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Dual ETF Momentum April Update

Scott’s Investments provides a free “Dual ETF Momentum” spreadsheet, which was originally created in February 2013. The strategy was inspired by a paper written by Gary Antonacci and available on Optimal Momentum . Antonacci’s book , Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk, also details Dual Momentum as a total portfolio strategy. My Dual ETF Momentum spreadsheet is available here and the objective is to track four pairs of ETFs and provide an “Invested” signal for the ETF in each pair with the highest relative momentum. Invested signals also require positive absolute momentum, hence the term “Dual Momentum.” Relative momentum is gauged by the 12-month total returns of each ETF. The 12-month total returns of each ETF is also compared to a short-term Treasury ETF (a “cash” filter) in the form of the iShares Barclays 1-3 Treasury Bond ETF (NYSEARCA: SHY ). In order to have an “Invested” signal, the ETF with the highest relative strength must also have 12-month total return greater than the 12-month total returns of SHY. This is the absolute momentum filter, which is detailed in depth by Antonacci, and has historically helped increase risk-adjusted returns. An “average” return signal for each ETF is also available on the spreadsheet. The concept is the same as the 12-month relative momentum. However, the “average” return signal uses the average of the past 3, 6, and 12-month (“3/6/12″) total returns for each ETF. The “invested” signal is based on the ETF with the highest relative momentum for the past 3, 6 and 12 months. The ETF with the highest average relative strength must also have an average 3/6/12 total returns greater than the 3/6/12 total returns of the cash ETF. Portfolio123 was used to test a similar strategy using the same portfolios and combined momentum score (“3/6/12″). The test results were posted in the 2013 Year in Review and the January 2015 Update . Below are the four portfolios along with current signals: Return Data Provided by Finviz Click to enlarge As an added bonus, the spreadsheet also has four additional sheets using a dual momentum strategy with broker specific commission-free ETFs for TD Ameritrade, Charles Schwab, Fidelity, and Vanguard. It is important to note that each broker may have additional trade restrictions and the terms of their commission-free ETFs could change in the future. Disclosure: None

Tax Loss Harvesting And Wash Sales

Whenever you have significant losses in a taxable account, you should consider tax loss harvesting, selling those losses as a part of tax planning and then buying a placeholder security for 30 days. Capital losses can offset capital gains or can give you a capital loss which you can report on your tax return . Up to $3,000 of losses each year can be taken as a deduction to reduce ordinary income each year. Capital losses, which are not used in one year, can be carried forward indefinitely to be used in future years. The Internal Revenue Service (IRS) prohibits a taxpayer from claiming the loss on their taxes if they buy a substantially identical security within 30 days before or after the sale. Selling Apple (NASDAQ: AAPL ) stock on Monday and buying it back on Friday, for example, triggers the wash sale rules. In that case, the loss which you attempted to realize on Monday must be applied to the cost basis of the stock purchased on Friday, giving you none of the capital loss benefits. As an example, suppose you owned stock with a cost basis of $60 per share and sold it for a loss at $40 per share. The stock starts to move back up and you repurchase it too quickly at $50 per share. Instead of receiving a $20 per share realized capital loss, you would have to assume a cost basis on your new stock of $70 so that you have transferred the loss to your new purchase. Something similar happens when you purchase a stock on Monday and then try to sell an identical position for a loss on Friday. As an example, suppose you owned stock with a cost basis of $60 per share. On Monday, you purchase a similar position at a cost of $40 per share. Then the stock price rises to $50 per share. On Friday, you sell the first position for what is now a $10 per share loss. Instead of receiving a $10 per share realized capital loss, you would have to add that back to the cost basis of the stock purchased on Monday. Monday’s purchase would now have a cost basis of $50 per share and coincidentally be trading at $50 per share. The $10 unrealized gain would be negated by the $10 transferred loss from the wash sale. The computation of wash sale cost basis adjustments can be complex to follow. That being said, the stock of one company is not “substantially identical” to a stock in a different company, regardless of the two companies. However, contracts or options on a stock are considered substantially identical to the stock itself, and preferred stock which is convertible into common stock without any restrictions may also be considered substantially identical. To avoid the wash sale rules while still harvesting the gains, you could just wait the 30 days to buy the security back. However, when a position has a loss can be one of the worst times to miss being invested in it. Assuming it is part of a brilliant investment plan, you would like to realize the loss and still remain invested in it or something very similar to experience any rebound that may occur. There are several ways to remain invested in something which is very similar but not substantially identical. At Schwab, wash sales are computed automatically and cost basis adjusted for securities which have identical symbols. For securities which have different symbols, they assume that such investments are not substantially identical. Early on, we wrote an article on the fund selection choice between the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) and the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ). Both are good choices and their returns are extremely highly correlated. While the investments are very similar, they are not substantially identical. They follow two different emerging markets indexes. The number of holdings differs by 177 stocks. One invests 14% in South Korea and the other one invests nothing. One expense ratio is over four times that of the other. While the IRS has never issued a ruling, I am comfortable stating that for any of these reasons the two funds are not “substantially identical.” The wash sale rules were written prior to the advent of mutual funds and exchange-traded funds and the IRS has never pursued investors for changing investments which have some overlap of underlying funds. For this reason, it is nice to have two different investments for each sector of your asset allocation. You can sell EEM for a tax loss and buy VWO the same day to remain invested in the sector. Investments which are similar enough to stay invested do not have to be as similar as EEM and VWO. Any fund with a relatively high correlation will help maintain investment returns for the 31-day wash sale waiting period. But what if you prefer one investment selection for a category above all the others? In this case, you have to wait 31 days between your buy and sell. You have two options. First, you could sell the original position for a loss and allow the proceeds to wait for 31 days out of the markets until you can buy back into the identical position. Or second, you can buy more of the position and have twice what you would normally have for 31 days before you sell the original position for a loss. Wash sale rules need to be followed when realizing capital losses for taxes. They can be burdensome to track and monitor when you are trading on your own and are therefore another way an investment advisor can add value to your portfolio management.

