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Wednesday, January 3, 2018

Market Review 2017 and 2018 Outlook

Year End Review 2017

2017 was an excellent year for virtually every asset class around the world. It was a year in which economic growth showed positive trends globally. In fact, in a bit of a “catch up” and as a response to lower valuations non-US stock returns exceeded those of the US. Technology stocks dominated equity markets both in the US and abroad.

US Markets
The S+P 500 had an excellent year with a return of 21.7%

The buzzword in the US stock market was FAANG (Facebook, Apple, Amazon Netflix and Google) as a shorthand for the dominance of these few technology companies in the market rally. More correctly one would substitute Microsoft for Netflix in the list due to its much larger market cap/weight in indices.
 Facebook, Apple, Amazon, Microsoft and Alphabet (Google). Those stocks together increased in value by 43%, The overall technology index grew 33.2%.

Some attribute the rally to a “Trump bump” in reaction to regulatory changes and changes in tax rates. In fact, the large technology stocks already pay tax rates at or below the newer lower corporate tax rates and are not particularly impacted by those regulations that have been changed.

 Earnings growth has exceeded expectations been strong benefiting from improving economies around the world. The trends in technology among the big four profit opportunities for others in areas such as semiconductors and cloud computing.

The Federal reserve has continued its long anticipated “unwind of QE 2” or in simpler terminology it has begun to raise short term interest rates. After raising short term rates once in 2016 rates were increased three times in 2017 to a current level of 1.5% on the Federal Funds rate.  The stock market showed no negative reaction to the rate hikes likely both because the move was so anticipated and because rates remain so low. Thus far Employment has grown without wage increases .

With the concentration in technology and thus large cap growth stocks large cap and small cap value showed smaller gains. Large cap value stocks which have a high weighting in financials sector that benefit significantly from the lower taxes. Towards the end of the year large value outperformed the S+P 500.

Viewing the market based on “smart beta” factors it shouldn’t be surprising that the momentum factor (ETF) significantly outperformed the S+P 500 (37.5% vs. 21.7%).

 Pessimistic observers continue to point to the historically high market valuations particularly in the next year when we will see further increases in interest rates. The extremely low volatility during the past year is seen by many as complacency with investors underestimating the possibility of a market drop.

While it is unlikely to see the type of returns we had in 2017 (numbers few if any predicted at the beginning of the year) the positives for the market seem to significantly outnumber the negatives.

The high market valuations cannot be considered a bubble; certainly nothing akin to the tech bubble of the late 1990s. Sometimes it really is “different this time”. The p/e of the S+P 500 at 25.7 is well above its long-term average of 15.7. But part of that high valuation is due to the high p/es of the tech giants…and p/e is an incomplete measure of their worth

The leaders in the market (except for Apple with a p/e of 18.4) have high valuations.  Facebook at a p/e of 34, Google at 35, Microsoft at 30.24. But these companies are sitting on massive cash holdings which can be used for stock buybacks, dividends and acquisitions.
 Both Microsoft (1.94% yield) and Apple (1.49% yield) pay dividends. In fact, one could argue the market is “rational” and conservative in its low valuation of AAPL which is most vulnerable to the success of a single product line: the iPhone. Amazon has a massive p/e of 298 but obviously short term profits are not a major objective of its strategy at this point. 

 With their domination of their respective markets a case can be made to justify the valuation of the small group of tech stocks that dominate the market. That group in turn pushes up the overall valuation of the broad indices.  And the derivative effect of the growth of those companies pushes demand for other technology sectors such as semiconductors. Many of those stocks already pay dividends.

Major US Indices
Market Sector
3 year
total US
SP 500
US Small Value
US Momentum
US Minimum Volatility

Non US stocks
Both developed and emerging markets performed even better than the US markets in 2017.

Developed Markets
European stocks continue to benefit from lower interest rates even as the US Federal Reserve has begun to raise rates. The European economic recovery is at earlier stages than the US. Concerns related to Brexit have faded from the market and even signs of possible change at the top in Germany and the Catalan crisis in Spain had no impact on the market. Valuations in Europe are low relative to that of the US.
The Japanese stock market also showed a very strong performance accelerating from a recovery that began in 2016 after years of poor performance

Emerging Markets
These markets also outperformed the US in 2017. Much as in the US the gains were in the technology sector and thus the highest performance was in Asia. The Asian market’s tech giants like Alibaba, Baidu, China Mobile, and Tencent dominate the indices and the technology weighting of the Emerging Asia ETF (GMF) is 32%. Looking forward the earnings growth forecasts are strong and Asia trades at only a p/e of 13; far lower than either the US or Europe. Emerging markets tend to be a place where investors chase performance (buying high and selling low) but for the long term investor the additional flows into this area should be an additional positive factor.

