Tag Archives: financial

Melt-Up Or Meltdown?

Summary U.S. market capitalization weighted indexes have outperformed in 2015. The largest U.S. capitalization stocks have melted up, and this trend forged ahead in 2015. Under the surface, the meltdown of out-of-favor assets has accelerated. Either a broader melt-up or meltdown scenario remains a probable outcome. A large cash weighting and an exposure to out-of-favor assets (a barbell approach) is an ideal portfolio strategy for this environment. “A dramatic and unexpected improvement in the investment performance of an asset class driven partly by a stampede of investors who don’t want to miss out on its rise rather than by fundamental improvements in the economy.” – Definition of “Melt Up” from Wikipedia “A rapid or disastrous decline or collapse” – Definition of “Meltdown” from Merriam-Webster “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.” – Sir John Templeton – 1958 Introduction I have written two articles on the stealth U.S. bear market on Seeking Alpha in 2015. In part one of this series, authored on July 9th, 2015, I examined building negative divergences in the U.S. stock market, and those divergences ultimately foreshadowed the August market sell-off. In part two , authored on December 1st, 2015, I highlighted two distinct markets under the surface of the U.S. stock market, profiling the “Winning” and “Losing” companies, and their distinctive stock prices. The conclusion of that piece suggested buying the “Losers” and selling the “Winners”, which, as a contrarian, I have openly advocated for over the last several years, with little success thus far, and a whole lot of pain. Third Avenue confirmed last week that this advice remained too early, as credit markets continued to seize up, with high-yield bond prices undercutting their August lows. As yield-chasing and bottom-fishing investors continue to be punished, the world’s central banks, with the notable absence of the Federal Reserve (who may have to shift course from their tightening rhetoric very soon), remain poised to inject further liquidity into the system. The end result is that more than any time in recent history, the markets are dually poised for a climatic melt-up or meltdown scenario. Proponents of the melt-up scenario will argue that many investors who capitulated in 2008 and 2009 remain out of the market, providing a wall of worry to climb. Advocates of the meltdown scenario believe that stock market divergences have been developing for years, setting the stage for a historic unwind, as low-conviction investors bail out of their thinking that stocks are the only game in town. Which direction will the market break, and how should investors position their portfolios? Thesis Melt-up and meltdown scenarios are equally plausible for U.S. equity investors. Thus, a barbell approach, where a high cash weighting is combined with extreme out-of-favor assets remains the best approach. QQQ> SPY> RSP> IWM In the U.S. stock market in 2015, a bigger market capitalization has correlated very positively with outperformance. This can be illustrated by looking at the performance of the PowerShares QQQ ETF (NASDAQ: QQQ ), which is designed to track the performance of the NASDAQ 100 Index, which counts five of the world’s ten largest market capitalization companies among its largest holdings, Apple (NASDAQ: AAPL ), Alphabet (NASDAQ: GOOGL ), Microsoft (NASDAQ: MSFT ), Amazon (NASDAQ: AMZN ), and Facebook (NASDAQ: FB ). These aforementioned companies are weighted more heavily in the PowerShares QQQ ETF, than they are in the S&P 500 Index, as measured by the SPDRs S&P 500 ETF (NYSEARCA: SPY ), and their weightings in the respective indexes are responsible for a large portion of the outperformance of the QQQ (up 8.06% YTD) over the SPY (down 0.35% YTD) as shown in the charts below: An equal-weighted version of the S&P 500 Index, which is represented by Guggenheim S&P 500 Equal Weighted ETF (NYSEARCA: RSP ), is disadvantaged by its lower relative weighting to the biggest market capitalization companies, and it is down over 4% in 2015. Moving further down the market capitalization spectrum, U.S. small capitalization stocks, which are prominently measured by the Russell 2000 Index, represented by the iShares Russell 2000 ETF (NYSEARCA: IWM ), are down over 5% in 2015. From the charts above, clearly the performance of the U.S. stock market in 2015, has been heavily influenced by investor flows and fund flows to larger companies, who are perceived to offer an attractive combination of safety and growth potential in a slowing global GDP world economy. AAPL, AMZN, GOOGL, FB, MSFT = Amazing It cannot be overstated how important Apple, Amazon, Alphabet, Facebook, and Microsoft have been to the performance of the U.S. stock market in 2015. These five stocks and one other, Netflix (NASDAQ: NFLX ), have accounted for the vast majority of the market capitalization gain in the S&P 500 Index, and the resilience of their stock prices in the face of broader market weakness, has kept the market capitalization indexes from showing far greater losses on a year-to-date basis. Visually, the contrast