Prices of the largest and most diversified U.S. equity index known as the S&P500 continue to increase faster relative to company earnings, leading to an overvalued U.S. market. The problem is what to do next.
If the trend in graph 1 continues, the chances of a market correction will continue to increase, and if a correction occurs, investors will lose value on their investments. The biggest problem with corrections is that investors holding the most stable companies with the best fundamentals tend to be driven down along with the market. This type of risk is known as systemic risk. Although this presents a buying opportunity, it could also mean taking considerable losses for other investors.
Figure 1
Running for Cover
To avoid this problem, many money managers have already started to shift their investments to European markets. However, this will not necessarily lead to investment outperformance due to the positive correlation of U.S. and European markets in the past year as shown in graph 2. Even more worrisome is the fact that the chance of another European crisis is very high[i], which could eat away at investment returns. More importantly, volatility lowers the risk-to-reward ratios, such as the Historical Sharpe ratio, as shown in Figure 1.
Emerging Markets
One asset class that has the potential to outperform the S&P500 over the next few years is known as the emerging market economy (EME). Regrettably, there are a limited number of emerging economies that can be accessed by the average investor. The best way to invest in these markets recently has been through equity traded funds (ETFs). These ETFs provide opportunities to investors that would like to invest in a single asset group. In the case of emerging markets, ETFs can offer low-expense ratios that are relative to actively-managed mutual funds. ETFs allow the investor to buy a single financial product that reflects the economic growth of a single country and that is composed of different industries (utilities, financials, industrials, etc.).
Unfortunately, many emerging market ETFs have been underperforming over the past few years due to the low commodity prices. Even worse, many emerging market economies suffer from being overdependent on one or more commodities. For example, Nigeria is highly dependent on the price of oil for its economic growth. This over-dependence has made ETFs specializing in single commodities popular with investors, but if this is the case, investing in a single commodity may be the smarter move. Graph 3 shows that the Brent Crude Oil Spot Price correlates strongly with the Global X MSCI Nigeria ETF price. As a result, if the goal is to outperform the market on a risk-to-reward basis, single commodity country dependent ETFs may not be the best choice if the ETF fails to offer diversification among various industries.
The right emerging market ETF would need to have a significant chance at being positively impacted by near future events. It would also have to be diversified enough to have a significant chance of outperforming the S&P500 on a risk-to-reward basis. More importantly, the ETF would need to serve as a hedge against S&P500 systemic risk.
China
Since the end of 2015, Graph 4 shows that industrial metals such as zinc and copper have signs of recovery[ii]. As the biggest consumer of industrial metals, this recovery has been driven by Chinese investment in their infrastructure. This spur in demand should continue to increase this year as the Chinese party will inaugurate its 19th National Congress party in October[iii]. Historically, change in leadership can create political upheaval within the Chinese party, which is why investors expect the Chinese government to continue to increase infrastructure spending in the hopes of maintaining political stability. Additionally, China’s infrastructure initiative, “One Belt, One Road” (OBOR), should keep driving up the price of industrial metals such as zinc and copper[iv][v]. The problem with zinc, however, is that China is the largest producer and consumer of zinc in the world. This makes it much harder to profit from this metal without a significant amount of systemic risk. The bottom line is that investing in zinc exposes individuals to China’s production and consumption whims. The result is that investing in zinc would overexpose the investor to China; then, we must look at the biggest producer of copper, Chile.
Chile
Although 60% of Chile’s export is copper, it only drives 20% of its GDP, leaving room for industry diversification[vi]. 63.4% of Chile’s economy is moved by the service sector and 32.4% by industry but only 4% by agriculture[vii]. This is an important fact because economies that are driven by services tend to have a greater elastic labor force. Additionally, Chile’s human capital is much higher than other emerging market countries[ix]. Although the country is politically stable, high tax policies and regulations have started to have an impact on the Chilean economy. Fortunately, this can be reversed given a change in leadership[x].
Sebastian Piñera
In November of this year, Chile will be having elections, and leading the polls is Former President (2010-2014), Sebastian Piñera[xi]. This self-made billionaire and Ph.D. Harvard-trained economist is promising pro-business policies and double digit growth if he wins the presidency[xii]. He argues that the Chilean economy is in trouble, not because of fundamentals, but because of over-taxation and over-regulatory policies originated by the current president, Michelle Bachelet[xiii].
Donald Trump
A tax plan, that would include infrastructure spending in the U.S. could also drive up the price of copper, which should positively influence the Chilean economy[xiv]. Although a bill has not been presented to the Senate yet, House Representative Paul Ryan assured that a bill would be introduced before August of this year[xv]. In another interview, Treasury Secretary, Steven Mnuchin stated that an infrastructure bill should be signed by the end of this year[xvi]. During the presidential election, Donald Trump promised that one of his biggest priorities would be a one-trillion-dollar infrastructure bill[xvii]. If this bill is passed, it could spur a copper rally as investors speculate on the future price of copper.
Copper and the USD
Graph 5 shows that copper tends to have an inverse relationship with the USD, which serves as a hedge against inflation for U.S. investors[xviii]. Although many metals, including gold, generally hold this inverse relationship, few commodities will be influenced in the next couple of years by many political and economic variables such as copper. If this inverse relationship stays constant, a decline in the USD could be good news for copper.
