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SCHX: Low Fees Just Got Lower And The Portfolio Is Still Great

Summary SCHX is a leader among low fee ETFs. This balanced portfolio works great as a core holding. The fund holds most of the major companies in the domestic market, so diversification should focus on bonds, international exposure, and REITs. One of my favorite funds that is not currently in my portfolio is the U.S. Large-Cap ETF (NYSEARCA: SCHX ). This fund offers investors exposure to the domestic equity market and has a rock bottom exposure of .04%. Or at least, I used to think .04% was the lowest investors would find on domestic equity. It turns out Schwab is in a pricing battle with BlackRock’s (NYSE: BLK ) iShares products and will be lowering the expense ratio from .04% to .03%. What does SCHX do? SCHX attempts to track the total return of the Dow Jones U.S. Large-Cap Total Stock Market Index. At least 90% of funds are invested in companies that are part of the index. SCHX falls under the category of “Large Blend.” Largest Holdings The portfolio has solid diversification. The SPDR S&P 500 Trust ETF ( SPY) is holding a very similar portfolio but with a slightly larger allocation to the top companies, such as 3.55% in Apple (NASDAQ: AAPL ). However, the additional diversification for SCHX can be partially set off by some of the companies near the top being less volatile or by the ETF having less trading volume. (click to enlarge) Perhaps the question should be why investors would choose options with higher expense ratios when the holdings in SCHX make so much sense. The huge holdings here are established dividend growth champions, which the exception of AAPL and Facebook (NASDAQ: FB ), however I suspect that within 10 years those companies will have a very solid history of raising their dividends. Sector The one thing that concerns me about the way the fund is set up is the relatively light weights given to utilities and to consumer staples. I feel that makes this portfolio a little more aggressive than I prefer to be with the core of my portfolio. (click to enlarge) The reason these sectors are so appealing to me has everything to do with where we are in the macroeconomic sector. We’ve been in a prolonged bull market for quite a while and the valuations have started to get fairly rich. The Federal Reserve has given clear signs that they are desperate to raise rates, but I don’t foresee them being able to raise rates more than once or twice because the international rates are so low. If the Federal Reserve does manage to raise rates, I would be concerned about it creating headwinds for the domestic equity market and the possibility of establishing a new recession. To guard against that risk without having to sell out of the market, I prefer to increase the allocation to the more defensive sectors. Utilities benefit from functioning as regulated monopolies which allows them to expect to earn a fairly steady rate of return. Their prices do move up and down with bonds which would make higher bond yields suggest that utility prices might go down, but the utilities also offer dividend yields that are often superior to the bond yields and they benefit from increasing dividends in most years. That creates a very compelling risk/reward proposition and gives investors a solid reason to favor adding a utility allocation to their portfolio when using SCHX as the core. Consumer staples benefits from having established positions and selling products that consumers buy in good times and bad times. For instance, the tobacco industry has been a great source of returns for the consumer staples sector and continues to create sales regardless of what is happening in the market. My estimates on reasonable allocations for consumer staples and utilities for a highly risk-averse investor would be running as high as 40% of the domestic equity position. Since these sectors only give us 9.1% and 3.0%, that would require investors to specifically add exposure to the portfolio. Meanwhile they could use a fund like SCHX for another 40% of the domestic equity allocation. I would want the remaining 20% of the domestic position for REITs. Investors looking for an easy way to invest in the consumer staples sector may want to consider the Vanguard Consumer Staples ETF (NYSEARCA: VDC ) as a solid partner for working with SCHX in a portfolio. For utilities, I would suggest the Vanguard Utilities ETF (NYSEARCA: VPU ). Conclusion SCHX is a very strong contender to be a core holding in the new portfolio. I wanted a replacement for SPY that I would be able to trade without commissions. Of course, I also wanted to see a lower expense ratio, and SCHX delivered that. I like the idea of combining a large cap fund like this with domestic positions in consumer staples and utilities to create a more defensive weighting since the market has been in a prolonged bull period and the price/earnings ratios have become fairly rich. Prices have dipped back down since late summer, but now investors are facing the possibility of weaker earnings in 2016 which could offset the reduction in price.

