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Highly Overvalued Market? Consider Employing These Strategies

It is one of the hardest things for investors to do. What am I referring to? It’s this: Breaking away from the tendency, in making investment decisions, to be highly influenced by how things have been going lately , and then assuming such observations suggest that the same general type of results will carry forward for at least the next several years, if not indefinitely. While it may often be true that investments that have been doing well lately will continue to do well over the relatively shorter term, investors, in my opinion, should be much more cautious when ETFs/ stock funds appear to be showing signs of moderate to gross overvaluation. Those happenstances may not occur that often: they most likely will occur mainly late in extended bull markets. Investors mindfully, but perhaps just sub-consciously, have much greater tendency to invest more in stocks during a long bull market, and with greater confidence, than when stocks aren’t in one, and instead are either a) just chugging along moderately well but not some downside, b) essentially going nowhere over a considerable period, or c) are in, or near, a bear market. For many, it seems hard to not to invest more during a prolonged bull market, and also not to invest in the prior best performing types of funds under what appear to be highly favorable conditions. People seem naturally inclined to extrapolate past to future. They tend to assume that what has been working well will continue to do so, which in the case of a bull market, is typically stocks in general. Additionally, they also tend to believe those specific categories of stocks which have been performing particularly well, and the best performing market sectors, will continue along the same path. A Re-think Is Often Necessary Under such circumstances, investors, rather than investing as they might have before the overvaluation began, need to think even more than otherwise, about what their returns might be as far as three years ahead, as opposed to, say, merely over the next six months, or even the next year or more. Why? Here are some data showing what might otherwise happen: About a year and a half ago (July 2014), stocks from around the developed world were on a tear. Prior one year returns were at least 20% pretty much no matter where one looked, and even more caution-inducing from my point of view, 5-year annualized returns were generally in the high teens, such as the S&P 500 index, up 18.8%. Virtually all stock fund categories were overvalued, as repeatedly emphasized over many months before that date in articles I authored on my website and elsewhere, including on Seeking Alpha. Which types of stock funds were looking the strongest, and therefore, to the unwary, deemed most likely to continue their sizzling performance? Some sector fund returns were showing near 30% one-year returns or better, including health care, natural resources, and technology. Over the prior 5 years, small- and mid-caps, as well as health care and real estate sector funds were approximately averaging at least 20% annualized returns. So, it is not surprising that back then, aside from investing heavily in the broad market and international stocks, investors had also gravitated toward relatively large positions in small caps, mid caps, and the above sectors through funds and ETFs. By one year later, that is, by July 2015, the returns on these investments presented a mixed picture. While the S&P 500, mid-caps and small-caps were still holding on to moderate one year gains in the 6 to 7% range, international stocks had generally tanked into moderately negative territory. Only health care sector funds continued to sizzle; while technology and real estate funds were still positive, they slowed considerably from their prior performances. Now here we are a little more than another 6 months later. So where do these year and a half ago choices stand today? Most of the above gains have been wiped out, or nearly so, although small health care gains still remain intact. The following table shows prices for some representative Vanguard stock ETFs from the start of the period compared with now (all data in this article thru Jan. 25). The percentage change in price gives one a close approximation as to how each ETF has performed over the period. Such ETF performance can be taken as a close proxy for other identical category funds, both unmanaged and managed: ETF (Symbol) 6-30-14 Price 1-25-16 Price Percent Change Over 1.5+ Years (not annualized) S&P 500 ETF (NYSEARCA: VOO ) 179.46 172.07 -4% Mid-Cap ETF (NYSEARCA: VO ) 118.66 107.64 -9 Small-Cap ETF (NYSEARCA: VB ) 117.12 98.34 -16 Total International Stock ETF (NASDAQ: VXUS ) 54.15 40.96 -24 Health Care ETF (NYSEARCA: VHT ) 111.58 122.31 +10 Materials ETF (NYSEARCA: VAW ) (Natural Resources) 111.77 80.97 -28 Information Technology ETF (NYSEARCA: VGT ) 96.75 98.82 +2 REIT ETF (NYSEARCA: VNQ ) 74.87 75.93 +1 Note: An ETF’s total return, including dividends and capital gains if any, is not reflected when just looking at the above prices alone. So, for example, if a given ETF pays a 2% yearly dividend, you will not see how that dividend affected the fund’s year and a half return. To get a better estimate of actual performance, you would need to add the approximately 3% in dividends for the 1 1/2 year period to the percent change shown above. This also applies to all the percent change figures below. Implications for Stock/Bond/Cash Allocations Are there any other types of investments investors might have considered investing more in back in July 2014? Unfortunately, most other categories of stock ETFs/funds have not performed any better, and some have done even worse. On the other hand, in some