Tag Archives: seeking

Flatter Yield Curve, Narrow Stock Leadership Forewarn Extreme Risk Takers

Summary How confident should diversified investors be that U.S. stocks can power ahead without the extraordinary stimulus of quantitative easing (QE) and zero percent interest rate policy? Not too confident. Some folks are glad to see seven years of extraordinary accommodation come to an end. Understanding late-stage bull market phenomena help tactical asset allocators monitor changes in risk-taking. Here are two gauges of “risk off” behavior that I am watching. How confident should diversified investors be that U.S. stocks can power ahead without the extraordinary stimulus of quantitative easing (QE) and zero percent interest rate policy (ZIRP)? Not too confident. Stocks that trade on the New York Stock Exchange are down roughly 7.0% from their May highs and down nearly 3.5% since the last QE asset purchase by the Federal Reserve occurred on December 18, 2014. Some folks are glad to see seven years of extraordinary accommodation come to an end. Consider Andrew Huszar. He is the former Fed official who managed the acquisition of $1 trillion in mortgage-backed debt, then subsequently condemned the endeavor in 2013. Huszar told CNBC, “[QE] pushed up financial asset prices pretty dramatically. A lot of that is the Fed pushing the market’s paper value way above it’s true value.” Is he wrong? Probably not. Metrics with the strongest correlation to subsequent 10-year returns – Tobin’s Q Ratio, P/E10, market-cap-to-GDP, price-to-sales – all suggest that current valuation levels are at extremes not seen since 2000 . Worse yet, if previous cycle extremes are any indication, one should be prepared for a 40%-50% bearish decline for popular benchmarks like the S&P 500. The typical argument against overvaluation – the “this time is different” argument – involves the assumption that unprecedented lows for interest rates render traditional valuation methodologies insignificant. There are at least two problems with this notion. First of all, for rates to stay this low well into the future, it would likely correspond to a feeble U.S. economy as well as anemic corporate revenue. (Corporate sales per share have already declined for three consecutive quarters.) It follows that a deteriorating fundamental backdrop would offset borrowing costs that remain low on a historical basis. The second trouble with pointing to low interest rates to dismiss overvalued equities? It ignores the directional shift from emergency level QE stimulus to zero percent policy alone to the highly anticipated quarter point tightening. Again, a diversified basket of equally-weighted stocks is down nearly 3.5% since the last QE asset purchase. (Review the NYSE chart above.) As always, overvaluation doesn’t matter until it does; exceptionally overpriced can become ludicrously overpriced for several years. On the other hand, understanding late-stage bull market phenomena help tactical asset allocators monitor changes in risk-taking. Here are two gauges of “risk off” behavior that I am watching: 1. Flattening Of The Yield Curve When spreads between longer and shorter treasury bond maturities rise, the yield curve steepens. Investors are less inclined to purchase long-dated treasury debt because they have faith in the strengthening of the economy. In contrast, when spreads fall, the treasury yield curve flattens. Investors demand the perceived safety of longer maturities because they are concerned that economic conditions are deteriorating. Now consider the current “risk off” behavior. One year ago, the spread between 10-years and 2-years chimed in at 1.8. Today it is roughly 1.3. The 2-year treasury bond yields have soared on the prospect of the Fed’s imminent rate hike, yet the 10-year yield has barely budged because investors are expressing concern about the potential for Fed policy error. Take a look at what transpired in the middle of 2012. The Federal Reserve met rapidly falling spreads head on, jolting “risk on” investing behavior via open-ended quantitative easing stimulus (QE3). Right now? Investors are exhibiting the kind of “risk off” preferences that transpired back in mid-2012. Yet the Fed is not gearing up to provide additional liquidity. On the contrary. Fed committee members seem resigned to raising borrowing costs, if ever so slightly. The narrowing between 30-year maturities and 2-years demonstrates a similar “risk off” pattern. The spread is even lower than when the Fed shocked and awed the investing world with QE3. The declining spreads and the flattening of the yield curve are a sign of risk aversion – one that, historically, has worked its way into stocks. If the current pattern of yield curve flattening