when we discuss business opportunities, first and foremost the most important part about that is examining the opportunities that have already been implemented and developed in the United States, Canada, Australia, Germany, UK. Entrepreneurs can take these types of trends, developments and these business ideas to the frontier and emerging markets — the types of places I tend to travel to.
That’s where opportunities lie as you can introduce a new trend, whether it’s a healthy food trend or a fitness and gym trend or even a cryptocurrency trend which of course is extremely popular today. You can introduce that to the masses in frontier markets which haven’t had the opportunity or the exposure to that product, trend, technology or that food or that kind of a service. That’s where you can make money.
I think Germany, similar to the UK, France and the United States, Australia and Canada, is extremely developed. You really have to be a disruptor in some ways and a business innovator to be looking for new business opportunities. And unfortunately, I’m not.
Jordan: Okay, Tiho, let’s move on to taxation in Germany. How does it compare to France?
Tiho Brkan: Well, nothing is as bad as France, Jordan. Honestly speaking, France is up there with the highest in the world. But Germany is still pretty high. It’s a theme that’s common in the western part of Europe. Taxes in Spain, Italy, France, Germany, Sweden, Denmark. You name it. Taxes are very high in western Europe.
Corporate taxes in Germany are 23-33%, depending on the region within Germany. For individuals, the highest rate is 47.5%, which is obviously not as high as France (over 50%). But still, when you factor in value-added tax and some other small taxes, more than half of your salary will go to the government.
The value-added tax or sales tax is at 19% which is fairly high. And, finally, withholding taxes on dividends and interest as an investor, you’re looking at 25% on each. So taxes are very, very high. Germany, similar to France, does have several tax havens around the country. In particular, Belgium and Netherlands are a little bit more attractive. Liechtenstein and Switzerland are two other options and there are other options as well.
I should note that recently the ECB has been blacklisting some of these countries or tax havens as we call them. About a week prior to recording this episode, the ECB came out with a list of jurisdictions that were blacklisted as having very, very low taxes. And so Germans are having a high difficulty using some of these other jurisdictions to lower their taxes. It’s not that easy anymore.
One of the obvious ones that I’ve noticed, which nobody talks about, (well I did in episode 5 in Prague, Czech Republic), is that just across the border you have an eastern central European country, Czech Republic. Taxes there are extremely low. I’ve noticed a lot of wealthy German investors, businessmen and company leaders moving across the border towards the Czech Republic and thereby lowering their taxes efficiently.
And as you know, in the overall European Union, there is free movement of capital and free movement itself (without travel documents), so you can basically change your jurisdiction and your tax residency quite easily, Jordan.
Jordan: Great information. Now, Tiho, with all that being said, please give us a final verdict on Germany.
Tiho Brkan: Germany is an extremely developed, clean country. However, I think there are quite a few problems coming up. In particular, right now there is a bit of political instability. German business confidence is booming and that could be a problem if you’re a contrarian and you think whenever optimism gets this high the stock market and the economy will disappoint 12, 24 or 36 months down the road. And, finally, Germany is kind of going through an immigration problem because there’s been a high influx of refugees, in particular from the Middle East over the last two years. I think during that period 1.3 to 1.5 million refugees have come into the country.
Regarding Berlin and real estate itself, I think it’s priced very similar to Luxembourg and Copenhagen which are in that area. And in Berlin, you want to see rental yields increase a bit more. Basically, we’re looking at Berlin’s rental yield of 4% relative to Luxembourg at 4.4% and Copenhagen at 4.8%. That makes Berlin a little bit more expensive relative to the other two cities that I just discussed, which are between 21 to 23 times price to rent while Berlin is at 25.
But nonetheless, wages are growing, especially over the last two years, and that should continue. In comparing to Berlin to Prague, we find there are some reports now from the Financial Times that the real estate boom in Prague is basically overtaking Berlin and wages there and rental income there is even lower. So Prague is becoming a bit more expensive on this metric at least.
