Tag Archives: cycles

Cartography Corner – November 2019

J. Brett Freeze and his firm Global Technical Analysis (GTA) provides RIA Pro subscribers Cartography Corner on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework. We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

GTA presents their monthly analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide


A Review of October

Random Length Lumber Futures

We begin with a review of Random Length Lumber Futures (LBX9, LBF0) during October 2019. In our October 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for October are:

  • o M4         447.90
  • o M1         407.70
  • o PMH       393.50
  • o Close      367.10
  • MTrend   364.03
  • M3           363.20
  • M2         357.10             
  • PML        348.10                         
  • M5           316.90

Active traders can use 363.20 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

In our October edition, we anticipated a breakout from consolidation and recognized our ignorance as to which direction by highlighting, “The lumber market has been building energy for the next substantial move for four quarters and four months, respectively.  Relative to our technical methodology, it is a 50-50 proposition as to which direction.”

Figure 1 below displays the daily price action for October 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first eight trading sessions were spent with Lumber oscillating around our isolated pivot level of 363.20.  Longs and shorts were battling to establish a sustained directional move away from equilibrium at MTrend: 364.03. 

Astute readers will notice that the low price of the month was realized at the price of 357.50.  That price was four ticks above October’s M2 level of 357.10.  M2 was the first monthly support level under our isolated pivot.

The following seven trading sessions were spent with Lumber making an assault upon, and settling above, September’s high at PMH: 393.50.  The final eight trading sessions saw Lumber achieve and exceed our isolated resistance level at M1: 407.70.

Conservatively, active traders following our analysis had the opportunity to capture most of the trade up which equated to an approximate 10.5% profit. 

Figure 1:

E-Mini S&P 500 Futures

We continue with a review of E-Mini S&P 500 Futures during October 2019.  In our October 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for October are:

  • M4                 3275.75
  • M1                 3037.25
  • M3                 3032.25
  • PMH              3025.75
  • M2               3002.25      
  • Close             2978.50
  • MTrend         2952.81     
  • PML               2889.00     
  • M5                2763.75

Active traders can use 3037.25 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2952.81 as the downside pivot, whereby they maintain a flat or short position below that level.

Figure 2 below displays the daily price action for October 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  We commented in October, “… the slope of the Weekly Trend could be in the initial stage of forming a rounded top.”  The first two- and one-half trading sessions of October saw the market price descend 123.50 points from September’s settlement price.  The decline accelerated once it settled below our isolated pivot level at MTrend: 2952.81.

The low price for the month was realized (early in the session) on Thursday, October 3rd at the price of 2855.00.  Please pay attention to the commentary that follows next, as it highlights the importance of our multi-time-period analysis.  The Weekly Downside Exhaustion level for the week of September 30th was at W5: 2868.00.  Once our Weekly Downside Exhaustion level was reached, we were immediately anticipating a two-week high to occur over the following four to six weeks.  This was reason one to cover any shorts.  Quarterly Trend for the fourth quarter of 2019 resides at 2840.92.  As we have communicated before, this is the most important level in our analysis and, at a minimum, we expect Quarterly Trend to be defended vigorously on the first approach.  This was reason two to cover any shorts.  By the time of the market’s close on October 3rd, the price had rotated back above September’s low price at PML: 2889.00.  The following five trading sessions were spent with the market price oscillating between MTrend: 2952.81, now acting as resistance, and support at PML: 2889.00.

On October 11th, the market price ascended above and settled above MTrend: 2952.81.  This afforded the market the opportunity to make an assault on our next isolated resistance level at M2: 3002.25.  Two trading sessions later, on October 15th, the market price achieved a high price of 3003.25.  This is notable because it achieved the two-week high that we were anticipating from October 3rd.   The following five trading sessions were spent with the market price oscillating around our isolated resistance level at M2: 3002.25.

On October 23rd, the market price settled above M2 and began its final ascent into the October 30th FOMC meeting.  It is worth noting that the market did not settle above our isolated upside pivot level at 3037.25 prior to October 30thWith one trading session remaining in October, common sense suggested waiting for November’s analysis to be produced in lieu of committing capital on the day of the FOMC meeting.

Humbly offered, our analysis captured the trade down early in the month, the rally into the pre-FOMC high, and the significant pivots in between.

Figure 2:

November 2019 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESZ9).  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Daily Trend             3038.39       
  • Current Settle         3035.75
  • Weekly Trend         2980.58       
  • Monthly Trend        2950.42       
  • Quarterly Trend      2840.92

In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures have been “Trend Up” for three quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures have been “Trend Up” for five months.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures have been “Trend Up” for three weeks.  The relative positioning of the Trend Levels is bullishly aligned.  The market price is above all of them (with exception of Daily Trend) which is bullish as well.

In the monthly time-period, the “signal” was given in August 2019 to anticipate a two-month high within the following four to six months.  That two-month high was realized in October 2019, with the trade above 3025.75.

 

Support/Resistance:

In isolation, monthly support and resistance levels for November are:

  • M4                 3221.00
  • M3                 3093.00
  • M1                 3084.25
  • PMH              3055.00
  • Close             3035.75     
  • MTrend         2950.42
  • PML               2855.00     
  • M2                 2821.00    
  • M5                2684.25

Active traders can use 3055.00 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2950.42 as the downside pivot, whereby they maintain a flat or short position below that level.

New Zealand Dollar Futures

For the month of November, we focus on New Zealand Dollar Futures (“Kiwi”).  We provide a monthly time-period analysis of 6NZ9.  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Quarterly Trend    0.6640           
  • Current Settle       0.6416
  • Daily Trend           0.6382           
  • Monthly Trend      0.6361           
  • Weekly Trend        0.6354

As can be seen in the quarterly chart below, Kiwi is in “Consolidation”.  Stepping down one time-period, the monthly chart shows that Kiwi has been “Trend Down” for four months.  Stepping down to the weekly time-period, the chart shows that Kiwi has been “Trend Up” for three weeks.

In the monthly time-period, the “signal” was given in August 2019 to anticipate a two-month high within the following four to six months.  That two-month high can be realized in November 2019 with a trade above 0.6462.

Our first priority in performing technical analysis is to identify the beginning of a new trend, the reversal of an existing trend, or a consolidation area.  With that in mind, we chose to focus on Kiwi for the month of November.  Since its peak in 2Q2017, Kiwi has traded down in five of the previous eight quarters.  In the calendar year 2019, it has only traded up in three months out of ten.  But something caught our attention… Monthly Trend for November has “quietly tiptoed” beneath the market.  In our judgment, the risk-reward is favorable for anticipating a trend reversal.    

Support/Resistance:

In isolation, monthly support and resistance levels for November are:

  • M4         0.6627
  • M3         0.6558
  • PMH       0.6444
  • M1         0.6426
  • Close       0.6416
  • MTrend   0.6361
  • PML        0.6215             
  • M2         0.6169                         
  • M5           0.5968

Active traders can use 0.6361 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

 

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight into many different markets.  If you are a professional market participant and are open to discovering more, please connect with us.  We are not asking for a subscription; we are asking you to listen.

Value Your Wealth – Part Six: Fundamental Factors

In this final article of our Value Your Wealth Series we explore four more fundamental factors. The first four articles in the Series researched what are deemed to be the two most important fundamental factors governing relative stock performance – the trade-off between growth and value. In Part Five, we explored how returns fared over time based on companies market cap. Thus far, we have learned that leaning towards value over growth and smaller market caps is historically an investment style that generates positive alpha. However, there are periods such as now, when these trends fail investors.

The last ten years has generally bucked long-standing trends in many factor/return relationships. This doesn’t mean these factors will not provide an edge in the future, but it does mean we need to adapt to what the market is telling us today and prepare for the day when the historical trend reverts to normal.  When they do, there will likely be abundant opportunities for investors to capture significant alpha.

The five prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Part Five: Market Cap

Four Factors

In this section, we explore four well-followed factors to understand how they performed in the past and how we might want to use them within our investment decision-making process.

The graphs in this article are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

Earnings to Price

Investors betting on companies with a higher ratio of Earnings to Price (E/P), also known as the earnings yield, have historically outperformed investors betting on companies with lower E/P ratios. Such outperformance of companies priced at relatively cheap valuations should be expected over time.

The following chart compares monthly, ten year annually compounded returns for the highest and lowest E/P deciles. 

The graph of E/P is very similar to what we showed for growth versus value. Other than a period in the 1990s and the current period value outperformed growth and the top E/P companies outperformed the bottom ones. This correlation is not surprising as E/P is a key component that help define value and growth.

Investors buying the top ten percent of the cheapest companies, using E/P, have been docked almost 5% annually or about 50% since the recovery following the financial crisis versus those buying the lowest ten percent of companies using this measure.

Given our fundamental faith in mean reversion, we have no doubt this trend will begin to normalize in due time. To help us gauge the potential return differential of an E/P reversion, we calculate future returns based on what would happen if the ten-year return went back to its average in three years. This is what occurred after the tech bust in 2000. In other words, if the ten year annualized compounded return in late 2022 is average (4.81%) what must the relative outperformance of high E/P to low E/P companies be over the next three years? If this occurs by 2022, investors will earn an annual outperformance premium of 28.1% for each of the next three years. The returns increase if the time to reversion is shorter and declines if longer. If normalization occurs in five years the annual returns drop to (only) 14.75%.

Needless to say, picking out fundamentally solid stocks seems like a no-brainer at this point but there is no saying how much longer speculation will rule over value.

Cash Flow to Price

The graph below charts the top ten percent of companies with the largest ratio of cash flow to price and compares it to the lowest ones. Like E/P, cash flow to price is also a component in value and growth analysis.

Not surprisingly, this graph looks a lot like the E/P and value vs. growth graphs. Again, investors have shunned value stocks in favor of speculative entities meaning they are neglecting high quality companies that pay a healthy dividend and instead chasing the high-flying, over-priced “Hollywood” stocks. Also similar to our potential return analysis with E/P, those electing to receive the most cash flows per dollar of share price will be paid handsomely when this factor reverts to normal.

Dividend Yield

Over the last 100 years, using dividend yields to help gain alpha has not been as helpful as value versus growth, market cap, earnings, and cash flows as the chart below shows.

On average, higher dividend stocks have paid a slight premium versus the lowest dividend stocks.While dividend yields are considered a fundamental factor it is also subject to the level of interest rates and competing yields on corporate bonds.If we expect Treasury yield levels to be low in the future then the case for high dividend stocks may be good as investors look for alternative yield as income. The caveat is that if rates decline or even go negative, the dividend yield may be too low to meet investors’ bogeys and they may chase lower dividend stocks that have offered higher price returns.

Momentum

Momentum, in this analysis, is calculated by ranking total returns from the prior ten months for each company and then sorting them. Before we created the graph below, we assumed that favoring momentum stocks would be a dependable investment strategy. Our assumption was correct as judged by the average 10.89% annual outperformance. However, we also would have guessed that the last few years would have been good for such a momentum strategy.

Quite to the contrary, momentum has underperformed since 2009. The last time momentum underperformed, albeit to a much a larger degree, was the Great Depression.

Our initial expectation was based on the significant rise of passive investing which favors those companies exhibiting strong momentum. As share prices rise relative to the average share price, the market cap also rises versus the average share and becomes a bigger part of indexes.  If we took the top 1 or 2% of companies using momentum we think the strategy would have greatly outperformed the lower momentum companies, but when the top and bottom ten percent are included momentum has not recently been a good strategy.

Summary

Factors give investors an informational edge. However, despite long term trends that offer favorable guidance, there are no sure things in investing. The most durable factors that have supplied decades of cycle guidance go through extended periods of unreliability. The reasons for this vary but certainly a speculative environment encouraged by ultra-low and negative interest rates has influence. Investors must recognize when they are in such periods and account for it. More importantly, though, they must also understand that when the trends are inclined to reverse back to normal. The potential for outsized relative gains at such times are large.

At RIA Advisors, Factor analysis is just one of many tools we use to help us manage our portfolios and select investments. We are currently leaning towards value over growth with the belief that the next market correction will see a revival of the value growth trends of the past. That said, we are not jumping into the trade as we also understand that growth may continue to beat value for months or even years to come.

Patience, discipline, and awareness are essential to good investing. 

