The Market is Preparing For Rising Rates
The prospect of rising rates has been the most widely talked about topic among market participants for the last year. Fed language is being scrutinized and dissected like maybe no other time in market history. It has been fascinating to witness;all the while we were told to prepare our portfolios for rising rates and to the chagrin of many, yields have done nothing but fall. 
Today, in lieu of conjecture, I want to point your attention to the facts. As the 5-year treasury note yields hit their highest levels since May 2011, the XLF/XLU ratio is up over 2% and is having the fourth largest daily increase of 2014.
This is something worth paying attention to because these sectors are both very sensitive to interest rates, albeit in different ways. In theory banks should benefit from rising rates while utilities and their bond like characteristics benefit from falling rates. 
I’m not concerned with what people say, I’m more interested in what they do. Today we are seeing signs that market particpants are starting to prepare for rising rates, I’ll be watching these sectors closely. Zoom Permalink

The Market is Preparing For Rising Rates

The prospect of rising rates has been the most widely talked about topic among market participants for the last year. Fed language is being scrutinized and dissected like maybe no other time in market history. It has been fascinating to witness;all the while we were told to prepare our portfolios for rising rates and to the chagrin of many, yields have done nothing but fall. 

Today, in lieu of conjecture, I want to point your attention to the facts. As the 5-year treasury note yields hit their highest levels since May 2011, the XLF/XLU ratio is up over 2% and is having the fourth largest daily increase of 2014.

This is something worth paying attention to because these sectors are both very sensitive to interest rates, albeit in different ways. In theory banks should benefit from rising rates while utilities and their bond like characteristics benefit from falling rates.

I’m not concerned with what people say, I’m more interested in what they do. Today we are seeing signs that market particpants are starting to prepare for rising rates, I’ll be watching these sectors closely.

Big Returns, Big Volatility

Tesla has returned almost 1,500% since the IPO in 2010, compounding at 72% per year. The S&P 500 has returned 85% over the same time, compounding at “just” 13% per year.

Today, as Tesla is down 10%, it’s a good reminder that with individual stocks, above average returns comes with above average volatility.

Tesla has had 140 sessions where the stock was down at least 3%, or roughly one out of every seven sessions. For some context. that has only happened on six occasions for the S&P 500 over the same time, or one out of every one hundred and seventy-six days.

I hate to be the bearer of bad news, but ‘d argue that achieving these returns is virtually impossible for most investors. As a stock exhibits parabolic rise, a few things happen: 

1) It becomes an increasingly large percentage of your overall portfolio.

2) As the size of the position grows larger, you become more sensitive to the huge dollar swings.

3) You expect the meteoric rise to continue indefinitely

If you’re investing in a growth company that you think is going to change the world, you very well may achieve out sized returns, but be prepared for out sized volatility..

Photo by Gary

Gold Manipulation
According to the World Gold Council, the first gold coin was struck around 500 BC. Twenty-five hundred years later, at ~$2.4T, gold is larger than all European sovereign debt markets.
So I guess the obvious question is, can a market of this size be manipulated? I’m not sure, but gold manipulation is a tale as old as time and where there’s smoke there’s fire. Below check out the fire which comes from Benn Steil’s “The Battle of Bretton Woods.”
"From his bed each morning, Roosevelt would, after briefly conferring with his advisers, set a daily target for bumping up the gold price, not always through scientific methods. One day, November 3, the president suggested that gold should go up twenty-one cents. "It’s a lucky number," he explained, chuckling, "because it’s three times seven."
"If anybody ever knew how we really set the gold price through a combination of luck numbers, etc.," observed Morgenthau, I think they would be frightened."
Obviously a lot has changed since the 1930’s but there are still people who insist that gold is manipulated (usually when it’s down). Just Google “gold manipulation” and you’ll see 11.2 million results. I’m not qualified to have an opinion on the matter but the quotes above certainly make the case that gold once was heavily manipulated.
Photo by Lawrence Chard Permalink

Gold Manipulation

According to the World Gold Council, the first gold coin was struck around 500 BC. Twenty-five hundred years later, at ~$2.4T, gold is larger than all European sovereign debt markets.

