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Thursday, December 20, 2012

Before You Read All those Forecasts for The Stock Market For 2013……

You might want to read this paper from Vanguard's research department on the utility of major macro approaches to predicting future stock returns.  The conclusions are so well stated I’ll reprint a long quote from the article:
Asset allocation and the difficulty
of predicting the future
We’ve shown that forecasting stock returns is a
difficult endeavor, and essentially impossible in the
short term. Even over longer time horizons, many
metrics and rough “rules of thumb” commonly
assumed to have predictive ability have had little
or no power in explaining the long-run equity return
over inflation. Although valuations have been the
most useful measure in this regard, even they
have performed modestly, leaving nearly 60%
of the variation in long-term returns unexplained.
What predictive power valuations do have is
further clouded by our observation that different
valuations, although statistically equivalent, can
produce different “point forecasts” for future
stock returns.
This underscores a key principle in Vanguard’s
approach to investing: The future is difficult to
predict. As such, we encourage investors not to
focus on the “point forecasts” that result from
various forecasting models and instead turn their
attention to the distribution of potential future
Once future prospects are viewed in a distributional
framework, the benefits of strategic asset allocation
become clear. A focus on the distribution of possible
outcomes highlights the benefits and trade-offs of
changing a stock allocation: Stocks have a higher
average expected return than many less-risky asset
classes, but with a much wider distribution, or level
of risk. Diversifying equities with an allocation to
fixed income assets can be an attractive option for
those investors interested in mitigating the “tails” in
this wide distribution, and thereby treating the future
with the humility it deserves

A couple points from the article:

·         In the short term markets are basically unpredictable.      
·         In the longer term p/e ratios offer some predictability high p/e ratios predict lower long term returns as they revert to the mean and vice versa. But even this measure had only correlation of .40 to future returns meaning even in the best case 60% of market returns were unpredictable.

Some Implications for Investors:

1.       These relationships between p/e ratios and future returns might argue for a bit of a “value tilt” in a portfolio overweighting low p/e stocks. But such a strategy can only be expected to generate a higher long term return if the investor is willing to stick with the strategy for a long period.


 During the tech boom of the 1990s with growth significantly outperforming value many investors sold their value stocks. And since there is a herding (momentum) factor in the shorter term markets can “overshoot” taking prices and p/e ratios higher before they revert to the mean and fall. This makes it even harder for value investors to hold on.  In light of human nature and well known factors in behavioral finance one might be well advised not to weight too highly to value stocks.

Professional investors are not immune to the tendency to join the move to high p/e stocks and abandon value investing …even if their basic instincts tell them not to do so. Professional investors face “benchmark risk” which translates into “career risk”. A period of 3,2, or even 1 year of underperformance vs. a benchmark  such as the S+P 500 will lose to outflows of funds from the pool of assets under management. Less assets under management = lower compensation for the manager and the fund company in turn raising “career risk” for the manager. Hence a tendency for even the more knowledgeable professional investor to join the herd in a bubble rather than “fight the tape”.

Recognizing these tendencies it’s not hard to see why bubbles and busts can occur in the short term and why virtually all the great (few as they are) long term investors have been value investors and why all the  most successful factor based investing strategies (used by passive vehicles such as ETFs and index funds) use some variant of a value tilt even while they may differ on exact methodology.

2. Point forecasts are basically useless but longer term probabilistic approaches can be useful.

I am in the midst of reading Nate Silver’s The Signal and the Noise  and he reinforces this approach. While it is extremely difficult to make a point forecast it is far easier to forecast a range of returns and a probability of outcomes. Although people focused on his highly successful forecasts for the results of the last two elections they might have overlooked the fact that he always gave his forecasts in terms of  probabilities rather than a point forecast. He has some interesting things to say about financial markets
In this interview (interestingly the motley fool which hosts the interview promotes exactly the approach Silver argues against)

He pretty much lines up with the view the view that  one can forecast the long term probability of a range of return with much greater success than trying to make a point forecast
probability of identifying the probability of returns over a ten year period far more useful than a point forecast. While it may disappoint those looking for a point forecast here is how Vanguard views the outlook for future returns:

Turning to real returns, we estimate a
slightly greater than 50% likelihood that over the
2012–2022 period, the broad U.S. stock market
will earn at least a 5% average annualized real
return. As such, we feel our expectation for the
forward real return is quite in line with the historical
average of 6.8% that has been observed since 1926,
and does not represent a drastic change in the
risk–reward characteristics of the equity market.

