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5 Ways To Handle A Low Return On Capital Environment

Summary Basic market valuation fundamentals suggest that investors should prepare for more muted returns from their equity portfolios. Economy wide transformations led by technological progress also support decreasing returns on capital. Although this low return on capital environment is undoubtedly more challenging, there are 5 strategies that can help investors build and manage a portfolio of stocks more effectively. CNBC pundits, analysts, hedge fund gurus and amateur market watchers love to make predictions about the future. They hum and haw about macro forces. They discuss the possible impacts of a rate increase and they debate the importance of China as the world’s growth engine. They try and pinpoint what the next “game-changing” technologies or companies will be and they try and estimate what the overall market will do. This preoccupation with the future is certainly fascinating to seasoned market participants but what does it all mean for the majority of investors who most likely have a large portion of their savings exposed to the stock market or at the very least is considering where to allocate their savings? At the very least market fundamentals and economy wide transformations suggest that investors should prepare for more muted returns from their equity portfolios. Market Fundamentals Suggest More Modest Returns First and foremost, basic market fundamentals support more modest returns. In terms of valuation, the Shiller CAPE ratio for the S&P 500 (NYSEARCA: SPY ) which is a cyclically adjusted price/earnings ratio – has been stuck at around 27 which is high given the median of 16. This represents its highest level since 2000 and suggests that profits are far higher than normal and should either plateau or sink from these highs, a process that may already be underway . In addition, Morningstar’s price/fair value chart suggests that value is becoming harder and harder to find. In addition, the current 12-month forward P/E ratio for the S&P 500 is 16.7. This P/E ratio is above the 5-year average of 13.9 and the 10-year average of 14.1. These valuation indicators are a cause for concern as low starting valuations have historically been one of the best indicators of market performance. Whether we are in a bubble on the verge of popping is unclear, yet what is obvious is that when prices are elevated versus earnings, future gains will be lower. Economy Wide Transformations Suggest Return On Capital Will Continue To Decrease Nevertheless, there is something more significant going on than just above average stock market valuations. More fundamentally, there are transformational economic forces that are re-shaping our societies and thus our markets. The effects of this technological progress indicate that the return on capital (or cost of capital) will decrease as technological progress increases. Why? Because technology makes innovation cheaper and thus capital more abundant. Think back to the industrial revolution. During this period it was virtually impossible for someone to start a business without substantial capital reserves. This was due to the fact that innovation was cap ex heavy (commodities, infrastructure, wages etc.). Fast-forward to today and things have changed dramatically. It has never been cheaper to start a business and thus we have large (by market cap not by employee count) companies like Facebook (NASDAQ: FB ) buying companies with 55 employees like WhatsApp for $19 billion dollars. This is a world in which the barriers to entry are dropping across all industries. Such “new age” businesses generate enormous wealth for shareholders and entrepreneurs, yet result in comparatively few new jobs. Instead, what is generated is a rapidly increasing supply of capital. Corporations are piling record amounts of cash and thus we have a lower demand for capital which causes an increasingly higher supply. The higher the supply of capital, the lower the returns on capital. Yet the transformational change does not stop here. Not only does technology make capital more abundant, it also makes capital markets and the allocation of abundant capital more efficient. This is evidenced by the rapid adoption of algorithmic trading and information technology which makes the flow of information more efficient. In this environment arbitrage opportunities become more difficult to find as information asymmetries become more unusual. There isn’t a day that goes by without a high profile hedge fund manager bemoaning the lack of opportunities for return. Thus, the cycle continues: abundant capital chasing fewer return opportunities leading to even lower returns. Nevertheless, all is not lost. Although this low return on capital environment is undoubtedly more challenging, these 5 strategies can help investors build and manage a portfolio of stocks more effectively. 1) Reset Intuitions and Assumptions Since the market bottomed in March 2009 the S&P 500 has returned around 20% on an annualized basis. This amounts to a tripling in value rising by a staggering $12.8 trillion. So given the forces outlined above which suggests lower future returns what can be expected? Traditionally, for a diversified portfolio of stocks the typical expected annual return has hovered around 6-7% . Is this lower number even reasonable? Some leading investment analysts are suggesting that a more reasonable number would be around an average of 2% annual return, after inflation and fees. Thus, projecting an annual return of around 5% would be a more useful guide. 