So I guess the obvious question is, can a market of this size be manipulated? I’m not sure, but gold manipulation is a tale as old as time and where there’s smoke there’s fire. Below check out the fire which comes from Benn Steil’s “The Battle of Bretton Woods.”

"From his bed each morning, Roosevelt would, after briefly conferring with his advisers, set a daily target for bumping up the gold price, not always through scientific methods. One day, November 3, the president suggested that gold should go up twenty-one cents. "It’s a lucky number," he explained, chuckling, "because it’s three times seven."

"If anybody ever knew how we really set the gold price through a combination of luck numbers, etc.," observed Morgenthau, I think they would be frightened."

Obviously a lot has changed since the 1930’s but there are still people who insist that gold is manipulated (usually when it’s down). Just Google “gold manipulation” and you’ll see 11.2 million results. I’m not qualified to have an opinion on the matter but the quotes above certainly make the case that gold once was heavily manipulated.

Photo by Lawrence Chard

A Closer Look At The Dow
Have you ever seen the majority of your watch list is red, yet the indices are flat or even green? You’re not going crazy, the indices can do a really poor job representing what is actually happening with the majority of individual stocks.
The most widely quoted index- the Dow Jones Industrial Average- is the biggest offender of distorting the action. Unlike traditional market cap weighted indices, the Dow weighs the individual components by price.
So what exactly is it distorting? 
After making a new all-time high on August 26th, we have seen the Dow basically trade sideways for the past twelve sessions. You’ll hear people say that we are either stalling out before a correction, or digesting the recent gains before we break out of this range. Whatever your opinion, here are the facts: Currently, the Dow is just 1% from the all-time high, however, if we take a closer peek under the hood, we find that the average Dow component is actually 5.2% off their high.
A closer examination shows that the top three weightings in the Dow (Visa, IBM, and Goldman Sachs) make up 22% of the index, yet represent just 8% of the total market capitalization. Furthermore, the top ten Dow stocks make up ~52% of the index, although they only represent ~36% of the total market cap.
The most over-weight stock in the Dow is Visa, which is awarded an 8.1% weighting although its market cap is only 2.8% of the index. The most under-weight stock is Microsoft, which is just 1.8% of the index, although it represents almost 8% of the total capitalization. To put this in some context, Microsoft is a bigger part of the S&P 500 than it is of the Dow 30, pretty amazing.
So next time you hear that the Dow was up/down by “X” points, understand that it is heavily influenced by a few companies and is not a fair representation of the broader market. Permalink

A Closer Look At The Dow

Have you ever seen the majority of your watch list is red, yet the indices are flat or even green? You’re not going crazy, the indices can do a really poor job representing what is actually happening with the majority of individual stocks.

The most widely quoted index- the Dow Jones Industrial Average- is the biggest offender of distorting the action. Unlike traditional market cap weighted indices, the Dow weighs the individual components by price.

So what exactly is it distorting? 

After making a new all-time high on August 26th, we have seen the Dow basically trade sideways for the past twelve sessions. You’ll hear people say that we are either stalling out before a correction, or digesting the recent gains before we break out of this range. Whatever your opinion, here are the facts: Currently, the Dow is just 1% from the all-time high, however, if we take a closer peek under the hood, we find that the average Dow component is actually 5.2% off their high.

A closer examination shows that the top three weightings in the Dow (Visa, IBM, and Goldman Sachs) make up 22% of the index, yet represent just 8% of the total market capitalization. Furthermore, the top ten Dow stocks make up ~52% of the index, although they only represent ~36% of the total market cap.

The most over-weight stock in the Dow is Visa, which is awarded an 8.1% weighting although its market cap is only 2.8% of the index. The most under-weight stock is Microsoft, which is just 1.8% of the index, although it represents almost 8% of the total capitalization. To put this in some context, Microsoft is a bigger part of the S&P 500 than it is of the Dow 30, pretty amazing.

So next time you hear that the Dow was up/down by “X” points, understand that it is heavily influenced by a few companies and is not a fair representation of the broader market.

