CONVERGENT VIEWS

Good US Consumer

2015-01-28T10:22:00.002-05:00

Stocks haven’t had the greatest start to 2015. Regardless, economic fundamentals are seemingly still solid. Here are 3 charts indicating consumption could be tailwind in spite of the latest retail sales report:

The most apparent, oil is cratering and along with it gas prices, giving consumers more funds to spend on retail items they likely don’t need:
Wages are likely heading higher, so consumers can use that extra income to get that totally unnecessary Apple Watch.
And less of that increasing income is going to service debt, so maybe sometime soon Americans can go back to the good old days of maxing out their credit cards!

Of course none of this means stocks can’t go down. But historical returns suggests a drawdown of greater than 20% is highly unlikely.

*Please see the important disclosures that apply to this commentary HERE. The above charts are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Oil Down, Good

2014-10-20T09:00:00.004-04:00

There has been a big fuss made over lower oil prices and they are cratering:

So the logic goes: lower oil prices = less global demand for oil = weaker economy. Makes sense. Except in the US lower oil prices = more cash available for other consumer purchases = stronger economy. And in reality it’s spikes in oil prices, not dives, that correspond with recessions:

Maybe the market is signaling something different this time, but in the past lower prices have been good for the economy and stocks.

Following the Lead on Interest Rates Isn’t a Strategy

2014-09-24T09:03:00.000-04:00

Building a portfolio based solely on market consensus or projections isn't a strategy – it’s hope based investing.

Interest rates going up has been the consensus view since 2009. Eventually this view will be right, so far it really hasn’t. When exactly they go up I am unsure of, though I tend to think later than most.

One thing I will not due is blindly follow market projections or consensus calls, which appear to be nothing more than throwing darts. While the recent Fed statement contains “considerable time” before an interest rate increase, futures markets are assuming this will happen mid 2015:

Note: This chart isn’t easy to read. The blue line shows the actual Fed Funds rate, which is effectively 0 and has been since mid-2009. The orange line shows what the futures market is predicting the rate will be in the future at the start of the line (e.g. when rates reached 0 in mid-2009 futures markets expected rates to rise back up quickly and be at 2.50% or so by mid-2010). Lastly, the green line shows where we currently are that rates are projected to rise in mid-2015 and be at almost 3% by 2017. Also, this chart was printed before the latest Fed Statement and thus futures markets may have adjusted.

What we can observe in the above charts is that market participants always expected the next rate rise to come and it never did. Now markets did get better, projecting the rate rise out further and further, but none the less were still off.

Will it be mid-2015? Not sure, but even some widely used Fed models project the rate increase will be further out:

What about consensus analyst? Not much better:

Source: DoubleLine Funds

As you can see the black line where analysts expect the 10 year to be at year-end. It has consistently moved down all year, along with interest rates. Again, analysts have missed the calls on interest and this has been a reoccurring theme since 2009.

I am not advocating totally ignoring projections (though not a terrible idea I must admit and certainly better than the other extreme – following them religiously), nor am I advocating making your own market calls.

But building a portfolio based solely on market consensus or projections isn’t a strategy – it’s hope based investing. Instead, 1) make probabilistic assessments 2) have a plan if/when those move against you.

Stocks Should be Okay as Long as Economy is Expanding

2014-09-16T10:56:00.000-04:00

According to the chart below, since 1954, economic expansions tend to be a good time to be invested in stocks (SPX = S&P 500*):

Some observations:

As the numbers show, we are about 62 months through this one
It’s right around the average and median since 1954
Further, there were 4 expansions longer than this once
The market return has been greater than average, though the market did have a lower bottom than any market prior
Valuation level was also at a relative low:
And regardless, there have been 2 expansions where the returns were higher
Anyway, all this says to me that we aren’t in unprecedented territory in terms of length or stock growth in this expansion…
And while we might be long in the tooth, nothing in the data indicates we are at extreme levels
But what if the expansion is ending…

Maybe the expansion ended this month and we didn’t realize it for 6 months (recessions are usually decided after the fact). Highly unlikely with GDP coming in at 4.2%, but even so the first 6 months of a recession haven’t been destructive for stock market returns, assuming you hold throughout:
Ok, we likely aren’t in a recession now, but what if we start a recession in 6 months? After all, the common mantra is that markets lead the economy. Again, while the returns are likely negative:
Altogether Now:

Expansions yield solid returns for stocks
It’s likely we are still in an expansion (note: ISM has been in recession once with ISM at 59 or higher):
Even if we are going into a recession, the months leading up to a recession haven’t had a HUGE drawdown (> 25%), despite a likelihood they will be negative
Thus, as it’s highly probable the economy is expanding there are potential equity returns that outweigh the risk of a drawdown…
And as a result waiting to pair back your equity exposure until you are certain the economic fundamentals have deteriorated is likely prudent

Euro Economy = Bad; Euro Stocks = Good (maybe)

2014-09-04T09:36:00.001-04:00

Europe’s economy is going back in the trash as GDP is flat with even all mighty Germany turning negative (see red bars indicating economic growth from the prior period):
This has been a persistent theme, since 2009 other developed economies – US, Japan, Britain – have grown faster while Europe has stagnated:
European stocks have reflected this economic weakness as US stocks (SPX on chart below) have returned much more than European stocks (FEZ on chart below) since the end of 2008 (note: the S&P 500* bottom early March 2009, though chart is intra-month making bottom appear to be February 2009):
However, this underperformance of European stocks has possibly presented an opportunity though as European stocks are now cheaper (note: cheap stocks in general should have more room to grow than more expensive stocks):
Further, the ECB has yet to institute quantitative easing (QE), but the rumors are swirling. In the US, QE worked out nicely for US equity markets as each listed program in the chart below resulted in a subsequent move higher in the stock market:
Thus, if/when the ECB version of QE it could have a positive effect on European equity prices as it did on the US. Plus the stocks are relatively cheap so there could be some more room to grow.

Caveat: the trend in the European stocks is weak so for the time being caution should be used.

