Good investment and trading practice is that you always have a thesis and the thesis implies certain milestones, and profit and loss levels. If the milestones are not met, and the thesis is unchanged, even if profit targets are met or exceeded, one should reassess the trade, preferably cutting it while the reassessment is taking place.

I have long held that the US economy was on a sustainable growth path and that the level of growth would be low, circa 2% long term trend rate. This is a view held since October 2011. With the continuing recovery, one would reasonably have expected an eventual roll back of unconventional policy involving the large scale asset purchases by the Fed. QE tapering was therefore a positive signal, in my view. With the telegraphing of QE tapering, the moderation in the pace of Fed asset purchases, my view was that there would be some significant weakness, despite the advance signal from the Fed, and that this would be a buying opportunity. The prevarication by the Fed has meant that one of the milestones in my investment thesis, a particularly important one, had been missed. Regardless of the profit or loss situation on the trade, I would take it off the table. Do I think the US equity market will rise further? Yes, probably. However, my initial thesis implied an important milestone that was missed. This is a matter of investment discipline.

I maintain the view that the US economy is on a path of sustainable growth. That the new equilibrium trend growth rate is now closer to 2% than to 4% is likely to be confounding the models used by most forecasters and the Fed. This is a contributing factor for the Fed to be likely to be more accommodative than it needs to be on an ongoing basis, at least until it revises its long term growth rate.To be clear, I do not see a weak economy and I do not see the Fed as interpreting it as such. The delay of QE tapering is likely in respect of a confluence of a couple of risky events which the Fed would like to see out of the way before it moderates its asset purchases. Topical issues like the German elections and the uncertainty around the possible structure of the coalition, the impending fisticuffs over the US debt ceiling and the historical turbulence around October time, have probably led the Fed to postpone QE tapering by a month or two. There may be some weakness in the market then that may be worth buying into.

We began to be bullish US equities 14 Oct 2011. On 13 Jan 2012, we called a buy on Europe across all risk assets on the back of the ECB’s unprecedented 3 year repo facility. This was a bit early and required the investor to sit through quite a lot of volatility. Some would have folded in May 2012 on the adverse price movements, but it turned out to be a profitable trade after all.

We continue to like the US and Europe. US equities, while still attractive on the back of a recovery are no longer as cheap as they were a couple of years ago, and are also more advanced in the profit cycle. While we continue to maintain exposure to the US, we now turn our attention to Europe, an under-represented exposure in many investors’ portfolios.

First of all, Europe is a high risk investment. The Euro as a single currency clearly doesn’t work. Its financial symptoms have been clear enough with mini crises precipitating in the periphery of the Eurozone every so often. Greece, Italy, Spain and Portugal continue to look flimsy. The banks continue to periodically wobble. But the true cost of the Euro is yet more insidious, it is that factor markets, particularly the labour market, fails to clear. A host of issues remain unresolved and await the German election where incumbent Angela Merkel is expected to win. After that the hard work begins.

Yet for all its risks and flaws, Europe remains an attractive hunting ground for investment opportunities. A number of features make Europe stand out as a region where detailed analysis can be rewarded by the discovery of mispriced assets.

1. The global nature of its companies.
2. The heterogeneity of its economies and businesses.
3. The complexity of its financial system.
4. The complexity of its political system.
5. The length and traction of its history.

The current opportunity consists of a number of things. Europe is currently in the early stages of a recovery, much like the US was nearly two years ago. Europe had a different crisis than the US. Whereas the US leant on and broke the pole of residential housing, Europe had an unsustainable financial model and monetary system which was laid bare by sudden contraction of credit in 2008. Europe’s economic woes were and continue to be much more serious than in the US. As a result, compared with the US, Europe is still in the very early stages of recovery. Now an inspection of the broad European stock indices might make it appear as if Europe had already recovered, but these are the consequence of global companies listed in Europe pulling up the aggregate indices.

