Will The Rally In Cheap Markets Continue?

Stock markets around the world have appreciated significantly from their late March lows but the rebound has not been even. Since the lows, US equity markets have rebounded more than most developed market countries during Q2 2020, but continue to trade at much higher valuations that other markets.

Current Global Stock Market Valuations
 US Markets[1]Non-US Markets[2]Emerging Markets[3]
Price/Cash Flow11.766.234.82
Source: Morningstar
[1] SPDR S& P500 ETF Fund (SPY) as of July 10th, 2020
[2] iShares EAFA Index Fund (EFA) as of July 7th, 2020
[3] Vanguard FTSE Emerging Market ETF (VWO) as of May 31st, 2020

This is important because there is a strong long-term correlation between current equity valuations and future expected returns.
Correlation of CAPE Ratio with S&P 500 Index Real Return

Source: Research Affiliates, LLC, based on data from the Robert Shiller database. 1881 – October 2017
CAPE: Also known as the Shiller P/E, the Cyclically Adjusted Price to Earnings Ratio (CAPE) is a measure of price divided by an average of 10-year earnings, all adjusted for inflation. The objective of the CAPE is to provide a measure of price to earnings that is independent of short-term fluctuations in the business cycle.
During a recent interview with one of the Co-Founders and Managing Partners of our sister firm MASECO Private Wealth in London, Nobel Laureate Robert Shiller reiterated how non-US markets appear to be inexpensive with higher expected returns. Click here for the full interview. 
On a relative basis, non-US markets are also trading at inexpensive valuations compared to their own historical valuations. Emerging Market equities are cheaper than 88% of history and non-US Developed Market equities are cheaper than 77% of history while the US is only cheaper than 5% of history.[4]  
Current and Historical Market Valuations.[5] 
Source: Research Affiliates, June 30th 2020

As you might recall from our recent article on valuations released in April, the long term valuation differences between regions has led to our relative overweight of Emerging Markets versus US stocks. This decision has started to pay off for investors and recently Emerging Market equities have outperformed US equities. In the past month, Emerging Market equities have outperformed the US and non-US Developed Market equities by circa 10% respectively.

Emerging Markets Outperformed US and Non-US Developed Markets in the Past Month [6] 
Source: Morningstar, June 8th to July 8th 2020

To summarize, investors need to decide where to take risk in their pursuit of returns. In equities, we currently favour International and Emerging Markets over the US because of their inexpensive valuations in both absolute and relative terms and because there is a high correlation between current valuations and future expected returns.

[4] Based on CAPE valuation as of May 31st, 2020 source: Research Affiliates
[6] SPDR S&P 500 ETF Fund (SPY), iShares EAFA Index Fund (EFA) & Vanguard FTSE Emerging Market ETF (VWO)
Accessing Your Accounts

If you wish to find out the current value of your investment portfolio, you can do so the following ways:
  • log on to the client portal provided by your platform provider; or
  • contact your Wealth Manager.

Main Street vs. Wall Street

Main Street and Wall Street seem to have decoupled in the last few weeks. It appears that investors are ignoring any future negative financial impact of the COVID-19 pandemic. They seem to expect global economies and corporate profits to return  to lastear’s level (V-shaped recovery) and that a vaccine will be found before a new wave of infection hits. However, most of the recent economic data released paints a different picture , for example, unemployment is still at very high levels.

Risky assets had a rapid recovery
Returns of global equities and investment grade bonds are now positive for the first time since the start of March 2020 and high yield and emerging market debt have recovered much of their losses.

Source: Morningstar, own calculations, data as at 22nd June 2020

From a behavioral angle, hope and greed have overcome fear. The most commonly quoted fear gauge, the VIX, has receded significantly from its March high:

Source: Yahoo.com, data as at 22 June 2020

Many people still suffer
Many people have lost their jobs over the course of the pandemic and its rapid spread across the world. In the US, unemployment has increased to record levels:

Source: US Bureau Labor of Statistics, data as at 01 May 2020

Some leading US economic indicators like The Purchasing Managers’ Index (PMI) have bounced back from recent lows, but a turn in US corporate profits has not yet been reported:

Source: U.S. Bureau of Economic Analysis, National income: Corporate profits before tax (without IVA and CCAdj), retrieved from Federal Reserve Bank of St. Louis, data as at 01 January 2020

For 2020 the Fed projects that US real GDP will shrink by 7.6% to -5.5%. Two months ago, the IMF urged governments tto provide further economic stimulus to avoid a steeper recession; both the European and US governments are in discussions to do just that.

