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AQR On Evaluating Defensive Long/Short Strategies

By DailyAlts Staff Heightened market volatility has many equity investors contemplating a move to defense. But in this environment, are defensive stocks too expensive to work? This is the question considered by AQR Principals Antii Ilmanen and Lars Nielsen and Vice President Swati Chandra in the November white paper Are Defensive Stocks Expensive? A Closer Look at Value Spreads . Value Spreads The paper’s authors begin by explaining the concept of value spreads: “Value” quantifies the “cheapness” of a long-only asset “relative to a fundamental anchor.” For a long/short style factor such as “defensive,” value spreads can be measured by comparing the value of the long portfolio (the most “defensive” stocks) to the value of the short portfolio (the least “defensive” stocks). When the style grows cheaper, the value spread “widens” – when the style becomes more expensive, the value spread “narrows.” Valuation and Strategies It only makes sense that a wide value spread is preferable to a narrow one, since a wide spread will (presumably) have the tendency to revert back to the mean, thereby “narrowing” and becoming more expensive (i.e., outperforming); while a historically narrow spread is more likely to “widen” and get “cheaper” (i.e., underperforming). AQR’s Cliff Asness and others have published research indicating that “over medium-term horizons, the future return on value-minus-growth stock selection strategies is higher when the value spread is wider than normal.” But Messrs, Ilmanen and Nielsen and Ms. Chandra argue that “valuations may have limited efficacy in predicting strategy returns” – strategy returns as opposed to asset returns. The authors highlight the “puzzling” case in which a defensive long/short strategy performed well during a recent two-year period when its value spread “normalized from abnormally rich levels.” They conclude that the relationship between valuation and performance – strong for most asset classes – is weaker for long/short factor portfolios. Wedging Mechanisms Buying a “rich” investment, seeing it cheapen, and yet still making money – how is this possible? Ilmanen et al. cite the following “wedge mechanisms” that allow the managers of long/short factor portfolios to loosen the “presumed strong link” between value spread changes and returns: Changing fundamentals Evolving positions Carry Beta mismatches Fundamentals May be Offsetting The efficacy of value spreads in predicting returns relies on the assumption that changes in valuations are primarily driven by prices, so that an asset or portfolio that becomes more expensive necessarily appreciates in price. This assumption, combined with the assumption that value spreads will always mean-revert, make the case that wide spreads are preferable to narrow ones. But valuation measures always compare price to a fundamental factor , and improving or deteriorating fundamentals – more than just price – can loosen the links between valuation and performance. Evolving Positions Portfolio returns are based on the price appreciation and “carry” of the portfolio’s holdings, as they evolve , but value spreads only consider the portfolio’s current holdings. Thus, the link between valuation and performance is therefore weakest for the most actively traded, fastest-evolving portfolios. Carry Returns Value spreads look entirely at prices, but portfolio returns are the sum of changes in price and portfolio income – i.e., dividends and interest. Portfolios that derive a greater-than-average percentage of their total returns from so-called “carry returns” will thus naturally have a weaker link between valuation and performance than portfolios that derive their returns more primarily through price changes alone. Misaligned Betas In AQR’s study, this final “wedge” had the most impact: Since the value spread will generally have a net non-zero beta, while a long/short portfolio may target beta-neutrality, the value spread could indicate cheapening or richening driven by its beta to the market, while a long/short portfolio designed for beta-neutrality won’t fluctuate with the market. Conclusion So are defensive stocks expensive right now? The authors give a concise answer to that question: “Yes, mildly, taking a 20-year perspective.” But as the “Tech Bubble” proved, mispricing can persist for a long time. The important thing, in the view of the paper’s authors, is for investors to be cognizant of the mechanics of value spreads and spread design choices.

What Assets Should You Have In Your Moderate Portfolio?