Cartography Corner – October 2019

J. Brett Freeze and his firm Global Technical Analysis (GTA) provides RIA Pro subscribers Cartography Corner on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework. We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

GTA presents their monthly analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide


A Review of September

U.S. Treasury Bond Futures

We begin with a review of U.S. Treasury Bond Futures (USZ9) during September 2019. In our September 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for September are:

  • M4         181-00
  • M1         176-26
  • M3         174-29
  • PMH       166-30
  • Close        165-08
  • MTrend    157-17
  • M2         157-02             
  • PML        154-31                          
  • M5            152-28

Active traders can use 166-30 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

In our September edition, we anticipated weakness and cautioned, “Short-time-period-focused market participants. . . Caveat Emptor.”  Figure 1 below displays the daily price action for September 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first nine trading sessions were spent with bonds descending in price by seven points and twenty-two thirty seconds.  Ours was a most timely warning. 

Astute readers will notice that the low price of the month was realized at the price of 157 18/32.  That price was one tick above September’s Monthly Trend level of 157 17/32.  Monthly Trend was also the first monthly support level offered by our analysis.   Another prime example of the importance of Monthly Trend as a significant pivot level.

The final eleven trading sessions were spent with bonds retracing as much as 75% of the initial decline.

Active traders following our analysis had the opportunity to capture the entire trade down, which equated to a $7,687.50 profit per contract.  Once Monthly Trend held, drawing from their understanding of our analysis, they also would have known it was worth using the Monthly Trend to acquire a long position with a well-defined stop in place (clustered support at Monthly Trend / M2) to limit risk.

Figure 1:

E-Mini S&P 500 Futures

We continue with a review of E-Mini S&P 500 Futures during September 2019.  In our September 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for September are:

  • M4                 3073.00
  • PMH              3014.25
  • M1                 2999.00
  • MTrend        2924.92
  • Close            2924.75      
  • M3                 2867.25
  • PML               2775.75     
  • M2                 2596.00    
  • M5                2522.00

Active traders can use 2924.92 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Figure 2 below displays the daily price action for September 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first nine trading sessions of September saw the market price ascend 101.00 points from August’s settlement price.  The gains accelerated once it settled above our isolated pivot level at MTrend: 2924.92.  The high price for the month was realized on September 13th, the exact same day that the low price in bonds was achieved.       

The purpose of every trading month is to surpass the high or low of the previous trading month.  As can be seen in Figure 2, the high price for August 2019 was at PMH: 3014.25.  The price action exceeded PMH: 3014.25, running the “obvious brothers’” buy-stops in the process.  However, the market did not settle above that level which signaled that it was time for active traders following our analysis to take profits on their purchases.

On September 20th, the market price rotated and settled back below M1: 2999.00, now acting as support.  If active traders following our work had not previously sold their long positions, they should have on that day. The final six sessions of September were spent with the market price declining back towards Monthly Trend.

Active traders following our analysis had the opportunity to capture the initial trade up, which equated to a $4,412.50 profit per contract.

Figure 2:

October 2019 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESZ9).  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Weekly Trend         2989.90       
  • Current Settle         2978.50
  • Daily Trend             2974.61       
  • Monthly Trend        2952.81       
  • Quarterly Trend      2840.92

In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures have been “Trend Up” for three quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures have been “Trend Up” for four months.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures are in “Consolidation”.

Like we commented in August, the slope of the Weekly Trend could be in the initial stage of forming a rounded top.  Also, the market price has settled below Weekly Trend for two consecutive weeks.  Weekly Trend for this week is at 2989.90.  This deserves focus from short time-period-focused market participants.  A trend change in the short time-period is often a precursor to a trend change in the longer time-period(s).  We will watch closely to see if this occurs, bolstering the case for a topping pattern.

Support/Resistance:

In isolation, monthly support and resistance levels for October are:

  • M4                 3275.75
  • M1                 3037.25
  • M3                 3032.25
  • PMH              3025.75
  • M2               3002.25      
  • Close             2978.50
  • MTrend         2952.81     
  • PML               2889.00     
  • M5                2763.75

Active traders can use 3037.25 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2952.81 as the downside pivot, whereby they maintain a flat or short position below that level.

Random Length Lumber Futures

For the month of October, we focus on Random Length Lumber Futures.  Lumber prices are often seen as an indicator of economic activity due to its widespread use in real estate.  Regardless of whether you may trade lumber, the analysis and price action of lumber may provide some clues as to the future direction of the economy.  We provide a monthly time-period analysis of LBX9.  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Weekly Trend        376.33          
  • Daily Trend            370.83
  • Current Settle        367.10          
  • Quarterly Trend     366.80          
  • Monthly Trend       364.03

As can be seen in the quarterly chart below, lumber is in “Consolidation”.  Stepping down one time-period, the monthly chart shows that lumber has been “Trend Up” for four months.  Stepping down to the weekly time-period, the chart shows that lumber has been “Trend Up” for three weeks.

In the quarterly time-period, the lumber market realized its last “substantial” price move (lower) in 3Q2018.  It has been consolidating since.  In the monthly time-period, the lumber market realized its last “substantial” price move from February 2019 to May 2019.  It has been consolidating since.  Astute readers will also notice that the current market price is resting just above BOTH Quarterly Trend and Monthly Trend.  The lumber market has been building energy for the next substantial move for four quarters and four months, respectively.  Relative to our technical methodology, it is a 50-50 proposition as to which direction.  As noted earlier, once this direction reveals itself, we may be simultaneously gifted with an indication of the state of the economy.

Support/Resistance:

In isolation, monthly support and resistance levels for October are:

  • M4         447.90
  • M1         407.70
  • PMH       393.50
  • Close      367.10
  • MTrend   364.03
  • M3           363.20
  • M2         357.10             
  • PML        348.10                         
  • M5           316.90

Active traders can use 363.20 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight into many different markets.  If you are a professional market participant and are open to discovering more, please connect with us.  We are not asking for a subscription; we are asking you to listen.

Cartography Corner – September 2019

J. Brett Freeze and his firm Global Technical Analysis (GTA) provides RIA Pro subscribers Cartography Corner on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework. We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

GTA presents their monthly analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide


In addition to the normal format in which we review last month’s commentary and present new analysis for the month ahead, we provide you with interesting research on long-term market cycles.

A Review of August

Silver Futures

We begin with a review of Silver Futures (SIU9/SIZ9) during August 2019. In our August 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for August are:

  • M4         18.805
  • M1         17.745
  • M3           17.469
  • PMH       16.685
  • Close        16.405
  • M2           15.265
  • MTrend   15.263             
  • PML          14.915                        
  • M5            14.205

Active traders can use 16.685 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Figure 1 below displays the daily price action for August 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first five trading sessions were spent with silver ascending to and settling above, our isolated pivot level at PMH: 16.685.  Silver’s rally, which began in June, extended significantly in August. 

The following twelve trading sessions were spent with silver consolidating with an upward bias, testing our clustered resistance levels at M3: 17.469 and M1: 17.745.  On August 26th, silver settled above M1: 17.745 and proceeded over the following three trading sessions to test our Monthly Upside Exhaustion level at M4: 18.805.   The high price for August 2019 was achieved on August 29th at 18.760, a difference from M4 of 0.24%.

 Active traders following our analysis had the opportunity to capture a 12.4% profit.

 

Figure 1:

E-Mini S&P 500 Futures

We continue with a review of E-Mini S&P 500 Futures during August 2019.  In our August 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for August are:

  • M4                3330.25
  • M2                3182.25
  • M1                3089.75
  • PMH              3029.50
  • M3               3020.25      
  • Close             2982.25
  • PML               2955.50     
  • M5                 2941.75    
  • MTrend         2897.03

Active traders can use 3029.50 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Figure 2 below displays the daily price action for August 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first four trading sessions of August saw the market price collapse 206.50 points from July’s settlement price.  The descent accelerated once our isolated support levels at PML: 2955.50 and M5: 2941.75 were breached.  When August Monthly Trend at MTrend: 2897.03 was breached, the descent accelerated again.      

The remaining trading sessions of August 2019 were spent with the market price oscillating between 2817.00 (roughly) and our isolated support level at M5: 2941.75, now acting as resistance.  As can be seen in Figure 2, there were essentially five swing trades during the remainder of August, three up and two down.  Each swing covered approximately 125 points.

The war between bulls and bears continues with the battles becoming fiercer.

Figure 2:

September 2019 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESU9).  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Monthly Trend        2924.92       
  • Current Settle         2924.75
  • Daily Trend             2905.47       
  • Weekly Trend         2884.92       
  • Quarterly Trend      2727.50

In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures are in “Consolidation”.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures have been “Trend Up” for three months.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures are in “Consolidation”.

We commented in August:

“We would like to point out the slope of the Weekly Trend has been forming a rounded top over the previous three weeks.  Weekly Trend is currently developing at 2996.58 for the week of August 5, 2019.  If that developing level holds (or develops lower), the topping process will be complete (in the weekly time-period) as 2996.58 is lower than this week’s Weekly Trend level of 2999.83.  Also, a weekly settlement this week below 2999.83 will end the current eight-week uptrend.”

The formation of the rounded top in the Weekly Trend was an excellent indicator of the directional turn in the short time period. 

Support/Resistance:

In isolation, monthly support and resistance levels for September are:

  • M4                 3073.00
  • PMH              3014.25
  • M1                 2999.00
  • MTrend        2924.92
  • Close            2924.75      
  • M3                 2867.25
  • PML               2775.75     
  • M2                 2596.00    
  • M5                2522.00

Active traders can use 2924.92 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

U.S. Treasury Bond Futures

For the month of September, we focus on U.S. Treasury Bond Futures (“bonds”).  We provide a monthly time-period analysis of USZ9.  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Daily Trend            165-20          
  • Current Settle        165-08
  • Weekly Trend        164-22          
  • Monthly Trend       157-17          
  • Quarterly Trend     147-27

As can be seen in the quarterly chart below, bonds have been “Trend Up” for three quarters.  Stepping down one time-period, the monthly chart also shows that bonds have been “Trend Up” for nine months.  Stepping down to the weekly time-period, the chart shows that bonds have been “Trend Up” for five weeks.

The condition was met in August 2019 that makes us anticipate a two-month low within the next four to six months.  That would be fulfilled with a trade below 152-28 in September 2019.  This is the second “signal” that has been given since this nine-month uptrend began.  The first was given in December 2018 and the two-month low was realized three months later.  In the week of July 29th, the condition was met that made us anticipate a two-week low within the next four to six weeks from that week.  The market is entering the fifth week of that time window and a two-week low can be realized this week with a trade below 162-06.

Like the rounded top highlighted in E-Mini S&P 500 futures in the August 2019 edition of The Cartography Corner, the Weekly Trend in bonds is beginning to take on the same curvature.  Short-time-period-focused market participants. . . Caveat Emptor.

 

Support/Resistance:

In isolation, monthly support and resistance levels for September are:

  • M4         181-00
  • M1         176-26
  • M3         174-29
  • PMH       166-30
  • Close        165-08
  • MTrend    157-17
  • M2         157-02             
  • PML        154-31                          
  • M5            152-28

Active traders can use 166-30 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

 

Equity Cycle, 1799 – 2061

What if the basis of causation in human affairs, economics, and markets is embedded in the law of vibration of nature?  Sound, light, and heat are all forms of vibration.  Sound is energy vibrating at a frequency that the ear can perceive.  Light is energy vibrating at a frequency that the eye can perceive.  Heat is energy that vibrates at a frequency that our internal thermometers can perceive.  Radiation that penetrates the Earth’s atmosphere causes proven psychological changes in people.

My dog barking at 2:30 each afternoon does not cause the mailman to deliver the mail to my house.  However, when my dog barks at 2:30 each afternoon, I can reliably trust that the mail is being delivered.  Similarly, it is not necessary for the market participant to answer in-depth questions of how or why, with regards to causation.  It is only necessary to answer the question of correlation and, if a correlation exists, what are the results?  Market participants of old, including W.D. Gann, Louise McWhirter, Donald Bradley, and others, not only recognized but successfully utilized the law of vibration across many individual markets.

We spent significant time collecting, organizing, and processing planetary data in the identification and construction of the composite equity cycle graphed on the following three pages.  The composite equity cycle is comprised of six individual cycles, each with a different phase, amplitude, and length.  The average cycle length is 13.5 years.

