Tag Archives: oud

Stocks Aren’t Bad, They’re Just Not Good

When we’re doing our due diligence on an Alternative Investment, one of the first questions we ask managers is what are the market environments in which the program struggles to find returns. And once we get into when they’re likely to do poorly, we then analyze just what that poor performance looks like. In essence – how bad is it when it’s bad? Does everyone/anyone who tracks the stock market with low cost index tracking ETFs do the same? With stocks all but flat since mid-way through 2014, some investors are starting to question where the returns are, rightly so. But the stock indices aren’t human. We can’t tell them to try a little harder. Or go for a moonshot. Or shake off the rust and get back into the game. No, the stock indices are a rule-based investment model. So while pundits and economists are grasping at straws to identify the problem, we’re more apt to ask the manager of the investment model “Why is the current market making it difficult for your trading model to find returns?” We’ve said this before, but it bears repeating, stock indices like the S&P 500 are a trading system; or if you prefer a set of investment rules or stock picking model. Look no further than Winton Capital’s CEO on the matter. We really couldn’t have said it better. Harding: “The S&P 500 is a trading system. The S&P 500 is a set of rules for buying and selling stocks. And by the way… not a very good one! Think about this for a second. If you took the S&P 500’s monthly returns and put them under some sophisticated sounding hedge fund name, everyone would tell you the drawdowns are too large and last too long, while the annualized volatility is too high for the performance it generates. There would be a Bloomberg article demonizing the system for large drawdowns and for tricking investors. And what’s worse, this model is a one trick pony. It’s solely focused on one asset class, and only makes money when that asset class goes up. Of course, it does have the Fed doing everything in its power to avoid a 20% drawdown in the markets at the cost of creating a future bubble. Not to mention buybacks are preventing real growth while 3 companies make up 10% of the market’s capitalization . Put that all together and the S&P 500 is nothing more than an investment model that is high reward-high risk. We dare say, it’s a very basic equity focused hedge fund, choosing which stocks to “own” and which to avoid. To paraphrase Captain Barbossa, “You better start believing in hedge funds Ms. Turner – you’re in one !” There’re bouts of volatility, drawdowns, and low risk-adjusted returns. But that doesn’t make the most beloved system in the world a bad investment. By all means, take a look at it. There’s a lot to like. Chief among them is probably choosing to align yourself with the majority of investors out there; the government and a huge industry hell-bent on seeing it go up year after year. The S&P 500 isn’t a bad investment, it’s just not a good one. It will test your nerve, and then test it some more. As a recent post by Reformed Broker noted: Just because it’s cheap and easy to get exposure to stocks these days, that doesn’t mean it’ll be mentally cheap and easy to stick with them.

What Happens To ‘Hold-N-Hope’ Portfolios When An Economy Struggles To Expand?