So generally speaking, there are opportunities in Berlin when it comes to real estate. And I highly recommend to those that have the time, the capital and the resources to go and have a look. I think Berlin is going to be and become an exciting media, culture and creative hub in the next five to 10 years. It’s really coming of age. I’m very optimistic about the city and looking forward to visiting it again, perhaps this time more in-depth as of 2018.
Jordan: Okay, Tiho. Before we start with our global macro segment today, let’s do a bit of a recap first.
Tiho Brkan: Sounds good, Jordan. Let me see what you have for us.
Jordan: Okay. Well, Tiho, in the first two episodes of the Atlas Investor podcast we discussed US and foreign stock markets. Now, these are the key asset classes acting as foundational building blocks for global portfolios. And so it is time for an update once again.
Now, just to recap, we looked at two sides of the US stock bull market by discussing high valuations and strong momentum. Now, if you haven’t listened to the first podcast, please go out and do so by downloading it on iTunes. Or even better, you can go to theatlasinvestor.com and you can watch it there on the YouTube channel with a transcript and all the charts for easy viewing.
Tiho, now tell us what’s been happening over the last couple of months in the US stock market.
Tiho Brkan: Basically more of the same. We’ve had a little bit of a pullback, a couple of percent pullback I think when North Korean geopolitical tensions started to escalate between Donald Trump and the North Korean president. But since the market calmed down, it just rocketed straight back up. So we’re still stuck in this period of high valuations versus strong momentum. One is negative and spells much lower or even negative future returns, while the other is implying that as they say in the financial world, the trend is your friend — and the trend is strong.
I would like to add something about sentiment. Sentiment has been getting very, very bullish as well. So we’ll discuss all of these things. But in general, momentum is now reaching the point at which it’s running very, very hot. We’re now approaching 370 trading days since the last 5% drawdown and this is something that we haven’t experienced since the ’60s and the ’90s. And I think the upper limit that was around 400 trading days. I think by the end of December and start of January, we would be breaking a record if we don’t have at least a 5% pullback.
This is a historical anomaly and it remains to be seen how long the current trend can run without a pullback. For the time being, as of this podcast, United States stock market is making new all-time highs. It’s above the three-month moving average. And technically speaking, everything still looks pretty good. So as long as the trend is moving in the right direction, there is no reason to turn bearish and to start shorting this. This is a very powerful move and you would have to respect that, Jordan.
Jordan: Okay, you mentioned the streak for US stocks. What about global stocks? Are they on the same kind of winning streak? Because I know here and there over the last week or two we’ve seen a few cracks, but not major cracks yet.
Tiho Brkan: No, not at all, actually. We’ll delve into a few of the cracks but, generally speaking, we do not find any within the broad indices like S&P or the All Country World Index. The All Country World Index, MSCI developed market index, is up every single month this year. That is something that hasn’t happened since the inception in 1988.
On the other hand, when you look at the ETF, it was down a little bit in June. So we kind of broke that streak. But generally speaking, it’s been a red-hot run, since November of last year after Donald Trump won the election. At the same time, the S&P 500 total return is up 13 months in a row, which is a record. We’ve never seen that over the last 100 years. It has been an incredibly powerful run.
On top of that, Jordan, I would just like to add another statistic. The market has enjoyed a winning streak from January to November, and December has never, in the history of S&P 500 going back to 1920s, been the worst month of the year. And in terms of seasonality, December, November, and January, have been pretty strong months. It probably means that we might finish the streak with 12 great months, which would be remarkable.
Jordan: Okay, Tiho, I want to turn to volatility because this has been trending down in recent months. Those who are watching here on YouTube and viewing the transcription with the charts on theatlasinvestor.com, they can see this chart of the Vix. Since the end of 2015, the VIX has been in a steady downtrend. Over the past year, the declines in the VIX have been sharper
What’s your take on this? At what point is volatility going to move higher or will it continue to trend lower and lower and lower? It looks like there’s not much room left on the downside.
Tiho Brkan: The VIX tends to hit lows around 8 or 9. It doesn’t go much lower than that. But you never know. Maybe we’re going into a new paradigm shift where stocks are going to start trading like bonds. And they will give you a 20% return a year but with only 5%-7% volatility every year.
