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The Federal Reserve’s Path: 4 Hikes, 2 Hikes, Zero Hikes, QE4

Three months ago, the Federal Reserve anticipated raising overnight lending rates four times in 2016. Now they are projecting just two hikes. At this rate, by the time June rolls around, Janet Yellen’s Fed will declare zero changes to interest rate policy for the entire calendar year. And in the fall? If there’s enough financial market turmoil, voting members of the central bank’s Open Market Committee (FOMC) may announce new quantitative easing measures in what will be dubbed by the media as “QE4.” Lost in the euphoria over slashing rate hike estimates in half? The Fed cannot meaningfully distance itself from zero percent rate policy . For one thing, the financial markets themselves go haywire at the mere prospect of “gradual stimulus removal.” Stocks plummeted in August of 2015, forcing the Fed to wait until December to make a singular quarter-point effort. And that negligible move in December? It brought about January’s collapse of faith that sent the average U.S. stock into bear market territory for the first time since the Great Recession. Secondly, the Fed may place the blame for the lackluster U.S. economy on global stagnation, but the results remain the same. The U.S. manufacturing segment fell into recession in 2015; the U.S. services sector recently hit a 28-month low, hitting a data point that is consistent with economic contraction. The impressive stock rally off of the early February lows – an 11.5% monster bounce for the market-cap weighted S&P 500 – has many investors believing that the worst is in the rear view mirror. However, since the Fed began curtailing its bond buying /electronic money printing program (a.k.a. “QE3″) in earnest circa mid-2014, the U.S. economy has struggled. A peek out the front windshield suggests that the U.S. economy is likely to suffer if the Fed raises overnight borrowing costs any further. Why on earth would modest quarter-point hikes have such a devastating impact on stocks? In a world where all of the central banks are loosening the reins, any tightening by the Fed is likely to strengthen the U.S. dollar. An unusually strong greenback adversely affects 50% of the strained earning potential of U.S. multi-national corporations. And that might lead to more earnings declines for already overvalued companies . Instead, the Fed’s capitulation on its rate hike path has already sent the P owerShares DB USD Bull ETF (NYSEARCA: UUP ) down 200 basis points in two sessions. The lower dollar is sending the price of commodities higher, stoking interest in the Materials Select Sector SPDR ETF (NYSEARCA: XLB ) and the Energy Select Sector SPDR ETF (NYSEARCA: XLE ). The lower dollar is also increasing investor hope that companies might turn the tide on four consecutive seasons of profits-per-stock-share deterioration. To recap, the slowest pace of Fed tightening in the central bank’s history just became even more “gradual.” And the dollar, while still quite strong relative to a basket of world currencies, is sitting near a 12-month low. The question going forward is, “Did the Fed do enough to keep the stock bull market alive or, absent more quantitative easing (QE), will elevated valuation levels keep a lid on risk appetite?” Economist Brian Barnier, principal at ValueBridge Advisors, probably believes we will need more QE. Barnier employed visual analysis techniques and regression analyses to investigate the primary factors responsible for bull markets throughout history. In the current bull market, the single biggest driver of stock growth was Fed asset acquisition with electronic dollar credits (QE). How big of a driver? The timing and amount of growth in the Fed’s balance sheet accounted for 93% of stock price appreciation in the current stock bull. It follows that the excitement over the Fed’s “it’s only going to be two hikes” is likely to fade. Stretched valuation levels will encourage more sellers than buyers when earnings season rolls back around. One may want to recall that earnings estimates for S&P 500 corporations are plummeting at the quickest pace since the financial crisis. At the onset of 2016, the “Street” projected 0.3% first-quarter earnings growth. Now Wall Street anticipates an 8.3% contraction – the largest shift since the initial two months of 2009. There’s more. Economic weakness continues to assert itself in hard data like the Inventories-to-Sales Ratio. The ratio has spiked form 1.3 to 1.4 in a matter of months, suggesting that U.S. companies are stockpiling goods because the demand for those goods simply isn’t there. And if it were, retail sales would not have fallen -0.4% in January and -0.1% in February. Naturally, it would be easy to focus on the “risk-on” rally for stocks without taking note of the premier performers. Health care? Financials? Technology? Nay, nope and hardly. Energy boost notwithstanding, it is the non-cyclical “risk off” segments like the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) and the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ). What else is appreciating since the Fed’s step backwards? “Risk-off” the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) and “risk-off” the SPDR Gold Trust ETF (NYSEARCA: GLD ). Both are near 52-week peaks. In sum, the world economy will continue to adversely impact the U.S. economy. Corporate earnings will continue to suffer. Valuations will remain elevated. And the only path to bull market glory involves an innovative Fed package that will be dubbed by the media as QE4. Without the balance sheet expansion that sits at the heart of the current cycle’s price appreciation, it would be foolish to take up large positions in riskier assets. 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.

