Tag Archives: stock valuations

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, 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.


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. 

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.  


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. 

Quick Take: The Treasury Bill Yield Curve Says A Recession Is Imminent

We have discussed yield curves in quite a few commentaries and articles over the last few months. The reason we stress the topic is that yield curve inversions are not only uncommon, but their occurrence is highly correlated with recessions.

Typically, when people use the phrase “the yield curve,” they are referring to the 10 year/2 year Treasury curve spread. While that curve is important, there are other curves that are predictive of future Fed rate policy as well as the prospects of a coming recession.

For example, the graph below shows the 6month/3month Treasury bill curve. Because the maturities making up this curve are so short, its usefulness is in providing an outlook for what the Fed might do and how soon they might do it.

As shown above, the 6m/3m curve now sits at negative 13 basis points, meaning 6 month T-bills now yield .13% less than 3 month T-bills. The 3 month bill is currently priced at a yield of 2.26 which is about 14 basis points below where it traded earlier this year prior to when the market thought the Fed would ease in 2019.  

Given the yield decline, the timing of the Fed’s meetings, and the term to maturity, the current 3 month bill implies nearly a 100% chance that the Fed will reduce rates by 25 basis points at the July 31st meeting. The yield on the 6 month bill implies the same rate cut plus a 50% chance of another rate cut at the September 18th meeting which is the next meeting after the July 31st meeting.

Essentially the graph highlights that the last two recessions occurred shortly before or after the T-bill market implied a greater than 50% chance of consecutive rate cuts by the Fed, as it is now.

The bond markets for the moment are signaling that a recession is imminent as the chances of Fed rate cuts becomes more likely by the day. At the same time, the stock market appears to think that easier Fed policy will protect the value of the stock market. Based on historical precedence and current valuations in stocks and bonds, we would argue they cannot both be right.

Six of the last seven times the Fed has lowered rates a recession followed. August of 1998, the one instance it did not occur, was Fed action to minimize the effect of the failure of Long Term Capital Management, one of the world’s largest hedge funds at the time. It is worth noting, their actions, along with Y2K spending, likely forestalled the recession which followed two years later. 

The table below shows the previous seven times the Fed reduced rates by 75 basis points or more and the maximum drawdowns that occurred in the S&P 500 over various time frames.  Needless to say, heed the message of the bond market and trade with care.

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.  


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.


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.


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.

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.


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.

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


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.


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.  

Sailing Versus Rowing : Active Versus Passive

Investor preferences shift between active and passive investing in a cyclical manner. Periods where the market has a strong tailwind of momentum behind it tend to attract a greater demand for passive strategies especially when that momentum carries on for a prolonged period of time. Alternatively, periods of market turbulence tend to swing sentiment back to active investing as a means of avoiding the risk of large losses. In the most recent bullish cycle the combination of market direction and the availability of index-friendly instruments like exchange-traded funds (ETFs) have resulted in an unprecedented shift towards passive strategies and securities.

To clarify the difference between the two investment approaches, active investing seeks to outperform the market by beating a benchmark such as the Dow Jones Industrial Average or the Barclays Aggregate bond index. Passive investing on the other hand pursues a strategy that mimics a benchmark index and attempts to replicate its performance. It is a contrast that has been effectively described by Ed Easterling of Crestmont Research as rowing (active) versus sailing (passive). Active investors are engaged in constant evaluation of companies and their fundamentals as means of finding value investment opportunities while passive investors are at the grace (or mercy) of the winds of the market wherever they may blow.

The graph below highlights the underperformance of active strategies versus the S&P 500 index in past years which further explains the growing popularity of passive investing.

This article is primarily focused on fixed-income passive investing, however, many of the issues brought up in this article can be applied to most asset class ETFs and securities that allow ease of passive investing.

How Passive Investing Works

The mechanics of passive investing in the stock market are straight-forward. Select an equity index to which you would like to gain exposure, for example the S&P 500 or the MSCI China Index, and then buy the stocks in the proper amounts that are tracked in that index to replicate the performance. Done manually this can be a complex and cumbersome exercise especially when trying to replicate the index of a less-liquid market. As the market moves and the value of the securities underlying the index change, one must rebalance their holdings to remain aligned with the index. For a deeper understanding of the many factors that make replicating an index diffiuclut please read our article The Myths of Stocks for the Long Run Part V.