Our data series of the nominal equity index level spans 220 years, with a low value of 2.85 and high value of 26,864.27.  We faced the challenge of how to graphically present this data series in the most aesthetic manner.  We started by graphing lognormal values, but the result did not “tell the story” in a legible way.  We finally were enlightened (thank you, Jack) to present a rolling return.  The benefit of using a rolling return is that the range of values is relatively narrow and presents itself well graphically.  We set the length of the rolling return equal to the average cycle length.

The first graph displays the cycle over the entire time period, 1799 – 2061.

The second graph highlights the peaks in the cycle and how well they line up with peaks in the rolling 13.5Y annualized return in the Dow Jones Industrial Average.  The dashed lines represent anticipated future peaks.

The third graph highlights the troughs in the cycle and how well they line up with troughs in the rolling 13.5Y annualized return in the Dow Jones Industrial Average.  The dashed lines represent anticipated future troughs.

Compelling.

CLICK TO ENLARGE

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight into many different markets.  If you are a professional market participant and are open to discovering more, please connect with us.  We are not asking for a subscription; we are asking you to listen.

Value Your Wealth – Part Five: Market Cap

The first four articles in this series focused on what might be the most important pair of fundamental factors – growth and value. Those factors have provided investors long-standing, dependable above-market returns.  Now, we take the series in a different direction and focus on other factors that may also give us a leg up on the market. 

The term “a leg up” is important to clarify. In general, factor-based investing is used to gain positive alpha or performance that is relatively better than the market. While “better” than market returns are nice, investing based on factor analysis should not be the only protection you have when you fear that markets may decline sharply. The combination of factor investing and adjustments to your total equity exposure is a time-trusted recipe to avoid large drawdowns that impair your ability to compound wealth.

We continue this series with a discussion of market capitalization.

The four prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Market Cap

Market capitalization, commonly known as market cap, is a simple calculation that returns the current value or size of publicly traded companies. The formula is the number of shares outstanding times the price per share. For example as we wrote this article, Apple has 4.601 billion shares outstanding and Apple’s stock trades at roughly $210 per share. Apple’s market cap is $966.21 billion. 

Most investors, along with those in the financial media, tend to distinguish companies market caps/size by grouping them into three broad tiers – small-cap, mid-cap, and large-cap. Over most periods, stocks in the three categories are well correlated. However, there are periods when they diverge, and we are currently amidst such a deviation. Since September 1, 2018, the price of the Large Cap S&P 500 Index has risen by 4.1%, while the price of the Small Cap S&P 600 Index is down 12.9%.  Deviations in historical relationships, whether short or long-term in nature, can provide investors an opportunity to capitalize on the normalization of the relationship, but timing is everything. 

Historical Relative Performance

The following graphs are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

The data set provides returns based on market cap groupings based on deciles. The first graph compares annualized total return and annualized volatility since 1926 of the top three (High) and bottom three (Low) market cap deciles as well as the average of those six deciles. To be clear, a decile is a discrete range of market caps reflecting the stocks in that group. For example, in a portfolio of 100 stocks, decile 1 is the bottom ten stocks, or the smallest ten market cap stocks, decile two is the next ten smallest cap stocks, etc.

The next graph below uses monthly ten year rolling returns to compare total returns of the highest and lowest deciles. This graph is a barometer of the premium that small-cap investing typically delivers to long term investors.

The takeaway from both graphs is that small-cap stocks tend to outperform large-cap stocks more often than not. However, the historical premium does not come without a price. As shown in the first graph, volatility for the lowest size stocks is almost twice that of the largest. If you have a long time horizon and are able and willing to stay invested through volatile periods, small caps should fare better than large caps. 

Small-cap stocks, in general, have high expected growth rates because they are not limited by the constraints that hamper growth at larger companies. Unfortunately, small-cap earnings are more vulnerable to changes in industry trends, consumer preferences, economic conditions, market conditions, and other factors that larger companies are better equipped and diversified to manage. 

Periods of Divergence

The second graph above shows there are only three periods where large caps outperformed small caps stocks since 1926. Those three exceptions, the 1950’s, 1990’s and, the post-financial crisis-era are worth considering in depth.

The 1950s The Nifty Fifty- The end of World War II coupled with a decade of historically low interest rates disproportionately helped larger companies. These firms, many global, benefited most from the efforts to rebuild Europe and partake in the mass suburbanization of America.

The 1990s Tech Boom- With double-digit inflation a distant memory and the swelling technology boom, larger companies that typically benefited most from lower rates, less inflation, and new technologies prospered. While this new technology benefited all companies in one form or another, larger ones had the investment budgets and borrowing capacity to leverage the movement and profit most. 

The 2010’s Post Financial Crisis Era –The current period of large-cap outperformance is unique as economic growth has been prolonged but below average and productivity growth has been negligible. Despite relatively weak economic factors, massive amounts of monetary stimulus has fueled record low corporate borrowing rates, which in turn have fueled stock buybacks. Further, the mass adaptation of passive cap-weighted investment strategies naturally favors companies with large market caps. Circularly, passive investing feeds on itself as indexed ETFs and mutual funds must increasingly allocate more to large caps which grow in size relative to the other holdings.

To reiterate an important point: the current period of outperformance is not based on solid economic fundamentals and resulting corporate earnings growth as in the two prior periods described. This episode is a byproduct of monetary actions.

The graph below highlights the distinction between the current period and the two prior periods where large caps outperformed.  

Summary

Historically, small-cap stocks tend to provide a return premium over large-cap stocks. However, as we pointed out, there are periods where that is not the case. Currently, large-cap stocks are the beneficiaries of overly generous monetary and fiscal policy. We do believe the relationship will return to normal, but that will likely not occur until a bear market begins.

As we wait for a normalization of valuations and traditional relationships that have become so disfigured in this cycle, we consider the current relative valuations on small-cap stocks similar to those we described in value stocks earlier in this series. The time to weight your stock portfolio allocation more heavily toward small-cap opportunities is coming, but every investor must decide on their own or with good counsel from an advisor when to make that adjustment.  When appropriate, a gradual shift to small-cap stocks from large caps depends on an investor’s risk appetite and defensive preference.

More importantly, have a plan in place because when the market does meaningfully correct, the premium small-cap stocks provide will likely help cushion against a stock market correction. 

Value Your Wealth – Part Four: Mutual Fund & ETF Analysis

Parts One through Three of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

In Part One, the introduction to our Value Your Wealth series, we documented how recent returns for investors focused on growth companies have defied the history books and dwarfed returns of investors focused on value stocks. In particular: “There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.”

In this, the fourth part of the Value Your Wealth series, we focus on growth and value mutual funds and ETFs. Our purpose is to help determine which professional value and growth fund managers are staying true to their stated objectives.

Fund Analysis

A large part of most investor’s investment process starts with the determination of an investment objective. From this starting point, investors can appropriately determine the asset classes and investment strategies that will help them achieve or even exceed their objectives. 

Once an investor decides upon an objective, strategy, and asset class, they must select individual securities or funds. This article focuses singularly on assessing growth and value mutual funds and ETFs. In particular it shows how an investor focused on growth or value can choose funds that are managed properly to meet their goals.

Investors usually key on the following factors when selecting a mutual fund or ETF: 

  • Declared fund strategy (Growth or Value in this case)
  • Prior period returns
  • Fee and expense structure
  • Reputation of the fund family and possibly the manager

These four factors provide valuable information but can be misleading.

For instance, prior returns provide a nice scorecard for the past but can be deceptive. As an example, if we are currently scanning for value funds based on performance, the highest ranking funds will more than likely be those that have leaned most aggressively toward growth stocks. While these funds may seem better, what we believe is more important the fund managers adherence to their objectives.  Given we are looking forward and believe value will outperform growth, we want fund managers that we can trust will stick with value stocks.

It is also important not to shun funds with the highest expenses and/or gravitate towards those with the lowest. We must be willing to pay up, if necessary, to achieve our objectives. For instance, if a fund offers more exposure to value stocks than other comparable value funds, it may be worth the higher fee for said exposure. Conversely, there are many examples where one can gain more exposure to their preferred strategy with cheaper funds. 

Most investors check the fund strategy, but they fail to determine that a fund is being effectively and cost efficiently managed towards their stated strategy. 

We now compare the largest growth and value mutual funds and ETFs to assess which funds offer the most value, so to speak. 

Mutual Fund/ETF Analysis

In order to limit the population of value and growth mutual funds and ETFs to a manageable number, we limited our search to the largest funds within each strategy that had at least 85% exposure to U.S. based companies. We further restricted the population to those funds with a stated strategy of growth or value per Bloomberg.

In prior articles of this series, we have used Bloomberg growth and value factor scores and our own growth and value composite scores. While we would prefer to use our own computations, the large and diverse holdings of the mutual funds and ETFs make it nearly impossible for this exercise. Accordingly, Bloomberg growth and value factor scores provide us the most accurate description of where the respective funds lie on the growth/value spectrum. It is important to note that Bloomberg assigns every fund both a growth and a value score. We consider both scores and not just the score pertinent to growth or value.

We understand most of our readers do not have access to Bloomberg data. As such, we provide a DIY approach for investors to track growth and value exposure amongst mutual funds and ETFs.

Growth and Value Scores

The scatter plot below shows the 54 funds analyzed. Each dot represents a fund and the intersection of its respective growth (x-axis) and value scores (y-axis). The funds most heavily skewed towards value (high value scores and low growth scores) are in the upper left, while heavily growth oriented funds are in the bottom right (high growth score and low value scores).  Information about the funds used in this report and their scores can be found in the tables below the graph. Certain funds are labeled for further discussion.   

A few takeaways:

  • VIVAX (Growth -.60, Value +.37): While this value fund is farthest to the left, there are other funds that offer more value exposure. However, this fund has the lowest growth score among value funds.
  • DFLVX (Growth -.43, Value +.68): This value fund offers an interesting trade off to VIVAX sporting a higher value score but a less negative growth score.
  • AIVSX (Growth +.10, Value -.05): Despite its classification as a value fund, AIVSX has a slight bias towards growth. Not surprisingly, this fund has recently outperformed other value funds but would likely underperform in the event value takes the lead.
  • FDGRX (Growth +.88, Value -.64): This growth fund offers both the highest growth score and lowest value score. For investors looking for an aggressive profile with strong growth exposure and little value exposure, this fund is worth considering.
  • VPMCX (Growth -.04, Value +.16): Despite its classification as a growth fund, VPMCX has a slight bias towards value.
  • In our opinion, the six funds with growth and value scores near zero (+/-.20) in the red box do not currently have a significant growth or strategy orientation, and as such, they are similar to a broad market index like the S&P 500.

It is important to stress that the data represents a snapshot of the fund portfolios for one day. The portfolio managers are always shifting portfolios toward a value or growth bias based on their market views.

 (CLICK on the tables to enlarge)

Data Courtesy Bloomberg

The data above gives us potential funds to meet our strategic needs. However, we also need to consider fees.  

Fees

The scatter plots below isolate growth and value funds based on their respective growth or value score and fees charged.

We circled three groupings of the growth funds to help point out the interaction of fees and growth scores. The four funds in the blue circle have average or above average fees versus other growth funds yet provide a minimal bias towards growth. The yellow circle represents a sweet spot between low fees and a good exposure to growth stocks. Lastly, the red circle shows funds where  heavy exposure to growth comes with above average fees.

This graph circles three groupings of value funds to help point out the interaction of fees and growth scores. The blue circle contains funds with little to no bias towards value. The yellow circle represents a good mix of value and cheap fees. The red circle, our sweet spot in this graph, shows that heavy exposure to value can be had with fees near the group average.

Alpha and Bad Incentives 

Alpha is a measure that calculates how much a portfolio manager, trader, or strategy over or underperforms an index or benchmark. From a career perspective, alpha is what separates good fund managers from average or bad ones.

We mention alpha as we believe the current prolonged outperformance of growth over value is pushing professional fund managers to stray from their stated objectives. As an example, a value based fund manager can add exposure to growth stocks to help beat the value index he or she is measured against.

Adding growth to a value fund may have proven to be alpha positive in the past, but we must concern ourselves with how well the fund manager is adhering to the fund’s objective Simply put, we are trying to find managers that are staying true to their objectives not those who have benefited from a deviation from stated strategy in the past.

