Tag Archives: market

Should We Be Getting Ready To Cover Our Shorts In Energy?

Summary Crude oil priced in gold is near a 30-year low. Crude oil priced in inflation-adjusted dollars tells another story. What are the crude/gas ratios and technicals telling us about our short positions? Getting paid to be patient while we wait for the bottom in energy markets and stocks. Now that oil and gasoline cost less than bottled water, maybe it’s time to start looking at covering our short positions. Don’t get me wrong; I’m not ready to use the L word just yet (long), but I can clearly see long positions on the horizon at lower levels. The downward spiral is still intact, but history has proved short-selling parties can’t last forever. Just how inexpensive is crude oil? Let’s look at the 30-year chart for a barrel of crude priced in gold. All-time high 0.15050 of an ounce, June 2008. All-time low 0.03322 of an ounce, July 1986. Current 0.03370 of an ounce, December 2015. 1986-2015 average, 0.69889. Distance from the all-time low priced in gold 0.00048 of an ounce or about 50 cents. Source & supporting data Federal Reserve data 1986-2105-cost-of-oil-priced-in-gold 1986-2015 oil gold ratio (oil normally trades above gold on this ratio) Source Federal Reserve Is $34.52 per barrel misleading if you look at the historical price action from 1993-2015 calculated in inflation-adjusted dollars? All-time high $147.27 per barrel, July 2008 ($162.34 in 2015 USD). All-time low $10.35 per barrel, December 1998 ($15.80 in 2015 USD). The 30-year average price for oil is $42.87 ($59.09 in 2015 USD). 2015 dollars generated using the bls.gov inflation calculator . Current cash oil price $34.52 per barrel Data source Chicago Mercantile Exchange The fundamentals are still weak The technicals are still weak Daily = downtrend Weekly = downtrend Monthly = downtrend The spread between a gallon WTI crude and wholesale gasoline is more than twice the historical average. 1990-2015 historical average, $0.2147 ($0.28 in 2015 dollars). Current 12-month rolling average = $0.4426. Spread between WTI crude and retail gasoline, better than average. 1990-2015 historical average is $0.8642 ($1.14 in 2015 USD). Current 12-month rolling average = $1.2612. Spread between wholesale and retail gasoline, consistent with the historical average. 1990-2015 historical average is $0.6496 ($0.86 in 2015 USD). Current 12-month rolling average = $0.8186. Where the futures market is pricing crude oil through December 2024. Ratios tell me to maintain shorts, technicals say stay short, futures markets indicate higher prices. One current crude oil position to track Short March 2016 deliver at $46.80, contract value $46,800. Deposit posted per contract = $15,000. Exchange margin per contract = $3,800. March 2016 is currently trading at $36.74, contract value $36,740. I’d like to cover these $46.80 shorts, reverse to long at $33.00. 1) To cover my $46.80 shorts, I’m going to write a put at the $33.00 strike , collecting $1.24 per barrel or $1,240 per contract (expires in 58 days). The only way my current $46.80 short can be “pulled” away is if the market falls from the current price of $36.74 down to $33.00. Should this occur, my short position would appreciate by another $3,740 per contract between now and 17 February 2016 expiration. If March delivery never goes down to $33.00, I keep the $1,240 put premium collected against my $46.80 short. 2) I’m also going to write another put at $33.00, collecting another $1,240. Again, if March 2016 WTI crude does not trade down to $33.00, I keep the $1,240 in time premium. If it does go below $33.00, I was paid $1,240 to enter a new long position at $33.00 or $3,740 per contract better than where the market is currently trading ($36.74), (yes, I’ll have to offset and roll the position in March). 3) If the market stays the same, I’ve collected $2,480 over the next 58 days on a position if delivered is worth $33,000. 