Worry, Worry, What? More Worry?

Summary Once again, stock prices seem headed down. How far? How long? Why? A competent answer to these questions calls for perspective as to where we are now, and where we have been, both recently and at prior extremes. Who can provide that perspective of the past? Our best candidate(s) are folks who bet big money, frequently and constantly, on the near future. Who can answer the questions of the future? Our best suggestion is: “No one, definitively, because surrounding circumstances keep changing.”. But continual monitoring of the near future prospects compared to similar data at prior extremes may be a help. Folks who bet big money constantly on future stock prices They are the market-making [MM] community, acting in the opportunity for their own profit by servicing the intentions of clients managing billion-$ equity investment portfolios. What makes that community different from their clients, besides their forecast time horizon, is that as a group they bet directly against one another at the present moment, and the market for that activity presents useful expectations information. The clients, meanwhile are making bets against one another, but with ill-defined forecast time horizons, in markets not addressed to anything but immediate price discovery – that price which will provide a supply~demand clearing transaction of the moment. One that will simply queue up the next transaction challenge immediately following. Expectations of the transactors are not revealed except as to their preference for cash in comparison to the transaction subject. Where the transactors’ cash has come from, or is going to is an un-answered question. The lack of an answer prevents any further analysis or clues from this line of pursuit. In contrast, it is almost perfectly known where the market-makers cash has come from and is going back to. It is from their own capital (and funding) resources, to be used in providing market liquidity time and again, as the opportunity for them to profit presents itself. It needs to be kept liquid, as unencumbered as possible so it repeatedly can be put to work. Market liquidity is provided both by the MM firms’ block trade desks temporarily positioning (owning, net long or short) the momentary imbalance between buyers and sellers, and by other MM speculators (proprietary trading desks) willing to protect the MM positioners by selling them price-change protection insurance in a hedging deal. The cost of the price-change protection is a market-liquidity cost that is borne by the MM client-fund stock transactors. It is wrapped into in the bid-offer spread required by the to-be-consummated block trade. Both buyers and sellers in the negotiated transaction are impacted by their acquiescence to the transaction. The size of that cost, and the way the hedge deal is structured tells the story of what expectations the market-making community holds about what the clients are likely to do next with the subject stock. They are in communication with their clients constantly during every trading day, as they usually have been on several fronts for many years. The MMs have a pretty good idea of client intentions and action targets, despite client attempts to be obscure. The MM community augments that understanding with the instantaneous communications from a world-wide, local people-supported, 24×7 information-gathering system designed to keep them a step ahead, or at least not materially behind, the clients. We systematically translate the MM hedging actions into near-term price range forecasts. Forecasts with time horizons of the periods required to unwind the several types of derivative security contracts that may be involved in the hedge transactions, often no more than two to three months. Those price range forecasts have the great benefit of simple comparability. The extremes of the forecasts, in conjunction with the current market price, define upside and downside price change prospect limits. The balance between those, as portions of the whole range, are useful indications of near-term future price changes for each subject. Our common denominator for that we label the Range Index [RI]. The RI numeric is the percentage of that subject’s current forecast range between the current price and its lower extreme. RIs can span from over 100 (above the top future forecast) to negative numbers (below the lowest likely price forecast) although such extremes are not common. The smaller the RI, the larger is its upside proportion. For that subject a low RI implies the stock is cheaply priced at this point in time. Let’s check out to what extent there may be some forecast ability in the RI for a given security. We choose as a good example the ProShares UltraPro DOW30 (NYSEARCA: UDOW ), because as an ETF tracking the Dow Jones 30 index it is based on stocks actively being traded by major investment funds. Because the ETF is highly (3x) leveraged, its price changes through time are accentuated and easy to recognize. We will take every market day of the last 5 years, and from each starting point measure by how much UDOW’s price changed progressively, week by week, 5 market days at a time, out to nearly 4 months – 16 weeks, or 80 market days. Those results will be shown in a table with a blue central row that is the average price change trend for the ETF over the last 1261 market days – 5 years. To make comparisons easier between time periods of different lengths, all of the averages will be stated in annual compound growth rates, or CAGRs. Then