Indexology^® Blog

The New York-listed iShares Europe 350 ETF has more than doubled in size in the past six months; the front page of last Friday’s Financial Times reported that U.S. purchases of European equities have surged, while the Wall Street Journal noted yesterday that “Europe is back.”

European equities have underperformed U.S. equities by around 45% since the financial crisis. Despite having a good year in  2013, the S&P Europe 350 remains well below its pre-crisis levels; the S&P 500 spent much of late 2013 recording new highs.  So why would U.S. investors take an interest in European stocks?

One explanation is that while the Euro crisis of 2012 discouraged transatlantic investment, with better economic news it is natural to expect some returning investment from U.S. asset allocators. But valuations may also be playing an important role.

The comparatively small rise in European stock prices since 2009 has resulted  in much more attractive valuation levels than in the U.S., both at the security and Index level.  Dividend yield provides one example:

European equities look attractive on a risk-free rate comparison, too.  While the dividend yield for the S&P Europe 350 is well above the German 10 year rate of 1.6%, the dividend yield for the S&P 500 is below the current 10 year UST yield of 2.6%.

Such metrics are attracting attention, and not just from U.S. investors.  In the U.K., The Telegraph’s list of countries with the most attractive CAPE valuations is heavily biased towards European entries.  Other examples abound.

Note in both cases that the yield of the index (which is tilted in favour of larger companies) is higher than the average stock yield, suggesting that smaller-cap companies have not been the drivers of income.  That means that the risk profile can look attractive too: a dividend yield of 2.8% is available even when restricting attention only to those members of the Europe 350 that have increased dividends every year for the past 10 years*.

All other things equal, the Europe 350 would have to gain 50% in price to match U.S. dividend yields.  The stock markets are famed for their regular mockery of predictions, but to the degree that valuations are driving U.S. flows into Europe, such dynamics are likely to remain in place for some time.

As we all know by now, Ben Bernanke is gone. He was focused on not having a depression on his watch so he pulled out all kinds of never-before-tried policy tools. Consequently, Janet Yellen will have to cope with the unintended consequences of QE — namely big unrealized losses in the Fed’s bond portfolio. 

Recently, I had the privilege to sit down with Bluford Putnam, Managing Director and Chief Economist, of our partner, CME Group, to discuss how the Fed under Yellen will be different from Bernanke’s Fed.

Although Yellen is also a strong advocate for the traditional Fed culture, which balances inflation and employment goals, she is likely to move to a more “hawkish” position if inflation pressures were to rise unexpectedly, at least from her point of view. Given her specialty in the labor markets, she is likely to focus in much greater detail in all areas of the labor markets, not just headline unemployment but also duration of unemployment, turnover of jobs and part-time employment. She wants to see who got fired versus who left their job voluntarily since a voluntary move may reflect confidence to secure another job, possibly indicating greater market confidence.  By evaluating the numbers in greater depth than the prior Fed, Yellen will use her insight into the labor markets as the starting point to forecast inflation.  While she doesn’t want inflation more than anyone else, her way may be different of finding the indication.

Another key difference in the New Fed is the addition of the new Vice-Chair, Stanley Fischer. He is the former head of the Israeli Central Bank, a former MIT Professor (Bernanke studied under Fischer), and brings an international view that has been missing at the Fed since Robert Heller retired from the board 20 years ago.  The policy implications for the US dollar and other currencies and central banks may get some much needed attention that has been absent for decades.

When Bernanke adopted QE, he made the asset size of the Fed’s balance sheet huge so its importance to the economy and to politicians has increased dramatically.  Possibly as a result of that, the second confirmation vote in the Senate (2010) had more dissents than any previous vote.  That trend followed through to Yellen.  According to Putnam, The Fed Chair is going to be a very divisive appointment in Jan-2018 when Yellen terms is up.  On the way, as members of the Board of Governors leave their posts, each new appointment may face greater political scrutiny and polarization in the US Senate.

For more on the New Fed, my colleague, David Blitzer, also posted some of his New Fed insights earlier this year.

Someone asked me this last week: “What’s a normal or typical VIX level?”  That’s a good question.  Here is the answer: 20.2.

And 17.1.

And also 13.0.