It is important to note that positive alpha can be attained by sticking to the stated objective and finding stocks that outperform the index. This is the type of alpha that we seek.

DIY

As discussed, growth and value factors can change for funds based on the whims of the portfolio manager. Therefore, the data provided in this article will not age well. If you do not have access to Bloomberg to track value and growth scores we offer another approach.

Morningstar provides a blunt but effective style analysis tool.  To access it, go to www.morningstar.com and select your favorite fund. Then click on the tab labeled Portfolio and scroll down to Style Details.

The following screen print shows Morningstar’s style analysis for value fund DFLVX.

The box in the top right separates the fund’s holdings by market capitalization and value growth classifications. We can use this data to come up with our own scores. For instance, 59% (46+13) of DFLVX is biased toward value (red circle) while only 6% (5+1) is in growth companies (blue circle). To further demonstrate how a fund compares to its peers, the Value & Growth Measures table on the bottom left, compares key fundamental statistics. As shown by three of the first four valuation ratios, DFLVX has more value stocks than the average for funds with similar objectives.

Summary

The word “Value” in a fund name does not mean the fund takes on a value bias at all times. As investors, we must not rely on naming conventions. This means investors must do some extra homework and seek the funds that are truly investing in a manner consistent with the funds, and ultimately the investor’s, objective.

As we have mentioned, we are at a point in the economic and market cycles where investors should consider slowly rotating towards value stocks. Not only is the style historically out of favor, many of the names within that style are unjustifiably beaten down and due for mean reversion to more favorable levels. We hope this article provides some guidance to ensure that those who heed our advice are actually adding value exposure and not value in name only.

Yes, The Yield Curve Matters

Recently several subscribers asked us why an inverted yield curve is a strong predictor of a coming recession. We will address the question in this article but first, we provide current context with two graphs that update you on the status of yield curves, and in the process help explain why this question is being asked with increasing frequency.

The first graph below, courtesy of the St. Louis Federal Reserve, clearly shows why the yield curve is becoming more and more of a concern for the Federal Reserve, along with many economists and the media. Since 1976, the last five recessions, denoted by gray bars, were preceded by a flattening and inversion of the 2yr/10yr Treasury yield curve. Currently, the curve is sitting at a mere 17 basis points (0.17%) and threatening inversion.

While the 2yr/10yr curve is the most popular yield curve to follow, it can be somewhat limiting as it only applies to those that borrow and lend in the two and ten-year maturity sectors. For example, the 2yr/10yr curve is not as important for a bank considering using customer deposits to make five-year auto loans. In this case, the bank’s chief concern is likely the 3-month/5yr curve.

The next graph steps beyond the 2yr/10yr curve to examine many variations of Treasury curves and provide a broader perspective of the entire Treasury yield curve.

As shown, 70% of 10 important yield curves are inverted, up from 40% in early April.

With an understanding of the current state of the yield curves, we examine the profitability of lending to explain better why the yield curve has such a big effect on the economy.

The Profitability of Lending

There are essentially two ways that a bank or lender makes money lending. They can arbitrage time or credit, and most frequently they do both at the same time. Lenders employ time arbitrage when they borrow for short periods and lend that same money out for longer periods. Credit arbitrage occurs when a higher rated entity with a lower cost of capital borrows and then lends to a borrower with a lower credit standing and higher cost of capital.

Time Arbitrage: This is the oldest money-making trick in the book. It is frequently referred to as borrowing short and lending long. The risk to the lender of using time arbitrage is that short term borrowing rates rise in the future and effectively reduce or eliminate profits. An inverted yield curve, coupled with poor lending practices was the cause of the Savings and Loan crisis of 1987-1989.

The steeper the yield curve, the more potential profit, and the more incentive for a bank to borrow short and lend long. Conversely, the flatter the curve the less incentive. An inverted curve can lead to losses for lenders employing this strategy.

The key takeaway is that in an economy heavily dependent on the creation and refunding of debt, anything that detracts from a willingness to lend money causes economic weakness.

Credit Arbitrage: The riskier a borrower, the higher the interest rate to borrow money. Banks tend to be highly rated, thus allowing them to borrow at lower rates and then turn around and lend the money to lesser rated borrowers at higher rates. As the shape of the yield curve greatly affects time arbitrage, credit spreads play a big role in credit arbitrage. When spreads are tight, as they are now, the potential profit of lending is reduced, and therefore lenders are less incentivized to lend. Currently, credit spreads, as quantified by BBB-rated corporate bonds, are historically tight. Once default expectations are factored in the incentive to lend is minimal. 

Quantifying Profitability

With an understanding of the two predominant types of lender arbitrages, we now provide a rough estimate of banking profitability based on the 2yr/10yr yield curve as a proxy for time arbitrage and BBB-rated corporate OAS spreads as a proxy for credit arbitrage. The following graph combines the two measures of probability to quantify the incentive for banks to lend.

Not surprisingly, the most recent recessions occurred when profitability, using these measures collapsed. The current reading is at levels seen before the 2001 recession and slightly above those preceding the financial crisis of 2008.

Data Courtesy St. Louis Federal Reserve

Summary

Tax reform, hurricane/fire disaster relief and a surge in the government’s deficit all provided an economic boost over the last few years. As we have written in the past, these economic tailwinds will no longer meaningfully contribute to economic growth. Real gross domestic production (GDP) will likely shrink to its natural growth rate of 1.5-2.0%. However, flat to inverted yields curves and tight credit spreads are becoming a headwind to growth.

If the yield curves stay flat and/or flattens or inverts further and credit spreads remain tight, it is highly likely lending will be curtailed. Assuming this were to happen, we could be staring down the barrel of another recession, which is what the bond markets appear to be telegraphing. That is why the yield curve matters!

Value Your Wealth – Part Three: Sector Analysis

When we embarked on our Value Your Wealth series, we decided to present it using a top-down approach. In Parts One and Two, we started with basic definitions and broad analysis to help readers better define growth and value investment styles from a fundamental and performance perspective. With this basic but essential knowledge, we now drill down and present investment opportunities based on the two styles of investing.

This article focuses on where the eleven S&P sectors sit on the growth-value spectrum. For those that invest at a sector level, this article provides insight that allows you to gauge your exposure to growth and value better. For those that look at more specialized funds or individual stocks, this research provides a foundation to take that analysis to the next level.

Parts One and Two of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Sector Analysis

The 505 companies in the S&P 500 are classified into eleven sectors or industry types. While very broad, they help categorize the S&P companies by their main source of revenue. Because there are only eleven sectors used to define thousands of business lines, we must be acutely aware that many S&P 500 companies can easily be classified into several different sectors.

Costco (COST), for instance, is defined by S&P as a consumer staple. While they sell necessities like typical consumer staples companies, they also sell pharmaceuticals (health care), clothes, TVs and cars (discretionary), gasoline (energy), computers (information technology), and they own much of the property (real-estate) upon which their stores sit.

Additionally, there is no such thing as a pure growth or value sector. The sectors are comprised of many individual companies, some of which tend to be more representative of value and others growth.

As we discussed in Part Two, we created a composite growth/value score for each S&P 500 company based on their respective z-scores for six fundamental factors (Price to Sales, Price to Book, Price to Cash Flow, Price to Earnings, Dividend Yield, and Earnings Per Share). We then ranked the composite scores to allow for comparison among companies and to identify each company’s position on the S&P 500 growth-value spectrum. The higher the composite score, the more a company is growth oriented and the more negative the score, the more value-oriented they are.  

The table below summarizes the composite z-scores by sector.  To calculate this, we grouped each company based on its sector classification and weighted each company’s z-score by its market cap. Given that most indexes and ETFs/Mutual funds are market cap weighted, we believe this is the best way to arrange the sector index scores on the growth-value spectrum. 

Data courtesy Bloomberg

As shown, the Financial, Energy, and Utility sectors are the three most heavily weighted towards value.  Real-estate, Information Technology, and Consumer Discretionary represent the highest weighted growth sectors.

While it might be tempting to select sectors based on your growth-value preferences solely using the data in the table, there lies a risk. Some sectors have a large cross-section of both growth and value companies.  Therefore they may not provide you the growth or value that you think you are buying. As an example, we explore the communications sector.

The communications sector (represented by the ETF XLC) is a stark combination of old and new economy stocks. The old economy stocks are traditional media companies such as Verizon, Fox, CBS and News Corp. New economy stocks that depend on newer, cutting edge technologies include companies like Google, Facebook, Twitter, and Trip Advisor. 

As one might expect, the older media companies with more reliable earnings and cash flows are priced at lower valuations and tend to be defined as value stocks by our analysis. Conversely, the new economy companies have much higher valuations, are short on earnings, but come with the prospect of much higher growth potential.

The scatter plot below offers an illustration of the differences between growth, value and market capitalization within the communications sector. Each dot represents the intersection of market capitalization and the composite z-score for each company. The table below the scatter plot provides fundamental and performance data on the top three value and growth companies.

Data courtesy Bloomberg

As shown in the graph, the weighted average z-score (the orange circle) for the communications sector leans towards growth at +0.19. Despite the growth orientation, we deem 58% of the companies in the communications sector as value companies.

The following table compares the weighted average z-score for each S&P sector along with the variance of the underlying companies within the sector and the percentage of companies that are considered value and growth. We use standard deviation on the associated composite z-scores to determine whether companies are close together or far apart on the growth/value spectrum.  The lower the standard deviation, the more similar the companies are in terms of growth or value

Data courtesy Bloomberg

Again here, weightings, market capitalization, and the influence of individual stocks within a sector are important to understand The industrial sector, as shown above, has a score of +0.232, which puts it firmly in growth territory. However, Boeing (BA), due to its large market cap and significant individual growth score skews this sector immensely. Excluding BA, the weighted average composite score of the industrial sector registers as a value sector at -0.07. Again this highlights the importance of understanding where the growth and or value in any particular sector comes from.

Takeaways

The graph below shows the clear outperformance of the three most heavily growth-oriented sectors versus the three most heavily value-oriented. Since the beginning of the post-financial crisis, the three growth companies grew by an average of 480%, almost three times the 166% average of the three value companies.

This analysis provides you a basis to consider your portfolio in a new light. If you think the market has a few more innings left in the current expansion cycle, odds continue to favor a growth-oriented strategy. If you think the economy is late-cycle and the market is topping, shifting towards value may provide much-needed protection.  

While we believe the economic and market cycles are late stage, they have not ended. We have yet to receive a clear signal that value will outperform growth going forward. At RIA Advisors, growth versus value is a daily conversation, whether applied to sector ETF’s, mutual funds or individual stocks.  While we know it’s early, we also know that history has been generous to holders of value, especially after the rare instances when growth outperformed it over a ten-year period as it has recently.

Valuations, Returns & The Real Value Of Cash

Since the beginning of 2019, the market has risen sharply. That increase was not due to rising earnings and revenues, which have weakened, but rather from multiple expansion. In other words, investors are willing to pay higher prices for weaker earnings.

The issue, of course, is that while it may not seem to matter in the short-term, valuations matter a lot in the long-run.

I know what you are thinking.

“There is NO WAY cash will outperform stocks over the next decade.” 

I understand. After a decade-long market advance, it’s hard to fathom a period where stocks fail to perform. However, despite what you have been told, this time is not different, valuations do matter, and “no,” Central Banks do not have it all under control. (In reality, the Federal Reserve are the “Firemen” in Fahrenheit 451.)

While the media is rife with historical references about why you should only “buy and hold” investments over a 100-years, they tend to ignore the measures which dictate 5, 10, and 20-year investing cycles which have the greatest impact on most Americans.

Let me explain that.

Unless you have contracted “vampirism,” then you do NOT have 90, 100, or more, years to invest to gain “average historical returns.” Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.

What drives those 12-15 year periods of flat to little return? Valuations.

Despite commentary to the contrary, the evidence is quite unarguable. As shown in the chart below, the cyclical nature of valuations and asset prices is clear.

Not surprisingly, valuations are linked to future returns. This is as it should be, and why Warren Buffett once quipped:

“Price is what you pay. Value is what you get.” 

This is why over rolling 10- and 20-year periods you have stretches where investors make little or no money.

Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals. One great thing+ about valuations, such as CAPE, is that we can use them to form expectations around risk and return. The graph below shows the actual 20-year annualized returns that accompanied given levels of CAPE.

20-years is a long time for most investors. So, here is what happens to returns over a 10-year period from 30x valuations as we have currently.

Again, as valuations rise, future rates of annualized returns fall. This is math, and logic states that if you overpay today for an asset today future returns must, and will, be lower.

I know. Ten years is still long. How about 5-years?

We can reverse the analysis and look at the “cause” of excess valuations which is investor “greed.” As investors chase assets, prices rise. Of course, as prices continue to rise, investors continue to crowd into assets finding reasons to justify overpaying for assets. However, there is a point where individuals have reached their investing limit which leaves little buying power left to support prices. Eventually, prices MUST mean revert to attract buyers again.

The chart below shows household ownership of equities as a percent of household ownership of cash and bonds. (The scale is inverted and compared to the 5-year return of the S&P 500.)

Just like valuation measures, ownership of equities is also at historically high levels and suggests that future returns for equities over the next 5, 10, and 20-years will approach ZERO.

No matter how you analyze the data, the expected rates of return over the next decade will be far lower than the 8-10% annual return rates currently promised by Wall Street.

Every Year Won’t Be Zero

This is where things get confusing.

When you discuss a decade, or more, of near-zero returns it does NOT mean that every year will be ZERO.

During that period there is going to strong up years, an extremely bad year or two, then some more good years. In the end you average annual return for the past decade will be close to zero. (Here is an example of how that plays out.)

Or here is how it played out the last time we ran a large national debt, had high starting valuations, and had just finished a period of excessive investment accumulation. (1929-1948)

This is because there are only two ways in which valuations can revert to levels where future returns on investments rise.

  1. Prices can rapidly decline, or;
  2. Earnings can rise while prices remain flat.

Historically, option #2 has never been an outcome.

Michael Lebowitz explained why this is the case for our RIA PRO members (Try FREE For 30-days)

“The all-important link between stock prices, economic and productivity growth, and true corporate earnings potential are being ignored. Stock prices and many other investment asset prices are indirectly supported by the actions and opinions of the central banks. Investors have become dangerously comfortable with this dubious arrangement despite the enormous market disequilibrium it is causing. History reminds us time and again that a state of disequilibrium is highly unstable and will ultimately revert to equilibrium – often violently so.”

The Real Value Of Cash

For most of the last decade, the mantra was “T.I.N.A. – There Is No Alternative” because cash in the bank yielded ZERO.

Today that is no longer the case with money market yields now pushing 2%, or more, in many cases. Nonetheless, the belief was ingrained into the current investing generation that “cash” is a “bad” investment.

I do agree that if inflation is running higher than the return on cash, then you do lose purchasing parity power in the short-term. However, there is a huge difference between the loss of future purchasing power and the destruction of investment capital.

The chart below shows the inflation-adjusted return of $100 invested in the S&P 500 (using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller’s CAPE ratio. I have capped the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets in the past. Lastly, I calculated a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves to cash at a ratio of 23x.

(I would never recommend actually managing your portfolio this way, but this is for illustrative purposes.)

I have adjusted the value of holding cash for the annual inflation rate which is why during the sharp rise in inflation in the 1970’s there is a downward slope in the value of cash. While the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset concerning reinvestment may be different since asset prices are negatively impacted by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises.

While cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at low valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover.

We can debate over methodologies, allocations, etc., the point here is that “time frames” are crucial in the discussion of cash as an asset class. If an individual is “literally” burying cash in their backyard, then the discussion of loss of purchasing power is appropriate. Alternatively, if the holding of cash is a “tactical” holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future.

8-Reasons To Hold Cash

Over the last 30-years, I have that while a “rising tide lifts all boats,” eventually the “tide recedes.” I made one simple adjustment to my portfolio management over the years which has served me well. When risks begin to outweigh the potential for reward, I raise cash.

The great thing about holding extra cash is that if I’m wrong I make the proper adjustments to increase risk in portfolios. However, if I am right, I protect investment capital from destruction and spend far less time “getting back to even” and spend more time working towards my long-term investment goals.

Here are my reasons having cash is important.

1) We are not investors, we are speculators. We are buying pieces of paper at one price with an endeavor to eventually sell them at a higher price. This is speculation at its purest form. Therefore, when probabilities outweigh the possibilities, I raise cash. 

2) 80% of stocks move in the direction of the market. In other words, if the market is moving in a downtrend, it doesn’t matter how good the company is as most likely it will decline with the overall market.

3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb they all believed one thing – “Buy low and Sell High.” If you “Sell High” then you have raised cash. According to Harvard Business Review, since 1886, the US economy has been in a recession or depression 61% of the time. I realize that the stock market does not equal the economy, but they are somewhat related. 

4) Roughly 90% of what we’re taught about the stock market is flat out wrong: dollar-cost averaging, buy and hold, buy cheap stocks, always be in the market. The last point has certainly been proven wrong because we have seen two declines of over -50%…just in the past two decades! Keep in mind, it takes a +100% gain to recover a -50% decline.

5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this over and over again. 

6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also simply transfers the “risk of being wrong” from one side of the ledge to the other. Cash protects capital. Period. When a new trend, either bullish or bearish, is evident then appropriate investments can be made. In a “bull trend” you should only be neutral or long and in a “bear trend” only neutral or short. When the trend is not evident – cash is the best solution.

7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that by not “selling rich” you do not have the capital with which to “buy cheap.” 

8) Cash protects against forced liquidations. One of the biggest problems for Americans currently, according to repeated surveys, is a lack of cash to meet emergencies. Having a cash cushion allows for working with life’s nasty little curves it throws at us from time to time without being forced to liquidate investments at the most inopportune times. Layoffs, employment changes, etc. which are economically driven tend to occur with downturns which coincide with market losses. Having cash allows you to weather the storms. 

Importantly, I am not talking about being 100% in cash. I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.

With the fundamental and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important. 

Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop; reviewing cash as an asset class in your allocation may make some sense. Chasing yield at any cost has typically not ended well for most.

Besides, what’s the worse that could happen?

Has The Fed Done It? No More Recessions?

“Wow!”

That is all I could utter as my brain spun listening to an interview with Chamrath Palihapitiya on CNBC last week.

“I don’t see a world in which we have any form of meaningful contraction nor any form of meaningful expansion. We have completely taken away the toolkit of how normal economies should work when we started with QE. I mean, the odds that there’s a recession anymore in any Western country of the world is almost next to impossible now, save a complete financial externality that we can’t forecast.”

It is a fascinating comment particularly at a time where the Federal Reserve has tried, unsuccessfully, to normalize monetary policy by raising interest rates and reducing their balance sheet.  However, an almost immediate upheaval in the economy, not to mention reprisal from the Trump Administration, brought those efforts to a halt just a scant few months after they began.

A quick Google search on Chamrath revealed a pretty gruesome story about his tenure as CEO of Social Capital which will likely cease existence soon. However, his commentary was interesting because despite an apparent lack of understanding of how economics works, his thesis is simply that economic cycles are no longer relevant.

This is the quintessential uttering of “this time is different.” 

Economists wanting to get rid of recessions is not a new thing.

Emi Nakamura, this years winners of the John Bates Clark Medal honoring economists under 40, stated in an interview that she:

“…wants to tackle some of her fields’ biggest questions such as the causes of recessions and what policy makers can do to avoid them.”

The problem with Central Bankers, economists, and politicians, intervening to eliminate recessions is that while they may successfully extend the normal business cycle for a while, they are most adept at creating a “boom to bust” cycles.

To be sure the last three business cycles (80’s, 90’s and 2000) were extremely long and supported by a massive shift in financial engineering and credit leveraging cycle. The post-Depression recovery and WWII drove the long economic expansion in the 40’s, and the “space race” supported the 60’s.  You can see the length of the economic recoveries in the chart below. I have also shown you the subsequent percentage market decline when they ended.

Currently, employment and wage growth is fragile, 1-in-4 Americans are on Government subsidies, and the majority of American’s living paycheck-to-paycheck. This is why Central Banks, globally, are aggressively monetizing debt in order to keep growth from stalling out.

Despite a surging stock market and an economy tied for the longest economic expansion in history, it is also is running at the weakest rate of growth with the highest debt levels…since “The Great Depression.”  

Recessions Are An Important Part Of The Cycle

I know, I get it.

If you mention the “R” word, you are a pariah from the mainstream proletariat.

This is because people assume if you talk about a “recession” you mean the end of the world is coming.

The reality is that recessions are just a necessary part of the economic cycle and arguably an crucial one. Recessions remove the “excesses” built up during the expansion and “reset” the table for the next leg of economic growth.

Without “recessions,” the build up of excess continues until something breaks. The outcomes of previous attempts to manipulate the cycles have all had devastating consequences.

In the current cycle, the Fed’s interventions and maintenance of low rates for a decade have allowed fundamentally weak companies to stay in business by taking on cheap debt for unproductive purposes like stock buybacks and dividends. Consumers have used low rates to expand their consumption through debt once again. The Government has piled on debts and increased the deficit to levels normally seen during a recession. Such will only serve to compound the problem of the next recession when it comes.

However, it is the Fed’s mentality of constant growth, with no tolerance for recession, has allowed this situation to inflate rather than allowing the natural order of the economy to perform its Darwinian function of “weeding out the weak.”

The two charts below show both corporate debt as a percentage of economic growth and total system leverage versus the market.

Do you see the issue?

The fact that over the past few decades the system has not been allowed to reset has led to a resultant increase in debt to the point it has impaired the economy to grow. It is more than just a coincidence that the Fed’s “not-so-invisible hand” has left fingerprints on previous financial unravellings.

Given the years of “ultra-accommodative” policies following the financial crisis, the majority of the ability to “pull-forward” consumption appears to have run its course. This is an issue that can’t, and won’t be, fixed by simply issuing more debt which, for last 40 years, has been the preferred remedy of each Administration. In reality, most of the aggregate growth in the economy has been financed by deficit spending, credit creation, and a reduction in savings.

In turn, this surge in debt reduced both productive investments into, and the output from, the economy. As the economy slowed, and wages fell, the consumer was forced to take on more leverage which continued to decrease the savings rate. As a result, of the increased leverage, more of their income was needed to service the debt.

Since most of the government spending programs redistribute income from workers to the unemployed, this, Keynesians argue, increases the welfare of many hurt by the recession. What their models ignore, however, is the reduced productivity that follows a shift of resources from productive investment to redistribution.

All of these issues have weighed on the overall prosperity of the economy and what has obviously gone clearly awry is the inability for the current economists, who maintain our monetary and fiscal policies, to realize what downturns encompass.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the result, is clearly wrong. It has not happened in four decades. What is missed is that things like temporary tax cuts, or one time injections, do not create economic growth but merely reschedules it. The average American may fall for a near-term increase in their take-home pay and any increased consumption in the present will be matched by a decrease later on when the tax cut is revoked.

This is, of course, assuming the balance sheet at home is not broken. As we saw during the period of the “Great Depression” most economists thought that the simple solution was just more stimulus. Work programs, lower interest rates, government spending, etc. did nothing to stem the tide of the depression era.

The problem currently is that the Fed’s actions halted the “balance sheet” deleveraging process keeping consumers indebted and forcing more income to pay off the debt which detracts from their ability to consume. This is the one facet that Keynesian economics does not factor in. More importantly, it also impacts the production side of the equation since no act of saving ever detracts from demand. Consumption delayed, is merely a shift of consumptive ability to other individuals, and even better, money saved is often capital supplied to entrepreneurs and businesses that will use it to expand, and hire new workers.

The continued misuse of capital and continued erroneous monetary policies have instigated not only the recent downturn but actually 40-years of an insidious slow moving infection that has destroyed the American legacy.

Here is the most important point.

“Recessions” should be embraced and utilized to clear the “excesses” that accrue in the economic system during the first half of the economic growth cycle.

Trying to delay the inevitable, only makes the inevitable that much worse in the end.

The “R” Word

Despite hopes to the contrary, the U.S., and the globe, will experience another recession. The only question is the timing.

As I quoted in much more detail in this past weekend’s newsletter, Doug Kass suggests there is plenty of “gasoline” awaiting a spark.

