Fear What You Can Control
"I’ll put money to work when things settle down in the Middle East"
Human violence has a far longer history than modern day stock markets. Waiting for the dust to settle before you invest requires infinite patience because the threat of war, while sometimes dormant, is omnipresent.
Setting aside the human tragedy and just focusing on performance, the chart above shows that peacetime Bear Markets are far more punitive for equities than World Wars.
Being that war is ubiquitous in human history and its onset unknown, worrying about how it might affect your investments is a complete waste of time. Rather, you should focus your energy on something that is entirely in your control, your behavior. Here are a few things you should always keep on the forefront of your mind:
1) Is your asset allocation appropriate?
2) Does your risk tolerance depend on the direction of the market? In other words, are you less risk averse in bull markets than you are in bear markets?
3) How do you behave during volatile markets?
4) Are you investing for the next thirty years or the next thirty-six months?
5) When the market is down a few hundred points, are you going online more than you normally do?
6) Are you susceptible to fear mongering in the media?
7) How did you behave in the last bear market? What about the one before that?
8) If you are paying somebody to manage your money, does that person have a data-driven process?
9) What are you going to do when that person goes through a rough patch?
10) Have you fired money managers in the past? If so, what lessons have you learned?
Your behavior can have a much larger affect on your portfolio than geopolitics, political turmoil or even recessions. My advice would be to think long-term and don’t chase past performance. Time and compound interest are an investors greatest asset yet so few of us have the emotional capability to leverage it.
The Music is Still Playing
Through the first six weeks of 2014, retail stocks- as represented by XRT- were down as much as 12.8%. This was the first of many divergences to rear its ugly head. Whether it was bad weather or a consumer crimped by stagnating wages, there was concern that this would be a harbinger of something bigger. Six months later, we are quietly seeing retail stocks break out to new all-time highs.
All of the “red flags” we have been seeing throughout much of the summer are resolving themselves to the upside, which is what we should expect in a bull market (full disclosure, I’m fearful when others are fearful and I only say “expect” with the benefit of hindsight).
Failed head and shoulder patterns are ubiquitous. Small-cap stocks, regional banks, and high-yield bonds are all giving us the green light. Furthermore, you have individual “leading” stocks showing massive relative strength. Based on what we’re seeing with buyers and sellers, i.e. supply and demand, I think there is a high probability, say 73.45% that we see a continued move higher in equities. I don’t know how much longer the music is going to last but I’m pretty sure we’ll know when it’s over via lower highs and lower lows, not RSI divergences.
Photo by Desiree Delgado
Chasing Past Performance is Expensive
Buy and hold might not be the optimal investing strategy, but the data shows it to be significantly more effective than chasing hot mutual funds.
Vanguard- the biggest proponent of buy and hold- recently came out with a study which quantified how dangerous it was to chase past performance. They defined previous winners as any fund in existence for the full three-year period that had an above-median three-year annualized return.
Over the last decade, each of the nine style boxes showed that investors would have been better off holding the index, rather than chasing previous winners. This shouldn’t surprise anybody, the inability of mutual funds to persistently outperform is well documented. However, what I did find surprising about this study was the degree to which chasing the hot hand under performed the buy and hold strategy. The average out performance for the nine style boxes of buy and hold versus chasing hot mutual funds was 52%!
If you are going to make decisions based on previous performance, you are better off chasing losers than you are winners.
Read the whole study here.
The Real Divergence is Within Small-Caps
All year long we’ve heard about the divergence between the Russell 2000 and the S&P 500. Today I want to take a closer look at the divergence within the small-cap space itself, specifically between the Russell 2000 and the small-cap value stocks, represented by Vanguard’s VBR.
These two indices have basically moved in lockstep for the past few years until this March, when we saw a distinct change in character; IWM fell 10.9% through May while its value counterparts fell just 3.7% over the same period. YTD the small-cap value ETF is up 7.23% while IWM is up only 0.28%.
So, what’s going on?
The real story here is valuation. The small-cap value stocks are trading at 22.5x trailing 12-months earnings and 9.8x price/cash flow. The Russell 2000 is significantly more expensive, trading at 41.8x trailing 12-months earnings and 13.7x price/cash flow.