The advent of index mutual funds and more recently exchange-traded funds handle the complexities of multiple holdings, weightings, and rebalancing allowing an investor to simply pay a small fee, buy a ticker and essentially own an index. An investor’s ability to obtain general equity exposure or to build a portfolio with customized exposures has never been easier with the  proliferation of ETFs.

To offer some perspective about just how many ETFs are available, consider there are 38 ETFs available that are focused on U.S. energy stocks and over 132 ETF’s hold Exxon Mobil (XOM) shares. Looking abroad to less liquid markets, one would find ten U.S. incorporated funds holding Indian stocks. The simplicity and customizability currently offered in the market is quite powerful.

Bond Exposure

Traditionally, investors gained exposure to bonds through individual debt securities offered by brokers. Unlike stocks, the availability of most bonds, not including U.S. Treasuries, is dependent upon the inventory held by one’s broker or their ability to source a bond from another broker. As such, finding a specific bond is more challenging and comes at a higher cost for an individual investor than buying an individual stock. A similar problem can emerge in the event an investor wants to sell a specific bond. This problem results in an indirect fee called the bid/offer spread and on occasion can cost the investor multiple percentage points.

There are other considerations related to the dynamics of buying individual bonds versus acquiring bond exposure through a fund. These issue are well-articulated by Lance Roberts.

The advent of index mutual funds and ETFs relieves much of the frustration and high costs of buying and selling specific bonds.

The protocol described in selecting equity funds above is similar for bonds in that one can identify investment preferences in various major bond categories quite easily. The primary categories include:

  • Treasuries securities
  • Mortgage-backed securities, asset-backed securities and collateralized debt obligations
  • Agency bonds
  • Municipal bonds
  • Investment Grade corporate bonds
  • High yield corporate bonds
  • Emerging market bonds
  • Developed nations sovereign bonds

It is relatively easy, through these funds, to quickly gain exposure that tracks an index covering any variety of these options and specific sub-catagories of these options.

Not As Advertised

The flexibility and customizability offered through the world of index mutual funds and ETFs is remarkable. As such, there is a natural inclination by investors to assume that one will get precisely what has been advertised by these funds. However, confidence in that idea is easily challenged. Much of what has been developed over the past several years, especially with many ETFs, remains untested. The following are concerns investors should be aware of:

  • Tracking Error: ETF exposures to certain markets might not be precisely what the investor receives. For example, it has been documented that an investor who wishes to invest in an ETF for the equity market in Spain actually gets exposure to a variety of companies that although domiciled in Spain, produce most of their revenue outside that country. In that instance, and many others like it, an investor would not get the exposure to Spain he or she expects and may indeed be very disappointed in the ETFs tracking of the index for Spain.
  • Optimization: The structure of index funds and ETFs are such that in many cases the fund managers are only able to establish positions in the underlying stocks or bonds of the indexes they track with some imprecision. This means they will use creative means of gaining desirable exposures and then gradually, if possible, reposition over time in order to more closely track the index. This tends to be a much bigger problem for bond funds. Since full replication of a bond index is generally not possible, bond funds rely on “optimizing” the portfolio in order to most effectively replicate the index.

Bond offerings, like stocks, are finite so if the size of a fund grows as a percentage of the underlying index constituents, it will increasingly face the constraint of replicating the index and effectively mimicking index performance.  Optimization is imperfect so the ETF will suffer performance drift from the target index. Unfortanately, the flaws of replicating are often exagerated during periods of market stress when investors expectations are the highest.

  • Underlying Liquidity: Another related issue that arises with bond funds is that of establishing daily market value. The market price of some bonds held in a fund, especially those that are investing in less liquid markets, may not be readily available. If a bond fund holds securities that are illiquid, meaning they do not trade very often, then a realistic current price may be difficult to obtain. Many fixed income ETFs hold thousands of securities some of which do not trade daily or even weekly. This means that pricing is dependent upon estimates of the value on those bonds. These estimates of value may be derived from a third-party pricing service, surveys of bond market trading desks and internally generated models. Mis-pricing of securities is a known problem and one not typically considered until the fund is forced to sell. If the fund receives an inordinate number of redemption requests, what happens if they have bonds that do not trade very often but are nevertheless required to liquidate based upon investor requests? It is likely the sale price could vary, and sometimes significantly, from the last assumed price. Again this is most likely to occur at the wrong time for investors.

