Defense Is Still The Best Offense

With the broad market struggling to find a floor in the midst of a disappointing earnings season, it still pays to play defense. This week’s ISM releases reinforce that a defensive over cyclical portfolio bias is still warranted. The bottom panel of the chart shows the relative employment outlook for ISM manufacturing versus ISM services, with the pendulum swinging in favor of services industries. This relative employment ratio heralds more pain for cyclical vs. defensive equities, as most defensive sectors are services-oriented while deep cyclicals are manufacturing-intensive. Meanwhile, the bond market continues to flag elevated financial stress. Cyclical junk bond yields have been shooting higher, especially compared with defensive junk yields, reflecting relative deteriorating balance sheets. The implication is that relative share prices have more room to fall (top panel). Bottom Line: we continue to recommend a defensive versus deep cyclical portfolio tilt.

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EM Equity Valuations: A CAPE Model

The bear market in emerging markets (EM) is in full force, and volatility will remain high for now. Nevertheless major financial market bottoms often transpire amid pervasive bearishness and liquidation. Therefore, investors should monitor valuations.


Our EM strategists have constructed a cyclically-adjusted price-to-earnings ratio (CAPE) for EM stocks. Cyclical adjustment is certainly needed at this point of the cycle because EM corporate earnings have been contracting for some time and will continue to do so. Hence, it is reasonable to examine P/E ratios after adjusting for the cyclicality of corporate profits.

The chart above shows that EM stocks now trade at more than one standard deviation below their historical mean, according to the CAPE ratio. The chart, illustrates that the EM CAPE ratio is getting close to its 2008 lows.

That said, our EM team believes that EM equity valuations will drop further and reach 1.5 or two standard deviations below their historical mean. That corresponds to another 10% to 20% drop in EM share prices in local currency terms.

Bottom Line: At some point, EM stocks will become compelling on a valuation basis, but our EM strategists do not advise buying yet.