The Sunny Side Of ETFs
09.05.07, 12:10 PM ET
For all the noise, the S&P 500 index finished the month of August slightly up and has risen 3.9% so far this year. The Dow Jones industrial average was flat for the month, and is up 7.2% this year. Not bad for the domestic averages, but international markets performed better, especially Asia, with the exception of Japan.
The key question for investors going forward is, Will the current financial turmoil work itself out like the savings and loan problem of the 1990s or will it spread to the real economy? Another issue is whether the U.S.-grown financial problems will spread to international markets or lead to ETF investors increasing their exposure to overseas markets.
There is little doubt that real estate markets are weaker than expected. The backlogs of existing unsold houses rose to a 16-year high and average prices in America's 10 main cities fell by 4.1% this year to June. JPMorgan expects average house prices to fall between 7.5% and 15% by the end of 2008.
There are several ways that real estate problems could hurt the real economy. The first is consumer sales. Across the world, household spending has been supported by both property and equity prices. If the U.S. housing slump deepens and markets continue to be weak, consumption growth will likely slow. Then there is the spillover effect whereby homeowners having mortgage payment problems start having credit card payment problems, and so on down the line.
In addition, there is the negative effect of rising borrowing costs on companies’ capital spending and hiring. Global business spending has been supported by record cash flows, as well as by debt-funded investment. While expenditures in these areas may slow gradually as companies adapt to the new environment, there is already some evidence that equipment spending is softening in the U.S.
Watch for signs that indicate what is happening to the real economy: jobs, spending and capital expenditures. But keep in mind that despite the steady drumbeat of negative stories on TV business channels, the record of the American and global economy in weathering challenges is actually quite extraordinary.
Take a look at the "sunny side" before going to cash and hibernating for the winter.
Here is the big picture, which you can find in the American Funds mountain chart. The S&P 500's total return has exceeded the return on "risk-free" Treasury long-term bonds in all but four 10-year periods over the past century--the ones ending in 1974, 1977, 1978 and 2002. Despite wars, inflation, recessions, gasoline shortages and housing crashes in various parts of the nation, the S&P 500, with dividends reinvested, has yielded an average 10-year return of 243% vs. 86% for the highest-grade bonds. Since 1959, there has only been one year, 1980, when consumer spending fell.
Here are some more reasons to be optimistic that the U.S. and global markets will again be resilient.
First, consumer spending will likely stay strong because the top 20% of income earners account for a higher percentage of total consumer spending than the lower 60%.
Second, share buybacks from a broad range of firms may help soften the blow of weaker share prices. Some of the companies with sizable pending buyback programs are Procter & Gamble (nyse: PG - news - people ), Home Depot (nyse: HD - news - people ), Nestle (other-otc: NSRGY - news - people ), Wal-Mart Stores (nyse: WMT - news - people ), ConocoPhillips (nyse: COP - news - people ), UBS (nyse: UBS - news - people ), Bank of America (nyse: BAC - news - people )Johnson & Johnson (nyse: JNJ - news - people ), JPMorgan (nyse: JPM - news - people ) and Walt Disney (nyse: DIS - news - people ).
Third, corporate earnings seem to be rather firm. According to data from Thomson Financial, earnings per share for S&P 500 companies in aggregate are expected to rise 8.1% in 2007 and 11.5% in 2008. For the MSCI World index companies, the number is 13.2% for 2007 and MSCI Asia is even stronger at just over 18%.
Fourth, corporate balance sheets in aggregate have improved. The net debt of S&P 500 companies has fallen 11% since 2001.
Fifth, there is now a wide expectation that the Federal Reserve will cut interest rates next month and central banks around the world have demonstrated their willingness to take actions to inject liquidity and calm markets.
Sixth, valuations in the U.S. and around the world do not seem overdone to me. The S&P 500 is trading at 16 times earnings and international markets and, with the exception of Indonesia and India, appear undervalued. Ireland, Germany and the U.K. are trading at 11 times, the Netherlands at 10 times, Sweden and Singapore at 12 times and Mexico is trading at 13 times earnings.
Lastly, many global companies are increasing the proportion of their total sales to emerging market countries and economic growth in these fast-growing markets seems to be alive and kicking. The major themes driving this growth, which has averaged well over 7% in annual terms over the past five years, seem clear.
Economic market reforms, openness to foreign capital, better balance sheets and fiscal discipline leading to higher credit ratings and bulging FX reserves, urbanization leading to higher productivity and the ability to catch up more rapidly due to breakthroughs in technology and communications have all helped emerging market countries catch up fast. The world is truly filling in leading to tens of millions moving from poverty to the middle class.
Indeed it appears that sophisticated global ETF investors are not backing away from international and emerging markets like Hong Kong (amex: EWH - news - people ), up 17.5%, and Thailand (nyse: TF - news - people ), up 38%, but fueling their stellar returns.
Bottom line: Keep healthy cash positions for flexibility and use dips in markets to accumulate shares in high-quality U.S. and global ETFs that have strong currencies and that have demonstrated fiscal discipline and a commitment to market reforms.
