Equities: US Against the World

By Jason Pearce

The Gundlach Trade of 2017

Every year, investors and money managers flock to the Sohn Investment Conference in New York to hear the investment pitches from the top minds in the industry.  Jeffrey Gundlach, the CIO of DoubleLine Capital, is one of the most anticipated speakers of the event.

Given his track record, it’s no surprise.  This is the man that often outperforms the market and most of his peers, who predicted the Trump election win, and who even told traders to buy natural gas when it was scraping the bottom of the barrel at multi-year lows.

Not that he’s always right (he has been bearish on the stock market for years), but his opinion is not one you want to quickly dismiss.

This year, Gundlach’s big idea was to go long on the Emerging Market Index (EEM) and short the SPY.  Now, he did clarify that this does not mean that he’s bearish on the US stock market.  He simply thinks that the Emerging Markets will outperform the US market.

This idea is not a directional bet on the market.  Rather, it is a relative value play or a pairs trade.  In futures trader parlance, it’s what we call a good ol’ spread trade.

Valuations

One of Gundlach’s main points for this idea is that the US market is overvalued and the Emerging Markets are undervalued.  So with both of them poised for a reversion to the mean, a relative value play is the logical way to go.

This makes perfect sense.  In a prior post, I noted that the current level of the CAPE ratio indicates that the US market is historically expensive.  Right now, the CAPE ratio is either side of 29:1.

The only other two times in the last century when the CAPE ratio in the US was at this level or higher occurred in 1929 and again at the end of 1999.  And we all know how things turned out at the end of the Roaring Twenties and the Dot Com bubble.  Perhaps it’s time to queue up the song Party Like It’s 1999

At the same time, the CAPE ratio on the MSCI Emerging Markets Index is at a historically low reading of 14:1.

The spread between the CAPE ratio in the US and Emerging Markets hasn’t always been this wide.  During the Financial Crisis of 2008, the CAPE ratios for both the S&P 500 and the MSCI Emerging Markets Index had crashed to a similar level of about 10:1.  The ratios for both then rebounded into early 2011 as the US took the lead higher.

Two Paths Diverged

After the ratios of both markets experienced a setback in 2011 and bounced back at the start of 2012, the CAPE ratio on the MSCI Emerging Markets Index rolled over once again.  It continued to drop for another half a decade until it finally returned to the Financial Crisis low in early 2016.

On the other hand, the CAPE ratio on the S&P 500 continued to climb for the last several years.  It is now sitting at a nine-year high.

On an interesting note, when the Emerging Markets CAPE ratio returned to the same level as the Financial Crisis low last year, PIMCO said that buying down there would be “the trade of the decade.”

It looks like they were right, too.  The Emerging Market Index (EEM) has risen a stellar 39% over the last year and a quarter.

So how has your stock portfolio performed over these last fifteen months?

Even though the Emerging Market Index (EEM) has rocketed higher since early 2016, the CAPE ratio is still only sitting at a modest 14:1.  With the CAPE ratio on the S&P 500 now at nose-bleed levels and the CAPE ratio on the Emerging Markets at bargain levels, the disparity between their valuations have become glaringly obvious.

But that’s not gonna help us out with the timing.  We need to see some price action to accomplish that.

Ratio Action

The S&P 500 has outperformed the MSCI Emerging Markets Index since 2010.  However, technical action suggests that this trend could finally be coming to an end.  We are going to look at the ratio between SPY and EEM to determine this.

A near perfect double top pattern in the ratio may have formed on the weekly chart between the multi-year high of 6.60:1 that was posted in early January 2016 and the mid-December 2016 high of 6.58:1.

To confirm that a double top has indeed been established, the SPY/EEM ratio needs to break the lowest point between the two highs.  That level is located at the mid-October correction low of 5.69:1.

The ratio is within spitting distance of the October correction low right now.  Any trader who’s interested in shorting the SPY/EEM spread better have their finger on the trigger and be ready to squeeze it at the drop of a hat.