to see what effect might be provided by knowing what the current-day RI was, we will exclude the likely most frequent RIs, the ones where the upside to downside price change proportions on cheaper days are between 1:1 and 2:1, and for the more expensive forecast days are 1:2. Corresponding RIs would be 33 to 50, and 50 to 66. In our table of price change calculations we will aggregate all the price changes in days with forecast RIs of 33 or lower into a row just above the blue average row. For all the days having RIs above 66 we will create a row of average price changes just below the blue average of all days. Please see Figure 1. Figure 1 (click to enlarge) By continuing this process we can fill out our table of annual rates of price changes at different levels of beginning forecast RIs from zero to one hundred, with those beyond contained in the 100:1 and 1:100 rows. Just don’t get overconfident; it’s not shooting fish in a barrel. The data of Figure 1 are averages of annual rates, meaning some are larger, some smaller, and some are even negative where the data are positive (profits), or may be positive where the data is negative. Figure 2 tells what proportion of the experiences indicated by the #BUYS column are in fact positive. For the whole 5 years’ days, that is a bit better than two of every three measures which offer a long investor the chance to make money. But a loss is taken in every third. Figure 2 (click to enlarge) Yes, the nearly half of forecast days (553 of 1258) with twice as much or more downside price change prospect (1:2 RWD:RSK) have worse odds for gain then the average, as well as negative payoffs. But far better PAYOFFS under better ODDS exist for the long-position players. That doesn’t make investing in UDOW an easy task, even with the MMs help. They’re not GOD. One troublemaker in the assignment is TIME. A great philosopher (at least) once observed: “You only have from now on.” No do-overs in most stock investing. It may be interesting, reassuring, (or scary) to study history, but we can’t go back. Do it NOW or tomorrow, or not at all. But yesterday is out. Another troublemaker was identified by the great philosopher, POGO: “We have met the enemy and he is us.” Stock investing is a more challenging game than chess, because moves by the pieces are not tightly defined. There are rules, and over time they may change some, usually well announced. But the true challenge is in trying to guess what the other side will do, and when they may do it. Each side attempts to anticipate the other, some more stridently. That, combined with time, keeps the game alive. Here is a two-year illustration of how the expectations for coming prices of UDOW by the MM community (the vertical lines) have been followed by actual market quotes (the heavy dots splitting each vertical) Figure 3 (click to enlarge) (used with permission) The colors reflect the imbalances between upside and downside price prospects in each forecast, as defined by the contemporary market quote. When current price is at or close to the bottom of the range, green is seen, and at the top, red. Caution lights appear when price is nearing the top of the range. That guidance is helpful, but not perfect. Please note the “go” signals in mid-August this year before UDOW dropped from mid-60’s to mid-40’s. Still, we perform our standard behavioral analysis on the actions of the MM community because it provides another forward-looking evidence of how significant players in this serious game evaluate not only the other investor players, but all of the fundamentals that go into their decisions and probable actions as well. And by providing a disciplined analysis of their conclusions in a wealth-maximizing portfolio setting, we have an historical background of whether and when the behavioral analysis has provided useful guidance. Here is the update of that analysis for UDOW to Monday’s close, November 16, 2015. Figure 4 (click to enlarge) (used with permission) Figure 4 provides a recalculation of MM forecasts indicating a Range Index of 26, or some three times as much upside price change prospect as price drawdown exposure. The row of data between the pictures tells that past UDOW 26 RIs, 38 0f them in the past 5 years of daily forecasts, have actually experienced worst-case price drawdowns averaging -10.3%. Of those 38, 34 or 89% of them, recovered in price over the next 32 market days sufficient to produce profits (along with the 4 losers) of +6.6%, a CAGR of +65%. Conclusion UDOW is an interesting gauge of market sentiment since its price is driven by a market index of 30 huge-cap stocks making up a part of market capitalization that cannot be ignored in market valuations. Its structured price leverage forces additional attention to the ETF, and conversely back from the ETF onto the market as a whole. No question of which is driven by the other, but they must accompany one another. The perspective UDOW provides at this point in time is that UDOW is an odds-on ETF likely to provide a capital gain at a high rate of CAGR over the next 2-3 months. The question of whether a better opportunity may soon be present is ever present, since prior experiences at present forecast levels have seen -10% further price drawdowns. In terms of unleveraged market indexes, that might be -3% to -3.5%. But there is no sign that a more serious concern is present among folks continuously and seriously addressing the matter. Save powder for a better shot, or go for a bird in hand? It’s your capital; it should be your call.