Wall of Money
In March, the Fed went beyond decreasing interest rates and started buying assets on an unprecedented scale and scope. The Fed has continued to take significant actions. Only this month it announced that it is expanding its asset purchase program from buying exchange-traded funds of investment-grade bonds to purchasing individual bonds. Consequently, the below chart shows that its balance sheet has almost doubled to over $7tn.

Source: Federal Reserve Bank of St. Louis, data as at 17 June 2020

Equally remarkable, growth in U.S. M2, a broad measure of money supply, has been its strongest since the Federal Reserve’s records began in 1960. Such huge liquidity is trying to find good investments, and part of it supported the recent stock market rallies.

Source: Federal Reserve Bank of St. Louis, data as at 01 May 2020

Mr. Market: An expert in assessing the future
Mr. Market was introduced by Benjamin Graham in his book “The Intelligent Investor” published in 1949. Graham is often referred to as the “father of value investing” and was the teacher of Warren Buffet at Columbia University.

Mr. Market is always a step ahead of the economy, as he prices in future economic developments. Therefore, he reacts positively to news on government stimulus, low interest rates and other central bank actions, as well as progress on developing a vaccine against the COVID-19 virus, because all of these are positive for economies and future corporate profits. Therefore, it is fair to expect economic developments to become positive in the not too distant future. The big questions such as “when?” and “by how much?” may have different answers from what Mr. Market currently prices in, as Mr. Market cannot assess known unknowns. , equally, nor can anyone else. Mr. Market is also influenced by broad investor opinion and sentiment, as well as excess liquidity.

However, doubting whether Mr. Market is right and betting against him takes exceptional skill and expertise to successfully assess vast amounts of data. Many famous investment voices from Graham to Buffet, Bogle to Fama advise investors against trying to time the market, just as we advised our clients only three months ago not to give in to fear and sell equities. We now caution them not to follow feelings of “missing out” and buy into the recent rally, proactively increasing equity exposure. Instead, following Mr. Market within your current strategy should be the better approach, versus hoping to be lucky. This article is authored by Helge Kostka,
Chief Investment Officer of MASECO Private Wealth, and Investment Committee member for MASECO Asia.

Will the rally in cheap markets continue?


Globally, stock indices are on the up again after a slight jitter in June. We are questioning how synchronised this move is, monitoring the effects of our regional equity allocations daily. As you might recall from our article on valuations released in April long term valuation differences, the main driver behind our relative overweight of emerging markets versus US stocks, were very high at the end of March.

Early signs that neglected cheap markets are attracting investors’ attention
Today we look at our main regional split, comparing cumulative returns in USD between Global stocks as well as US, International and EM equity over the last 2 months.


Source: Morningstar, July 6th 2020


International equity (yellow) has been outperforming US stocks (grey) since early June but has given back some of that outperformance more recently. However, EM equities (orange) have been on a run since mid-June, widening the performance gap over US equities.

Valuation gaps remain

At MASECO, we watch CAPE – a market valuation measure that uses real earnings per share over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. Changes in cyclically adjusted price earnings (CAPE) ratios are driven largely by price changes and to a lesser extent by changes to 10-year average earnings. US, International and EM regions all have a higher CAPE, as at the end of June, versus three months ago. However, valuation differences are still very large (US high, EM and International low) which is important when one considers the source of future expected returns.


Source: Research Affiliates, June 30th 2020


The CAPE of Emerging Markets equities is still at the 10th percentile compared to its own valuation history. In other words, 90% of all historic CAPE values have been higher than the current CAPE of 13.3x. US equities are still at the other end of the spectrum, its current CAPE of 29.9x is in the 95th percentile, meaning US equities have rarely been as expensive as they are today.

Therefore, from a long-term valuation perspective, our case is still intact for EM to outperform US stocks in the coming months or years.