2) Reduce Investment Costs In light of projected lower future returns, controlling a portfolio’s various costs will yield major benefits over time. For example, paying a 1% expense ratio on a balanced portfolio that earns 10 percent on an annualized basis takes a 10% cut out of the return. Lower that 10% portfolio return to 5% and a 1% expense gets much more significant. As such, purge any mutual funds replacing them with low cost ETFs and be sure to use a low cost broker. 3) Reconsider Asset Allocation Beware of over exposure to bonds. Starting yields on Treasury bonds have explained much of their performance over the subsequent decade and with yields as low as they are, overexposure to bonds will almost guarantee low returns. On the other hand investors who maintain higher allocations to equities will be better positioned to eke out the best returns possible over time. 3) Invest In Quality And Focus On Dividends Effectively dealing with a lower return environment starts with putting together a portfolio of high-quality stocks. Although high-flying growth stocks may be alluring, the risk of a terrible year of returns far outweighs the possible benefits of a fleeting moment of outperformance. Instead focus on ” wonderful businesses ” with high moats that are profitable and that will survive whatever an uncertain economy may throw at them. In addition, focus on dividends and their re-investment. Dividends have historically accounted for the vast majority of all stock returns for the last century. Some have even postulated that dividend growth is the most important factor for creating long-term wealth. Thus, companies with strong returns, consistent earnings and consistently growing payout ratios should see better than expected returns over the long term. 4) Consider Increasing Exposure to Non-U.S. stocks Despite reports of a “relatively stagnant” global economy, research suggests that there are many global markets that are projected to grow at high rates. Although foreign stock outperformance is no sure thing , there are certainly pockets of relative geographic market undervaluation worth considering. In Europe , the UK, Germany and Spain present compelling opportunities. Elsewhere, Singapore, Thailand, Australia and Russia remain significantly undervalued by Prof. Shiller’s CAPE measure. 5) Avoid Chasing Returns And Stay Focused On The Long-Term Common during bull markets yet even more common when markets are going sideways is the impulse to buy stocks that are skyrocketing while your portfolio remains grounded. Yet if you chase the best-performing stocks or sectors you risk leaving your plan behind and jumping in when these assets are reaching their peak. Try and relax, pay attention to valuation and stick to your long-term dividend growth plan. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

A Prudent Portfolio For A Melt-Up Or A Meltdown Redux

Summary Uses a mix of trend-following, active, hedged, and passive management style funds. Selects a stalwart, plain-vanilla benchmark for performance going forward. Constructed in the context of an aging bull market for both equities and bonds. Many portfolios, especially from the DGI crowd, have the dynamic active benefit of additions, subtractions, and constant tweaking by their authors. We always know what they are considering buying, selling, etc., with every article. I also feel that tmy hypothetical “Prudent Portfolio for a Melt-Up or Meltdown,” discussed in 2014, is not a static experiment; it should benefit from some updating and tweaking as well. The main goal of this hypothetical portfolio was simplicity and balance using only five funds in the context of an aging bull market that could still participate if the bull market continues or could ride out some punches from a correction. Much has happened since the inception of this portfolio back in 2014. Old Portfolio and Lessons Learned: TNDQ , PHDG , AGG , GGN , and UUP The TNDQ ETN and all the other RBS ETNs have been discontinued by their sponsor. Gold has continued its downward chaffing spiral, taking = with it the GGN closed-end gold income fund. Too much portfolio weight was given to this falling knife. Tame VIX futures in contango has mercilessly beleaguered the PHDG holding with its partial volatility futures holdings. All was not dreary, as the dollar surged this year, and correspondingly, the UUP fund benefited. Bonds have been a bit of a roller coaster, but the modest net durations of the AGG ETF still provided some desirable ballast. The “Updated Melt-Up or Meltdown” Portfolio: PTNQ , VQTS , TOTL , CEF , and AMFQX Pacer Trendpilot 100 ETF (BATS: PTNQ ) This ETF replaces the recently defunct TNDQ ETN. It has a similar moving average timing strategy tracking the same alpha rich NASDAQ 100 index – but is tweaked with a “50/50” allocation before totally going to the safety of 3 month U.S. treasuries. The complete strategy is as follows: When the NASDAQ 100 index closes above its 200 day simple moving average for 5 consecutive days the fund will be 100% invested in the NASDAQ 100 index. When the NADAQ 100 index closes below its 200 day simple moving average for 5 consecutive days the fund will switch to 50% to the index and 50% to 3 month treasuries. When the NASDAQ 100 index 200 business day simple moving average closes lower than its value from five business days earlier, the exposure of the Index will be 100% to 3-Month US Treasury bills. Once this “T-Bill Indicator” has been triggered, the Index will not