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Season Of The Glitch

When I look over my shoulder What do you think I see? Some other cat lookin’ over His shoulder at me. – Donovan, “Season of the Witch” (1966) Josh Leonard: I see why you like this video camera so much. Heather Donahue: You do? Josh Leonard: It’s not quite reality. It’s like a totally filtered reality. It’s like you can pretend everything’s not quite the way it is. – “The Blair Witch Project” (1999) Over the past two months, more than 90 Wall Street Journal articles have used the word “glitch”. A few choice selections below: Bank of New York Mellon Corp.’s chief executive warned clients that his firm wouldn’t be able to solve all pricing problems caused by a computer glitch before markets open Monday. – “BNY Mellon Races to Fix Pricing Glitches Before Markets Open Monday”, August 30, 2015 A computer glitch is preventing hundreds of mutual and exchange-traded funds from providing investors with the values of their holdings, complicating trading in some of the most widely held investments. – “A New Computer Glitch is Rocking the Mutual Fund Industry”, August 26, 2015 Bank says data loss was due to software glitch. – “Deutsche Bank Didn’t Archive Chats Used by Some Employees Tied to Libor Probe”, July 30, 2015 NYSE explanation confirms software glitch as cause, following initial fears of a cyberattack. – “NYSE Says Wednesday Outage Caused by Software Update”, July 10, 2015 Some TD Ameritrade Holding Corp. customers experienced delays in placing orders Friday morning due to a software glitch, the brokerage said.. – “TD Ameritrade Experienced Order Routing, Messaging Problems”, July 10, 2015 Thousands of investors with stop-loss orders on their ETFs saw those positions crushed in the first 30 minutes of trading last Monday, August 24th. Seeing a price blow right through your stop is perhaps the worst experience in all of investing because it seems like such a betrayal. “Hey, isn’t this what a smart investor is supposed to do? What do you mean there was no liquidity at my stop? What do you mean I got filled $5 below my stop? Wait… now the price is back above my stop! Is this for real?” Welcome to the Big Leagues of Investing Pain. What happened last Monday morning, when Apple was down 11% and the VIX couldn’t be priced and the CNBC anchors looked like they were going to vomit, was not a glitch. Yes, a flawed SunGard pricing platform was part of the proximate cause, but the structural problem here- and the reason this sort of dislocation WILL happen again, soon and more severely- is that a vast crowd of market participants- let’s call them Investors- are making a classic mistake. It’s what a statistics professor would call a “category error”, and it’s a heartbreaker. Moreover, there’s a slightly less vast crowd of market participants- let’s call them Market Makers and The Sell Side- who are only too happy to perpetuate and encourage this category error. Not for nothing, but Virtu and Volant and other HFT “liquidity providers” had their most profitable day last Monday since… well, since the Flash Crash of 2010. So if you’re a Market Maker or you’re on The Sell Side or you’re one of their media apologists, you call last week’s price dislocations a “glitch” and misdirect everyone’s attention to total red herrings like supposed forced liquidations of risk parity strategies. Wash, rinse, repeat. The category error made by most Investors today, from your retired father-in-law to the largest sovereign wealth fund, is to confuse an allocation for an investment. If you treat an allocation like an investment… if you think about buying and selling an ETF in the same way that you think about buying and selling stock in a real-life company with real-life cash flows… you’re making the same mistake that currency traders made earlier this year with the Swiss Franc (read “ Ghost in the Machine ” for more). You’re making a category error, and one day- maybe last Monday or maybe next Monday- that mistake will come back to haunt you. The simple fact is that there’s precious little investing in markets today- understood as buying a fractional ownership position in the real-life cash flows of a real-life company- a casualty of policy-driven markets where real-life fundamentals mean next to nothing for market returns. Instead, it’s all portfolio positioning, all allocation, all the time. But most Investors still maintain the pleasant illusion that what they’re doing is some form of stock-picking, some form of their traditional understanding of what it means to be an Investor. It’s the story they tell themselves and each other to get through the day, and the people who hold the media cameras and microphones are only too happy to perpetuate this particular form of filtered reality. Now there’s absolutely nothing wrong with allocating rather than investing. In fact, as my partners Lee Partridge and Rusty Guinn never tire of saying, smart allocation is going to be responsible for the vast majority of public market portfolio returns over time for almost all investors. But that’s not the mythology that exists around markets. You don’t read Barron’s profiles about Great Allocators. No, you read about Great Investors, heroically making their stock-picking way in a sea of troubles. It’s 99% stochastics and probability distributions – really, it is – but since when did that make a myth less influential? So we gladly pay outrageous fees to the Great Investors who walk among us, even if most of us will never enjoy the outsized returns that won their reputations. So we search and search for the next Great Investor, even if the number of Great Investors in the world is exactly what enough random rolls of the dice