Secrets Of 2015’s Top 3 New Hedge Funds On Interactive Brokers Hedge Fund Marketplace

A great place to look for the smartest managers: Interactive Brokers (NASDAQ: IBKR ) has long been the trading venue of choice for sophisticated high net worth investors. Chairman and CEO Thomas Peterffy once explained the reason for this: “We believe that the better the prices we get for our customers, the better their performance will be and the more business they will bring to us. On the other hand, our competitors believe that most customers cannot tell the difference between good and bad executions. I think we’re both right. As a result, they end up with the customers who cannot tell the difference, and we end up with those who can. I like the side we are on. ” The point he is making applies equally to new hedge fund managers; the smartest, most client-oriented managers will find their way to the trading platform with the lowest-cost and best execution. Interactive Brokers leads by a mile in this respect due to its highly automated processes. It can be extremely difficult to find smart new hedge fund managers due to marketing restrictions that regulators impose. For that reason I was very excited to learn of the new Hedge Fund Marketplace that Interactive Brokers recently launched. This allows clients who are high net worth/accredited investors to request information on those funds which use Interactive Brokers for trade execution. If investors like what they see, they can invest directly in the funds through the platform. Given that the smartest new managers are likely to migrate to the IBKR platform for its low costs, the Marketplace should represent an excellent source of prospective hedge fund investments. With this in mind I looked up the top 3 new funds in the Marketplace based on 2015 returns. Since performance is generally higher for new hedge funds , I restricted my analysis to those that were founded from 2014 onwards. 1. Summit Premium Plus Fund Limited Partnership Fund manager contact: Malcolm Clissold Investment approach: Mr. Clissold runs a registered investment advisor known as SCC Capital Group . Mr. Clissold’s investment approach is to use technical analysis and a quant-oriented approach to position the fund’s investment portfolio. The technical indicators used to time investments include advance/decline measures, new highs/lows, interest rate measures, price/volume measures, price/volume trends and relative strength indicators. Discussion: From the detail given on technical measures used, these appear to be fairly well-known techniques so the magic of this fund is probably in its quant model. It can be difficult to assess quantitative strategies without knowing the inner workings of the “black box”, which of course managers are hesitant to publish. Prospective investors in this fund should request that detail in a discussion with the manager. Since speaking with the manager is outside the scope of this analysis, I’ll move on to other funds where it’s possible to figure out the source of superior returns from the available written material. 2. Shannonside Capital Fund Fund manager contact : Brian Flynn Investment approach: Shannonside follows a long-term, fundamental value approach in its long/short stock-picking strategy . The manager conducts extensive research calls to industry experts in addition to reading all the company filings, news archives and conference call transcripts to build up a mosaic on prospective investments. They look to invest in situations where the picture that they’ve meticulously assembled on a company is different from what the market (mis)perceives . This is the kind of second-level thinking that Howard Marks describes as critical to generating superior returns and is a solid reason for believing that an investment could be a bargain. It is also a very difficult approach to copy due to its time-intensive nature. The fund holds a concentrated portfolio with large positions taken in its top ideas. Discussion: Shannonside can go the extra mile with its research because it first filters the investment universe down to a smaller pool of interesting stocks using proprietary screens. These guys are willing to hold a concentrated portfolio in their best ideas. Hence they can focus their research on a small number of promising opportunities. Other managers that can’t handle volatility must be much more diversified (the norm is to hold over 200 stocks). Diversified managers can’t focus on their top ideas because they have to spread research efforts among many more stocks. Diversification (deworsification?) is the norm in the fund management industry because most managers are afraid of losing their jobs if they under-perform in the short run. My point is that Shannonside’s process is difficult for other managers to copy. As such it may generate superior returns for many years to come. Negatives: As a European-domiciled fund, Shannonside Capital Fund is not currently available to U.S. investors. It is a concentrated fund with big positions in its top ideas so it is only suitable for investors that can ride out temporary volatility along the way to building long-term wealth. For those who can, Shannonside may present the opportunity for excellent returns of the kind the fund earned in 2015. 3. Phoenix Capital Fund, LP (Note – I’m only analyzing new funds here so some older funds that had higher returns than Phoenix in 2015 are not discussed) Fund manager contacts : Erik Trofatter, Jordan Causer Investment approach : Short option premium selling. Phoenix’s managers sell short high probability, out-of-the-money option premium on liquid and efficient underlying securities. Furthermore, the fund times its trades in an attempt to sell short option premium on underlying securities that are trading at the high range of their implied volatility. Discussion: Out-of-the money call options with strike prices far above the current market security price are like lottery tickets – there is a low probability that they pay off big if the security moves up by a lot but most people who buy these will lose the amount they paid for their “ticket”. By going short a portfolio of out-of-the-money call options, Phoenix is like a lottery operator – selling overpriced “tickets” to all the punters who dream of hitting it big. On the other side of the spectrum, nervous investors are also willing to pay a steep price for insurance against extreme downside events. By going short a portfolio of out-of-the money put options, Phoenix is like an insurance company that sells insurance for 100-year storms to buyers whose area only gets hit by a storm once in a thousand years. By timing trades, Phoenix is like an insurer that tries to only sell insurance when insurance premiums are expensive. In other words, it seeks to sell when volatility is high with the hope that vol will revert to the lower norms of the past. In selling lottery tickets and tail-risk insurance, the fund appears to be designed to take advantage of the human tendency to pay too much for these products. Peoples’ willingness to pay above the odds is a result of a bias to overweight low-probability events. This ingrained tendency was studied by Daniel Kahneman (author of “Thinking Fast and Slow”) and Amos Tversky when they developed prospect theory . The result of this bias is that positive long-term rewards are possible for firms that sell lottery tickets and insurance to the “suckers” that pay too much. If this is what Phoenix is doing, they could certainly generate excess returns for years to come. Negatives: The main downside to this type of strategy is that it could be like picking up pennies in front of a steamroller. The fund could appear to be consistently profitable by earning premiums from selling out-of-the-money options, and then a flash crash or 1987-style rout hits and suddenly all the out-of-the money put options jump to become in-the-money. In such a market, losses from selling puts could result in a big hit to the portfolio. I think the best way to get comfortable with this risk is to appropriately size any prospective investment in the fund. Conclusions: Hedge fund managers generally have their best years when they are young, hungry and driven but due to marketing restrictions this is also when they are hardest to find. Interactive Brokers Hedge Fund Marketplace is an exciting new place to discover managers at this early stage. This service should accelerate IBKR’s growth because it will attract new hedge fund clients to its brokerage platform. It is great for clients because they can find rising hedge fund stars and it is great for the funds because new clients can invest through the platform. As discussed above, I think I’ve found funds that could generate superior returns for investors for years to come. I’m excited to look further because I’ve only scratched the surface of what is available. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SHANNONSIDE OR PHOENIX over 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.

