Where to Invest $10,000 Right Now

Asia on Sale

As many markets started the year at already-full valuations, investors could be forgiven for thinking that there are few bargains left. Interestingly, many Asian equities appear really cheap.

For example, as of the end of September, Japanese equities remain the cheapest in the developed world. The Topix Index (TPX) is trading at 1.3 times price-to-book (P/B), less than half the level of the S&P; 500. The current discount is close to the widest since 2012, a period that preceded a three-year, 150 percent rally.

The Asia discount applies to a number of emerging markets as well. South Korean equities remain not only the cheapest in this category, but looking across equities, sovereign debt and credit, they are by some measures the cheapest asset class. The current valuation represents a 35 percent discount to the rest of the emerging markets, the largest discount since the Asian financial crisis.

Historically, many of these markets, especially Korea, have traded at a discount. The same is true for Japan, but while the discount may have been justified in the past, much has changed in recent years. Japan has witnessed a significant improvement in both corporate governance and profitability. The return on equity for Japan’s Topix index now stands at around 10 percent, close to a multi-decade high. When you factor in Japanese monetary conditions that are still ultra-accommodative, the low equity valuations seem even harder to justify.

Rather than resting on fundamentals, today’s Asia discount can arguably be attributed to three trends: stellar U.S. earnings growth, a stronger dollar as a headwind for emerging markets stocks, and rising trade frictions.

While trade and the U.S. dollar remain real issues, these concerns already appear reflected in equity prices. As a result, Japan and much of Asia appear to be that increasingly rare find: a bargain.

Way to play it with ETFs: The iShares MSCI Japan ETF (EWJ) is far and away the largest Japan ETF, at $17.4 billion in assets, said Bloomberg Intelligence ETF analyst Balchunas. It has a fee of 0.49 percent. For cheaper ETFs that basically track the same stocks he likes the Franklin FTSE Japan ETF (FLJP), which charges 0.09 percent, and the JPMorgan BetaBuilders Japan ETF (BBJP), which charges 0.19 percent.

Performance of last quarter’s ETF plays: Balchunas highlighted the SPDR S&P; Emerging Asia Pacific ETF (GMF). It fell 2.4 percent in the third quarter.

Seek Value in Emerging Markets

Following a stellar 2017, emerging-market equities are once again on the back foot. Despite bouncing in recent weeks, so far this year the MSCI Emerging Market Index is trailing the MSCI World Index of developed countries by about 8 percentage points. The selling has left many of these markets cheap at a time when economic prospects are improving and the dollar is stabilizing.

The MSCI Emerging Market Index is trading at 13.5 times trailing earnings and 11.3 times forward earnings. The former represents a 26 percent discount to developed markets. Based on price-to-book (P/B), emerging-market stocks look even cheaper. Currently, the stocks are trading at a 30 percent discount, the largest since the summer of 2016.

The magnitude of the discount looks odd given that EM economic data is improving relative to expectations. From late March through mid-June, the Citi EM Index of Economic Surprises plunged from a positive 40 to a negative 25. In other words, economic data went from reliably beating expectations to chronically missing estimates. However, since late June, things have started to improve.

It’s important to highlight that a more constructive view on EM equities comes with three big caveats: financial conditions, trade and precision. EM assets are still vulnerable to tightening U.S. financial conditions, particularly a stronger dollar. Outside of the dollar, investors should be concerned about trade. While trade issues have faded in recent weeks, fundamental tensions with China haven’t been resolved. If trade concerns escalate, EM assets are vulnerable.

Finally, the notion of EM equities assumes a homogenous asset. In reality, EM is a heterogeneous collection of countries, with wildly varying fundamentals and valuations. Turkey is not Taiwan, and Brazil is not Poland.

For myself, I see the best opportunities and value in EM Asia. While not without risks, this part of the world looks to once again offer some value.

Way to play it with ETFs: To play emerging-market countries in Asia, investors could use the SPDR S&P; Emerging Asia Pacific ETF (GMF), said Balchunas. It has heavy allocations to China, Taiwan and India, but also includes countries like Malaysia and Indonesia. It charges 0.49 percent.

Performance of last quarter’s ETF plays: The iShares Core MSCI Emerging Markets Index (IEMG) was Balchunas’s choice to play emerging-market stocks; it had a rough second quarter, falling 10 percent.

Emerging Markets May Be Cheap

Given that we’re in the 10th year of the bull market, the second-longest on record, investors are not inundated with investment bargains. Most asset classes are somewhere between reasonable and off-the-charts expensive. At the same time, volatility has returned with a vengeance, and an escalating trade dispute has the potential to disrupt what was supposed to be a year of synchronized growth. This combination does not immediately suggest adding to one of the riskier asset classes: emerging-market stocks. That said, given cheap valuations, a still-resilient economy and a stable dollar, emerging markets may represent one of the more interesting opportunities in 2018.

In an environment where valuations have been pushed ever higher by an extended bull market, most emerging-markets countries stand out as cheap. The MSCI Emerging Market Index is trading at approximately 1.6 times its book value, a 27 percent discount to developed-markets indexes. The current discount compares favorably with the 10-year average discount of 15 percent.

A larger discount might be justified, given higher volatility and political uncertainty. The irony is that much of that uncertainty is emanating not from emerging markets but from the United States. And despite the lingering questions over trade, most indicators still suggest a year of solid growth, which has historically been a tailwind for emerging markets’ outperformance.

Finally, there is the U.S. dollar. While investors sometimes exaggerate the role of the dollar in emerging markets, a weaker dollar has generally been supportive of emerging markets assets.

To be clear, there are risks. An economic slowdown or a more abrupt tightening of U.S. monetary conditions, particularly in the context of a stronger dollar, would probably cause emerging market stocks to lag. However, to the extent that the global expansion continues, emerging markets is the rarest of things in a prolonged bull market: a cheap asset class.

Way to play it with ETFs:  Balchunas points to a “cheap and deep” way to play EM in the iShares Core MSCI Emerging Markets ETF (IEMG). It serves up nearly 2,000 stocks across several countries, with China the largest weighting at about 24 percent of assets. It charges a 0.14 percent fee and has quietly grown assets to $50 billion since launching a little over five years ago.

Performance of last quarter’s ETF plays: Balchunas’s picks to play Koesterich’s previous recommendation to expand stock holdings internationally, the SPDR Euro Stoxx 50 ETF (FEZ) and the iShares MSCI Australia ETF (EWA), fell 1.7 percent and 6.2 percent, respectively, in 2018’s first quarter.

Stick With Equities—Just Cast a Wider Net

The past year was, in every sense, as good as it gets. Stocks posted gains of more than 20 percent, with virtually no pullbacks. While we’re unlikely to be so fortunate in 2018, this is not the time to abandon stocks. Given a synchronized global recovery and still-easy financial conditions, 2018 is likely to be another year in which stocks beat bonds. For those already heavily invested in U.S. equities, there are four reasons to consider adding to your holdings of international stocks.

Cheaper valuations. Based on the trailing price-earnings ratio, the S&P 500 is trading at a 13 percent premium to other developed markets. While the U.S. has recently enjoyed a strong rebound in corporate earnings, valuations have expanded even faster. This leaves the U.S. as the world’s most expensive stock market.

Faster earnings growth. Part of the reason U.S. valuations have risen relative to the rest of the world is that while earnings are growing in the U.S., they are rebounding even faster elsewhere.

More income. As stocks have risen, dividend yields have fallen. In the U.S., the dividend yield on the S&P 500 is below 2 percent. For the first time since the financial crisis, the dividend yield on large-cap stocks is now below the yield available on a 2-year Treasury note. In contrast, the dividend yield on the Euro Stoxx 50 is well above 3 percent. Australian equities yield over 4 percent. Income-oriented investors should ponder the opportunities outside the U.S.