  • Slowing Domestic Economic Growth
  • Slowing Non-U.S. Economic Growth
  • The Earnings Recession
  • The Last Two Times the Fed Ended Its Rate Hike Cycle, a Recession and Bear Market Followed
  • The Strengthening U.S. Dollar
  • Message of the Bond Market
  • Untenable Debt Levels
  • Credit Is Already Weakening
  • The Abundance of Uncertainties
  • Political Uncertainties and Policy Concerns
  • Valuation
  • Positioning Is to the Bullish Extreme
  • Rising Bullish Sentiment (and The Bull Market in Complacency)
  • Non-Conformation of Transports

But herein lies the most important point about recessions, market reversions, and systemic problems.

What Chamrath Palihapitiya said was both correct and naive.

He is naive to believe the Fed has “everything” under control and recessions are a relic of the past. Central Banks globally have engaged in a monetary experiment hereto never before seen in history. Therefore, the outcome of such an experiment is also indeterminable.

Secondly, when Central Banks launched their emergency measures, the global economies were emerging from a financial crisis not at the end of a decade long growth cycle. The efficacy of their programs going forward is highly questionable.

But what Chamrath does have right were his final words, even though he dismisses the probability of occurrence.

“…save a complete financial externality that we can’t forecast.”

Every financial crisis, market upheaval, major correction, recession, etc. all came from one thing – an exogenous event that was not forecast or expected.

This is why bear markets are always vicious, brutal, devastating, and fast. It is the exogenous event, usually credit related, which sucks the liquidity out of the market causing prices to plunge. As prices fall, investors begin to panic sell driving prices lower which forces more selling in the market until, ultimately, sellers are exhausted.

It is the same every time.

While investors insist the markets are currently NOT in a bubble, it would be wise to remember the same belief was held in 1999 and 2007. Throughout history, financial bubbles have only been recognized in hindsight when their existence becomes “apparently obvious” to everyone. Of course, by that point is was far too late to be of any use to investors and the subsequent destruction of invested capital.

This time will not be different. Only the catalyst, magnitude, and duration will be.

My advice to Emi Nakamura would be instead of studying how economists can avoid recessions, focus on the implications, costs, and outcomes of previous attempts and why “recessions” are actually a “healthy thing.” 

Value Your Wealth – Part Two: Quantifying the Value Proposition

This article is the second in a series focused on growth versus value investment styles and its significance to managing your wealth in the current environment. If you have not read Part One, we urge you to read it first as it provides a foundation upon which this article builds. If you already read Part One, it may be helpful to go back and review the fundamental definitions of growth and value.

Human behavior has demonstrated the willingness of investors to get caught up in the euphoria of financial bubbles. The history books are chock full of tales about investors chasing the prices of tulips, technology stocks, and real estate to stratospheric levels. The collective enthusiasm of such periods has a hypnotic way of lulling even the most astute investors into the belief that stocks have reached “a permanently high plateau” (prominent economist Irving Fisher, 1929).

Like seasons and tides, however, markets and human behavioral patterns are cyclical. Mean reversion, like change, is one thing we can all count on. As the analysis below will illustrate, we appear to be in another one of those euphoric periods.

In time, euphoria will turn to despair. It is with this knowledge that we continue to expose the current paradigm between growth and value stocks so that you can prepare for this inevitability. Those who seek to compound wealth are well-served to understand the current circumstances and the nature of the contrast between the two investment approaches.

Currently, the differences in their valuations and performance are extreme in both magnitude and duration. If we are to believe that the realities of the world in which we live have been permanently suspended and there will be no mean reversion, then we should proceed to do what we did yesterday. If we believe that this cycle too will end, then we need to understand what is at risk and strategize on how to protect ourselves.

The data which follows puts a much finer point on the extremes we are currently observing and therefore the risks we assume by failing to acknowledge them.

What Constitutes Growth and Value

After coming across compelling work articulated on Bloomberg by Nir Kaisser, we decided to look deeper into the contrast between growth and value stocks. In taking on this project, we had two problems. The first problem was deciding how to quantitatively define growth and value. The second problem was retrieving and processing the data required to fairly analyze these two broad categories.

To keep this analysis both simple and applicable, we chose to limit our analysis to the constituents of the S&P 500. We also decided to use the six fundamentals listed below to quantitatively define and screen between value and growth.

  • Price-to-Sales (P/S)
  • Price-to-Book (P/B)
  • Price-to-Cash Flow (P/CF)
  • Price-to-Earnings (P/E)
  • Dividend Yield (DY)
  • Earnings per Share (Trailing 12-Months) (EPS)

Growth companies tend to have higher price-to-sales, price-to-book, price-to-cash flow and earnings per share and lower (often zero) dividend yield. Value companies are the opposite.

Keep in mind, the S&P 500 accounts for roughly 80% of U.S. stock market capitalization and within that index, 100 of the largest companies in the United States reside firmly in either the growth or value category. They are the top 50 in growth and the top 50 in value (by our definition) selected based on the fundamentals as described above.

Growth vs. Value Analysis

Identifying companies within the S&P 500 that properly fit into either the growth or value category was done by evaluating the valuation metrics referenced above, ranking companies based on a standard deviation (z-score) for each metric, and then aggregating data to compute a composite z-score.

The z-score, which tells us how many standard deviations from the mean a specific number is, can be calculated by taking the company-specific reading in one category, subtracting it from the average for the S&P 500, and then dividing that number by the standard deviation for the total S&P 500. One standard deviation includes approximately 68% of the data.  To clarify, we provide the example below.

  • The price-to-sales (P/S) for Boston Scientific (BSX) is 4.94
  • The average P/S for the S&P 500 is 3.60
  • The standard deviation for P/S for the S&P 500 is 3.25 (~68% of the data has a P/S of 3.60 +/-3.25)
  • Therefore, BSX has a P/S z-score of 0.413 calculated as (4.94-3.60)/3.25
  • This tells us that BSX’s P/S is 0.413 standard deviations above the average (conversely, if the z-score had been -0.413 then BSX P/S would have been 0.413 below the average)
  • Based solely on its positive P/S z-score and above average P/S ratio, BSX can be defined as a growth company.

We performed the same analysis for each S&P 500 company and each of the six fundamental metrics listed above.  We then created a composite based on the six z-scores for each company and ranked them.

Of the 500 companies in the S&P 500, we selected the 50 companies with the highest z-score composite, those clearly demonstrating the characteristics of a growth company, and the 50 lowest z-score composites, which are companies that fit the characteristics of a value company.

Using the results of the z-score analysis, we also looked at the total rate of return over various time frames for those stocks in our growth and value identified sectors. Return figures are inclusive of dividends.

Results – Fundamentals

The data below shows the sharp contrast between the average metrics for the 50 growth stocks and the 50 value stocks.

Data courtesy Bloomberg

The next table contrasts this data in a z-score format for each metric. The z-score analysis provides the ability to compare the two styles and understand how the growth and value companies compare to the entire S&P 500. As a reminder, the higher or lower the z-score, the more it varies from the average.

Data courtesy Bloomberg

Results – Total Returns

To calculate returns for the top and bottom 50 stocks, we stretch a bit and assume that the 50 growth and value stocks identified today have been in that realm for the past ten years. While we know that is not entirely the case; it is not unreasonable to think both groups have been in the ballpark. The table below highlights the total returns of each group across various timeframes.

Data courtesy Bloomberg

Conclusions

The contrast in metrics between growth stocks and value stocks could not be starker. The differentials are incredibly large, which indicates one is either paying eye-watering prices for growth, or they are truly finding value in the value category. The total return performance over each time frame highlights the chasm between investor preferences for growth over value since the financial crisis.

Growth stocks have rewarded investors for taking risk and punished those with a tried and true value approach. While memories are nice, we remind you that as investors we must look forward. Value stocks provide a large cushion for error, whereas growth stocks are priced for a level of perfection not since the technology bubble. As long as the market remains euphoric, growth will likely continue to outperform value. However, when rationality strikes the market over the head, the ridiculous prices the market assigns to growth stocks will normalize. At the same time, investors will seek out boring companies with steady earnings and relatively cheap valuations that constitute the value sector.

Value Your Wealth – Part One Introduction

In this article and a series of others to follow, we explore the distinction between growth and value investment styles. Those looking in their rearview mirror will likely laugh at our analysis and focus on what worked yesterday. Those aware of the inevitable turns in the road ahead will understand the unique worth that a value-focused investment style offers.

We believe the market is on the precipice of a monumental shift, and one that will blindside most investors. Through this series of articles, we aim to provide research and investment ideas that will allow you to protect your wealth when the investment cycles shift and thrive when most investors suffer.    

Discipline, Process, and an Appreciation for Cycles

Spring has sprung, flowers are blooming, and pollen is swirling through the air. It’s time to put away our winter boots, scarves, and bulky jackets and replace them with swimming trunks, baseballs gloves and the promise of afternoon naps on the beach.

Investing also has its seasons. Economic and investment cycles alternate between periods where risk-taking and speculating is preferred and periods where conservatism and discrimination are essential. Unlike the seasons, there is no calendar that tells us when these investing cycles begin and end. Nevertheless, an appreciation for history along with an understanding of economic trends, valuations, demographics, and monetary and fiscal policy provides helpful clues.

Awareness of potential changes in economic and market cycles, however vague the timing is, allow us to strategize on how to reposition our portfolios when the change in season appears imminent. Because of vastly different investing environments and associated outcomes, success in building wealth over long time frames requires discipline and a durable investment process. It is important to ride the market higher in the good times, but we can’t stress enough the value of avoiding the inevitable large market drawdowns that erase wealth and the precious time you have to compound it. 

Value vs. Growth

The market’s surge higher since the financial crisis and the governmental and corporate policies used to sustain economic and market growth have been nothing short of extraordinary. In many articles, we discussed topics such as the unparalleled use of monetary policy to prop markets higher, massive fiscal spending designed to keep economic growth positive, how corporations have shunned future growth to buy-back stock, and the substantial shift towards passive investment styles.

As a result of these behaviors and actions, we have witnessed an anomaly in what has historically spelled success for investors. Stronger companies with predictable income generation and solid balance sheets have grossly underperformed companies with unreliable earnings and over-burdened balance sheets. The prospect of majestic future growth has trumped dependable growth. Companies with little to no income and massive debts have been the winners.

Over the past decade, investors have favored passive instruments that track a market or a large swath of the market. By doing so, they have easily outperformed active investors that are doing their homework and applying time-tested fundamental analysis to their investment selection process. This passive behavior is circular in nature and has magnified the growth/value imbalance. The investment world has been turned on its head.

The underperformance of value stocks relative to growth stocks is not unique, but the current duration and magnitude of underperformance are unprecedented. Before embarking on a more detailed discussion, a clear definition of what is meant by growth and value is important.

Growth- Growth stocks represent companies that have demonstrated better-than-average gains in sales and/or earnings in recent years and are expected to continue delivering high levels of profit growth. They are generally higher priced than the broad market in terms of their price-to-earnings and price-to-sales, and their stock prices tend to be more volatile. To help fuel earnings, growth stocks often do not pay out a dividend.

Growth stocks generally perform better when interest rates are falling and corporate earnings are robust. On the other hand, they are also most at risk of losses when the economy is cooling.

Value- A value stock tends to include companies that have fallen out of favor but still have good fundamentals such as dividends, earnings, and sales. Value stocks are lower priced than the broader market, are often priced below similar companies in their industry, and are perceived to carry less risk than the market.

Value stocks generally hold their value better in an economic slowdown, tend to do well early in an economic recovery, and frequently lag in a prolonged bull market. In general they pay above market dividends.

Historical Context – Growth vs. Value

It is important to understand which investment styles have been successful during the post-financial crisis era. Given that we are statistically and logically very likely nearing the end of the cycle, it is even more crucial to grasp what decades of investment experience through all sorts of economic and market climates, not just the last ten years, tells us should be successful in the future. 

The graph below charts ten year annualized total returns (dividends included) for value stocks versus growth stocks. The most recent data point representing 2018, covering the years 2009 through 2018, stands at negative 2.86%. This indicates value stocks have underperformed growth stocks by 2.86% on average in each of the last ten years.

The data for this analysis comes from Kenneth French and Dartmouth University.

There are two important takeaways from the graph above:

  • Over the last 90 years, value stocks have outperformed growth stocks by an average of 4.44% per year (orange dotted line).
  • There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.

