Category Archives: etf

Estimating Future Stock Returns, Follow-Up

Click to enlarge Idea Credit: Philosophical Economics Blog My most recent post, Estimating Future Stock Returns was well-received. I expected as much. I presented it as part of a larger presentation to a session at the Society of Actuaries 2015 Investment Symposium, and a recent meeting of the Baltimore Chapter of the AAII. Both groups found it to be one of the interesting aspects of my presentation. This post is meant to answer three reasonable questions that got posed: How do you estimate the model? How do we understand what it is forecasting given multiple forecast horizons seemingly implied by the model? Why didn’t the model forecast how badly the market would do in 2001 and 2008? And I will add 1973-4 for good measure. Ready? Let’s go! How to Estimate In his original piece , @Jesse_Livermore freely gave the data and equation out that he used. I will do that as well. About a year before I wrote this, I corresponded with him by email, asking if he had noticed that the Fed changed some of the data in the series that his variable used retroactively. That was interesting, and a harbinger for what would follow. (Strange things happen when you rely on government data. They don’t care what others use it for.) In 2015, the Fed discontinued one of the series that was used in the original calculation. I noticed that when the latest Z.1 report came out, and I tried to estimate it the old way. That threw me for a loop, and so I tried to re-estimate the relationship using what data was there. That led me to do the following: I tried to get all of them from one source, and could not figure out how to do it. The Z.1 report has all four variables in it, but somehow, the Fed’s Data Download Program, which one of my friends at a small hedge fund charitably referred to as “finicky”, did not have that series, and somehow FRED did. (I don’t get that, but then there are a lot of things that I don’t get. This is not one of those times when I say, “Actually, I do get it; I just don’t like it.” That said, like that great moral philosopher Lucy van Pelt, I haven’t ruled out stupidity yet. To which I add, including my stupidity.) The variable is calculated like this: (A + D)/(A + B + C + D) Not too hard, huh? The R-squared is just a touch lower from estimating it the old way… but the difference is not statistically significant. The estimation is just a simple ordinary least squares regression using that single variable as the independent variable, and the dependent variable being the total return on the S&P 500. As an aside, I tested the variable over other forecast horizons, and it worked best over 10-11 years. On individual years, the model is most powerful at predicting the next year (surprise!), and gets progressively weaker with each successive individual year. To make it concrete: you can use this model to forecast the expected returns for 2016, 2017, 2018, etc. It won’t be very accurate, but you can do it. The model gets more accurate forecasting over a longer period of time, because the vagaries of individual years average out. After 10-11 years, the variable is useless, so if I were put in charge of setting stock market earnings assumptions for a pension plan, I would do it as a step function, 6% for the next 10 years, and 9.5% per year thereafter… or in place of 9.5% whatever your estimate is for what the market should return normally. On Multiple Forecast Horizons One reader commented: I would like to make a small observation if I may. If the 16% per annum from Mar 2009 is correct we still have a 40%+ move to make over the next three years. 670 (SPX March 09) growing at 16% per year yields 2900 +/- in 2019. With the SPX at 2050 we have a way to go. If the 2019 prediction is correct, then the returns after 2019 are going to be abysmal. The first answer would be that you have to net dividends out. In March of 2009, the S&P 500 had a dividend yield of around 4%, which quickly fell as the market rose and dividends fell for about one year. Taking the dividends into account, we only need to get to 2,270 or so by the March of 2019, works out to 3.1% per year. Then add back a dividend yield of about 2.2%, and you are at a more reasonable 5.3%/year. That said, I would encourage you to keep your eye on the bouncing ball ( and sing along with Mitch … does that date me…?). Always look at the new forecast. Old forecasts aren’t magic – they’re just the best estimate of a single point in time. That estimate becomes obsolete as conditions change, and people adjust their portfolio holdings to hold proportionately more or less stocks. The seven-year-old forecast may get to its spot in three years, or it may not – no model is perfect, but this one does pretty well. What of 2001 and 2008? (And 1973-4?) Another reader wrote: Interesting post and impressive fit for the 10-year expected returns. What I noticed in the last graph (total return) is, that the drawdowns from 2001 and 2008 were not forecasted at all. They look quite small on the log-scale and in the long run but cause lot of pain in the short run. Markets have noise, particularly during bear markets. The market goes up like an escalator, and goes down like an elevator. What happens in the last year of a ten-year forecast is a more severe version of what the prior questioner asked about the 2009 forecast of 2019. As such, you can’t expect miracles. The thing that is notable is how well this model did versus alternatives, and you need to look at the graph in this article to see it (which was at the top of the last piece). (The logarithmic graph is meant for a different purpose.) Looking at 1973-4, 2001-2 and 2008-9, the model missed by 3-5%/year each time at the lows for the bear market. That is a big miss, but it’s a lot smaller than other models missed by, if starting 10 years earlier. That said, this model would have told you prior to each bear market that future rewards seemed low – at 5%, -2%, and 5%, respectively, for the next ten years. Conclusion No model is perfect. All models have limitations. That said, this one is pretty useful if you know what it is good for, and its limitations. Disclosure: None