Lies, Damned Lies, Corporate ‘Earnings’ And Up Markets

Summary Corporate earnings aren’t always what they seem. The loudest headlines often give the wrong impression. We prefer to stick with oversold value, like those we suggest below…. ” The stock market is never obvious, It is designed to fool most of the people, most of the time.” – Famed market trader Jesse Livermore One thing the market volatility of 2015 has done is decimate some of our best-laid plans, like owning hedges like QID into monster earnings from the QQQ stalwarts like Amazon (NASDAQ: AMZN ), Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), Facebook (NASDAQ: FB ), Microsoft (NASDAQ: MSFT ) and Apple (NASDAQ: AAPL ). But on the good side it has also opened up some amazing opportunities, punishing brilliantly-run companies with great revenue and earnings potential just because they were in the wrong sector at a time when the markets’ primary participants wanted something other than what they offer. For the year thus far, for instance, that means New Tech / Social Media and Consumer Discretionary. So while Amazon, Google, Apple, Microsoft, Facebook et al have been on a tear, financials, utilities, most health care (particularly the high-tech biotechnology subset,) industrials, materials, consumer staples, utilities and energy are down for the year. That’s six of the original nine S&P sectors of our economy! (S&P just added two new sectors this month.) The V-shaped rally of October lifted health care to a 1.7% gain for the year, but the others are all still in the red. It’s important to recognize this because, in this too-much-data world we live in, people tend to be swayed by the biggest headlines, like the one recently on Marketwatch.com, proclaiming “Stock indexes enjoy best month since 2011” and think, “Wow, the market must really be up this year!” Not exactly. Even after October’s 8.8% rally, the S&P 500 is down 1.7% as of Friday, November 13th. For those who prefer the Blue Chips, alas, you are still down even more. I would rather see it up 2000 but, regrettably, facts are facts. This same “recency versus primacy” bias prevails in looking at individual companies’ shares, abetted by Wall Street’s desire to paint a rosy picture on the most ugly of earnings reports. They do this in two ways; first, by constantly lowering their “estimates” of earnings growth until they are certain that most companies will easily surpass expectations, and second, by ignoring massive losses as long as they are “non-recurring.” As to the first, suffice it to say that, if at the beginning of the quarter, success is measured as a 6-foot high-jump, but that is consistently lowered to a 5, then, a 4, then a 2-foot high jump, it is hardly exceptional to call it a high-jump when it requires only a simple step-over. The less transparent but equally deceptive practice is to say, “After non-recurring items, the company made a profit of x .” If the company, say, sells a money-losing division or abandons a major project, the losses incurred in so doing are considered “non-recurring” and therefore not germane to future earnings flow. Two brief examples: Johnson & Johnson (NYSE: JNJ ) is a longtime favorite of ours (we currently own it via our Tekla Healthcare fund.) The company released earnings for the 3rd quarter that most analysts gushed were a continuation of JNJ’s 4 consecutive quarters of “positive earnings surprises.” I have a problem with considering this the end-point of analyzing JNJ’s numbers. First, they once again showed less revenue this quarter. Earnings can easily be manipulated; revenue not so much. A company is either selling more of its products and services or they are not. One of the more popular ways to manipulate earnings is to buy back shares of your own stock rather than invest in R&D or customer acquisition. JNJ just announced another stock buyback going forward of up to $10 billion. This when its share price is within 10% of the highest it has ever been since the company’s founding in 1886. Second, JNJ only cleared the earnings hurdle after divesting itself of a smaller division at a loss, or as the WSJ put it, “Excluding special items, the company said it earned…” This “”excluding special items” clause also helped us decide to keep only a token amount in our family accounts of our once and future favorite, Royal Dutch Shell (NYSE: RDS.B ), which, every quarter it seems, takes a “one time” non-recurring action like $2.6 billion this past quarter to abandon its Arctic drilling exploration and another $2 billion to abandon its oil sands project in western Canada. The bottom line on these “one time” write-offs that companies take is: who knows how many other skeletons lurk in their closet for the next quarter and the quarter after that? More