Tag Archives: radio

How To Prepare For Volatile Markets

The last few years have been a relatively calm period for the US stock market, with few of the large swings that characterized markets during the financial crisis and the subsequent few years. But if the start of this year is any indication, 2016 may be more turbulent. What should you do with your investments to protect yourself from that possibility? The answer might actually be “nothing.” The first few days of a year don’t necessarily predict how the rest of the year will turn out. And larger market moves don’t necessarily mean you should make any changes to your portfolio. Markets go up and down all the time, and taking no risk with your investments would mean you wouldn’t have the chance to achieve more than meager returns. But if you are worried about market volatility, there are a number of ways to try to combat it, some more advisable than others. One way to try to protect yourself is to directly bet on volatility so that you’ll profit if markets become more tumultuous. These types of bets typically involve complex financial products such as options or exchange-traded products based on an index of stock market volatility. While betting on volatility can work in the short term if you guess correctly, it’s generally a terrible long-term strategy. For example, the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ), one of the exchange-traded products tied to volatility, has lost more than 99% of its value since early 2009. Unless you fully understand how these types of products work and the unique risks involved, betting directly on volatility probably isn’t a good idea. A second way to try to counteract stormy markets is to shift some of your stock allocation into “low-volatility” funds. These investment products have proliferated in recent years and hold stocks that historically have had been less volatile. These funds can indeed help reduce the impact of choppy markets, but there’s no guarantee that the stocks that historically bounced around less will outperform during any one future period of stock market instability. It’s also worth considering that some of these funds may shift your exposure not just toward less-volatile individual stocks, but also more broadly to less-volatile market sectors (such as utilities). Changing your sector exposure isn’t necessarily good or bad, but it’s something to be aware of if you’re thinking about low-volatility funds. Perhaps the simplest way to prepare for market turbulence is simply to shift some of your allocation in higher-risk investments (such as stocks) into lower-risk investments (such as bonds). Shifting your allocation doesn’t mean completely abandoning stocks – you don’t want to make it impossible to achieve your financial goals if stocks actually perform well – but rather, making slight adjustments so that you’re more comfortable with how your portfolio is positioned. After all, if the possibility of more volatile markets is keeping you awake at night, that might be a sign that your portfolio isn’t properly calibrated to your risk tolerance.

Best Stock ETF/Fund Categories For Future Gains

I’ll start with the good news. The overall market, including nearly all subcategories of ETFs/funds, especially international ones, is no longer at what I previously felt was a dangerously high level. One year of relatively flat, or even negative returns, have helped restore fund performance to more sustainable levels. (However, more traditional measures of stock valuation, such as forward-looking price to earnings ratios remain elevated – over 17, vs. the long-term average of about 14 for the S&P 500, according to bloomberg.com). I look at both stock valuations and on-going momentum as important yardsticks in judging the relative attractiveness of a particular stock fund and its overall category. While over- vs. under-valuation tends to arise as a result of long-term factors, momentum (relatively positive or negative) can be regarded as more short-term in nature. Given this, I place somewhat more importance on valuation issues than momentum in determining which stock fund categories look the most and least promising over the next several years at any given point. Now for the not-so-good news: Unfortunately, most stock ETF/fund categories, while not appearing excessively overvalued, don’t appear undervalued either. Of course, any time stocks are undervalued, they can be assumed to have much better prospects than if they are overvalued, or even fairly valued. At the same time, virtually every category of stocks has lost the momentum they exhibited in early 2015. My most favored and least favored stock category selection procedures do not employ the use of economic variables, such as GDP, level of interest rates, etc. However, since stocks often become over- vs. under-valued or momentum-impacted based on investors’ reactions to such data, my procedures do, in a sense, indirectly reflect such variables. Using my proprietary selection procedures has resulted in my specific fund selections outperforming an equivalently composed portfolio of benchmark index funds over the most recently available 3 year period, 10.9 vs. 9.6%, as well as the entire 5 year period, 11.1 vs. 9.6%. (Data annualized thru Sept. 30, 2015; see here to review the data. Note: One, 3, and 5 year data that include the just completed 4th quarter will be published on my website during the 2nd week of Jan.) Based on current valuation and momentum factors, the best that can be said is that the majority of fund categories are what I consider to be HOLDs. There are very few categories that exhibit the characteristics I consider as meriting a BUY designation, along with a few REDUCE/SELLs; for specifics, see the tables below. All categories designated as HOLDs are expected to be worth holding over the next 3 to 5 years, generating decent returns if held over the entire period. Here, then, are my current category recommendations for the nine most recognized U.S. ETF/fund categories starting with those with the most positive longer-term prospects near the top to those with least promising prospects near the bottom: Fund Category Recommendation Large Growth HOLD Mid-Cap Growth HOLD Large Blend HOLD Small Growth HOLD Large Value HOLD Small Value REDUCE/SELL Mid-Cap Value REDUCE/SELL Mid-Cap Blend REDUCE/SELL Small Blend REDUCE/SELL Note that none of the above basic fund categories show up as having particularly strong prospects over the next several years according to my research. While not currently overvalued, each of these categories has run up considerably over nearly the last 7 years, limiting, in my view, their future prospects. International Funds The following table shows my current category recommendations for five international fund categories starting with those with the most positive longer-term prospects near the top down to those with least promising prospects: Fund Category Recommendation Emerging Markets HOLD Japan HOLD Europe HOLD Diversified Pacific/Asia HOLD Diversified International HOLD My research shows that the first 4 out of the 5 international stock fund categories shown above show better prospects than any of the above U.S. fund categories. International stocks have had their problems in recent years, but looking ahead, I believe that prospects, including the economic fundamentals not directly considered in the above recommendations, will improve going forward. Sector Funds While I am not a big advocate of sector funds/ETFs, I present this data for those relatively aggressive investors who might be. Note that because sector funds can be highly volatile and relatively unpredictable, even when considered as longer-term investments, there is an above average risk that any sector forecasts, including mine, will not turn out as expected. Additionally, while you may not choose to invest in sector funds at all, you may find that the non-sector funds you do invest in (or are considering) can have a sizeable proportion of their holdings within one or more sectors. To learn what the sector breakdown is, enter the fund symbol at morningstar.com and look for “Top Sectors.” If the fund overweighs sectors that show up near the lower end in the table below, you may want to factor in this information when considering your ownership of this fund. For example, the PRIMECAP Odyssey Growth Fund (MUTF: POGRX ), a fund highly recommended by Morningstar (see my Dec. Newsletter ), has about 36% of its investments in the Health sector. Since this sector is one that my research does consider highly overvalued and a REDUCE/SELL sector, one might want to be cautious about owning this fund. The following table shows my current recommendations for 14 sector fund categories starting with those with the most positive longer-term prospects at the top to those with least promising prospects near the bottom: Fund Category Recommendation Precious Metals BUY Natural Resources BUY Energy BUY Commodities BUY Technology HOLD Communications HOLD Consumer Defensive (Consumer Staples) HOLD Consumer Cyclical (Consumer Discretionary) HOLD Global Real Estate HOLD Real Estate (U.S.) HOLD Financials HOLD Health REDUCE/SELL Industrials REDUCE/SELL Utilities REDUCE/SELL