Valuations: Asessing the change

Market Commentary

A month feels like an eternity in today’s unparalleled environment – markets sold off at a faster rate than at any point in history and found a base and bounced by entirely necessary fiscal and monetary stimulus. Many people are asking themselves if it is a good time to buy equities given current valuations? To be able to identify cheap or expensive equity markets, investors must, amongst other things, look to analyse and interpret the market and consider valuation ratios that compare fundamental data for equity indices such as book value or earnings with current prices (P/E or P/B).

Various valuation ratios exist, and each comes with its benefits and deficiencies (such as having no predictive power in the short term). One ratio MASECO takes most guidance from, because of its reasonable ability to predict long term (10y plus) equity returns, was developed by Campbell and Shiller in 1988: the cyclically adjusted price-to-earnings ratio (CAPE). It looks at a business’s current market price in relation to the average inflation-adjusted profits of the previous 10 years. The purpose of the 10-year period is to ensure that the profits are averaged over more than one business cycle and to account for different levels of inflation over the period.

Is the US equity market still expensive?

In the chart below, one can see that the average US CAPE since 1880 was 17. Its latest reading as at the end of March 2020 was 24.6 having fallen from 30.6 just 2 months earlier.

US Cape 1880-2020

Source: Yale University. March 2020

As one can see these CAPE numbers are above the long-term average. US equities have seemed expensive for the past few years and therefore most investors would see them as still being overpriced. There is an argument that a higher average CAPE is justified because we now live in a world of low interest rates however even if one takes this into account US equities are still looking dear.

Expected returns for US equities have increased from a low level

The good news is that it is possible to infer long-term return expectations from the assumption that CAPE returns to its long-term average. The bar charts below show the implied level of CAPE and implied long-term expected return at various levels of draw-down from the S&P 500’s peak of 33.86 on February 19th April 2020. A 30% equity market pullback implies a CAPE level near 22 and an increase in expected return of 1.7% a year for the next decade because of lower valuations.

This assumes a long-term fair value multiple of 17. For investors who believe that fair values multiple to be higher than 17 (because of lower interest rates today) these expectations will differ, but the point remains the same—the market’s drop translates into higher expected returns.
CAPE and Expected Returns Estimates at Different Market Prices

Source: “As Markets Burn”, Research Affiliates, April 2020

Investing always means you chose to buy one thing instead of another and, unless there is available cash, it also creates the need to sell another investment to finance that purchase. Therefore, it seems that one should look at multiple markets when considering how to allocate assets.

Changes in CAPE show little dispersion

Over the past 2 months, the CAPE for global equities has dropped from 22.6 to 17.7 a decline of 22%. Regional variations have been relatively small, with the UK and Europe having dropped the most by 24.4% and Asia ex Japan, where CAPE has fallen by only 18%.

Is Europe now the most attractive place to invest? Not really. Emerging Markets had the lowest CAPE ratio before the big market drop, and still remain the cheapest region. However, what if emerging markets are always the cheapest? In that case, an investor should not expect a big change in CAPE driven by a big change in price towards a long-term average.

Changes in CAPE

Source:Research Affiliates, April 2020

Comparisons should be across investments as well as across time

Just like it is possible to compare any value against a long-term average, it is possible to compare current market valuations against their historical maximum and minimum values. The below chart does just that for CAPE ratios of US, Japanese, UK, EAFE, and Emerging equity markets as of March 2020. The current CAPE ratio for US equities is the only value that remains in the top quartile. The rest of the world has current CAPE ratios, that are in the bottom quartile. In fact, stocks in Asia, Japan, and Emerging Markets each have a CAPE that even ranks in the bottom 5% of all their respective historical CAPE ratios.

If one believes that higher CAPE medium average should be applied for the US market (with lower interest rate) then one should apply the same logic for markets ex-US. This would imply that the rest of the world markets are even cheaper than otherwise would be expected!

Shiller P/E of selected markets (March 2020)

Source: This data is calculated by Research Affiliates LLC using data provided by MSCI Inc. and Bloomberg. The number shown on per region indicates the current P/E Shiller as per the date disclosed. The graph also indicates the Max Shiller P/E, the 75th percentile Shiller P/E, the Median Shiller P/E, the 25th percentile Shiller P/E, and the Minimum Shiller P/E per region, as illustrated for Japan’s region.

