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Sector Rotation Watch: The FED Is ‘The New Anchor’

Summary The FED changed everything. The Sector Rotation Model since “crash Monday” had been indicating a turn to ‘risk on’ as bullish sectors began outperforming and bearish sectors lagged. Sector performance since the FED announcement has become decidedly bearish. The FED changed everything. Sector Rotation Background If you’re familiar with my discussions on “Sector Rotation”, you can skip to the next section ” Current Sector Performance” as the info here is simply a repeat for newcomers. Professional money managers rotate through the different market sectors depending on their beliefs about where we are in the economic cycle. These managers have a mandate to be fully invested, so when the economy – or market – turns down, professionals seek safety in “non-cyclical” stocks, or those where earnings are less likely to decline in a recession, and vice versa. The Sector Rotation model below explains it in a simple diagram. Chart 0 – Sector Rotation Model Individual investors have greater flexibility than professionals because they don’t have mandates to be fully invested, so they can exit the stock market rather than finding sectors “to hide in.” However, individuals are notoriously poor at making these decisions and have to deal with numerous behavioral biases, so a word to the wise: if you are older, nearing retirement, then caution and conservatism are warranted and your allocation to volatile equities should be decreased regardless of where we are in the investment and business cycle. If you are younger and can remain invested for the long-term, then you may want to remain fully invested, and possibly tilted toward “the right sectors” during weaker economic times. Current Sector Performance In my September 16, 2015 “Sector Rotation Watch”, while discussing the upcoming September FED announcement, I said “… but with the dissentions on the FOMC board, I’m not sure they are close to a decision.” By this I meant I did not think they could make a decision at all, implying they were “deer in headlights”. They froze, didn’t they? I also said “I’m not sure it even matters.” While I was right about the FED freezing, I might have been very wrong about the market not caring. In the comparison chart below, the left panel shows what the sectors were doing ahead of the FED announcement (since the “crash Monday”, 8/24) while the right panel shows sector performance after the FED. Chart 1 – Comparison of Sectors, pre- and post-FED (click to enlarge) Since “crash Monday” (8/24) on the left, the Sector Rotation Model would have you believe it was “full risk on”, with bull market “cyclical” sectors like Tech (NYSEARCA: XLK ) and Discretionary (NYSEARCA: XLY ) performing very well and “non-cyclicals” of Staples (NYSEARCA: XLP ), Healthcare (NYSEARCA: XLV ), and Finance (NYSEARCA: XLF ) lagging. Utilities (NYSEARCA: XLU ) aren’t just lagging, they seem to be showing a significant bullishness by lagging so far behind. Re-“anchoring” the comparison to the FED announcement and the Sector Rotation Model has reversed course; “places to hide” – aka non-cyclicals – have started performing better and “bull market” cyclicals have fallen off. The most notable performance is from the utilities sector, which is clearly in the lead, and even has a slightly positive return. This stands in sharp contrast to the pre-FED performance for utilities, although you should note they started performing better prior 5 days prior to the FED announcement (see the left panel). Not quite as important, but notable, is that consumer staples has pulled ahead of consumer discretionary, the long-time winner of this bull market. I would watch the discretionary sector very closely going forward, to see if it continues to weaken (bearish) or bounces back (bullish). There are two other things of note since the FED spoke, both being weak performances. The bull market mavens of Energy (NYSEARCA: XLE ) and Industrials (NYSEARCA: XLI ) had fallen hard in the past year, perhaps giving early warning caution signs, but since “crash Monday” they had been experiencing the “bounce back tendency” of laggards. Since FED day, these two sectors have tried to join their cohort of Basic Materials (NYSEARCA: XLB ) in a race to the bottom. Healthcare is almost winning that race, thanks to an idiot ex-hedgie CEO and the heavy media mania on his drug price increases, helping to create some “HillarySpeak”, or simply, a whole lot of bad press on drug stocks. We have gone from “risk on” to “risk off” very quickly, but more precisely, it was actually “risk-on, FED announcement, more risk-on, but just for 1 hour, then it turned sharply, intraday at 3pm, to risk-off”. This is essentially the title to an Instablog I posted on Sept 19. I’m trying to post “more timely” comments than publishing allows by using my Instablog, although it may be sporadic this next week due to outside time constraints. To get notices when I write an Instablog, you have to “follow me.” In chart 2 below, you can see the intraday reversal on FED day (a Thursday), which I highlight with the blue vertical line. I show it on three different symbols to show problems that occur when you look at index symbols. In the left panel, I show the S&P 500 index, and since not all 500 