return to its 50/50 position until the index closes above the 200 day sma as described earlier, followed by the 50/50 Indicator being triggered as described above. In summary this fund gradually seeks to avoid a deep correction in a gradual manner using 5 business day windows for signals rather than popular end of month signals. The strategy essentially hedges in steps and attempts to limit affects of market “head fakes” of brief periods when falling below the 200 day sma. The fund already has assets of over 27 million and is less than 2 months old. The other two Pacer index based trend following ETFs are growing rapidly as well. This author is long PTNQ. See pictorial below of the hedging strategy from the folks at Paceretfs : ETRACS S&P 500 VEQTOR Switch Index ETN (NYSEARCA: VQTS ) This ETN essentially addresses the drawbacks of the strategy index that PHDG and VQT follows. It dynamically allocates between the S&P 500, VIX futures (either long or short depending on slope of the VIX futures curve), and cash. I wrote about it here as well as fellow SA contributor Vance Harwood’s nice write up here . This ETN seeks to exploit the main weakness of the regular VEQTOR index by “switching” and having a short position in VIX futures and gaining additional alpha from the negative VIX futures roll yield during periods of steep contango. It makes for an excellent replacement for PHDG from the previous portfolio. Assets are still rather on the light side at about 25 million, but this ETN is young and will likely grow to robust asset levels. Especially if there is a steep correction like we had in 2011. SPDR DoubleLine Total Return Tactical ETF (NYSEARCA: TOTL ) The iShares AGG aggregate total bond ETF’s “dumb index” has been replaced with the steadfast expertise of Jeffery Gundlach’s active management for the bond portion of the portfolio. Bonds in my opinion, especially now more than ever need some active management. With upcoming rate increases promised by the FED, a bond guru will be a welcome addition to help tame some bond angst and volatility. This ETF version of his flagship portfolio has outperformed the total bond index handily. The mild average durations of 4 years along with hands on active management should make for some nice ballast for the portfolio. This ETF has an expense ratio of 0.55% and a healthy AUM of over 850 million. More info about this fund available here . Central Fund of Canada Ltd. (NYSEMKT: CEF ) This closed-end fund replaces the beleaguered and volatile GGN fund. With gold down in the trash heap of most investors radar this well regarded CEF was chosen for the small precious metals portion of the portfolio. This fund holds marketable gold and silver bullion. The fund currently sports around a 9% discount to NAV. This popular fund has a long history and is cheaper with fees of only 0.32%. No one knows how low gold will go especially in this backdrop of a strengthening dollar and threats of higher rates, but one could catch the falling knife and could take comfort that with this fund you will at least take a position at a considerable discount to NAV. More about this fund available here . 361 Managed Futures Strategy Fund (MUTF: AMFQX ) As bonds become less desirable and correlations increasing throughout asset classes – an alternative type of fund may be beneficial to a portfolio. For this updated portfolio a managed futures strategy seemed like a logical fit for this balanced “melt up or meltdown” theme. This four star Morningstar rated 361 Managed Futures Strategy Fund uses a counter trend strategy designed to navigate choppy volatile markets. Managed futures by design have low correlations to core assets such as bonds and equities and can reduce overall risk and volatility to a portfolio. Fees run about 2%. The fund’s performance so far this year have been stellar with it being up around 10%. More about this fund available here . Weightings The weightings of the balanced Updated Prudent Portfolio for Melt-Up or Meltdown are as follows: 30% PTNQ 30% VQTS 20% TOTL 15% AMFQX 5% CEF This summarily is 60% U.S. equities (index based and systematically hedged), 20% bonds (actively managed), and 20% alternatives and precious metals (actively managed and partially passive). The Benchmark: Vanguard Balanced Index Fund (MUTF: VBINX ) This venerable stalwart is cheap, passive and effective over the long term. It’s U.S. centric and is a formidable benchmark for this upgraded portfolio. It consists simply of 60% the total U.S stock market and 40% the aggregate U.S. bond market. It’s fees are only 0.23% and that immediately gives this “Melt Up or Meltdown Portfolio” a hump that will have to be overcome with alpha and/or reduced drawdowns. It should be a fun exercise comparing this updated portfolio to the this popular passive mutual fund. Summary and Caveats The construction of this updated hypothetical portfolio was an interesting exercise. The bar is set high for the future – competing with the performance of the before mentioned Vanguard Balanced Index Fund. In the context of an aging bull market for both equities and bonds it seemed timely for portfolio mixes of smart beta, index hedged, managed futures, and active management funds to hopefully shine in some outperformance in the years to come. One could use Morningstar or portfoliovisualizer.com,etc. to track it. Always read prospectuses and other fund literature before investing. Always use limit orders for lightly traded funds. Disclosure: I am/we are long VQTS, PTNQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.