To say the post-financial crisis era has been an anomaly is an understatement. The current five-year string of a negative trailing 10-year annualized return differential is the longest on record, and the most recent ten-year return ending last year is the lowest on record at NEGATIVE 2.86%.

When the cycle turns, we have little doubt the value-growth relationship will revert. As the graph above shows, seldom does such reversion stop at the average. To better understand why this is so important, consider what happens if the investment cycle turns and the relationship of value versus growth returns to the average over the next two years. In such a case value would outperform growth by nearly 30% in just two years. Anything beyond the average would increase the outperformance even more.

Summary

This article and the others to follow are not intended to implore you to immediately buy value and sell growth. They will, however, provide you with a road map that allows you to plan, strategize and use discipline in moving to a more conservative, value-based strategy if you so choose.

As mentioned, we will explore this topic in much more depth in coming articles. Already in the works are the following analyses: 

  • A stock screen that discerns between value and growth stocks.
  • A tool to help find funds and ETF’s that provide value versus those that use Value in their name but provide little value.
  • Sector analysis to steer you toward specific industries that tend to have more value stocks than growth stocks.

Value and growth are just two of the many factors to explore. In the future, we will also introduce and discuss others such as momentum and size.

We want to be astute stewards of wealth and safeguard our portfolios so that when the investing cycle comes to an end, we are prepared to take advantage of what the next season has in store. This will help ensure those naps on the beach are not dreams but reality.  

Trying To Be Consistently “Not Stupid”

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger

As described in a recent article, Has This Cycle Reached Its Tail, an appreciation for where the economy is within the cycle of economic expansion and contraction is quite important for investors. It offers a gauge, a guidepost of sorts, to know when to take a lot of risk and when to take a conservative approach.

This task is most difficult when a cycle changes. As we are in the late innings of the current cycle, euphoria is rampant, and everyone is bullish. During these periods, as risks are peaking, it is very challenging to be conservative and make less than your neighbors. It is equally difficult taking an aggressive stance at the depths of a recession, when risk is low, despair is acute, and everyone is selling.

What we know is that a downturn in the economy, a recession, is out there. It is coming, and as Warren Buffett’s top lieutenant Charlie Munger points out in the quote above, successful navigation comes down to trying to make as few mistakes as possible.

The Aging Expansion

In May 2019, the current economic expansion will tie the expansion of 1991-2001 as the longest since at least 1857 as shown below. 

Since gingerly exiting the financial crisis in June 2009, the economy has managed to maintain a growth trajectory for ten years. At the same time, it has been the weakest period of economic growth in the modern era but has delivered near-record gains in the stock market and significant appreciation in other risk assets. The contrast between those two issues – weak growth and record risky financial asset appreciation make the argument for caution even more persuasive at this juncture.

Although verbally reinforcing his optimistic outlook for continued economic growth, Federal Reserve (Fed) Chairman Jerome Powell and the Federal Open Market Committee (FOMC) did not inspire confidence with their abrupt shift in monetary policy and economic outlook over the past three months.

The following is a list of considerations regarding current economic circumstances. It is a fact that the expansion is “seasoned” and quite long in the tooth, but is that a reason to become cautious and defensive and potentially miss out on future gains? Revisiting the data may help us avoid making a mistake or, in the words of Munger, be “not stupid.”

1. Despite the turmoil of the fourth quarter, the stock market has rebounded sharply and now sits confidently just below the all-time highs of September 2018. However, a closer look at the entrails of the stock market tells a different story. Since the end of August 2018, cyclically-sensitive stocks such as energy, financials, and materials all remain down by roughly 10% while defensive sectors such as Utilities, Staples and Real Estate are up by 7%.

2. Bond markets around the world are signaling concern as yields are falling and curves are inverting (a historically durable sign of economic slowdown). The amount of negative yielding bonds globally has risen dramatically from less than $6 trillion to over $10.5 trillion since October 2018. Since March 1, 2019, 2-year U.S. Treasury yields have dropped by 35 basis points (bps), and 10-year Treasury yields have fallen by 40 bps (a basis point is 1/100th of a percent). 2-year Treasury yields (2.20%) are now 0.30% less than the upper-bound of the Fed Funds target rate of 2.50%. Meanwhile, three-month Treasury-bill yields are higher than every other Treasury yield out to the 10-year yield. This inversion signals acute worry about an economic slowdown.

3. Economic data in the United States has been disappointing for the balance of 2019. February’s labor market added just 20,000 new jobs compared with an average of +234,000 over the prior 12months. This was the first month under +100,000 since September 2017. Auto sales (-0.8%) were a dud and consumer confidence, besides being down 7 points, saw the sharpest decline in the jobs component since the late innings of the financial crisis (Feb 2009), reinforcing concerns in the labor market. Retail sales and the Johnson Redbook retail data also confirm a slowing/weakening trend in consumer spending. Lastly, as we pointed out at RIA Pro, tax receipt growth is declining. Not what one would expect in a robust economy.

4. As challenging as that list of issues is for the domestic economy, things are even more troubling on a global basis. The slowdown in China persists and is occurring amid their on-going efforts to stimulate the economy (once again). China’s debt-to-GDP ratio has risen from 150% to 250% over the past ten years, and according to the Wall Street Journal, the credit multiplier is weakening. Whereas 1 yuan of credit financing used to produce 3.5 yuan of growth, 1 yuan of credit now only produces 1 yuan of growth. In the European Union, a recession seems inevitable as Germany and other countries in the EU stumble. The European Central Bank recently cut the growth outlook from 1.9% to 1.1% and, like the Fed, dramatically softened their policy language. Turbulence in Turkey is taking center stage again as elections approach. Offshore overnight financing rates recently hit 1,350% as the Turkish government intervened to restrict the outflow of funds to paper over their use of government reserves to prop up the currency.

5. The Federal Reserve (and many other central banks) has formalized the move to a much more dovish stance in the first quarter. On the one hand applauding the strength and durability of the U.S. economy as well as the outlook, they at the same time flipped from a posture of 2-3 rate hikes in 2019 to zero. This shift included hidden lingo in the recent FOMC statement that appears to defy their superficial optimism. The jargon memorialized in the FOMC statement includes a clear signal that the next rate move could just as easily be a cut as a hike. Besides the dramatic shift in rate expectations, the Fed also downgraded their outlook for growth in 2019 and 2020 and cut their expectations for unemployment and inflation (their two mandates). Finally, in addition to all of that, they formalized plans to halt balance sheet reductions. The market is now implying the Fed Funds rate will be cut to 2.07% by January 2020.

Summary

Based on the radical changes we have seen from the central bankers and the economic data over the past six months, it does not seem to be unreasonable to say that the Fed has sent the clearest signal of all. The questions we ask when trying to understand the difference between actions and words is, “What do they know that we do not”? Connecting those dots allows us to reconcile the difference between what appears to be an inconsistent message and the reality of what is written between the lines. The Fed is trying to put a happy face on evolving circumstances, but you can’t make a silk purse out of a sow’s ear.

The economic cycle appears to be in the midst of a transition. This surprisingly long expansion will eventually end as all others have. A recession is out there, and it will make an appearance. Our job is not guessing to be lucky; it is to be astute and play the odds.

Reality reveals itself one moment at a time as does fallacy. Understanding the difference between the two is often difficult, which brings us back to limiting mistakes. Using common sense and avoiding the emotion of markets dramatically raises one’s ability “to be consistently not stupid.” A lofty goal indeed.

Videocast- Has The Cycle Reached Its Tail?

On March 20th we published Has This Cycle Reached Its Tail? With the help of a badly drawn bird, the article described the economic and market cycle of the last ten years. Through an understanding of cycles and importantly, where we are in within a cycle, investors are provided clues on how to position our portfolios for what the cycle has in store.

We believe the current economic cycle is close to a turning point. This is incredibly important to managing wealth, as such we produced the following video that dives further into cycles.

View Part 1

View Part 2

Has This Cycle Reached Its Tail?

We asked a few friends what the picture below looks like, and most told us they saw a badly drawn bird with a wide open beak. Based on the photograph below our colorful bird, they might be on to something. 

As you might suspect, this article is not about our ability to graph a bird using Excel. The graph represents the current bull market and economic cycle as told by the yield curve and investor sentiment.

As the picture is almost complete, the bird provides a clue to where we are in the current cycle and when the next cycle may begin. For investors, one of the most important pieces of information is understanding where we are in the economic cycle as it offers a critical gauge in risk-taking.

Cycles

Economic Cycles- Economic cycles are frequently depicted with a sine wave gyrating above and below a longer-term trend line. Throughout history, economic cycles include periods where economic growth exceeds its potential as well as the inevitable busts when slower than potential growth occurs.  Most often cycles track a trend line, oscillating above and below it, but spend little time at the trend other than passing through it.

Boom and bust periods occur because economic activity is governed by human behavior. In other words, our spending habits are erratic because we are subject to bouts of optimism and pessimism about the economy, our financial prospects and a host of other non-financial issues.

The graph below shows the sine wave-like quality of U.S. GDP growth, which has wavered above and below trend growth for decades. 

Data Courtesy: St. Louis Federal Reserve (FRED)

Stock Market Cycles- Stock markets also follow a pattern that is well correlated to economic cycles. Strong economic activity results in investor optimism. During these periods, investors tend to believe that rising economic growth and strong corporate profits are long-lasting. As such they are prone to extrapolate these shorter-term trends over longer periods. Investors temporarily forget that periods of above-average growth will inevitably be met with periods of below-average growth. During bust periods, these mistakes are corrected and often over-corrected.

Implied volatility is a great measure of aggregate investor sentiment. It measures the expected market movement as determined by the supply and demand for options. When investors are optimistic about future returns, they tend to neglect to hedge in the options market. The sustained and methodical reduction in options pricing causes implied volatility to decline. In recent years, ETF’s and professional strategies whose objectives were to be short volatility steadily gained in popularity and helped push implied volatility down. Conversely, when investors grow concerned over higher valuations, they hedge more frequently using options and drive implied volatility higher.

Yield Curve Cycles- The yield curve also takes on a similar path that tends to mirror economic cycles. When the economic cycle portends strong growth, the yield curve steepens. That is to say, the difference between longer and shorter maturity yields rises. This occurs as investors in longer maturity bonds become increasingly concerned with the potential for rising inflation resulting from stronger economic growth.

When strong growth spurs inflation expectations or actual inflation rises, the Fed begins to take action. To combat rising price expectations, they tighten policy with a higher Fed Funds rate. Shorter-term bond yields follow the Fed Funds rate closely, and as the Fed tries to dampen growth, the yield curve flattens. In that instance, longer-term investors are comforted by the Fed actions. This causes longer maturity yields to rise by less than those of shorter maturity yields, or it can help push longer maturity yields lower on an outright basis.

A steeper yield curve increases the incentive to lend and generates more economic growth while a flatter curve reduces the incentive and slows economic growth. The graph below shows how an inverted yield curve, where the yield on a  2-year U.S Treasury note is higher than that of a 10-year U.S. Treasury note, has paved the way for every recession since at least 1980.

Data Courtesy: St. Louis Federal Reserve (FRED)

The Bird is the Word

The graph below shows a scatter plot of the relationship between implied volatility as represented by spot VIX and the 3-month to 10-year yield curve spread. With proper context, you can see the bird is a graph depicting the most recent cycle of stock market optimism (VIX) and the economic growth cycle (yield curve). The graph uses monthly periods encompassing two -year averages to smooth the data and make the longer-term trends more apparent.

Data Courtesy: St. Louis Federal Reserve (FRED)

When we started on this project, we expected to see an oval shaped figure, slanting upward and to the right. Despite the irregularities of the “beak” and “front legs,” that is essentially what we got.

The blue triangle on the bottom-left is the first data point, representing the average VIX and yield curve spread from January 2006 through December of 2007. The years 2006 and 2007 were the economic peak of the prior market cycle. As shown, the two-year average progresses forward month-by-month and moves upward and to the right, meaning that VIX was increasing while the yield curve was steepening. In this period, the yield curve steepened as the Fed began rapidly reducing the fed funds rate in mid-2007. Likewise, VIX started spiking thereafter as the recession and financial crisis began to play out.