The VIX has been making lower highs. We had the China crash during which the VIX hit 40. And then the high in the VIX was 30 around the oil bottom, at the start of 2016. Then the VIX made another lower low which was at 25 and then it hit 20 between Brexit and US election. Tensions with North Korea resulted in a VIX of only 16 while recent turbulence marked a VIX of 14.
The VIX is following a pattern of compression like I discussed in earlier podcasts. It is akin to keeping a basketball under water. At one point, you look away for one second and you let the basketball go. It could eventually explode out of the water and smack you in the head. So you’ve got to be careful with this.
Moving away from the VIX, realize that the one-year volatility on the actual S&P 500 is around 7.5% per year. That is essentially where bonds trade. This is now lower than the period between ’94 and ’95, and it’s approaching the lows of the period last seen in ’64, ’65. When volatility is this low, it could stay there for a while, Jordan. Historically, looking at volatility, it doesn’t always dramatically spike back. That doesn’t mean that it won’t, but usually volatility kind of bases and builds an arching base and pattern from which it begins to slowly rise.
Perhaps we’re in a period of very boring markets where they’re going to stay extremely un-volatile and quiet for a long time. It remains to be seen. We’re watching this on a weekly basis.
Jordan: Speaking of other things you’re watching, credit spreads, which you covered so brilliantly in episode number six, usually, when volatility is so low, credit spreads are also low, these two can correlate closely. Please give us an update on credit markets and if anything’s changed in the last month or so.
Tiho Brkan: No major changes. One of the most important things about the junk grade credit spreads is that they’re not narrowing or compressing that much anymore. Essentially, they’re not outperforming treasuries the way they did for a majority of 2016 and into 2017.
In particular, I would like to point our readers and listeners towards CCC credit spreads, which are not showing in any charts on the transcript or the YouTube video. Essentially these credit spreads, relative to equal maturity treasuries, have started trending up and widening a little bit. Usually, it’s an early sign of something going wrong. But at the moment, Jordan, nothing major.
Credit spreads are kind of quiet. They’re hovering and muddling through in a sideways fashion and whenever something negative starts to develop, we have to watch credit spreads to see if they’re going to be breaking from this tight range which is 4.0 to 4.1 on the upside for junk grade and roughly 3.5 to 3.6 on the downside. So the spread is very, very tight right now and I think a break on the upside might signal the start of a trend of widening credit spreads. That would eventually be negative for the stock market, which is in a euphoric and momentum-filled run-up without any kind of a correction for over 370 days.
Jordan: Okay, Tiho, now let’s turn our attention to foreign stocks and emerging markets in particular. They’ve obviously performed really well this year and you correctly predicted this out-performance at the beginning of the year and your clients have benefited so nicely. What are the developments recently in this space that you want to discuss?
Tiho Brkan: Well, similar to credit spreads and the way that I look at junk grade bonds over treasuries, (which are a risk free rate of return), I also look at the difference between, let’s say, S&P 500 or the US which I would regard as quality in the world relative to emerging market stocks. So junk bonds tend to correct before there is something wrong within the overall credit space because they’re the most sensitive, especially the triple C, the really low junk that has a high chance of default during crises.
At the same time, we can apply the same quality mechanism and thinking process to stocks. Basically, here we’re watching emerging markets start to show early signs of cracks. I mean, I think they’re already down some 4%-5% from their recent record high. And it’s very important to watch emerging markets here, Jordan, because they’re starting to lose a bit of momentum. They’re starting to correct while the S&P has not.
A similar story is actually happening in some of the tech names. In particular, semiconductors. They’re also starting to correct. And critically speaking and technically speaking as well for emerging markets, they’re at a very important technical junction because they just broke above this decade-long horizontal resistance line. Now, if we broke up we ought to stay there if it’s a bullish move. But at the same time, we’re very far away from the 12-month moving average. So the distance between the price and the moving average itself reached almost 20% recently.
So it seems that there is a bit of a mean reversion here. Now, if the mean reversion is very powerful and Emerging Markets break below this horizontal line, some technical analysts and some investors might take that as a failed breakout and a bull trap. In that case, the correction to the downside could be a bit more violent. I’m not necessarily predicting that. I’m just warning that this is a possibility and we ought to watch this very carefully. This development is very interesting.
