US and global equity markets remained choppy in Q3, with numerous trend reversals occurring as investors wrestled with mixed economic data. The market has so far weathered a double-dip scare that temporarily caused a 16% pullback in the S&P 500 during the May-July timeframe. As of Q3 end, the S&P 500 rallied back to within 6% of 2010 highs, and was posting a small positive gain for the year-to-date period. In more secularly bullish markets, like emerging Asia, markets rallied to new highs.
Macro analysis points to a decoupled world. During the past decade, developing countries (China, Brazil, etc.) have been bolstered by large trade surpluses, while developed countries (US, Europe, Japan) have weakened due to large trade deficits. Chart 1 illustrates the tremendous changes that have taken place in just the last seven years, as developing markets picked up 10% of global market cap share, at the expense of developed nations.
Stock markets have reflected this decoupling by rewarding emerging markets (developing countries) with higher returns than developed markets. In response, developed market countries have attempted to massively devalue their currencies in order to normalize the situation. A cheaper currency reduces the cost of exports, which makes them more attractive to foreigners. Additionally, a cheaper currency reduces the value of the debts owed to foreigners from previous borrowings, albeit driving inflation over the longer-term. As a result of these inflationary actions, hard asset classes such as gold and basic materials have seen significant advances, as have other assets priced in stronger currencies (foreign equities, real estate, currencies).
We continue to believe that emerging markets are in a secular bull trend, having already fully recovered from the global recession. In contrast, developed markets in the US, Europe, and Japan continue to struggle economically, specifically with high levels of unemployment and deflation persisting in the US. Consequently, we have allocated a larger share of our client assets to emerging market equities, expanding our allowable volatility bands to let these investments run a bit more to the upside. Simultaneously, we have reduced our developed market equity positions and expect to trade a bit more in these investments as their recoveries develop in a choppier manner.
Outside of equities, we continue to hold deep-value positions in natural gas and short US Treasuries. These are longer term holdings that are severely undervalued, and should deliver sizable returns over the next 3-5 year period. We also continue to hold an oversized position in high-yielding debt and foreign sovereign debt, with a smaller amount in convertibles and TIPS. We have reduced our gold position, believing that it is a bit overheated. Finally, we are continuing with our positions in diversifiers, offering downside protection against a possible renewed decline. These diversifiers include managed futures, long/short funds, merger-arbitrage, and absolute return strategies.
Despite our more bullish positioning, we are keeping an eye on key resistance levels that might indicate a renewed bear market. Possible catalysts could include another spike in housing defaults, stimulus failures, election outcomes, or potential tax increases from the expiration of Bush tax cuts. As usual, we continue our daily vigilance to grow and protect your wealth.