Match that up with a commonly held approach that current yields represent the best forecast of future  nominal bond returns one could get an idea of a portfolios expected return. A strong case has been made that this argues for a negative real return on treasury securities. As a consequence it would argue for a significant weighting in corporate bonds as well avoiding long duration since a low future inflation expectation is built into future corporate and treasury bond yields.

So final thought: skip the end of year forecast articles, instead spend your time enjoying family and friends over the holidays.

Tuesday, December 18, 2012

While You Might Not Have Been Looking....

The US stock market is certainly closing on a great year. + 16,3 %for the SP 500 (ETF SPY) and +16.4% for the US total market (VTI)
But while you might not have been looking emerging markets (etf EEM) have just about caught up. They are up 16.1% ytd.
The biggest surprise for some is the   gain for German stocks +30.7.

Growth of $100,000 top chart, Total Return and Volatility Below  YTD Also included is AGG the total bond market index etf.

Long term stock market forecasts (unreliable as they are) seem to range from the +5% to +7%. That means that if returns revert to the long term mean forecasts, missing this years 16% + returns will mean a big hit to the long term returns on investors.....

And it seems that many investors did exactly that moving money out of stocks and into bonds. An anecdotal example of investment behavior is here .

Numbers on the flows from Lipper are here. Reflecting the trend seen all through 2012, during November 2012 investors added $25.7 billion into bond funds and $69.6 billion into money market funds while they pulled a net $14.4 billion out of stock funds.

Individual investors are notorious for performance chasing and market timing rather than sticking to a long term asset allocation, It seems investors had their eyes firmly directed into the rearview mirror making their allocation for 2012 based on the 2011 results: +1.9% for the SP 500 (SPY) and + 7.7% for the Aggregate bond index (AGG) and emerging markets -18.8%. Growth of $100,000 and return volatility below.

Low Volatility ETFs: So Far So Good

Academic research has found that it “beta doesn’t always line up” that it is possible to construct portfolios that produce alpha relative to the cap weighted market index : higher risk adjusted returns. Note that the strategy is not expected to outperform the market but rather to offer greater return relative to the risk of the portfolio. Thus the expectation is that they will outperform the market cap index in stable or down markets and outperform in up markets but produce higher return per unit of risk (alpha). You can find a discussion of this strategy by one of its principal academic advocates Robert Haugen here 

ETFs replicating this strategy have been in the market a bit over a year and so far have met their expectations. Additionally although they correlate strongly with value stocks (there is considerable overlap in holdings) they produce meaningfully different risk/retun characterisitcs.

Here is the one year total return (top)and volatility ( bottom) a measure of risk) for one year for. VTI the total stock market, VTV large value US, SPLV the S P 500 low volatility strategy and USMV the total US market minimum volatility ETF as well as AGG the total bond market index: 

Note that although the  low/minimum volatility ETFs have produced lower absolute returns they have delivered on their goal of better risk adjusted returns. They have produced a bit over 80% of the return of the cap weighted index with less than 70% of the risk.

The international minimum value portfolios in emerging markets EEMV and developed markets minimum volatility EFAV. In the developed markets EFAV has given better risk returns than the cap weighted EFA 

Both the emerging and developed international one year return (top) and risk (volatility) are below

and in emerging markets EEMV has achieved the holy grail of inveting more return and less risk vs. the cap weighted EEM.

