There seems to be a consensus in the market that the Fed will gradually start tapering in the next few months (our guesses at BSIC is in December). Therefore it is time to understand what could happen to markets and get prepared.
What could happen on the equity market in the US on the short term? The Price/Earnings and Price/Sales ratios reveal that even though stocks start to be a little bit expensive, they seem fairly
valued. Another important fact is that less and less investors feel the need to hedge their position as the put/call ratio on the S&P is historically low. This would suggest that no major correction is expected and that most investors are firmly invested in a long position.
However we don’t think it is time to pull your money out of the US stock market right now. On this great article on Seeking Alpha (http://seekingalpha.com/article/1846652-fed-tapering-history-revealing-data-investors-need-to-know) we have a look at the FED tapering history since World War II and usually it is optimal to get out of equities few weeks after the start of tapering as long as short-term interest rates don’t increase.
Nevertheless it is necessary to know where to invest next. After some time has passed since the tapering announcement our strategy is to go back to emerging markets as the valuation gap with developed economies is at its highest since 2008. However last summer has reminded us that emerging markets, especially their exchange rates, are very sensitive to the tapering decision.
How to make money from that?
We recommend countries with current account surpluses. Our selection includes Philippines, Russia, China and South Korea. We think that investing in equities of countries that have high current account deficits is too risky, since they showed the most volatility after Bernanke unexpectedly hinted at the possibility of early tapering in May. Indeed if you compare India (large deficit) and Philippines (large surplus), the Rupee had depreciated by more than 28% while the Peso lost “only” 12%. To a certain extent and to be more geographically diversified, we would also recommend Mexico even if they were currently facing a CA deficit. From a structural point of view, we expect our selected group of countries to perform well in the medium and long term.
In order to protect our position against the exchange rate, we suggest to hedge it with a put option on the 10Y US treasury, which have little downside at the current price and will very likely go down after the tapering.