Easier monetary policy. To be sure, 2018 is the year when most of the world’s large central banks will either be withdrawing monetary accommodation or publicly pondering its withdrawal. That said, the U.S. Federal Reserve is ahead of the curve in tightening monetary policy. Other central banks, notably the Bank of Japan, will be slower to withdraw easy money policies.

Way to play it with ETFs: The SPDR Euro Stoxx 50 ETF (FEZ) is a way to track that European blue chip stock index, and investors can use the Shares MSCI Australia ETF (EWA) for exposure to Australia. The ETFs charge 0.29 percent and 0.48 percent, respectively.

Performance of last quarter’s ETF plays: The ETFs chosen to play on Koesterich’s theme of not giving up on value investing were the Vanguard Value ETF (VTV), the iShares Edge MSCI USA Value Factor ETF (VLUE) and the ValueShares US Quantitative Value ETF (QVAL). The ETFs gained 6.5 percent, 8.1 percent and 13.1 percent, respectively.

Don’t Give Up on Value 

After a stellar back half of 2016, U.S. value names have largely disappointed in 2017. As the post-election euphoria faded and everyone faced up to the reality of still modest growth, most investors reverted to old habits: a focus on yield and growth at the expense of value.

Still, value’s relative performance may once again be inflecting. Value stocks outperformed their flashier growth cousins in September, and there are several reasons to believe that trend can continue.

First, value is cheap. While value stocks are by definition cheaper than growth, today they are much, much cheaper. Since 1995 the average ratio between the Russell 1000 Value and Russell 1000 Growth Indices (based on price-to-book) has been 0.45; i.e., value typically trades at a 55 percent discount to growth. Currently the ratio is 0.30. Value has not been this cheap relative to growth since early 2000.

In addition to being cheap, for the first time this year value may once again have a catalyst. It normally outperforms when economic expectations are improving. In contrast, when economic growth is modest, investors are more likely to put a premium on companies that can generate organic earning growth, regardless of the economic climate. This dynamic helps explain the strong year-to-date rally in technology and other growth stocks.

Recent economic data, however, have been modestly stronger, and investors are, once again, entertaining visions of tax cuts. Granted, the economic impact of temporary tax cuts is more a sugar high than structural reform, but you take what you can get. At this point, even a modest boost in near-term growth expectations is arguably enough to shift investor preferences.

This creates an opportunity for value. In an environment in which investors are more sanguine about economic growth, they are more likely to notice that value stocks are not only cheap but also offer better leverage to any economic acceleration. Value is not dead yet.

Way to play it with ETFs: When it comes to picking a value ETF, the question is how bargain basement you want to go. The Vanguard Value ETF (VTV) is the most popular but has only a slight tilt toward value. The iShares Edge MSCI USA Value Weighted Index Fund (VLUE) is much more exposed to value stocks. For hard-core value seekers, the ValueShares US Quantitative Value ETF (QVAL) goes very deep to “buy stocks everyone else hates,” as its manager puts it.

Performance of last quarter’s ETF plays: Balchunas pointed to the iShares U.S. Preferred Stock ETF (PFF) as a way to play Koesterich’s preference for preferred stock in last quarter’s writeup. It was down 0.8 percent for the quarter.

Seek Yields With Protection

There are times to stretch and take more risk, and there are times when discretion is the better part of valor. Following a bull market that turned eight years old in March and countless trillions of dollars of central bank asset purchases, few asset classes are obviously cheap. Still, in a world in which interest rates are barely 1 percent, investors can be forgiven for not wanting to stick their spare cash under the mattress.

This suggests to me a compromise: finding assets with a respectable yield that will provide downside protection if markets turn south.

U.S. preferred stock is currently yielding about 5.50 percent. This compares favorably with most of the other alternatives, including high-yield, investment-grade and emerging-market debt, and a basket of U.S. common dividend-paying stocks. [Preferred shares are sort of a stock and bond hybrid; they generally pay a fixed dividend and put you ahead of common-stock holders in cashing in shares if the company's assets are liquidated.]

More to the point, following a disastrous period during the financial crisis, preferred stock has become a much less volatile asset class, currently offering the most attractive ratio of yield to volatility of the yield-oriented plays. Comparing the yield to the three-month trailing volatility of the asset class, you get a ratio of more than 1.3. In other words, investors are receiving 1.3 percentage points of income for every percentage point of annualized volatility. This is significantly higher than any of the alternatives.

Some will recall that preferred stocks did not live up to their reputation for low volatility during the financial crisis. At that time, an index of U.S. preferred, dominated by financial issuers, fell approximately 70 percent, worse than the broader market.

I see much less downside risk today. It is not clear that U.S. financials will be at the epicenter of the next crisis, as was the case in 2007-09. The sector is much better capitalized and run more conservatively than it was 10 years ago.

While preferred stocks aren't likely to send anyone’s heart racing, a yield of 5 percent-plus in a world still characterized by low rates, high valuations, and uncomfortably low volatility is worth a look.

Way to play it with ETFs:The iShares U.S. Preferred Stock ETF (PFF) currently yields 5.6 percent and has great liquidity. Its 0.47 percent fee is high for an ETF but below average for an ETF specializing in preferred stocks.

Performance of last quarter’s ETF plays: To follow Koesterich’s strategy of focusing on Asian equities, Balchunas pointed to the iShares MSCI Japan ETF (EWJ), which gained 5.2 percent, and the iShares MSCI Emerging Markets Asia ETF (EEMA), which returned 8.5 percent.

Look to Japan

We see the best opportunities within Asian equities, with an emphasis on Japan.

We’re now in the eighth year of the bull market in U.S. equities, and it's increasingly difficult to find bargains. U.S. stocks have done exceptionally well, but investors have been pushing valuations to somewhat extreme levels. Large-cap U.S. equities are trading at approximately 22 times trailing earnings, the highest multiple since 2010 and at more than 30 times the CAPE ratio, a level last seen near the peak of the tech bubble. Making matters worse, U.S. Treasury bond prices look extremely rich after several years of buying by central banks.

In this environment, Asian equities stand out as a relative bargain. In recent years, Japanese stocks have traded at a discount to the U.S., and that discount is particularly large today. The Topix index is trading at approximately 1.3 times book value, vs. more than 3 times for the S&P 500.

Japanese profitability has been improving since 2012, thanks to better corporate governance and share buybacks. In addition, Japanese equities offer accounting standards that are strict relative to the U.S., low leverage and the continuing tailwind of monetary accommodation. Finally, to the extent the global economy is likely to modestly accelerate in 2017, Japanese exporters are well positioned to benefit from improving global growth and a firmer economy.

We also see select opportunities in other parts of Asia, including emerging markets. In particular, Indian companies offer an interesting take on emerging markets. [Click on last quarter's tab for Sarah Ketterer's take on India.] India is a large, domestically oriented economy that is relatively insulated from many of the more macro risks that often derail other segments of the emerging-market universe.

Ways to play it with ETFs: Investors can use the iShares MSCI Japan ETF (EWJ)  for Japan exposure. It is by far the most popular Japan ETF and charges 0.48 percent, about average for a single-country ETF. For Asia emerging markets, the iShares MSCI Emerging Markets Asia ETF (EEMA)  tracks many Asian countries such as China and Taiwan, as well as India, which has a 12 percent weighting in the ETF. EEMA charges a fee of 0.48 percent.

Cash Today Beats Cash Tomorrow

High-dividend-yielding, undervalued stocks may finally reign over growth stocks. In this global environment of gradually tighter monetary policy, the cash that a company returns to its shareholders in the next few years may be much more valuable than a potentially unfulfilled promise of rapid growth in profits many years ahead.

The massive growth in liquidity created by global central banks after the financial crisis has stalled in 2018, and will likely shrink in 2019. Meanwhile, valuation spreads between expensive and cheap stocks, measured by relative price-to-earnings ratios, are at extremely wide levels vs. history. In the past 20 years, these especially wide valuation spreads typically led to a narrowing of the gap and subsequent outperformance of cheap stocks.