These concerns have not yet emerged as a deterent in the new age of passive investing popularity. We have only seen slight glimpses of what may be ahead in terms of challenges for the passive investor but it is fair to say this could be a major problem.

Investors naturally assume they will be able to exit as easily as they entered these funds and at the stated value seen on their statements or trading screens. In a calm market the concerns are minor but there are serious questions about that reality should a wave of selling hit bond ETFs all at once.

Although somewhat unique in its characteristics and certainly not a bond ETF, the recent debacle related to the inverse VIX ETF, XIV, seems to foreshadow some of the issues highlighted here. The graph below shows the price of XIV over the last two years. Investors unaware of how the NAV for XIV was calculated were certainly in for quite the shock.

Data Courtesy Bloomberg

Risk Analysis – The Benefit of Stress Testing

Given the importance of the issue of liquidity and what may transpire in an adverse scenario, we decided to look at the performance of a few ETFs and their related indices through the financial crisis as an indication of what a possible “worst-case” scenario might hold. In doing so, we acknowledge no two historical events are the same but the analysis seems important to consider.

From peak to trough, between April and November 2008, the Barclays Corporate Investment Grade index fell -10.8%. At the same time the LQD ETF which tracks that index fell -12.2%. The Barclays High Yield index fell -32.3%. In the same time frame the two high yield ETF alternatives, HYG and JNK, fell -29.8% and -34.5% respectively.

Today, these funds and others like them are much larger than they were in 2008. Furthermore, Bloomberg recently reported that many corporate debt funds are reaching further down the credit and liquidity spectrum in efforts to boost returns and some are even replacing high yield bond exposure with equities. As Lisa Abramowicz put it, “While this is somewhat concerning, it’s also logical. Fund managers don’t see any imminent risks on the horizon that could shake markets, and clients will penalize lower returns.

The remarkable thing about this observation is that paying too high a price for an asset is in itself an imminent risk.  One could convincingly argue that point as the most basic definition of risk. Nonetheless, it does indeed offer an accurate profile of the current character of the market. Unlike actively managed funds where the manager evaluates individual securities, there is no price discovery mechanism for index funds and ETF’s as their only consideration is whether or not they received a dollar to invest.


According to Benjamin Graham, this approach to putting money to work in the market defines the term speculation as it does not apply “thorough analysis” nor does it “promise safety of principal and an adequate return.” Although sympathetic to the idea that it is different this time as profit margins do indeed remain unusually high, the more defining characteristic is the means companies are using to sustain those profits. It is what has been referred to as corporate self-cannibalism as debt is ever accumulated as a means of buying back shares or paying dividends. The eventuality is credit downgrades and self-destruction.

Data Courtesy St Louis Federal Reserve

The cyclical nature of passive and active investing will continue to play out and that which is wildly popular today will eventually turn unpopular. The hidden risks embedded in passive vehicles will emerge and those who so enjoyed the cheap grace of effortless and exceptional market gains will end up begging yet again for mercy amid the markets’ unforgiving justice.

15 Bullish Assumptions

If all goes well for nine more months, the post-financial crisis economic expansion will become the longest economic expansion in recent U.S. history. The U.S. stock markets are also on a tear, having just become the longest bull market since World War II. Regardless of your views about these trends continuing, the fact of the matter is that they are both much closer to ending than a beginning. Ray Dalio recently quantified this continuum, declaring that the economy is in the 7th inning, implying another one to three years of continuation.

While the markets can certainly keep motoring ahead, as Dalio and many others expect, there are some factors supporting the bullish case that investors should contemplate.

While this list is not by any means exhaustive, it does offer many of the most important assumptions supporting the market and some details to provide context and clarity.

1. Corporate managers have become so adept at their jobs that profit margins and equity valuations will remain at, or rise from current nearly unprecedented levels.