Note: On 09/04/14 the ECB cut interest rates and may or may not enact quantitative easing later in the day or in coming months. European stock markets were higher. This post was written before today’s news.

*Please see the important disclosures that apply to this commentary HERE. The above charts are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Why the QE Tapper Matters.

2014-08-21T10:47:00.003-04:00

Stocks have gone up with the Fed’s balance sheet, so what happens when the latter is no longer the case?

There are a lot of things that don’t really matter to the markets much of the time. A short list:

Geopolitical – the world is always fighting somewhere
Congress – do they ever get along?
Data Points – trends > one piece of data
Analyst Targets – no idea how any of these can be accurate

Not that any of those can’t ultimately change the markets, but I can’t think of a logical reason to sell because country X on the other side of the world might invade country Y on the side of the world. How does that matter to the US again?

Anyway, I digress. One thing I do think matters is the quantitative easing tapering (QE). QE is when the Fed buys longer-term Treasuries to force down rates in attempt to increase lending and subsequently boost the economy. Its actual impact on the economy can be argued, but from my point of view it has had a large impact on the stock market:

Shown another way:

So what is obvious from the charts is that the larger the Fed’s balance sheet, the higher the S&P 500*. Further, when the balance sheet didn’t move we had almost a 20% move down in the stock market (red circle).

Anyway, the Fed is “tapering” their purchases. What was once $80b a month is now around $25b. They haven’t stopped buying and certainly aren’t selling, but they are cutting back. So while day to day noise tend to be the headlines, the real focus should be on what happens when the Fed’s balance sheet stops getting bigger?

Please see the important disclosures that apply to this commentary HERE. See important definition on the S&P 500 at the same link. The above charts are for illustrative purposes only and does not attempt to predict actual results of any particular investment. In regard to both charts, Source: S&P 500 - FRED and FED Treasury Holdings - FRED; calculations by CAL and idea via Market Anthropology

Avoid an Investment If…

2014-08-01T08:56:00.001-04:00

Use research to come to an investment decision, avoid being a sheep

Maybe avoid is the wrong word. More like don’t blindly follow. I am talking about information friends, clients, family, etc. use as a justification why they (and you) should invest in ABC. The following should give you pause, as they are fairly weak justifications:

Advice from a political pundits or their sponsors
Chain emails
A guy who got a past market call right
Anything said from a permabull or permabear
Golf course investing tips
Any inside information
A guy who has a TV show
Anything from an investment company
Returns that are much higher than the market
Anything you can’t really understand

And why:

They are pushing politics or their revenue stream, not investments
Usually crazy rumors with little basis in reality
Yes, could give the guy credibility OR every blind squirrel finds a nut
If they are always bullish or always bearish they have a predisposed view of the market
Typically people only talk about their winners
Aside from being illegal probably isn’t inside anyway
He or she is gunning for ratings, not necessarily investment advice
They are pushing a product (caveat: they could have some pretty good research)
All good things come to an end or it’s a total fabrication
More confusing = more costly AND/OR less idea of how it will perform

Of course, this list is not all encompassing. Just what popped into my head.

Justified is the key word. Any of the above may ultimately have the right call on the market or an investment; however, I would bet using any of the above as the ONLY reason to invest in something will often end in disappointment.

Point being, do your own research to formulate your own thesis or find some research with an actual thesis before making a decision either way and if you see fit use one of the items from the list above to compliment that thesis.

Please see the important disclosures that apply to this commentary HERE.

Reducing the Risks from Your Brain

2014-07-24T10:29:00.000-04:00

“Knowledge alone isn’t enough. Even though we know it’s a bad idea to buy high and sell low, spend more than we earn, or invest in only one stock, we still repeat these mistakes… So ignoring what we’ve learned in the past makes it difficult to benefit from that knowledge. And pretending that there’s no consequence in the future for the decisions we make today creates a similar conflict.”

The above sums up what I found to be a quick, insightful article in the New York Times. It touches on the most overlooked issue in personal finance – the psychological barriers to making sound financial decisions.

We take great pride in trying to educate our clients, often using the phrase “a great client is an educated one.” However, as the article indicates information alone may have limitations when rubber meets the road as the client may convince him or herself otherwise using the “this time is different” or “we can make up for it down the road” or anything really as a reason.

The article mentions “by recognizing the impact our [psychological issues] may have, we stand a greater chance of turning that knowledge into good behavior”, but does little mention ideas to help with the recognition. We understand that human nature won’t change and thus those issues will never go away. Thus, we have taken steps to minimize their impact and proactively prevent them:

Build a financial roadmap so clients have a clear understanding of how a financial decision will affect their long-term goals and objectives and balance sheet/cash flow trends.
On top of client education, we take time to answer all client questions thoroughly so they will understand our plan to alleviate their concern.
Transparency in our process helps understand the how and why of our recommendations.
Reducing risk as market movements indicate a higher probability or large loss in the future in order to keep them from selling at the bottom.
Meeting clients in the middle. For example, putting a % of what they were going to invest in a private investment instead of the original amount

Of course, these methods are not perfect and we constantly evolve to find new and better ways to mitigate the psychological risks. Still, the above are good first steps to recognizing the deficiencies we have and taking steps to avoid the pitfalls the deficiencies can bring.

Please see the important disclosures that apply to this commentary HERE.

Time for Active to Shine?

2014-07-18T08:50:00.005-04:00

Picking active managers isn't easy, but for those who are disciplined and know what they are looking for this could be the right time to go active.

For at least a decade now passive management (managers who attempt to mimic an index) has been all the rage. Originally passive management advocates were only on posters in Tiger Beat, but now they are on the cover of Vanity Fair. More and more we get research, white papers, even client calls extolling the virtue of passive management over their active counterparts (managers who attempt to beat an index). The trend continues to move more and more toward passive managers. Will this ever change?

No, at least not forever, and I am a big advocate of passive management. The reason was highlighted to me in the article.* Thesis: the trend will continue to move as millennials, who are skeptical of active management, migrate to passive managers and the older active managers, who make up the bulk of active management, retire leaving new managers with little track record.