would produce with Ordinary Investors. So we all aspire to be Great Investors, even if almost all of what we do- like buying an ETF- is allocating rather than investing. The key letter in an ETF is the F. It’s a Fund, with exactly the same meaning of the word as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your overall portfolio, not a fractional piece of an asset that you want to directly own. Yes, unlike a mutual fund you CAN buy and sell an ETF just like a single name stock, but that doesn’t mean you SHOULD. Like so many things in our modern world, the exchange traded nature of the ETF is a benefit for the few (Market Makers and The Sell Side) that has been sold falsely as a benefit for the many (Investors). It’s not a benefit for Investors. On the contrary, it’s a detriment. Investors who would never in a million years consider trading in and out of a mutual fund do it all the time with an exchange traded fund, and as a result their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug. What we saw last Monday morning was a specific manifestation of the behavioral fallacy of a category error, one that cost a lot of Investors a lot of money. Investors routinely put stop-loss orders on their ETFs. Why? Because… you know, this is what Great Investors do. They let their winners run and they limit their losses. Everyone knows this. It’s part of our accepted mythology, the Common Knowledge of investing. But here’s the truth. If you’re an Investor with a capital I (as opposed to a Trader with a capital T), there’s no good reason to put a stop-loss on an ETF or any other allocation instrument. I know. Crazy. And I’m sure I’ll get 100 irate unsubscribe notices from true-believing Investors for this heresy. So be it. Think of it this way… what is the meaning of an allocation? Answer: it’s a return stream with a certain set of qualities that for whatever reason – maybe diversification, maybe sheer greed, maybe something else – you believe that your portfolio should possess. Now ask yourself this: what does price have to do with this meaning of an allocation? Answer: very little, at least in and of itself. Are those return stream qualities that you prize in your portfolio significantly altered just because the per-share price of a representation of this return stream is now just below some arbitrary price line that you set? Of course not. More generally, those return stream qualities can only be understood… should only be understood… in the context of what else is in your portfolio. I’m not saying that the price of this desired return stream means nothing. I’m saying that it means nothing in and of itself. An allocation has contingent meaning, not absolute meaning, and it should be evaluated on its relative merits, including price. There’s nothing contingent about a stop-loss order. It’s entirely specific to that security… I want it at this price and I don’t want it at that price, and that’s not the right way to think about an allocation. One of my very first Epsilon Theory notes, “ The Tao of Portfolio Management ,” was on this distinction between investing (what I called stock-picking in that note) and allocation (what I called top-down portfolio construction), and the ecological fallacy that drives category errors and a whole host of other market mistakes. It wasn’t a particularly popular note then, and this note probably won’t be, either. But I think it’s one of the most important things I’ve got to say. Why do I think it’s important? Because this category error goes way beyond whether or not you put stop-loss orders on ETFs. It enshrines myopic price considerations as the end-all and be-all for portfolio allocation decisions, and it accelerates the casino-fication of modern capital markets, both of which I think are absolute tragedies. For Investors, anyway. It’s a wash for Traders… just gives them a bigger playground. And it’s the gift that keeps on giving for Market Makers and The Sell Side. Why do I think it’s important? Because there are so many Investors making this category error and they are going to continue to be, at best, scared out of their minds and, at worst, totally run over by the Traders who are dominating these casino games. This isn’t the time or the place to dive into gamma trading or volatility skew hedges or liquidity replenishment points. But let me say this. If you don’t already understand what, say, a gamma hedge is, then you have ZERO chance of successfully trading your portfolio in reaction to the daily “news”. You’re going to be whipsawed mercilessly by these Hollow Markets , especially now that the Fed and the PBOC are playing a giant game of Chicken and are no longer working in unison to pump up global asset prices . One of the best pieces of advice I ever got as an Investor was to take what the market gives you. Right now the market isn’t giving us much, at least not the sort of stock-picking opportunities that most Investors want. Or think they want. That’s okay. This, too, shall pass. Eventually. Maybe . But what’s not okay is to confuse what the market IS giving us, which is the opportunity to make long-term portfolio allocation decisions, for the sort of active trading opportunity that fits our market mythology. It’s easy to confuse the two, particularly when there are powerful interests that profit from the confusion and the mythology. Market Makers and The Sell Side want to speed us up, both in the pace of our decision making and in the securities we use to implement those decisions, and if anything goes awry … well, it must have been a glitch. In truth, it’s time to slow down, both in our process and in the nature of the securities we buy and sell. And you might want to turn off the TV while you’re at it.

