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Un-Expectedly High Expected Return Of Global Equities

It seems just about everyone I talk to these days is underwhelmed by the long-term expected return of the global stock market. I too am more worried than normal about owning equities. However, my defensiveness arises from their negative momentum, not their valuation, which I see as surprisingly attractive. The valuation picture is blurred by the dramatic divergence between US and non-US equities. For the past four and half years, the US equity market has outpaced non-US equities by more than 10% a year. After that relative outperformance, US equities do appear overvalued, but the attractive valuation of non-US markets more than compensates in a global portfolio. The table below shows the cyclically adjusted earnings yields (using the past 10 years of earnings) of each regional equity market. The Baseline regional weights I’m using fall in between the weights published by MSCI and those calculated by Bloomberg using their WCAP function. 1 Click to enlarge The earnings yield of the global equity market is 6.6%. To get to an estimate of the long-term expected real return, I assume that 60% of earnings can be paid out in dividends (besides sounding like a reasonable assumption, it also happens to be the average payout ratio from 1915 to 2015 in the US), which will grow at about 1.5% above inflation in the long term. Many observers prefer the even simpler estimate of just using the earnings yield itself, which is 6.6%, but I prefer basing the estimate on cash flow to investors, which is generally more conservative. This results in 5.5% for the long-term expected real return for global equities (6.6% * 0.6 + 1.5%). 2 So how attractive is a 5.5% expected return above inflation? Here are four perspectives to consider: US equities returned 5.4% after inflation in the 50 years from 1965 to 2015, which many people view as having been a good time to be an equity investor (although not nearly as good as the 8.2% from 1915 to 1965). The chart below shows that 5.5% is well above the average expected return of 4.5%. It is in the top decile of expected returns calculated this way since 1985, a period of time longer than the careers of 80% of the people currently employed in the finance industry. 3 By contrast, other assets, such as fixed income and real estate, are currently offering low expected real returns in the bottom decile of expected returns over the past 30 years. It is difficult to come up with a simple prospective measure of expected real returns for alternatives such as hedge funds, but they certainly have been struggling recently to generate the attractive returns they produced in the ’80s and ’90s. Caution: Equities can get a lot cheaper, quickly. Just a month ago, global equities were more than 10% lower than they are now, in case we need any reminder. While 5.5% appears attractive as a long-term expected real return, we need to keep in mind that we may see much higher expected returns than that in the future. Bottom line: Global equities are pretty attractively valued, and when they enter a period of positive momentum, we’ll probably see very healthy returns. Click to enlarge Footnotes: MSCI bases its weights on strict investible market cap data while Bloomberg bases theirs on unrestricted market cap. The Baseline weights used here go beyond market cap, using other economically relevant data to compute weights. See this note for details, and here for a further comparison of weighting schemes. Based on the belief that earnings and dividends will grow at less than the rate of real GDP growth due to various slippages. For a more detailed discussion, watch this video , and read this short note . Furthermore, if we think of this as the central case in the return distribution, and if we believe the long-term return is distributed relative symmetrically around this value, then there is a convexity adjustment that makes investing in equities even more attractive. A back-of-the-envelope illustration is to note that if we thought there were two equally likely long-term (say 30 year) outcomes for the real return, of say 5.5% + 2% and 5.5% – 2%, we would see that the return associated with the expected value of equities would be 6.02%, or 0.52% higher than the 5.5% base case. From US BLS data, here . 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.

Can You Trust A Roboadvisor With Your Money?