But the reason the trend will eventually reverse is the same reason why the money ultimately started flowing that way – returns:

Active management became popular in the 80s as ways to get diversified* market exposure and good rates of return
As it gained in more popularity, more managers entered the field = lower % of managers beating their respective index as quality erodes.
Many of these managers raised their fees given the increased demand, lessening their chance to beat the benchmark
So here comes passive managers, cheaper and better performing than active managers
Repeat steps 2 and 3 AND lower quality active managers leave the field as dollars move to passive AND if everyone is buying an index stocks will naturally become over and undervalued, creating a nice situation for active managers AND creates a self-reinforcing problem - during a market selloff who is buying if everyone is passive? This is where we are at.
The small pool of high quality active managers who were probably in cash before the sell-off and may now be well positioned to outperform over the full market cycle
Start over again

The debate of for academics, but why does this trend matter to retail investors? Opportunity. With everyone moving towards passive management, quality active managers should be better situated to beat an index over a full market cycle. Picking active managers isn’t easy, but for those who are disciplined and know what they are looking for this could be the right time to go active.

Please see the important disclosures that apply to this commentary HERE. See important definition on diversification at the same link.

The LeBron Trade

2014-07-09T14:55:00.002-04:00

Huge upside and a downside that doesn’t cripple you may be an investment worth making

NBA Free Agency is the ultimate reality show. Rumors, innuendo, last minute game changes, etc. Quite fascinating really. The winner gets LeBron James, the loser, a set of steak knives …

Well not really a set of steak knives for the Cavs. They have a young, talented roster they can continue building with or without LeBron, though would certainly be better with him. The Heat on the other hand would pretty much be destitute.

Regardless, it’s really a binary outcome – you either get him or you don’t. The former obviously puts you in a substantially better situation.

But diverting resources to get LeBron hampers your ability to sign other free agents, who would improve your team. The opportunity cost of chasing LeBron is enormous where you can’t really do anything until he signs. For example, the Cavs lost out on Gordon Hayward as they have dedicated themselves to trying to get LeBron back on the team.

Thus, the argument could be made are you better off going after lower level free agents who you have a better chance of signing and will still improve your team? To illustrate, let’s say the Cavs have a 10% chance of signing LeBron and 75% chance of signing free agent ABC. Free agent ABC makes the Cavs a playoff team, maybe even a high seed in the East. LeBron however makes you an instant title contender and a possible free agent destination, not to mention makes you increasingly more relevant.

Point being the upside is so great with LeBron that the opportunity cost of losing other free agents is totally irrelevant and thus the argument of using your resources to target more likely lower free agents moot. The Cavs need to and have make this LeBron trade.

I do need to attempt to tie this back to investing. And I think I can. If you can find an investment, whether in the market or private or a startup, with huge upside and a downside that doesn’t cripple you it may be an investment worth making. This may be true even if the likelihood of success is low and the opportunity cost is marginally high. Good look finding your LeBron trade…

Please see the important disclosures that apply to this commentary HERE.

Use LeBron to Assist Your Portfolio Plan

2014-07-01T13:40:00.000-04:00

LeBron will probably stay with the Heat; how I came to that conclusion can apply to portfolio management.

In all likelihood the best player in the NBA isn’t leaving the Heat. As someone who likes the Cavs, I am a tad bummed; however, the Cavs and Heat should both be very entertaining.

On the surface this has little to do with your portfolio, but let’s use this as an example:

What I did in the above picture is list reasons why he would stay on the Heat and why he would leave.
Everything in the above picture I deem as signals, items that indicate the direction of the ultimate outcome.
Items above the red are why I think he stays, and below why he might leave (though those are more mixed).
Anything else I hear about LeBron I deem as noise, distortions that cause a loss of focus on what is the likely outcome. For example: his kids are enrolled at school ABC, his wife wants to move back to Akron, he wants to play with Carmelo, etc.
Thus, given the signals as I read them the evidence is overwhelming he stays.

In short, I ignore the noise and read the signals to formulate that thesis. But in practice it isn’t that simple: maybe some of the noise were actually a signals OR vice versa OR one of the mixed signals comes to fruition OR I missed something entirely OR maybe I am looking for confirmation bias. Despite the sound process in theory, it certainly isn’t infallible given the highly subjective nature.

When it comes to portfolio management, I apply the same decision making process – look for signals (e.g. + likelihood of solid economic growth, + loose Fed, - uncertainty of QE unwind, +/- above average valuation) and ignore the noise (e.g. whatever is going on in Ukraine, endless Fed comments) to formulate a thesis (e.g. the background for stocks should be positive though with some headwinds).

Much like my LeBron thesis, the above can ultimately prove to be untrue as my assessment of the signals is subjective. However, unlike like the LeBron thesis there are more objective signals from the market I can incorporate into portfolio management in the event my thesis fails. It’s these objective signals that help hedge against the “OR” mistakes listed above, a luxury that wasn’t available when I formulated my assessment on LeBron.

So while in portfolio management it’s imperative to ignore noise and pay great attention to signals when going through the process, it’s equally imperative to have measures in place to guard against making the wrong decision. The latter may not help figuring out where LeBron will land, but it could help minimize your drawdowns when the market corrects.

Please see the important disclosures that apply to this commentary HERE.

Cash is Okay, if You Hold it the Right Way

2014-06-24T12:13:00.001-04:00

Don’t be in cash for the wrong reason, be cognizant of all the risks you can, but avoid making investment decisions until they start to materialize…

Investors are holding cash. Not only that…

They are holding more than they were a few years ago
This is a global phenomenon with the US being somewhere in the middle at roughly 36% of assets in cash (40% Global average)
This is true, regardless of age and wealth
Paradoxically, younger investors who have a longer time horizon are increasing their cash holdings as much as older investors

(Source: NYT)

Why the apprehension? Fear makes the most sense. The amount of things to worried about seems to be endless and evolving, off the top of my head: high frequency trading, Iraq, Iran, Afghanistan, let’s just call it the whole Middle East, Europe is on the brink (as always), Russia is being mean, China’s real estate bubble never goes away, the Fed will tighten and the market will drop, the Fed will stay easy and inflation will be a huge issue, stock valuations are high, we just had a negative Q1 GDP print, Game of Thrones is gone for a year, the Cavs will blow another top pick, etc.