EMB Offers Investors An Interesting Play On Credit Risk With Mixed Durations

Summary The portfolio for EMB is heavy on bonds that are just barely investment grade. The maturity of those bonds is heavily diversified but the one empty part of the curve is short durations. A mixed duration on the bonds allows it to have a positive correlation with medium-term treasury ETFs. Despite the positive correlation with treasuries, it also has a positive correlation with the equity markets due to the credit risk exposure. The iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) is a very interesting option for investors wanting to add some new exposures to their portfolio. There are plenty of reasons for investors to be worried, but it remains an interesting allocation for a small part of the portfolio. Expense Ratio The expense ratio on EMB is .40% which feels like it would be typical for finding exposure to a somewhat niche market like investing in the bonds of emerging markets. That would probably be a fair assessment as well. While Vanguard also runs a fund in this niche market, the Vanguard Emerging Markets Government Bond Index Fund ETF (NASDAQ: VWOB ), the expense ratio in that fund is .34%. While there is a difference in the expense ratios, the difference is not very substantial. While EMB does have a higher expense ratio, it also has more than ten times the average volume with around 1.3 million shares per day changing hands compared to a hundred thousand for VWOB. Since shares of EMB are more expensive, adjusting for the difference in price would only extend the liquidity advantage of EMB. Credit Ratings The credit ratings on bonds in the portfolio can be seen below The majority of the bonds can be considered investment grade since the heaviest position is in the BBB rated bonds. However, it should be clear that there is still a substantial weighting to investments with lower credit ratings and this portfolio should be seen as being a fairly aggressive debt investment and share prices could be hit from factors as simple as an increase in the credit spread between riskier bonds and treasury securities. Maturity The following chart shows the maturities: This portfolio is incredibly diversified in the maturity of the securities. However, since the diversification includes a very material allocation over 20 years and very little at the shortest end of the yield curve it would be wise for investors to keep in mind that they are facing both substantial credit risk and duration risk. That makes this an interesting ETF for investors trying to optimize their portfolio for low volatility. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are for higher yielding debt from emerging markets and (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting”, but there are plenty of other areas to find “excitement” in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion When EMB is measured simply on the annualized volatility it does very fairly well. However, the difficult part about having mixed duration emerging market debt is that the poor credit rating encourages the portfolio to have a positive correlation with the market. If an investor is trying to minimize volatility they may be using a position in medium or long term treasury ETFs which would create some overlap on the long duration exposure but at very different credit ratings. Simply put, EMB manages to have positive correlation with both the market and with the treasury securities that have a negative correlation with the market. I like this bond space, however due to the strange situation with the correlations I would lean toward using it as a small portion of the portfolio. In this example I used it at 10%, but I suspect that 5% might be a more reasonable way to allocate it into the portfolio. Overall, you could say I find more things to like than dislike, but I would still limit the size of the exposure. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

Value Investors: The Best Valuation Ratio May Not Be What You Think

