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How To Look At Negative Yields Inside A Portfolio

Negative yields on bonds are no longer unicorns. In Switzerland, Germany, Denmark and several other European countries, government bonds are trading at negative nominal yields. Recently, the Bank of Japan announced it is adopting negative interest rates. For investing, there are four potential reasons that can illustrate trade-offs between different investment strategies as a result of negative interest rates. First and foremost, negative yields could simply be a consequence of active monetary policy (with the expressed goal of stimulating economic activity) in a world where bond supply and demand is not balanced. Central banks in major developed economies have amassed close to $12 trillion in government bonds since 2004, and still remain a source of demand of close to $3 trillion a year. Meanwhile, the net issuance of government bonds of about $2.5 trillion has been on the decline since 2013. This demand mismatch is likely one of the reasons there are $6.3 trillion in government bonds outstanding trading at a negative yield. This represents about 10 percent of total outstanding government debt worldwide, estimated by McKinsey to $58 trillion. Second, negative yields could potentially be correctly forecasting a sharp economic slowdown, which, as a consequence, could lead to an increase in defaults (both corporate and sovereign) in the future. Paying up now and receiving less nominal money in the future can be profitable if the price of goods has fallen sufficiently. Third, negative yields could also be a consequence of the ecology of current market participants. Choosing to not own these government bonds as an active allocation decision can (even with good cause due to their negative yields) carry risk for certain investors – e.g., the potential for higher tracking error to their benchmark or underperformance versus their peers. That said, as government bonds have an increased representation in many bond indexes that are used as benchmarks, holding these bonds to stay close to the benchmark also carries a cost: lower absolute returns due to a portfolio with an increasing component of negative return. Fourth, certain investors who have a preferred investment horizon may require a meaningful risk premium to buy bonds with maturities outside their preferred habitat. For instance, when investors with a shorter horizon are faced with short-term yields in negative territory, the steep slope of the yield curve and longer-maturity bonds might provide the inducement to buy longer bonds. Because they join other investors who invest regularly in longer maturities as part of their own preferred habitat, the ensuing higher demand could be a reason for negative yields on longer-maturity bonds, as was recently the case in Switzerland and Japan. And lastly, negative interest rates cause currency volatility and capital flight. By adopting a negative rate to weaken the currency, the true goal is to apply a haircut to government debt that is unsustainable as GDP growth stays anemic. The result is negative interest rates lead to one currency appreciating to super strength, namely the US dollar, while the rest of the world’s currencies depreciating by central banks printing money. The result of negative rates is the opposite from what it was intended; instead of a stimulus, it has led to deleveraging debt. The effect was first through the energy sector by causing distress in high yield markets that has now spread more broadly. ​ Portfolio Strategy If one believes negative yields are primarily due to demand from passive or indexed investors, then an active investment strategy should tolerate the tracking error and take the other side of the indexing herd. Despite the profit uncertainty of investing in negative yielding bonds, there is a logical approach to constructing robust portfolios. First, control exposure to risk factors where the uncertainty of outcomes may be the most severe, for instance, by adjusting overall portfolio duration. Second, tilt portfolios in directions where relative asset valuation is more attractive, e.g. equity and bonds of companies with solid fundamentals. Third, look for sources of diversification, where the ultimate and eventual resolution of the negative yield conundrum is likely to create large trends and market movements. And finally, in very broad terms, aggressive central bank intervention with negative interest rates continues to underwrite risk taking. At the same, negative rates also cause volatility, currency depreciation and deleveraging of debt. So as more central banks jump on the bandwagon to drive rates more negative, an appropriate asset allocation of conservative, higher quality credit risk, floating rate exposure, and maintaining high liquidity remains prudent. 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.