4) If oil starts to rally, I can cover my $46.80 shorts and watch the $33.00 puts expire worthless (+$2,480). There are several other ways to offset my $46.80 shorts, example, writing an in-the-money put at $40.00 currently trading at $4.59, collecting $4,590 in premium ($920 in time value). On the upside, the current position is trading at $36.74 contract value $36,740 (1,000 barrel contract x $36.74 per barrel) or I’m getting paid 6.750% in total time value over the next 58 days to liquidate my $46.80 if the market goes down to $33.00. If $33.00 in put is hit, my gain on the trade = $13,800 per contract plus the collected time value of $2,480 for a total of $16,200. The margin I’m allocating on this position is $15,000 per contract ( exchange margin = $3,800 per contract). What this strategy has done is paid me 16.53% in option time value on my $15,000 deposit per contract to be patient over the next 58 days. Many traders don’t realize how collecting fat time premium can work for you. Let’s assume the market is right and crude oil bottoms at the current price of $36.74 (March 2016 delivery). Let’s assume you go long crude oil at $36.74, wrote an out-of-the-money call at $39.50, and the $39.50 call is trading at $1.59, then you’re collecting $1.59 per barrel, $1,590 per contract, $27.41 per day or $10,006 per year on a position that has a total value of $36,740. The time value writing out-of-the-money options = 27.23% in annual time premium collected or 66.70% on the $15,000 allocated to cover the $3,800 in exchange margin. We’re posting $11,200 more than is required by the exchange to minimize the probability of a call. Our margin for error without being in jeopardy of having a call is $11.20 a barrel plus whatever option premium collected; in this case, $1.59 for a total of $12.79. In order for us to be on call (in this example) March 2016, crude oil would need to fall below $23.95 a barrel between now and 17 February 2016 (58 days). Again, I’m not advocating getting in at $36.74, I’m using this as an example to show you how hefty the time premium is writing out-of-the-money calls to generate income against a long crude oil position. In this example, the only way your $36.80 position can be called away from us is at $39.50 for a $2.70 profit per barrel or $2,700 per contract. If it does not get called away, we’d keep the time premium against our long of $1,590 (+10.60% on the $15,000 deposit for 58 days). In my case, I’m writing the $33.00 put to get into a $33.00 long position collecting $1,240 in time value; if delivered at $33.00, I’ll write the $36.00 or $37.00 call against the delivered $33.00 long collecting another $1,000 to $2,500 against the $33.00 long (I will have to roll this position to forward delivery month). Energy Stocks Energy stocks might not be as sick as all the academic chatter generated by the tradeless master debaters. Sure, crude may go down to $20, maybe $10, who cares? There are defined risk strategies to capture the move in both crude and energy stocks if you’re up to speed and can handle the risk. Fact, over the next five years, the world will need energy and the additional products crude produces. Demand may go down, but population will increase, and there are scores of situations that could generate a nice rally in crude from the low $30s as well as energy stocks. Many of these energy stocks you can trade using the same strategy of writing puts to get in and calls to get out as I’ve explained in the crude oil example above. Word of caution, you have to watch your bid/ask spreads, make sure you get firm quotes on the bid/ask, match them up to your other desks and always use price orders. On the horizon, I see short covering and potential net new long positions entering in energy stocks. Yes, the charts still look ugly. If you want to be less aggressive, wait for the turn (change in trend) using something as simple as a Bollinger 20,2 and exponential moving average 9 on weekly data in the examples below. Exxon Mobil Corporation (NYSE: XOM ) BP p.l.c. (NYSE: BP ) Royal Dutch Shell plc (NYSE: RDS.A ) Chevron Corporation (NYSE: CVX ) Valero Energy Corporation (NYSE: VLO ) (no short on this) Petrobras – Petroleo Brasileiro S.A. (NYSE: PBR ) Marathon Petroleum Corp. (NYSE: MPC ) (no short on this) ConocoPhillips (NYSE: COP ) Suncor Energy, Inc. (NYSE: SU ) Total S.A. (NYSE: TOT ) Statoil ASA (NYSE: STO ) Yes, oil is inexpensive and appears to be moving lower, but the world still needs it. We will eventually find a bottom, might as well get paid on our short positions while we wait.