The global consumer staples sector contains some of the cheapest, highest-dividend-yielding stocks. Many of these companies generate mountains of near-term cash flow. Within staples, the most maligned and possibly misunderstood segment is tobacco. Both U.S. and European-listed large-cap tobacco stocks trade at sizable discounts to their history. The discount may stem from investor concerns about the FDA’s tobacco regulation, shrinking U.S. cigarette volumes, a surge in demand for alternative products such as e-cigarettes and weakness in emerging market economies and currencies.

Much of this may be transitory, leaving investors with well-managed consumer marketing giants able to transition to a growing e-cigarette category. Heavily-taxed (and clearly very unhealthy) combustible cigarettes will likely disappear in the years ahead, replaced by less harmful forms of nicotine delivery. The more that global regulators focus their efforts on vapor, the better for these large incumbent tobacco companies, which are better able to absorb the costs of regulation than new entrants. Even in the shift to noncombustible products, global tobacco giants have the financial strength and prolific free cash flow generation to reward shareholders today and invest for tomorrow.

Way to play it with ETFs: Balchunas suggests the First Trust Morningstar Dividend Leaders Index Fund (FDL) which screens for stocks that have shown dividend consistency and then picks the 100 highest-yielding names. It’s heavy in consumer staples stocks, with big tobacco companies among top holdings. The $1.4 billion ETF charges 0.45 percent.

Performance of last quarter's ETF plays: Balchunas pointed to the SPDR Oil & Gas Equipment & Services ETF (XES) as a way to play Ketterer’s suggestion of oilfield services companies. The ETF rose about 1.5 percent in the third quarter.

Check Out Oilfield Services Companies

Despite the recovery over the past year in crude oil prices, some energy-related equities can’t seem to shake investor skepticism.

One of the most undervalued areas of the U.S. unconventional oil and gas industry is oilfield services. Of the onshore oilfield service stocks, the pressure pumpers have sagged significantly in price.

Pressure pumping is closely tied to drilling rig activity and is used in development of oil fields. After the well is drilled, pumpers mix water, sand and chemicals, then blast it into the reservoir rock so that the hydrocarbons will flow. Aided by technological improvements, producers have exceeded even their own expectations.

In the Permian Basin of western Texas, producers have extracted oil faster than the pipeline infrastructure can transport it to Gulf refineries and port terminals. The Permian Basin, notable for its enormous supply of crude oil and gas, has no near-term answer to these serious transportation bottlenecks. However, the problem should disappear in 2019 with the addition of pipeline capacity.

Investors, apparently unwilling to wait, have cast aside oil services stocks, especially those with sizable exposure to the Permian Basin. But pipeline squeezes don’t last long in the shale era; they incentivize midstream companies to accelerate new pipelines or expand existing capacity to fill the gap.

Meanwhile, oil prices seem well supported. New crude oil discoveries since 2013 probably can’t offset the drag from aging oilfield production declines, falling reserves and insufficient replacement of produced volumes. Supply constraints in countries such as Venezuela, Iran, Libya, Nigeria and Mexico may get worse.

As a recent affirmation of U.S. shale’s promising future, energy majors are making sizable acquisitions of U.S. onshore oil and gas assets. Producers will need oil services companies—even the beleaguered pumpers—to develop these newly acquired fields.

Way to play it with ETFs: To play the oil services industry, investors could use the SPDR Oil & Gas Equipment & Services ETF (XES), an equal-weighted basket of large, mid- and small-cap oil services companies; its expense ratio is 0.35 percent.

Performance of last quarter’s ETF plays: The iShares Global Telecom ETF (IXP), which Balchunas chose as one way to play on Ketterer’s investing themes in the second quarter, dropped 5.7 percent in value over the quarter.

Go for Defensive Value

There’s a lot to be said for investment income, especially delivered via companies that are fully capable of sustaining that income for many years ahead. In sagging stock markets, some portion of an investor’s portfolio needs to produce returns now, not later. With plenty of dividend income, the wait for a market recovery shouldn’t seem quite so painful. Peer inside the global telecommunications sector and you will find many generous dividend payers also boasting financial strength far in excess of overall market averages.

These telecom stocks, unloved for their lack of recent growth and bland forecasts, have lost the interest of bull market investors. Mention Tencent or Alibaba and people will listen intently; refer to China Mobile or SK Telecom for yawns of boredom. Yet telecom behemoths offering mobile and fixed broadband services should grab our attention as ideal ballast for the inevitable bear markets. We need the services they offer—and will need them even more when fifth-generation wireless systems (5G) become commercially available.

The MSCI All Country World Telecommunications Services Index is made up of 81 constituents in developed and emerging-markets countries. By one valuation measure, enterprise value-to-Ebitda, it trades at a discount of more than 40 percent, compared with the aggregate equity market benchmark, the MSCI All Country World Index. (Enterprise value includes debt and cash when calculating company value, rather than just multiplying a company’s shares outstanding by its share price to arrive at market capitalization; Ebitda, a cash flow measure, refers to earnings before interest, taxes, depreciation and amortization.) The index also has a dividend yield almost 50 percent higher than the benchmark.

If sustainability of dividend yield makes you sleep better at night, focus on the companies with very low (or zero) net debt, defined as a company’s long-term debt less cash. In capital-intensive industries such as telecommunications, larger company size brings scale economies and cost advantages. Competitive, mature telecom markets typically cannot support more than three players, or returns on capital will decline for all participants. China, Japan and South Korea are three of the most attractive mature telecom markets globally.

Three-player telecom markets, in which competitors typically don’t engage in devastating price wars, often have stable participants generating reliable streams of cash. Companies rewarding shareholders by returning capital, through dividends and share repurchases, are less likely than growth-oriented peers to squander shareholder capital through overpriced acquisitions. Many telecom companies have learned that stability is one of their most attractive characteristics.

Way to play it with ETFs:  There is no ETF tracking the MSCI All Country World Telecommunication Services Index, but Bloomberg Intelligence analyst Eric Balchunas says there is something very close: The iShares Global Telecom ETF (IXP) tracks 43 telecom stocks from about a dozen countries. It is notable for its high dividend yield of 3.5 percent, says Balchunas—and for its above-average fee (for a sector ETF) of 0.47 percent.

Performance of last quarter’s ETF plays: Balchunas chose the Vanguard Utilities ETF (VPU) and the Global X Lithium & Battery Tech ETF (LIT) as ways to play Ketterer’s suggestion that investors consider global utility stocks. In 2018’s first quarter, VPU fell 4.1 percent and LIT tumbled 15.3 percent. LIT fell as analysts turned bearish on lithium, fearing a supply glut, as well as possibly less demand for electric vehicles in 2019.

Think Smart Power

Utility stocks around the world have generally trailed their respective equity market performance over the past year. In the U.S., rising interest rates will push up utility borrowing costs, and corporate tax reform won’t boost earnings if the tax benefit must be passed on to customers. But just look a few years ahead, and the prospects for electric utilities may be considerably brighter than they are today.

The global conversion of internal combustion engine vehicles to electric vehicles (EVs, including plug-in hybrids) will boost the demand for electricity delivered efficiently to public charge points and homes. If large concentrations of EVs were to charge in the same hour, demand could spike to several times the norm, overloading the grid, causing overheating and blackouts. To avoid this, many electric utilities, especially in countries determined to reduce carbon emissions, will need to increase power utility investments substantially.

With new capacity, utilities may find it more efficient and cost-effective to provide power to large industrial customers, possibly operators of autonomous vehicle fleets, where recharging can be centralized rather than scattered across countless garages and parking spots. Electric utility regulators should allow the utilities to earn a healthy return on grid upgrades, new connections (such as new power lines to electrify parking bays), smart architecture, digitization and new peaking capacity. According to Goldman Sachs, these will be big global investments: $2.6 trillion for charging infrastructure to support full passenger vehicle electrification, plus another $3 trillion spent by the utilities for transformers, new lines and smart infrastructure.