of their stock charts is stunning to see, so I have included charts of AMZN, GOOGL, and MSFT as follows: By itself, Amazon has added $150 billion dollars in market capitalization in 2015. That is amazing, especially when it was viewed as overvalued by a majority of investors entering 2015. The ominous takeaway from the dominance of a handful of stocks is that this concentrated leadership often marks the tops of bull markets, and one only has to look back to March of 2000, when six stocks accounted for the entirety of the gain of the S&P 500 Index, to see a similar, negative reference point. A Meltdown Alongside A Melt-Up? While the broad market averages bounced back strongly following their August 2015 lows, high yield bonds, as measured by the SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK ) and iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA: HYG ), only managed a weak recovery, and have subsequently made new lows as shown in the charts below: Many analysts have attributed the unrelenting sell-off in high-yield bonds to the ongoing carnage in the commodities sector, specifically the energy market, which had extensively used high-yield financing. The fall of oil, as measured by the United States Oil Fund (NYSEARCA: USO ), seems to add credence to this thought process. Crude oil, which is down nearly 50% in 2015, after a difficult 2014, and natural gas, which is represented by the United States Natural Gas Fund (NYSEARCA: UNG ), down nearly 50% as well, which is shown in the chart below, both demonstrate how difficult the operating environment has been for energy firms. The end result is that stocks like Chesapeake Energy (NYSE: CHK ), the second largest natural gas producer in the U.S, and a major oil producer, with some of the best land acreage in the industry, has seen its shares devastated, down over 78% in 2015. Even better operators, like Antero Resources (NYSE: AR ) have lost over 50% of their market capitalization. The energy unwind has even spread to solar companies, which seemingly have the world’s political tailwinds at their back. This is best evidenced by the dramatic decline in SunEdison (NYSE: SUNE ), a company I recently authored a contrarian article on , whose shares have fallen precipitously since making their highs in July of 2015. The high-yield bond market, commodities, and a large number of dislocated stocks clearly show that there has been an ongoing meltdown, which has been partially obscured by the outperformance of a narrow group of mega capitalization technology stocks. A Fork In The Road With a large number of stocks already in their own bear markets, which can be defined as being off 20% from their highs, but the broad market indexes still far from a bear market, what is the best course of action for investors? There are two possible, probable scenarios that are as different as night and day. First, in an optimistic light, the correction in asset markets may have already run its course. If the market leadership stocks can simply tread water, any improvement in the economically sensitive, out-of-favor sectors of the market, could initiate a rotation that propels broad market indexes to new highs, climbing the proverbial wall of worry. Market analysts that reference this scenario, often recall an overvalued market getting more overvalued, similar to the NASDAQ market in 1998 to 2000. This is the melt-up scenario. The second scenario is decidedly more bearish. Its interpretation would be that the weakness in commodity prices is foreshadowing the next recession. Thus, high-yield bonds, at their current levels, could be fairly priced, not mispriced, and if that is the case, they are indicative of a fair value of 1,650 for the S&P 500 Index, which would be an 18% decline from its closing price on December 11, 2015. Under this scenario, with valuations where they are today (see the below chart from Ned Davis), the markets could gather momentum on the downside, so the ultimate sell-off could cut much deeper, hence the risk of a meltdown. (click to enlarge) The Barbell Approach On December 7th, 2015, I authored a portfolio strategy article on Seeking Alpha, which has generated a terrific commentary section, titled “Why A 90% Cash Portfolio Will Probably Outperform”. In this article, I investigated the merits of an extreme portfolio approach given the uncertain environment, where 90% of an investor’s portfolio was kept in cash, and the remaining 10% was invested in a concentrated portfolio of deep-value, distressed equities. The graphic I produced to illustrate the merits of the portfolio is replicated below: (click to enlarge) On December 7th, 2015, I also lau nched ” The Contrarian “, a p remium research service on Seeking Alpha. As part of my research service, I have several model portfolios that I am tracking with real-world transactions, so that readers can see a working example of my portfolio theory. One of the portfolios I am tracking with positions is the “90/10 Portfolio”, which I am posting an update on today. With the S&P 500 Index retreating 3.7% for the last week, the “90/10 Portfolio” was actually positive for the week. While admittedly