MorningWord 2/25/16: Blame it on Rio

by Dan February 25, 2016 9:36 am • Commentary

Regular readers know that macro ain’t exactly my bag, I’m more of a U.S. stock/options monkey. But every so often a headline outside my wheelhouse catches my eye and I dig a little deeper. Like this from Bloomberg:

The Pimco sub-adviser’s view is seems largely predicated on valuation, and the long period of relative under-performance to developed markets in the post financial crisis era and the potential for a reversion trade:

The exodus from emerging markets is a wonderful opportunity — and quite possibly the trade of a decade — for the long-term investor,” Christopher Brightman, chief investment officer at Research Affiliates, said in a post on Pimco’s website Wednesday.


He pointed out that the so-called Shiller P/E Ratio, a measure of valuation based on cyclically adjusted price-to-earnings ratio, fell to 10 in January. There have been only six times when the measure has dipped below 10 over the past 25 years. In the following five years, the stocks rallied an average 188 percent,

To be honest, the beach photo of Rio is what initially caught my eye. It looks to be Impanema and brought back a sort of warm and fuzzy feel as I had one of my best family vacations ever in Rio back in early 2011 that followed a business trip to Sao Paulo. At the time, I was amazed at the near universal optimism by locals (and expats) about the potential for the B in BRIC to breakout from the acronym.  With the acknowledgement of China’s slowdown, Russia’s non-stop political shenanigans and who knows what in India, Brazil appeared to be in a post financial sweet spot due to their oil production, and the strength of the commodity prices.

At the time of my visits there was still enthusiasm for their hosting of an upcoming World Cup and Olympics, and the recent election of their first woman president, a former Marxist Guerrilla who represented the workers party and whose goal was to thwart poverty. All of this was happening with the assumption of massive investment in the country.

That optimism crumbled alongside the collapse in oil prices over the last year and half and the rise of the dollar. The country’s largest equity index (Bovespa) is down 75% from its 2008 highs in dollar terms, below the financial crisis lows. However it is starting to show a good bit of relative strength in 2016, down only 3%:

Bovespa 10 year chart from Bloomberg
Bovespa 10 year chart from Bloomberg

For investors thinking about dipping their toe in Brazilian stocks, the EWZ, the IShares MSCI Brazil etf could be worth a look.  The EWZ’s top 5 holdings, which make up almost 40% of the etf’s weight are beer, food. tech and banks. Obviously the banks are fairly levered to oil, but the largest, Itau, has shown great relative strength to the broad market in Brazil, up 30% from its 2011 lows, despite the Bovespa being weighed down by oil stocks.  If oil were to stabilize, and the Brazilian economy to show greens-shoots of improvement, the EWZ could be a coiled spring after such a steady (but dramatic) decline since it post financial crisis recovery:

EWZ 16 year chart from Bloomberg
EWZ 16 year chart from Bloomberg

Longer dated risk reversals could make a lot of sense for those who might look to set buy on a dip, willing to be put the stock at lower levels, but also like the potential for a low cost way to play for a massive reversion trade. Stay tuned for some trade ideas.