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Do Historical Comparisons Matter? Strong Similarities Between 1937 And 2015

The case for the continuation of the U.S. bull market heavily rests on the shoulders of steady economic growth and low interest rates (on an absolute basis). Many believe that, as long as these circumstances exist, stocks will provide venerable results. Market participants might want to consider a similar period in history – a time when the 10-year Treasury offered paltry yields, GDP grew at a reasonable clip and the Fed tightened monetary policy. The case for the continuation of the U.S. bull market heavily rests on the shoulders of steady economic growth and low interest rates (on an absolute basis). Many believe that, as long as these circumstances exist, stocks will provide venerable results. However, market participants might want to consider a similar period in history – a time span when the 10-year Treasury offered paltry yields, gross domestic product (GDP) grew at a reasonable clip and the Federal Reserve tightened monetary policy. In late 1936, GDP had been growing steadily and the 10-year yield averaged 2.6%. The Fed chose to modestly compress the money supply after years of extraordinary stimulus. Indeed, the 1929-1932 “Great Depression” seemed as though it had been been vanquished. Unfortunately, by the second quarter of 1937, investors became alerted to signs of economic deceleration. Risky assets began to falter. The Fed quickly reversed course from tightening to easing, even engaging in market-based asset purchases. To no avail. An insipid recession occurred in spite of the central bank’s rapid policy reversal. Before all was said or done – by the time the 1937-1938 bear had finally ended – stocks had already plummeted 51.5%. Here in 2015, we have experienced steady economic growth for six-plus years with GDP expanding at approximately 2.2% per year. It has been an anemic recovery, but an expansion nonetheless. ( Indications of economic deceleration abound .) Meanwhile, the U.S. stock bull has been remarkably robust, both in duration and magnitude. One researcher estimates that the current bull market period has been more powerful (since 3/09) than 90% of the preceding rallies since 1900. (See chart below.) Similar to the circumstances in late 1936, when the economy appeared relatively healthy, stocks performed admirably, and the Fed started to tighten monetary policy after a long hiatus, the 2015 Fed recently embarked on its first overnight lending rate hike. Those who ignore the similarities say that it is only 25 basis points; they believe that members of today’s Federal Reserve are smarter than their predecessors and that they would not endeavor to normalize borrowing costs unless the economy were strong enough to withstand the shift. Me? I am skeptical. Here are three additional similarities between 1937 and right this moment: 1. The Last Time Stocks, Bonds, And Cash Did Not Work . Asset allocation is not working . Granted, the iShares S&P 500 (NYSEARCA: IVV ) is up 3% through December 2009, with 1% coming on today’s (12/29) price jump and the rest of it coming from dividends. Yet the iShares Mid-Cap ETF (NYSEARCA: IJH ) that tracks mid-sized corporations in the S&P 400 logged -0.5% through 12/29 and the iShares Russell 2000 (NYSEARCA: IWM ) that tracks small-cap stocks registered -2.3% through 12/29. The more that one diversifies, the worse things get. Add foreign stocks via iShares All-World excluding U.S (NASDAQ: ACWX ) for -4.0%. Inject iShares High Yield Corporate Bond (NYSEARCA: HYG ) for -5.2%. Dare to emerge with Vanguard FTSE Emerging Markets (NYSEARCA: VWO ) for -14.7%. In fact, Bloomberg tracked 35 ETFs that invest in different asset types to uncover a median loss (-5.0%). Even the all-in-one solution via iShares Core Growth Allocation (NYSEARCA: AOR ), which offers 60% in stocks and 40% in bonds, served up a negative result (-0.7%). According to research compiled by Bianco Research LLC in conjunction with Bloomberg, you have to go back to 1937 to find a 12-month run where asset allocation performed as poorly. Coincidence? Could be. Or perhaps investors in 1937 struggled with the same concerns about a return OF capital as opposed to a return ON capital. 2. Overvaluation Then, Overvaluation Now . Nobel laureate in economics, James Tobin, proposed that the combined market value of all companies listed on the exchanges should be roughly equal to their replacement costs. He then developed the “Q Ratio,” which divides the total price of U.S. stocks by those replacement costs of corporate assets. Tobin’s Q hit 1.1 earlier this year, suggesting that stocks traded 10% above the value of companies’ assets. Not so bad? That reading has only been surpassed by the year 2000. Moreover, if one assumes the year 2000 was a moment of ridiculous dot-com euphoria, you’d have to go back to 1937 to find a reading that suggests similar overvaluation. Keep in mind, this ratio has only surpassed the 1.0 threshold on one-tenth of trading sessions, most of which occurred in the late 1990s. The average (mean) Q ratio is approximately 0.68. 3. “Spread Spike” For High Yield Bonds . Back in May of 1937, the high-yield bond spread rocketed 85 basis points. Here in 2015? We have two occasions where high-yield bond spreads have spiked by more than 1%. Normal market fluctuations? Hardly. When investors abandon the credit markets, they are concerned about a wave of corporate defaults. And they’re not just worried about energy defaults either. High yield corporate credit is struggling clear across all sectors of the economy. (See Bloomberg chart below.) Are the circumstances in 2015 identical to those in 1937? Of course not. Every well-read market participant recognizes that history has a habit of rhyming, not repeating. Nevertheless, keeping a higher allocation to cash than you might otherwise keep is sensible in this late-stage stock bull. 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.