Best And Worst Q1’16: Mid Cap Value ETFs, Mutual Funds And Key Holdings

The Mid Cap Value style ranks tenth out of the twelve fund styles as detailed in our Q1’16 Style Ratings for ETFs and Mutual Funds report. Last quarter , the Mid Cap Value style ranked seventh. It gets our Dangerous rating, which is based on aggregation of ratings of 9 ETFs and 124 mutual funds in the Mid Cap Value style. See a recap of our Q4’15 Style Ratings here. Figure 1 ranks from best to worst all nine Mid-Cap Value ETFs and Figure 2 shows the five best and worst-rated mid-cap value mutual funds. Not all Mid Cap Value style ETFs and mutual funds are created the same. The number of holdings varies widely (from 36 to 1761). This variation creates drastically different investment implications and, therefore, ratings. Investors seeking exposure to the Mid Cap Value style should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2. Figure 1: ETFs with the Best & Worst Ratings – Top 5 Click to enlarge * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 Click to enlarge * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The Nuance Mid Cap Value Fund (MUTF: NMVLX ) is excluded from Figure 2 because its total net assets are below $100 million and do not meet our liquidity minimums. The Vident Core US Equity Fund (NASDAQ: VUSE ) is the top-rated Mid Cap Value ETF and the BMO Mid-Cap Value Fund (MUTF: BMVGX ) is the top-rated Mid Cap Value mutual fund. VUSE earns a Very Attractive rating and BMVGX earns an Attractive rating. The PowerShares Russell Midcap Pure Value Portfolio (NYSEARCA: PXMV ) is the worst-rated Mid Cap Value ETF and the Nuveen Mid Cap Value Fund (MUTF: FASEX ) is the worst-rated Mid Cap Value mutual fund. PXMV earns a Dangerous rating and FASEX earns a Very Dangerous rating. East West Bancorp (NASDAQ: EWBC ) is one of our favorite stocks held by BMVGX and earns an Attractive rating. Over the past decade, East West Bancorp has grown after-tax profit ( NOPAT ) by 14% compounded annually. Since 2008, the company has improved its return on invested capital ( ROIC ) from 2% to 14% for the last twelve months. Best of all, the recent share price decline has provided a great buying opportunity. At its current price of $31/share, East West Bancorp has a price-to-economic book value ( PEBV ) ratio of 0.9. This ratio means that the market expects East West Bancorp’s NOPAT to permanently decline by 10% from current levels. If EWBC can grow NOPAT by just 7% compounded annually for the next decade , the stock is worth $39/share today – a 26% upside. American Campus Communities (NYSE: ACC ) is one of our least favorite stocks held by TCVAX and earns a Dangerous rating. Despite positive GAAP net income, which doesn’t fully account for changes to the balance sheet, American Campus Communities has generated negative economic earnings in each year since 2005. Over that same time frame, the company’s already low ROIC of 5% in 2005 has fallen to a bottom quintile 4% over the last twelve months. Despite the fundamental issues above, ACC is significantly overvalued. To justify its current stock price of $43/share, ACC must stop destroying shareholder value and grow NOPAT by 12% compounded annually for the next decade . This expectation seems awfully optimistic given ACC’s track record. Figures 3 and 4 show the rating landscape of all Mid Cap Value ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst Funds Click to enlarge Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Funds Click to enlarge Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme. 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.