Market Sector
3 year
Developed Markets
Emerging Markets
Emerging Asia

Looking Forward
The economic environment seems benign with interest rates rising slowly, low inflation, earnings growth and consumer consumer confidence high. As was the case both in 2016 and 2017 a reasonable forecast would be for single digit returns this late in a bull market in the US…but such forecasts were wrong in both cases.

The tax reform legislation puts an incentive on companies to bring the billions in cash they have abroad back to the US. Two industries: technology and pharmaceuticals have the bulk of the all the cash holdings by US companies abroad. Neither industry is likely to relocate jobs or manufacturing back to the US.  But they are likely to use the cash for dividends and stock buybacks a boost for the stocks. The technology giants may also use their cash to continue acquisitions further increasing their dominance of their market niches. If anything, this makes the case for those top performing large cap tech stocks to remain attractive.

The lower tax rates and increased domestic demand will likely be a positive for domestically oriented small cap stocks giving a further positive for the US market. Changes in the regulatory environment seem to be making corporations more comfortable expanding operations.

It did seem reasonable to forecast higher returns outside the US for 2017. Given the lower relative valuations and earlier stages in the recovery.and low interest rates in Europe that is that is likely to repeat itself in 2018.

What could go wrong?
It seems that the greatest risks to the equity markets come from the political risk side.

Regulators around the world may tighten regulations around the tech giants such as Google, Facebook and Amazon. This in turn would lead to a decline in the stocks of these companies that have been responsible for so much of the rise in the US market.

Geopolitical risk: the probability of an escalation in tensions with North Korea reaching military confrontation may be underestimated by the public and certainly by the financial markets in the US and abroad. It is of course impossible to predict how this would play out politically or in the markets.

China could always be a source of political or economic instability with consequences for the global market.

Nafta repeal of Nafta would be a negative for the US economy although not likely one that would cause extensive damage to the overall economy.

Trade wars In addition to Nafta repeal there is a possibility that the US will use tariffs or other measures to counter countries exporting heavily to the US. That would be destabilizing to the world economy and ultimately increase costs to US consumers.

Within the United States an extensive investigation into the relationship between the Trump campaign and Russia could lead to an administration bogged down in dealing with a crisis associated with this issue.

Bond Markets
The Federal Reserve raised interest rates  3 times in 2017 in its unwinding of the “quantitative easing” in the aftermath of the 2008 financial crisis. Looking at the recovery in the economy without any major increase in inflation or economic or further financial market instability it is hard not to call the QE with the near zero interest rates to spur the economy a major success.

The Federal Reserve will continue to try to sort out the question of whether” it’s different this time” when making its decisions to raise interest rates. We all know economics is not a science and one of the basic assumptions of classical macroeconomics seems not to be in place. Unemployment is extremely low, yet wage growth and overall inflation are low.

The macroeconomics that people like Yellen learned and taught includes the assumption of the “Phillips curve” That view of the world stipulates that low unemployment leads to high wages and inflation. In that environment the Federal Reserve would need to raise rates to lower inflation.

The federal reserve has an inflation target as 2% as representing the right level to keep inflation in check and allow for economic growth. Yet inflation persists below that level. That leaves the Federal Reserve in the position of raising rates amid low inflation…the reason the Yellen Fed has been so slow to raise rates. Signs of wage and inflation increases would hasten the pace of rate increases. The market seems to anticipate 3 increases over the course of 2018.

The bond market seems to be voting with its money that inflation is not on the horizon. As the Federal Reserve has raised short term interest rates, longer term interest rates which would react to long term inflation expectations have remained steady. The ten year Treasury bond yield ended the year pretty much where it started at 2.4% showing little concern with inflation. The long term inflation expectation as reflected in inflation protected bonds has moved up a bit this year but is just under 2%.

 The impact of the rate increases can be seen in the bond market in the “flattening of the yield curve” a decline the differential between long term and short-term interest rates. The difference between the 10 year and 2 year bond yields has reached a ten year low of .5% down from 1.2% at the beginning of the year a dramatic move. 

In the corporate bond market, the market has been characterized by a combination of a “search for yield’, optimism on economic conditions and what many would argue is complacency. This has led to strong performance (low yields) for investment grade and high yield bonds.