Identifying Alpha With The Capital Asset Pricing Model: An Example In Dr Pepper Snapple

The Capital Asset Pricing Model (CAPM) is a tool that can be used to identify whether a stock can potentially generate alpha based on its risk-return characteristics relative to the market index. For instance, suppose that we have a stock that returns 5 percent annually where the market index returns 7 percent. Given a high risk in terms of beta (discussed further below), the CAPM would argue that this stock is a non-alpha stock; since the return generated does not compensate an investor for the given risk. On the other hand, suppose that the stock now returns 10 percent while the market index returns 7 percent. Additionally, the stock has very low risk meaning that the risk of a lower return is, well, very low. This type of stock is said to generate alpha returns – it compensates an investor above and beyond that which they should be entitled given the risk and return on the market index. Parameters Average Daily Return vs. Expected Return: The average daily return shows the actual percentage daily return of each company over the given time period; this is the benchmark that we use against the expected return (the return that the CAPM says we should receive for holding the stock) to determine if a stock is undervalued or overvalued. The expected return is defined as the risk-free rate plus the product of the company’s beta and the average daily market return, i.e. Risk-free rate + ß(Average Daily Market Return) = Expected Return. If the stock lies above the Security Market Line, it is undervalued. If it lies below, it is overvalued. Beta: This figure tells us how volatile a company’s price is relative to its market index. In this case, a company with a beta of less than 1 is less volatile than the S&P 500 Index; a company with a beta of greater than 1 is more volatile than the S&P 500 Index. R-Squared: The R-Squared figure indicates the degree of the company’s returns that can be explained by the market return, e.g. a company with an R-Squared of 100% means that 100% of the company’s returns are “explained” by the market. Conversely, a company with an R-Squared of 0% means that none of the company’s returns can be explained by the market return. Jensen’s Alpha: Jensen’s alpha indicates the excess return generated by a stock over its expected return according to the CAPM. If a company has an average daily return greater than the expected return, then the excess return is defined as Jensen’s alpha. An Example of Dr Pepper Snapple Group ( DPS ) Companies Coca-Cola PepsiCo Dr Pepper Market Daily Return -0.04% -0.04% -0.04% Company Daily Return -0.04% -0.02% 0.06% Beta 0.64 0.75 0.74 R-Squared 45.39% 56.29% 39.66% Intercept -0.00018 0.00006 0.00082 Expected Return 0.02% 0.01% 0.01% Jensen’s Alpha -0.06% -0.03% 0.04% Valuation Non-Alpha Non-Alpha Alpha With data run over a one-year period (November 2014 to November 2015), we see that of the three companies, only Dr. Pepper shows alpha returns of 0.04%. This means that the average daily return of the company is 0.04% higher than what is required to compensate the investor for the risk of holding the stock. Moreover, we see that the company has the lowest R-Squared of the three companies, which means that only 39.66% of the company’s returns are attributable to the returns on the market index; the rest are unrelated to the market. Additionally, with a beta below 1, Dr. Pepper could be considered an ideal low-risk alpha stock on the basis of its past returns. Conclusion An obvious limitation of the Capital Asset Pricing Model is that it is backward looking and cannot predict the future. Nevertheless, it is extremely useful in the sense that it allows us to analyse other fundamental factors taking past returns into account. While past returns cannot predict future returns, understanding a stock’s return characteristics allows for a very handy guide in making investment decisions. Original source .