No holy grail exists in investing

While the above comparison looks like convincing information to act upon and make money by selling US equities and re-investing in the rest of the world, unfortunately it is not as simple. Just because an indicator has proven useful to forecast equity markets in the past, does not mean the same will hold in the future. For example, we all might experience economic environments, that have no historical precedent. And CAPE itself has some critics, just like other valuation ratios. The US market generally has a higher proportion of securities in the information technology sector when compared with other markets hence its higher CAPE versus others. Given the recent price moves in this sector this has given it a higher CAPE multiple.

The investment philosophy at MASECO leads us to be guided by the principles of both academic evidence as well as diversification at every level of investment thinking. So, while we view CAPE as one useful indicator, we would never “bet the house” on it. Instead, we budget a limited amount of risk to our regional equity allocation decisions. They are just one element in our approach to seek improved risk adjusted returns over the long term for our clientele. It is accompanied by other return drivers in both the asset allocation dimension (carry, trend, quality, etc) as well as the security selection (value, small cap, profitability, etc). While even these combinations can fail to deliver the desired outcome, the odds of success are improved.

Despite the recent recovery rally, one should also not forget, that the Covid-19 pandemic is a “known unknown”: Even as visibility of both economic and market consequences has recently increased , there are still unknowns over how long the pandemic will last, how prolific it will be and how long the lockdown order(s) will be needed.

FBAR, PFIC and Other Four-Letter Tax Words U.S. Expats Should Know

Life as an expat in Hong Kong has all sorts of “get out of jail free” benefits – especially when it comes to family obligations.  But there is one family member American expats can’t avoid: Uncle Sam.  If you’re new to filing taxes abroad, here is a list of some four-letter terms and associated tips you should know.

FEIE:  The U.S. is one of two countries in the world[1] that taxes its citizens (or other “connected persons”) on their worldwide income, regardless of where they reside.  News to you? Rather than hurl expletives, get familiar with this four-letter word: FEIE, which stands for Foreign Earned Income Exclusion.  For the 2018 tax year, you can exclude up to USD103,900 of earned income from U.S. tax, subject to certain restrictions.  The FEIE for the 2019 tax year is USD105,900.  In addition, U.S. expats residing in Hong Kong can exclude certain housing costs (notably rent) up to a maximum of USD114,300 (again, subject to certain restrictions).

In order to qualify for the FEIE, you must have been out of the U.S. for a total of 330 days over a 12-month period or deemed a “bona fide resident” of a foreign country.  Don’t fret if you don’t satisfy either requirement, as partial exclusions may be possible.

Additional exclusions: If the FEIE and housing-related deductions don’t fully offset your U.S. taxable income, you may be able to use the income taxes you pay in Hong Kong as an itemized deduction or a foreign tax credit when filing your U.S. taxes.  Make sure to explore what option would be best for you with your tax advisor.

FBAR: FBAR refers to Reports of Foreign Bank and Financial Accounts. An FBAR must be filed if the total amount of your financial interests in or signature authority over financial accounts maintained outside the U.S.  exceed USD10,000 at any point during the tax year and regardless of whether any of the accounts produce any income.  Failure to report in any applicable year can incur some pretty hefty penalties or even jail.  Still not convinced?  Google it.

The filing deadline for FBAR is April 15 (although it can be extended in certain cases) and can be done electronically here: https://bsaefiling.fincen.treas.gov/main.html

Shameless Plug #1: At MASECO Asia, our clients’ assets are domiciled in the U.S., and are therefore not subject to FBAR filing.  This can help reduce the reporting burden during tax time.

PFIC:  I leave you with one more four-letter tax word: Passive-Foreign-Investment-Company (PFIC).  PFICs encompass pooled investments (e.g., mutual funds, ETFs, hedge funds, insurance products) domiciled outside the U.S.  Why care?  Well, Uncle Sam really cares. In his effort to disincentivize investing offshore, PFICs are subject to some rather punitive tax rates.

