Equity valuation

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5/10/13

Equity Market relative value

We would like to provide a brief outlook with respect to some reasonably well known equity ETFs and the indexes that they represent. This may provide a starting point for investment committees that want to dissect their equity portfolio and dig deeper into their mutual funds and ETFs in order to see how closely they match these and to determine if their managers are stagnant benchmark huggers.

Price/Revenue Revenue growth Price/cash flow Cash flow growth
ACWI 1.1 -10.4 8.8 -2.3
SPY 1.5 2.9 9.9 6.4
EFA .9 -21.3 8.4 -36.5
AAXJ 1.2 -24.3 8.4 -27.2
DEM 1 -5 5.3 1

We purposely left out EPS and P/E in order to focus on a couple metrics that do not garner the attention that they deserve.

ACWI-I-Shares All Country World Index

SPY-Standard and Poor 500 Domestic Large Cap

EFA-I-Shares Europe, Far East and Asia-Large Cap

AAXJ-I-Shares All country Asia ex-Japan

DEM-Wisdom Tree Emerging Markets Equity Income Fund

It is interesting to note that revenue and cash flow growth is largely negative or flat other than with the S&P 500 ETF SPY.  In part this has to do with the slump in Europe and the Asian slowdown. Flows have been strong in the US and this may continue.

Our suggestion is for firms that own ETFs and mutual funds to examine the fundamental metrics and position for the second half of the year in a combination of ETFs and funds with the best forward looking fundamental growth.

Credit condition outlook for investment firms

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Zenith Credit Update

Since credit conditions are an important part of a healthy real economy and of the  financial markets, we will review a few pieces of evidence and some thoughts as it relates to asset allocation.

 

TED Spread

The TED spread is an indicator of perceived credit risk in the general economy.[2] This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders, therefore, demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases.[3]

The long term average of the TED has been 30 basis points with a maximum of 50 bps. During 2007, the subprime mortgage crisis ballooned the TED spread to a region of 150–200 bps. On September 17, 2008, the TED spread exceeded 300 bps, breaking the previous record set after the Black Monday crash of 1987.[4] Some higher readings for the spread were due to inability to obtain accurate LIBOR rates in the absence of a liquid unsecured lending market.[5] On October 10, 2008, the TED spread reached another new high of 457 basis points.

It is currently 21 basis points which is less than the long term average and indicates that the system is flush with liquidity. We would note that in a highly leveraged system, liquidity can dry up very fast especially if a bank like the highly leveraged Deutsche bank is hit with massive bond write downs on a sovereign bond default for instance.

 

Office of the Comptroller of the Currency 4th quarter 2012 survey

Financial performance of the community banking industry in nine Central District states is improving and the number of problem banks has fallen, according to the Office of the Comptroller of the Currency.

At the same time, bank earnings, on the mend for several quarters due to improving asset quality and reduced provision expenses, remain under pressure as a result of low interest rates and asset yields, compressed margins, and heavy competition for quality assets, said agency officials during a conference call with regional reporters.  

Our concern is that in this fierce competition, banks take on low quality assets to offset low margins setting the stage for a credit bubble.

 

April 17th 2013 Federal Reserve Beige Book

 

Loan demand was steady to slightly up at most District Banks that commented on

lending. Most District banks said credit conditions remained favorable, with improved credit quality for business and consumer loans.

 

While credit is the fuel to an expansion it can quickly contract if loan growth is met with sub-par economic numbers in the quarters ahead. Currently though there does not seem to be a credit contraction beginning and this is a reasonable sign of health.

 

 

Credit spreads

 

Option adjusted spreads

 

Investment Grade 10yr average is 172 basis points while at the end of March it stood at 139basis points.

 

High Yield 10yr average is 569 basis points and stood at 457 at the end of March

 

Most all sectors are tight and warrant caution. This is not due to an imminent collapse in the credit markets but rather a caution that the risk inherent in many areas of the corporate market are not worth the little yield compensation.

 

We suggest advisory firms examine their credit exposure and limit unnecessary risk. If your high yield exposure it broad based and mirrors the aggregate high yield index, find a manager that has a portfolio with less volatility and higher conviction and that possess a valuation “cushion”.

 

Examine the manager’s information ratio, alpha and aggregate portfolio price against the larger index. While the flush of liquidity can continue to lift risk assets, we believe that a focused approach in fixed income can allow for reasonable returns while preparing for the time when the TED spread is not at 21 basis points.