Why US Investing Differs A Lot From Europe Investing…

Summary US is definitely not a market for traditional stock-pickers, as this market is a flow-driven market. In Europe, the economic knowledge of the population is very low. Stock-pickers should focus on Europe, and systematic or factor-based investors on the US. Smart risk management is as important as finding equity ideas to generate alpha. The whole study with all the statistics and charts may be found on SSRN at http://ssrn.com/abstract=2701901 .Or just ask the author. We compare European Indices (DJ Stoxx 600, Eurostoxx 50, FTSE 100) to US Indices (Russell 2000, S&P 500, Nasdaq Composite, Nasdaq 100) and Japanese Indices (Topix, Nikkei225). First, from 2014, December 31st to 2015, November 11th. Using a longer period could lead to wrong conclusions given the important turnover of the components within each index (roughly 5% per year), and the death-survivo r ship bias. Therefore, in a second attempt, we compare the behavior of the large indices such as Topix, Nasdaq Composite and Russell 2000, year after year, from 1999 to 2015. We do the same analysis for DJ Stoxx 600, even if the sample seems tight. Why year after year and not the 16 years in a row? Because turnover is huge on US indices, and the Russell 2000 or Nasdaq Composite composition as of 2015 is very different from the one as of 1999… RUSSELL 2000 Beta per couple (capitalization; volatility) (click to enlarge) · First of all, turnover is huge. Therefore, it is important to stress again that a study over a long period of this index versus its components is not relevant. · Second, looking at the performance vs (capitalization; volatilities) we can notice that although over the period, the performance of the index is largely positive (+249% total return between Dec, 31st 1998 and Nov, 11th 2015) – meaning it was a bull market with on average 7.7% per year, the red cells are much more represented on the right column of the table. This happens when the index performance is negative of course (2002, 2008), but it happens as well when the index performance is flat or mildly positive (2000, 2001, 2004, 2011, 2012, 2014, 2015). On the other hand, these high volatility stocks strongly outperform the universe in two periods out of seventeen: 1999 and 2003, with respective total return performance of the Russell2000 of +21%, +47%. This means that the outperformance of volatile small caps is very hard to capture because over the long run it may be easy to experience huge drawdowns with difficulties to recover. Keep in mind that when a stock drops by 50%, it needs to increase by 100% to come back to the initial level. Regarding capitalization effect, things seem to be more difficult to explain. As a summary for this part, should you want a smooth pattern, focusing on the low-volatility stocks in N-1 is worth in order to succeed in such a challenge, whereas dealing with historically high-volatility stocks may suffer from huge drawdowns (2002, 2008), and only rare astonishing performances, which may struggle in erasing the previous underperformance. The issue is always the same: what is your investment timeframe? And it has to deal with the way performance fees are calculated and rewarded. If the latter depend on High-WaterMark (HWM), then low-volatility should be chosen. If it does not, then the performance fees may be perceived as a yearly call on performance…And when you are long a call, it depends positively on volatility, and do not suffer if the market is negative end of year, as its value is null. Therefore, the asset manager is likely to choose the riskier stocks as he may – even if it is only 2 years among 17 – sharply outperforms the index punctually and underperform most of the time. HWM is strongly needed in order to protect investors from these type of greedy and unconscious asset managers. This phenomenon is likely to persist and be amplified by the emergence of smart-beta, risk premia, through the ETF market which is huge in the US and tends to offset the traditional Mutual and Hedge Funds: flows focus on ETF, and the latter focus on low-volatility stocks creating and feeding the famous “low-volatility puzzle”, challenging the well-known Markowitz theory. In this puzzle, the lower the volatility, the higher the expected return, whereas Markowitz used to state the opposite… · Regarding the persistence of the winners and losers, this relationship is quite volatile. According to the numerous papers by Bouchaud (“Two centuries of Trend-Following”), most of the time the market is trend-followers, but when the regime changes, it hurts a lot (examining the performance of CTAs may help to understand – CTAs being by construction trend-followers). 