Get Off The Roller Coaster With Vanguard Total Stock Market ETF

Roller coaster start for investors in 2016 This year, evidence of stress came early as the market dropped like a brick before swinging back up like a rocket. Rampant, wrenching, volatility is maddening for many investors who see no choice but equities for financial gains in the current low interest rate savings environment. Picking individual stocks is risky in a traders’ marketplace. For the long-term investor, a maximally diversified ETF may reduce stress helping to weather short-term shocks like those that were seen last January while offering modest gains across a 5 to 10 year time horizon and greater peace of mind. Volatility and Downside Risk Recent Fed commentary and behavior can only confuse the Markets, and that spells continued and perhaps even greater volatility . The contradictory nature between the ” Fed speak” of the Chair, Janet Yellen, and other members of the FOMC has sent mixed messages about removing unprecedented accommodation from U.S financial markets. Yellen’s dovish response to maintain low interest rates in the U.S. signals a fear of declining global economic growth. The picture concerning the future direction of interest rates is clouded and that presages the possibility of a continued roller coaster stock market ride. At Fortune’s Global Forum, JPMorgan (NYSE: JPM ) CEO, Jamie Dimon, hinted at expected greater volatility stating that, “markets will be scary until a normal interest rate environment returns.” This view is mirrored in the recent low interest rate of the 10 year U.S. Treasury Bill which has fallen to 1.77% as scared money retreats from the markets. For some savvy traders, volatility may translate into higher short-term returns, but this isn’t always the case because the psychology of greed, and more importantly, in my experience, of fear, can reverse markets on a dime. This can result in devastating losses for some market segments as well as individual stocks. On the other hand, the average investor, by nature, tends to be a long-term animal, and that means having to contend with both volatile whiplash swings as well as the fear of downside market risks. It has always been a maxim for me to take both volatility and downside risk into consideration when I am in investment mode. I have also come to believe that volatility does not always translate into higher returns. Diversification is a great tool for dealing with both volatility and downside risk. Vanguard Total Stock Market ETF The Vanguard Total Stock Market (NYSEARCA: VTI ) ETF is a significantly diversified proven winner. It seeks to track the performance of a benchmark CRSP U.S. Total Market Index. The investment approach is focused on: Large-, mid-, and small-cap equities diversified across growth and value styles. A passively managed, index sampling strategy. Maintaining a fully invested fund utilizing low expenses to minimize net tracking errors. Accurately representing the U.S. equity market while delivering low turnover. Key Fund Facts Clearly, a key fact for investors to consider is the expense ratio for purchasing the ETF. As of 04/28/2015 it is 0.05% and compares very favorably with the Lipper peer average expense ratio of 1.17% as of 12/31/2005. Total net assets are $389.8 billion as of 02/29/2016. Outstanding shares are 560,322,004 as of 03/31/2016. The risk and volatility Beta based on the 5 year Primary benchmark and the Broad-based benchmark is 1.00. Sector Weightings Courtesy of the Author As noted in the chart above, at present the heaviest sector weightings are in Financials, Technology and Consumer goods while the lowest are in Basic materials, Telecommunications and Utilities. Comparative Performance Courtesy of the Author Of the 13 funds listed in the table above, VTI leads the group with a ten year average return of 6.13% while maintaining a maximum level of diversification. The 3 and 5 year returns are 8.21% and 8.63%, respectively. Short-Term Performance The fund’s overview is described by the table below. It is highly capitalized and provides a 2.2% dividend yield as well as capital gains. Click to enlarge Courtesy of the Author Although VTI shows a loss for the first three months of this year and an -8.2% one-year return, it sports a 10% total market return for the last three years during a period of exceptional market volatility. Cumulative Long-Term Performance Click to enlarge Courtesy of the Author Long-term cumulative performance over 10 years is 97.52% with a cumulative performance of 133.12% since inception on 05/24/2001. VTI 5 Year Chart A 5 year weekly stock price chart shows strong performance. Extrapolating data from the chart shows a low close of 51.04 on October 3, 2011 and a close on April 4, 2016 of 105.04 for a share value gain of 51%. This corresponds to an approximate 5 year annual gain of 8.3% seen in the Betterment Comparative Performance chart provided above. Click to enlarge C ourtesy of the Author VTI Bounce-Back As Market Recovered Courtesy of the Author VTI showed a strong bounce-back in mid-February of 2016 following the volatile 10% market decline that took place during January 2016. Additional data supporting VTI which is also available as a mutual fund can be reviewed on the Vanguard site . Where Should We Be In The Market? Nobody can call the market; we can only consider economic variables and try to place ourselves in the best situation to profit from our investments, and most importantly, to avoid significant financial loss. We can also learn from past experience if we are in a position where we are personally vulnerable to the stressful impact of severe market swings. I am not sanguine in my near-term expectations that stock markets can continue to rise in the current cycle . I make no predictions, but point out the following for your consideration: U.S. Market Indices are nearing highs in a climate of weak global economic conditions. But, I cannot know what will happen in the longer term and therefore the choice of selling my portfolio and exiting the stock market is a poor choice in my opinion. I consider the U.S dollar to be the strongest currency and the U.S. economy to have the greatest potential to generate wealth given better economic policies. The question for all investors now is, where do you feel the most comfortable putting your money? Conclusion Remaining invested for the near term, in my opinion, requires the broadest diversification in the strongest companies, and I consider the U.S. the best place to be at this time. The Vanguard Total U.S. Market ETF may be a place for some investors to seek refuge. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VTI over 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. Additional disclosure: The information and data that comprise the content of this article came from external sources that I consider reliable, but they have not been independently verified for accuracy. Although I reserve the right to express points of view, they are my reasoned opinions, and not investment advise. I am not responsible for investment decisions you make. Thank you for reading and commenting.