With flat to slightly negative returns, one could make the case that the static Ibbotson model for diversification is working just fine. On the other hand, the more that one has minimized the downside risk of investment canaries in the financial mines, the more one has been able to relax. Based on the evidence, moderate growth investors who choose an allocation of 60% in large-cap U.S. stocks and 40% investment grade U.S. bonds are likely to outperform the static Ibbotson model in the near-term. If market internals continue to deteriorate and if the macro-economic backdrop continues to weaken, a tactical asset allocation decision to reduce the risk of exposure to extremely overpriced U.S. stocks may be called for. Ibbotson Associates provides asset allocation guidelines that span the risk spectrum from conservative to aggressive. The moderate portfolio consists of roughly 42% in U.S. Stock, 18% in Non-U.S. Stock, 35% Fixed Income and 5% in Cash. It follows that the static Ibbotson model might employ the following ETFs to achieve its moderate growth and income aim: With flat to slightly negative returns, one could make the case that diversification is working just fine. On the other hand, the more that one has minimized the downside risk of investment canaries in the financial mines – high yield credit, emerging markets and smaller corporations – the more one has been able to relax. An allocation of 60% in large-cap U.S. stocks (NYSEARCA: SPY ) and 40% investment grade U.S. bonds (NYSEARCA: BND ) improved performance to 1.6% – a swing of 240 basis points. An argument in favor of diversification across asset class segments is that, if one holds recommended percentages for the next 20 years, recent underperformers will provide value down the road. Moreover, the combination of the above-mentioned asset types performed better than an ethnocentric large-cap-only allocation (60% S&P 500, 40% Barclays Aggregate Bond Index) over the previous 20 years. Here’s the problem: There are times when the breakdown in an asset grouping and/or an influential sector(s) of an economy is symptomatic of larger issues for market-based securities. For instance, the collapse of the banking system in 2008 had been telegraphed by financial stock woes nearly a year beforehand. The Financial Select Sector SPDR ETF (NYSEARCA: XLF ):S&P 500 SPDR Trust ETF ( SPY ) price ratio had been highlighting the rapid-fire demise of financial stocks relative to the broader benchmark. (Note: Back in 2007, “ex Financials” was the popular excuse offered to dismiss S&P 500 overvaluation; in 2015, many are using “ex Energy” to justify S&P 500 overvaluation.) There’s more. Even as SPY notched new record highs in October of 2007, other asset groupings did not recapture highs set in July of 2007. Small companies via the iShares Russell 2000 ETF (NYSEARCA: IWM ) did not make it back. In the fixed income space, preferred shares via the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) were weakening as well. In the last year of the previous bull market (2007), lightening up on smaller companies, higher-yielding preferred shares as well as the financial sector benefited investors. Here in 2015, lightening up on smaller company stock ( IWM ), foreign developed stock (NYSEARCA: EFA ), emerging markets (NYSEARCA: VWO ) and high yield bonds (NYSEARCA: HYG ) has also been beneficial. For one thing, each of these asset types sits below long-term 200-day averages – a bearish sign for these asset classifications. Secondly, even when one excludes energy from the high yield bond picture, “ex Energy” spreads have been diverging from the S&P 500 throughout the year. Based on the evidence, moderate growth investors who choose an allocation of 60% in large-cap U.S. stocks and 40% investment grade U.S. bonds are likely to outperform the static Ibbotson model in the near-term. One might consider spreading the large-cap exposure across several ETFs such as the iShares Core S&P 500 ETF (NYSEARCA: IVV ), the iShares S&P 100 ETF (NYSEARCA: OEF ), the Technology Select Sector SPDR ETF (NYSEARCA: XLK ), the iShares Russell 1000 Growth ETF (NYSEARCA: IWF ) and iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). I have had virtually no allocation to small caps, high yield bonds or emerging market stocks during this late-stage bull market. All of those areas remain mired in long-term technical downtrends. In addition, I have only 25% allocated to investment grade bonds with another 15% in cash/cash equivalents. If market internals continue to deteriorate and if the macro-economic backdrop continues to weaken , a tactical asset allocation decision to reduce the risk of exposure to extremely overpriced U.S. stocks may be called for. Make no mistake about it… large-cap U.S. stocks are overpriced. Year-over-year, corporate earnings have fallen from a height of $106 on 9/30/2014 for the S&P 500 to the most recent estimate just shy of $91 (October 2015). That is a decline of approximately 14%. The earnings contraction over multiple quarters with the TTM P/E Ratio at 22.7 is well above the average since 1870 of 16.6. For those who would rather embrace Forward P/Es, Birinyi Associates at WSJ.com estimates a value of 17.4. This implies that $91 is going to be $121 in the next 12 months. Short of a miraculous revival in energy demand, 33% earnings growth is not particularly plausible. Even a forward P/E of 17.4 is 25% higher than the 35-year average forward P/E of 13. Overvaluation by itself is not a reason to reduce exposure to large caps. A late-stage bull market could continue for several more years; highly priced can become exorbitant. That said, if an economic slowdown becomes an economic standstill, and if the number of large company stocks holding up the market-cap weighted indexes further retrenches, reducing one’s overall equity profile and raising one’s cash level is sensible. Keep in mind, positions that haven’t been working (e.g., high yield bonds, small caps, emerging markets, etc.) will probably cause even greater pain when the market falls. It is critical to keep losses small. Similarly, it is constructive to exercise a methodical approach to raising cash as a late stage bull market carries on. Having some cash available is the way to purchase investments at a better price in the future. Indeed, there’s a reason that one of the premier rules for investing rule is “Sell High, Buy Low.” For Gary’s latest podcast, click here . 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.