Whereas profit margins in the US are at cyclical highs, in Europe, corporate profitability remains weak. Yet investors are happy to assign multiples of 15X to US earnings and only 12 X to European earnings. Europe is facing discounted valuations on trough earnings making the market quite attractive. With a nascent recovery, profitability and earnings have a higher probability of recovering to trend levels. Markets tend to also reward such recoveries with higher multiples. The upside potential is significant.

In the US recovery, companies with high operating leverage prospered. A similar scenario is likely to occur, if the European recovery gains traction. As political systems more Socialist and labor markets less efficient, European companies on average have higher operating leverage. Even the much vaunted German companies have codetermination and labor representation on boards. Excess capacity abounds in Europe, a delaying factor in a recovery, but a boost to profits when a recovery gets underway.

While the US contemplates moderating its central bank asset purchases (QE Tapering), the ECB is expected to remain accommodative. Tightening will not be on the ECB’s agenda for some time to come. Cost of debt will remain low, especially for companies with access to the debt capital markets, while global operations provide diversified sources of revenues, making for attractive economics.

In many ways, the conditions that favor European equities may favor European high yield bonds even. Low interest rates, weak positive growth, international companies, bode well for high yield credit.

No investment is without its risks. The risks of investing in Europe, we have already highlighted. The fundamental flaw of the single currency, the Euro, will create periodic mini-crises, as markets, for goods and services as well as financial assets struggle to clear. This can be a risk as well as an opportunity. Sometimes, the best assets are found in the scrapheap.

Do not fear QE tapering. Its a good thing.

1. Its a sign of strength, that the economy is able to tolerate tighter monetary conditions.

2. US treasury issuance is falling as a result of improving economic growth and thus tax receipts. If the Fed maintains its purchases as a proportion of issuance, it would have to slow its rate of purchases.

3. By operating QE, the Fed is removing from the market the most ubiquitous, important, and highest quality collateral used in repo agreements. The Fed does not rehpothecate its assets on a large scale ongoing basis, although it has been contemplating a reverse repo facility in its last FOMC meeting. QE therefore reduces the liquidity in the collateralized lending market. Given that LIBOR markets have thinned, since 2008 and then the LIBOR scandal, the repo market is extremely important to global credit and liquidity. QE tapering is positive for repo liquidity. Because collateralized lending, particularly on such short tenures has a highly advantageous risk weighted treatment under Basel 3 capital rules, it is an important source of credit in the current environment.

Its all rather confusing. But not any more so than usual. Things are always confusing in the present and clear in the past. What is confusing today, are the number and strength of the conflicting signals. We therefore consider, in broad summary, the bull and bear cases for general conditions. 

The bull case.

The US economy is onto a sustainable recovery. Europe appears to be editing recession bnnand establishing a sustainable recovery. Even China appears to be stabilizing sufficiently for the government to embark upon structural reform. Japan has staged a remarkable comeback under the new, or old, prime minister. Only the emerging markets look a bit tired. Markets have experienced some turbulence mostly because the US Fed has publicly contemplated the gradual withdrawal of extraordinary stimulus. This has send interest rates higher and bonds lower. Emerging market assets have corrected sharply on an apparent switch in capital allocation. However, generally, the signs mostly point to a healthier global economy with the tapering of QE testament to central bank confidence in the US and China, which is undergoing their own brand if QE tapering.

The bear case.

There is some convexity around the bear case. Fundamentally, the US economy’s growth is both weak and potentially unstable. Unemployment numbers are only suppressed by a declining participation rate. Inflation numbers are not indicative of a strong recovery. The housing market seems to be slowing as mortgage rates climb. Corporate profitability seems to have peaked. Earnings growth has been powered by the financial sector and only then by a reduction in provisions for bad loans.

Europe remains financially fragile with most of the problems back ended until after Merkel, hopefully, wins the German elections. Greece, Spain, and Portugal are cash flow insolvent with Italy not far behind. The Draghi Put is untested and hopefully will remain so.

