Tag Archives: management

What To Do When Your Stocks And Bonds Portfolio Reaches Minimum Volatility

Summary Investors typically increase exposure to bonds as they near retirement, hoping to reduce volatility and drawdown risk. It is very possible to reach a point where further increasing exposure to bonds will increase rather than decrease volatility. This phenomenon is more likely to occur with longer duration bond funds. Once you reach minimum volatility for a two-fund stocks and bonds portfolio, you can further reduce risk by (1) buying treasuries or (2) switching to a shorter term bond fund. There is no general result for which strategy is preferred, but (2) tends to give better returns and may be easier to implement. Expected Returns and Volatility as you Increase Bond Exposure Suppose you are implementing a basic stocks and bonds portfolio comprised of two Vanguard mutual funds: Vanguard 500 Index Fund Investor Shares (MUTF: VFINX ) and Vanguard Long-Term Bond Index Fund (MUTF: VBLTX ). Using historical data going back to Feb. 28, 1994, here is how expected returns and volatility of the VFINX/VBLTX portfolio vary with asset allocation. (click to enlarge) Here the top-right point represents 100% VFINX/0% VBLTX; the next data point is 90% VFINX/10% VBLTX; and so on until the bottom-most point, which is 0% VFINX/100% VBLTX. As you near retirement, you may increase your VBLTX allocation to reduce risk. If you go from 90% VFINX/10% VBLTX to 60% VFINX/40% VBLTX, for example, you reduce your expected returns a little (0.041% to 0.037%), while reducing volatility considerably (1.06% to 0.70%). Further increasing the VBLTX allocation reduces volatility, but only to a point. At 25.8% VFINX/74.2% VBLTX, you reach the leftmost point on the curve, and further increasing VBLTX allocation actually increases volatility while reducing expected returns. Of course, there is never a good reason to increase volatility and decrease expected returns. So looking back at the past 21.5 years, you would never have wanted to allocate more than 74.2% to VBLTX in a VFINX/VBLTX portfolio. Longer Duration Bond Funds Have Lower Critical Points The expected returns vs. volatility curve doesn’t always have a clear critical point like we saw for VFINX/VBLTX. In general, longer duration bond funds are more likely to exhibit this phenomenon. You can see this when you compare the curve for VFINX paired with VBLTX to VFINX paired with Vanguard’s short-term and intermediate-term bond funds, VBISX and VBIIX . (click to enlarge) Looking at the blue curve, VFINX/VBISX does have a minimum volatility point, but it’s at a very high VBISX allocation (4.3% VFINX/95.7% VBISX). Note however that if you’re using VFINX and VBISX you probably wouldn’t want to go higher than 90% VBISX, as doing so sacrifices considerable expected returns while reducing volatility very little (if at all). The green curve is in between the first two, with minimum volatility at 12.7% VFINX/87.3% VBIIX. I would not recommend going any higher than 80% VBIIX, though, from an expected returns/volatility standpoint. Reducing Volatility Beyond the Critical Point What do you do if you want to further reduce volatility after reaching your portfolio’s critical point? I see two reasonable options: Allocate some of your portfolio to treasuries (e.g. 10-year US treasury bonds). Swap for a shorter duration bond fund. Let’s go back to the first two-fund portfolio, VFINX/VBLTX. Suppose we’re at 25.8% VFINX/74.2% VBLTX and we recognize that we’ve reached minimum volatility. We would like to reduce volatility to one-fourth that of VFINX (the leftmost dotted line in the previous figures, at 0.298). We can’t do it with all of our assets allocated to VFINX or VBLTX. Let’s consider option (1). Allocating some of your portfolio to cash would pull the red curve down and to the left. But if you’re going to have cash, you may as well get some interest on it. So instead of cash let’s say we generate risk-free returns on whatever percentage we pull out of our VFINX/VBLTX portfolio, from investing those assets in US treasuries for example. The next figure shows the expected returns vs. volatility curves for various allocations to a risk-free investment that returns 1.5% annually. (click to enlarge) To clarify, the highest curve the same as we saw before; the next highest is 10% receiving risk-free 1.5% annual returns, and the remaining 90% split to VFINX/VBLTX in 10% increments; and so on until the lowest curve (which you can barely see), which is 90% risk-free 1.5% annual returns, and the remaining 10% split to VFINX/VBLTX in 10% increments. The first curve to extend to a volatility of 0.298 is the one with 40% allocated to the risk-free investment. For this portfolio, we would have to allocate the remaining 60% of our assets to 30% VFINX/70% VBLTX, to achieve an expected return of 0.0226% with volatility of 0.298%. Now let’s consider option (2). The next figure is the same as the last one, but with the curves for VFINX/VBIIX and VFINX/VBISX included. (click to enlarge) Interestingly, swapping VBLTX for VBISX lets us reach a volatility of 0.298 with a mean daily return slightly higher than that reached with VFINX/VBLTX and 40% risk-free. A 24.7% VFINX/75.3% VBISX portfolio has means