The gray and yellow segments on the graph reflect the decline in volatility as the financial crisis abated. Since 2010, the yield curve steadily flattened, and volatility fell to record lows. The one real break to the cycle trend was the “bird leg,” or the periods including 2013 when the yield curve steepened amid the taper tantrum. After that period, the oval-cycle pattern resumed. The red circle marks the most recent monthly data points and shows us where the trend is headed.

Interestingly, note that the number of dots forming the belly of the bird is much greater than those forming the back. This is typical as the expansionary portion of economic and market cycles tend to last five to ten years while market declines and recessions are usually limited to two or three years.

Summary

Think of the economy and stock market as a long-distance runner. At times they may pick up the pace for an extended period, but in doing so, they will inevitably overexert themselves and then must spend a period of time running at a below average pace. 

The stock market has been outrunning economic growth for a long time. This is witnessed by valuations that have surged to record highs. The yield curve is quite flat and volatility, despite spiking twice over the last year, currently resides well below the long-term average and not far from record lows. The current trajectory, as shown with the dotted red arrow in the chart above, is on a path towards the peak of the prior cycle.

The Fed has recently made a dovish (no pun intended) policy U-turn and appears to be on the path to lower rates. This likely means that the curve flattening is nearing an end and steepening is in the cards. At the same time, the market is showing signs of topping as witnessed by two large drawdowns and spikes in implied volatility over the last 15 months.

Based on the analysis above, it appears that the current cycle is close to completion. It is, however, but one piece of information. To borrow from Howard Marks, author of the book Mastering Market Cycles, he states the following:

While they may not know what lies ahead, investors can enhance their likelihood of success if they base their actions on a sense for where the market stands in its cycle….there is no single reliable gauge that one can look to for an indication of whether market participants’ behavior at a point in time is prudent or imprudent.  All we can do is assemble anecdotal evidence and try to draw the correct inferences from it.

We concur and will use the “bird” as evidence that the cycle is mature.

10-Investing Axioms Every Investor Should Learn

Martin Tarlie of GMO just recently wrote a great piece on the issue of the current U.S. Stock Market Bubble asking the question of whether or not it has finally burst. To wit:

“A new model explains this dichotomy between price action and fundamentals by suggesting that a bubble in the U.S. stock market started inflating in early 2017, and continued to inflate through the third quarter of 2018. In the fourth quarter, however, indications were that the bubble had started to deflate. And when bubbles deflate, they generally do so with a volatility bang.” 

The primary premise is one of “mean reversions” particularly from elevated levels of valuations. These reversions are simply the liquidation of the excesses built up during the previous bull market cycle. The chart below shows the secular cycles of the market going back to 1871 adjusted for inflation. As Martin notes, current valuations, while lower than the 2000 peak, are still at levels seen only rarely in history. As I discussed just recently, new “secular” bull markets are not launched from such lofty levels.

As Martin concludes:

“The Bubble Model teaches us that bubbles form when times are good – high valuation – and expected to get even better – changes in sentiment are positive. Bubbles burst when changes in sentiment – not level out – turn negative. 

Given that valuation is still high, our advice, consistent with our portfolio positions, is to continue to own as little U.S. equity as career risk allows.”

Since Martin is most likely correct in his assumptions, here are 10-basic investment rules which have historically kept investors out of trouble over the long term. These are not unique by any means but rather a list of investment rules that in some shape, or form, has been uttered by every great investor in history.


1) You Are A “Saver” – Not An Investor

Saving

Unlike Warren Buffet who takes control of a company and can affect its financial direction – you are speculating that a purchase of a share of stock today can be sold at a higher price in the future. Furthermore, you are doing this with your hard earned savings. If you ask most people if they would bet their retirement savings on a hand of poker in Vegas they would tell you “no.” When asked why, they will say they don’t have the skill to be successful at winning at poker. However, on a daily basis, these same individuals will buy shares of a company in which they have no knowledge of operations, revenue, profitability, or future viability simply because someone on television told them to do so.

Keeping the right frame of mind about the “risk” that is undertaken in a portfolio can help stem the tide of loss when things inevitably go wrong. Like any professional gambler – the secret to long term success was best sung by Kenny Rogers; “You gotta know when to hold’em…know when to fold’em.”


2) Don’t Forget The Income

Investment

An investment is an asset or item that will generate appreciation OR income in the future. In today’s highly correlated world, there is little diversification left between equity classes. Markets rise and fall in unison as high-frequency trading and monetary flows push related asset classes in a singular direction. This is why including other asset classes, like fixed income which provides a return of capital function with an income stream, can reduce portfolio volatility. Lower volatility portfolios will consistently outperform over the long term by reducing the emotional mistakes caused by large portfolio swings.


3) You Can’t “Buy Low” If You Don’t “Sell High”

Buy-Low-Sell-High-Rogers

Most investors do fairly well at “buying,” but stink at “selling.” The reason is purely emotional driven primarily by “greed” and “fear.” Like pruning and weeding a garden; a solid discipline of regularly taking profits, selling laggards and rebalancing the allocation leads to a healthier portfolio over time.

Most importantly, while you may “beat the market” with “paper profits” in the short term, it is only the realization of those gains that generate “spendable wealth.”


4) Patience And Discipline Are What Wins

Patience-and-Dicipline

Most individuals will tell you they are “long-term investors.” However, as Dalbar studies have repeatedly shown investors are driven more by emotions than not. The problem is that while individuals have the best of intentions of investing long-term, they ultimately allow “greed” to force them to chase last year’s hot performers. However, this has generally resulted in severe underperformance in the subsequent year as individuals sell at a loss and then repeat the process.

This is why the truly great investors stick to their discipline in good times and bad. Over the long term – sticking to what you know, and understand, will perform better than continually jumping from the “frying pan into the fire.”


5) Don’t Forget Rule No. 1

2-rules-Warren-Buffett

As any good poker player knows – once you run out of chips you are out of the game. This is why knowing both “when” and “how much” to bet is critical to winning the game. The problem for most investors is that they are consistently betting “all in, all of the time.”

The “fear” of missing out in a rising market leads to excessive risk buildup in portfolios over time. It also leads to a violation of the simple rule of “sell high.”

The reality is that opportunities to invest in the market come along as often as taxi cabs in New York City. However, trying to make up lost capital by not paying attention to the risk is a much more difficult thing to do.


6) Your Most Irreplaceable Commodity Is “Time.”

Time-vs-Money

Since the turn of the century, investors have recovered, theoretically, from two massive bear market corrections. After 15 years, investors finally got back to where they were in 2000,.

Such is a hollow victory considering that 15-years to prepare for retirement are now gone. Permanently.

For investors getting back to even is not an investment strategy. We are all “savers” that have a limited amount of time within which to save money for our retirement. If we were 15 years from retirement in 2000 – we are now staring it in the face with no more to show for it than what we had over a decade ago. Do not discount the value of “time” in your investment strategy.


7) Don’t Mistake A “Cyclical Trend” As An “Infinite Direction.”

The-trend-is-your-friend

There is an old Wall Street axiom that says the “trend is your friend.”  Unfortunately, investors repeatedly extrapolate the current trend into infinity. In 2007, the markets were expected to continue to grow as investors piled into the market top. In late 2008, individuals were convinced that the market was going to zero. Extremes are never the case.

It is important to remember that the “trend is your friend.” That is as long as you are paying attention to it and respecting its direction. Get on the wrong side of the trend, and it can become your worst enemy.


8) Success Breeds Over-Confidence

Overconfidence

 Individuals go to college to become doctors, lawyers, and even circus clowns.  Yet, every day, individuals pile into one of the most complicated games on the planet with their hard earned savings with little, or no, education at all.

For most individuals, when the markets are rising, their success breeds confidence. The longer the market rises; the more individuals attribute their success to their own skill. The reality is that a rising market covers up the multitude of investment mistakes that individuals make by taking on excessive risk, poor asset selection or weak management skills.  These errors are revealed by the forthcoming correction.


9) Being A Contrarian Is Tough, Lonely & Generally Right.

Howard Marks once wrote that:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

The best investments are generally made when going against the herd. Selling to the “greedy,” and buying from the “fearful,” are extremely difficult things to do without a very strong investment discipline, management protocol, and intestinal fortitude. For most investors the reality is that they are inundated by “media chatter” which keeps them from making logical and intelligent investment decisions regarding their money which, unfortunately, leads to bad outcomes.


10) Comparison Is Your Worst Investment Enemy

paint-dry

The best thing you can do for your portfolio is to quit benchmarking against a random market index that has absolutely nothing to do with your goals, risk tolerance or time horizon.

Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus.

If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that ‘everyone else’ made 14%, you have made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy. Money in motion creates fees and commissions. The creation of more and more benchmarks and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.

The only benchmark that matters to you is the annual return that is specifically required to obtain your retirement goal in the future.  If that rate is 4%, then trying to obtain 6% more than doubles the risk you have to take to achieve that return. The end result of taking on more risk than necessary will be the deviation away from your goals when something inevitably goes wrong.


It’s All In The Risk

Robert Rubin, former Secretary of the Treasury, changed the way I thought about risk when he wrote:

“As I think back over the years, I have been guided by four principles for decision making.  First, the only certainty is that there is no certainty.  Second, every decision, as a consequence, is a matter of weighing probabilities.  Third, despite uncertainty we must decide and we must act.  And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty.  They assume they’re lucky, and that the unpredictable can be reliably forecast.  This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty.  If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each.  Then, on that basis, you can make a good decision.”

It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach goes beyond that.  For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it.  Another benefit of “acknowledged uncertainty” is it keeps you honest.  A healthy respect for uncertainty, and a focus on probability, drives you never to be satisfied with your conclusions.  It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.

The reality is that we can’t control outcomes; the most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

Interview: No…Really…Open Your Statements

Last week, my dear friends at Fox26 Houston, Melissa Wilson and Tom Zizka, shared a few minutes with me to discuss the plunge in the markets, the drop in oil prices and how big of a correction there could be.

Importantly, as I have been writing from some time now, is that the dynamics of the market have changed. Since the financial crisis lows, the financial markets have been elevated by repeated rounds of artificial liquidity from the Federal Reserve combined with artificially suppressed interest rates.

SP500-QE-012016-2

With the Federal Reserve now trying to lift interest rates, and with no more injections of liquidity currently, the markets have begun to struggle. Combine that lack of support with weak economic data, deteriorating economic data, and decline corporate profitability and you have the same ingredients that have preceded both previous bull market peaks.

Could this time be different? Sure. However, history suggests that it likely won’t be.

If I am correct, this is NOT the time to avoid paying attention to your money. Throughout history, the market has spent more time getting “back to even” than making new highs.

SP500-RecordHighs-010615

While the market has no expiration data, unfortunately you do. Therefore, you really can’t afford to spend the majority of saving and investing time frame repeatedly trying to get back to even.

There are indeed times that you want to be heavily invested in the financial markets. However, now is not likely one of them.

Pay attention to your money.  If you don’t, why should any one else?

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter and Linked-In

Interview: Bad Start For Stocks

On Monday, my new friend Scarlett Fakhar from Fox 26 came to visit me during my radio show broadcast to discuss the market rout and the what investors should be doing now.


Following Monday’s sell-off, the markets were unable to gain any traction yesterday. The lack of a rebound suggests that market dynamics still remain extremely weak.

As discussed yesterday, there is critical support sitting just below the market currently. If that support fails to hold by the close of trading of Friday, there is likely to be an acceleration to the downside.

SP500-MarketUpdate-010516-3

Importantly, as I discussed in the interview with Scarlett, what investors need to remember is that after 6-years of a bull market advance, the risk of a correction has risen markedly. Given that roughly 95% of any bull market advance is simply making up previous losses, maybe investors should consider trying to avoid some of the losses before they occur.

SP500-RecordHighs-010615

As Chuck Prince, former head of Citigroup, said, 

“As long as the music is playing, you’ve got to get up and dance. We are still dancing.”

The thing the majority of investors tend to forget is that eventually the music stops playing. It is when everyone stops dancing that the tipping point is reached. When the trend is reversed, from bullish to bearish, the market action becomes self-reinforcing in the opposite direction.

As I state in the interview, the problem for most investors who are chasing market returns is most won’t realize the music has stopped playing. For most, the issue of spending the next bull market making up losses, yet again, will leave many far short of the retirement goals they had hoped for.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter and Linked-In