importantly, does it matter where the loss comes from? A loss is a loss is a loss. It means there is less money available to grow the firm going forward. In the first quarter of this year, my firm’s biggest and longest-served client died and his children have now effectively frozen the portfolio squabbling in court over who gets what. Did I say, “Oh, well, it was a non-recurring event so our real earnings to pay salaries, pay for research, etc. is untouched?” Of course not! And if you live in an older home in California and don’t have earthquake insurance and The Big One moves the remaining pieces of your home a quarter mile from its foundation, do you tell your family, “Wow! Aren’t we lucky that was a non-recurring loss?” As a result of financial chicanery I have become less trusting of corporate “earnings” over the years. The whole stock buyback house of cards may bolster earnings per share by reducing the shares outstanding – and will also keep the stock price high (a boon to the few executives in the inner circle whose bonuses are tied partly to the price of the shares) but what really matters in securities analysis? If you are looking for growth, to me that means two things: growth in top line revenues and growth in bottom line earnings, unadjusted for “impairments, special items, divestitures, the high price of the US dollar” or any other thing. Just because a company makes less money because the dollar is strong – it still makes less money . This leaves us with a conundrum. Of the companies out there that are growing real revenues and real earnings, AMZN sells for nearly 3 times sales and 894 times what are likely real earnings, GOOG at 6.5 times sales and 40 times earnings, and FB at 19 times sales and 104 times earnings. Fortunately, AAPL and MSFT are still possibilities and we have indeed begun to nibble at AAPL. But at this point, it simply doesn’t make sense to chase the high tech darlings in social media, online sales or cloud computing — with one against the grain exception. We are nibbling at stodgy old IBM, which has reinvented itself so many times over the past century that, especially at these prices, we aren’t going to count it out! If you can maintain a long-term viewpoint and avoid the emotion that inevitably accompanies volatile markets such as this one, I believe you will enjoy remarkable gains from these overlooked gems. We don’t need to chase the few already high-priced tech darlings to find hi-tech. Every sector and industry uses technology to increase its productivity and revenue. It is these innovators that use technology wisely that we are buying today – for profits tomorrow. There is high tech in industrials, materials, energy, health care and every other sector; it is seen in the ways in which productivity is enhanced and costs reduced. If we can buy stellar companies performing well in their business (but not seeing it reflected in their stock prices) at well below our assessment of their fair value, over any reasonable time frame we will do much better than we would by chasing the currently-highest-momentum Wall Street darlings that need just one mis-step to drop 31.8% in a week. [See: Netflix (NASDAQ: NFLX ) chart Aug 17 to 24…] Energy High Tech Last month I advised we were moving out of most of our RDS.B and BP (NYSE: BP ) positions to begin initial positions instead in Chevron (NYSE: CVX ), Range Resources (NYSE: RRC ) and Antero Resources (NYSE: AR ). Chevron is cutting-edge in LNG production and Range and Antero use technologies that didn’t exist a year ago to extract natural gas at lower cost than most of their peers. Yet all are held back by yet another decline in the price paid for their product. The reason? Projections are for a mild early part of winter. Somebody isn’t thinking very far ahead. We bought these 3 because we like their long term growth. Here at Lake Tahoe, we’ve just had our first snow (it’s so beautiful!) but for most of the nation, early winter temps are expected to be pretty mild – see chart below. But then… (click to enlarge) …look out below! Like I said, somebody isn’t thinking very far ahead. While we are early in our projection for the long-term recovery for natural gas, I think prices will rise short term as utilities start getting their contracts in place for January to March. You and I aren’t the only ones studying the meteorological soothsayers’ reports right about now. Buy your straw hats in the fall and, if you are a Southern, Midwest or Northern US utility, get your natural gas lined up while you can. If these projections for winter are accurate and the rig counts and drilling continue to decline, our 3 natural gas favorites will be ideal for both a short-term blip and, better still, long term profits. Materials High Tech As of