The spread of high yield bonds to Treasury bonds has fallen to record lows at 3.5% vs. 4.1% a year ago. The drop-in spreads for investment grade bonds has brought them down to record lows of 1% down from 1.3% a year ago.

These low spreads could only be justified by extremely low levels of default risk. Even with benign economic conditions it seems clear that the risk is for yields on these bonds to widen. Of course, this was a reasonable forecast at the beginning of 2017 and it proved to be wrong.

Looking Forward
The current market is characterized by low short term rates likely to rise, a flat yield curve with extremely low long term interest rates and very tight credit spreads. The most prudent strategy would seem to be to keep maturities short across a mix of bonds in terms of credit quality.

Bond Indices
Market Sector
3 year
US Aggregate Bond
US Govt
US Corporate Investment Grade
US High Yield
Short Term Bond
Short Term US Govt
Short Term Corporate
Short Term High Yield

Monday, January 1, 2018

The Trump Bounce in 2017 ? Overseas Markets Performed Even Better than The US

 One of the most repeated phrases to describe stock market performance in 2017 is to atribute it to a "Trump Bounce".

I'll leave the analysis to others but will point out that non US markets had a better year than the US markets.

While the S+P 500 had a return of  21.3% Here are how some non US indices did

All world ex US 27,3%

Developed Markets:

Total developed markets: 26,5%
Eurozone 28.7%
Germany 28.1%

Emerging Markets

Total Emerging Markets 36.6%
Emerging Asia    41.4%

ETF Charts Below

SP 500 (SPY)\ black
World ex US (ACWX) gold
Total Emerging (IEMG) green
Total Developed (EFA) blue

Thursday, December 28, 2017

It's Not Justy Alot of Apple You Likely Own in Your Portflio

I posted recently about the large and growing weighting to Apple (AAPL) in the market weighted indices like the S+P 500.

Not surprisingly this is not true just of Apple but of the technology sector in general. The market has been led by what is referred to as the FANG stocks (Facebook, Amazon,Netflix and Google) In fact the more accurate acronym is FAAG (Facebook, Apple,Amazon and Google )..since even despite its large price increase this year,Netflix has a far lower market capitalization and thus weighting in the indices.
In fact Microsoft which is the second largest holding in the S+P 500 (after AAPL) and had a 27% increase in price this year strarting this year at the 52 week low and now at the 52 week high. The  S&P is top heavy with f the entire technology srctor.

From the WSJ

Led by Apple Inc., Facebook Inc. and their peers, the weighing of technology stocks in the S&P 500 index has climbed to 23.8% as of Dec. 26, from 20.8% at the end of last year, according to S&P Dow Jones Indices.

Those looking to balance out the exposure to large cap technology in their portfolio might look at adding the following smart beta ETFs (technology weighting listed in parantheses).:

Large Cap ETFs:

USMV mimimum volatility (12.02%)
QUAL quality                       (18.6%)

and Small Cap Value             (10%)

Not surprisingly MTUM momentum has a technology weighting of 28.7%

Thursday, December 14, 2017

It's Not Easy to be A Successful Hedge Fund

Despite the terrible record of hedge funds in beating simple passive investing it seems that they keep trying "new strategies.

The track record of hedge funds is poor and even that database has a large "survivorship bias" . So may funds close or the managers reinvent themselves with new fund names and new strategies it is literally impossible to have reliable data on their performance.

Hedge funds have been closing particularly those with the traditional long short strategy (long favored stocks/short unfavored stocks. It also seems that some funds are using the long/short strategy based on smart beta factors.

from Bloomberg

Traditional long-short hedge funds and their managers have recently felt like an endangered species, with many giving up after finding it increasingly hard to turn a profit, as Bloomberg News detailed Tuesday. The latest to throw in the towel is John Burbank, who hit it big after the financial crisis, but this week announced he was shutting his hedge fund Passport Capital. After two years of poor returns, recently from investments in Saudi Arabia, Burbank said he needed to rethink how he invests. He may launch a bitcoin fund.

Other long-short fund managers are coming to the same conclusion. In September, Whitney Tilson closed Kase Capital, saying he no longer had a high degree of confidence he could beat the market. Hedge fund manager David Einhorn, who is famous for making public cases against the companies he's shorting, has recently said he wasn't sure if his brand of value investing could still work. And Joel Greenblatt, a long-time hedge fund manager who launched long-short mutual funds a few years ago, has recently been allocating more of his funds to indexes in order to combat losses.