stocks open exactly at 9:30 – some are delayed – it appears the S&P opened at the prior days close. This issue occurs across all the sources I checked. The middle panel is the S&P e-mini but I can set TradeStation to only show the trading during the NYSE “normal” hours, and while the shape is right (Friday shows a gap down), the e-mini shows greater volume on Friday; this is due to the fact that it was a “triple witching day”. Thus I prefer the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and any other “index ETFs” rather than the index themselves; the SPY shows volume on the FED day to be the greatest. Chart 2 – FED announcement (click to enlarge) A lot of people I respect keep telling me the economy is doing fine, recovering slowly but recovering nonetheless. They watch for “early warning signs” in the economy and the picture seems unclear (isn’t that what the FED just said through its “in-action”?). The market fell hard on China economic weakness, revealing its vulnerability, but rebounded; then the FED rained on the parade. It is obvious the market did not like the FED announcement as it has turned, sharply and decisively. There is one aspect to the Sector Rotation Model that is really interesting and might even give clues by itself. I noted how the utilities sector has gone from extreme lagging to extreme leading. Michael A Gayed , #3 on Seeking Alpha’s list of tops for Market Outlook, runs a “beta rotation strategy” at his firm and it is based simply on what the utilities sector is doing. They look at a rolling 4 week return for the XLU and if the utilities sector is outperforming the broader stock market, up more or down less, then the following month position yourself in utilities, and vice versa. In simpler terms, if over the last 4 weeks, professionals are “running for the exits”, out of the broader market and into the safety of utilities, then join them; and vice versa. Michael gave a very insightful presentation on December 28, 2014, to the Virginia Chapter of the CFA Institute, explaining this strategy. It is well worth the time to watch his presentation, but their study is a fast read. The model performance is significant, with it outperforming about 80% of the time and generating 4.2% outperformance annually. This 4.2% may not seem like much to an individual investor, who dreams of “double-baggers” and “triple-baggers” and such, but if stocks return 7% annually, in 20 years, your portfolio will be 3.9x larger; returning 11.2% annually, it’s 8.4x larger, more than twice as large. Like I say so often, you have to “do the math” and the math of compounding is significant. That is why everyone should start savings and investing as soon as they start working. I have to repeat one thing Michael said in the presentation and it is “the reason buy and hold does not work is that no one holds.” You need to have a plan and be careful about “running hot and cold” every time you read an article that runs counter to your thinking. Keep this in mind when you read the “spoiler alert” about his strategy that I simply must give you now. Michael says you might not want to buy utilities for the next month if they “show a pulse of strength” because 10% of the time, this type of move foretells a VIX spike. In other words, 10% of the time utilities “show a pulse of strength”, the market sells off hard. I wish Michael had defined this numerically because utilities are looking like they might be “showing a pulse of strength”, especially starting early last week (~9/22). Watching short-term news like the FED announcement can be important, especially when it might impact the long-term picture, but be careful about the short-term noise in the market. Fed speak is not noise, not always, such as Yellen mentioning “negative interest rates”. Negative interest rates is loosening, the exact opposite of the expected tightening rate hike some expected. The possibility of the FED pursuing negative interest rates is an important long-term dynamic. Understanding the long-term is critical no matter what your trading time frame; that is, if you trade on a 5 minute basis, you had better know what is happening on an hourly and daily basis, and while you would not trade on a 5 minute time frame based on what is happening on a yearly or decade basis, you still need to understand that higher time frame. If you have not read them yet, my first three articles are “primers for investing”, explaining the long-term nature of market moves. My sector rotation article discusses trying to “play rotating sectors” in a secular bear market (almost impossible) and it also discusses the extreme volatility you will experience, down and up, as discussed in greater depth in my article on long-term secular bear markets. Understanding these secular equity markets is dependent on understand long-term secular moves in interest rates . Given the background these prior articles provide, I’ll stick with the view from my prior Sector Watch article, even though the short-term call was “risk on” at that time and now it’s “risk off.” I repeat what I said then: “Whether we break to new highs, only time will tell, but given the higher risks associated with a longer-term view, and in light of my recent articles, I would still use any rally to raise cash, probably even if I was really young and investing for the long run.”