I want to see is whether emerging markets are leading other areas and other regions of the stock market to the downside.
Jordan: And I think another thing you’re going to be watching with emerging markets is emerging market credit spreads. Give us an overview of that and what you see there and if it has any implication if this is going to be a small correction in emerging markets or something more severe.
Tiho Brkan: Well, since the Federal Reserve, ECB and the Bank of Japan has goosed up the overall bond market, this applies also to emerging market credit spreads as well. Emerging Market credits are close to record lows in yield. And the credit spreads there are really narrowing to some of the lowest levels since we’ve seen in 2007.
Now, unlike the junk grade which tends to signal an early warning sign for US stocks, the emerging market credit spreads are not that tuned into the overall risk dynamic. Essentially, you will notice that they tend to react a little bit later and they can lag relative to emerging market equities. For example, it the middle of 2015 or even April of 2015 where emerging market equities peaked and started to fall. It was only a month or so later that emerging market credit spreads finally bottomed and started to widen. It was quite a late warning signal. The equity market was the first and, surprisingly, the credit markets, which tend to be earlier, were actually giving the signal last.
Finally, when emerging markets bottomed in January of 2016, credit spreads actually peaked out in February of 2016. So once again they were late, even on the other side of the trend. So I don’t pay much attention to emerging markets credit spreads as a leading indicator. But I do watch them very carefully for other signals. And right now, they’re signaling that investors are taking a large amount of risk in emerging market corporate credit space.
Jordan: Now, Tiho, as you know, emerging markets have corrected by about 5%. But US stocks made another record high this week. Has the out-performance trend from emerging markets, has that stopped for now? What do you read into this recent development, if anything?
Tiho Brkan: Well, that’s a very interesting question, a great question, Jordan. So we’ve had outperformance from November 2016 until recently as emerging markets were performing much better than the United States. And they’ve had a great rebound since the January 2016 lows. However, recently they’ve started to break down and correct in part because they’ve had such a tremendous run. Anything that gets too far away from its mean, and rises too far and fast, (in a performance and return perspective), tends to correct.
Everything apart from Bitcoin and Litecoin, actually. Those can keep going up forever. But everything else, though, tends to revert back towards its mean eventually, either over the short term or long term. And that’s what emerging markets seem to be doing here. They’re correcting a little bit to the downside. This out-performance that they’ve had over the United States stocks is starting to lose traction.
So this is a development that’s interesting to watch. And one of the things that is important to discuss here, Jordan, is the way that emerging markets also started to lead United States stocks after the Asian financial crisis from 1998. They performed quite well from then into the early 2000 dot-com peak. But after that, they started to lose out-performance again. Eventual, y the emerging market bull market would start in 2002-2003 and emerging markets would strongly outperform US stocks for the next five years.
So the question here is whether this was just an emerging market temporary uptrend and the US will regain the dominance of years prior. So I’m keeping a close eye out. Emerging markets have performed well over the last 12 months and now they’re losing their leadership and I want to see how this develops over the coming weeks.
Jordan: Okay. So if momentum, for the time being, has stalled out for emerging market stocks, how much longer then can the bulls keep pushing US stocks higher?
Tiho Brkan: Well, that’s a great question. In theory, they can keep going up as far and as high as they want. And they can take as long as they want to do so. We’ve seen all kinds of things happen in markets and we should always have an open mind to many possibilities. Having said that, history is a pretty good guide. It’s not a perfect guide and by no means is it a set of rules that we should set in stone. But nevertheless, when we look at history, and I’ve got some data here for our listeners and readers, it’s a good guide.
So the current run for US stocks (as far as days without a 5% drawdown from an all-time high) is approaching 370 days (as of this podcast), which is about 1.5 to 1.6 years. That is 18 months. The longest ever is 394 days so by the middle of January or even early January we could be there. That would be the longest run without a 5% correction. At that point in time, with regards to people who say to me the momentum is the reason I’m holding stocks, I would say, yeah, sure, I agree but even momentum itself is getting so ahead of itself, by any historical measure, and running so hot by any historical statistic, that even momentum will take a breather.
