Don’t Fight a Central Banker on a Mission

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Opinions of the Federal Reserve were far from unanimously positive when it kicked off its first quantitative easing (QE 1) program on Dec. 16, 2008. But the performance of equities since has to receive five stars.eurozone
Since QE 1 began the S&P 500 has rallied 133%. The Nasdaq and the Russell 2000 small-cap index have soared by 219% and 160%, respectively. And the Dow Jones Industrial Average is up by 105%.
The positive impact (both real and perceived) of the Fed’s easing policies could also be credited for buoying global markets since 2008. One measure of global stock performance, the Vanguard Total World Stock ETF (NYSEArca: VT), is up by 120%. The VT fund has over 7,100 positions, and 54% is allocated to North America.
The likelihood that QE 1 was the catalyst that pulled U.S. equities out of a tailspin has strengthened the argument of those who proclaim that it never pays to fight the Fed.
One can easily extend the argument overseas, and state that markets are rarely inclined to fight any central banker on a mission, regardless of nationality. Especially when that mission is to drive down interest rates and increase liquidity by buying up sovereign debt.
So let’s not close our eyes to the potential of economic growth and a period of strong performance in equities in the eurozone, due to a much larger quantitative easing program than that which was first announced here in 2008.
Because if history is any guide, companies with eurozone exposure are looking forward to a nice run, even if there are a few differences between the implementation of the eurozone’s and the United States’ policies.
Recall that the Fed launched QE 1 with the intent to purchase $600 billion in agency mortgage-backed securities. Launched in January, European Central Bank President Mario Draghi’s program kicked off with an intent to buy over 1 trillion euros’ worth of government and private sector bonds by September 2016.
It’s obviously too early  to make a conclusive call, but reports out of the eurozone suggest that credit is easier to get, loan volumes are rising, lending rates are falling and financial flows into the area are on the rise. These all portend good things for modest gross domestic product growth in 2015.
And in fact, in the first quarter the eurozone expanded by 0.4%, outpacing the relative scant pace of 0.2% growth in the U.S.
Neither rate is going to win any awards. But given that the eurozone has been one of the world’s economic laggards, the moderate expansion still gives investors reason to cheer. The most recent expansion marks the fourth consecutive quarter of sequential growth.
If Draghi’s QE program helps European companies generate sales, it’s easy to imagine a long cycle of GDP growth and rising earnings. This means that on a forward earnings basis, a lot of European companies are likely trading at discounted valuations.
It also means that investors are going to continue to jump on the bandwagon because, as I stated earlier, it rarely pays to fight a central banker. And it’s entirely possible that this could just be the first of several bond-buying programs.
Remember that in the U.S. QE 1 was followed up by QE 2, Operation Twist and QE 3. While each had its own particular strategy, the general purpose and end result of buying up various forms of debt was the same. Liquidity increased, rates fell (or stayed low) and investors stayed in equities.
So far, the returns have been pretty darn nice.
Granted, we’ll have to see what happens after the Fed has raised rates to a more normal level to fully assess the success of such impressive monetary stimuli. Perhaps the pundits will be right in stating that with so much money sloshing about investors have lost the ability to differentiate good investments from worthless trash.
But as Emilio Estevez told his band of outlaws in “Young Guns” when hanging seemed imminent, there’s many a slip twixt the cup and the lip.
Thus far the Fed has done an impressive job avoiding a big spill – impressive enough that Draghi is following suit. And so should investors.
Year-to-date, European equities as measured by the iShares Europe ETF (NYSEArca: IEV) are up by an impressive 11.4%, as compared to a 3.4% rise in the S&P 500. Nearly 7% of that rise has come over just the last two months.
The IEV fund yields almost 3.5% and is primarily a large-cap fund (87%), with 10% exposure to mid caps. It’s a good place to gain European equity exposure, given its diversity of exposure across sectors and countries.
Investors can also use ETFs to play individual countries in Europe and to try to avoid the slower growth areas in favor of the more rapidly expanding ones. Recent data suggests France and Switzerland are both growing by 0.6%, while Italy and Germany are each growing by 0.3%. Greece continues to contract at a pace of negative 0.2%.
But I think this strategy probably makes life more complicated than it needs to be. Quarter-to-quarter GDP growth doesn’t necessarily correlate with quarter-to-quarter stock country ETF performance, especially when many of the performance differences are so slight.
And the IEV fund provides relatively good exposure to the entire area, with 28% of the fund exposed to the U.K., 15% to Switzerland, 15% to France, 13% to Germany and between 1% and 5% each to remaining countries in the area.
My preferred strategy for those looking to capture additional performance is to move down the market cap ladder to smaller companies.
The iShares MSCI Europe Small-Cap ETF (NASDAQ: IEUS) and the WisdomTree Europe SmallCap Dividend ETF (NYSEArca: DFE) are two excellent options. And both have handily outperformed large caps in both the U.S. and Europe year-to-date by rising 17%.
And then there are individual companies too. Almost all of the top 10 holdings in the IEV fund are companies you can buy on U.S. exchanges (in some cases through U.S. market makers), starting with Novartis (NYSE: NVS), Nestle SA (OTC: NSRGY), Roche Holding AG (OTC: RHHBY) and HSBC Holdings (NYSE: HSBC).
BP PLC (NYSE: BP), Royal Dutch Shell (NYSE: RDS-A) and Total SA (NYSE: TOT) add energy exposure and attractive yields in the 4% to 6% range, while the top 10 is rounded out with health care exposure from Sanofi (NYSE: SNY), Bayer (OTC: BAYRY) and GlaxoSmithKline (NYSE: GSK).
Things get a little more complicated for investors looking for European small-cap exposure with individual stocks, especially if trying to avoid purchases on foreign exchanges. Peruse the top 10 holdings for both the IEUS and the DFE funds and you’ll see that most trade on foreign exchanges. Shares that are available through U.S. market makers are much less liquid than most investors would probably like.
That said, there are numerous U.S.-based small caps that have significant exposure to European economies. And while they may not be “pure-euro,” they can get the job done. Discussing these is a bit beyond the scope of today’s discussion though.
I personally think that investors are best off playing this trend by buying the IEV (or a similar offering from another ETF issuer), either the IEUS or DFE, and a few mid- and large-cap European companies that trade on U.S. exchanges. This strategy allows for easy averaging in (and when desired, out) and keeps trading costs down.
It should also permit most investors to keep a clear handle on their overall portfolio diversification, since it provides European exposure without a lot of complexity.
As the performance of European ETFs shows, this trend is well underway. But I think it’s far from over. This is one of those situations where it’s likely to be far more profitable to go with the flow than fight against it.

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