How Survivorship Bias Distorts Reality

Summary We tend to only consider information that’s presented to us and ignore absent information that may be extremely relevant. But focusing on one side of the equation while neglecting the other distorts your thinking and decision making process. This bias frequently arises in all kinds of contexts; once you’re familiar with it, you’ll be primed to notice it wherever it’s hiding. Back during World War II, statistician Abraham Wald was tasked with helping the Allies decide where to add armor to their bombers. The hope was that this extra protection would help minimize bomber losses to enemy anti-aircraft fire. The top brass of the Allied army thought the answer was obvious: just look at the bombers that returned from missions, and add armor to the areas that showed the most damage. But Wald disagreed. He explained that the damage actually revealed the locations that needed the least additional armor; in other words, it’s where a bomber could be hit and still survive the flight home. Wald’s solution was counterintuitive. He recommended adding more armor to places like the engine where there was no damage, because that’s where the bombers that didn’t make it back were hit. This simple advice would end up saving the lives of thousands of Allied air crews. Typical Damage Patterns on Returning Bombers Source: A North Investments The bomber problem is a classic case of “survivorship bias” – the tendency to only consider information that’s presented to us (e.g., bombers that survived), and ignore absent information that may be extremely relevant (e.g., bombers that got shot down). Focusing on the former and ignoring the latter distorts the way you think and make decisions. It’s a bias that frequently arises in all kinds of contexts. And once you’re familiar with it, you’ll be primed to notice it wherever it’s hiding. Like health and longevity advice. We look to old people on guidance for living a long life when we should really examine those who died early to learn what to avoid. I recall watching a documentary about centenarians (100+ year olds) who claimed that the key their longevity was smoking and drinking every day. The non-statistically minded (which includes most of us) will misinterpret this as proof that smoking and drinking isn’t that harmful, not realizing that centenarians represent the lucky few who won the genetic lottery. There’s a much larger pool of people who made the same poor health choices and didn’t live long enough to appear on television; so the unusually lucky few tend to stand out and, hence, receive the most attention. Survivorship bias also skews our understanding of the past. Take the widespread and highly romanticized belief that old things (pick one: cars, TVs, toasters, etc.) were made better than they are today. The much more likely truth is that 99% of old things were poorly made and are now rusting out of sight. The few things that did manage to survive intact were the ones that were well made. That doesn’t mean everything was. The same goes when it comes to music. Songs that leap from memory when someone mentions a decade like the 1980s tend to be songs that became hits. As a result, good songs begin to represent 1980s music because we still listen to them, even though the vast majority of music produced during that decade was less than memorable. Our childhood memories work much the same way. We tend to remember the good times and forget the bad, deceiving ourselves into thinking that the “good old days” were far better than they really were. No wonder the present never seems as good as the past. Even religious beliefs are affected by survivorship bias. Consider the story told by Marcus Tullius Cicero about the atheist Diagoras. He was shown the painted portraits of faithful worshipers who prayed and were later saved from a shipwreck. The implication was that praying protects you from drowning. Diagoras asked, “Where are the portraits of those who prayed, then drowned?” There were none. Dead worshipers, like the downed bombers, can’t advertise their experiences, so they get excluded from the sample. This is how people get fooled into believing in miracles (which are nothing more than positive low-probability events). Let’s say a disease is 99.99% fatal and 1,000 people get it. The single survivor will surely see his recovery as a miracle; of course, the reality is that the statistics of the situation simply dictated that “someone” would survive. The lucky survivor gets to stick around and tell his miraculous story; the 999 non-survivors, being dead, can’t tell their non-miraculous ones. Something similar occurs in the investment industry. It claims that some people are extremely skilled, since year after year they’ve outperformed the market. They’ll identify these “investment gurus” and convince you of their abilities. But a simple thought experiment can show that it would be impossible to not have these gurus produced just by luck. Imagine you had thousands of money-managing chimpanzees picking stocks at random. If every year you fired the losers, leaving only the winners, eventually you’d end up with long-term steady winners. Since all you see are the handful of survivors, you’ll be led to believe that random stock selection is a good investment strategy, and that some chimpanzees are considerably better investors than others. Plus, since chimpanzees charge lower fees than their human counterparts (bananas are inexpensive), you might even be tempted to let one of these hairy creatures manage your portfolio. I wouldn’t recommend it. Even though human money managers employ more sophisticated investment strategies, it’s still easy to get fooled by survivorship bias. Given the multitude of different strategies, some are bound by pure luck, even over long periods of time, to produce superior performance even if they don’t genuinely possess predictive power. And it’s this small subset of surviving strategies that attract the most attention and investment capital. Consider the famous Super Bowl Indicator, which says stocks go up in years when a team from the NFC wins and down when an AFC team wins. It was right 63% of the time between the first Super Bowl in 1967 and 2014. In years where an NFC team has won, however, the indicator’s accuracy improves to 88%. Sounds impressive. Unfortunately, as is the case with many popular investment strategies, the indicator has no predictive power – it’s simply a case of spurious correlation (just like ice cream sales and forest fires are correlated, but neither causes the other). Making investment decisions based on such random relationships is how you go broke. S&P 500 Returns as Predicted by the Super Bowl Indicator Note: The 2015 Super Bowl was won by the New England Patriots (an AFC team), which means that 2015 should be a down year for stocks . . . so far it appears to be the right call. Source: A North Investments Some of today’s most widely used investment strategies are nothing more than Super Bowl Indicators in disguise. Take Warren Buffett’s focused value investing, which involves betting heavily on a few high quality, undervalued companies. He’s made tens of billions of dollars following this approach, and it seems to work for others too. Forbes’ wealthiest people list is almost entirely made up of individuals who, like Buffett, were rewarded for putting all of their eggs in one basket. You simply don’t become as rich as Facebook’s (NASDAQ: FB ) Mark Zuckerberg or Microsoft’s (NASDAQ: MSFT ) Bill Gates by holding a well-diversified portfolio. But the reverse is also true – holding an under-diversified portfolio probably won’t make you that rich either (if anything, it’ll help you go bankrupt). Just look at the cemetery. The graveyard of failures is full of unlucky people who, just like the population of life’s lottery winners, put all of their eggs in one basket. Ignoring them is like ignoring the bombers that were shot down, it’s financial suicide. Which brings us to the whole notion of success itself. Numerous studies on the topic follow a similar methodology. They take a population of suit-and-tie-wearing hotshots and look at what they all have in common: courage, passion, risk taking, vision, and so on, and infer that these traits are the “secret to their success.” To recognize the flaw here, simply look at the cemetery of failed persons. What traits do they all share in common? Here’s a hint: courage, passion, risk taking, vision, etc., just like the population of hotshots. This is difficult to see because failures don’t appear on television and on the covers of magazines. They don’t write books and memoirs. They don’t travel the world giving seminars and lectures. In short, nobody’s interested in what they have to say (even though they can teach you some useful tricks like “what not to do” and “mistake to avoid”). There may be some differences in skills, but what truly separates life’s winners and losers is plain old luck. The moral here is to be careful from whom you seek advice, because advice-giving is a monopoly run by lucky survivors. To paraphrase the famous psychologist Daniel Kahneman, stupid decisions that work out well become brilliant decisions in hindsight. The things people like Steve Jobs or Mark Zuckerberg or Bill Gates did right are like the damaged bombers that managed to survive the flight home. The much larger pool of people, those who made equally risky bets and failed, exit the sample. This gives us a distorted view of the odds of success. So, before you emulate a famous entrepreneur by dropping out of college and starting a business in your parents’ garage, ask yourself this question: How many people have done this same exact thing and failed? Way too many to count. No one remembers or cares about these losers and their unsuccessful companies. For every wealthy startup founder, there are thousands of other entrepreneurs who end up with only a cluttered garage. Surviving those statistical odds is nearly impossible. In Plato’s “Allegory of the Cave,” he describes a cave where prisoners are chained, unable to see anything, except shadows on the wall before them. The prisoners believe the shadows to be reality. However, one prisoner is freed and brought outside for the first time. At first he’s blinded by the brightness of the sun, but after his eyes accustom he realizes that the shadows were only fragments of reality. The point here is that what we see isn’t always the whole truth. Spending your life only learning from survivors, reading books about successful people, and poring over the history of companies that changed the world is like being imprisoned in Plato’s Cave – all you get is a biased and incomplete view of the facts. However, leaving the cave and acknowledging the other side of the equation (i.e., the non-survivors, losers, failures, etc.) prevents you from getting fooled by survivorship bias.