Without a proper reconfiguration of a country’s electricity distribution grid, as well as security of electricity supply, the EV rollout simply cannot happen. This effort to build infrastructure for a massive global conversion to EVs should benefit electric utilities able to distribute low-cost power incorporating renewables such as solar and wind.

Way to play it with ETFs: For a cheap and deep utilities ETF, the Vanguard Utilities ETF (VPU) tracks 77 utility stocks for a fee of 0.10 percent. A more out-of-the-box but related play on the move to electric vehicles is the Global X Lithium & Battery Tech ETF (LIT). It tracks lithium miners and battery producers and has a fee of 0.76 percent.

Performance of last quarter’s ETF plays: Last quarter, the ETF that was the closest fit for Ketterer’s theme of investing in China’s health care demand was the Global X China Consumer ETF (CHIQ), which had about 8 percent of assets in the sector. In 2017’s final quarter, it gained 8.7 percent.

Invest in China’s Health Care Demand

Shifting from an emerging to a developed country, China can’t escape its demographics. As a byproduct of the one-child policy, China’s enormous population increased at only 0.6 percent per year from 1996 to 2015. That compares with the U.S. population’s expansion of 0.9 percent a year over the same period.

Low growth implies an aging population, and aging has its societal costs. Many Americans are struggling to pay for health care, and the Chinese are facing an even bigger tab. By 2050, roughly a quarter of China’s citizens will be older than age 60. With less than 6 percent of gross domestic product spent on health care (vs. 9 percent to 12 percent in most developed countries), the Chinese will likely devote more of their resources to staying healthy.

With rising disposable income per capita, China’s demand for health care, especially top-tier hospital services, exceeds supply. The central government recognizes the problems and aims to relieve congestion at the most reputable public hospitals by welcoming private capital into the industry. This flow of funds should improve conditions and spawn many higher-quality private hospitals. Other reforms include the elimination of unneeded middlemen in drug distribution, as well as prohibiting the markup of drug and medical devices.

Hospitals had become heavily dependent on drug sales to keep the lights on. To supplement their measly salaries, doctors accepted prescription-related bribes from pharmaceutical manufacturers. After a successful pilot program, zero markup of drugs became reality for most hospitals across the country this year. To speed up the approval process for efficacious drugs, the China Food and Drug Administration quadrupled its staff in 2015-16 and is on track to increase staff by 50 percent this year.

China’s health-care industry reforms, combined with the inevitable consolidation or demise of smaller or weaker players, will likely result in much greater efficiency and profitability in such areas as hospital management, drug and medical equipment distribution, private supplemental health insurance, and new-drug discovery and launch.

To complement reforms, the Middle Kingdom boasts a rising supply of young scientific talent, who are paid about a third as much as their peers in the developed world. Add to the mix a 15 percent corporate tax rate plus government subsidies to spur innovation, and the investment landscape looks very promising for Chinese health-care companies. (The standard Chinese corporate income tax rate is 25 percent, but the rate could be reduced to 15 percent for qualified enterprises engaged in industries encouraged by the Chinese government. Indigenous Chinese health-care companies are included in that category.)

Way to play it with ETFs: There are many China ETFs but none specific to the health-care sector, and most broad China ETFs have next to nothing in health-care exposure. The ETF with the most exposure to health care is the Global X China Consumer ETF (CHIQ), which has about 8.7 percent of its assets in the sector.

Performance of last quarter’s ETF plays: The Energy Select Sector SPDR Fund (XLE) rose 5.6 percent in the quarter ended Sept. 30. Top holdings Chevron Corp., Schlumberger Ltd., and Exxon Mobil Corp. rose 12.6 percent, 6 percent, and 1.6 percent, respectively. 

Fuel Up on Energy

Buy high-quality energy. Investor skepticism weighs heavily on the sector, making this one of the more promising areas in this mature bull market.

Oil and gas companies exhibit cyclicality in sales and earnings, traits that investors have shunned in recent years in favor of steady growth. Relative to high-flying technology stocks, the recent performance of energy equities looks abysmal. Over the past 12 months, global energy indexes have underperformed global technology by more than 30 percent and are trading at a sizable valuation discount.

The forces of supply and demand dictate the price of semiconductors as well as oil, with the lowest marginal cost producers having a distinct advantage over the competition. Advertising, including the internet, also has a cycle. The last time markets ignored the cyclicality of technology was in the late 1990s, a rough period for the most overvalued stocks.

Investors may be worried about a global glut of crude oil, especially from rising U.S. shale oil production. U.S. shale productivity continues to surprise on the upside, especially in the Permian Basin. As marginal costs have fallen from 2014, oil producers have increased wells and drilling volumes. The threat of a possible lack of OPEC production discipline also clouds the oil price outlook.

But exploration and production costs have recently turned upward in pressure pumping, sand, rail, trucking and labor. Oil-producing nations, including OPEC members as well as U.S. shale producers, cannot afford to spend more cash than they generate. As industry profits get squeezed, oil and gas companies’ credit ratings deteriorate, constricting lending to energy. At current spot prices, the world’s oil and gas industry doesn’t generate enough cash flow to sustain the spending required to expand capacity. In U.S. shale, production volumes per well decline particularly rapidly without additional investment.

On the demand side, the energy industry will not thrive in a recession. But technology doesn’t fare well in that scenario, either. Expect at least two more decades of rising demand for crude oil and gas, as electric vehicles will only gradually substitute for gasoline.

Look for companies with productive acreage and experienced management, financial strength, and cyclically low valuations. As the crude oil price recovers—perhaps approaching $60 per barrel, with natural gas reaching $3.25 per thousand cubic feet—energy sector share prices should prove rewarding.

Way to play it with ETFs:The Energy Select Sector SPDR Fund (XLE) is high-quality energy. Top holdings Exxon Mobil Corp., Chevron Corp., and Schlumberger Ltd. make up more than 40 percent of the portfolio. There’s a liquid market for the ETF, and it's cheap, with a fee of 0.14 percent.

Performance of last quarter’s ETF plays: The SPDR S&P International Health Care Sector ETF (IRY) was Balchunas’s pick as a way to play Ketterer’s focus on big pharma companies selling at a discount. It returned 7.9 percent from Mar. 31 to June 30. 

Buy the Pharma Discount

Why do several of the large global pharmaceutical stocks trade at above-market dividend yields and below-market price/earnings ratios? Perhaps the repeated threats by President Trump to cut drug prices have scared investors.

The president will likely claim victory for something that is already happening. The large buyers of U.S. pharmaceuticals, such as pharmacy benefit managers and health insurers, continue to exert tremendous pressure on drug companies to discount prices. This is evident in 2016 data from Express Scripts that show year-on-year price percentage shrinkage in traditional pharmaceuticals and a slowing, mid-single-digit percentage increase for specialty drugs.

Importantly, utilization growth rates are greater than unit cost rises, indicating product efficacy. If the drugs weren't effective, doctors wouldn't prescribe them. Assuming buyers will pay for efficacious drugs, then the prognosis for the more innovative pharmaceutical companies is good.

Notably, several of the European drug giants with promising pipelines trade at valuation discounts to the health-care sector and to their own historical averages. Examples include Novartis AG, AstraZeneca Plc, Roche Holding AG and GlaxoSmithKline Plc. These well-managed, shareholder-friendly companies generate plenty of surplus cash to reward investors. Many of them have dividend yields at least a full percentage point in excess of the global pharmaceutical and biotech industry and well above overall equity market averages.

Famously profitable, the best-managed pharmaceutical companies should be able to offset reduced unit prices with volume growth. In their report dated January 2017, Evercore ISI analysts Umer Raffat and Akash Tewari note that most of Medicare/Medicaid spending increases are due to higher enrollment, not because of pharmaceutical costs. While total U.S. health-care spending continues to increase, the percentage attributable to prescription drugs has stayed flat, at around 10 percent.

