The 3 ETFs this investor would buy with an extra $10,000

When he appeared on Livewire's Signal or Noise recently, MPC Markets CEO and Head of Equities Mark Gardner was bearish. While he thinks the equity market "got very ahead of itself" last year, this year's rally has been more indicative of the kind of price action we see just before a recession really hits the tape. 

Gardner is still bearish, especially on the Magnificent Seven mega-cap tech stocks, where he argues that this bullish run smells a lot like the TMT bubble of 2001. Indeed, as he wrote on this very website last month, he feels that the Goldilocks scenario is "about to be mauled" by three larger economic bears of China, bond yields, and insane single-stock valuations. 

In this edition of The $10,000 Idea, Gardner shares with us how he is investing cash on behalf of new clients. While he admits it's "not very exciting", it is indicative of what a looming market crash. 

If this is the first time you're reading an instalment of the series, here's a quick reminder of the rules that we have set our participating fundies:

We've asked a range of Australia's top fund managers to tell us how they would invest $10,000 in new capital. They each answer a couple of quick-fire questions about their process and views on valuations, each participant can invest the (hypothetical) cash in up to three individual assets with any spare money going into a term deposit that will fetch (for the sake of simplicity) 4% yield.

What's your read on market valuations at the moment?

At MPC, we are playing things very defensively at the moment, looking at opportunities in the non-cyclical end of the market or fixed income. We are of the view that US mega-cap technology stocks are wildly overvalued and the effects of higher interest rates is yet to bear its teeth on the global economy.

The hardest thing about the most recent August reporting season was resisting the fear of missing out, given the big upside moves in sectors we aren’t investing in at the moment, like consumer discretionary and technology.

How did you pick the assets you did for this experiment?

We firstly take a top-down view to decide which sectors or locations we see as good opportunities. Based on those views, we set our allocation to the sector. For the top-down part of our process, we use the following signals:

• Historical sector performance data for where we see the economy is in the cycle
• Fixed income and bond market indicators like yield curve, credit spreads

Then, a bottom up approach is applied with companies in unfavourable sectors having to meet a higher standard than those with a tailwind. We use the following signals in our bottom-up approach to identify the best opportunities:

• P/E and PEG ratios, yield etc
• Balance sheet and management track record of executing plan
• Business plans (growth/value). For example, much more inclined to buy Xero (ASX: XRO) now that management has abandoned aggressive growth plan

For this exercise, only having 3 choices made it difficult for us as we often use baskets of stocks to smooth the risk of positions. For example, QBE Insurance (ASX: QBE) and Johns Lyng Group (ASX: JLG) are the insurer and the insurance repairer double-play due to high occurrences of weather events. Or, GrainCorp (ASX: GNC) and Duxton Water (ASX: D2ON) are the grain processor and water rights stocks which we would use to hedge against El Nino.

For this case, we used ETFs to best represent our view.

Gardner's $10,000 Ideas

The case for the Betashares Australian Major Bank Hybrids Index ETF

This ETF yields 7.3% after franking and is one of the highest yielding A-rated fixed income products in the market. We like the flexibility of owning an ETF that pays monthly as we can switch back into the equity market quickly when opportunities come up as opposed to term deposits, bonds or funds. So why would we want to own hybrids instead of the bank stock itself?

• Firstly, you are getting a B+ style return on an A-rated fixed income product at 5% (let alone with the franking taking it up to 7.1%)
• Australian bank stocks historically only rally in periods of expanding money supply and falling rates, of which we have neither right now. With Australia having one of the highest house price-to-income ratios in the world, we see little room for any further growth in mortgage sector without causing a systemic bubble
• An inverted yield curve is not good for the bank net interest margins (NIMs). An inverted yield curve means the banks are having to loan capital at higher short term rates and lending at the lower long term rates
• With credit default rates rising and bank deposits falling, we expect another regional bank could fall this year in the US, causing broad panic for the sector (although this will likely be a buying opportunity for Australian banks)

The case for the Betashares Global Agriculture ETF

A drought in the US is likely to end as El Nino comes into effect in the Southern Hemisphere. With a 55% allocation to the US, we think this defensive ETF provides exposure to everything from fertilisers, machinery, agricultural products/distributors and packaged food/meat.

The case for the iShares Global Healthcare ETF

This choice is in-line with our preference to non-cyclicals. This Healthcare ETF has some of the world's best health care companies in it. Examples include Novo Nordisk (CPH: NOVO-B), Merck & Co (NYSE: MRK) and Eli Lilly (NYSE: LLY) and it has consistently performed well, returning 10.4% per annum over the last 5 years.

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