Take for example a mutual fund that invests in European stocks but is domiciled in the U.S.  Long-term capital gains from this product are taxed at 0%, 15%, or 20%, depending on your tax bracket and filing status.  Now suppose that same European stock mutual fund is instead domiciled in Hong Kong.  Those same capital gains would be taxed at the highest current federal tax rate of 37%.  The PFIC story gets even uglier when considering the taxation of distributions and compounded interest charges on deferred gains.  The good news is that there are several different accounting treatment options (and hence taxation outcomes) for PFICs.

Shameless Plug #2:  MASECO Asia investment portfolios are PFIC-free, lending to a more tax-efficient wealth solution versus for U.S. expats versus other providers.

Need more advice?  Although we are not expert tax advisors, we are expert tax advisor referrers!  Please don’t hesitate to contact us for direction.

[1] Fun fact: the other country is Eritrea, located in East Africa.

Junk Boating and Investing

Ahh, Hong Kong summer…hot, sweaty and gross, just the way we hate it. But at least we can all find refuge on a junk boat. Well, sort of. There are many factors that contribute to your experience at sea on one of these 6-hour(!) outings. Some factors you can control (e.g., who you invite, how much you drink), some you try to control (who other people invite, how much your spouse drinks), and some you can’t possibly control – notably the weather. It’s how you handle the uncontrollable factors that makes all the difference. Case in point: my most recent junk boat trip one rainy, rocky, T1 Saturday in July.

As a co-host of the junk boat, I wanted everyone to have a fabulous time, despite the Gilligan’s Island/S.S. Minnow conditions. But what I observed – in my cheap prosecco haze – is that it really wasn’t the weather that mattered. It was an individual’s attitude towards the weather that was make-or-break…much like an investor’s reaction to a bout of market volatility. Two archetypes unfolded:

1) The Panic Seller: Riddled with nausea, this guest wants off the boat NOW. He/she is fixated on the waves and is antisocial at best. As far as he/she is concerned, it is a day lost at sea.

2) The Big Picture Thinker: This more seasoned junk boater knows the key to avoiding motion sickness is to focus his/her gaze on the horizon. 15-foot waves? Pff – this too shall pass.

And so it did. By the afternoon, the floaties were floating and the free flow was flowing. Even the Panic Sellers found something to talk about other than the shortcomings of the Hong Kong Observatory.

As investors, we should all aspire to be Big Picture Thinkers. When markets are choppy, it’s my job as a wealth manager to convince you to stay invested and avoid selling at the wrong time. This means shifting your gaze from daily market fluctuations (waves) to a much longer-term perspective (horizon).

Take the performance of the global equity market since January 2000 for example¹ . If you focus solely on the monthly fluctuations (waves), you would be hard-pressed to stay invested during the rough times, as seen in the chart on the top.

The other (better) way, is to focus on how much your wealth can grow if you stay invested, as shown in the ‘horizon’ chart on the bottom. Ten thousand dollars invested in global equities since January 2000 would have more than doubled by the end of July 2018. Better yet, if you stick with this discipline, you will have a guaranteed source of bragging rights for many junk boat seasons to come!


The Waves

The Horizon


¹ MSCI All Country World Index (USD, net div). Source: Dimensional Fund Advisors.

ETFs May Not Be What You Bargained For

In a prior blog post, I discussed the performance hurdle that fund costs impose for actively managed strategies, making the case for lower cost solutions. Was this a plug for pure ETF portfolios? Hardly. Yes, ETFs have low direct costs, but there are notable caveats and indirect costs associated with ETF investing.

Pick an ETF, any ETF? The popularity of ETFs was borne out of investor demand for a simple, low-cost way to gain broad exposure to a chosen asset class. But the investor experience can vary widely within seemingly similar ETFs, with a key differentiator being the underlying indexes that the ETFs attempt to track. Suppose an investor has to choose between two US small cap growth ETFs, one that tracks the MSCI US Small Cap Growth Index and the other that tracks the Russell 2000 Growth Index. Despite its apparent randomness, this choice may offer significantly different outcomes, especially over the longer term. Over the 25-year period ending March 2018, the MSCI US Small Cap Growth Index returned an annualized 10.5%, while the Russell 2000 Growth Index returned an annualized 8.1%. The disparity likely stems from differences in index inclusion criteria and how and when indexes are rebalanced (more on this below).

Is There Still Value in Pursuing Value?

