If you’ve been wondering if the stock market is nearing correction territory and it’s time to get out, you really need to ask yourself another question: Where else should I go? One option is to simply park your money in cash and await the fall—usually a terrible approach, as even investors who get out before a correction tend to wait far too long to get back in on a market recovery and end up in a zero-sum game, at best.
Professional money managers, on the other hand, are paid to do better than sit in cash. A particular group of managers who constantly update their view on the best macro opportunities are known as ETF strategists—they use index ETFs to create a global stock and bond portfolio. And right now the prediction that many ETF strategists are making is that the U.S. stock market is, indeed, a bubble waiting to burst, and the question is not “if” but “when.”
“The capital markets are doing very well, and there are signs of froth and overly high investor confidence—all things that traditionally would make most global tactical asset managers increasingly cautious,” said Tyler Mordy, president and co-chief investment officer of HAHN Investment Stewards. The view that the central banks are all-powerful is the narrative that continues to push asset prices higher, Mordy said, but it will be proved wrong over time, simply because the underlying fundamentals will always reassert themselves. “It’s not a time to be taking an aggressive asset-mix stance, but rather a broad and diversified strategy,” Mordy said.
The SPDR S&P 500 ETF, the oldest and most popular proxy for the U.S. market in use by money managers, saw $8 billion in outflows in August. But exactly where are the bears hiding out ahead of the correction they expect? We asked the ETF experts and ETF strategist firms for their bubble-worthy advice.
Only a year ago, during the height of the rising interest-rate fears tied to Fed tapering, investors were exiting bond funds in droves.
“Investors were saying that the bond market was done and it was time to reallocate into divided-paying equities,” said Matt Hougan, president of ETF.com, but he says that trend hasn’t sustained itself. “We are seeing more movement into longer-duration Treasuries,” Hougan said.
Bond ETF inflows totaled about $8 billion in August, while flows into equities, most into international strategies, totaled almost $7 billion, according to ETF.com. The iShares 7-10 Year Treasury Bond ETF was the most popular fund last month, pulling in $1.47 billion—it has gathered almost $4 billion in 2014 through August. Not far behind it were the iShares 1-3 Year Treasury Bond ETF and iShares 3-7 Year Treasury Bond ETF, both among the top 10 ETF asset gainers in August. The iShares 20+ Year Treasury Bond ETF has also been receiving increased attention from investors.
“Interest rates will be slow to rise, and in a slow-rise interest-rate environment, bonds are not necessarily a bad thing,” Hougan said, adding that bonds aren’t anyone’s idea of a “fantastic opportunity,” but the expectation that there would be a 1 percent to 2 percent increase in the 10-year yield has dissipated. Instead, investors are seeing a sustained period of low interest rates, with a potentially slow gradual rise. “In that environment, you probably want bonds in your portfolio,” Hougan said.
One “canary in the coal mine” could be a move further away from high-yield bonds and into investment-grade fixed income. That’s because if the equity markets do finally tumble, the high-yield bond markets will also take a hit, said Barry Fennell, senior research analyst at Lipper. This quarter to date, near-$3 billion has flowed out of the Lipper High Yield ETF category. By contrast, many investors are moving into diversified investment-grade fixed products, such as the IShares Core U.S. Aggregate Bond ETF (AGG), which has had net inflows of $435 million this quarter and $2.2 billion of net inflows year-to-date.
While that might suggest the “smart money” is signaling a swift correction, don’t necessarily buy it: Lipper research found that “following the most recent periods of four or more consecutive weeks of net outflows from the Lipper High Yield ETF segment, the market—as measured by the BofA Merrill Lynch U.S. High Yield Master II Index—performed relatively well in the calendar month that immediately followed. What’s more, the iShares iBoxx High Yield Corporate Bond ETF (HYG) was No. 10 among all ETFs in August in asset gathering, according to ETF.com.
Inflows into equity ETFs in August were heavily focused on non-U.S. strategies: Of the $6.8 billion in August, almost $6.3 billion of that went to internationally focused funds.
European equities is one area where EFT investors are looking for bargains.
The rationale for heavy interest in Europe is that it’s 12 to 18 months behind the U.S. in terms of an economic recovery, Fennell said, adding that investors are also betting Europe is serious about continuing a U.S.-style quantitative easing (QE) program. Fennell said that the U.S. dollar’s appreciation against the euro in the last few months has also made Europe a good buying opportunity.
Still, it’s not just Europe that is attracting attention when it comes to making bets on developed markets outside the U.S. In fact, the Vanguard FTSE Developed Markets ETF is proof of investors’ interest in the broader global investment universe. It has seen $3.9 billion in net inflows in 2014. “It might be a better place to be in the next year or two rather than in the U.S. if the global recovery continues its slow grinding pace upward, and you are particularly focused on total return potential,” Fennell said.
In love-hate relationship with emerging markets, love reemerges
The iShares MSCI Emerging Markets ETF added almost $900 million in August, according to ETF.com data, a sign that emerging markets are coming back into favor after a major selloff in 2013. The emerging markets trend has been gaining steam throughout 2014: After a weak start to 2014, when a combined $10.8 billion left the Lipper Emerging Markets ETF category in January and February, each month since then has witnessed positive net flows that have totaled $13 billion. “Inflows are surprisingly strong compared to the slow pace of returns seen last summer and relative to the domestic markets,” Fennell said.
“We see value in the emerging markets because, on a fundamental basis, they are the cheapest stocks in the world and will be for a number of years,” said Hafeez Esmail, chief compliance officer and director of marketing at Main Management.
Marina Goodman, investment strategist at Giralda Advisors, is betting on emerging markets consumer stocks specifically because they will continue to see growth for a number of years. “The domestic consumer sector of the economy is growing in the emerging and frontier markets, and we would like to take advantage of that,” Goodman said, adding that there are also derivative bets being placed on growing emerging markets consumer wealth in financial services and utilities, among other sectors.
Hougan is seeing investor interest in Vietnam and other non-core Asian countries, including Indonesia. “The feeling there is that stable currencies, relatively stable governments and low wage bases will continue to move those countries up the path of development,” he said.
Mordy is one of those investors who likes Vietnam. He said Vietnam fulfills all three criteria for investment in emerging markets: a reasonably valued stock market, encouraging structural reform and faster progress in dismantling the dominance of state-owned enterprises than the market is appreciating.
Esmail said that the emerging markets are in some sense reliant on China as an economic engine, and China’s shadow banking crisis is the biggest risk to emerging markets, but valuation-wise the emerging markets are the most appealing part of global equities universe.
What about China? Isn’t it even more likely to crash than the U.S.?
Should we still be waiting for China to crash?
In late August, Mordy wrote an article entitled “China’s Crash: Postponed” asserting that while China is, indeed, moving toward a market economy, it is still controlled largely by the government, and therefore policy remains the most important risk factor. “On that front, policymakers will not allow an aggressive deleveraging cycle to take place,” he said.
“People tend to think that the China pullback is overdone,” Hougan said. “While the economy is slowing, the market is so sharply off its highs that it’s priced in disaster, and the reality appears more moderate to many of the strategists we monitor.”