But hope springs eternal new hedge funds emerge peddling new strategies and if there is a short period of success money rolls in. Hedge funds are usually limited legally to what are called "sophisticated investors". But their behavior shows they are anything but.

Some funds hit by the long bull market are switching to long only strategies based on computer stock screening...something that could be done more cheaply and more transparently with smart beta funds.

Joel Greenblatt for years a successful stock picking value investor has created a blended portfolio combining the passive strategy of part of the money invested in the S+P 500 and part of the portfolio long stocks he favors and short those that he sees as overvalued..a hybrid of passive and long short. Of course any strategy involving short positions has potential for large losses and it is unclear that the long and short positions can offset each other. Again with smart beta ETFs with fees of less than .10% and broad index ETFs with fees near zero it may well be investors are better off with a combination of a broad index combined with smart beta for lower cost and volatility with potential for higher returns as well

John Burbank who made returns of 200% betting against mortgage backed securities in 2007. Funds flowed into his funds based on that success. But not surprisingly the success of 2007 didn't translate into long term success in the stock and bond markets...and the money flowed out assets are now under $1 billion .


Passport has struggled for years to equal its crisis-era success, and now manages a fraction of what was once a roughly $5 billion war chest. Several prospective investors approached about the new venture say the firm’s flagship fund was down double digits last year, and was down again in 2017.
Passport said in a letter to investors late Monday it would close its main fund, having earlier told some investors it expected further redemptions by year-end, a person close to the firm said.

Burbank has indicated he is moving some of his assets in a fund concentrating on cryptocurrencies. It is hard to see how anyone even the most experienced trader can claim any expertise in tis area.

Other funds are moving into esoteric non stock investments according to Bloomberg such as "
litigation finance or private debt and equity, from Deere & Co. tractor dealerships to a banana plantation in Costa Rica.
It's hard to see how managers have much of a track record in this area, what kind of past data they have..and what it could mean for the future and what kind of liquidity thse asset classes have

One of the new type of hedge funds are based on

Another hot category is  algo trading.based on "big data" and "machine learning" techniques used  From the WSJ

The Future Is Bumpy: High-Tech Hedge Fund Hits Limits of Robot Stock Picking

Voleon is among investors deploying machine learning, a technology in which computers develop trading strategies. It’s harder than it sounds

Machine learning, a set of techniques that empowers computers to find patterns in data without using rules prescribed by humans, has been producing advances in a range of fields, from robotics to weather forecasting to language translation. The technique is at the heart of efforts to build self-driving cars.
Why not use it to crack financial markets? The notion has led to an arms race of sorts, as multibillion-dollar investment firms that already were mathematically focused have been signing up the smartest computer scientists and statisticians they can find.
The gambit seems to be working for two of this year’s top-performing hedge funds. Quantitative Investment Management LLC, up 68% this year in its biggest fund, attributes its success to the technique. Teza Capital Management LLC credits machine learning in part for its more than 50% gain so far this year.
Yet instances of parlaying machine learning into investing success over a sustained period are rare. Much of the reason can been seen in the yearslong struggle of Voleon, one of the first investment firms to commit itself fully to the kind of machine learning that is producing many advances in other fields.

These computer experts discovered what anyone in the financial markets could have told them. Markets are complex and dynamic with patterns, particularly shorter term which constantly change. Nothing based on past data could have predicted the 2008 financial crisis..although a few people such as those profiled in the movie the Big Short did so through rolling up their sleeves with old fashioned research. Not only is there lack of consistency in returns even in those years of high returns it is unclear what the volatility is and if leverage is used. Ultimately leverage is the downfall of many strategies that show eye popping short term returns.

The WSJ continues

The basic problem they faced was that markets are so chaotic. Machine-learning systems have been best applied so far to situations where patterns are more of a repeating nature, and thus easier to discern, such as in playing the ancient game of Go or even guiding a driverless car. The financial markets are “noisier”—continually being affected by new events, the relationships among which are frequently shifting.
The protean nature of the markets also means yesterday’s relationships can vanish as investors figure them out and move to take advantage of them. This isn’t a problem faced by machine learning in other fields, such as converting human speech to text; computer engineers can count on human speech continuing to have the same basic characteristics

George Soros the master trader who eschewed such techniques wrote of the reflexivity of markets years ago. And Richard Brookstaber who worked for years in financial derivatives for major investment banks makes arguments for the complexity of markets in his recent book .The End of Theory which focuses on the influence of human interactions on financial markets...the exact opposite of combing through machine learning

It's hard not to look at the constantly changing hot strategies among hedge funds and not conclude that individuals are not better off not fitting the category of "sophisticated investors" and getting access to these funds. Anyone remember Long Term Capital with its Nobel Prize winning and top Wall Street brains at the helm ?