cases, where returns for many the above types of stock funds have been negative, at least for the period under consideration, investors would have been better off by just being in cash or money market funds. While such funds hardly returned much more than zero, at least they did not show negative returns. How about bond funds ? The following chart shows prices for some representative ETFs and funds from Vanguard then and now. ETF/Fund (Symbol) 6-30-14 Price 1-25-16 Price Percent Change Over 1.5+ Years (not annualized) Total Bond Market ETF (NYSEARCA: BND ) 82.15 81.31 -1% Total Intl Bd Idx (MUTF: VTIBX ) 10.25 10.62 +4 Interm-Term Tax-Exempt (MUTF: VWITX ) 14.14 14.37 +2 Note: Returns from tax-exempt bond funds should be regarded as higher than they appear because, unlike with taxable bonds, one typically gets the full return rather than the after-tax lowered return that will result from ordinary bonds held in a taxable account. But Short-Term Returns Often Fail to Show the Whole Picture Of course, the above data presents only a snapshot taken at the current point in time. Therefore, one cannot say conclusively that investors will continue to have been better off in non-stock investments because, if held further, the stock investments could well rebound and eventually outpace holding the non-stock investments. Obviously, though, there is no guarantee that stock prices will quickly return to their winning ways. And because it is a fact that many investors do wind up switching out of losing positions and thus missing out on eventual recoveries, it may therefore turn out that many investors would have been better off by not having invested as much as they might have in mid-2014’s overvalued stock funds, and instead, by having reallocated some of these investments to cash or bonds. Thus, while we still don’t know how well stocks will do in the next few years, it is highly possible that there would have been some better options looking forward from mid-2014 than the well-performing, but overvalued, funds/ETFs mentioned above. Instead of investing based on current data which often just suggests, at best, a possible relatively short-term investment direction, it is often better to invest with at least a three year horizon which looks beyond the “here and now” and tries to anticipate where things are more likely to go if and when there is a change in underlying economic data and/or investor sentiment. And over such a lengthier span, it makes sense to consider the downside of sticking with highly “overvalued” fund categories, and the potential upside of any possibly less overvalued categories that may not have performed as well but are still likely to do considerably better in the future. Another possibility is just to become more defensive, increasing one’s allocation to cash, and possibly, bonds. A Flashback to the Past Is there a recent comparable period of time in which investors turned out to have likely mistakenly gravitated toward high-flying stocks? The last time this happened was in the fall of 2007 when, as above, virtually all stock fund categories had become overvalued. The average US stock fund had returned 17.6% over the prior year and 16.1% over the prior 5 years annualized. International stock funds had done even better, showing 26.3% and 22.6% gains over the same periods. Among the standout categories were mid and small caps, technology, communication, utilities, natural resources, and emerging markets. On the other hand, at that time, bond funds weren’t doing terribly, but not particularly well over the prior 5 years with the benchmark (NYSEARCA: AGG ) returning 4.1% annualized. But things turned around sharply over the following three years. Most of the above mentioned stock fund/ETF categories showed deeply negative 3-year returns by the fall of 2010. The AGG bond benchmark, on the other hand, returned better than 21%, or 7% annualized. The following table shows how some of the high-flying stock performers in the fall of 2007 fared over the following three years: ETF (Symbol) 9-28-07 Price 9-30-10 Price Percent Change Over 3 Years (not annualized) S&P 500 ETF 140.61 105.06 -25% Mid-Cap ETF 79.64 66.30 -17 Small-Cap ETF 72.63 63.51 -13 Total International Stock ETF 20.67 14.95 -28 Information Technology ETF 60.68 55.59 -8 Telecommun Serv ETF (NYSEARCA: VOX ) 83.09 62.72 -25 Utilities ETF (NYSEARCA: VPU ) 83.02 66.36 -20 Materials ETF (Natural Resources) 88.05 70.92 -19 FTSE Emerging Markets ETF (NYSEARCA: VWO ) 103.80 45.35 -56 Now, here’s how two Vanguard bond funds and its main money market fund did over the same 3 year period: ETF/Fund (Symbol) 9-28-07 Price 9-30-10 Price Percent Change Over 3 Years (not annualized) Total Bond Market ETF 75.44 82.56 +9% Interm-Term Tax-Exempt 13.19 13.89 +5 Prime Money Market Fund (MUTF: VMMXX ) 1.00 1.00 +5 Note: Return for the money market fund was 1.5% annualized, or approximately 5% non-annualized over the period. Final Thoughts While history unlikely ever exactly repeats itself, and 2007 through 2010 was undoubtedly different than 2014 through 2016 and beyond will be, investors should be on guard against certain similarities. Evidence suggests that once stocks get “ahead of themselves” for too long, returns tend to be subdued, if not outright negative, for a number of years going forward. Research I have conducted suggests that making “contrary-to-the-prevailing-sentiment” decisions based on extreme overvalued (or, for that matter, undervalued) conditions may appear wrong-headed and wrong-footed over the short term. However, over periods of at least three years, these decisions likely will come out ahead of sticking with what the majority of investors opt for as their current favorite choices which are often based heavily on current conditions, relatively devoid of overvaluation considerations.