Some analysts may dismiss 115 years of economic data. I do not. In particular, if one averages the results of four respected stock valuation methodologies, one finds that stocks are wildly expensive. Greater irrationality in stock price exuberance only existed during conditions prior to the Great Depression circa 1929 and the tech wreck of 2000. Consider the chart below. Based on the analysis by Doug Short, the widely cited Vice President of Research at Advisor Perspectives, the U.S. stock market is overvalued by 76%. It is worth noting that on all three occasions when the aggregate average approached two standard deviations above a geometric mean — 1929, 1999, 2007 — U.S. stocks collapsed by 50% or more. In addition, current valuation extremes surpass those reached in 2007. Investors should be mindful of the fact that Mr. Short does not typically offer “bearish” or “bullish” commentary. He usually provides investment and economic research, allowing others to draw their own conclusions. That said, he has served up bullet points on the high probability that market returns will be low over the next 7-10 years. Mr. Short has also mentioned that tactical asset allocation will be more important in the coming decade, as holding the S&P 500 for the next 7-10 years is likely to be “disappointing.” Keep in mind, elevated valuations in and of themselves may not provide much insight with respect to reducing risk in one’s portfolio. Years of valuation extremes can persist when other factors are at play. (Think central bank interest rate and balance sheet shenanigans.) Nevertheless, an economy that shows signs of stagnation coupled with signs of “risk-off” positioning can break the back of a stock market bull, particularly when interest rate manipulating, balance sheet expanding central banks are only running on fumes. I mentioned that the economy is stagnating and that signs of “risk-off” positioning are evident. Let me first address the economy. Corporations are not increasing their profits, as corporate earnings per share have declined for four consecutive quarters. Business revenue is even more abysmal. Companies have fallen back to 2012 levels with respect to revenue generation, and that does not even adjust for inflation. Click to enlarge Traditional retailers are struggling and some are disappearing (e.g., Wal-Mart, J.C Penney, Sears, Macy’s, Office Depot, Walgreens, Sports Authority, Sports Chalet, Aeropostale, etc.). Oil and gas? Yikes. According to reports on a Deloitte study, one-third of oil corporations may go belly up in 2016. The study focused on some 175-plus companies with more than $150 billion in debt. What about gross domestic product (GDP)? At a pace of 1% over the last six months, it is hardly expanding at all. Even the bright spot of job growth is deteriorating. Consider the Federal Reserve’s own Labor Market Condition’s Index (LMCI), which evaluates 19 unique indicators of labor market health. The LMCI peaked in April of 2014; its intermediate-moving average (6-months) peaked in August of 2014. (Note: S&P 500 earnings per share hit its all-time top in September of 2014, representing Q3 on 9/30/2014). Click to enlarge The 6-month moving average on the LMCI has not rolled into negative territory since the Great Recession (2007-2009). Before that, you’d need to look at the NASDAQ’s tech wreck and 2001 recession (2000-2002) for significant troubles in the well-being of the labor market. Does this mean that a recession is imminent? No. But it sure as heck means that labor market conditions are weakening. With “job growth” having been the one supposed saving grace in a slow-growing economy that required near 0% interest policy for seven-plus years, it seems optimism for a turnaround prior to a sell-off in risky assets would be misplaced. Of course, there are those that are keeping the faith with respect to stocks rallying well into the end of 2016 without a correction or bear. The thinking? As long as the economy muddles through, the Federal Reserve won’t be able to raise rates, and the dollar will move lower in the absence of tightening, and the lower dollar will help businesses increase their overseas sales and profitability. In other words, bad news will be good news for never-say-die hold-n-hopers. Unfortunately, there are a number of problems with the muddle-through scenario. Problemo numero uno? Household debt exceeds disposable personal income. Granted, Americans have been spending more than their take-home pay after taxes since 2001. Yet the modest deleveraging that occurred after the Great Recession has passed us by. Sooner or later, as families continue to accumulate increasing amounts of debt to spend more than they clear via disposable personal income, a retrenchment period comes to pass. Either households will be challenged in accessing credit (involuntary deleveraging) or they themselves will choose to borrow less in spite of ultra-low rates (voluntary deleveraging). Click to enlarge Economic data on consumption shows that the consumer has been softening. Bring disposable personal income into the picture, and the consumer is likely to weaken even more. The second problem for the muddle-through economy dream is the reality that “risk off” investing has been outperforming the U.S. market for 18 months already. 18 months. Consider the fact that three of the best performing assets in the 2008 systemic financial meltdown were the yen, the dollar and long-maturity treasury bonds. You could have invested in each via CurencyShares Yen Trust (NYSEARCA: FXY ), PowerShares Dollar Bullish (NYSEARCA: UUP ) and iShares 20+ Treasury Bond (NYSEARCA: TLT ). Over the last year-and-a-half, all three of these “risk-off” assets have beaten the SPDR S&P 500 Trust (NYSEARCA: SPY ). In sum, stock valuations are exorbitant, business sales are soft, consumption is strained, the labor market is weakening and “risk-off” assets are outperforming. Add it all up? There is limited upside reward for the risk one takes by remaining overexposed to equities and higher-yielding vehicles. If you normally leave 65%-70% in a diversified basket of stock (e.g., large-cap, mid-cap, small-cap, foreign, emerging, etc.), downshift to 45%-50% high quality larger-caps only. If you typically allot 30%-35% to diversified income (e.g., investment grade, cross-over corporate, high-yield, convertible, foreign, etc.), dial it back to 20%-25% investment grade only. The 25%/30%/35% that you raise in cash or cash equivalents by selling riskier assets at relatively higher prices will minimize portfolio volatility. More importantly, it will be the “dry powder” you require to buy “risk-on” assets at more attractive price in the future. Click here for Gary’s latest podcast. 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.