Should You Buy Value Stocks Today?

The third quarter was abysmal for stock markets. October has proven the pain short-lived. Growth stocks have outperformed value stocks. But value has the long-term track record of outsized returns. The typical investor is a notoriously bad timer at buying and selling. A good advisor helps limit emotion-driven mistakes. The third quarter is now on the books and it was an ugly one for stocks. The S&P 500 ( SPY , IVV ) fell 6.4% while the Russell 1000 Value ( IWD ), arguably one of the best indices to benchmark “value” stock performance, was down 8.4%. We commented last month, “We concede that there are plenty of reasons to hesitate, but we’re putting capital to work. The economic landscape in the U.S. remains favorable to equities and more importantly, ample long-term investment opportunities exist. … And that’s why we’re buyers.” At least for now, the recent turmoil has proved short-lived. The S&P 500 is up over 8.0% in October and the Russell 1000 Value has posted a similar gain. For the year, the S&P 500 has delivered a 2.5% gain, while the Russell 1000 Value returned negative 1.8%. Growth stocks are up over 6.0% in 2015. Value stocks’ year-to-date underperformance of growth stocks isn’t a new trend. It’s been a tough going for value for many years now. (click to enlarge) Since Black Cypress’s inception in the summer of 2009, over six years ago, growth stocks have outperformed value stocks by 23% — about 3.0% per year. Growth’s cumulative outperformance stretches back even further, all the way to the end of 2006 before the onset of the recent financial crisis. Growth has bested value by 5% per year for almost nine years. There are only two other instances in history where growth’s dominance reigned longer: the Great Depression (another financial crisis) and the technology bubble of the 1990s. Such multi-year value underperformance is unusual. Historically, it lasts a few years at most and growth’s cumulative gains are reversed over a one or two-year period. At least that’s the historical precedent. Since 1927, value stocks have returned an average 2.5% more per year than growth stocks. Academics call this historical outperformance of value over growth the “value premium”. And yet, while the value premium is a well-documented phenomenon, most investors fail to capture it. Owning an underperforming asset taxes one’s patience. Continuing to own it requires a deep conviction in one’s research as well as the emotional fortitude to withstand the frustration that comes with being at odds with the market. Most investors have neither. And therein lays the likely reason the value premium remains despite widespread knowledge of its existence: capturing it entails suffering through occasional periods of underperformance. Individual investors buy and sell at inopportune times, fund managers fear redemptions and hug their benchmarks, and advisors chase the hottest funds. And the value premium persists. One of the best studies to illustrate such bad investor behavior and its impact on performance is DALBAR’s Quantitative Analysis of Investor Behavior. This study doesn’t address the value premium in any way, but it is illustrative of investor actions and their effects, which makes it relevant to our discussion. The 2014 QAIB stated that over the last 30 years, investors in stock mutual funds averaged annual returns of 4.0%, while the S&P 500 averaged about 11.0%. That is, the very investors that were seeking equity market performance by buying stock mutual funds underperformed stock markets by over 7.0% per year. The culprit? Poor timing decisions. Investors — including individuals, advisors, and consultants — added to their stock positions at or near stock market peaks and sold near market lows. Investors also hesitated to invest again after markets bottomed. Investors are their own worst enemy. We choose to address these topics for two reasons. First, because we’re value-oriented investors and it has been one of the more inhospitable environments in history for our investment approach. In the last two years alone, growth stocks have outperformed value stocks by 9.0%. To say the least, it has been a challenge to provide outsized returns with our currently out-of-favor approach. And yet, despite the headwind of growth over value since our firm’s inception, our strategies have held their own with broad markets. Considering what we’ve been up against, including growth’s dominance as well as no opportunity to showcase our risk management practices in this ongoing bull market, we’re pleased with our results. And today, we think our portfolio is about as well-positioned against the market as it has ever been. Broadly, we like value’s prospects over the next five years. The second reason we delved into these topics is because one of the most important functions of an investment advisor is to provide a check on emotion-driven decisions. Coaching to buy, sell, and hold, and the timing of these recommendations, often goes overlooked in an advisory relationship. But it can be more important than security selection itself. Get an advisor you can trust if you’ve found yourself buying and selling for no other reason than emotion. You’ll save yourself some well-deserved self-ridicule and probably a lot of money too. Our portfolio is well-positioned to capture the value premium and to create excess value through our carefully selected individual company holdings in the years ahead. Is yours?