AGG: A Solid Bond Fund Offering Low Expenses And Diversification

Summary The expense ratio on AGG is one of the drawing factors for this fund. At .08% it is one of the cheapest bond funds in the market. The fund has extensive diversification in the maturity of the bonds which provides more diversification in the risk. The credit ratings are fairly high with a significant allocation to treasury securities. Allocation to MBS does not thrill me since mREITs are available at material discounts to book value, but the low expense ratio still helps the expected return. Overall, there is more to like about this fund than to dislike. The major risk factor facing the fund is rising domestic rates. The iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ) is a highly diversified bond fund with a reasonable yield, great expense ratio, and great liquidity. Expenses When I’m looking for a bond ETF, I normally want to see diversification in the holdings. The only real exception would be if I’m looking for treasuries with a fairly steady maturity date. Getting any thorough due diligence on the bonds in a fund can require having a higher expense ratio to cover the costs of doing research. The challenge for a bond fund with a high expense ratio to create solid returns is that it requires them to be doing sufficient research to consistently produce superior default estimates to those available in the market or to have a method for acquiring bonds at a discount by dealing in illiquid bonds where counterparties are more difficult to find. Some funds are able to offer low expense ratios and mitigate their risks by strictly dealing in the most liquid bonds where pricing is most likely to be efficient and relying on the market to ensure that the risk/return profile is appropriate. Generally I favor ETFs that have low expense ratios and strictly deal in highly liquid bonds where the pricing will be more efficient. The expense ratio for AGG is a .08%. This is one of the funds falls into my desired strategy of using highly liquid securities and a very low expense ratio to rely on the efficient market to assist in creating fair values for the bonds. Yield The yield is 2.41%. The desire for a higher yield should be fairly easy for investors to understand. Bond funds that offer a higher yield are offering more income to the investor. Unfortunately, returns are generally compensating for risk so higher yield funds will usually require an investor either take on duration risk or credit risk. In many situations, an investor will take on a mix of the two. Junk bond funds generally carry a high degree of credit risk but low duration risk while longer duration AAA corporate funds have only slight to moderate credit risk combined with a significant amount of duration risk. Theoretically treasuries have zero credit risk and long duration treasuries would have their risk solely based on the interest rate risk. Duration The following chart demonstrates the sector exposure for this bond fund: At the present time I’m concerned about taking on duration risk in early December because of the pending FOMC (Federal Open Market Committee) meeting. I believe it is more likely than not that we will see the first rate hike in December. I think a substantial portion of that probability has already been priced into bonds, so investors willing to take the risk prior to the meeting could see significant gains if the Federal Reserve does not act. Even though most of the impact is priced in, I suspect it will happen and that there will be some impact on rates which may trigger a solid opportunity for starting investments in bonds. I’ll be looking to increase my positions in interest sensitive assets if rates move higher. I’ve been focused on bond funds that are free to trade for me or have a longer duration exposure to corporate debt, but AGG is a pretty solid option for investors looking to add bonds in December. Credit Risk The following chart demonstrates the credit exposure for this bond fund: The exceptionally high rating to triple AAA stocks includes positions in treasury securities. The very high credit rating of this fund is excellent for investors looking for something that can withstand a sharp decline in the equity market. Rather than declining with equity markets this bond fund should see strength in share prices when investors are scared about the risk of higher defaults and weaker equity performance. When things look ugly, this fund should perform well. When things look great, this fund should underperform some of the riskier options. Sectors The following chart demonstrates the sector exposure for this bond fund: I have some concerns about the sector allocation including a substantial allocation to MBS Pass-Through securities. There are several mREITs where investors can get MBS exposure at a substantial discount to book value. On the other hand, that exposure also includes exposure to hedging the portfolio with Eurodollar Futures contracts in most scenarios and the expenses of management for an mREIT will dramatically exceed the .08% expense ratio of holding AGG. Conclusion Overall the diversification here is pretty solid and I don’t see much to complain about. This is one of the largest bond funds on the market and it offers great liquidity, a decent but not incredible yield, and a very low expense ratio. That liquidity extends to the point of millions of shares trading in a single day. That keeps the bid-ask spread small and makes trading in and out the ETF much easier for investors that want to use it to stabilize their portfolio value.