Proposed drug pricing reforms, such as bidding, reimportation, Medicare negotiating prices and value-based pricing either already exist or have serious, likely insurmountable flaws, such as public safety. Even Medicare, the colossus of U.S. pharmaceutical buyers, probably can't negotiate prices more favorable than under current law without being forced to restrict access, as drug demand may rise. Aging demographics imply increased drug usage over at least the next decade. The most innovative pharmaceutical companies will likely benefit, even as traditional branded drug prices fade.

Ways to play it with ETFs: The  SPDR S&P International Health Care Sector ETF (IRY) has the most exposure of any ETF to international pharma companies such as Novartis AG and AstraZeneca Plc. Those companies are in the top 10 holdings. The ETF has 75 percent allocated to pharma companies, 25 percent of which are based in Switzerland. IRY comes with a fee of 0.40 percent.

Performance of last quarter’s ETF plays: The  iShares MSCI India ETF (INDA) rose 16.9 percent over the past three months. Balchunas's other pick, the  PureFunds ISE Mobile Payments ETF (IPAY), gained 10 percent.

Think Long, Think Far

India is far. Flying from Los Angeles to Mumbai via Hong Kong takes about 24 hours, several meals, and almost 10,000 miles. Despite the distance, Causeway has this populous country on our investment radar. India’s demographic bulge of young consumers want to buy smartphones, cars, and homes, and their spending power rises annually.

India’s 2016 real gross domestic product growth of 7.3 percent tops the charts, beating all major countries including China. The recent demonetization to encourage a shift from cash to a digital (taxable) economy should ultimately fuel growth. Rising tax revenues facilitate fiscal spending on roads, bridges, highways, hospitals, etc., thereby boosting commerce. India’s stock market, which is severely lagging most global markets this year, has become a source of investment ideas for our clients.

Imagine a country with 90 percent of all transactions in cash. Of the roughly $240 billion of currency in circulation, the government has recently made 86 percent of that currency illegal. Exchange your soon-to-be-obsolete bank notes or they become worthless. A shortage of legal tender has placed severe working-capital constraints on businesses and harmed roughly half the population without a bank account.

Poorly implemented, the demonetization has dragged on the country’s economy as the banking system could not meet the demands of cash distribution. Longer term, the formal, taxable economy should prosper, and the central and state governments can proceed with much-needed infrastructure projects. The payment and growth inefficiencies of a cash economy should lessen.

We expect the population to open hundreds of millions of new bank accounts, resulting in a lower overall cost of funding for the country’s banking system. Prime Minister Modi's demonetization offers India an opportunity to leapfrog several banking stages, avoiding checks and bank cards and moving directly to digital payments. We believe non-cash transactions should grow 50 percent annually through to 2025 and account for 40 percent of payment transactions. Banks that already have scale in credit and debit cards, point of sale, and mobile banking should see a substantial pickup in market share.

Way to play it with ETFs: The iShares MSCI India ETF (INDA)  is the fastest growing and cheapest of the India ETFs, with an expense ratio of 0.68 percent. There is an ETF that specifically tracks the move to mobile payments, called the PureFunds ISE Mobile Payments ETF (IPAY) , but it holds 80 percent of assets in U.S. companies, with just a dash of international exposure. It's also a little expensive, with a fee of 0.75 percent, and doesn’t trade a lot, so potential buyers should use a limit order that specifies the price they want to pay.

Performance of last quarter’s ETF plays: The ETF Balchunas chose to track Ketterer's advice back in October was First Trust NASDAQ Technology Dividend Index Fund (TDIV) . It rose 3.6 percent for the three months ended Dec 31.

Invest in Corporate ‘Self-Help’

In this seemingly endless environment of economic stagnation, what will drive revenue and profit growth? Central banks may be running out of monetary solutions to stimulate credit and demand. While we wait for the political landscape to become less muddled, investors can get access to companies engaged in operational restructuring or “self-help.”

These companies, boasting strong balance sheets and modest levels of debt, typically have managements committed to a continuous and inexorable process of cost cutting and increased efficiency. In mobile telephony, especially in Japan, China, and South Korea, several of the largest listed companies have found increasingly ingenious ways to extract above-industry-average returns from the mature telecommunications market. [China Mobile Ltd. and SK Telecom Co. Ltd. were in the top 15 holdings of the Causeway International Value Fund (CIVIX), as of June 30.] Smart self-help moves by senior managements of these companies have led to a reduction in capital expenditures and operating costs.

These companies are typically creating innovative and value-added services, introducing popular data plans and benefiting from supportive local regulations. Similarly, in the more mature segment of technology, “legacy tech” companies also have managements committed to reinvigorating growth. Even though these companies have valuable proprietary technology, sell-side analysts put some of them in the dinosaur category. But the analysts often take a short-term view. Market pessimism can give investors a chance to buy world-class technology franchises in transition.

For example, large enterprise software companies must make a successful transition from an on-premises licensing business model to a cloud-computing subscription-based model. Semiconductor companies currently expert in mobile wireless technology are making measurable progress to deliver next-generation technology. Look for efficient operations, focused and shareholder-friendly managements, as well as inherent advantages in research and development expertise and resulting defendable intellectual property. [SAP and Samsung Electronics are CIVIX holdings.]

Economic malaise aside, these great companies, albeit often labeled mature and in transition, still trade at valuations that imply the potential for above-market returns.

Way to play it with ETFs: The First Trust NASDAQ Technology Dividend Index Fund (TDIV)  holds tech companies that pay the highest dividend, which means it has the largest percentage of “legacy tech” names such as Intel Corp., Microsoft Corp., Cisco Systems Inc., and Oracle Corp. This “I love the 90s” portfolio has the lowest volatility, lowest average price-to-earnings ratio, and highest dividend yield of the technology ETFs.

Performance of last quarter’s ETF plays: The ETF Balchunas chose to track Ketterer's advice back in June was The WisdomTree Japan Hedged Equity Fund (DXJ) . It rose 11 percent for the three months ended Sept. 30.

Play Japan

Something interesting is happening in the Land of the Rising Sun. The Japanese equity market has slipped 20 percent from its five-year high, reached last August, reflecting an economy unresponsive to monetary stimulus. Despite this gloom, many Japanese companies have the financial wherewithal to reward shareholders with dividends.

As of late May, over 200 Japanese stocks with market caps above $1 billion also have dividend yields greater than 2 percent (several offer yields of 4 percent), with dividend payout ratios less than 50 percent. In other words, these dividends should be well covered by earnings, and (thanks to the low payout ratios) have room to grow.

Some of the best-managed companies with generous dividends include Sumitomo Mitsui Financial Group Inc. (4 percent yield), Japan Airlines Co. (3 percent), Komatsu Ltd. (3 percent), KDDI Corp., and Hitachi Ltd. (both 2.5 percent). Bonds can’t compete. The 10-year Japanese government bond yield is negative, making generous dividends all the more appealing.

In the U.S., investor demand for high-dividend-yielding stocks, and exchange-traded funds that track such stocks, has risen sharply in our own prolonged low-interest-rate environment. Perhaps the same will happen in Japan. Mrs. Watanabe, the proverbial Japanese retail investor, wants income. It may make sense to own some of these income-generating, better-quality Japanese stocks before she does.

Ways to play it with ETFs: The WisdomTree Japan Hedged Equity Fund (DXJ)  goes long the stocks mentioned by Ketterer, and many more, said Balchunas. It also shorts—bets against—the yen, and weights stocks by the size of their dividend. It yields 3 percent.

Go Long on Treasuries

U.S. Treasuries have seen a perfect storm these last few weeks. The key question for investors is whether they are now a buy or a sell. We say buy!