Before I go into why it takes at least three numbers to answer this question, let me remind you that the history of the CBOE Volatility Index (VIX) looks like this:

Figuring out the normal VIX level is akin to figuring out how high Alaska, my home state, is above sea level.  A skilled topographer could determine an average for the whole state, but this statistic would be skewed by Mount McKinley and the other huge mountains in the Last Frontier.  But an average is still useful to know.  For VIX, the average daily closing value for the 10 years ending December 2013 was 20.2.

When people worry about outliers skewing the average, they often turn to the median.  This is the second number I introduced: 17.1.  If you were to order the 2,517 trading days over the last 10 years by their closing VIX value, 17.1 would be next to the 1,259^th observation, the middle one.

Finally, you may want to know the mode.  The closing VIX value that showed up most – after rounding to the nearest whole number – was the last number I introduced, 13, followed by 12 and other levels just higher than those (see chart below).  This surprised me.  I would’ve guessed higher.

To go back to the Alaska analogy, if you were to trek across that state, you would spend most of your time trudging through tundra, navigating lakes and rivers, and hiking small and medium sized mountains.  You would want to prepare mostly for this.  On rare occasions, though, you would come across a breathtaking mountain that would lodge itself in your memory and define your experience.

VIX works in a similar way.  Lots of the mundane, but then peaks you won’t soon forget.

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Related posts:
You’ve seen VIX. Now finally learn what it means
Turn VIX into information you can use
Where VIX comes from

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*By the way, the mean elevation of Alaska is 1,900 feet.  Mount McKinley is 20,320 feet.

Similar to fixed income securities, the U.S. Preferred Stock market has started 2014 with positive performance. The S&P U.S. Preferred Stock Index  (Total Return) ended January 2014 up 2.68% .  A good start given the S&P 500 Index (Total Return) was down 3.46%.  As a fixed income comparison the S&P/BGCantor U.S. Treasury Bond  7-10 Year  Index was up 2.98% for the month.

Looking back over a longer period the price return (excluding dividends) of the index declined 5.42% for the twelve months ending January 31^st.  The dividend yield of the S&P U.S. Preferred  Stock Index ended January at slightly over 6.9%.   The net result was a positive return of 1.23% during that twelve month period.  Simply put, the dividend income helped keep the returns in positive territory.

The 12 month total returns of both indices are charted below.

Over the five year period ending January 31, 2014, the S&P U.S. Preferred Stock Index had a five year annualized return of over 17.6% while the S&P 500 returned over 19.1%.  The five year total return values for both indices are charted below.

The equity markets are getting nervous with the S&P 500 almost 6% off its high, foreign equity markets down at least that much or more and emerging market currencies slipping and sliding.  Normally in such moments there are two opinions: the correction is here versus the economy is solid so don’t worry.  Were the weather warm and sunny, the don’t worry advice would probably rule the day.

The problem is that this winter in much of the US it is unseasonably cold, wet and snowy and that will chill the economy.  Auto sales for January were down from December and below analysts’ forecasts. The ISM Manufacturing Index was down from 56.0 to 51.3 while the ISM Prices Paid series popped up to 60.5 from 54.0.  All negative news for the markets.  Economic releases often seem to follow the herd – if a few indicators are weak early in the monthly cycle, the rest of that month’s reports are as bad or worse. There are a couple of explanations for this pattern. First, on a month to month basis, the weather really does matter.  Shopping days lost to snow and rain means excess inventories which mean reduced orders.  Further, most of the data series are a mixture of hard numbers and estimates in the initial release; after a month or two there are revisions.  The next few economic reports may be no better.  Add to this the Fed’s continuing roll back of QE3 and it looks like the economy won’t do anything good for the markets.

There may be one reprieve on the horizon: Friday’s employment report for January including payroll growth, the unemployment rate and annual revisions to the payroll survey.  December was a weak report and many argued that it was far weaker than reality, so we could see a bounce back in this release.  The annual revisions are likely to boost the numbers for 2013 as well. The unemployment rate is less followed than the growth in payrolls and for now that may be just as well.  The unemployment rate has been dropping not because people are getting jobs, but because they are leaving the labor force.  In any event, the predictions seem to be around 185,000 to 190,000 for payrolls and little change in the unemployment rate.

As to whether the market is correcting or just suffering from the January snows, only time – and hopefully a warmer February – will tell.