returns of 0.0232%. A natural question is how the risk-free rate affects whether strategy (1) or (2) is better. For the Vanguard funds examined here, strategy (1) would always outperform strategy (2) if the risk-free rate was 4% or higher (i.e. rarely or never). Strategy (2) would always outperform strategy (1) if the risk-free rate was 0% (i.e. you held cash rather than treasuries). For risk-free rates between 0% and 4%, it really depends on the particular level of volatility you’re trying to achieve. Conclusions I think a lot of investors operate under the assumption that increasing exposure to bonds reduces volatility. But in fact there is often a point where further increasing exposure to bonds increases volatility and reduces expected returns. You don’t want to go past that point. To reduce volatility further than your two-fund portfolio allows, you can either allocate some of your assets to a risk-free investment, say US treasuries, or you can switch to a shorter duration bond fund. I favor the second strategy, as it tends to allow for greater expected returns and seems logistically easier to implement. More generally, I think it is very important to know where your portfolio is at in terms of the expected returns vs. volatility curve. You should have a good idea of how any potential change in asset allocation or choice of funds affects your portfolio’s characteristics.

S&P 500: The Perfect Short

Summary Valuations at their highest levels in over a decade on a price/book, price/sales, and price/cash flow basis. Buy backs / M&A now representing 70% of all buying volume. Declining market breadth. The world is back to normal. The S&P (NYSEARCA: SPY ) is ~1% from its high, China is stabilizing, the U.S. is adding jobs, average hourly earnings are rising, and Dennis Gartman is ever so slightly long crude. This change in sentiment from the August lows led to the largest point rally in history, significantly weakening bear sentiment among individual investors, asset managers and the boys/girls with leverage, shown below. (click to enlarge) (click to enlarge) While the vicious upward move shook a lot of bears, including myself on the second leg, the concerns voiced during the sell-off are still present today, if not worse; however, the market seems to be operating under the assumption that everything is normal again given its recent price action, bringing me to one of my favorite graphics (note “return to normal.”) Yours truly, the S&P. (click to enlarge) So here we are, hovering around all-time highs with: Valuations at their highest levels in over a decade on a price/book, price/sales, and price/cash flow basis The largest amount of non-gaap adjustments as a % of total earnings since 2009 Buy backs / M&A now representing 70% of all buying volume The highest amount of corporate leverage in history Companies issuing debt to buyback record amounts of stock (’00, ’07) Two quarters of negative earnings growth 80% of IPOs with no earnings (last seen in 1999) A dollar that is breaking out 9.6 trillion of foreign debt denominated in dollars The highest sales/inventory levels since 2008 Declining market breadth Eerily similar price action to 2001 and 1937 And A Fed that “is definitely raising rates” in December With this as the backdrop, my view is that the path of least resistance is to the downside. I see an 8% chance that we break the previous highs. If that is that does manifest, a blow-off top may be in the cards. Valuations: I detailed in my previous post on gold (NYSEARCA: GLD ) that the current market multiples across a series of valuation metrics are the highest we have seen in 10+ years. This is by no means an indication that the market will go down, as something overvalued can become additionally overvalued, but should be used as an indication of how far the market could move under a perception change, which I believe we are currently undergoing given two quarters of negative earnings growth. As you can see below, the S&P currently trades at a price-to- EBITDA multiple of 10.4x, roughly in-line with the tech bubble. That turned out well. (click to enlarge) H/t @Jpcompson Buying Volume: In a recent interview , Ray Dalio sat down with Tom Keene and Michael McKee to talk all things markets. While the headline news was Ray calling for additional easing (QE4), his comments on buying volume were just as interesting. DALIO: American businesses right now are the number one thing is they’re flush with cash. And as a result, the biggest force in the stock market right now is the buy backs and mergers and acquisitions. So something like 70 percent of the buy, the buying in the stock market, is along those lines. So the largest buyers of stocks are corporations themselves. Think about this for a minute. 