continues, equity prices of popular benchmarks are likely to fall. 2. Narrowing of Stock Breadth According to Bespoke Research, the top 1% of Russell 3,000 stocks (30 largest) are up roughly 6.6% YTD. That is the top 1%. The other 99%? The remaining 99% of Russell 3,000 stocks have averaged a decline of -3.0% YTD. Others have identified the lack of participation using the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). The top 20 components have gained 59% while the other 480 components are collectively down 3.0% YTD. The result for the market-cap weighted ETF? A 3% gain. Historically, narrow breadth rarely bodes well for the intermediate- to longer-term well-being of market-cap weighted funds. A better picture of what is actually happening to risk preferences is evident in equal-weighted proxies like the Guggenheim Russell 1000 Equal Weight ETF (NYSEARCA: EWRI ). We can see that, much like the NYSE itself, EWRI is still close to 7% below its May high; EWRI is still trading at a lower price than when the Fed exited QE for good with its final mortgage-backed bond purchase on 12/18/2014. Similar to stock valuations, weak breadth may not matter until it does. Thin leadership where a few stocks carry the entire load can become even thinner leadership. Historically, however, the top 1% or the top 5% tend to buckle. That’s why it is sensible to ask one’s self, is it likely that the other 95% or the other 99% will join the top 1% or top 5% at extremely overvalued price levels? Or is it more likely that profit-taking on stocks like Facebook (NASDAQ: FB ), Amazon (NASDAQ: AMZN ) and Netflix (NASDAQ: NFLX ) will result in a take-down of the heralded S&P 500? For the majority of my moderate growth and income clients, I maintain a 60% stock (mostly large-cap domestic), 25% bond (mostly investment grade) and 15% cash/cash equivalent mix . This contrasts with a more typical “risk on” allocation of 65%-70% stock (e.g. large, small, foreign, etc.) 30%-35% bond (e.g. investment grade, convertible, high yield, foreign bond, etc.). Top stock ETF holdings include the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) , the Technology Select Sector SPDR ETF (NYSEARCA: XLK ) and the iShares Core S&P 500 ETF (NYSEARCA: IVV ). Top bond holdings include the Vanguard Total Bond Market ETF (NYSEARCA: BND ) as well as the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) . D isclosure: 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.

Nontraditional Bond Funds: The Best And Worst Of October

By DailyAlts Staff Nontraditional bond funds bounced back from September’s losses of 1.04% to post a 0.73% aggregate gain in October, according to Morningstar. In addition to the category swinging from losses to gains, the best-performing nontraditional bond funds posted bigger gains in October than September, and the worst-performing funds posted lighter losses. What follows is a recap of last month’s best and worst performers, concluding with a follow-up report on September’s standout funds. (click to enlarge) Top Performing Funds in October The PIMCO Floating Income Fund (MUTF: PFIIX ) was October’s top-performing nontraditional bond fund, gaining 3.19% for the month. In September, PFIIX was one of the category’s three worst performers, falling 2.80%. The fund’s rebounding performance was emblematic of the nontraditional bond category’s swing from loss to profit in October, but despite its solid gains for the month, PFIIX was still down 2.69% for the twelve months ending October 31. Over longer periods, its returns have been more attractive: The fund’s three- and five-year annualized returns of 1.34% and 2.25%, respectively, besting the category averages of 1.00% and 2.11%. PFIIX debuted in 2005 and has $657.4 million in assets under management (“AUM”). The second-best nontraditional bond fund to own in October was the WHV/ Acuity Tactical Credit Long/Short Fund (MUTF: WHAIX ), which returned +3.11% for the month. The fund launched on December 16, 2014, so it still didn’t have a one-year return as of October 31. For the first ten months of 2015, WHAIX boasted impressive gains of 8.01%, ranking at the very top of the category. Its AUM recently stood at $52.5 million. October’s third-best nontraditional bond fund – for the second month in a row – was the Robinson Tax Advantaged Income Fund (MUTF: ROBNX ), which added gains of 3.02% on top of the previous month’s 1.04%. The fund, which originally launched on September 30 of last year and has $64.1 million in AUM, returned +2.86% for the year ending October 31. (click to enlarge) Worst Performing Funds in October The Parametric Absolute Return Fund (MUTF: EOAIX ) was the worst-performing nontraditional bond fund in October, falling 3.45%. EOAIX, which launched