Are The Tailwinds For Stocks Turning Into Tornadoes?

The risk of hold-n-hope at a time when valuation levels are extreme and market internals are sketchy is a recipe for disaster. In contrast, tactical shifts designed to reduce risk when valuations are extreme and market internals are weakening can lessen the adverse impact of bearish catastrophes. A breakdown in market breadth accompanied by highly overvalued equity prices should be met with a decision to reduce one’s risk exposure. Recently, I was speaking with one of the co-founders of the popular exchange-traded fund web site, ETF Database . He wanted to get my thoughts about the problems with “buy-n-hold.” I did not hesitate to give him an earful. Rather than chronicle my conversation in its entirety, or reiterate my commentary from dozens of previous articles on the topic, readers may wish to contemplate the risk of holding onto a permanent portfolio at this moment. Indeed, the risk of hold-n-hope at a time when valuation levels are extreme and market internals are sketchy is a recipe for disaster. For instance, assume that your approach to investing is to hold 80%, 90% or 100% in U.S. stocks for the next 30 years. Your reasoning? Stocks are extremely unlikely to lose value over a 10-year span, let alone a 30-year period. Unfortunately, at this particular juncture in the bull market cycle, current stock valuations suggest that it is quite possible, if not probable, that the asset class will lose HALF of its value in the next bear market. Why is it worth considering 50% depreciation in stock prices? It happened in 2000. It happened in 2007. And the recent extremes in the median price-earnings ratios (P/E) and median price-sales ratios (P/S) actually went beyond the peaks hit in 2000 and in 2007. What happens, then, if your portfolio is worth HALF of what it was worth at the bull market top. If you are fortunate enough to witness an 8-year bull market compounding at 9% from the bearish bottom, you will only find yourself back at the starting gate. Even Steven. And that’s after realizing a remarkable 9% compounded for eight years! Keep in mind, the break-even scenario described above also implies that one never wavered on the hold-n-hope approach. You never once panicked. You never once sold. You never came to the conclusion at any point that the return of your principal was more important to you than the return on your principal. Eight years. Same dollars in your accounts, though they would have less purchasing power due to inflation. Heck, at that time, people will be thinking about who they might like to replace President Hillary Clinton as she is rounding the bases of her second term. (That’s not a prediction… just an effort at some humor.) In contrast, tactical shifts designed to reduce risk when valuations are extreme and market internals are weakening can lessen the adverse impact of bearish catastrophes. An individual who loses HALF of his/her account value needs 100% to recover. The individual who only loses 20% requires 25% to be made whole. If that takes a year or two or even three, the individual would have 60 more months in the hypothetical 8-year bull cycle to grow his/her account value substantially. Hold-n-hope advocates disparage the notion that one can reduce exposure to riskier assets (or raise them) in a manner that might prove successful. Doing so, they claim, amounts to little more than sporadic market timing. That is incorrect. Had one simply used extreme valuations alongside deteriorating market internals to reduce exposure to U.S. stocks in 2000 and 2007, they’d have preserved more of their account values for enhanced long-term compounded growth. Consider valuations at the start of the year 2000. The trailing twelve month P/E (34.0) and trailing 10 year P/E (44.2) for the S&P 500 had been hitting never-before-seen extremes in history. In the same vein, the New York Stock Exchange Advance Decline (A/D) line was buckling at an increasingly rapid pace; the downward slope of its 200-day moving average indicated fewer and fewer participants in the “New Economy” bull. The deterioration in market breadth coupled with extreme overvaluation prior to the March 2000 bearish beginnings provided ample opportunity for investors to lower risk exposure. What’s more, since the improvement that occurred for the NYSE A/D line in the broader stock market in 2001 as well as 2002 was not accompanied by improvement in the NASDAQ A/D Line – and since there was little improvement in fundamental value – maintaining a lower risk profile for longer was warranted. Now let’s turn our focus to the year 2007. By the middle of that year, the trailing twelve month P/E (20.0) and trailing 10 year P/E (27.3) had been signaling caution. A wide variety of other valuation methodologies were also indicating a severely overpriced backdrop. As if that weren’t