But despite all that, the S&P 500 is up almost 40% since the start of 2013 and positive this year. Just my guess, but those who have been invested in cash have maybe earned 1%? I would guess cash people at the start would list those risks as why they are in cash. Now they would mention those reasons and a rising equity market as to why they should stay there.

Admittedly this is easy in hindsight. Further, there are legit strategic investment reasons to hold cash, many investors psychologically can’t handle the volatility of the markets (and that’s okay), and/or who is to say that some of those fears won’t materialize? What is of concern is how those decisions are made, if reading headlines, watching the News, looking daily at your portfolio values, or listening to a Gold infomercial has you moving to cash there is a high probability this move(s) was made for the wrong reason(s).

Naturally, this begs the question of what to do. I will tackle this working backwards, here is a list of don’ts:

Don’t take on more volatility than you can handle – too much risk means you will likely move to cash as soon as the market moves against you, but most of the time this will be noise
Don’t be overly reactive – going to cash because XYZ just happened, again most of the time this will be noise
Don’t be overly proactive – dismissing everything as noise, when sometimes there are signals that indicate a market shift
Don’t Not Have a Plan (sorry for the 2x negative) – pretty much encompasses the prior three

My approach is simple – be cognizant of all the risks you can, but avoid making investment decisions until they start to materialize and always stay hedged against the unknown and those risks which occur quickly.

Side Note: We are working on a way to shrink the disclosures. Hopefully in the future they won’t be as overwhelming.

S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market.

International investing involves special risks, including, but not limited to, currency fluctuations, economic instability, and political uncertainties, not typically present with domestic investments.

Gross Domestic Product (GDP) is a measure of output from U.S factories and related consumption in the United States. It does not include products made by U.S. companies in foreign markets.

Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. Hyperinflation, with prices rising at 100% a year or more, causes people to lose confidence in the currency and put their assets in hard assets like real estate or gold, which usually retain their value in inflationary times.

Advisory services offered through Capital Advisors, Ltd, Capital Analysts, Inc. or Lincoln Investment, Registered Investment Advisors. Securities offered through Lincoln Investment, Broker Dealer, Member FINRA/SIPC. www.lincolninvestment.com

Capital Advisors, Ltd and the above firms are independent, non-affiliated entities.

Selling Your Business: The Right Price at the Right Time

2014-06-05T13:36:00.002-04:00

First, sorry for posting this twice; however, I was informed the first link didn't work in the last post. Thus, I have updated the link so those who receive by email have a working link to part 1...

Neil and I wrote this two part blog series for Crain's. They are different from the typical investment themes on here; however, they are still worth checking out! Please go to Crain's to read:

Selling Your Business: The Right Price at the Right Time

2014-06-05T09:32:00.000-04:00

Neil and I wrote this two part blog series for Crain's. They are different from the typical investment themes on here; however, they are still worth checking out! Please go to Crain's to read:

Bonds Holding Strong?

2014-05-13T10:00:00.000-04:00

Bonds are moving against what logic would dictate this year and investor portfolios should be prepared for a multitude of outcomes.

As of last Friday bonds, as measured by ETF AGG, are up 2.88%. (per Yahoo! Finance) This is a slap in the face to the consensus, which expected yields up and bond prices down.

Here are some facts/consensus:

Stocks are also up a little over 2%. (per Yahoo! Finance)
While economic growth stunk it up in Q1, consensus is still positive for the year.
The Fed is tapering, which means they are buying less long dated bonds.

The above, at least in theory, should equate to higher bonds yields and lower prices because:

Stocks and bonds are thought to move in opposite directions as the former is considered risk-on and the latter is risk off.
Positive economic growth should increase risk appetite (see above) and inflation, which hurts bonds.
Less buying = less demand with same supply = lower prices = higher yields.

So it all makes sense for higher yields, but maybe this is the reality:

Stocks and bonds aren’t really negatively correlated. Sometimes they move together, other times they don’t, sometimes they move in opposite directions. It really depends on the period.
Maybe bonds are telling us the economy isn’t going to pick up? Inflation is still in a downtrend too.
Some other buyers are picking up the slack. Think about it, a 10 year at 2.60% is a lot more appealing than at 1.40%.
BONUS! The bond market is wrong.

I am not sure which one it is, but one thing is certain - bonds are moving against what logic would dictate this year and investor portfolios should be prepared for a multitude of outcomes.

Advisory services offered through Capital Analysts, Inc. or Lincoln Investment, Registered Investment Advisors. Securities offered through Lincoln Investment, Broker Dealer, Member FINRA/SIPC. www.lincolninvestment.com

Capital Advisors, Ltd. and the above firms are independent, non-affiliated entities

A Plan When Good Things (Rising Equity Market) Come to End

2014-04-29T12:01:00.001-04:00

Tailoring downside portfolio risk to an investor’s risk tolerance, goals/objectives, and future cash flows can help reduce the probability the investor will experience a catastrophic loss.

I last wrote (way too long ago) that hope isn’t an investment strategy when the markets start moving against you, but I failed to give a solution. A client then wisely asked me to elaborate on the plan we have in place for him, so I walked him through it.

Below is an abridged version of my response. It outlines his, as well as other clients, portfolio risk management strategy. Nothing is full-proof, but what this strategy does attempt to do is prevent losses from becoming catastrophic. This is where panic selling often takes place, compounding the losses.