The year 2017 tested the patience of US value investors. While US value stocks returned a decent 13.66% (as measured by the Russell 1000 Value index), they were overshadowed by the phenomenal 30.21% return of US growth stocks (as measured by the Russell 1000 Growth index) – an underperformance of 16.55%. This negative value premium marked the fifth worst year since 1979 and pulled the five-year rolling premium into negative territory. Ouch.

The pain for US value investors has persisted into 2018, with US value stocks underperforming US growth stocks by 6.01% 1. Despite this seemingly relentless underperformance, we believe there is still value in pursuing value for the long-term investor. Here’s why:

We have seen this movie before. Even over extended periods, underperformance of the value premium (or any other return premium) is not unusual. For example, over the 10-year period ending in March 2000, US value stocks underperformed US growth stocks by 5.61% per year (on an annualized basis). But this underperformance quickly reversed course. By the end of February 2001, US value stocks had outperformed US growth stocks over the previous one-, three-, five-, 10-, and 20-year periods.2
Return premia are nearly impossible to predict and relative performance can change rapidly. This underscores the need for discipline in an investment strategy.

Value rewards long-term investors. Empirical evidence dating back to 1926 shows that US value stocks typically beat US growth stocks, with the odds of outperformance increasing as the time period lengthens, as illustrated in the chart below3. For example, US value stocks beat US growth stocks in 61% of the 1-year rolling periods since 1926, while over the 15-year rolling periods the odds of outperformance increased to 94%. Similar track records have been exhibited in other markets, with value beating growth in developed ex-US markets in 95% of 10-year rolling periods since 19754. In emerging markets, value beat growth in 86% of 10-year rolling periods since 19895.


Beware the allure of growth trends. We’ll admit it: value investing can seem boring compared to its trendier growth counterpart. Take the popularity of FAANG (Facebook, Apple, Amazon, Netflix and Google’s parent Alphabet) stocks. FAANG investors were undoubtedly well-rewarded last year, receiving a simple average of 49% (versus the S&P 500 at 22%); but merely latching on to the latest investment catchphrase does not an investment strategy make. Sure, the FAANGs do have their merits, but investors should not allow their allure to result in an overly tech-concentrated portfolio (remember the dot-com bubble?). Broad diversification across sectors and markets is a much more prudent investment strategy.

Bottom Line: Discipline and diversification are the name of the game. While there is empirical evidence to support our expectation that value stocks will outperform growth stocks over longer periods, there will be periods of underperformance. Discipline and diversification across multiple sources of return premia will lead to a more positive investment experience.

1 Year-to-date total return of Russell 1000 Value index and Russell 1000 Growth index as of market close, 9 March, 2018.
2 Source: Dimensional Fund Advisors LP; total returns quoted are for the Russell 1000 Value and Russell 1000 Growth indexes.
3 Source: Dimensional Fund Advisors LP; Value is Fama/French US Value Research index. Growth is Fama/French US Growth Research index. There are 919 overlapping 15-year periods, 979 overlapping 10-year periods, 1,039 overlapping 5-year periods, and 1,087 overlapping 1-year periods.
4 Source: Dimensional Fund Advisors LP for the period ending December 31, 2017.
5 Ibid.

Is Your Portfolio Space Efficient?

The key to Hong Kong survival is efficiency.  We have to be time efficient, cost efficient and – I think we can all agree – space efficient!  Take my closet for example, which is crammed with too many similar and/or “what was I thinking?” items; hardly the model of space efficiency.  It’s time I let go of misguided shopping decisions to make room for a wiser mix of wardrobe choices.  This sounds a lot like portfolio optimization.  Is your portfolio space efficient?  Here are some tell-tale signs that it could use a rethink:

To Bit or Not to Bit: What Should Investors Make of Bitcoin Mania?

Bitcoin and other cryptocurrencies are receiving intense media coverage, prompting many investors to wonder whether these new types of electronic money deserve a place in their portfolios.
Cryptocurrencies such as bitcoin emerged only in the past decade. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and no regulator or nation state stands behind it.
Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet. In the case of bitcoin, there is a finite supply of 21 million, of which more than 16 million are in circulation. Transactions are recorded on a public ledger called blockchain.