enough, the NYSE A/D Line began showing significant and persistence weakness as 2008 had been getting underway. Not paying attention to the breakdown resulted in unnecessary pain for investors. Again, a breakdown in market breadth accompanied by highly overvalued equity prices should be met with a decision to reduce one’s risk exposure. One does not have to short the market or seek to eliminate risk entirely. However, it is sensible to insure against the possibility of monstrous loss. What’s more, when improving market internals occur in conjunction with more favorable stock valuations – as they did in 2002 and 2009 – one can rebalance back to a target allocation. So what are the circumstances for today’s valuations and today’s market internals? Not so hot. As I mentioned earlier, the median price-earnings ratios (P/E) and price-sales ratios (P/S) actually surmounted the peaks at the end of the last two bull market cycles – the metrics went beyond the valuation peaks hit in 2000 and in 2007. Corporate earnings have now fallen from a height of $106 in 2014 to current levels of $95.4 on the S&P 500 for a 10% decline. They’ve fallen for two consecutive quarters and they are expected to fall in Q4 in what has been dubbed an “earnings recession.” The trailing 12-month P/E Ratio is 22.7, while the average since 1870 is 16.6. Meanwhile, the PE10 at 26 sits in highest quintile, implying that equities are severely overpriced. What about forward 12 month P/Es? Aren’t they still attractive? Although this “guestimate” methodology did little to help folks avoid the staggering losses of 2000 and 2007, the forward P/E of 17.2 right now is higher than it was in 2007 and it is well above the Goldman Sachs 35-year average (13.0). Naturally, perma-bulls and buy-n-hold advocates alike have endeavored to paint a prettier picture. Just exclude energy from earnings per share. For that matter, exclude corporations with 50% or more of their profits coming from overseas, and the earnings picture brightens considerably. Now how silly is the mistake of “Ex energy” or “Ex foreign exposure?” That’s akin to tossing the double-digit earnings expansion of the health care sector because the results are too wonderful. That’s about as sensible as removing the positive contributions from the consumer discretionary sector, since the savings at the pump have presumably gone into spending online or eating at restaurants or purchases at the auto mall. Conjuring up “Ex energy” is like putting lipstick on an elderly pig or providing a face lift for an aging dog. (Yes… those politically incorrect references.) Remember, “Ex-tech” discussions were floating around in 2000. “Ex-financials” were popular with analysts in 2007. If you’re going to argue “Ex energy” earnings per share today, then you should have ran with this line of thinking when crude traded north of $105 per barrel. Bottom line? It is true that valuations only carry weight when stock tailwinds turn to stock tornadoes; it is accurate than decidedly overpriced equities could thrive until they become insanely priced. Nevertheless, booms become busts and the current bull cycle is no different. It follows that preparing for a bust involves monitoring the forces that drive valuations as well as monitoring market internals. For instance, we know that ultra-low borrowing costs over the last seven years have fueled everything from consumer purchasing activity to mortgage refinancing to real estate speculation to corporate share buybacks. The question an astute investor may wish to pursue is whether or not corporations will even be positioned to take on more debt to buy back their shares going forward. Total corporate debt has more than DOUBLED since pre-crisis levels of 2007, while the average interest paid on debt for corporations has jumped from 3.5% in 2007 to 4.5%. That’s right. Corporations are paying more and more of the money they make/borrow to service TWICE as much debt at HIGHER interest rates than they were paying in 2007. Meanwhile, the Federal Reserve’s upcoming directional shift will make it more expensive to borrow new money in the bond market, hampering stock buybacks as cash flow from sales continues to decline. For the time being, an allocation to S&P 500 proxies like the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) is holding up admirably. If you are over-allocated to riskier segments of the equity markets or higher-yielding bond markets, take your small gain or “tax-loss harvest” the small loss. Valuations for small caps in the iShares Russell 2000 ETF (NYSEARCA: IWM ) are even more troubling than their larger-cap brethren. The rising price ratio for the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ): iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) also indicates investor preference for perceived safety. 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.