Estimating Future Stock Returns

Click to enlarge Idea Credit: Philosophical Economics , but I estimated and designed the graphs There are many alternative models for attempting to estimate how undervalued or overvalued the stock market is. Among them are: Price/Book P/Retained Earnings Q-ratio (Market Capitalization of the entire market / replacement cost) Market Capitalization of the entire market / GDP Shiller’s CAPE10 (and all modified versions) Typically these explain 60-70% of the variation in stock returns. Today I can tell you there is a better model, which is not mine, I found it at the blog Philosophical Economics. The basic idea of the model is this: look at the proportion of US wealth held by private investors in stocks using the Fed’s Z.1 report. The higher the proportion, the lower future returns will be. There are two aspects of the intuition here, as I see it: the simple one is that when ordinary people are scared and have run from stocks, future returns tend to be higher (buy panic). When ordinary people are buying stocks with both hands, it is time to sell stocks to them, or even do IPOs to feed them catchy new overpriced stocks (sell greed). The second intuitive way to view it is that it is analogous to Modiglani and Miller’s capital structure theory, where assets return the same regardless of how they are financed with equity and debt. When equity is a small component as a percentage of market value, equities will return better than when it is a big component. What it Means Now Now, if you look at the graph at the top of my blog, which was estimated back in mid-March off of year-end data, you can notice a few things: The formula explains more than 90% of the variation in return over a ten-year period. Back in March of 2009, it estimated returns of 16%/year over the next ten years. Back in March of 1999, it estimated returns of -2%/year over the next ten years. At present, it forecasts returns of 6%/year, bouncing back from an estimate of around 4.7% one year ago. I have two more graphs to show on this. The first one below is showing the curve as I tried to fit it to the level of the S&P 500. You will note that it fits better at the end. The reason for that it is not a total return index and so the difference going backward in time are the accumulated dividends. That said, I can make the statement that the S&P 500 should be near 3000 at the end of 2025, give or take several hundred points. You might say, “Wait, the graph looks higher than that.” You’re right, but I had to take out the anticipated dividends. Click to enlarge The next graph shows the fit using a homemade total return index. Note the close fit. Click to enlarge Implications If total returns from stocks are only likely to be 6.1%/year (w/ dividends @ 2.2%) for the next 10 years, what does that do to: Pension funding / Retirement Variable annuities Convertible bonds Employee Stock Options Anything that relies on the returns from stocks? Defined benefit pension funds are expecting a lot higher returns out of stocks than 6%. Expect funding gaps to widen further unless contributions increase. Defined contributions face the same problem, at the time that the tail end of the Baby Boom needs returns. (Sorry, they *don’t* come when you need them.) Variable annuities and high-load mutual funds take a big bite out of scant future returns – people will be disappointed with the returns. With convertible bonds, many will not go “into the money.” They will remain bonds, and not stock substitutes. Many employee stock options and stock ownership plan will deliver meager value unless the company is hot stuff. The entire capital structure is consistent with low-ish corporate bond yields, and low-ish volatility. It’s a low-yielding environment for capital almost everywhere. This is partially due to the machinations of the world’s central banks, which have tried to stimulate the economy by lowering rates, rather than letting recessions clear away low-yielding projects that are unworthy of the capital that they employ. Reset Your Expectations and Save More If you want more at retirement, you will have to set more aside. You could take a chance, and wait to see if the market will sell off, but valuations today are near the 70th percentile. That’s high, but not nosebleed high. If this measure got to levels 3%/year returns, I would hedge my positions, but that would imply the S&P 500 at around 2500. As for now, I continue my ordinary investing posture. If you want, you can do the same. Disclosure: None