70% of the buying volume is coming from corporations not market participants. Companies typically buy back their stock for a few reasons: The stock is cheap, i.e. (NASDAQ: AAPL ) There is a lack of investment opportunity/uncertainty Artificially inflate EPS With that being the premise, let’s look at the current environment. Stocks are clearly not cheap, although value can still be found ($AAPL). The domestic economy according to many economists and pundits is doing “fine,” so there should be plenty of investment opportunities. So by process of elimination, companies are levering up to reduce shares out, in turn artificially inflating numbers and making their stocks look cheaper than reality. If companies are deploying capital to buy their stock at 16-17x non-gaap earnings (30+x gaap), the return over the following year would need to be 17% (30%+) to justify the investment. What we are witnessing is one of the most value destructive deployments of capital in history that will reemerge in future earnings, or the lack of. Corporate Leverage / Buy Backs / Cash Usage: The process of levering up to buy back stock is a direct effect of ZIRP and lack of corporate discipline, as companies allocate cash to please shareholders rather than invest in the future of their businesses. Goldman Sachs details this in the chart below. As you can see, buy backs as a percentage of total cash use has doubled since 2009 when stocks were arguably the cheapest. The percentage of cash used for CAPEX is 30%, or 2% off the lowest level seen in the past 16 years. Cash used to invest in growth is also near the lowest levels seen since 1999, while cash returned to investors nears an all-time high. (click to enlarge) Due to the abundance of short-termism, corporate leverage, buy backs and debt issuance are at or near the highest levels we have seen in 25, shown below. This is in the face of back to back quarters of declining sales and earnings growth, according to FactSet. Excessive leverage is akin to running a marathon with a 100 pound weight on your back. That said, earnings growth in the face of a stronger dollar, global slowdown, wage inflation, corporate leverage, higher rates, and diminishing CAPEX leads me to believe the past two quarters of declines are just the beginning. (click to enlarge) Forward Estimates: Wall Street analysts currently see earnings growing substantially over the next year as FactSet highlights below. While this is completely possible, I’m not sold given the trends that we are seeing today. Friday’s jobs report showed the strongest average hourly earnings y/y growth since 2009, reinforcing corporate comments on wage inflation. Barbarian Capital had a great post recently highlighting restaurant wage pressure, which he views as a good proxy for the following reasons: “The US food service labor market is probably the deepest and most liquid labor market in the US. At the entry level, there are no entry barriers either in terms of credentials or task skills (people already make sandwiches and wash dishes at home).” “The labor force in the industry is big: 14 million people, or about 10% of the labor force” “Employee turnover is very high : it was 66% in 2014 and 81% in 2007 (chart at the bottom of the linked article). So at the entry level, 100%+ turnover is likely the norm. This means that employers, as a whole, pay the market rates: there is no lag or scheduled increases (ex of local min wages), unlike professional or unionized industries” “Publicly traded restaurant companies generally report direct labor costs in their filings, unlike retail establishments (another large liquid labor market). My impression is that this fosters labor discussions more often than in retail.” Here are a few of the many examples of wage inflation outlined on recent conference calls: Historically, SG&A has been ~17% of sales, COGS ~66% of sales, interest and taxes ~5% of sales, depreciation and other ~5%, leading to a 9% EBIT margin (note this is as of 2013.) Over this period, yields, the employment cost index, and effective corporate tax rates have all fallen, providing a tailwind to operating earnings. While the quality of gains in the jobs report are debatable, it is clear that the risk is to the upside on wage inflation, which will clearly have an adverse effect on operating income. And given the fact that Bernie Sanders is somehow in the presidential race, who knows where corporate tax rates will be. I am assuming that taxes remain around current levels and spreads widen (outlined below), which will further reduce the operating earnings. Below are the Wall Street margin assumptions that get you to $128 in earnings power for FY16. While the trend looks like it is about to roll over, people much smarter than I are forecasting continued expansion. I’ll take the other side. H/t @Callum_Thomas As I previously stated there is clearly some wage pressure being felt by corporations. At ~17% of sales (likely lower given additional items in SG&A), that alone puts material pressure on margin expansion, but price and COGS are the real levers here. Price – COGS (66%) = Gross Margin. I’m no economist, but when there is demand for goods, a seller is likely able to raise prices at a faster clip than the costs of those goods, in turn increasing margins. That being said, below is a chart of the personal consumption expenditures deflator showing that inflation is near post crisis lows and almost negative. H/t @Mktoutperform Core PCE is much stronger, but again minimal signs of inflation given its current downtrend. (click to enlarge) So as prices of goods and services continuously trend lower, how is it that margins will expand from here if Price – COGS = GM, especially given the recent dollar strength and a 70% chance of