By focusing on the client, their risk tolerance, goals/objectives, and future cash flow we can put together a plan that helps reduce the probability of a loss that would have drastic implications for the client moving forward:

Diversification. By utilizing bonds we can help reduce the downside if equity markets fall. This smooths returns over the long-run and helps balance the account when stock returns get ugly. Still, even with diversification returns can be much lower than would be expected given historic returns and volatility…
Quality. We keep the bulk of our assets in Large Cap equities and also allocate more to blue chips in that space. This minimizes exposure to some of the riskier equity asset classes out there. So while we may have a muted upside, we believe the downside should also be muted. Still, the baby can get thrown out with the bath water when the market tanks, so we aren’t done…
De-Risk. We are still bullish on equities now, but what if that changes or we are wrong? We look for market signals to tell us when we should de-risk the portfolio (e.g. sell equities). These signals tell us if the market is at a greater risk of a large loss and happen as the market moves down, so we aren’t trying to pick the top, but rather avoid much of the bottom(ing). These signals have been very good in the past, we have custom models that illustrate this, but there is a chance they could not work…
Custom Waterline. We put together a bespoke cash flow model for our clients, which maps their inflows and outflows moving forward. From this we can develop a “waterline” – the minimum portfolio value a client can have and may still reach their long-term financial goals. What this means is that if all the above risk metrics fail we can move to cash on the equity side when this value is met. Using the waterline allows us to manage specifically to THE CLIENT’S needs and helps increase the probability we keep them financially stable over the long-run.

Ultimately these strategies are in place to protect the downside for the client, and subsequently help give them some clarity. If we can do that by minimizing the downside risks, the returns should take care of themselves.

While there is no assurance that a diversified portfolio will produce better returns than an undiversified portfolio, and it does not assure against market loss, a diversified portfolio can reduce a portfolio’s volatility and potential loss.

Large cap stocks typically have at least $5 billion in outstanding market value.

Good Things Come to End, Have a Plan

2014-04-02T12:11:00.004-04:00

Hoping and wishing your portfolio will hold up when the market turns negative, and turn it will, isn’t a strategy. Being prepared is the only prudent way to invest.

The last few commentaries have had a bullish bent, and rightfully so, but it’s important for me to scratch my “always concerned about the markets” itch.

Here is a snippet from legendary investor Seth Klarman’s letter. The whole thing is great, but below are my favorite parts:

On the current state of the economy/markets: monetary policy is distorting markets, Fed can change how things look, but not what they are, Europe isn’t any better, not many bears left, unsustainable tech business models.
“Someday, financial markets will again decline.”
“Someday, professional investors will come to work and fear will have come to the markets and that fear will spread like wildfire. The news flow will be bad, and the markets will be tumbling.”
“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

Currently, in light of all this, Klarman returned $4b to investors and is 40% in cash. He can’t find much to buy as everything has been bid up. Does that mean the market is destined to collapse at any moment? No, and Klarman noted that in his letter.

But what he does say is that markets will decline again. I wouldn’t bet against that assumption. Further, he noted that most will be unprepared for such a drop and thus will be very vulnerable when this happens.

Don’t wish, don’t hope. Have a plan to protect your capital. That is the foundation of how I approach investing.

Recessions Matter

2014-03-24T11:55:00.001-04:00

Despite the lack of correlation between equity markets and economic growth, de-risking before a recession can help investors avoid large losses.

Sorry for the delay, but have been out of the country only to return and have a presentation to put together. Luckily the presentation yielded much commentary level material. The first of which I want to cover is why recessions matter.

Most probably view this as common sense, but the reality is often times the market and the economy don’t run in sync. For example, the market bottomed in Q1 of 2009, but the economy was still very weak. Recently, GDP growth for much of 2013 was lower than that of 2012, but the market basically doubled its return in 2013 from 2012.

Anyway, by and large is that economic forecasting shouldn’t be a huge factor in determining how you allocate your portfolio. Aside from being terribly unreliable, even when they are spot on the market may behave in an unexpected way. I agree with that for the most part, except when it comes to recession forecasting. Here I walk through why:

A reduction in corporate profits often leads or coincides with recessions.
As one would expect, profit growth is highly correlated with the S&P 500. Also, that larger market declines happen when earnings fall at or around recessions:
Thus, it follows that if economic growth is positive, as it is projected to be, earnings should grow and subsequently the market.
But more importantly, if you have a beat on when the economy will slow (and that is very hard to do) you can get out in front of a fall in corporate profits and the subsequent fall in the market.

The takeaway is to use economic forecasts as part of your risk control strategy to move out of stocks before they have a large move down. But don’t have it be your only piece and certainly don’t go risk heavy because the economic growth is expected to rip as there are other factors at work. This is a drawn out way of saying “win by not losing big” and seeing storm clouds on the horizon can help with that.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market The Dow Jones Industrial Average is a widely watched index of 30 American stocks thought to represent the pulse of the American economy and markets.

Not Seeing 1929 Today

2014-02-20T12:41:00.000-05:00

While a chart comparing 1929 to now is unsettling, digging deeper reveals the risk is marginal, more subdued, and noise to disciplined investor.

A friend of mine asked my thoughts the above chart, which has been popular over the last week. Naturally when you see our current stock market compared to 1929 that raises some alarm bells, but let me dampen some of those concerns (also see here and here):

Chart overlays are relatively common. I see maybe 5 a week? This one took off I would suspect given the 1929 comparison. That doesn’t invalidate the chart, just shows that this isn’t the only chart overlay around.
When looking at the chart, the first thing that came to mind was the scale (see below numbered bullets). As Jeff Saut notes: “You can ‘scale’ any chart to do just about anything you want it to imply! In this case, the scale makes the comparison to 1929 with the present stock market chart pattern appear eerie. However, if you index that same chart so that you are comparing apples to apples, the correlation to 1929 disappears.”
For arguments sake, let’s say this isn’t just a coincidence and that the market does follow the path implied by the chart. The 1929 fall was about 50% per the chart, when scaling to today that fall would be almost 20%. So while it would indicate a bear market, a properly diversified portfolio with some risk control parameters would certainly weather this storm.
The 1929 crash was after a near 10 year bull market. We are 5 years into this bull market and I would guess the euphoria in 1929 dwarfs the enthusiasm for stock now.
The 1929 crash was also after a massive leveraging up. We are currently deleveraging or maybe bottoming there, but certainly not in ramp up mode.
Totally different monetary systems. We were pegged to Gold then and have a fiat currency now. This means the Fed can create liquidity during market stress if they see fit, which could (and has since 2009) put a floor on the drop.