2009 is a very good example (with the red circle): the losers of 2008 were the winners of 2009, within a strong rebound of the market. It looks as if after a huge drop, the rule is to buy the worst performers. · Looking at the beta per volatility quartile, the higher the historical volatility, the higher the beta, whereas there is no clear pattern with respect to capitalization. This can be explained by the fact that small capitalizations are perceived to be more volatile than large, but in practice this is not the case. Do not forget that beta is the ratio of covariance over the product of standard deviations, therefore the surprising “in-range” beta is much more explained by the low numerator (covariance): small caps are volatile but not correlated with the benchmark, whereas large caps are less volatile but much more correlated with the benchmark. · Regarding stock-picking, stock-pickers are likely to pick their stocks in the upper right hand side of the table: low capitalization, high volatility. Low capitalization, because they aims at being anti-benchmark, and high volatility because their way of choosing relies on fundamental analysis and upsides – the higher the volatility, the higher the upside. · The Russell 2000 is definitely not a territory for stock-pickers, with 2% of the stocks exhibiting more than 100% YtD performance in 2015, and more than 55% doing worse than the index. · Should you want to post performance by picking up small caps and high volatility stocks within the Russell 2000 universe, then you have to be very sharp in terms of choosing the right ones, and avoiding all the underperformers (which are numerous – “Many are called, but few are chosen”), and be very sharp in terms of market-timing, given the number of years small caps largely underperform. NASDAQ COMPOSITE Beta per couple (capitalization; volatility) (click to enlarge) · Turnover is huge with less than 5% of the components remaining after 16 years. · The “capitalization effect” is more important on Nasdaq Composite than it is on Russell 2000. Russell 2000 only refers to small capitalization (less than 10BlnUSD), whereas Nasdaq Composite gathers stocks whose capitalization lays between 2MlnUSD and 700BlnUSD in 2015. The beta is decreasing with respect to capitalization, and is increasing with respect to historical volatility, with a beta close to 2 for the couple (1st capitalization; 4th historical volatility). · As for Russell 2000, the red part of the table is concentrated on the right hand side, with scarce very high outperformances. Same explanation about the smoothness profile required, and the performance fees policy needed. · Regarding the persistence of the winners and losers, this relationship is quite volatile, as for Russell2000. Most of the time (and easy to see in 2002 and 2015), the winners of N-1 remain the winners of N (momentum effect), whereas in a year such 2009, the breach is very sudden and the relationship no longer holds. · Looking again at the couple (1st capitalization; 4th historical volatility), which we use as a proxy for stock-picking here the ranking of this couple among the other couple per year. The ranking goes from 1 to 16. We could say that the higher the index performance, the higher the ranking of this “stock-picking couple proxy” (“SP”). Before 2012 it works. But since 2012, we can notice that in spite of the huge performance of the index (respectively +17.8% and +40.2% in 2012 and 2013), this stock-picking proxy lags a lot . We compare the stock-picking proxy to its opposite, the “benchmark proxy” which is the couple (4th capitalization; 1st historical volatility) (“B”). In 2012 and 2013, the respective median performance (in absolute value) of “SP” and “B” were The impact of ETF and “low-volatility” Smart Beta (“Minimum Variance” products, “Equal Risk Contribution” products) dramatically changed the market, developing thanks to the high risk-aversion of customers (still traumatized by the 2008 drop in equities). The flows are huge and totally offset any fundamental reasoning since 2010. At this date, 2 years after the big krach, investors are eager to take some equity risk again, but with strong risk management. This is the promise of these ETF. On the other hand, one can notice the difference of magnitude between the performance boundaries over the years: It is interesting to look at this table as of logarithmic return, as this type of returns keeps the symmetry. Therefore, we can notice that “B” suffer less from asymmetry than “SP”. The same reasoning we already made on Russell 2000 holds here again about huge drawdowns for “SP”, and the smooth pattern for “B”, with less difficulty to recover. Once again, the performance fees policy is the key to secure the shareholder, and prevent him from any rogue asset manager. · As for the Russell 2000, the Nasdaq Composite is definitely not a territory for stock-pickers, with 2.5% of the stocks exhibiting more than 100% YtD performance in 2015, almost 2/3 doing worse than the index, and a random stock picking underperforming the index by almost 10%. · The market evolution and the emergence of ETF does not allow any stock-picker to outperform the index. DJ STOXX 600 Beta per couple (capitalization; volatility) (click to enlarge) · Turnover is pretty low compared to US Indices. · Beta depends as on capitalization (negative relationship), and historical volatility (positive relationship). The difference between stock-picker (“SP”) as explained for the Nasdaq Composite and benchmark investors (“B”) is pretty clear on the table, with a beta of 0.66 for “B” in the lower left, and a beta of 1.57 in the upper