The relevancy of 6 valuation ratios is evaluated in the S&P 500 universe on a 17-year period. The idea is to measure the performance of the 20% of stocks with the lowest price-to-something. Such filters may improve the total return, but sometimes degrade the risk-adjusted performance. Many seasoned investors use valuation fundamental factors as filters before going further in stock analysis. The most popular factor is certainly the Price/Earnings ratio. This article evaluates the relevancy of 6 valuation ratios available in most financial websites and in good stock screeners. The methodology is to compare the historical performance of the 20% stocks in the S&P 500 universe with the lowest valuation ratios. In every case, it is a set of 100 stocks, updated and rebalanced in equal weight every week to take into account the latest earnings reports, companies entering and exiting the index, M/A and liquidations. The period of comparison covers 2 market cycles: 1/2/1999 to 9/2/2015. SPY is usually taken as a benchmark for the S&P 500 universe, but for this study it is more accurate to take all S&P 500 companies in equal weight and rebalanced weekly, as for the 20% sets. For all the following simulations, dividends are accounted and reinvested. All S&P 500 stocks, equal-weighted rebalanced on weekly opening: (click to enlarge) This index returned 325% on the period, almost tripling SPY’s total return and doubling its annualized return. The excess return of our benchmark over capital-weighted SPY has two reasons: Size effect: lower-range large caps usually perform better than mega-caps. Weekly rebalancing: rebalancing frequently a big set of stocks is a kind of simplistic “buy-low-sell-high” strategy. Simplistic, but not stupid. This benchmark index is impossible to implement as a strategy for an individual investor because of the capital needed to absorb transaction costs. Moreover, there is an ETF for that: the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA: RSP ). Since inception on 4/24/2003, it has an annualized excess return of 2.1% over SPY, making it a better instrument of passive index investing. On the same period, the annualized excess return of my benchmark index is 3.5%. The difference can be explained by trading costs, management fees, rebalancing frequencies. Now that the benchmark is defined, it’s time to examine the “best 20%” sets, ratio by ratio. 20% S&P 500 companies with the lowest P/E: (click to enlarge) 20% S&P 500 companies with the lowest Forward P/E: (click to enlarge) 20% S&P 500 companies with the lowest PEG: (click to enlarge) 20% S&P 500 companies with the lowest Price to Sales: (click to enlarge) 20% S&P 500 companies with the lowest Price to Book: (click to enlarge) 20% S&P 500 companies with the lowest Price to Free Cash Flow: (click to enlarge) Summary: Annualized Return % Max Drawdown % Benchmark 9.08 -59.29 20% lowest P/E 11.77 -64.14 20% lowest forward P/E 12.82 -69.43 20% lowest PEG 9.90 -63.63 20% lowest Price to Sales 11.94 -68.43 20% lowest Price to Book 9.12 -76.98 20% lowest Price to FCF 14.03 -67.65 Interpretation : Filtering the 20% lowest valuations using any ratio increases the return, but also the downward risk. The Price to Free Cash Flow gives the highest excess return and risk-adjusted performance (Sharpe and Sortino ratios). P/E, Forward P/E and Price to Sales also increase significantly the return and risk-adjusted performance. The Price to Book, used by a lot of investors to limit the downward risk, unexpectedly gives the highest downward risk when used alone. The excess return given by the Price-to-Book and PEG ratios, used alone, is very weak. For both of them, the Sharpe ratio is inferior to the benchmark. It doesn’t mean that PEG and Price to Book are bad ratios, just that they don’t work very well alone on the broad market. They may be more useful in combination with other factors, and they are more relevant in specific sectors like energy (this assumption is not justified here, maybe in a future article – some statistical evidence is in my book “The Lazy Fundamental Analyst”). The purpose of this article is not only to show the most useful valuation factors, but also to justify my choice of using the best 4 in my next series of articles. In this series I plan to give a valuation score of every sector in the GICS classification relative to its historical averages, and update it every month. I may also go deeper at the industry level in some cases. This series aims at improving the dashboard of investors who want a top-down vision of the S&P 500 universe and the stock market in general. If you are interested in the idea, you can click on the “follow” link at the top of the article, then tell me in a comment what you think and which other information specific to every sector’s fundamental status you would like to read in this series. Data and charts: portfolio123 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I short the S&P 500 index for hedging purposes