Is there anything to the chart overlay? Probably not. It could be coincidence or perhaps the author was looking for confirmation bias (searching for evidence to support his claim). While I do think investor behavior tends to rhyme (not repeat), I just have a hard time seeing that in this chart. And at least on the positive side this is a good reminder there is always risk in the markets.

Hopefully investors didn’t react emotionally to the chart as since it came out the S&P had a nice snapback and is close to flat for the year. Nothing about the latest pullback indicates there will be a sustained fall in the markets, but if that proves to be false and the chart overlay comes to fruition a strategy to minimize drawdowns likely will prove more useful than the chart.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market The Dow Jones Industrial Average is a widely watched index of 30 American stocks thought to represent the pulse of the American economy and markets.

Patience Can Help With Capital Preservation

2014-02-12T10:37:00.000-05:00

“A cheap asset presents an opportunity for increased future returns, but if your goal is minimize your drawdowns, then wait for those assets to stabilize.”

In my 2013 thesis I used the following: “On a relative value basis… emerging markets face secular headwinds they do appear cheap.”

If you read my commentary and/or listen to Warren Buffet you buy assets when they are cheap. The price you pay is as important as the quality of the asset you are buying. This increases the likelihood that future returns will be higher. The logic is simple, but I do think comes with a caveat.

I noted later in that thesis the following on Emerging Markets: “while there are opportunities for upside until the trend reverses it’s hard to have much conviction”. Trends in major asset classes start quickly, but play out over a longer time period. As result, if your goal is to get reasonable returns over a longer time horizon and reduce your risk it makes sense to wait until the trend appears to have bottoms and more than likely has moved into an uptrend. Thus, while you miss some of the upside, maybe even the bigger moves, you also avoid the large moves down in that asset.

Which brings me to Emerging Markets, here is what they look like as of 02/03/14 close:

What I see:

YTD down 7%
Trend is moving down, doesn’t appear to be stabilizing
Valuations are now cheaper, but they were cheap to start the year (i.e. just because an asset is cheap doesn’t mean it will reverse)

Thus, while enticing on a value basis patience can help you avoid any further drawdowns before adding to this position, or any other asset class in a downtrend.

Stocks Look Good in 2014, but Stay Vigilant

2014-01-29T10:38:00.000-05:00

The backdrop indicates the equity market appears to have a low probability of a large drop, but that doesn’t mean positive returns are guaranteed or that investors can be apathetic.

Domestic stocks ripped in 2013 and ended the year strong. That’s great, but where do we go from here? I am firm believer that investors should focus on risk, not return. So let’s quickly analyze three risks to the domestic stock market:

Fed tightening and rising interest rates can have negative ramifications on the equity market:

If quantitative easing ends the reduction of “money” in the system will be small.
The Fed will keep short-term rates very low for some time, perhaps until 2016, as labor markets and inflation remain weak.
When longer-term interest rates rise from low levels it has been positive for stocks.

During a recession earnings and valuations fall leading to lower stock prices:

Currently though, the recession risk appears to be low. While we look at a variety of economic indicators, let’s focus on the yield curve as history indicates that the last five recessions were preceded by an inverted yield curve (long-term rates > short term rates):

Valuations are too high especially given the record profit margins:

We view intermediate-term valuations as high (Shiller PE, Market Cap to GDP, Q Ratio); however, none of these say anything about the near-term.
Shorter-term metrics indicate we are slightly above average, but nothing alarming.
We concede profit margins are high, but outside of rising interest rates we struggle to find a catalyst to change that.
Further, history suggests that valuations can expand even if earnings fall unless they are at bubble levels (they are not) or a recession is on the way (see #2).

Succinctly put, when looking at the market in 2014 a low recession risk + an accommodative Fed + non-bubble valuation levels = a market that doesn’t appear to have a high probability of a large drop.

Having said that, there are still a few reasons for concern:

The higher level of intermediate-term valuations indicate lower real returns over the next 10 or so years
The above premise is wrong, in particular the impact of the Fed and interest rates
Something unforeseen

As a result, moving forward it’s important to stay up the quality chain, allocate to absolute return-ish strategies, look outside our own market (international equities appear to have more attractive valuations) and pair back exposure when the market has historically been more susceptible for a large loss.

Despite Falling Prices, Fixed Income Still Has a Place

2014-01-22T11:36:00.001-05:00

Investors need to balance the expected fall of bond prices (portfolio ladder, tactical managers) with the benefits (equity hedge, price stability) that fixed income brings.

The 10-Year hit 3% at the end of 2013 while the Aggregate Bond ETF fell just under 2%:

Not to beat the thesis to death (see the bold paragraph here), but moving forward rates are expected to rise. If we assume this to be the base case and bond prices fall, a logical question is why hold bonds at all?

To answer that, let’s first examine the roll of a fixed income portfolio:

Despite being correlated over longer time periods, bonds can provide stability in the event equities fall. From August 2007 to March 2009, using monthly closes, US stocks had an annualized return of -30% while US bonds had an annualized return of 6%. Diversification away from equities with bonds minimized portfolio volatility.
Utilizing the same data going back to 1970, we see the max drawdown on US stocks was 51% while for bonds in was 13%. Thus, historical returns indicate the largest amount of risk in a portfolio is from stocks.

See the above, that even with a 70% plus climb on the 10 year interest rate, AGG was only down 2%. For returns of other Fixed Income ETFs, see here.

A caveat to the previous bullet is making sure the portfolio’s duration risk (the sensitivity to interest rate changes, the higher the duration the greater susceptibility to rising interest rates) is managed. If we look at TLT (iShares 20+ Year Treasury Bond) the duration is over 16 years and the ETF was down roughly 17% in 2013.