in 2010, generated gains of 3.38% in the first ten months of 2015, but lost 4.20% for the three months ending October 31. The fund has $29.6 million in AUM. The Palmer Square Long/Short Credit (MUTF: PCHIX ) and the Legg Mason Alternative Credit (MUTF: LMANX ) funds were the category’s next-worst performers in October, posting respective losses of 2.45% and 1.85%. Of the two, PCHIX is the smaller and younger fund, with $20.6 million in AUM and a November 2014 launch date, compared to LMANX’s $789.5 million AUM and August 2010 debut. PCHIX’s losses have also been steeper over the three- and ten-month periods ending October 31, at 4.73% and 7.28%, respectively; compared to LMANX’s lighter losses of 3.77% and 5.21%. (click to enlarge) September’s Best and Worst: Follow-Up As previously stated, September’s third-best and third-worst nontraditional bond funds found their way into October’s top three – but what happened to the #1 and 2 best- and worst-performers from the prior month? The best nontraditional bond funds in September were the Cedar Ridge Unconstrained Credit Fund (MUTF: CRUMX ) and the Forward Credit Analysis Long/Short Fund (MUTF: FLSIX ), both of which returned +1.07%. In October, CRUMX posted gains but underperformed at +0.58% compared to the category average of +0.74%. FLSIX outperformed, gaining 0.94% for the month. The Highland Opportunistic Credit Fund (MUTF: HNRAX ) was September’s worst performer by a longshot, falling 7.2%. The month’s next-worst fund, the Fortress Long/Short Credit Fund (MUTF: LPLIX ), posted comparatively lighter losses of 3.17%. In October, HNRAX was able to eke out a 0.07% gain – still well under the category average – while LPLIX outperformed with an impressive gain of 1.29%.

Alternatives For The Future

The article first appeared in the December issue of REP . magazine and online at WealthManagement.com Along with other Yuletide treats, some Yanks are now anticipating the gift of a Fed rate hike. Better-than-expected employment numbers, an uptick in the manufacturing sector and pickup in wages have given the U.S. central bank the backstory for normalizing the nation’s monetary policy. The odds of a rate step-up, implied by Federal Funds futures, shot up from 7 percent to 70 percent in November. Simultaneously, expectations pushed the Treasury long bond yield up nearly a quarter of a point, effectively discounting the Fed’s anticipated action. Now that the markets have priced in the first Fed rate hike, it’s debatable whether it will be “one-and-done,” or the first step along a steady path of snugging. Either way, the die is cast: Rates are bound to rise, and sooner rather than later. With the coming of the end of the zero-rate environment, investors and advisors must rethink their portfolio strategies, most especially their alternative investment allocations. The basic question facing them now is which exposures are most likely to continue providing risk diversification in a rising rate environment. To answer that question, let’s look back at the liquid alt universe over the past five years and gauge each category’s correlation to a fixed income market proxy, the iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ). AGG tracks an index of investment grade notes and bonds including Treasuries, agencies and corporates as well as mortgage- and asset-backed paper, all with a weighted average maturity just under 13 years. Currently, AGG offers a 2.4 percent distribution yield. Two Things An ideal diversifier should be negatively correlated to AGG. Thus, when rates rise (and AGG’s price, as a consequence, falls), the alternative investment should appreciate. There are five categories that are negatively correlated to AGG: arbitrage, hedged equity, commodities, long/short equity and market-neutral. Based on the foregoing criterion alone, the arbitrage category seems to have the best track record over the past five years. Keep in mind two things, though. First, the correlation coefficient doesn’t measure cumulative returns. It only depicts the statistical relationship between each investment’s month-to-month price movements. And second, the category performance represents the market-weighted average of several portfolios. The arbitrage category, for example, comprises five products, four mutual funds and one exchange traded fund (ETF). Market weighting gives us insight into investor behavior and allows us to more clearly see how investors are actually putting their capital to work. The stand-out arb portfolio is the relatively small Quaker Event Arbitrage Fund (MUTF: QEAAX ) with a correlation of -0.21 to AGG and an average annual return of 2.39 percent. QEAAX deals in mergers, takeovers, spin-offs and other reorganizations, hoping to capture