In the emerging markets, Brazil and India struggle to regain competitiveness while the current accounts of Indonesia, India and Turkey lead a pack of deficit countries raising fears of crisis. And China’s semi closed capital account may insulate it from contagion, but its debt levels and opaque shadow banking system represent a significant tail risk.

Making sense of all the signals.

Both bull and bear signals coexist as they often do. Complicating the analysis are the outright conflicting signals between fundamentals and market prices. With little evidence of inflation, US rates are expected to rise and the term structure has indeed already steepened. The market regards QE tapering with trepidation even as it is a sign of underlying strength in the economy. Emerging markets still represent the main marginal driver of global growth yet capital has fled on apparently no significant catalyst.

One of the complicating factors is QE itself. Administered as an analgesic during the crisis it has sheltered the economy and the market to the extent that it is hard to estimate the health of the economy without QE. Such uncertainties plague asset markets.

The lack or an unadulterated signal also impairs the ability of policy makers to measure the normal equilibrium condition of the economy. Policy makers end up making policy to manage legacy policies, and are required to think iteratively through the feedback loop. Feedback loops are as we have experienced in the past, rather unstable and unpredictable. This makes policy increasingly difficult to get right.

For the investor, the level of noise risks swamping signal. Short term trends can be confusing and provide false signals. Longer term horizons can mitigate some of this. What it means is that I am for the moment suspending my usual reliance on shorter to medium term signals in favor of longer term ones, and relying more on fundamental, bottom-up security selection than on tactical, momentum driven, macro trading. For the moment.

Is Caterpillar a US company or a Latin American one, or a European one, or an Asian one? Is Santander Spanish, British, or Latin American? Is Alstom French, or Nestle Swiss, or HSBC British, or Chinese? Are any of the large listed Swiss companies Swiss?

When we say equities are cheap and bonds expensive, to which companies do we refer?  Should we compare the equity valuations of large caps with the bond yields of high yield issuers? Could the cheap equity issuers have even cheaper bonds?

The world fears peripheral European banks. How then should an investor regard the securities of the German operations of a Spanish bank? Or the securities of the Swiss operations of a US investment bank? How much did the holder of Lehman International UK bonds get in recovery, 9 cents or a dollar and change?

Established investment methodology has always puzzled me. The modus operandi involves having a top down macro view, from which the regional and country allocations are made. A macro analysis of the relative attractiveness of equities and bonds are made, sometimes before, sometimes after the regional and country allocations are established. Bottom up stock picks are then made to populate the asset allocation. In an increasingly globalized world, this approach appears less relevant. Companies are more global than ever before. They do business and thus derive their revenues from various regions and countries and they fund themselves sometimes locally and sometimes globally, making their commercial prospects the result of complex interactions not captured by traditional methods of asset allocation.

Instead, companies should be analyzed from the bottom up by assessing the revenues from each region and country, and their costs and financing, in the same manner, from where they originate. Top down macro analysis can direct the search for opportunities but should not determine the asset allocation directly. Once the fundamentals of a company or business have been estimated, the value of the firm needs to be distributed across its corporate and capital structure. Each security is therefore valued on fundamentals. Then the hard work begins.

Asset prices and markets are driven by fundamentals not through a mechanical couple but through an elastic or viscous couple. Having a fundamental valuation of each asset is necessary but not sufficient. Market technicals and psychology need to be considered in the investment decision. For each market, an intimate understanding of all the major market participants, their motivations and capabilities, needs to be obtained and factored into the investment decision. Market participants are motivated by their economics, agency compensation, cultural peculiarities, regulation, et al. Their capabilities will involve their sources, costs, availability and stability of funding.

The result of all this analysis is the efficient portfolio. Asset allocation between equities and bonds, between regions or countries, is a consequence of the process, not the root of it.