In my last post I gave a broad overview of my views on the market going forward and I broke it down to the sectors that I thought would outperform in the next year given the current state of the economy and the markets. In this post, I would like to highlight a few of the specific bets that I have made and analyze what I consider my “risky” segment of my portfolio, making an informed bet on what will happen going forward.

Dollar Bear

Low rates and fiscal stimulus are at the core of my medium term view of the dollar. Low rates are more apparent given that rates are at their floor but the government spending portion isn’t as apparent for some so I thought I would elaborate why this contributes as well.

There is a special quality to the dollar as the reserve currency of the world which means it has the ability to run ever greater trade deficits and still maintain a capital surplus to fund the deficits. This capital surplus tends to be funded by the countries that manufacture goods and fix their currencies to the dollar to stay competitive. It doesn’t matter for this argument what they are selling to the US whether it is oil or electronics, fixing their currency to the dollar will obligate them to keep their money in dollars and invest it somewhere, usually safe US treasuries. However, there are plenty of governments that want to pursue their own monetary policy independently and don’t want to chase the dollar downward. Think the EU, UK, Canada, Mexico and Asia outside of China and Japan.

As the US economy accelerates and the stimulus hits, the demand for imports from consumers will increase, pushing down the dollar. Combine this with low rates and the tolerance of the Fed for a period of inflation above the 2% trend and you have a recipe for a medium term dollar decline.

The valuations in the US are the other side of the coin that is turning me off to both the growth sectors as well as big tech here. The US market forward premium is trading at a 29.6% premium to the MSCI EAFE market, an index that tracks advantages economies outside of the US. This is one of the largest premiums seen for the US market over other advantages economies in the past 25 years. Premiums can persist for long periods of time and indeed the US has traded at a premium since 2015, but as money managers shy away from richly priced tech in the US, I am looking for funds to naturally flow to more reasonably priced markets where value and dividend yield offer better medium term prospects.

Value Bull

We are at the tail end of a growth stock mania right now. The Nasdaq 100 has returned just 1.74% year to date versus the CRSP Large Cap Value Index which has returned 10.03%. Growth stocks as well as consumer cyclicals took the lead in returns last year as investors bet on the current (more tech) and the future (a consumer boom in reopening via the consumer discretionary sector), but these sectors have become so saturated and richly priced that investors are forced to look elsewhere for return. The high valuations of tech coupled with the low rates are what make me a value Bull. Value just means that the fundamentals of the stock are priced cheaply. This usually means however that a value strategy is heavy in cyclical stocks that tend to have a lower P/E and P/B. Those sectors right now are energy and financials, which happen to be the best performing sectors so far this year.

The move into low quality growth is also pretty worrisome for investors worried about valuations. I personally would never put my money in an SPAC knowing it’s a gamble on a manager finding an acquisition which may take years to become apparent if it was worth it. There will always be a few of these that will defy the odds and strike it rich but probability in this sector leans towards underperformance. Tech that has earned little or no money also seems to be riding this wave, defying the fundamentals. This was probably best exemplified in a recent chart put together by economists at Vanguard which showcase the return of low quality growth versus value over the past 10 years.

So starting to put the prices together in terms of value we have:

• An economy starting to heat up, this brings the cyclical stocks into the mix as consumers break out with new purchases and travel.
• High valuations for growth stocks that have outperformed value for near a decade and now look richly priced.
• Institutional flows starting to move towards value. Once trends are established in the first quarter or two, minus any negative shock, they tend to persist towards year end. The trend is your friend here. This was definitely the case last year, tech and consumer discretionary started to pull away from the pack and never looked back once the trend took hold.

Personally, I have a cognitive bias towards fighting the trend which I have done my best to try and control over the years. I go against the grain by nature and that is the same when it comes to my investing style. It has taken a lot of discipline to understand that as a small investor I can ride the wave of the trend toward higher returns, I need to let go of what I cannot control and let the institutional money pull my stocks up with them.

What This Translates Into

I prefer to make my bets via Vanguard ETF’s. I know there are cheaper ETF’s and some that are even free but those are gimmicks to me. I trust the brand of Vanguard to deliver specifically what I want: a low cost ETF that tracks the index, nothing more. I trust them to apply this consistently across their products so I don’t have to worry about hidden fees on a new ETF.

Blackrock, through their iShare funds also allow me to make country plays, which align with my macro outlook. I can isolate a particular National stock market as well as currency to take advantage of medium term mis-pricing.

So here are my picks based on the macro outlook I described above:

• Vanguard Small Cap Value (VBR)
• Vanguard FTSE All-World ex-US Small Cap Index (VSS)
• Vanguard Mid-Cap Value ETF (VOE)
• EAFE Value ETF (EFV)
• FTSE 100 ETF (EWU)

In addition to these I hold the index tracking the MSCI Emerging Market Index (VWO) as well as The Emerging Markets ex-China ETF (EMXC).

Of these I want to highlight specifically why I picked the UK stock market out of all of them. I picked these simply as a valuation play. In the medium term the Brexit vote and separation from the EU has hurt sterling and during the pandemic pushed the dollar all the way down to $1.16 per pound. Since that time sterling has rallied by 19% yet remains well below its pre-Brexit highs which reached as much as $1.70 to the pound in 2014.

Apart from a rosy currency picture, the stock market is looking cheap. It’s loaded up with “old economy” stocks in energy and banking but those are just the type of cyclicals I am expecting to do well in the coming months. Some names include Unilever, HSBC, AstraZenica, Shell and spirits maker Diageo. The entire market is trading at just 13.6 forward earnings as opposed to 21.9 times in the US market, a 38% discount.

Even across industries, every sector is trading at a discount compared to their US peer.

Finally the gap between the yield on government debt and the dividend yield of the market is the best it’s been in almost 100 years.

You will notice that despite my dollar bearishness, I still picked out mid-cap and small-cap dollar funds. These have more to do with my lack of exposure to these segments in my overall portfolio as well as the fact that I am hedging my bets in case my prognosis is wrong and the dollar holds up relatively well and the US does indeed outperform.

So there you have some of my bets for the next year going forward. It will be a great exercise to visit these calls in a year and see how right or wrong I was. If you are investing in overall macro themes or you fee there is a specific company that will outperform feel free to share in the comments or through social media.

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