There are some people in life that just have to go against the grain. Some of us use this as a philosophy in life which stretches into our investing habits. I count myself as one of those people, both in life as well as in the way I save and invest.

Although I don’t often discuss my penchant to go against the grain and what everyone else is doing, you will find pieces of it throughout this blog. Buying the cheapest apartment I could possibly find in NYC rather than trying to keep up with the Joneses. Learning foreign languages and working as one of the few Americans in emerging markets for 10 years, and living a frugal and humble lifestyle unabashedly all the while working in an industry which tends to celebrate flash, pomp and name brands.

I have found that rather than being a liability, going against the grain has been a strength for me this entire time. It has given me supreme confidence in my convictions yet the humility to admit when I was wrong and concede that sometimes, the majority is on to something.

Different people manifest their individuality in different ways in the investment world. Some turn into short sellers, others into niche strategies and some into contrarian investors. Two areas I have had a strong attraction to in this sense in the past 10 years have been value investing and, due to my experience working there, emerging markets. It has been a dismal decade for both of these strategies to say the least. 

Is Value (and EM) Dead?

It’s no secret that big tech has been tearing it up the past few years. The 4 biggest tech stocks have returned about 29.5% annually since the start of 2015 while the rest of the S&P 500 which returned around 5.7%.

Source: cmgwealth.com

Meanwhile the value strategy, which takes positions on heavily beaten down stocks with low p/e’s, book value and price to sales, is suffering from one of its longest periods of underperformance in the last 40 years.

Source: Russell Investments

As Jean van de Walle has pointed out in his fantastic blog on emerging markets, value and emerging markets share a lot of similar characteristics. They both tend to be focused on the more cyclical and risky companies traded in the market. You will notice in the chart from Russell above that value tends to do well when growth stocks are doing poorly and when the overall market is either bearish or little to no growth. This is a similar story for emerging markets over the years. Although the MSCI index for emerging markets was only started in 1987, de Walle captured the visualization of the outperformance of emerging markets precisely when US markets were underperforming.

Source: theemergingmarketinvestor.com

What’s even stranger this time around is that even though emerging market performance has been awful over the past 10 years, that terrible performance is also being propped up by tech in emerging markets. China and East Asia have been at the forefront outside the US of establishing competitive tech companies to serve their home markets as well as those abroad. China is the dominant equity market in the MSCI EM index now and often determines in what direction the index will head. Just take a look at the top 10 constituents of the MSCI EM index 10 years ago versus 2Q 2020.

When you break out emerging markets on a regional basis, the disparity becomes clear.

Source: theemergingmarketinvestor.com

Latin America and EMEA have produced negative returns annually over the past decade, the entire index was only saved by Asia. What’s worse is that the value segment for Latin America did even poorer than its own index. Tech start up Mercado Libre has managed to save face for the region, but apart from that, Latin America and emerging EMEA have been areas to state away from for the past decade.

Source: theemergingmarketinvestor.com

As we all know though, this kind of outperformance by tech cannot last forever. When will it end? It’s tough to say, and if anyone knows the answer, they likely wouldn’t share it because they would be trying to profit off of it. Although I don’t see strong headwinds in the near future for either value or emerging markets, there are major issues looming for developed markets that can have an effect on tech and US outperformance as a whole.

US Fiscal and Monetary Issues

There was a fascinating article in The Economist this week which provided a survey of the competing theories in response for the macroeconomic conundrum the US and much of the developed world now finds itself in: stuck in low growth, high debt and endless quantitative easing.

The overview of the academic response on what to do is broken down into 3 main camps. The first is to essentially maintain the status quo, meaning all will be well if the central bank can buy assets and print money. No other additional stimulus or policy response is needed, Fed backing will provide the confidence and liquidity needed to pull through this crisis, similar to the last one.

The second is that added fiscal stimulus is needed to boost growth with public deficits soaking up the private savings of individuals. The Harvard economist Larry Summers falls in this camp. Central Banks would merely become relegated to fiscal enablers whose main job would be to keep borrowing cheap as deficits soar. No credence should be given to high debt because the cost of servicing it will remain low.

This is similar to the modern monetary theory or MMT concept espoused by some on the left like congresswoman Alexandria Ocasio Cortez. The difference from MMT being that this camp makes its case in the sense that issuing debt with 0% interest is the same as printing money which is assumed to have 0% interest. However over time, the glut of debt would force interest rates to rise this camp says, and monetary policy could regain traction.

What is not mentioned in this is that issuing debt to eventually produce higher interest rates kicks the pain can down the road and risks a debt crisis in the US. Politicians who want to keep their job will likely do whatever they can to avoid a debt crisis so it risks becoming a Japan like policy where debt is piled on then stuffed down the throat of government entities and agencies like social security and federal pensions and we continue along a low growth, low interest spiral similar to Japan.

The third camp wants negative interest rates. In order to become effective, negative rates would have to permeate the economy. Central banks are creating their own digital currencies and toying with the idea of having these offered to the public directly through a digital savings account.

This last school of thought is the most extreme and could completely upend society. It could destabilize or wipe out the banking industry or make it fully government run. Imagine your money losing value were you to try and save it. Imagine the backlash for corporations being paid to issue debt or the rich with could credit being paid for their mortgages. The social ramifications of this may produce a backlash so large it could be politically destabilizing to society.

Apart from these schools of thought, inequality as sapping growth is being seriously looked at. Structural sources of high inequality may be the lack of competition. Some academics are urging for a return to large unionization and the breakup of large monopolies, especially in the tech sector.

What Does This Mean for Your Portfolio?

Like it or not, radical reform is being given serious thought in academic and policy circles and none of it seems to bode well for big tech or the US stock market. Higher taxes, higher debt, lower growth and more pain seem to be in the forecast for the US. We may be seeing the peak of US outperformance compared to other economies.

If you look back on factor and sector investing, this is hardly the first time a sector like value or emerging markets have underperformed for so long that they were written off by investors. Energy and commodities were terrible investments in the 90’s while the tech boom fueled a massive rally in growth stocks. When the tech bubble burst however, the sector remained an underperformer for 10 years while energy took off.

Source: awealthofcommonsense.com

Many have been anticipating this “great rotation” out of tech and into value and emerging market stocks which could well dominate returns for the next decade. Indeed, we are seeing some factors that may be starting to speak to this rotation, mainly:

• Without attractive interest rates, growth prospects and with high equity valuations, the US dollar may see a slide compared to other developed and emerging markets in the medium term.
• Commodity prices are at multi-decade lows. Stimulus from commodity hungry China could reignite demand and create a new appetite push globally.
• The low interest rates as well as inflation expectations have enabled emerging market central banks to lower rates like many never could in the past. Look for consumer and business borrowing there to jump and juice equity returns.

In other words, it may come in the next few years but will require patience. If you know a stock like Tesla is overvalued but, like many others, have no idea when it will come down, the analogous trade is to go long on a beaten down strategy. Having patience may pay off in this case.

If you don’t want to place a one sided bet, an alternative approach which I take, is to hedge that contrarian impulse by going long the index as well. It’s dominated by tech so if value is still a loser and tech continues its winning streak, you win too. There’s no shame in hedging your bets in this type of environment, happy investing.

The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.