A Major Problem With Analyzing Infrastructure Projects

Summary There are risks associated with businesses relying on government projects. Colt is an example of a business disrupted by losing government contract. What all investors have to be aware of for companies with a lot of government business exposure. There are an increasing number of calls for governments around the world spending a lot more money on infrastructure projects, as growth in the private sector continues to slow down. One of the tactics used to twist the arm of politicians is to point to decaying bridges and the last time they were upgraded, and similar pressures, asserted and leaked to the media to attempt to create a groundswell of public pressure to spend the money. Then there is the job creation side of it too. What lawmaker wants to be identified as one who resists the creation of more jobs; and in the case of government, those will generate above-market wages and benefits, even though in the longer term paying for all of it isn’t sustainable. With a lot of emotion on both sides of the issue, it lands on investors to sort through it and figure out if they can benefit from it. China’s ghost cities In recent history there probably isn’t anything more wasteful than the “ghost cities” created by China, which have few people living in them and no industry for jobs. They were built in order to create construction jobs, and once they were completed, the debt to develop them remained with nothing to generate revenue in the form of taxes, or to produce business momentum in the private sector. It was a classic catch-22. There were no people to inhabit the city, so there was no businesses that would want to locate in them. People were looking for jobs and businesses were looking for people to buy their products or services. Neither inhabited the cities. So the cities just sit there lying relatively bare with no reason for people to live in them. They’re simply brick and mortar built in the form of houses and buildings sitting empty. We know it won’t take long for nature to start reclaiming these cities. Political issues Since almost everything surrounding infrastructure projects are related to politics, there are all sorts of problems associated with them that the private sector usually doesn’t have to deal with; at least to the degree the public sector has to. For example, there are legal requirements for companies the work is farmed out to that they must adhere to if they want to have a chance at winning the business from the government. This plays out in a variety of ways, depending on the country. There of course is the strong potential for corruption, again, the level of which is determined by the specific region of the world infrastructure is being spent on. Also at issue over the longer term, is all of this infrastructure is very costly and debatable as to the real value it provides for citizens. That means it all has to be repaid, and that means either higher taxes or more printing of money by a central bank. That’s important because public sentiment can quickly change, which could have an impact on the future of a company doing business with the government. What’s the problem? Where the major challenge with all of this is at the level of exposure a company has in regard to government projects. That can be infrastructure or otherwise. One recent example on the government contract side was the loss of an $84 million contract by Colt three years ago, which ultimately led to its bankruptcy. Being able to provide guns to the military, once it had won the contract, meant during that time it had a monopoly on military gun sales for the duration of the contract. Once the contract was not renewed, it wasn’t able to compete in the direct to consumer market because its prices were higher than their competitors. Another reason example that’s shaking up the markets some was after the expiry of the Export-Import Bank, which Congress decided not to renew. General Electric (NYSE: GE ) has been the proxy of how it can have an effect on companies, as numerous contracts came under immediate threat because companies relied upon the Bank for financial support. Companies as large as General Electric won’t have trouble attracting financing because of its size and the type of jobs and projects it can bring to other regions of the world, but that’s not the point. The point is when dealing with governments, politics and fickle politicians can make abrupt decisions that can disrupt a business and an industry, specifically when relying on government contracts or government financing for a significant portion of a business. I’m not talking about changing laws here, I’m talking about losing government contracts or financial support that had a heavy impact on the performance of a business, and were expected to continue. Conclusion There is no doubt the global economy is slowing down, and one of the actions being called for is for governments to increase infrastructure spending. Not only does this include a lot of risk, as shown above, but many investors have ethical issues with the government taking on that type of debt and spending on dubious projects that have questionable value. That said, there are a number of companies that win contract year after year, and it’s a big part of their business success. Again, General Electric is an example of that. At issue for some investors is having to set aside personal preferences and analyze the company as it is, even if it is growing via government largesse. I’ve seen some investors look for minutia in order to find something wrong with these companies, even if they’ve locked in contracts that guarantee revenue for a number of years. For the reasons mentioned earlier, I tend not to invest in companies with a lot of reliance on government spending, because I see it as very risky. At the same time, it depends on the size of the company and the type of projects it’s engaged in as to the level of risk. It’s doubtful a company that started improving bridges would lose the contract in the middle of the work. What can’t be assumed is once a portion of the work under contract is completed, new work will be awarded to the company. That’s Colt’s story. And it’s not an unusual one when dealing with government. Infrastructure projects are highly controversial and scrutinized by a lot of special interest groups. It normally doesn’t hurt the brand of a company to be involved in them. The risk is spending money on the business with the expectations of doing further business with the government, and having another company get the business. Companies with significant exposure to government projects are okay as long as the investors understands the terms and duration of the contract. What can’t be counted on that once it’s completed the company will get more government business. That makes it hard to analyze the business because of capex needed to perform the job, and the resultant fallout if it no longer has the revenue stream to pay off its added expenses. Government infrastructure projects may sound good for the economy, but they aren’t always good for a company or investors. Invest accordingly.