International Capital Asset Pricing Model
The most popular ETF with exposure to the Chilean economy is called I-shares MSCI Chile Capped[xix] (ticker symbol: ECH). Before analyzing ECH, we can use a version of an old finance model to figure out whether we should look into this ETF further. The international CAPM model can serve as a quick benchmark before spending too much time looking into the potential foreign investment.
Figure 2
Figure 3
Figure 4
Using Ishares Core S&P500 (ticker symbol: IVV) as the benchmark:
Using 10-year bonds for the U.S. and Chile:
We get the following:
5.97% represents the minimum yield that we need to consider this investment.
Assuming a best case scenario of $79 per share for ECH, from Graph 6, we can calculate the holding period yield (HPY):
Figure 5
Because 79.54% is greater than 5.97%, and given the economic and political events taking place in the near future affecting copper and Chile, we can consider taking a closer look at ECH.
Treynor Measure
Looking at the three-month Treynor measure, we can see that ECH is becoming a good hedge against IVV.
Using ten-year bonds as our risk-free rate, we can calculate the three-month Treynor measure for ECH:
Now we can compare this Treynor measure to IVV:
Since the goal is to hedge against systemic risk from the S&P500, a negative Treynor measure due to a negative beta means that ECH has outperformed IVV on a risk-to-reward basis for the past three months[xx]. Although this is only one measure of risk-to-reward performance, ECH currently seems to be performing as a hedge against IVV.
Price Multiples
Looking into ECHs’ biggest sectors, utilities represent 26.6% of this ETF while financials represent 19.95%. Recently, a bill was introduced to the Chilean Congress proposing the adoption of Basel III[xxi] Rules, which should give the Chilean financial sector access to more capital by reducing sector risk if the bill is passed into law. One of the biggest financial holdings of ECH is Banco Santander Chile (ticker symbol: BASC), which accounts for 6.54% of this ETF. Using price multiples, we can find if this bank is correctly valued.
Using the 10-year average PE Method:
Figure 7
Using the current PS Method:
Figure 8
We can find our Historical Multiple Valuation Method using the PE and PS Method:
Figure 9
Because the current price of BASC is currently $25.53[xxii], we can see, using the PE and PS method, that historical-multiple valuations indicate that Banco Santander Chile is approximately 12.8% undervalued.
Given the market and economic conditions in the U.S., and the market correlation with European markets, ECH proposes a diversified alternative, given the global events taking place in the near future, to outperform the S&P500 on a risk-to-reward basis. The biggest drivers of this ETF currently seem to be dependent on future Chinese infrastructure investment, the upcoming Chilean elections, Donald Trump’s infrastructure plan, and the ability of Chilean banks to attract more capital, assuming they adopt new banking regulatory standards. This does not mean that you should invest in ECH but that some risk-to-reward measures indicate that investors looking to outperform the S&P500 on a risk-to-reward basis should consider looking further into ECH.
[i] https://www.ft.com/content/8fe6f7b6-5687-11e7-80b6-9bfa4c1f83d2
[ii] http://www.mining.com/copper-lead-zinc-prices-stay-boil/
[iii] https://www.ft.com/content/cca9dd28-20de-11e7-a454-ab04428977f9
[iv] http://www.mining.com/copper-best-performing-commodity-2017-analysts/
[v] http://www.cnbc.com/2017/05/22/one-belt-one-road-why-the-real-value-of-chinas-project-could-like-in-soft-power.html
[vi] http://www.economist.com/news/business/21576714-mining-industry-has-enriched-chile-its-future-precarious-copper-solution
[vii] https://www.cia.gov/library/publications/the-world-factbook/geos/ci.html
[viii] http://reports.weforum.org/human-capital-report-2015/report-highlights/
[ix] http://reports.weforum.org/human-capital-report-2015/report-highlights/
[x] https://www.ft.com/content/6e681350-2378-11e7-a34a-538b4cb30025
[xi] http://www.reuters.com/article/us-chile-politics-left-idUSKBN16T27J
[xii] https://www.forbes.com/profile/sebastian-pinera/
[xiii] http://www.emol.com/noticias/Economia/2017/05/03/856663/Sebastian-Pinera-propone-bajar-el-impuesto-a-las-empresas-y-crear-cuerpo-colegiado-en-el-SII.html
[xiv] http://thehill.com/policy/finance/330430-trump-tax-plan-likely-to-include-infrastructure-spending-report
[xv] http://www.newsmax.com/Newsfront/paul-ryan-tax-reform-long/2017/04/19/id/785320/
[xvi] http://money.cnn.com/2017/04/20/news/economy/mnuchin-tax-reform/index.html?category=economy
[xvii] http://fortune.com/2017/02/28/trump-congress-address-infrastructure-investment/
[xviii] https://www.thebalance.com/how-the-dollar-impacts-commodity-prices-809294
[xix] https://www.ishares.com/us/products/239618/
[xx] http://investexcel.net/treynor-ratio-excel/
[xxi] http://www.reuters.com/article/us-chile-banks-idUSKBN1932BC