Low Interest Rates Alone Cannot Prevent A Bear Market In Stocks

The most common definition of a bear market in stocks? A major index needs to fall 20% from a high watermark. And while that is precisely what has happened for most gauges of stock health – MSCI All-Country World Index, Nikkei 225, STOXX Europe 600, Shanghai Composite, U.S. Russell 2000, U.S. Value Line Composite – the Dow and the S&P 500 remain defiant. Yet, there’s another way to view bulls and bears. In particular, chart-watchers often use the slope of a benchmark’s long-term moving average. It is a bull market when the 200-day moving average is rising. During these times, investors often benefit when they buy the dips. In contrast, when the 200-day is sloping downwards, it may be a “Grizzly.” During these days, investors successfully preserve capital when they raise cash by selling into rallies. There’s more. During stock bears, stocks frequently hit “lower highs” and “lower lows.” That’s exactly what investors have experienced since May of 2015. There’s little doubt that – at the moment – we are witnessing the “rolling over” of the 200-day moving average. The exceptionally popular measure of market direction is sloping downward, giving support to the notion that a bearish downtrend is in command. Technical analysis notwithstanding, there are other reasons to believe that the stock bear will maul and mangle. Fundamental analysts note that the Q1 2016 S&P 500 earnings are set to record a decline of -8.0%. That is going to register a fourth consecutive quarter for year-over-year declines in corporate earnings per share – the first such sequence since 2008 (Q1, Q2, Q3, Q4). “But Gary,” you protest. “It’s only the energy companies. You should just exclude them from consideration.” (Like technology in 2000? Financials in 2008?). Actually, it’s not just the energy sector. Seven of the 10 key economic sectors will serve up profits-per-share disappointments. Telecom, healthcare and consumer discretionary companies may be the only sectors to provide a positive boost in the upcoming earnings season. Still, get a gander at the earnings expectations at the start of the year vs. the earnings expectations at the beginning of March. It only took two months for analysts to lower their expectations for every single stock segment – percentage revisions that have not dropped this fast since the Great Recession. Keep in mind, reported earnings for the S&P 500 peaked at $105.96 on 9/30/2014. At that time, the S&P 500 closed at 1,972 and traded at a P/E of 18.6. With the most recent 12/30/2015 S&P 500 earnings at $86.46, and the 3/8/2016 close of 1979, the market trades at a P/E of 22.9. That’s correct. The market is essentially flat since September of 2014, but it is far more expensive in March of 2016 . Nearly 20% more expensive since profits peaked . It is exceptionally difficult to make a case for the overall market to be “attractive” or “fairly valued.” Not that perma-bulls haven’t tried. The most common argument is the attractiveness of stocks relative to the alternatives in fixed income. Ultra-low interest rates not only force savers into equities, they argue, but it also primes the pump for companies to buy back shares of their own stock through the issuance of corporate debt. However, history has a similar circumstance when the U.S. had a low rate environment for nearly 20 years (i.e., 1935-1954). In that period, valuations were about HALF of what they are today. If low rates alone weren’t enough to DOUBLE the “P” relative to the “E,” why are low rates enough to justify higher stock prices regardless of valuations in 2016? When top-line sales and bottom-line earnings are contracting? It is also worth noting that low rates alone did not stop bear markets occurring in 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%), or 1946-1947 (-23.2%). Click to enlarge By way of review, the technical picture is inhospitable. The fundamental backdrop is unsavory. And even the perma-bull panacea of low interest rates cannot obliterate historical comparisons entirely. “Well, Gary,” you decry. “Back then, we were still coming out of the Great Depression. We don’t have anything like that right now… and we are not going into recession.” I’m glad that you brought up the Great Depression. For starters, Federal Reserve policy error in 1937-1938 went a long way toward reigniting recessionary forces – dynamics not unlike the depression-like disaster that plagued America from 1929 to 1932. Today, six-and-a-half years removed from the Great Recession, Fed policy error (December 2015) remains a distinct possibility. Members of the Fed’s Open Market Committee currently believe that they can raise borrowing costs in 2016 without reversing the Fed’s wealth effect ambitions . They may learn, however, that they will be returning the country to zero percent rate policy (ZIRP) and quantitative easing (QE) to squelch a 20%-plus decline in key barometers like the S&P 500. What’s more, the stock bears in 1939-1942 (-40.4%) and in 1946-1947 (-23.2%) are not attributable to recessions or the Great Depression. Those stock bears had low interest rates and booming economies. Is the U.S. economy booming right now? The surprising popularity of anti-incumbent candidates like Sanders and Trump suggests that the real economy – jobs included – is shaky at best. This simple chart that plots both manufacturing and non-manufacturing (services) demonstrates that economic weakness is an actuality, not a doom-n-gloom delusion. One might even choose to consider the most recent business headlines. Chinese exports plummeted by their largest amount since 2009. The International Monetary Fund (IMF) warned today that the world is looking at an increasing “risk of economic derailment.” And stateside, the NFIB’s Small Business Optimism Index fell for the fourth time in five months. It now sits at its lowest level in two years while demonstrating its steepest peak to trough drop since 2009. Instead of getting more stimulus from the U.S. Federal Reserve, like “Twist” and “QE3,” the Fed is pushing “gradual stimulus removal. ” In sum, the rallies of September-October (2015) and February-March (2016) share more in common with bear market bounces than buy-the-dip opportunities. Technicals, fundamentals, economics and Federal Reserve policy collectively favor a lower-than-usual allocation to risk. For my moderate growth-and-income clients, our 45-50% allocation to domestic large caps exists in stark contrast to 65-70% in a broadly diversified equity mix (e.g., large, small, foreign, emerging, etc.). Some of our core positions? The Vanguard High Dividend Yield ETF (NYSEARCA: VYM ), the iShares S&P 100 ETF (NYSEARCA: OEF ) and the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ). We have pure beta exposure to the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as well. On the income side of the ledger? We have benefited immensely from a commitment to investment-grade holdings, including the Vanguard Long-Term Corporate Bond Index ETF (NASDAQ: VCLT ), the iShares 3-7 Year Treasury Bond ETF (NYSEARCA: IEI ) and munis via the SPDR Nuveen Barclays Muni Bond ETF (NYSEARCA: TFI ). For Gary’s latest podcast, click here . Disclosure : Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.