Early Warning Shot

One could make the argument that the SPY/EEM ratio has already signaled a bearish trend change, despite the fact that a double top has not yet been confirmed.  This occurred back in mid-March when the ratio closed below technical support at the rising 100-week moving average.

In 2011, the ratio broke about above the 100-week moving average and closed above it every single week for five years straight.  (I wrote a post that explains my process for ending up with the 100-week moving average).  The bullish trend was a classic pattern of higher highs and higher lows, making it an easy pairs trade (long SPY and short EEM) to hold for anyone aware of what was going on.

In October, the ratio sank to a one-year low and closed just below the 100-week moving average.  It was a do-or-die moment.  As it turned out, this marked the bottom of the correction.  In just a couple of months, the swift recovery that immediately followed catapulted the ratio almost back up to the early January multi-year high.

After failing to clear the January 2016 high, the ratio rolled over again and started its descent.  Technical support at the 100-week moving average was breached again in mid-March, but this time the SPY/EEM failed to recover.  By this metric, it’s time to be short or be out.  Being long is currently not an option.

Buy, Sell, Switch

Even if you don’t intend to put on a SPY/EEM pairs trade, knowledge of how it’s performing is still valuable knowledge for the average investor.

From the perspective of diversification and/or marketing timing, knowing about the wide spread between the S&P 500 and the MSCI Emerging Markets Index CAPE ratios and tracking the trend in the SPY/EEM ratio can help one enhance returns and manage risk.

Since the case has been made that Emerging Markets should start to outperform the US market, an investor could use this information as a reason to lighten up on US equities and get a little heavier in the to the Emerging Markets.

If you’re an absolute return kind of guy, you could even say that this is a good reason to switch altogether from being invested in US equities to being invested in the Emerging Markets.

Better Risk/Reward

Not only does the recent change in the SPY/EEM trend suggest a regime change in market leadership, but the CAPE ratio also tells an investor where to go for lower risk.

Most people assume that the Emerging Markets carry the higher risk because of political risks, higher volatility in the currencies, less-developed economies, etc.  These are valid concerns.  But the price of Emerging Markets relative to what they actually earn indicates that they are a lot closer to being a good value than what the US market is.

Not to suggest that they can’t decline from here, but the Emerging Markets have much less further to fall than the US market does before getting to what has been an historically an undervalued level.

If there’s a global bear market lurking around the corner and you get caught wrong-footed, don’t you at least want to be invested in the market that drops the least instead of the one that drops the most?

Emerging Markets Have Emerged

Let’s forget this whole relative value play for just a moment and take a look at the Emerging Markets on their own merit.  For a few years the outlook for EEM was bleak.  But things have changed considerably over the last several months.

Back in the summer of 2015, the MSCI Emerging Markets Index broke out of a multi-year trading range…to the downside.  Not a good omen.  Once support at the October 2011 low was breached, there was no reason to try catching a falling anvil.

By January of 2016, EEM was trading at the lowest price since early 2009 and the CAPE ratio had returned to the Financial Crisis low.  At that point, one would not be surprised to see “Abandon all hope, ye who enter here” scrawled on their brokerage confirmations for any purchases of Emerging Markets equities.

But it’s always darkest before the dawn.

A mere two months later, EEM closed back above the October 2011 low.  This negated the downside breakout and triggered a Wash & Rinse buy signal.

Three months after that, the MSCI Emerging Markets Index closed above its 50-week moving average for the first time in over a year.  This signaled a bullish trend change.

Here we are nearly a year later and EEM is still going strong.  It’s stayed above its 50-week moving average this entire time and it’s now trading at the highest price in nearly two years.  Furthermore, the Emerging Markets Index is now trying to crack through trend line resistance (as drawn across the 2007 bull market high and the 2011 secondary top).

Add the current technical picture to the fact that the CAPE ratio has spent the last year and a quarter recovering off a double bottom at the 2008 and 2016 lows and you can see there’s plenty of fuel to keep the rocket going.  Buying the dips and riding the rips is currently the way to trade the Emerging Markets.