this is a small sample size, it shows the benefit of this extremely conservative/aggressive approach. Conclusion Large-capitalization stocks are the locomotive that keeps pulling an otherwise unhealthy market train forward up a steep hill. Active managers continue to struggle, as has been the case for nearly this entire seven-year bull market, as a narrower and narrower group of stocks have led the market averages higher. The negative divergences could be signaling the start of a significant downturn, or the general apathy and frustration towards a large swath of individual stocks could signal a significant wall of worry to climb in the future. The prevailing thought in the markets is akin to this quote from Steven Roge, in the previously linked Bloomberg piece on Third Avenue, “The past few years (have not) been a good time to be a contrarian investor…Investors in that group have been trying to catch a falling knife that keeps on falling.” Reversion to the mean is one of the most powerful forces in the financial markets. Today, a reversion to the mean in the broad market indices would imply seven years of zero-to-negative returns. For out-of-favor assets, however, a ‘reversion to the mean’ trade could spark a powerful upside move that is unexpected given the current headwinds facing the out-of-favor companies. A barbell approach works in this environment. From my perspective, for the first time since 2009, it is an ideal time to be a contrarian, and today that would mean a barbell approach heavily weighted towards unloved assets, like cash, and out-of-favor equities, like commodity stocks. For more information , please peruse my research in “The Contrarian”.

Assessing The Utility Of Wall Street’s Annual Forecasts

It’s that time of year when everyone starts preparing for the New Year and Wall Street makes its 2016 predictions. I’ll get right to the point here – these annual predictions are largely useless. But it’s still helpful to put these predictions in perspective, because it highlights a good deal of behavioral bias and some of the mistakes investors make when analyzing their portfolios. The 2016 annual stock market predictions are reliably bullish. Of the analysts that Barrons surveyed, they found no bears and an expected average return of 10%. This is pretty much what we should expect. After all, predicting a negative return is a fool’s errand given that the S&P 500 is positive about 80% of the time on an annual basis. And the S&P 500 has averaged about a 12.74% return in the post-war era. So, that 10% expected return isn’t far off from what a smart analyst might guess, if they’re at all familiar with probabilities. There is a chorus of boos (and some cheers) every year when this is done. No analyst will get the exact figure right, and there will tend to be many pundits who ridicule these predictions despite the fact that expecting a positive return of about 10% is the smart probabilistic prediction. In fact, if most investors actually listened to these analysts and their permabullish views, they’d have been far better off buying and holding stocks based on these predictions than most investors who constantly flip their portfolios in and out of stocks and bonds. But that’s the reason why these predictions exist in the first place. Because every year, investors perform their annual check-ups and evaluate the last 12 months’ performance before deciding to make changes. And of course, Wall Street encourages you to do exactly that, because turning over your portfolio means increasing the fees paid to the people who promote these annual predictions. But when we put this analysis in the right perspective, it becomes clear that this mentality is misleading at best and highly destructive at worst. Stocks and bonds are relatively long-term instruments. The average lifespan of a public company in the USA is about 15 years.¹ And the average effective maturity of the aggregate bond index is about 8 years.² This means an investor who holds a portfolio of balanced stocks and bonds holds instruments with a lifespan of about 11.5 years. When viewed through this lens, it becomes clear that evaluating a portfolio of long-term instruments on a 12-month basis makes very little sense. What we do on an annual basis with these portfolios is a lot like owning a 12-month CD that pays a one-time 1% coupon at maturity and getting mad that the CD hasn’t generated a return every month. But this annual perspective makes even less sense from a probabilistic perspective. As I’ve described previously , great investors think in terms of probabilities. When we look at the returns of the S&P 500, we know that returns tend to become more predictable as we extend time frames. And the probability of being able to predict the market’s returns increases as you increase the duration of the holding period. While the probability of positive returns becomes increasingly skewed as you extend the time frame, there is still far too much randomness inside of a 1-year return for us to place any faith in these predictions. The number of negative data points is only a bit lower than the number of positive data points, even though