  • Market Cap : GDP – 99% historical percentile according to Goldman Sachs Investment Research (GS)
  • Enterprise Value-to-Sales – 97% historical percentile (GS)
  • Shiller’s CAPE 10 – 90% historical percentile (GS)
  • Price-to-Book Value – 89% historical percentile (GS)
  • John Hussman’s margin-adjusted CAPE – Record high including 1929 and 1999.
  • Expected 10 year S&P 500 return as depicted in our article Allocating on Blind Faith is negative
  • GMO 7-Year real return forecast -4.90% for U.S. large cap, -2.30% for U.S. small cap and -3.80% for U.S. high quality
  • Doug Short’s (Advisor Perspectives) Average of the Four Valuation Indicators is 117% overvalued as shown below and nearly 3 standard deviations from the mean

2. Bond yields will remain historically low and the 30-year downward trend will not reverse

  • The 10-year U.S Treasury yield is slightly above a key 30-year resistance line at 3.11%
  • The 30- and 10-year U.S. Treasury yields are testing multi-year highs of 3.23% and 3.12% respectively
  • Since the lows of 0.70% in November 2016, the 2-year U.S. Treasury yield has risen 300% to 2.80%
  • 3-month LIBOR, a key global interest rate for floating rate financing, has risen 282% from 0.62% in June 2016 to the current level of 2.37%
  • Implied volatility on Treasury note futures is at historically low levels indicating extreme complacency
  • GMO’s 7-Year real return forecast is -0.20% for US bonds

3. Future Fed rate hikes and possible yield curve inversion will not cause economic contraction

  • The Federal Reserve (Fed) currently expects to hike rates an additional 1.50% bringing the Fed Funds rate to 3.50%, by the end of 2019
  • The 2s/10s U.S. Treasury yield curve stands at 26 basis points and has flattened 110 bps since December 2016
  • The Fed appears increasingly comfortable with inverting the yield curve “Over the next year or two, barring unexpected developments, continued gradual increases in the federal funds rate are likely to be appropriate to sustain full employment and inflation near its objective.” – Lael Brainard – Fed Governor
  • The last five recessions going back to 1976 were all preceded by a 2s/10s yield curve inversion
  • All six recessions going back to 1971 were preceded by Fed interest rate hikes. Two exceptions where rates hike did not lead to recession were in 1983-84 and 1994-95

4. Weakness in interest rate sensitive sectors will not have a dampening effect on the economy or markets

  • Total automotive vehicle sales have declined 7.8% since the Fed started raising rates
  • New and existing home sale have steadily declined since November 2017 as mortgage rates risen by over 0.50% over the this period

5. Wage growth will not accelerate further thus stoking inflationary pressures

  • Employees gaining leverage over employers as jobless claims and the unemployment rate both stand near 50-year lows
  • Wage growth is at a 9-year high
  • Spike in the “quit rate” to 18-year high suggests more wage growth pressure coming

6. Annual fiscal deficits over $1 trillion will power economic growth with no consequences

  • Current deficit equals 4.4% of GDP and is projected to rise to 5.5% in 2019 ($1.2T)
  • Recent projections of budget deficits have been revised aggressively higher
  • Interest expense rose 10% this past fiscal year and now accounts for $500 billion spending. To put that in context, the defense budget for 2019 is $717 billion.

7. Domestic political turmoil will not roil markets or inhibit consumer and corporate spending habits

  • Mueller’s findings
  • Mid-term elections
  • The potential for the Democrats to take a majority in the House and/or Senate and advance calls for Trump impeachment as well as impede further tax reform and possibly other corporate-friendly legislation

8. Possible additional U.S. dollar appreciation and the resulting financial crises engulfing many emerging markets will not cause financial contagion or economic slowdown to spread to developed nations or to the world’s largest banks 

9. Geopolitical turmoil will not roil markets or stunt global growth and trade

  • Brexit
  • Italy
  • Iran
  • Russia
  • Syria
  • Turkey
  • Brazil
  • Argentina
  • Venezuela
  • South Africa

10. The performance of U.S. stocks can diverge from the rest of the world

  • The following developed markets are all negative year to date and have a 50-day moving average below its 200-day moving average
    • United Kingdom -5%
    • Japan -3%
    • Hong Kong -9%
    • South Korea -6%
    • Germany -6%
  • World Index EFA (blue) vs. S&P 500 (orange) (Graph below courtesy Stockcharts.com)

11. Trade wars and increasing tariffs benefit the economy and global markets

  • China
  • Canada
  • Mexico
  • Europe
  • Japan

12. Corporations, via stock buybacks, will continue to be the predominant purchaser of U.S. stocks

  • Buybacks will reach a record high in 2018 (Graph below courtesy Trim Tabs)
  • Corporate debt can continue to rise to fund buybacks despite rising interest rates and risk of credit downgrades
  • Corporate debt as a percentage of GDP is now the highest on record 

13. Liquidity in the markets will remain plentiful

14. Central Banks can permanently prop up asset prices if they are to fall

 And…The most important factor long-term bulls must assume to be true:

15. This time is different

Don’t Worry About Trump; Worry About Earnings

If you’re concerned about President Trump’s influence on the stock market you’re concerned about the wrong thing. That’s not because political leaders – and their problems — don’t influence stock prices temporarily, but because if you own stocks you should own them for their long term earnings prospects (which is why retirees should have reduced stock exposure). Stocks are ownership units of business. And although the political climate influences the business climate, a stock’s price reflects anticipation of earnings far into the future, beyond any politician’s time in office. Procter and Gamble will be selling Tide laundry detergent and Crest toothpaste long after President Trump is out of office. And that doesn’t mean you should own Procter at its current price. It just means, barring any concerns with capitalism or the stability of the country in general, Procter’s current price relative to its  long-term future cash flows is what an investor should concentrate on.

President Trump has been in office for a year and a half, and stocks have shrugged off much of the turbulence that has accompanied his administration. There have been specific policies that seem friendly toward stocks such as the tax cut. But there have also been policies that have been unfriendly to them such as tariffs. No matter, the S&P 500 Index surged nearly 22% in 2017, and is up another 9% this year as of this writing. From taking his time to fill key posts, to feuding openly with his attorney general and the press, to an investigation into his campaign’s contacts with Russia and payments to women with whom he’s had extramarital liaisons, to often betraying a lack of understanding of constitutionalism, to an erratic foreign policy that simultaneously displays abrasiveness but also a diminished role for the United States in global affairs and questionable friendliness toward obvious U.S. enemies, markets have continued rising through it all.

The last week may represent a turning point, but it’s too soon to tell. Trump’s longtime attorney Michael Cohen pleaded guilty to violating campaign finance laws in buying the silence of a pornographic film actress and former Playboy model. In the process Cohen, who taped meetings with Trump when Trump was his client, implicated the president in conspiring with him to commit the crimes.

Moreover, Trump’s former campaign chairman, Paul Manafort, pleaded guilty to 8 counts that included tax fraud and bank fraud. Although Manafort’s trial didn’t touch directly on the accusations that the Trump campaign colluded with Russia to exploit damaging information Russia had on Hilary Clinton, the income that Manafort didn’t report came from advising a pro-Russian political party in the Ukraine. Finally, the chief financial officer of the Trump Organization, Michael Weisselberg, and tabloid executive, David Pecker, were granted immunity by the Southern District of New York regarding its investigation into Cohen.

All of this may or may not lead to impeachment, but the threat looks greater now than ever before. The outpouring of emotion over the death of John McCain, with whom President Trump also openly feuded and mocked for being captured during the Vietnam War, may also push public opinion further against Trump and make impeachment more possible. Perhaps sensing his vulnerability from these recent events, Trump himself said in a recent interview that impeachment would cause the stock market to fall. “If I ever got impeached, I think the market would crash. I think everybody would be very poor. Because without this thinking (pointing to his head) you would see numbers you wouldn’t believe – in reverse.”

But will it? Alex Shepard notes in the New Republic that stocks fell in 1974 when President Nixon resigned from office, but recovered the next year. (The S&P 500 Index lost 26% in 1974 and gained 37% in 1975.) Also, the stock market rose after Bill Clinton was impeached in late 1998. (The S&P 500 Index was up nearly 29% in 1998 and another 21% in 2009.) But Shepard argues that Nixon left before impeachment and that Clinton sailed through his problems with consistently high approval ratings. Trump, by contrast, remains unpopular, and almost certainly wouldn’t leave without a fight. Therefore, Trump’s reaction to impeachment would probably be bad for markets, Shepard concludes.

Interestingly, Trump’s recent poll numbers haven’t moved much. And markets continue to surge, uninterrupted by political concerns or anything else. That should tell investors how hard it is to forecast market moves based on the political climate. President Trump just suffered his worst week in office, and the market’s aren’t registering the problems he’s facing at all.

None of this is to say that the market can’t fall on increasing political problems. But the real problem investors face is valuation – stock prices relative to earnings. Stocks are trading at higher prices relative to past earnings than they have in all but two other moments in history – 1929 and 2000. Often, political tumult can sink a market already vulnerable from high valuations. So far it hasn’t. But if you own stocks, that’s your real problem — the extent to which prices are divorced from past earnings and to which they are anticipating future earnings growth that is unachievable.

It’s Okay To Hold Some Cash

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.