Investment Themes for 2012 and Beyond
by Nihar Dalal, CFA
  
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Most investors like to think of the market as being either bullish or bearish. This is an artificial distinction that does not capture the full range of opportunities that the market presents at a given point in time.

 

ďA more useful way of looking at the market is in terms of investment themes that cut through the day-to-day noise and allow investors to focus on ideas, trends and world events that actually matter. Think of investment themes as the stories behind the trillions of dollars of money flowing through financial markets. There are generally dozens of investment themes running through the markets at the same time. Some can be obvious while others require connecting the dots. Some reinforce each other while others directly conflict one another. Some can be structural and unfold over several years while others are more fleeting and get done over a few months. Regardless of the nature, thinking in terms of investment themes allows the investor to form a world view and position his portfolio accordingly.

 

Here are some of the themes that have been dominating the markets in recent months.

 

The Great Yield Chase

 

Investors live in a world in which interest rates are below one per cent in about 20 different countries. Such extraordinary low yields cannot meet the long-term return expectations for anyone, neither pension funds and insurers functioning in a new world of long lives and little growth, nor individual investors looking for income to survive in a world of volatile equity markets and high inflation levels. This has led investors of all stripes to go on a wild yield chase.

 

From real estate investment trusts, preferred stock and master limited partnerships for infrastructure and pipelines, to junk bonds and high dividend stocks in the telecoms and utilities sectors, investors have cast a wide net. Even subprime and other residential mortgage bonds that triggered the financial crisis are back in favor owing to their fat yields.

 

The Search for Safe Havens

 

The search for investments that carry little to no risk of default or safe havens as they are called has become a dominant theme driving flows of money around the world. It started a few years ago during the financial crisis, and has intensified recently as the economic future of European countries that used to be viewed as safe investments has been thrown into question. Although government bonds issued by the United States, Germany and Japan are still the primary havens for scared investors around the globe, increasingly investors are turning to fringe countries like Australia, Norway, Canada and Sweden and buying bonds or other assets tied to the fortunes of these economies. The desperate search for safe havens was brought into focus last September when the Swiss National Bank (SNB) was forced to devalue the Swiss Franc which had appreciated due to its safe haven status. Welcome then to the new world where the Australian Dollar which was mocked as the South Pacific peso some years back is now the southern Swiss Franc.

 

The US Dollar is Not Dead

 

A few years back it was fashionable to talk about the US Dollarís demise. That is no longer the case. The US Dollar (USD) has had a remarkable comeback due to the problems in Europe. However, that is only part of the story. The real story is that the USD bottomed long before the problems in Europe came to fore. The USD ended its multi year decline at the height of the US financial crisis in 2008 as the chart below shows  

 

 

It could possibly be in the beginning stages of a long term secular uptrend.

 

Emerging Markets or Submerging Markets?

 

Emerging markets have been underperforming most developed markets for many months now over concerns of slowing growth, high inflation and extended valuations. If the US Dollar continues to get stronger, it could provide an additional headwind to commodities and commodity producers which account for more than a third of the market capitalization of BRICs (Brazil, Russia, India and China) and over a quarter of the market cap of MSCIís benchmark emerging market index. The de-facto trade over the last decade was to go long emerging markets and short developed markets. It might be time to reverse that trade.

 

Large Cap Stocks vs. Small Cap Stocks

 

A casual observer might look at the SP500, which is virtually flat over the last 11 years, and conclude that the US markets have not gone anywhere during this period. He would be wrong. The Russell 2000, an index of small cap stocks has done reasonably well, up 70% since 2001. That is not bad when you consider that the much talked about Shanghai Stock Exchange Composite Index, after a roller coaster ride, is back where it started in 2001.

 

 

US small cap stocks have not only done well during the good times but have also bounced back quite well after the financial crisis. This performance differential has now led large cap stocks to trade at a substantial discount to small caps. More importantly, the market has begun to notice this disconnect and has been favoring large caps in recent months. If history is any indication, small caps can be expected to give up leadership to large cap stocks over the next several years. Investors with access to the US markets might want to capture this theme by going long large cap stocks using an ETF like SPDRs S&P500 (SPY) while shorting small cap stocks through an ETF like the iShares Russell 2000 Index Fund (IWM).

 

The list of themes noted above is by no means exhaustive but it illustrates the point that themes provide alternate world views that allow investors to overcome self limiting biases and capture the range of opportunities that markets presentĒ.