You’ll notice from the graphic that the sector holdings are very similar. However, if we take a closer look under the hood, we find that biotech’s were a big reason why IWM has stunk up the joint relative to VBR. Biotech’s are the second largest sub-industry in IWM, making up 5% of the index while they are just the thirty-fourth biggest sub-industry in VBR, making up just 1% of the index. Many of these companies don’t have earnings and even the adjusted P/E ratio of 83 for the S&P small-cap biotech index is well into nosebleed territory.
It’s impossible to pinpoint when market participants are going to shun expensive areas as there are a plethora of factors that affect investor psychology and the weight with which they drive decision making is never exactly the same. We know that valuations do matter, the tricky part is knowing when that’s going to be.
All You Need to Know About Emerging Markets
The following data came from studies done by Vanguard, Credit Suisse and WisdomTree
- At the end of 2013, emerging market stocks had a 12-month dividend yield of 2.7%. There have only been eight calendar years that began with a higher yield and the average return over those eight years was 46%.
- From 2000-2010. The annualized return on the MSCI Emerging Markets index was 10.9%, developed markets did just 1.3%.
- Going back to 1900, three countries are still “emerging” 114 years later: China, Russia and South Africa.
- From 1945-1949, Japanese equities lost almost 98% of their value, in US dollar terms.
- Since 1950, emerging market equities delivered annualized gains of 12.5%, versus 10.8% for developed markets.
- The ratio of emerging/developed market volatility was 1.9 in 1980 and has since fallen to 1.1, in other words emerging market stocks are now just 10% more volatile than developed market stocks.
- The average correlation for the 5 years ending in 1980 between emerging markets and developed markets indices for a U.S. investor was .57, by the end of 2013 that has risen to .88.
- Emerging markets pay around 17% of the global dividend stream.
- One-third of revenues from the MSCI All-Country World Index come from emerging markets, however only ~10% of the index is comprised of emerging market stocks!
- Contrary to popular belief, emerging market crises tend to be less contagious than developed market crises. Correlations shoot higher during crises originating in developed markets but stay at normal levels during emerging market crises.
- Value as a factor has worked better than momentum in emerging markets since 2000.
- Thirty years ago, emerging markets made up 1% of the world equity market cap and 18% of world GDP, today they are ~10% of the investable universe and are 33% of world GDP.
- Emerging markets have ~55% share of the global population.
- Since 1995, share issuance has accounted for the majority of market-cap growth for emerging markets, not price appreciation.
- Cumulative dividend growth for the last 3 years: Developed market- 32.9%; Emerging market- 67.9%.
- From 2001-2012, the global economy almost doubled in size, emerging markets account for roughly 64% of the increase.
Picture by Simon Cunningham
An Interesting Divergence
Home Depot and the Homebuilder ETF have pretty much moved in lockstep for the last three years. (Home Depot is the third largest holding in XHB)
This morning we are seeing Home Depot break out, hitting new all-time highs while XHB is trading below a flat 200-day moving average and is currently 8% off its highs made in February.
It is fascinating to note that the correlation- which has been as high as .97- has now gone negative.
Home Depot reports on Tuesday and following this recent breakout, coupled with the fact that investors are paying 50% more for each dollar of earnings than they were just three years ago, expectations are definitely high. However, Home Depot has beaten EPS for the last eight quarters in a row and have earned the benefit of the doubt.
How old is this bull market? It depends who you ask.
We have now gone 548 trading sessions since the S&P 500 has a 10% (intra-day) correction . However, If you go the official scorecard, the numbers look quite different. It has been 757 sessions, or 1,104 days since we have had a correction on a closing basis.
The fact that it has been so long since we have had any sort of meaningful pull back has led to interesting investor behavior. Each dip is more shallow than the last while top callers grow louder with every 3% pull back, always proclaiming “this time feels different.”
One can easily make the case that after eight months, with the S&P 500 flat YTD, we are correcting through time rather than price. After a 29% return last year, I can’t imagine a more bullish scenario for investors.
"It’s been 548 days since we’ve had a 10% correction"
"No, it’s been 757 days, we are so overdue!"
This is the epitome of splitting hairs and I can’t imagine a more useless argument. As if 10% is somehow a magic number. Why not 8%, why not 12%? This minutiae ought to be of absolutely no consequence. Investors should focus on their plan and let other people quibble over technicalities.