To summarize, a fixed income portfolio with managed duration risk can provide a hedge against a falling equity market and is not at a high risk for large principal loss. Still, we are left balancing the prospect of rising interest rates with the diversification benefits that fixed income bring:

Laddering individual bonds or ETFs with a set maturity assures that an investor face value of the bond back (assuming no default) and can lessen the sensitivity to interest rate changes as bonds that come due will be re-invested at higher rates.
Utilizing tactical managers who can enhance returns even if interest rates are rising.
Find attractive relatively attractive yields in fixed income (e.g. municipal bonds).

While these ideas attempt to weigh rising rates with diversification, ultimately there is no free lunch – any move to hedge against rising rates probably reduces one’s ability hedge against a falling equity market. It’s imperative each investor recognizes this and then decides on his or her own course of action.

2013 and Beyond – The Bad, and The Ugly

2014-01-15T11:14:00.002-05:00

Negative ETF Ranking - 2013
9	-1.37% - shares International Treasury Bond ETF (IGOV)
10	-1.83% - iShares S&P GSCI Commodity-Indexed Trust (GSG)
11	-1.98% - iShares Core Total Aggregate U.S. Bond ETF (AGG)
12	-2.00% - iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
13	-3.44% - iShares National AMT-Free Muni Bond ETF (MUB)
14	-3.64% - iShares MSCI Emerging Markets ETF (EEM)
15	-6.09% - iShares 7-10 Year Treasury Bond ETF (IEF)
16	-6.73% - iShares Emerging Markets Local Currency Bond ETF (LEMB)
17	-28.33% - SPDR Gold Shares Trust (GLD)

Shockingly, not every asset class went up last year. I say shocking because usually when stocks are hot nobody really cares what anything else is doing.

Last post I covered the ETFs that finished in the black last year and what we should expect moving forward. This time I will cover the ETFs that finished in the red in 2013 (with the help of this file). Again, when looking forward I am using this thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk. Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat. On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap. The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

I will again mention the caveat that what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned and when things change portfolio and thesis adjustments will be made accordingly…

And now, the ETFs that had negative returns in 2013…

IGOV – 2013: International treasuries almost finished positive, but alas they finished with every other fixed income asset class. They did finish the second half of the year very strong with the help of a weaker dollar. Moving Forward: While the US is pulling in the reins on QE – pushing our yields higher and bond prices lower – other countries are expected to remain easy or possibly become more accommodative (see Japan’s “success” with their own QE). This would push their yields lower (or stable) and prices higher, but also cause their currencies to fall and thus washing out any positive. Thus, an investment that is USD hedged could provide some boost.
GSG – 2013: The commodity chart looked a lot like USO last year, but worse as it includes agriculture and precious metals. Commodities look to be in a range, and while that’s subjective the alternating black (Q1, Q3) then red quarters (Q2, Q4) would appear to validate that. Moving Forward: see USO (note: energy and industrial metals make up the bulk of index).
AGG – 2013: The pulse of the US bond market had its first negative calendar year return since inception and didn’t break its intermediate-term trend for the last eight months of the year. Interestingly though it only had one negative quarter (Q2). Moving Forward: Assuming interest rates to continue to rise in 2014 it should yield another negative year for bonds. While it appears interest rates may have hit a secular bottom in 2012, it’s important to remember that bonds hedge against a decline in risky assets (note: this has held as of late with equity markets off their highs and AGG moving up) and that they present much less risk (unless they are high yield or high duration) in terms of large capital loss. Finding a balance between rising rates and the portfolio hedging benefits fixed income brings should be the goal.
LQD – 2013: See AGG, though the Investment Grade Corporate Bond LQD did break its intermediate-term downtrend at the end of the year. Moving Forward: See AGG. There doesn’t appear to be much room for investment grade spreads to compress any further, so outside a 2008 credit event I would think they will have a high correlation with Treasuries.
MUB – 2013: Munis were hit harder than their taxable counter parts in 2013 with Detroit’s bankruptcy taking center stage. While they did recover in the later part of the year, MUB like AGG finished the year below its intermediate-term trend for the last eight months. Moving Forward: Quick math, 3% yield on MUB equates to a tax effective yield at the 40% bracket of 5.00%. AGG has a yield of 2.32%. So if you are in a higher tax bracket, pick out some attractive munis, ladder them by maturity, hold to maturity, and you get a decent yield with not much interest risk. Note: as interest rates rise prices do fall, so prepare to watch your values drop, but if you hold to maturity you get the face value back.
EEM – 2013: While EEM finished with two positive quarters and the last three months above the intermediate-term trend (barely), it still couldn’t overcome a poor start to the year as money moved out of Emerging Markets when our interest rates moved up. EEM is also over 60% below its 2008 peak. Moving Forward: Even more so than developed markets, emerging markets appear to have an attractive relative valuation to our market. Much of this is likely due to some longer-term demographic and geo-political issues and is especially true of the ones that got beat up last year (Russia, China). Further, a sharp rise in US interest rates could continue the capital flow out of emerging markets. Thus, while there are opportunities for upside until the trend reverses it’s hard to have much conviction.
IEF – 2013: See AGG. Moving Forward: See AGG, though I think it makes sense to take a more tactical (over and under weighting when the market dictates) approach to the 7 – 10 year Treasury space.
LEMB – 2013: See EEM; rising domestics rates equates to capital moving from emerging markets local currency bonds back into US markets. Moving Forward: See EEM and IGOV. While rising domestic rates would continue to be negative for emerging market bonds, a USD hedged exposure could be a nice boost.
GLD – 2013: The gold chart for the year went pretty much straight down. You can take your pick why: higher interest rates, decrease in systemic risk probability, lower inflation. But at the end of the day you see three out four negative quarters, the whole year below the intermediate term trend, and down nearly 30%. Moving Forward: All three items I listed for gold’s 2013 decline are still in place. Maybe one of those reverses and this turns into a great contrarian trade, but until the trend changes it’s difficult to allocate dollars to gold.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

2013 and Beyond – The Good

2014-01-08T11:24:00.003-05:00

2013 is a wrap! What a year it was if you invested solely in US stocks. Just a guess, but I would wager some investors probably will think now is a good time to get undiversified. That could work in 2014, maybe even longer, but ultimately other asset classes will begin to outperform and a diversified portfolio will provide good relative returns with lower volatility.