The Risk of Concentrated Portfolios

J.P. Morgan is out with a really interesting study that highlights the risks inherent with investing in a concentrated stock portfolio. This is an important part of investing that is often overlooked. We’re always searching for the next Apple, which had you invested $5,000 at the IPO in 1980 would be worth ~$1,300,000 today (a 26,000% return). However, we fail to mention that for every Apple, there are many more WorldCom’s.

Without any further adieu, let’s get into some of J.P. Morgan’s findings.

1) The return on the median stock since its inception vs. an investment in the Russell 3000 Index was -54%. 

2) Two-thirds of all stocks under performed vs. the Russell 3000 Index since their inception.

3) 40% of all stocks had negative absolute returns.

In other words, if you’re not Mario Gabelli, you’re probably better off going with the Jack Bogle approach.

Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value. Looking at the table below, we see that nearly sixty percent of Tech companies have had a catastrophic loss, which they define as “a 70% decline from peak value with minimal recovery.”

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Utilities and consumer staples, as you might expect, have presented investors with much less severe loss rates than has technology. 

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It would be disingenuous to talk about risk without looking at the reward, so how likely is it that you’re going to buy the next Apple? Just seven percent of the investable universe since 1980 has generated lifetime excess returns more than two standard deviations over the mean.

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If you are still inclined to have a concentrated portfolio, as my friend Patrick O’Shaughnessy has shown, Consumer Staples are the place to be. They have exhibited the best median excess return, the lowest percentage with negative absolute returns, and the highest percentage of extreme winners. 

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I mentioned that for every Apple, there are approximately a zillion companies that have gone out of business. Although you can’t argue with the facts, sometimes, looking at the data alone can be somewhat misleading because we overlook arguably the most important component of investing, which is behavioral.

Yes, Apple has delivered extraordinary results since its IPO, however there were certainly hiccups along the way, making it extremely difficult for investors to capitalize on these out sized returns. Apple has fallen twenty-five percent or more six times in the last ten years alone. The odds of you finding the next Apple, and sticking with it during severe draw downs are extremely unlikely, but you already knew that. Hopefully putting some numbers in front of you crystallizes exactly how hard it really is.

The study goes extremely in depth and has a tremendous amount of sector specific data. I highly recommend you take a look. 

Source: Eye on The Market, J.P. Morgan Asset Management

Check Out The Dollar Menu

McDonald’s has been a major laggard for quite some time, returning negative 7.5% since 2012. To put that in some context, the $SPY is up nearly 60% over the same period.

The headwinds McDonald’s faces are well known as consumers are shifting to healthier alternatives. The weak fundamentals- sub 2% revenue growth on average for the last eight quarters- has led to massive underperformance. However, there is a technical case to be made for why the Golden Arches might be good for a quick trade.

Today, we are seeing a bullish engulfing candle, after massive support ($93-$94) was taken out yesterday, this puts shorts who were pressing their bets in a precarious position. Furthermore, on the weekly chart, we see that McDonald’s tagged its 200-week moving average for the first time since 2004. 

There is serious structural damage here and I don’t think this is a stock you want to invest in, but for a quick trade, the risk/reward offers a good entry on the long side.

Wild Emerging Market Statistics

Morningstar is out with an epic research report that highlights the investment opportunities for Consumer Staple stocks, specifically how investors can take advantage of the tremendous growth coming out of Emerging Markets. I took some time to highlight statistics that really put into context how global demographics are changing. Everything has been taken directly from their report which I certainly encourage you to check out if you have some time, enjoy.

General Nuggets

By 2020 the number of middle-class consumers in emerging markets will likely exceed the United States and Europe combined.

Euromonitor forecasts that emerging markets will account for nearly three fourths of the world’s urban population by 2015.

Per capita beer consumption has had an R2 of 0.96 with per capita GDP growth in the largest 10 beer markets since 1999. We estimate the R2 of beer consumption and GDP growth in developed markets to have been just 0.05 over the same time period.

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China

1) According to the United Nations’ Department of Economic and Social Affairs, China’s population grew approximately 9% annually between 1975 and 1995.

2) In March 2014, China’s State Council approved plans to move more than 60% of the country’s total population to urban locations by 2020, up from approximately 53% today. This will effectively shift 15 million–20 million rural residents—roughly equal to the current size of the New York City metropolitan statistical area—to urban locations every year through the end of the decade.