Index ETF Investors Are Vulnerable To A Return To Rational Pricing

Recent financial research suggests that inclusion of a corporate share in an index ETF adds to its market value. As index ETF investor participation grows, overpricing apparently becomes more pronounced. As ETF participation has become a greater share of the investment universe, these effects have apparently become more important. As a result index ETFs may now be both less diversified and overvalued. A return of shares included by ETFs to their fundamental, rationally determined, values would adversely impact an index ETF investment. The effect of the new valuations on index ETF decision-making would be perverse, leading to further investor losses. According to much recent financial research, the market’s focus on index ETFs [such as the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), the iShares Core S&P 500 ETF (NYSEARCA: IVV ) and the Vanguard Total Stock Market ETF (NYSEARCA: VTI )] has led to overpricing of many of the common shares included in the important indexes, accompanied by underpricing of companies excluded by the indexes, among other pricing anomalies. This mispricing presents a hazard to investors. The only existing investor defense against a return of these overpriced stocks to their rational value is to buy underpriced stocks outside the index ETF with properties similar to the overpriced stocks inside the ETF. How can the simple publication of an index number intended to represent the value of the stock market as a whole change the value of common stocks? The indexes that are the subject of this article are the source of the dominant common stock investment strategy of the moment, the index ETF. For example the Standard and Poors 500 Stock Index (S&P, a value-weighted average of the 500 largest common shares listed on the NYSE or NASDAQ) is the oldest and still the most important example of a traded numerical characterization of the value of the equity market as a whole. Index exchange traded funds (ETFs) are exchange-listed instruments that replicate broad market measures such as the S&P. Index ETFs are big – about 30% of the volume of all investment funds under management. But there may be strange effects of the existence of index ETFs on the prices of stocks that are part of an index. Those effects, or at least the current scholarly take on them, is chronicled in an interesting October 10th article in the New York Times . The Times article points to substantial evidence produced by market researchers that common stocks included in the popular listed indexes are often, by all the usual measures, overvalued relative to similar stocks outside the indexes. In the current financial academic literature, this is a prominent example of market irrationality. It is not rational, the argument goes, for the simple inclusion of a stock in an index portfolio to change investor behavior and thus affect market prices of securities so profoundly. But the evidence points to several effects. It has been clear, almost since the S&P 500 index began to be published, that being newly included in an important index increases a stock’s market value; while a fall into exclusion leads to a decline in market value. But there is evidence of other more profound effects as well. It appears that as a greater share of the market is included in index portfolios, the effects of index inclusion on stock prices have become more pronounced. And the effects may not simply be higher prices of stocks within the indexes, but higher correlations among the prices of stocks within the indexes as well. This higher correlation is particularly interesting, since it has investor risk management implications. If higher past correlation continues, the major indexes no longer perform their function in portfolio theory – risk reduction through diversification. Why? If correlation between investments inside the indexes rises, correlation among instruments outside the indexes rises, and correlation between index-included and index-excluded investments falls, a diversified portfolio must include stocks outside the index. In other words, the behavior of stocks in index ETFs creates a paradox. The effect of index ETF growth is that the index no longer represents a diversified portfolio. Index ETFs are, in this sense, self-defeating. To form a truly diversified portfolio, investors must now add other stocks outside the ETF. The index ETFs are vulnerable to any trading strategy that exploits this mispricing. One trading strategy that a hedge fund might apply to restore rational pricing to the stock market has characteristics that can be found in my SA Instablog: ” A Trading Strategy Based on Index ETF Overpricing. An ETF Defense. ” Investors can protect themselves (imperfectly) now from a return to rational pricing of the shares included by the index ETFs, and simultaneously achieve the portfolio diversification index ETFs once provided, by buying diversified shares outside the ETFs.