The Treasury sell-off started with the short end of the yield curve, as the Federal Reserve hiked rates. The hawkish tone was bolstered by a record number on the ISM Non-Manufacturing index, which measures business conditions in nonmanufacturing industries. Inflation fears intensified as unemployment fell to 3.7 percent, its lowest level since 1969, and OPEC promised continued supply discipline, boosting oil prices. Finally, yields on very long-dated Treasuries went well above long-held ranges in the wake of Federal Reserve Chair Jerome Powell’s suggestion that this economic cycle might persist “effectively indefinitely.” As a result, U.S. 10-year yields moved toward 3.25 percent and the 30-year pushed toward 3.45 percent.

Such yields will be hard to maintain. Although U.S. growth currently remains healthy, rising real [inflation-adjusted] rates and a stronger dollar will begin to challenge activity, as will higher oil prices squeezing real incomes. The rest of the world will also suffer as dollar strength increases the funding costs for the $12 trillion of dollar-denominated debt raised outside the U.S.

For us, therefore, the expectation of rising prices on Treasuries makes those with yields above 3 percent attractive now. Slower global growth and an inability of OPEC to maintain its supply discipline will likely see West Texas Intermediate crude prices closer to $65 than $75 by yearend. We suggest buying very long-dated bonds—all the way up to the 30-year—with yields close to 3.4 percent, since even the hawks don’t expect more than four rate rises in the coming year.

Bonds also look attractive relative to equities. The recent weakness in equities suggests some investors are already selling them to lock in additional income. Alternatively, we suggest buying bond-sensitive equities. Although health-care stocks have already done well, utilities, telecoms, and food producers have yet to catch up.

Another equity strategy is to buy U.S.-exposed stocks in markets that have sold off aggressively for other reasons. A basket of U.S-exposed euro-zone stocks will likely perform well, and with Italian equities stressed due to domestic politics, companies such as Fiat-Chrysler Automotives N.V. and Luxottica Group SpA, which both have over 50 percent of their sales in the U.S., could provide a cheap route to buying U.S. earnings.

Finally, in a world where global growth is slowing, food producers typically outperform industrial metals, and with expectations of a new El Niño this year, prices on soft commodities [commodities that are grown rather than mined] should rally.

Way to play it with ETFs: Balchunas points to the $6.5 billion iShares U.S. Treasury Bond ETF (GOVT) which invests along the entire yield curve. It charges 0.15 percent.

Performance of last quarter's ETF plays: The iShares 20+ Year Treasury Bond ETF (TLT) and the Consumer Staples Select Sector SPDR ETF (XLP), Balchunas’s choice to play on the consumer staples theme, rose 5.2 percent in the third quarter. The iShares 20+ Year Treasury Bond ETF (TLT) fell 3.4 percent.

Look for ‘Peak Growth’ in the U.S.

A defining feature of 2018 has been how the Trump tax cuts have helped boost U.S. GDP to be consistently faster than other developed economies. However, GDP growth of 4.1 percent in the year’s second quarter will likely be “peak growth” for this cycle. Our early-warning indicators suggest that activity is now likely to slow in most major economies through the second half.

Despite the risk of slower U.S. growth, Federal Reserve Chair Jerome Powell has indicated his willingness to push rates higher in coming months. The U.S. dollar has gained due to the divergence in relative growth, higher U.S. rates and a faster pace of tightening. Not only has this meant pressure on developed markets, it’s also signaled that global liquidity conditions are tightening rather than easing. We expect dollar strength to be sustained through the second half.

U.S. investors have largely escaped the consequences of dollar strength and tightening global liquidity. The pain has been felt not only in emerging-market bonds, equities and currencies, but also in the global systemically important financial institutions (SIFIs), which fell 20 percent between late January and the end of June.

Given this backdrop for the global economy and liquidity, we expect markets to reward wealth preservation in the second half, with bonds looking increasingly attractive relative to equities. We believe there should be opportunities to make money buying 10-year and 30-year U.S. Treasuries above 3 percent.

For equity investors, such a backdrop will tend to keep financials under pressure and favors consumer staples and consumer service stocks. We are becoming less positive on the outlook for technology stocks; the adoption of the new communication sector will likely add to the regulatory volatility within the sector. [S&P; Global Ratings and MSCI Inc. are reclassifying a number of stocks previously in the technology, telecom and media sectors, and including some of them in a new communications-services group.]

We remain buyers of equity volatility, which we expect to rise on a trend basis in the next year, given the rise in real and nominal rates.

Way to play it with ETFs: For a Treasury play, investors can use the iShares 20+ Year Treasury Bond ETF (TLT), which is extremely liquid and charges 0.15 percent, Balchunas said. For the consumer staples play, there is the Consumer Staples Select Sector SPDR ETF (XLP). It, too, is super-liquid and also super-cheap, at 0.13 percent.

Performance of last quarter’s ETF plays: Balchunas suggested the VanEck Vectors ChinaAMC China Bond ETF (CBON) for those who wanted exposure to Chinese government debt. The ETF fell 4.5 percent in the second quarter.

Sell the Rallies

Equity clouds may have a silver lining.

Many investors appear to be assuming that the equity volatility of early February and mid-March was largely technical. It was shallow, short-lived and lacked major contagion into other asset classes, prompting an apparent willingness to “buy the dips.”

We, however, view these bouts of market nervousness as part of an incomplete market correction and suggest that investors should “sell the rallies” and focus on more defensive assets and strategies.

Why so cautious? First, we believe that the global economic cycle has begun to slow. Our activity surprise measures, which track the extent to which economic data deviates from forecasts of investment professionals on a daily basis from the previous quarter, are negative for the first time since 2016. We doubt that the U.S. can “decouple” from a global slowdown. U.S. tax cuts may only serve to offset the impact of the higher U.S. bond yields and Fed funds rates seen in the last 18 months. With Chinese growth slowing, euro-zone activity decelerating and global real money growth decelerating rapidly, global “peak growth” is probably behind us, making U.S. and global earnings forecasts liable to disappointment.

Despite these signs of slowing growth, policymakers in the U.S. and other developed economies appear intent on “normalizing” monetary policy. The combination of rate rises and the reduction in the pace of monetary stimulus from the European Central Bank and the Bank of Japan, as well as the reduction in the Fed balance sheet in the U.S., will challenge the upside for global risk assets.

Slower growth and tighter monetary conditions are also a toxic combination for highly indebted companies or economies. That means U.S. high-yield debt will likely struggle, as will the banking sectors and currencies of highly indebted economies such as Canada, Australia and Sweden, which may unsettle markets more generally.

In such an environment, where are the investment opportunities? As economic growth disappoints, expect bonds to beat equities. We favor U.S. Treasuries over other developed-market government bonds. Slowing growth and easing inflation pressure also favor Chinese government debt. Options strategies that bet on a long-term higher level of market volatility or that hedge equity risk will also likely be rewarded.

Finally, many investors typically turn toward gold if global growth slows. However, silver has lagged behind gold by 17 percent in the last year and almost 50 percent in the last five years, suggesting that it may have more upside potential if the economic outlook becomes cloudier.

Way to play it with ETFs: For Chinese government debt, an asset class thought impossible for retail investors to get exposure to just five years ago, Balchunas points to the VanEck Vectors ChinaAMC China Bond ETF (CBON). It tracks fixed-rate, renminbi (“RMB”)-denominated bonds issued in the People's Republic of China by Chinese credit, governmental and quasi-governmental issuers. While the fee of 0.50 percent is decent for such exotic exposure, Balchunas notes that the ETF is very small, at $4.8 million. Those wanting to buy the ETF should use a limit order to specify the price they are willing to pay.

Performance of last quarter’s ETF plays: The Guggenheim Defensive Equity ETF (DEF) was Balchunas’s pick as a defensive market maneuver. The ETF was virtually flat in the first quarter, down 0.1 percent. Two other picks, the PowerShares DB Agriculture Fund (DBA) and the VanEck Vectors Agribusiness ETF (MOO), were both positive, if barely—up 0.2 percent and 0.1 percent respectively.