Why I Still Like DoubleLine Total Return As A Core Bond Holding

Summary Certain bond funds, and fund managers, have proven to be successful navigators in the complex environment of security selection, duration, and risk management. I am a staunch advocate of ETFs and believe that they are one of the best tools in an investors’ arsenal. However, you simply can’t find this unique bond strategy in an ETF at this time, which is why we have continued to stick with the marginally more expensive mutual fund. Long time readers of our blog know that we are proponents of active management in the fixed-income world . Certain funds, and fund managers, have proven to be successful navigators in the complex environment of security selection, duration, and risk management. For that reason, we continue to recommend to our clients that they step outside the confines of a benchmark index to seek greater returns or reduced volatility as a result of interest rate fluctuations. One long-term core holding in our Strategic Income portfolio has been the DoubleLine Total Return Bond Fund (MUTF: DBLTX ). This actively managed mutual fund is governed by Jeffrey Gundlach, who has risen to fame as one of the premiere fixed-income experts in the world. DBLTX invests more than 50% of its portfolio in mortgage-backed securities, but can also hold assets like Treasuries, corporate bonds, and cash when needed. Over the last year, Gundlach and his team have added a significant measure of alpha over a diversified bond index such as the iShares Core U.S. Aggregate Bond ETF (NYSEARCA: AGG ). For an accurate comparison, I have also over laid a sector-specific mortgage index in the iShares MBS ETF (NYSEARCA: MBB ) as well. DBLTX has returned nearly double the gains of AGG and has also significantly outperformed the dedicated mortgage index over the last 52-weeks. If we widen the time frame to 3 years, you can see how substantial this performance gap has become. I am a staunch advocate of ETFs and believe that they are one of the best tools in an investors’ arsenal. However, you simply can’t find this unique bond strategy in an ETF at this time, which is why we have continued to stick with the marginally more expensive mutual fund strategy . The manager has earned that higher fee through superior performance, which is just what you want to see when you are paying a premium versus cheaper passively managed indexes. Now the question becomes – how much more juice can a fund like DBLTX squeeze out in relative performance versus its benchmark moving forward? It’s important to remember that DBLTX is not a “go anywhere, do anything” strategy. It’s going to behave like a bond fund, not like a stock fund or alternative investment strategy. The manager has guidelines that allow a certain degree of flexibility, but it is ultimately going to be directed by the interest rate and credit environment in any given year. While the timing is difficult to ascertain, there will almost certainly be periods of sharply rising interest rates on the horizon. I believe that this is where the managers of active mutual funds such as DBLTX can add the most value versus passive indexes. Treasury and investment grade-heavy benchmarks with intermediate term durations are going to underperform in a rising rate environment. The longer the duration or higher quality the bonds, the greater volatility that index will endure. However, an actively managed fund that can lower its duration and adjust its holdings to coincide with pockets of value or momentum will likely continue to earn its keep and outpace the competition. The Bottom Line Doubleline has been in the right places at the right times over the last several years. However, that doesn’t make them infallible to an incorrect call on interest rates or underperformance as bond market trends change. As with any active strategy, it’s important to regularly monitor the fund’s performance versus its peer group and benchmark to ascertain that they are achieving returns in line with your goals and realistic expectations.