3) According to China’s Ministry of Human Resources and Social Security, the average yearly wage in China grew by a CAGR of 13.8% from 2003 to 2013.

4) China had more than 600 million Internet users at the end of 2013 (according to World Bank data), representing a penetration rate of 45.8%.

5) Less than half of China’s Internet users are online shoppers, compared with 74% in the United States.

6) China has the world’s largest mobile Internet base with 500 million users (37% of the total population).

7) Based on data from iResearch, merchandise purchased on mobile devices is expected to increase by a CAGR of almost 60% over the next four years.

India

1) The population is expected to grow at a 1% CAGR to 2025, adding 167 million more people.

2) Just under two thirds of the population is of working age and that 64% is under the age of 35. By 2025, the World Bank expects that as the young generations age, around 68% of India’s population will be of working age, an increase of almost 137 million people.

3) The country’s consuming class (annual disposable income greater than $5,000) is expected to grow from under 100 million to between 450 million and 500 million individuals over the next decade according to Financial Times.

4) India’s GDP per capita growth rate (7.7% CAGR since 2000) outpaced the global average, but at just over $5,400, GDP per capita trails the world average ($13,301) by more than half.

5) More than 65% of India’s population still lives in rural areas.

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6)The Internet and Mobile Association of India estimates that 70% of India’s active rural Internet population accesses the network via their mobile phone.

Latin America

1) According to World Bank, Mexico and Brazil, the two largest Latin American markets, have only 38% and 14% of roads paved, respectively.

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Central and Eastern Europe

1) The long-term opportunity in the Central and Eastern Europe (CEE) region is less attractive than that of some other emerging markets because of unfavorable demographics. The population of the region is aging and shrinking.

2) Low birth rates are the driver of the population decline in Eastern Europe…. the equally weighted total fertility rate across the region has fallen from 3.6% in 1960 to 1.8% in 2012.

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3) Net migration has been negative for a decade.

4) The transition from centrally planned to free market economies has been rapid, and almost 25 years after the fall of the Iron Curtain, the accession of several post socialist nations to the European Union is confirmation that these countries are becoming integrated players in the global economy. This maturity is reflected in the material slowdown in GDP per capita growth, from 17.9% (nominal and in current U.S. dollars) between 2000 and 2008, when the region’s output growth was third only to that of China and India, to just 0.7% since.

5) Eastern European consumers are quite price-sensitive relative to those in developed markets. Between 2008 and 2013, retail value sales of private-label packaged food in Russia increased at a 31% CAGR. This is much faster than the 9.6% and 5.0% CAGRs of the United States and United Kingdom, respectively.

Africa

1) Africa’s population is anticipated to exceed China and India combined by 2065, according to U.N. projections.

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2) According to U.N. projections, Africa’s population is expected to grow from approximately 1.1 billion to 2.4 billion by 2050 using medium-variant fertility rate assumptions (Exhibit 2). This represents an 11.3% CAGR between 2010 and 2050, outpacing world population growth estimates of 4.4% and making it the highest potential growth region we’ve examined in this report.

3) Africa is also made up of a younger population than many emerging markets, with a median age of 19.7 years, using U.N. estimates, compared with just over 30 in Asia and north of 40 in Europe

4) According to an October 2012 McKinsey survey of African urban residents, 16- to 34-year-olds account for 53% of the continent’s income.

5) Africa’s workforce is currently made up of approximately 382 million individuals, with another 122 million expected to enter the workforce by 2020 according to McKinsey. This suggests that Africa’s consuming class could reach 500 million by 2020.

6) According to the International Labour Organization and McKinsey, almost 60% of Africa’s labor force was composed of government and agriculture jobs in 2010.

7) Over the past 10 years, Africa collectively posted a GDP CAGR of 4.7% (compared with 2.7% globally) and is home to six out of the 10 fastest-growing economies, according to The Economist.

8) Roughly 40% of the African continent lives in cities—a percentage similar to China and surpassing India—compared with 28% 30 years ago. 2030 is estimated to be the tipping point when more Africans will reside in urban areas than in rural areas.

Find the whole report (which you have to register for) here.

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. Zoom Permalink

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.