the average return is positively skewed: (click to enlarge) So, at what point do returns become reliably positive? If we look at the historical data, we don’t have reliably positive returns from the stock market until we look about 5 years into the future, when the average 5-year returns become positively skewed. A 50/50 stock/bond portfolio has a purely positive skew, with an average rolling return of 3 years. Interestingly, this stock market data is just as random even though it’s positively skewed. So, trying to pinpoint what the 5-year average returns will be is probably a fool’s errand (even though stocks will be reliably positive, on average, over a 5-year period). (click to enlarge) All of this provides us with some good insights into the relevancy of making forecasts about future returns. When it comes to stocks and bonds, we really shouldn’t bother listening to or analyzing predictions made inside of a 12-month period. The data is simply too random. As we extend our time horizons, the data becomes increasingly reliable with a positive skew. But it still remains a very imprecise science. The bottom line – If you’re going to hold stocks and bonds, it’s almost certainly best to plan on having at least a 3-5 year+ time horizon. Any analysis and prediction inside of this time horizon is likely to resemble gambling. As Blaise Pascal once said, “All of human unhappiness comes from a single thing: not knowing how to remain at rest in a room”. The urge to be excessively “active” in the financial markets is strong; however, the investor who can take a reasonable temporal perspective will very likely increase their odds of making smarter decisions, leading to higher odds of a happy ending. Sources: ¹ – Can a company live forever? ² – Vanguard Total Bond Market ETF, Morningstar

Vanguard’s Total Bond Market ETF Is A Great Fund For Investors Seeking Higher Quality

Summary BND offers a very low expense ratio that allows the interest to reach shareholders. The biggest risk factor for the fund is the diverging interest rate policies in the U.S. and Europe leading to potentially higher levels of volatility in rates. The exposure to MBS is unfortunate given the options investors have for using mREITs to acquire MBS at a discount to book value. Vanguard Total Bond Market ETF (NYSEARCA: BND ) is a solid bond fund. As I’ve been searching for appealing bond funds, I’ve found some of my favorites are from Vanguard. Given my distaste for high expense ratios, it should be no surprise that the Vanguard products would be appealing. 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 BND is a .07%. This is one of the funds that 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 2.45%. 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. The yield for BND is coming primarily from the interest rate risk on the fund. The average duration is 5.8 years and the average effective maturity is 8 years. Fluctuations in the interest rate environment will be a major source of changes in the fair value of the fund. 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. The very interesting thing we are seeing in the interest rate environment today is a divergence in policy between the domestic interest rates and the interest rates in Europe established by the ECB (European Central Bank). The ECB has announced another decrease in their short term rates to negative .30% while the Federal Reserve is planning to increase short term rates. That disconnect is going to make bond markets very interesting over the next few years. Credit Risk The following chart demonstrates the credit exposure for this bond fund: High quality corporate debt may often show significant correlation to treasuries but it offers higher yields. The biggest weakness for a high quality corporate debt fund is the fact that some bonds may still fall into lower credit quality and eventually default. Even if the fund sells the bonds before they default, they will receive a much lower fair value for those bonds when the market assess that the bond is riskier. I find high credit quality corporate debt to be a fairly attractive space for bond investing because it offers higher yields than treasuries but is unlikely to suffer from high default levels. By combining high credit quality corporate debt with treasury positions BND is able to create a higher yield than the fund would otherwise have while maintaining exceptionally high credit quality overall. The one notable concern I have in this regard is that over 20% of their “U.S. Government” debt is coming through the form of mortgages, and investors have access to mREITs that are trading at enormous discounts to book value. Conclusion I’m not a fan of holding the MBS at book value, but other than that I find the fund to be a solid choice for bond investors. It offers a reasonable yield for the very low credit risk on the fund and a very low expense ratio so the interest from the securities is actually reaching the shareholders. The biggest risk here, in my opinion, is the challenges we may see in the interest rate environment as the United States and Europe intentionally move in the opposite directions.