Robo-Advisors Are Desperately Clinging To A Dangerous Dogma

I’ve recently argued that the success of passive investing potentially sows the seeds of its own demise . Patrick O’Shaughnessy also made a similar point recently and probably a bit more eloquently. But, to dig deeper into the push towards passive, there’s one big problem I have with virtually every one of the major robo-advisors that very few folks seem to be talking about. That is they all seem to advocate a heavily overweight position in equities, and for the most part, this is skewed towards U.S. equities. For example, below is the allocation Wealthfront would put me in. It’s 91% in stocks, 49% U.S. stocks and 42% foreign, and 9% muni bonds (This is its taxable allocation, but the retirement allocation is very, very similar). Click to enlarge I assume this massive equity overweight is simply based on the, “stocks for the long run,” dogma that everyone has bought into in recent years. The trouble with this is that it fails to take into account the simple fact that, in recent years and across a wide variety of time frames, bonds have outperformed stocks and with far less volatility, or what some might call, “risk.” As The Economist points out , “there was a point in 2011 when equities had lagged Treasury bonds over the previous 30 years.” 30 years! Intrigued, I decided to run some of the numbers myself. The chart below tracks the difference in performance between Vanguard’s S&P 500 index fund versus its long-term treasury fund. It dates back to the start of 1999; that’s as far as StockCharts.com will let me go. Notice that since then, bonds have nearly doubled up on the performance of stocks, and this includes some of the greatest years in stock market history! This time frame is especially compelling to me because stocks are currently valued, according to the Buffett yardstick and a few other valuable measures, just as highly today as they were back in 1999-2000 . Click to enlarge We can also just look at the past 10 years. Stocks have had an incredible run recently; surely they’ve outperformed bonds over the past decade. Nope. Bonds win again and, if you owned them instead of stocks, you felt much better about your investments during the financial crisis and were thus much more likely to stick with your investment strategy through that difficult period. Click to enlarge So it’s fascinating for me to see so many hang on so fiercely to the idea that buying and holding U.S. stocks over any and all time frames is the way to go despite their much greater volatility and lagging performance in recent years. And to see this dogma take form across every robo-advisor I’ve found just validates how deeply ingrained this dogma has now become. In fact, Wealthfront is so in love with the idea it wouldn’t put any of my money at all into long-term treasuries. Why not? Because it’s clinging to a dogma that perhaps worked at one point a long time ago, when stocks were more consistently fairly valued. But this dogma hasn’t worked for quite a long time now. Maybe this is why Ray Dalio’s firm, which has adopted just the opposite dogma – overweight bonds versus stocks because they offer better risk-adjusted returns over the long term – has become the largest hedge fund firm by assets in the world. Now I’m not saying you should forget stocks and put all your money in bonds. But there is a wonderful case to be made for diversifying across a variety of asset classes. Wealthfront makes it appear as if it’s doing so. It’s not. In fact, it would just put all my money in the stock market and say, “good luck!” True diversification is something very, very different and also something far more valuable. Sadly, it may take another painful bear market in equities before the robos learn this important lesson.