Investment Themes for 2006
What strikes me most about the current investment environment is that everybody is bullish about something. Stock market investors around the world are positive for equity markets, traders involved in commodities are bullish about the prospects of resource prices, while bond investors are convinced that deflation is around the corner and that interest rates will resume their decline. In most countries, real estate investors are betting that property prices will continue to rise, while collectors are willing to pay at auctions record prices for paintings, jade, antiques, stamps, wines and other collectibles. Everybody seems to be convinced that the asset inflation we have experienced over the last few years will continue courtesy of Mr. Bernanke.
Now, I do not doubt that if the Dow Jones Industrial Average and US home prices declined by 10% each in future, and as a result hurt US consumption, Mr. Bernanke, would print money like there was no tomorrow. After all we should expect that even a central banker will recognize that the US economic expansion 2001 - 2006 depended on asset inflation fueled by debt growth. So, unless the Fed is prepared to accept a recession, this asset inflation will have to be reignited at all cost! However, whether in the next money-printing binge all assets will rise, is highly debatable.
For one, I doubt that US dollar holders and long-term bond holders would feel comfortable holding fixed interest securities in a country where money printing was the order of the day. Therefore, on the slightest hint of even easier monetary policies than we already had, the first asset class to decline would be the US dollar. Last week, a renewed trend toward a lower dollar seems to have begun and my first recommendation for 2006 would be to short the US dollars. But short US dollars against what???
Based on current account surpluses and deficits, I suppose that, in 2006, the currencies of Asian countries, which have large current account surpluses, could increase in value against the US dollar and the Euro. In particular, I like, now, the Japanese Yen and the Singapore dollar.
Figure 1: US Dollar versus Japanese Yen, 2001 -2006
Needless to say that investors should remain short the US dollar against precious metals (since Mr. Bernanke has been appointed Fed Chairman gold has risen against the dollar from 470 to 550). Moreover, I doubt that in a weak US dollar environment, US long-term interest will decline further. So, while the first reaction to weaker economic growth in 2006 could be some strengthening of bond prices (declining interest rates), in a second instance bond prices are likely to tumble along with the US dollar. Therefore, I would use any strength in bond prices as a selling opportunity (see figure 2).
Figure 2: 20 Year Treasury Bond Fund iShare (TLT), 2005
A major investment theme after the breakdown of the NASDAQ, which began in March 2000, has been to invest in small-cap and mid-cap stocks. As a result, large market capitalization stocks around the world have been miserable performers compared to small cap stocks. However, I believe the time has come when investors should switch back into large market capitalization stocks simply because they have become relatively inexpensive (see figure 3). So, another investment theme would be to emphasize high quality large market capitalization stocks in one's portfolio.
Figure 3: Performance of Large Market Cap Stocks compared
Small Cap Companies, 2002 - 2005
Source: BCA Research
The emphasis of investing in 2006 in large market-cap stocks rather than small and mid-cap shares leads me to another theme. Since 2001, US pharmaceutical shares, such as Pfizer, Schering Plough, and Merck have been among the worst performing stocks within the US stock market underperforming both the S&P 500 and mid-cap stocks (see figure 4).
Figure 4: Pfizer 2001 - 2005
Now, it is clear that the US pharmaceutical industry has had and still has some problems but much of these problems have already been discounted by the decline in these companies' share prices (see also figure 5).
Figure 5: Merck, 2001 - 2005
So, for investors who want to have an exposure to the US, I would recommend to buy a basket of US pharmaceutical companies.
The last investment theme, I would like to discuss, are Taiwanese shares. Why? In 2003, I began to recommend the purchase of the Nikkei Index when it was around 8000 and after it had declined from 39,000 in late 1989. Since then it has doubled in value. The reason I liked Japanese shares at the time was that investors' sentiment about the outlook for the share market was "extremely" negative and that cash positions among institutions and individuals were very high. But most importantly, the dividend yield on the Nikkei Index was higher than the yield on Japanese government bonds.
From figure 6, we can see that a) Taiwanese shares have grossly underperformed Asian shares since 1998; and b) that the dividend yield on stocks is now about twice as high as the yield on Taiwanese government bonds. Lastly, the Taiwan Stock Exchange Index, which hovers around 6,500 is down from over 12,000 in 1990! Just, as a side, if the Dow Jones Industrial Average were to decline to half its 1990 level it would trade at just 1,200!!
Figure 6: Taiwan Stock Market Index, absolute and relative
Dividend Yield compared to Bond Yields, 1998 - 2005
Source: The Bank Credit Analyst
So, at least on a relative basis, Taiwanese shares look like a life time buying opportunity!
A word of caution: All asset markets (except for the US dollar and US bonds) have been very strong in the first ten days of January and I expect a correction to unfold in the second half of January, which will last at the very least into February. What concerns me most is that we are in the midst of a real investment rage, which in my opinion cannot offer to the contrarian investor particularly attractive entry points in asset markets. May be a good time to short assets!