The definition of robo-advisor still isn’t fully set in stone, but roughly speaking it’s a software tool which manages your portfolio and gives financial advice and action items without the need to consult (often) an outside human advisor. Because there are so many Americans with similar financial goals, responsibilities and amounts saved it makes sense to offload some of the advisor burden onto an algorithm; unlike in business, often the best move with your finances is just to do exactly what others are doing and have done before. Can You Trust a Roboadvisor? Survey Says… Gallup set out to answer that very question, asking Americans if they would want a single human financial advisor, a roboadvisor, a combination of the two, access to on-call financial advisors… or other/none/not sure. The plurality went to the human advisors: 49% saying they wanted the individual attention of a single advisor, and 18% opted for the stable of on-call advisors. There was a follow-up question as well which really underscored how wary of roboadvisors we still are: 62% of respondents wanted only human help or a majority of human help, while 27% preferred to trust a roboadvisor with a majority of decisions… with humans on call. Only 9% of respondents wanted only digital advice… surely an important datapoint for the large number of Financial Technology companies currently targeting the space! Robots Don’t Have Good Bedside Manner The survey is worth reading in full, but it leads us to bring up a lot of interesting, recurring themes with human experience and automation. Although we’re warming up… at least in part… to the idea of some of our financial advice and investing tips coming from an algorithm, humans still prefer the emotional check of another human to the cold, calculating rationality of a machine. Can you Trust a Roboadvisor? “Take me to your bank account routing number!” (And this comes up over and over again in various fields!) We alluded to the bedside manner of doctors in this section’s heading, which has long been an important field of study , and can certainly help patient outcome . It came up in elevators – where humans resisted user-operated elevators when elevator operators once were supreme – which has echoes today in state laws and policy. And, perhaps at the forefront of public discussion – it comes up in automated cars (ironically, automated automobiles ), where the safety record of robot-operated vehicles is superb compared to our fallible human peers. Perhaps, like so many other things in life, our reluctance to trust a robo-advisor comes at least in part because of psychology. There is a concept where things that look real but not exactly real (a concept known as the uncanny valley ) cause the greatest reactions of disgust amongst humans (So, FinTech… careful about how friendly you make your robo-advisors). A psychological explanation might mean we are wary of robo-advisors for the same reason we’re wary of zombies – we don’t want something to try to be human, we want there to be some human with responsibility at the end of the day. (Even if we lose a few basis points with the human.) What Benefits Will Come if We Trust our Roboadvisors? There are many great theoretical effects that would come to us if we can convince enough of our peers to trust a robo-advisor. First, the cost benefit is incredible . Like all software, the marginal cost of spinning up another instance of a roboadvisor is just-about non-existant. Just as the marginal cost of you reading this webpage is immeasurable (we serve up 100s of thousands of pageviews a month for < $10), automating common financial advice could go a long way to expanding access for those in most need of help. In other words, it can go a long way towards solving that paradox of financial advice – often those who need it the most are the least able to pay. Second, it can automate a lot of the incredible value-adds that are tough to do today. Tax-loss harvesting is the first thing that comes to mind. If you’re unfamiliar, the IRS allows you to write down your income when you sell stocks at a loss, so long as you don’t buy the exact (or substantially similar) asset within a fixed time frame. It’s incredibly tedious work to always be shifting in and out of funds to capture tax benefits and computing the breakeven for when it is worth making the switch – not to mention the reporting requirements for your tax returns. On top of tax-loss harvesting, robo-advisors and algorithmic management can help you find opportunities in account types, tracking eligibility to the dollar in real time as you earn throughout the year. It can help recognize shortfalls and surpluses in checking accounts, automatically moving money to long term savings. With a little advancement, it can even help you plan purchases – finding the best combination of savings vehicle, and maybe even one day the best rewards when you go to pay for whatever you are buying. And that’s just off the top of my head. Surely you can think of some more. Third, it opens up the best financial advisors to more people. Humans are always going to be better at the human element, no matter how much we end up trusting our robo-advisors. However, a move to majority automatic financial advice would mean our best advisors would have more throughput and be able to see more ‘patients’ – either for periodic checks on a long term plan, or to address those corner cases which software wasn’t built to handle. What Will We See Next? Just like the aforementioned driverless cars, expect to see a lot more innovation in the robo-advisor field. As people appear to not mind at least some of their advice coming automatically, expect to see a lot of financial technology firms moving to advisor-guided robo-advisement sessions, or more human staff on call while people have their robo-advisement sessions. The future is undoubtedly bright in the field, and the momentum towards automation is clearly there. Clearly we’re going to see big changes – even innovation that we had no idea was possible or probable – before too long. The only thing we know for certain is that big changes are coming… and people will probably become more and more comfortable with the offerings out there. So, dear reader – could you trust a roboadvisor with your money today? What would it take for you to give a robot control – or at least allow it to guide you? What do you think we’ll see in the next few years?

Learn Why Traders Love Utilities ETFs

By Jonathan Jones and Tom Lydon The Utilities Select Sector SPDR (NYSEArca: XLU ) , the largest utilities exchange traded fund, is up nearly 14% year-to-date, by far the best performance among the sector SPDR ETFs, and more upside could be coming for utilities stocks and ETFs, reports ETF Trends . Utilities sector fundamentals remain strong. However, utilities have been underforming due to the sector’s inverse relationship to rising interest rates – when rates rise or investors fear higher rates, utilities typically underpeform, and vice versa. Most investors view utilities as a reliable, income-generating asset that exhibit some bond-like characteristics. As interest rates declined, the sector appealed to many income investors for its relatively higher yields. ETFs like XLU got a boost this week when the Federal Reserve opted to not raise interest rates. Further buoying interest rate-sensitive sectors such as utilities is the notion that the Fed will only be able to raise rates twice this year. “Big utility stocks trade at an average of 17 to 18 times projected 2016 earnings, which isn’t cheap considering annual industry earnings growth is generally in the low- to mid-single-digit range. The sector now trades at a premium to the S&P 500, which fetches about 16 times estimated 2016 operating earnings. The utilities ETF (TICKER: ) yields 3.8%, compared with 2.2% for the S&P,” according to Barron’s . Some investors see opportunity with rate-sensitive assets such as XLU and real estate ETFs, noting that 10-year yields are overbought and sentiment against the likes of XLU is at bearish extremes, which could create opportunity from the long side with the utilities sector. Looking at XLU’s chart “you can see that the horizontal trendline near $45 has acted as a very influential level of support and resistance over the past 1.5 years. The breakout (shown by the blue circle) and the subsequent retest of the trendline and its 50-day moving average are technical signals that suggest that the bulls are in control of the momentum and that prices could be headed higher. Most active traders will likely look to enter a position as close to the trendline as possible to maximize the risk/reward of the trade. From a risk management perspective, technical traders will likely set their stop-loss orders below the horizontal trendline or the 200-day moving average ($43.23) depending on risk tolerance,” according to Investopedia . Defensive sectors, such as consumer staples, telecom and utilities, often trade at multiples that are richer than the broader market. That is the price to pay to play defense. Utilities Select Sector SPDR Click to enlarge 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.