a hike in December. In addition, it will be very difficult to raise prices given current inventory levels. The inventory to sales ratio shown below was last seen during the financial crisis. Forced liquidations and falling orders is likely not good for margins. (click to enlarge) Corporate Leverage: To recap, we have the highest valuations in the past 10+ yrs, multiple factors are putting downward pressure on margins, and record amounts of corporate leverage is being used to purchase stocks at nose bleed valuations. This brings me to the leverage part of the equation. As shown below, the median debt-to-EBITDA ratio for both investment grade and high yield bonds is at the highest level since 2005, which is being accompanied by rising default rates. I am not an economist nor a credit analyst, but given the trends I’ve highlighted above I can make a pretty strong case for why this will likely deteriorate further. (click to enlarge) Rising spreads will have an adverse effect on earnings and make it increasingly difficult to refinance given that ~30% of the aggregate S&P debt matures in the next three years. (click to enlarge) As you can see below, junk bonds are rolling over again even as the market nears all-time highs. The same is true for investment grade corporates. I will put my money on bond market here. H/t @Callum_Thomas Breadth: Under the surface the S&P is losing steam, as the leadership of the market has narrowed substantially over the past few months. This has been evidenced by the difference between the S&P and the equally-weighted ETF, the RSP . As you can see the RSP:SPY ratio is breaking down to 2 year lows. Here is a chart from @NorthmanTrader that further illustrates the discrepancy. (click to enlarge) In addition, the number of stocks above their 200 day moving average and the current downtrend is indicating waning breadth. This further illustrates to me that the path of least resistance is to the downside. (click to enlarge) The Fed And The Dollar: The Fed’s recent commentary strengthened my view that their credibility, like the market’s breadth, is waning. From the press release: “household spending and business fixed investment have been increasing at solid rates in the recent months.” What are they looking at? Source: Zerohedge The committee then states the “pace of job gains has slowed,” and longer term inflation expectations remaining stable. This is clearly not the case as illustrated by the PCE deflator above. But fear not, the committee, “expects inflation to rise gradually toward 2% over the medium term as the labor market improves further” from its recent slowing. The illustration below from @NotJimCramer gives you an idea of the Fed’s talk and lack of action. (click to enlarge) The first thing that came to my mind was: www.youtube.com/watch?v=eKgPY1adc0A The Fed got their wish last Friday with a blowout jobs number, sending the Fed Fund futures probability of a December hike to 70% and moving the dollar up with it. In my opinion, the last thing the world needs right now is a stronger dollar. There is roughly 9.6 trillion of foreign debt denominated in dollars, 3 trillion of which has been added by emerging markets since Lehman. With global demand slowing, sovereigns are forced to devalue their currencies, in turn strengthening the dollar without the Fed’s move. It is my view, that there are currently multiple reflexive relationships that will force the Fed to hold off on hiking rates. Should the Fed hike, which the market and participants seem to believe is a foregone conclusion based on a jobs number that under the surface was not great, the dollar will: Hinder the repayment of emerging market debt Further reduce commodity prices, which will in turn hurt earnings and likely result in an abundance of defaults given the amount of debt tied to commodities Make U.S. goods less attractive, in turn further reducing sales and earnings That said, I am sticking with my view that the Fed is trapped in a corner and the next move will be to ease or cut rates, which has recently shown up in their verbiage. Price Similarities: In turning to history as a guide of the future I looked at 2001. The blue line is the S&P from 10/16/1998 to 12/20/2000 and the red line is the S&P from 10/10/2014 to present. As you can see the price action is almost identical. The next leg is clearly lower and should manifest over the next two weeks. Nautilus provides an additional analog comparing 1937 to today. Note the 93% correlation. Conclusion: Based on the evidence provided above, it seems the path of least resistance is to the downside. My thesis will be wrong should the following manifest: The dollar weakens significantly, aiding commodity prices, U.S. sales, and earnings Short-term: the market moves to all-time highs on increasing breadth Inflation increases significantly Wage pressures dissipate Spreads tighten Corporations halt buybacks and invest in the future at similar historical levels. (Although this would cut the current bid) The market fails to follow either analog sequence I am agnostic to the Fed in relation to my short thesis on the S&P. I believe a hike from them would be extremely detrimental to the macro economy, but the failure to hike can be as destructive. Feedback welcomed.