That is without a 10% drawdown, which is a more meaningful correction in the S&P 500. These can run for much longer. We’ve seen runs of up to 6.8, almost 7 years. So the current run of not having a 10% drawdown from an all-time high, can run during very strong secular bull markets for as long as they want. Even up to seven years almost.
So what I’m looking for here, predominantly, is at least a 5% to 10% pullback in the S&P 500. And because we’ve already explained that emerging markets are much cheaper on a relative basis to US stocks, those that want to invest in emerging markets, by the time this correction was to unfold, a 5% correction in the S&P 500 could be something like a 10% correction in emerging markets so even more. So a correction could generate some pretty good value in emerging markets, Jordan, over the short term.
Jordan: Okay, Tiho, so with that being said, please give us your final verdict right now on global equities.
Tiho Brkan: Well, momentum is very, very strong. It’s a bullish signal and it’s kind of in a total opposite spectrum relative to valuations, which are extremely high, and bullish sentiment which is also extremely high. Because those two are negative there is basically a fight between the bulls and the bears, and investors have to make their mind up whether they’re going to follow the trend and the momentum or whether they will turn cautious because just about everybody is piling into stocks.
Stocks are trading two standard deviations above the 50 days mean. They’ve been going up for 370 days without any kind of a pause. And this is, mind you, a year that has had the smallest drawdown, of two and a half percent, going back a hundred years. There’s only one year that’s similar to this and that’s 1995. Every other year has had at least a five to 10 percent intra-year drawdown. And we’ve had none of that stuff happen in 2017. So the question is how much longer can momentum carry us relative to the warning signals that we’re getting from valuations and also extremely bullish sentiment?
To close out, one of the things that I’m really looking at right now is emerging market stocks and the way they’re starting to break down a bit. They’ve been holding the three-month moving average since the US election bottom when they began to rally hard. And throughout the year they’ve bounced off this three-month moving average, but recently they’ve traded below it. And it’s an interesting development for me and I’m wondering if this signal applies to the rest of the market because emerging markets have led on the upside.
They’ve been a terrific performer and my clients and I have really benefited from that. But now I’m wondering if this is a negative signal and whether this will lead other markets, including the US, into a correction, Jordan.
Jordan: Great analysis Tiho. Now please tell us what you’ll be covering in episode nine, which I believe will be the last episode of 2017?
Tiho Brkan: Well, that’s perfectly said, Jordan, actually. So in the last episode for the year we’ll be actually doing the year in summary. We’ll look at every single major asset class and all the stock markets from the regions that we track. This includes all the bonds and credit and alternative assets. We’ll look at how they performed and whether there were any serious or nasty surprises along the way.
It’ll be an interesting episode so don’t miss out. Definitely, tune in. I’m looking forward to this one.
Jordan: Tiho, just a quick question. Will that also include the performance of the cryptocurrencies which have been on fire?
Tiho Brkan: Well, relative to the cryptocurrencies, I think everybody’s wealth is down by some 93-94%. When I measure my wealth, my returns this year, I’ve made over 26% for my own personal account and for some of the clients who invest with me. I’m basically down 99% in value if I adjusted to the new currency called the Litecoin.
So I’ve actually been impoverished this year despite the fact that I think I’ve performed very well. My purchasing power has declined significantly in Litecoins. So I don’t know what to do, Jordan.
Jordan: Well, Tiho, I’m really looking forward to episode number nine. Great work today, my friend. And as we close, we want to thank the listeners, of course. If you have a moment, please visit iTunes and leave a review of the podcast. We would really appreciate it.
Thank you for listening to The Atlas Investor podcast. To be notified of future podcast episodes sign up for our free newsletter and join our Youtube channel. Tiho Brkan offers his clients a wide range of services. Including portfolio construction and wealth management. One on one consultations. Global real estate opportunities. International tax planning. Citizenship and residency planning. And one on one mentoring. For a free consultation, visit the Atlas Investor dot com and contact Tiho Brkan.