Leveraged Bet

Gundlach recommends doing this ETF pairs trade with leverage of 2-to-1.  If you’re a conservative investor, you might want to do this without the leverage.  But if you’re really confident in this trade, that’s fine.  Go ahead and use the leverage he recommended.

But if you’re really, really confident in this trade…

You could step on the accelerator and put on the same spread trade position with futures contracts.

Now, perhaps Gundlach doesn’t understand the insane amount of leverage that’s available to futures traders to execute this idea.  More likely, though, he knows.  He just doesn’t want to be held responsible for telling the rest of the world to go out and trade futures contracts.

The leverage offered on futures contracts can give the typical novice investor way too much fire power.  Think 20-to-1 leverage instead of 2-to-1 leverage.  It’s like the difference between driving a Prius and a Ferrari.  If you’re gonna go for a drive, you had better know in advance how much horsepower you can safely handle.

If you’re conformable with the futures market, you can easily trade the E-Mini S&P 500 Index futures contract against the Mini MSCI Emerging Markets Index futures contract.  Conveniently, they both have the same multiplier of $50 times the index.

Given the fact that the value of the E-Mini S&P 500 is worth more than double the value of the Mini MSCI Emerging Markets Index (the ratio is currently 2.35:1), a trader who wants to lower the volatility might consider using a more dollar neutral position of spreading two Mini MSCI Emerging Markets Index contracts against one E-Mini S&P 500 contract.

The Market Is Master

If you are looking to make a play on the SPY/EEM pairs trade, or any trade for that matter, is very important that you take your instructions from the market’s action.  Put your trust in the price, not in the prognosticator.

For example, what if you’d gone short the homebuilder ETF (XHB) when Jeff Gundlach picked it in May of 2014?  Initially, it dropped about 12% over a five month period from when he made the recommendation.

But then XHB rocketed to new multi-year highs just a couple of months later.

In May 2013, he absolutely hated Chipotle (CMG) stock –even though he said that he likes their burritos- and said it was a short sale.  He didn’t like the chart, the P/E ratio, the low barriers to entry for the competition, etc.

Guess how that one turned out?

From the close of May 2013 through the end of the year, the stock actually increased in price by about 48%!  That wasn’t the end of the run, either.  The stock more than doubled in price in the months and years that followed his presentation.

Would you have stayed short on that?!

Not if you had any leverage.  Even if you did, it took nearly three and a half years before CMG finally dropped back down to the price where it had closed in May 2013.

The point of this is that Gundlach should not be your Guru.  While you may get some good ideas from some of the big traders and investment managers from time to time, it’s important that you overlay all of it with your own research as well.

More importantly than getting in a trade, you have to determine where you will get out of a trade.  A thorough examination of the price behavior will be able to provide you with those exact parameters.  You can’t rely on the other guy to tell you when to bail out of their big trade idea if it goes south.

Also, you need to have your risk management plan totally dialed in.  You shouldn’t ever put on a position that’s so big that one bad trade can wipe you out.  If you’ve caught a tiger by the tail and you’ve picked a big winner, you should have ample opportunity to add to it as the trend unfolds.

But until a trade proves itself, you need to be concentrating on playing good defense.  Remember, Emerging Markets have spent plenty of time acting like submerging markets.  If that happens again, you don’t want to go down with the ship.


More Articles by Jason Pearce:

Profiting From Failure: The Wash & Rinse Trade, Part II

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

Jason Pearce

Jason Pearce

Jason Pearce is a 25+ year veteran of the futures markets. Since 1991, he has played the roles of retail broker and managing director of a brokerage firm, trader, market analyst, newsletter writer/editor and trading systems/algorithms developer. Jason is now actively managing money as an independent RIA.
Jason Pearce

Latest posts by Jason Pearce (see all)

Jason Pearce is a 25+ year veteran of the futures markets. Since 1991, he has played the roles of retail broker and managing director of a brokerage firm, trader, market analyst, newsletter writer/editor and trading systems/algorithms developer. Jason is now actively managing money as an independent RIA.

Please note: I reserve the right to delete comments that are offensive or off-topic.