right. · Red and green colors seem a lot more balanced than in the US, either among columns or among rows. No pattern with respect to capitalization or to historical volatility may be exhibited. ETF did not modified significantly the European equity market (yet?). · We can notice that during years with very positive return (2005, 2006, 2009, 2013), high historical volatility stocks tend to outperform significantly, so do small caps. But the difference between “SP” and “B” performances remains very low compared to US extremes. · Regarding the “momentum effect” and the persistence of winners and losers, we find the same pattern as in the US, meaning a quite strong trend-following process, except during big breaches such as what happened in 2008-2009. Therefore, we can suggest to separate the ETF impact and the “low-volatility” puzzle their flows create in the US, and the trend-following process of the market. The latter does not rely on ETF flows, but on the behavioral and cognitive biases of investors. · Europe equity market remain a territory for stock-pickers. Definitely. The ETF impact remain very contained. The only major pattern that can be exhibited is a trend-following aspect of the returns over the years, but nothing relative to capitalization nor historical volatility. TOPIX · First of all, looking at the beta per couple, we can notice, that the higher the capitalization the higher the beta. This means that lower capitalizations post very dispersed returns with very low correlated returns among a given class, whereas the big caps exhibit very close behaviors among themselves. · Performances are well balanced between columns (volatilities) and rows (capitalizations). Using our former notations (“SP”) and (“B”), let’s have a look at the rankings over the years. · On the table, we can notice a change of pattern since 2014 (included), with a more European look-like pattern before and a US look-like pattern since then. · If we add the latter characteristic to the fact that beta depends positively on the capitalization, Topix seems to be at the middle of the road between US and Europe in terms of investment philosophy, US being the “new-way” of investing, flow-driven, and Europe being the “old-way” of investing, fundamental-driven. · “Momentumwise”, except in 2009, where the worst performers of 2008 posted the best performance of years, it is difficult to sort the Japanese market either on the “trend-following” side or on the “mean-reverting”. · The Topix remains quite difficult to understand, as it is a mix between European patterns and US ones. We can notice that there is no clear “trend-following” or “mean-reverting” process. Large capitalizations seems to be riskier, due to their high-intra correlated pattern, posting a higher beta than small caps, which suffer from highly dispersed returns. GLOBAL CONCLUSION First of all, we noticed over the past 15 years that US stocks returns are much more dispersed than Europe or Japanese. We have much more positive and negative extreme outliers in the US. US is definitely not a market for traditional stock-pickers, as this market is a flow-driven market. This relies on a structural fact: US people are all interested in stock exchange performances as their retirement relies on the latter. Therefore, the level of knowledge in the US is by far higher than the one in Europe, meaning that all the Americans are stock-exchange investors, providing huge flows, and expecting the same commitment from their financial advisors in term of risk exposure. People are still scared by the 2008 crisis and their come-back in the equity markets relies on a strict risk-management rule. Today, smart-beta ETFs provide solution, mainly known as “Minimum Variance” or “Equal Risk Contribution”. This is the reason why last years rally in US equities is often described as a “defensive” rally. Therefore, flows concentrate on these products encouraging the pattern to pursue. In Europe, the economic knowledge of the population is very low. In addition to that, financial practitioners and financial related topics are hated. There is no pension funds in Continental Europe. Therefore the equity market does not depend on huge flows as in the US, and remains the stronghold of some “happy-fews” whose way of thinking relies on fundamentals. Thus, European equity market still reacts on fundamental data and news, as flows are almost insignificant. The question is: until when these patterns may last? Why they may be threatened? In the US, we have been waiting for 6 years an “aggressive” rally. It will happen when the couple (“small caps”, “high vol”) will dramatically outperform the couple (“large caps”, “low vol”). It happened in 2009, after the 2008 krach, but this can be analyzed as a kind of “mean-reverting” process on very low levels of valuation. But, today in the US, valuation standards do not exist anymore. An investor just have to think as follows: Where do the flows go? What are the main drivers of the market with metrics such as capitalizations and historical volatilities? We could challenge this vision: how can a low volatility stock perform a high volatility stock? Because low volatility stocks