last week, the Materials sector was down 8.6% for the year. We’re talking iron and steel, aluminum, chemicals, copper, and other basics of manufacturing and industrial processes. With manufacturing moribund of late, we might expect these sorts of firms to be dead in the water. But all things regress to the mean at some point. I think great companies like duPont (NYSE: DD ) and Alcoa (AA,) while some of their products have become commoditized, are always on the cutting edge of new uses for their products. Alcoa has two primary markets: automobiles and aerospace. Lighter cars, using much more aluminum, mean better gas mileage. Defense and commercial air are both in growth mode and both need what Alcoa provides. For its part, duPont is no longer just a chemicals company. Like IBM (NYSE: IBM ), DD has become expert at reinventing itself. It is now a major factor in agriculture, in biosciences and in human and animal nutrition. Not your father’s Oldsmobile, is it? Teflon, Tyvek, Lycra, Kevlar – all advanced-level materials turned into now-familiar products, all invented and/or developed by duPont. Today, while still pursuing R&D in many areas, agriculture takes center stage at DD. With more and more hungry mouths to feed in the world and less and less arable land available, crop yield becomes critical. Providing hybrid seeds that are more pest-resistant or higher-yielding from the same level of water and nutrients will provide outsize profits to those who succeed in this area. Allegheny Technologies (NYSE: ATI ) and Carpenter Technology (NYSE: CRS ) are also in the boring manufacturing and materials sector. ATI is the Big Dog in producing airframes and other components for military and commercial aircraft engines. Their titanium- and nickel-based alloys are the best in the business and offer reduced weight and greater strength for future aerospace products. If you believe, as I do, that commercial aviation and military defense are growth industries, ATI is a great way to play it without worrying about revenue per passenger and all the other “stuff” the airlines deal with. Carpenter sells to the same end customers in aviation and energy production as ATI does, but they specialize in very different components they construct from their high-value alloys and specialty metals. In fact, CRS specializes in products designed to withstand extreme heat, pressure and corrosion. The next time you fly, just imagine the pressure, weight and heat the landing gear of your aircraft must withstand; that is just one product that CRS specializes in. Real Estate High Tech Real estate? What could possibly be high tech about real estate? Glad you asked. We may take for granted that we pull out our mobile phone and are handily connected to family, friends, and business contacts across the street or around the world, but that doesn’t happen because there are mystical forces in the ether that connect our calls. No, that job falls to the nearly 200,000 cell towers that dot the globe’s landscape, without which Verizon (NYSE: VZ ), AT&T (NYSE: T ), T-Mobile (NASDAQ: TMUS ) et al would be dead in the water. You think high tech is merely the latest gee-gaw on a smartphone? I say the stealth play in mobile telephones are the biggest cell tower owners, American Tower (NYSE: AMT ), SBA Comms (NASDAQ: SBAC ) and Crown Castle Intl (NYSE: CCI ) Of these I think CCI stands head and shoulders above the rest. It’s #2 in number of locations but most heavily concentrated in US urban areas, which garner the most traffic. And it pays a 3.7% dividend to go with what I believe is excellent future growth. As long as people continue to use cell phones, the tower operators will profit. Not Forgetting Our Hedges… 2015 has thus far fulfilled our expectation from January that we have entered a more volatile phase in this aging bull market, yet we recently had our head handed to us by owning short ETFs like QID et al. What to do? We have researched a number of long/short mutual funds and ETFs. One is the global version of our highly successful (MUTF: BPRRX ). Boston Partners Global Long/Short (MUTF: BGRSX ) gives us the same quality team in the global area. Burnham Financial Long/Short (MUTF: BURFX ) focuses almost exclusively on financials. This is an area where some companies regularly disappoint and others soar. In short, if the research at BURFX is good, the profits are good. They’ve averaged 9.4% a year for 10 years. We are buying both. Disclaimer: As Registered Investment Advisors, we believe it is essential to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as “personalized” investment advice. Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded! We encourage you to do your own due diligence on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.