Start Selling the Rallies

At the end of 1996, then-Federal Reserve Chairman Alan Greenspan chided market participants for their “irrational exuberance.” Today, there appears to be little reason to repeat his comments. The shift into risk assets by investors looks like rational exuberance in response to a benign economic backdrop not seen since the 1960s, with tax cuts and low rates expected to boost economic recovery. We doubt, however, that this can become sustainable exuberance, as 2018 will likely see this benign growth and inflation mix challenged. Fear will replace greed, rewarding more-defensive investments.

Signs of excess appear almost everywhere. The global economy looks close to a cyclical peak. The U.S. ISM manufacturing index, the Institute for Supply Management’s measure of economic activity in that sector, and similar measures for the euro zone are close to 30-year highs. Falling unemployment rates during the last six months in most of the Group of 20 biggest industrialized and emerging economies have helped boost consumer confidence, while low interest rates and stable inflation have encouraged consumers and corporations to reduce their savings and spend more.

Equities are showing classic late-cycle signs, with industrial stocks up 30 percent over the last 12 months. Basic-resource stocks are up 35 percent, while the 40 percent rise in oil prices is also characteristic of this phase for the global economy. The Goldilocks economy (sustained low inflation despite economic recovery) has helped push U.S. price-earnings ratios to 25 times trailing earnings and 32 times on a CAPE (cyclically adjusted p-e) basis, levels seen only in the tech bubble during the last 70 years—higher even than in the Nifty 50 era of the early 1960s.

With interest rates subdued and central banks adding $2.5 trillion to their balance sheets in the past year, liquidity has been plentiful, keeping volatility stubbornly low and creating some of the most benign financial market conditions of the last 30 years. Such benign conditions for the global economy and markets have rarely been sustainable for long. We worry that a China growth slowdown has the capacity to offset any U.S. or euro zone recovery, while liquidity is likely to be reined back in the U.S. as the Federal Reserve tightens monetary policy and in the euro zone with tapering by the European Central Bank.

If global growth slows, then interest rate expectations may have run ahead of themselves, making shorter-dated Treasuries attractive. With liquidity likely to be less plentiful, Treasury inflation-protected securities (TIPS) could underperform conventional Treasuries. Equities are now signaling “overbought” relative to bonds on our short-term tactical models and sentiment indicators. If earnings-per-share growth is 5 percent to 6 percent, as our models suggest, rather the consensus of 13 percent, oversold defensive sectors such as consumer staples and health care may outperform. Agricultural commodities are relative safe havens compared with industrial commodities.

Successful long-run investors are typically those who avoid the losses at the peaks of markets rather than those who focus on the next big win. It may not yet be time to be in full defensive mode. But after the gains of the last year and the post-credit-crunch bull market, it is time for equity investors to start selling the rallies rather than buying the dips.

Way to play it with ETFs: For defensive sectors, there’s the Guggenheim Defensive Equity ETF (DEF), which tracks the 100 companies that have the best risk and return profiles during a bear market. It charges 0.60 percent. To play agricultural commodities, there is the PowerShares DB Agriculture Fund (DBA) or the VanEck Vectors Agribusiness ETF (MOO). DBA charges 0.89 percent, and MOO’s fee is 0.54 percent.

Focus on Defense

The economic recovery is close to becoming the longest ever in U.S. history, and valuations are relatively high across the stock market. Inflation/overheat pressures are starting to surface, the 10-year bond yield recently rose above 3 percent, and the Federal Reserve is regularly tightening monetary policy. Although traditional recession indicators are not yet flashing red, several signs suggest that buy-and-hold returns from U.S. large-capitalization stocks are probably in the mid-single-digit range for the duration of this bull market. So while it’s not yet time to exit the stock market, it’s time to focus more on defense.

Even though yields are rising, balanced investors should reduce their equity allocations in favor of bonds. From here, a continued rise in yields may start to harm the stock market more than the bond market. By the end of this year, cash will yield about 2.5 percent, offering about one-half the expected longer-term return from the stock market without the downside risk. Therefore, holding some cash also seems attractive today and gives investors some dry powder should the stock market suffer a correction. Gold is another alternative investment with increasing merit. It is down about 10 percent since last spring and has just recently shown signs of bouncing back.

Finally, consider selling some of those popular technology and consumer discretionary winners and moving toward an overweight in defensive equity sectors including utilities, consumer staples and real estate. Defensive investments like the S&P; 500 Dividend Aristocrats Index and the S&P; 500 Low Volatility Index have begun matching the stock market’s overall performance in recent months. They should participate if the stock market keeps climbing, and preserve capital if the market hits an air pocket.

Way to play it with ETFs: For a gold ETF, a new breed of cheap offerings in the market include the GraniteShares Gold Trust (BAR) and the SPDR Gold MiniShares Trust (GLDM), said Balchunas. Both have assets of around $250 million and charge 0.18 percent.

Performance of last quarter's ETF plays: Balchunas chose Invesco DB Optimum Yield Diversified Commodity Strategy ETF (PDBC), which gained 3.7 percent in the third quarter, and the JP Morgan Diversified Alternatives ETF (JPHF), which had a 0.08 percent loss.

Beware the ‘3 Percent Problem’

Optimism abounds on both Main and Wall Streets. U.S. second-quarter real growth in gross domestic product (GDP) was a robust 4.1 percent, both jobs and profits seem plentiful and the S&P; 500 stock index recently rallied to its loftiest level since its January correction and is again near record highs!

While the bull appears to be in charge, expect some additional struggles for the stock market this year. Specifically, the U.S. economy appears headed for a period of slower growth in the second half, but not slow enough to stop inflation from continuing to build.

Several forces have turned negative for U.S. growth. They include a doubling of the 10-year Treasury bond yield since late 2016, a significant flattening in the yield curve, a major slowing in the M2 money supply [that’s money in cash and checking, as well as retail savings deposits and money-market funds and the like], higher commodity costs including energy prices and a decline in the real wage rate during the last year.

Moreover, before this year is over, the stock market may be forced to deal with its “3 percent problem”—that is, wage inflation (currently at 2.7 percent), consumer price inflation (at 2.9 percent) and the 10-year Treasury bond yield (at 2.98 percent) all surpassing 3 percent for the first time in this recovery. This would augment overheating fears, force the Federal Reserve to keep tightening and pressure the valuation of the stock market.

Despite the potential for more turbulence, investors should stay with stocks but diversify more broadly. Sell some optimistically priced U.S. stocks and move portfolio weightings abroad to both emerging and developed international markets. They are cheaper, underowned, have more hospitable policy officials and will benefit from renewed weakness in the U.S. dollar.

As well, raise some cash to take advantage of any panic selling should the U.S. stock market hit another air pocket, and perhaps de-FAANG your portfolio by selling some of those popular technology stocks. Consider adding exposure to a hedge fund that offers mid-single-digit returns without as much downside risk and substitute a commodity ETF for part of the equity portfolio. If inflation keeps climbing above 3 percent in the second half, commodities may well outperform the stock market.

Finally, barbell your sector exposures across inflation beneficiaries (e.g., materials, energy and industrials) and defensive sectors (e.g., utilities and consumer staples).

Way to play it with ETFs: For an investment in commodities, Eric Balchunas points to the Invesco DB Optimum Yield Diversified Commodity Strategy ETF (PDBC), a diversified basket of commodities futures. It charges 0.57 percent. For a hedge fund-like strategy, investors could turn to the JP Morgan Diversified Alternatives ETF (JPHF), a multistrategy hedge fund that offers mid-single-digit returns with low volatility, he said.

Performance of last quarter’s ETF plays: The JPMorgan Diversified Alternatives ETF (JPHF) was the ETF Balchunas recommended last quarter as one way to invest along Paulsen’s themes. The ETF was down about 1 percent in the second quarter, while the S&P; 500 index rose 2.9 percent.