exhibits positive volatility (volatility on upside moves) and a smooth pattern, whereas high volatility stocks exhibit negative volatility (volatility on downside moves) and jumpy charts. Thus the question is: given such matter of fact, is the stock exchange the best place for a start-up to raise money? Isn’t Private Equity a better shelter, and just wait to get a decent size or a decent brand-famousness (as Alibaba or Uber) to go listed? In Europe, while the money is still in the hands of the 50+ old generations, we will keep this fundamental-driven market. Recently, we noticed the emergence of Fintech actors in Europe, with 40- founders. This 40- generation is interested in stock exchange and portfolio management. When these guys will take the money of the elders, and given the difficulty of savings system in Europe, pension funds are likely to develop dramatically. Therefore, we can assume that today’s US pattern will cross the Atlantic. Thus, when this happens, it will be time to focus on large caps, low volatility names such as the Swiss. Japan is very difficult to understand. It seems to be a merge of Europe and US, but the trend tends towards a more US look-like market, with stock-picking that is likely to become more and more difficult. In addition to these area, type of investors – related pattern, there is a “momentum effect” that tends to be persistent. “Winners remains the winners, losers the losers”, same as for good and bad pupils. This stresses the “trend-following” pattern of the equity market, whatever be US, European or Japanese, with a kind of performance clustering over the years, as we can notice about volatility: period of good performance tends to be followed by good performance again. Stock-pickers should focus on Europe, and systematic or factor-based investors on the US. Should you want to pick-up stocks in the US, first select quantitatively a universe with capitalization and historical volatility factors. It is likely to enhance significantly the performance of this “conditional” stock-picking, and avoid large losses. Moreover, keep in mind that today, fundholders have access to financial information instantaneously, so do have the asset managers. There is no more information asymmetry. Information is now the same for everybody, professional and not professional. This means that finance has changed a lot: 30 years ago, the fundholder used to receive informations about his funds two times per year . Now it happens everyday. Therefore, his psychological risk-budget -which has not increased – is filled by far more quickly. The consequence? Implicitly, unconsciously, this phenomenon has dramatically reduced the holding period of the fund by the fund holder. Therefore, risk-management has – now more than ever – to be taken into account ex ante in the asset management process – and not ex post, as it can be seen too often in the French AM industry. Smart risk management is as important as finding equity ideas to generate alpha. It is a way to avoid negative alpha and then create added value for the fundholder. The other requirement is to know and understand the market you invest in. This is the aim of this article: it is not the same to know the companies you invest in (analyst), and to know the market you invest in (asset manager).

Noisy Market Hypothesis: Tilt Your Portfolio To Achieve Superior Returns (Part 1)

Summary In previous articles, we’ve shown how maintaining a diversified portfolio “beats the average retail investor”. In this articles, we will raise the bar and review the ways of “beating the market”. Initial building blocks (i.e. list of ETFs) for Satellite Portfolio are presented. This is the third article in the series that aims to develop portfolio investment approach that “beats the market”. The goal is to equip readers both with “knowledge about the path” and “confidence to stay on the path”. In the previous two articles, we’ve reviewed the ways of “beating the average retail investor”: These two articles serve as a practical guide to structuring core portfolio. We now move to the next step – satellite portfolio. We are raising the bar We saw what it takes to “beat average investor” and that doing so is pretty easy. All you need to do is maintain a diversified allocation to various asset classes. The key word is “maintain”; in other words, an investor should choose consistency over chasing the next “hot” stock or industry. As a reminder, please see the graph below; I hope that it will serve as a motivation: (click to enlarge) Source: J.P. Morgan and Dalbar Inc. Of course, managing emotions and staying the course is easier said than done. Especially, if your approach performed poorly for few years while your friend keeps on bragging about “that great stock” which made him a small fortune. How astonishing it is to see that few years of performance guide our long-term decisions. Just take a look at reactions that the second article in this series stirred up. It is true that commodities had very poor performance during last 4-5 years (and so did emerging market stocks). However, I wonder if half a decade performance warrants calling the commodities inappropriate for the