securities mispricings. The obvious problem with QEAAX, if a problem is to be found, is its high correlation to equities. QEAAX, after all, buys and sells stocks. If the prospect of rising rates spooks the equity market, as indeed it seems to have done, the Quaker fund’s NAV will likely be pressured. Hedged equity funds are also highly correlated to the broad stock market. The “hedge” in the category’s title refers to the variety of strategies employed by constituent funds to attenuate, but not necessarily eliminate, beta. The Schooner Fund (MUTF: SCNAX ), for example, is a long-biased fund that utilizes a buy-write (covered call) strategy to boost income. That said, SCNAX, with a -0.19 correlation to AGG, benefits most from a mildly bullish equity market. SCNAX pays just 0.57 percent in dividends. Commodity funds-long-only indexed portfolios-are only modestly correlated to stocks, but are suffering from a four-year disinflationary malaise. All, save one, are negatively correlated with AGG. It’s the PIMCO Commodity Real Return Strategy Fund (MUTF: PCRIX ), which overlays an actively managed fixed income strategy atop the index portfolio, that earns a 0.04 correlation to AGG. It should come as no surprise that long/short equity funds are highly correlated to the broad stock market. Nearly half of the 16 funds in the category, in fact, correlate to the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) at better than 0.85. Of these, one with the most negative correlation to AGG (-0.31) is the Diamond Hill Long-Short Fund (MUTF: DIAMX ), a portfolio that commands a 22 percent share of the category. Market-neutral funds attempt to hedge out general market exposure, i.e., aim for a beta near zero, to allow full expression of the manager’s concentrated bets. The multi-manager Deutsche Diversified Market Neutral Fund (MUTF: DDMIX ) accomplishes this with the category’s most negative correlation to AGG (-0.16). Alternative Income There’s a category we haven’t yet examined: alternative income. Three funds, in particular, have five-year track records, two mutual funds and an ETF. Collectively, these funds exhibit a modestly negative correlation (-0.06) to AGG, though you can see there’s a fair degree of “zig” to AGG’s “zag” in Chart 2. Viewed separately, these funds offer distinct value propositions: The $7.6 billion ALPS Alerian MLP ETF (NYSEARCA: AMLP ) tracks the price and yield performance of the Alerian MLP Infrastructure Index, a modified capitalization-weighted and float-adjusted benchmark of two dozen U.S. energy master limited partnerships (MLPs). To allow a full allocation to MLPs, AMLP is structured as a C-corporation, which means it can’t pass through the full return of its underlying index. Payouts are distributed net of corporate tax, which translates into a daunting expense ratio of 5.4 percent. The good news is that most of these distributions come tax-deferred to investors, making its 8.4 percent distribution yield doubly attractive. Worse News There’s, of course, worse news: The energy sector’s tanked this year, taking AMLP’s share price with it. The fund lost 28 percent on the year through mid-November. The JPMorgan Strategic Income Opportunities Fund (MUTF: JSOAX ) is an unconstrained bond fund with an absolute return orientation. The $18.4 billion fund has the flexibility to allocate its assets across a broad range of fixed income securities and derivatives as well as strategies employing cash and short-term investments. JSOAX is not afraid to load up on high-yield securities. JSOAX tends toward a short duration and holds a heavy slug of cash, all of which reduce its interest rate risk. The fund offers a 2.6 percent distribution yield. At $698 million, the Highland Floating Rate Opportunities Fund (MUTF: HFRAX ) is the category’s smallest asset collector. Still, it’s the best performer. HFRAX invests in floating rate bank loans-obligations with interest rates pegged to a spread over Libor (the London Interbank Offered Rate). This puts the fund in the catbird seat in a credit-tightening cycle. Currently, the fund offers a 5 percent distribution yield. You can see in Table 2 the countertrend nature of the HFRAX fund in its -0.22 correlation to AGG and a Sharpe ratio 40 basis points above that of the iShares product. So what have we learned from our little exercise? Simply this: When it comes to hedging interest rate risk, fund performance doesn’t draw assets. At least not yet. The Highland HFRAX fund, despite its impressive metrics, remains relatively obscure. It accounts for barely one-half of 1 percent of the alternative funds’ assets examined here. Perhaps that makes this fund-and newer funds on similar trajectories-undiscovered gems in the upcoming rate environment.