Brace for Inflation

Rising inflation and higher bond yields will likely be common during the balance of this recovery. While the bull market does not appear to be over, neither is its current, corrective phase. Therefore, expect a difficult bond market and a stock market poised for additional volatility—or even a further decline this year—without losing sight of the potential for additional gains during the next few years.

Bond exposure should be at a minimum, and a barbell approach may prove best in the stock portfolio. Own sectors that outperform if inflation worries intensify (the materials, energy and industrial sectors) or if yields keep rising (financials) but also have some defensive stocks (utilities, telecoms and consumer staples) which can buoy the portfolio should the market suffer a further decline.

International stocks offer a better risk-reward profile, compared to the U.S. stock market. They are relatively cheaper, do not face as intense overheat pressures, have younger economic and earnings recoveries, benefit more from a weak U.S. dollar and will likely benefit from more supportive policy officials. A tilt toward small-cap stocks also looks attractive. They tend to outpace during periods of rising inflation and higher yields and are currently under-represented in most portfolios.

Investors may also consider adding a few additional dimensions to their portfolios. Thanks to the Federal Reserve, cash finally has a yield, which should keep rising this year. A small allocation to cash may prove opportunistic should the stock market suffer a further decline. A direct allocation to commodities (via a commodity ETF) could also help diversify your portfolio. Commodity investments should perform well if inflation worries intensify, while both the stock and bond market may suffer declines.

Finally, consider a small allocation to a hedge fund. The best of this bull market is already past and for the rest of its duration, stock market returns are likely to be far lower and probably more volatile. A true hedge fund—one that aims to provide a return across all kinds of market environments—that offers stable, mid-single-digit returns is compelling and should help manage risk.

Way to play it with ETFs: Several hedge fund strategies are now available in ETFs, says Balchunas. Many of them, like real hedge funds, provide uncorrelated streams of returns. The JPMorgan Diversified Alternatives ETF (JPHF) is actively managed like a hedge fund but comes at about half the cost, with a fee of 0.85 percent.

Performance of last quarter’s ETF plays: The Vanguard Total International Stock ETF (VXUS) lost 0.7 percent in the first three months of 2018, and the SPDR Dow Jones Industrial Average ETF Trust (DIA) slid 2.5 percent. Balchunas’s third suggested ETF, the iShares Short Treasury Bond ETF (SHV), eked out a 0.1 percent gain.

Create a Meltproof Portfolio

The question for 2018 is how to deal with a melt-up. Clearly, the stock market is racing higher nearly every day, but risks are also rising. Challenges facing stocks include investor sentiment that is now too bullish, declining financial liquidity, rising interest rates, high valuations, stout economic and earnings expectations, and slowly but noticeably intensifying inflationary pressures. The primary risks are exiting a melt-up too soon and not exiting soon enough!

How best to respond to this quandary? Here are a few suggestions.

First, de-bond your stock portfolio. Last year, the Federal Reserve raised interest rates, and this year the bond market will probably raise yields. Reduce exposure to those sectors (utilities, telecom, consumer staples) that historically do the worst during periods of rising yields. [For a different take on the promise of utilities, see Sarah Ketterer’s comments below.]

Second, allocate away from U.S. stocks and toward international developed and emerging stock markets. Overseas markets face fewer challenges, offer better relative values and more conducive policy support, are widely underowned and would benefit from ongoing weakness in the U.S. dollar.

Third, focus on capital goods stocks. Business investment is likely to lead the U.S. recovery in the next few years, and stock sectors tied to this trend, including technology, industrials, materials and energy, should perform best. Technology gives the portfolio solid price momentum and sexy new-era unit growth. Industrials offer a play on the ongoing global manufacturing recovery. Materials are the quintessential inflation play in a U.S. economy likely to face intensifying overheat pressures. And energy is a contrarian play—out of favor but a good value in a sector that also benefits from higher inflation and rising yields.

Fourth, a small allocation directly to commodities may make sense this year. If inflation fears intensify, then a commodity ETF will likely outpace both stocks and bonds.

Finally, for the first time in this recovery, cash offers a return. Perhaps add a 5 percent cash position now and another 5 percent each time the 10-year bond yield rises by another quarter percentage point.

Way to play it with ETFs: For exposure to the international developed markets and the emerging markets in one fell swoop, there’s the Vanguard Total International Stock ETF (VXUS). It provides an investor with exposure to about 40 countries, from France to China to Peru, for a fee of 0.11 percent. The typically overlooked SPDR Dow Jones Industrial Average ETF Trust (DIA) is a good broad market play, but with a tilt toward industrials and financials. It has a fee of 0.17 percent. For cash, investors can use the iShares Short Treasury Bond ETF (SHV), which is essentially the ETF version of putting your money under a mattress. Its fee is 0.15 percent.

Play Digital Payments

Even after the recent market drop, a case can be made that after a decade-long bull market valuations still look stretched. But in our long-term view, that doesn’t preclude finding solid franchises that are well-positioned relative to a meaningful secular trend. One area we’ve recently found interesting surrounds the ongoing global transition to digital payments.

There are a number of tailwinds contributing to this trend. First, we’re seeing rapid growth in e-commerce, which requires that customers be able to make secure digital payments. The growth in cross-border transactions and the general impact of an increasingly globalized marketplace are helping accelerate this trend. Second, technological innovations that simplify cash transactions—such as Square and Uber, as well as point-of-sale devices in areas they’ve not historically been, such as taxis, vending machines, parking meters, etc.—are helping drive digital payments growth.

A third factor has been emerging economies’ growing push to bring their populations into the formal economy. One way this has manifested itself has been deliberate attempts on the part of some governments—most notably and recently India’s—to demonetize their economies. The move toward digital payments brings more consumers into the formal economy at a time when those payments are becoming faster, more efficient, and ultimately more secure. A final factor has been the growing volume of global travel, which is simpler when transactions are facilitated digitally. [The largest holdings in the digital payment space in Artisan Partners’ portfolios include Visa Inc., Pagseguro Digital Ltd., Worldpay Inc. and Q2 Holdings Inc.]

Way to play it with ETFs: Balchunas’s pick is the ETFMG Prime Mobile Payments ETF (IPAY). It is focused solely on capturing the growth in digital payments. It tracks the established credit card companies as well as newer firms, and is international in scope. The ETF, with $500 million in assets, has an above-average fee of 0.75 percent.

Ride out Market Cycles

Do the Fed’s plans for continued rate hikes signal trouble for bonds? We don’t think so. While rising short-term interest rates may sting, these losses will be offset by higher future returns as interest payments are reinvested at higher yields. And despite the recent volatility, we don’t expect a big impact on long-term bonds. Long rates are less influenced by the Fed than by inflation and the long-term growth outlook.

While a multilateral trade war seems unlikely in 2019, significant risks remain in the U.S.-China trade conflict. We haven’t changed our outlook on either country, as we have yet to see any major reaction to the current tariffs in the economic data. However, should the U.S. go forward with further tariffs in January, we may begin to see material effects in select sectors and lower market sentiment overall.

What about equities? While some equity investors may be spooked by higher rates’ impact on earnings and overall growth, Vanguard’s research has shown that in the last 50 years, equity returns remained positive during 10 out of 11 previous rate-hike periods. This time may be different, of course, but market timing is the wrong strategy.

A better approach is to stick with stocks through the market cycles to take advantage of discounts in the market and benefit from their potentially higher returns over the long term. With the large return differentials between the U.S. stock market and equity markets in the rest of the world, consider rebalancing into non-U.S. stocks if your portfolio has strayed from your target allocation. And even if bond returns are more muted, fixed income will continue to moderate volatility in equities and other assets.

So what should you do with $10,000 today? If you already have a diversified mix of stocks and bonds, more of the same.

Way to play it with ETFs: Balchunas’s pick is the Vanguard Total Stock Market ETF (VTI), a classic buy-and-hold ETF. The broad market fund covers the entire U.S. stock market. It charges 0.04 percent and recently crossed the $100 billion mark in assets—only the third ETF to ever do so.