portfolio [1]. History of the stock market is full with examples when the stock market pundits would conclude that some asset classes are no longer appropriate for portfolio, e.g. “stocks are dead” (typically, at the bottom of the market), just to observe market come back with a vengeance and prove all naysayers wrong. Putting short-termism aside, let’s go back to our long-term perspective. Commodity futures deliver equity-like returns (and risks as well) and have less than perfect correlation with stocks (i.e. provides diversification benefit). However, the focus of this article is not commodity futures, not even “Core Portfolio”. Our focus is “Satellite Portfolio” and how we can achieve even better returns through employing proven strategies. Our focus is on raising the bar. Noisy Market Hypothesis (NHM) and how to “beat the market” NHM provides a more realistic depiction of stock market dynamics when compared to Efficient Market Hypothesis (EMH). EMH claims that stock prices at every point in time represent the unbiased estimate of the true value of the firm. Such claims would have been true in ideal worlds where investors and speculators would not face liquidity constraints, tax considerations, institutional limitations, and many other externalities. Add to this list “popular delusions and madness of crowds” and you start questioning whether the even weak form of EMH is possible. I’m not suggesting to discard EMH. In the long term, information gets embedded in stock prices, but it may take a while. Quoting the “father of value investing” (Benjamin Graham): “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” In other words, in the short term, market “noise” might drive prices of particular stocks or even group of stocks significantly away from its intrinsic value and keep it there for a while. Just think of any stock market bubble. Unfortunately, taking advantage of such cases of mispricing is not easy. John Maynard Keynes reminds us that “the market can stay irrational longer than you can stay solvent.” As such one should expect that no trading strategy will consistently produce superior returns. This is one of the main implications of NMH. However, no need to despair. Based on academic research, Jeremy Siegel (father of NMH) concludes that over the long term it is possible to achieve better risk-adjusted return than holding very broadly diversified a portfolio. Jeremy Siegel mentions that taking advantage of “noise” might be achieved through “fundamental indexation” (i.e. weighting your holdings based on “fundamental factors”) instead of capitalization-weighted indexation. In other words, if the investor is able to stomach underperformance of his/her portfolio in short- and medium-term (which would be years), they might be well compensated in the long term for taking advantage of “fundamental factors”. We will discuss two of such fundamental factors – size (small caps) and style (value stocks) – in this article. Why value stocks and small capitalization stocks “beat the market”? Efficient Market Hypothesis (EMH) implies that strategy achieving higher absolute return is likely to be higher risk strategy. In other words, investors are compensated for taking the risk (only systematic risk, according to MPT) and, therefore, high risk equals potentially high return. As such, EMH advocates would claim that long-term outperformance of small caps and value stocks is due to higher risk. One can see why small caps would be a riskier proposition, however, value stocks are already selling at discount – how can they represent increased risk? One would expect that high-flying “hot” stocks with high multiples would expose investors to larger potential crash in price, compared to already “cheap” value stocks. However, EMH advocates would remind us about “value” trap. It’s when value stock continues to remain cheap for years and potentially keeps on getting worse. Instead of presenting you with arguments and counterarguments of various schools of thought, let me present you my version of why value and small-caps outperform. Small caps: Are riskier: typically higher volatility, higher chance to experience financial troubles (i.e. small to secure stable funding sources or access markets during rough patches). Are less liquid: low float, low trading volume, and higher bid-ask spreads. Are “under the radar”: not enough analyst coverage and institutional limitations (big asset managers or speculators might find it hard to establish meaningful exposure to single small-cap stock due to the limited amount of available issuance; at the end of the day, we are talking about small-cap stock). Value stocks: Might experience “value trap” (we will discuss how to address this concern in our next article). Are not “hot” names: typically boring names with seemingly mediocre stories. In “Stocks For the Long Run”, Jeremy Siegel presents information regarding the historical performance of small caps and value stocks from 1926-2012. For more details, please refer to his book; here, I’ve provided relevant excerpts: (click to enlarge) Source: Jeremy Siegel (click to enlarge) Source: Jeremy Siegel How do I know that small caps and value stocks will