The 2000’s Was the Worst Decade For Investors
What are the odds that had you bought the S&P 500 in the 1990’s, it would be higher twelve months later? It was all but guaranteed; any purchase made during this bull market had a 92% likelihood that you would have made money over the course of a year. Perhaps even more astonishing, the average change of +15.77% for the S&P 500 was the highest for any decade we’ve ever had! Think about that for a second, if you were to buy the S&P 500 any day in the 90’s, on average you would have made ~16% just twelve months later, pretty amazing.
In contrast, during the 2000’s, investors suffered through a lost decade. While the 90’s was the best time to be an investor, the 2000’s were the worst. The S&P 500 compounded annually at a loss of 2.7%. If you were to invest on any random day during the lost decade, the average return over the course of twelve months was -1.58%. To give you an idea of how bad this is, the only other period that can make a similar claim was the 1930’s, which returned -0.29% on average from a year earlier. Had you picked any day in the 2000’s, the chances you were higher one year later was just 56%, hardly better than a coin toss.
To put these numbers in context, looking at the data back to 1929, stocks are higher one year later 69% of the time with an average change of +7.58%.
So what might Milennials expect going forward? Let’s take a look at prior generations.
Baby boomers had a fantastic run investing in the 80’s and 90’s only to see their pre-retirement years burned by the lost decade. Their parents were less fortunate, enjoying good returns in the 50’s only to be left with feelings of nostalgia as the 60’s and 70’s can only be described as a period of max pain for investors. Baby Boomers’ Grandparents had an even tougher time; speculative fever ballooned in the 20’s only to be followed by two decades of virtually zero returns.
Notice a pattern here?
Each subsequent generation has been blessed with better and better investing opportunities. Despite having just experienced the worst decade for investors, I am extremely bullish on the opportunities my generation has to grow our wealth in the stock market over the next twenty to thirty years.
Photo by Sander van der Wel
Consumer Staples Just Got Destroyed
Consumer staples- think Proctor & Gamble and Coca-Cola- are down 3.7% so far this week, their worst performance since the Taper Tantrum of 2013.
As the Fed’s policies have kept interest rates near zero, investors have flocked to these names for their juicy dividend yields and relatively low volatility.
This has resulted in Staples valuations ballooning to rare levels. People are paying 30% more for every dollar of earnings than they were only three years ago. Dr. Yardeni's work shows these stocks are more expensive per share relative to their growth rate than any other sector; a PEG ratio of 2.01 is very expensive (see chart). They are also sporting the second highest forward P/E of any sector (17.6x).
It’s certainly possible that investors are rotating out of an expensive sector that has seen a few ugly earnings reports over the last few days. But maybe there’s more to the story; maybe large money is starting to place a wager that rates are finally going to rise over the next few months and quarters. Who needs the single stock risk if you can lend to the government at an equivalent yield?
Now rising rates have been a given for the last year and much to the chagrin of many people, rates have done nothing but fall all year. I’m not predicting that rates will rise, but I am trying to connect the dots and make sense of what I see in front of me.
Whatever the actual reason is, the only thing we can say with certainty is that they’re selling the staples harder than they have in over a year.
Photo by Marcy Leigh
When it comes to investing, there is no canary in the coal mine. I hate to burst your bubble but whichever straw eventually breaks the camel’s back will only be obvious in hindsight.
With that said, I do find it fascinating to watch how different areas of the market behave and right now we are witnessing Consumer Staples- which held up really well earlier in the year- roll over on heavy volume.
I posted a few charts and took away the candles, leaving only moving averages. This exercise allows us to take a less noisy look at how these securities have been trading. As you can see, the shorter term moving averages on consumer staples just fell off a cliff. All year we wondered how long could the high beta names break down before it spills over to the broader market; perhaps we are starting to see that now.
But not so fast; what’s really interesting is that staples are breaking down just as the Facebook’s, Twitter’s, and Yelp’s of the world are exploding higher. We continue to see money rotate as the market corrects through time. After a nearly thirty percent return last year, I would say this is the best possible scenario bulls could have hoped for heading into 2014.
So where does that leave us?
Large caps are strong while small caps are weak, giant banks are above their 20-day moving average while regionals can’t get above their 200-day, social media stocks are on fire while semi conductors are cooling off. The only thing that’s crystal clear is that the market is sending mixed messages. People will pay attention to whatever supports their bias. I’m okay with being net confused.
Photo by Giulia Torra