But that discussion is for another day. Below are some observations on ETFs (listed at the top) we look at that yielded positive returns last year. I used this file to help make those observations. For each ETF, I summarized 2013, and then outlined what should happen moving forward, based on the following thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk. Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat. On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap. The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

Will all that happen? Probably not, but these are my conclusions based on the current environment. Of course as the markets and facts change so will the above thesis; in other words, as I have pointed out before, nothing is static.

Making predictions is a futile business, so what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned, with the caveat that when things change portfolio and thesis adjustments will be made accordingly…

IWM – 2013: US Small Cap stocks were best in show and never came close to breaking their intermediate-term uptrend (roughly 10% above the 10-month moving average). Small Caps leading Large Caps is a good sign to market observers, though they also lagged a bit (still up over 8%) in Q4 and is something to keep an eye on. Moving Forward: This equity market segment seems relatively pricey to others and above average. While the environment is conducive toward continued appreciation, I prefer higher quality companies with strong balance sheets that tend to land in the large cap space (SPY) in case some of those conditions reverse or something unforeseen happens. Still, the trend in US stocks (this includes SPY) is overwhelmingly positive and as a result our risk metrics have not been triggered, in fact IWM and SPY are far from them. So until the environment changes or the risk metrics tell us otherwise it’s difficult to go against the market.
IVW – 2013: Growth had little difference from the Value stocks ETF, thus if you were invested in stocks it really didn’t matter much. Moving Forward: see SPY/IWM.
SPY – 2013: The S&P 500 ETF that everyone looks at really ripped and was up over 30% on a total return basis. Q4 was also the strongest quarter of the year and the index hit its high in the last week of the year. Like IWM, SPY never came close to breaking its intermediate-term uptrend. Moving Forward: See IWM, though valuations are more reasonable than small caps and probably at their average. I will again note, I prefer the quality companies moving forward that capture part of the up move, but also avoid some of the down move in the event the market reverses course. Lastly, a major fundamental equity concern is what happens as interest rates rise; however, in this environment rising interest rates have historically been a benefit to stocks.
IVE – 2013: see IVW. Moving Forward: see SPY/IWM.
EFA – 2013: Investing in developed international market stocks netted 20%+ though still had a decent lag relative to domestic stocks. The ETF is also still below its 2007 peak, but it’s close to making a new high on a total return basis. Moving Forward: Looking at prior returns and research, these markets tend to be a better relative value than our own stock market. What this doesn’t mean is that outperformance will happen overnight. Further, the trend is NOT your friend. What it does mean is that there are some opportunities here, especially as growth in those economies picks up.
USO – 2013: This is the first significant relative underperformance as the oil ETF’s return was a tad under 6%. Moving Forward: Typically cyclical commodities tend to rally more late equity cycle (see big Oil rise in 2007 and 2008 before it cratered), so assuming the equity market rally still has legs, I would expect the lag to continue. Further, many investment based countries (e.g. China) are trying to shift to a more balanced economy.
HYG – 2013: Only bond asset class up for the year, which isn’t surprising given high yield is more correlated with equities and has minimal duration risk. Moving Forward: Environment should still be supportive. However, while spreads (the difference between Treasuries and a similar high yield bond) have been narrower before, I do wonder how much juice is left in the squeeze? Just be careful as high yield bonds won’t provide a hedge if riskier assets stumble.
IYR – 2013: Logic would dictate real estate would perform better given a big bullish economic story last year was the increase in home prices, but IYR barely finished the year in the black. The chart looks eerily similar to the Treasury ETF, so there appears to be a correlation with interest rates. Plus REITs outperformed stocks every calendar year since 2009 except last year, so maybe much of those gains were priced in. Moving Forward: The correlation between real estate and stocks broke down for much of 2013, but did move together prior to that. Still, steadily rising interest rates with minimal inflation should result in lackluster performance and a loose correlation with bonds.

The 10-2 Indicator Says No Recession, Market Collapse

2013-12-19T11:34:00.003-05:00

A popular indicator is the 10 Year Treasury yield less the Two Year Yield. When the number is positive or upward sloping, that is typically indicative of a growing economy. The short version is that the Fed heavily influences the short-end of the curve, so when investors are confident about the economy they sell the long-bond pushing the yield up.

Now the Fed can and will, as evident by quantitative easing (the Fed buying longer dated bonds), control the long-end too. Thus, even though we have an upward sloping curve now there is still some heavy Fed influence as they are keeping short-term rates very low. Further, the drawing down of quantitative easing (no longer buying longer dated bonds) expected Q1 next year should push up the long-end of the yield curve.

Still, even with that caveat I found the chart below pretty fascinating. The blue line is the 10 Year yield less the 2 Year yield and the red line is the S&P 500.

A few things stick out:

A negative sloping yield curve has ALWAYS led to a recession. There all no false positives.
We have never had a recession since 1976 (from when the data was available) where the yield curve did NOT turn negative beforehand.
The last two major markets tops in 2000 and 2007 coincided with a negative yield curve.
We don’t have anything close to a negative curve now. In fact, the slope is moving higher.

While the sample size is small and everything works until it doesn't, it bares extremely well for the economy. This has important stock market implications. I have noted before that even if earnings lag (say the economy is weaker than expected or the record high profit margins come down) we can still have multiple expansion to push the market higher given short-term valuations are not at extreme levels. That isn't to say the market can’t or won’t have a hiccup or pullback around 20% or so, just that a larger bottom doesn't appear to be in the cards unless that 10-2 indicator reverses.