The biggest mistake that investors make is chasing what’s hot and avoiding what’s not. Our greatest value at Kobren Insight Management is to try and help our clients minimize those emotional mistakes and to help them stay the course with an appropriately built portfolio.

While over the long haul valuations and fundamentals such as earnings ultimately drive security prices, performance over shorter time frames has a much messier relationship with economic variables, and is more often fueled by human emotions.

What’s hot (and what’s not) in the market on a day-to-day basis, or even week-to-week or month-to-month, is more often the product of technical factors such as sentiment or liquidity than fundamental factors. So don’t pay too much attention to all the headlines and instant analysis from most of the financial media as they attempt to explain every wiggle in the market. And don’t get caught up in chasing what the crowd is chasing (usually recently hot performers).

How do you know if you are running with the crowd?
Investor sentiment is the best indicator of the “crowd mentality.” If you are bullish (or bearish) on some area of the market and investor sentiment readings reach a similar bullish (or bearish) extreme, it’s time to question your stance.

Typically, when sentiment reaches extremes, there are, in effect, few left to buy (or sell), and the market is often about to move in the opposite direction. We have already seen many good examples of this so far this year.

Investors were very bearish on interest rates (and bonds) a few months ago, and despite the Federal Reserve raising short-term rates, long-term rates dropped over ¾ of 1% and bonds rallied!

After a dismal first quarter performance, investors were very bearish on equities before stocks surged in May.

Sentiment in energy has been all over the place, but was recently quite bearish – and now oil is now back above $50/barrel.

After several years of declines, investors were extraordinarily bearish on the U.S. dollar early this year. But despite very little improvement in the federal and trade deficits (major reasons behind the dollars weakness), the dollar has rallied sharply this year.

In short, running with the crowd and chasing what’s hot (or running away from what’s cold), can be destructive to the long-term health of your portfolio.

Is The Crowd Wrong On China Now?
One source of many headlines and optimism in recent years has been China. One view that is generally considered the consensus is that China should be the global economy’s primary growth engine for the 21st century. It very well could be.

That said, the path of growth is not likely to be linear and could be more volatile than many people anticipate. We are great fans of emerging market investing (higher growth, lower valuations, increasing quality of underlying countries and securities), but we also recognize that for every two steps forward, there will likely be a step backwards.

After six years of strong economic growth (though not as strong market performance as many people might have expected), it would be reasonable for China’s economy to cool. In recent months, China has acknowledged that they need to rein in their property bubble and other economic imbalances. A slowdown will be felt on the world stage as China accounts for nearly 10% of the world's consumption of crude oil, nearly a quarter of aluminum consumption, and a third of coal, iron and other commodities.

In addition, there is a storm cloud on the horizon regarding China. It is the deteriorating trade relations between the U.S. and China. The U.S. has several beefs with China, including China not floating their currency (currently the Chinese currency is pegged to the U.S. dollar and therefore doesn’t change in value like most other currencies do depending on fluctuating economic and market variables). This fixed currency gives China, all else being equal, an unfair trading advantage and it makes Chinese goods cheaper to foreign consumers.

As a result of this and other complaints, the U.S. is considering bills that would enact large tariffs on Chinese imports. There is growing political support for this in the U.S. and a showdown could happen in late summer or early fall. Needless to say, China is not happy with that prospect. If this situation continues to escalate, there could be two very negative consequences.

After Japan, China is the largest foreign holder of U.S. Treasury bonds. What happens if a trade war reduces Chinese demand for our Treasuries? Could our interest rates spike higher? As we have detailed in the past, that’s not only a negative for the bond market, but also for other markets, including stocks and real estate.

Moreover, many would argue that a trade war is a large negative for the global economy. Some economic historians argue that trade wars were the primary cause of the Great Depression. Maybe China’s increased role in the global economy will indeed drive global growth – just not in the direction that many thought.

The Crowd Cools To International Investing
A common question at the beginning of this year was why didn't we have even more exposure to international securities? (We did and still do have an overweight in foreign securities.) That was eminently predicable given that most foreign stock markets had handsomely outperformed our own for several years.

Now, with the negative votes on EU Constitution, notably from France, and the U.S. dollar getting strong again, international markets have largely lagged the U.S. (in dollar terms) and we are starting to have to justify why we have any international exposure at all! However, we continue to favor having exposure to international securities. The primary reason remains the same: better overall growth prospects at lower valuations.

Currently, each major world region has lower valuations compared to our domestic stock market, with price/earning ratios averaging about 20% less. And that gap is forecasted to remain in 2006. Meanwhile, earnings growth overseas is expected to be modestly higher than here at home in 2005, and more substantially higher in 2006 (as it was in 2004).

The chart below summarizes this relative valuation story, showing that all of the major regions around the world offer a better “PEG” ratio — a measure of the trade-off of price for earnings growth — than the U.S. Technically speaking, the PEG ratio is the price-to-earnings ratio, or “PE,” divided by the earnings growth rate, or “G.” Think of PEG ratios as price tags for earnings growth; the lower the number, the better.

Foreign Markets Still Offer Better Values

This graphic shows the “PEG” ratios for different regions and countries around the world. The PEG ratio measures how much you pay (price-to-earnings, or “PE”) for earnings growth (“G”). The lower the number, the less you have to pay for earnings growth. Looking around the globe, the most attractive price tags for earnings can be found in emerging markets as well as developed markets in Asia. The U.S. is the priciest market relative to its expected earnings growth.

Not only are valuations better overseas, but you also get a better yield. The dividend yield on international stocks is currently 2.7%, compared to a current yield of1.9% for the S&P 500.

Another reason to like international exposure going forward is the dollar. Earlier this year, we were cautious on adding more non-dollar (international) exposure due to concerns that the dollar might strengthen.

In fact, in the January Report, I listed a stronger dollar as one of my potential surprises for 2005. (and to my point about crowd behavior above, extreme bearish sentiment was one of the reasons we thought the dollar might surprise on the upside).

So far this year, the dollar has indeed strengthened, rising about 9% against a basket of major currencies. However, many of the factors that supported the U.S. currency’s rise are no longer in place (for example, the extreme negative sentiment has dissipated).

While we respect the tendency of currencies to trend in price (higher prices tend to follow higher prices and vice versa), we will be on the look-out for fresh opportunities to add to our current international exposure.

A Chance To Learn More About Our Thinking
We are getting some nice comments on our other monthly pieces on our website. Our latest pieces are a “Research Perspective: Debunking Mutual Fund Tax Myths” and an “Analyst Spotlight: Baron Small Cap”. Please feel free to let us know what you think.

Sincerely,

Eric Kobren