Author Archives: Scalper1

3 Lies About The Stock Market

We’ve all been told outright lies about the stock market that do not square with the evidence. Today, we’re going to debunk some insidious lies. Lie #1: “Superior returns come from stock picking.” This lie is especially dangerous because it is partially true. High returns can come from stock picking. But higher returns most often come from not picking stocks. For example, if you had been smart enough to predict that Apple (NASDAQ: AAPL ) would trounce most of the S&P 500 after the unpleasantness of the financial crisis, you would be a great stock picker – you just wouldn’t be very bright at generating extremely high returns with a solid MAR ratio (CAGR/Maximum Drawdown). A 50/50 portfolio of leveraged S&P 500 and leveraged long duration government bond exposure would have trounced Apple. Take a look at 50% ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO )/50% Direxion Daily 30-Year Treasury Bull 3x Shares (NYSEARCA: TMF ), rebalanced weekly, vs. the performance of Apple. It’s not even close. And that’s holding stocks and bonds! The dramatic diversification not only provides Apple-trouncing performance but also does so with much higher Sharpe and MAR ratios. (click to enlarge) Click to enlarge Which leads us to: Lie #2: “Focus investing leads to the highest returns.” Absolutely not. As we have seen above, holding two major asset classes is the opposite of Phil Fisher style focus investing. If holding Apple (the greatest growth company of all time) since the summer of 2009 is not as good as holding two leveraged ETPs which give exposure to stocks and bonds, focus investing is not optimal. Focus investing may be better than holding the entire S&P 500, but it is not as good as holding the entire S&P 500 and long duration government bonds – i.e., dramatic diversification boosts returns more than focus. Remember, correlations between asset classes are, as a rule, more persistent than company earnings growth. Lie #3: “If you’re going to pick stocks, you need to predict earnings.” This lie is especially dangerous. Guessing quarterly earnings is a loser’s game. Here’s what’s better – measure the number of competitors in an industry. Long’s Law is the ultimate reductionist statistic which is predictive of sustained company outperformance. Long’s Law states that long-term free cash flow margins (FCF/revenue) in any industry over a multi-decade time frame tend towards the inverse of the number of competitors in that industry. Dozens of seemingly predictive statistical ratios really collapse causally to one number – the number of competitors in the industry. And there are the added benefits of determining if the measured outperformance is sustainable, and if and when the outperformance is threatened (the entrance of meaningful new competition, etc.). For example, in an industry with three competitors, FCF margins will tend towards 33.33% or 1/3. However, Economic “Laws” should best be termed Economic “Tendencies.” The rule roughly holds across a vast array of industries. But why is this important? FCF margins directly impact the sustainability of high long-term Return on Assets (ROA) rates. And longer term, sustained high ROA numbers dictate the unlevered return of a business. But the key word is “sustainable”. And high FCF margins, according to Long’s Law, are only sustainable longer term in industries with few substantial competitors. But what are examples of publicly traded companies that might rank very highly under Long’s Law? Here is an illustrative, but by no means complete, list below: Major Payment Networks (Network Effect Businesses) Visa (NYSE: V ) MasterCard (NYSE: MA ) Major Futures Exchanges (Network Effect Businesses) CME Group (NASDAQ: CME ) Intercontinental Exchange (NYSE: ICE ) CBOE Holdings (NASDAQ: CBOE ) Major Credit Rating Agencies (De Facto Regulators) Moodys (NYSE: MCO ) McGraw-Hill Financial (NYSE: MHFI ) Get the picture? Don’t predict earnings. Measure the number of competitors in the industry. Longer term, margins and sustained earnings growth follow the lack of or the brutality of competition in an industry. The robber barons understood this, and you should too. And you don’t even need to pick stocks, but if you’re going to, pick oligopoly businesses with few competitors. You’ll earn much higher returns than the major equity indices over time, but without the need to guess quarterly earnings. Why are these 3 lies so persistent and widespread? It’s because they are partially true. But if we want to optimize returns, we need to discard these lies, and replace them with evidence-based thinking. Thanks for reading. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Covered Call ETFs Sidestep Market Volatility

Many investors have now transitioned to a lower stock allocation during the midst of this early 2016 decline. In fact, it has likely created a new sense of reality that it may be time to transition to a structure of low volatility to wait out the storm. A conventional and highly touted method has been to own stocks with lower historical price fluctuations than their peers like the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). However, there is also another way for ETF investors to own a basket of stocks with built-in options to collect income and potentially reduce price volatility. Covered call ETFs are also often referred to as a “buy-write” options strategy. This process involves owning a group of publicly traded stocks and selling call options on the underlying securities to collect the premium. This can be done by sophisticated investors on individual positions or you can effectively own an ETF or two that will do it for you on a diversified basket of stocks. The end goal is to collect income from the options contracts, which will ultimately reduce the effectiveness of these ETFs during a sustained uptrend in the market. Nevertheless, they have shown far less relative drawdown than their fully loaded index peers during the last two recent corrections. The oldest and most established fund in this group is the PowerShares S&P 500 BuyWrite Portfolio (NYSEARCA: PBP ). This ETF debuted in 2007 and has accumulated $312 million in assets. As you can see on the chart below, PBP has been able to sidestep a great deal of the decline versus the broad-market SPDR S&P 500 ETF (NYSEARCA: SPY ). It was also able to accomplish that same feat in the summer 2015 swoon as well. It’s worth noting that over longer periods of time, the PBP performance story falls short of the stock-only SPY. This is primarily due to the drag of the options buy-write strategy on 3, 5, and 10-year time horizons. In addition, PDP charges a premium expense ratio of 0.75% for the implementation of its unique approach. The income from PBP is interesting because it often experiences big changes over time. Distributions are paid on a quarterly basis to shareholders and over the last 12-months the trailing yield is 5.40%. Some of those distributions have included short and long-term capital gains as well. Another worthy contender in this space is the Recon Capital NASDAQ 100 Covered Call ETF (NASDAQ: QYLD ). This ETF implements a similar strategy based on the NASDAQ-100 Index. The end result is a more concentrated mix of stocks with concentrations in technology and consumer discretionary sectors. This ETF has been able to achieve a similar pattern of reduced draw down relative to the PowerShares QQQ (NASDAQ: QQQ ) during periods of market stress. QYLD charges an expense ratio of 0.60% and income is distributed on a monthly basis to shareholders. This may be a more attractive feature for income investors who are searching for a more regular dividend stream . The trailing 12-month distributions indicate a yield of 10.49% based on the current share price of QYLD. These buy-write strategies have traditionally been a more obscure way to generate income while reducing draw down during sideways or falling markets. This likely means that they are going to be more of a tactical opportunity in the context of a diversified portfolio rather than a dedicated core position. Investors considering these funds should closely research the underlying mechanics of how the income is generated and compare against other potential low volatility alternatives as well. Disclosure: I am/we are long USMV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.