Tuesday, December 12, 2017

More Apple is Likely Coming Into Your ETF Portfolio

On this Friday December 15 the recompositions of both the S+P 500 and the Nasdaq 100 will be announced

MSCI will do its index recomposition early in 2018.

Given the 17%+ gain in AAPL since the last S+P recomposition in June and its large weighting in the major indices that weighting is likely to increase after the recompositions. Meaning holders of ETF portfolios will like find more AAPL in their portfolio.

AAPL his the largest holding at just under 4% in the largest ETF SPY which has over $250 billion in assets under management

 AAPL 17% weighting in the Nasadaq 100 and it QQQ has just under $60 billion in assets under management.

Iinterestingly for "smart beta" investors AAPL is the top holding in QUAL, the third largest holding in MTUM (these are based on MSCI indices)

It is also the larges holding in the S+P 500 large cap growth ETF IVW

The net result is that the % of your ETF portfolio  invested in AAPL is likely to go up. Whether or not that is a good thing is up to the individual investor. But it does show that it there is merit in looking "under the hood" of an ETF portfolio.

I am not a stock picker but I will point out thast AAPL has over $250 billion (!) in cash much of it abroad. Given the tax incentives for bringin in cash for abroad it is likely that a portion of that will be brought back to the US. And given that AAPL does next to no manufacturing in the US it is next to impossible it will shift production (which it outsources to Chinese manufacturers) back to the US.

That means the cash will likely go to dividends, stock buybacks and acquisitions (netflix has a market cap of around $80 bln...just sayin).. Yesterday Apple announced its acquisition of music identification service shazam for $80 million obviously a tiny dent in its cash.

Thursday, December 7, 2017


Not only do I view this idea as crazy this bitcoin "trust" regularly trades at a premium of 30% and more than the "cash" bitcoin.

Wednesday, December 6, 2017

Is Factor Investing Driving the Market ?

Bloomberg had a fascinating article pointing to the influence of factor investing in the market.

The popular narrative is that stock pickers are selling tech after the massive runup this year and are piling into companies set to benefit from U.S. tax cuts. But observers such as Andrew Lapthorne of Societe Generale SA don’t buy it. They look at the contours of the selloff over the past few days and have a different take: A few heavy hitters are dumping factor positions that incidentally hurt chipmakers and software companies and once they’re done, the rally will resume.

Two factors stood out last week. First, the plunge in the momentum trade (betting on past winners to continue winning), and second the gains in value (seeking out underpriced stocks) to near-record proportions. Because the moves were severe in U.S. stocks and occurred across sectors, macro forces aren’t causing a rotation from technology to financials, strategists reason. Rather, computer-driven funds liquidated or readjusted factor exposures, they say...

“The ‘momentum unwind’ effect is observable even within sectors,” Chintawongvanich wrote in a Tuesday note. “We find that they tend not to portend much for the market; once the unwind has run its course, typically the ‘long momentum’ stocks resume rallying.”

But more than momentum, the culprit here was probably value, according to Lapthorne, who notes that last week, the strategy betting on the cheapest stocks had its biggest daily rebound since March 2009.

What is fascinating here is that large numbers of computer driven traders are employing factor trades...and doing it on a long/short basis in the case of momentum going long stocks with positive momentum and short stocks with negative momentum. Such a trading strategy would need to be quickly unwound if it reversed. Given the underperformance of value stocks it is likely that many value stocks were on the short side.
Once short term players with leverage all follow a similar strategy the moves can be abrupt and not just driven by fundamentals.
With regards to factor investing it seems that the short term traders took the insight that factors influence stock movement and turned it into a strategy for leveraged trading,
In other words they are turning what should be a long term asset allocation strategy and using it for tactical trading.
Long term investors should do quite the opposite of what the traders do. They should have a portfolio balanced among factors holding both value and momentum since the two are generally not correlated. Therefore the combination of the two helps diversify a portfolio.
In fact the moves of short term traders is "noise" for long term investors best to be ignored or seen as opportunities to implement long term strategies.
Three month chart momentum (mtum)  etf vs large value (VTV)
VTV (brown) MTUM (black)