A Seasonal Biotech Portfolio Alternative To ‘Sell In May’

Summary The common sense strategy of sell in May fails to beat a buy-and-hold ETF strategy. I tested an alternative seasonal strategy to find it safer, but not better than the buy-and-hold strategy. Modifying the seasonal strategy to allocate capital to biotech instead tech beats the buy and hold strategy in at least two ways. This article is a return to the “sell in May” philosophy, which I previously outlined here . As it is now November, those who subscribe to this philosophy are getting ready to enter the market. If you are one such investor, I implore you to first read the following article, in which I show you how the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ) can more than double the effectiveness of your strategy. Sell in May The first thing I want to do is set a benchmark to which I will compare the portfolio strategy I plan to introduce here. Let’s take it a step further and use two benchmarks: buy and hold and sell in May. Buy and hold: Buy the SPDR S&P Trust ETF (NYSEARCA: SPY ) and continue holding, never selling Sell in May: Buy the SPY in October and switch to Treasury bills in May As you can see from the figure below, the buy and hold strategy actually beats the sell in May strategy over the past 10 years. This only bolsters my original article that states the sell in May strategy only holds is special occasions and should not be relied upon in the long-term. The upside is that you protect yourself a bit from the drawdowns, but as you’ll see in a bit, an even better strategy exists. So let’s stop with the mystery and great straight to the strategy… after one more portfolio strategy introduction. In this article , a different type of seasonality-based portfolio strategy is introduced. You can skip reading the article, as I’ll explain it in a nutshell in the following section. Kaepple’s seasonality Kaepple states that his extensive research of market seasonality led him to three main conclusions. First is to buy tech stocks during the market rally season, typically November to January (that’s now!). Second is to switch over to energy stocks during the winter. Then, in May, switch to cash (or bonds). In September, get into gold for one month, and then switch back to cash. I wondered how this strategy would do compared to the buy-and-hold and sell in May strategies. So, I ran a backtest. The strategy follows: November to January: Buy the Technology Select Sector SPDR ETF (NYSEARCA: XLK ) February to May: Buy the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) June to August: Stay out of the market September: Buy the SPDR Gold Trust ETF (NYSEARCA: GLD ) November: Stay out of the market Here are the results of this strategy: As you can see, the results of this strategy were better than the buy-and-hold strategy. Not in performance – they both performed equally well. However, this strategy reduced the drawdown and showed a stable upward trend. This portfolio allocation strategy could have protected you from much of the damage that most investors suffered in 2008. In addition, although we were in specific sectors via XLK and XLE, this portfolio was less volatile than simply buying the SPY. That is, this is a safer portfolio allocation strategy with fewer downsides. But couldn’t hedging do the same? After all, this strategy didn’t outperform the buy-and-hold strategy. But what if we focused on an even more specific sector during the market rally period? Choosing an individual stock, of course, would be too risky, as you’d be putting all your eggs in one basket. But what about focusing on a very specific subsector of the tech sector? My thoughts immediately turned to biotech, of which there are several good ETFs. Though I am long on the ALPS Medical Breakthroughs ETF (NYSEARCA: SBIO ), this ETF is relatively new, precluding it from backtesting. Instead, I reached for the next best thing: the iShares Nasdaq Biotechnology ETF . Thus, the new strategy invests in IBB from November to the end of January. The results follow. Now we’re talking! Half the max drawdown of the buy-and-hold strategy with double the cumulative gains! In addition, just like the original sector portfolio strategy with the XLK, this portfolio would have weathered the 2008 storm. Conclusion for Investors The conclusion is basically in the last image – a strategy that switches into different sectors of the market throughout the year is safer than an index fund and brings in double the revenue. (Devil’s Advocate: How does this compare to buying and holding IBB? Answer: Same cumulative returns with 30% lower max and average drawdowns.) As the first backtest shows, buy and hold beats sell in May but an IBB-focused seasonal strategy beats them both with no obvious disadvantages. Anyone using a seasonal strategy such as the “sell in May” strategy should reconsider how they play this game. If you’re looking for something easy, this is your four-trade-a-year investment strategy. And it should be rather cost effective to switch four times a year. No, it’s not a flamboyant investment strategy but it beats most mutual funds. If you’re interested in seeing some tweaks to this strategy, ask me in the comments section or via mail. I’ll be rolling out my premium Seeking Alpha backtesting newsletter soon, in which I backtest your strategies. Before I launch it, I’m willing to run a backtest on your portfolio allocation strategy or trading strategy per gratis. Request a Statistical Study If you would like for me to run a statistical study on a specific aspect of a specific stock, commodity, or market, just request so in the comments section below. Alternatively, send me a message or email.