continue outperforming? Past performance is not a guarantee of future performance, isn’t it? “History does not repeat itself, but it often rhymes”. And, I think that’s the blessing for those who will follow the recommendations in these articles consistently and disregard short-term market gyrations. Just because history does not exactly repeat itself, investors tend to lose confidence in proven strategy after few years of underperformance. Some of the main reasons are thought to be human nature and memory. It is only human to throw away proven strategies and jump on the bandwagon as they face “this time it’s different” environment. This was the case during tulip mania of early 1600s and in recent history (just recall peak of the dot-com bubble in 2000). How many of such cases of mass disillusionment were experienced during these 400 years? And what lessons we learned? It either we believe that ” this time it’s different” or memories faded away since the last roller-coaster. Or, perhaps, we remember that experience vividly and will try to outsmart the market this time, by jumping off the train just before it falls into the abyss. There is, of course, an argument that market participants realized the existence of small cap and value phenomenon and traded up these stocks. Supporters of such arguments claim that due to “arbitraging away” these opportunities – small caps do not offer any alpha, it’s purely higher beta play and value stocks correctly reflect the valuation of less than stellar companies (again, no alpha here). We will review if such arguments are warranted in the future articles when we finalize our proposed allocations for a satellite portfolio. Before we discuss execution, let us draw a preliminary conclusion. As a group of investors continue jumping from one bandwagon to another in search of alpha, another more passive investors might benefit from staying put. Unless, you have a crystal ball, it’s advisable to identify portfolio allocation and don’t deviate materially from these target allocations. In the long term, tilting your portfolio in the direction of small caps and value stocks is expected to lead to superior returns. However, it might take years before you achieve superior return; markets might favor large caps and/or growth stocks for long stretches of time. List of ETFs For core portfolio, recommended allocations are presented in previous two articles. For satellite portfolio, I suggest tilting portfolio to small-cap stocks and value stocks. Following are ETFs that I recommend to achieve this goal: (click to enlarge) Source: Vanguard, and my own recommendations As you can notice, all four are Vanguard ETFs. I recommend Vanguard ETFs mainly because of their low fees (I am not affiliated with Vanguard and do not receive any compensation for recommending its products). There are other low-cost ETFs as well; typically, I use other ETFs for very specific tax reason. I will plan to cover this topic in my book (expected to publish in Amazon in December 2015 or January 2016) or potentially in the future Seeking Alpha articles. Following table provides a brief summary about the recommended ETFs: (click to enlarge) Source: Vanguard Size (i.e. small cap) and style (i.e. value) are not the only factors that historically proved to generate superior returns. We will discuss “other” factors in the next articles and determine sensible allocation to various factors. At that point, I will present detailed execution plan (i.e. the list of all ETFs and allocations to each). To conclude, the superior performance of small cap and value stocks (and some other factors that we will discuss in the next article) has been identified decades ago. However, the opportunity is still there. Maybe sometime in the future large portions of stock investors develop longer-term approach, bid up the prices, and bring systematic alpha of small cap and value stocks to zero. That “sometime in the future” could be a so distant phenomenon that might not even happen during my lifetime. To quote from John Maynard Keynes: “In the long run we are all dead.” In a meantime, I don’t mind additional 2-4% return compounding for decades. References/Bibliography Jeremy Siegel, The Noisy Market Hypothesis , Wall Street Journal, June 14, 2006 Jeremy Siegel, The Future for Investors: Why the Tried and the True Triumph Over the Bold , 2005 Jeremy Siegel, Stocks for the Long Run 5/E: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies , 2014 Next article: Noisy Market Hypothesis: Tilt Your Portfolio to Achieve Superior Returns (Part 2) Disclaimer: I’m not a tax advisor, please consult your tax advisor for any tax related matters. ETFs covered: The Vanguard Mega Cap Value ETF (NYSEARCA: MGV ), the Vanguard Value ETF (NYSEARCA: VTV ), the Vanguard Mid-Cap Value ETF (NYSEARCA: VOE ), the Vanguard Small Cap Value ETF (NYSEARCA: VBR ), the Vanguard Small Cap ETF (NYSEARCA: VB ) and the Vanguard Small Cap Growth ETF (NYSEARCA: VBK ) [1] Once again, I would like to highlight that I’m not supporter of buying spot commodities (e.g. gold bars, silver coins) – I suggest using commodity futures. I will plan to write an article on this topic in the future.