The wide divergence between the 2 emerging markets instruments can be traced to the divergent sector weightings(below). EEMV has significantly lower weighting in the commodity industries : energy and basic materials which have high volatility due to the volatility of commodity prices. Given the short history of these instruments it is not hard to imagine a period in which strong and volatile commodity prices produced higher return and higher risk for EEM. Given the fickle nature of commodity prices on should be hesitant to draw too many conclusions.
EEM Sector Breakdown
Financial Services
Basic Materials
Consumer Cyclical
Consumer Defensive
Communication Services
Real Estate
Health Care
EEMV Sector Breakdown
Financial Services
Consumer Defensive
Communication Services
Consumer Cyclical
Basic Materials
Health Care
Real Estate

How to use these strategies:
There are two major uses for these instruments:

  • 1.       Constructing a lower risk/lower prospective return equity strategy. For investors looking for lower potential losses in a down market and willing to forego higher returns in strong bull markets this would be a good substitute for part of their equity holdings.

  • “     Risk Budgeting” based on the data a minimum/low volatility strategy could allow an investor to increase his equity allocation relative to lower volatility fixed income and increase portfolio return per unit of risk.

Sunday, December 16, 2012

The WSJ and Investors Get it Partially Right on Vanguard’s Emerging Markets ETF

The WSJ reported on a topic that has been revolving in professional circles for quite awhile. Vanguard will be changing benchmarks for its emerging markets ETF (ticker VWO)going from MSCI to FTSE as its index benchmark. The most important impact, as the article notes is that South Korea will no longer be in the Vanguard ETF:

As a consequence investors have been pulling large amounts out of the Vanguard ETF, the article reports $900 million in outflows in the past month .

Looking at performance over the last 3 years, it is not hard to see the reason for investors desire to retain investments in South Korea. 

3 year performance 

 VWO  Vanguard Emerging Markets (which still includes South Korea), 13.2%

 SCHE  Schwab Emerging Markets ETF (which is based on the MSCI emerging markets index which 
excludes South Korea) 6.8%

 South Korea country index EWY .33.4%


But investors and the WSJ may have jumped the gun. A strong argument can be made to retain the South Korean exposure but the change will not occur overnight and has not yet begun. Below is the performance of Vanguar

The transition at Vanguard will be done gradually over six months beginning in January, so arguably even those that want to retain South Korea as part of their emerging market holdings might have rushed to the exits too soon. The prospective change has not yet had an imapct on performance.

As can be seen below VWO the Vanguard ETF has had nearly identical performance to EEM the ishares ETF that has no plans to switch away from the MSCI index which includes South Korea.   During the period of those $900 million outflows (since November 1) Both VWO and EEM have outperformed Schwab’s emerging markets ETF SCHE which already uses the FTSE index which excludes South Korea. 

Performance is shown as growth of $100,000 VWO blue, EEM green, SCHE yellow) click to enlarge

What is the best  way for investors to proceed:
  •    They could switch before January from VWO to EEM. Based on inflows into EEM it seems that some investors are doing exactly that. EEM does however have relatively high management fees of .67%.  Investors might want to consider  the newer lower fee ishares emerging markets ETF IEMG (.18% management fee) which both include South Korea.
  • They could retain the low fee VWO and add holdings of EWY the South Korea ETF.

Some have expressed the view that in response to the VWO rebalancing  South Korean stocks may have a selloff that creates along term  buying opportunity in the South Korean market. Two ways to implement a timing strategy for buying South Korea would be:

Selling VWO  and investing  the proceeds into SCHE the Schwab ETF which  is based on the FTSE (non South Korea inclusive) index.
After a selloff of South Korean stocks sell the SCHE and then buy one of the ETFs that includes South Korea (EEM or IEMG)....or retain the SCHE position and add a country position in EWY (South Korea)


Hold the VWO position but add a position in the South Korea ETF (symbol EWY) either now, at some point during the transition process or at the time of a possible selloff.

Of course the latter move may just be too esoteric for many investors.

But as the number shows there is a good reason to make portfolio adjustments in the near future in response to the changes in VWOs indexing methodology.


While on the topic of emerging market investing it is worth making note of the relatively new minimum volatitlity emerging markets index which not only has a significant holding in South Korea 10.45% but also has a different mix of companies compared to other emerging market indices thus giving more diversification in emerging market holdings. While EEMV has only been in existence since October 2011 it's track record is impressive (eem vs eemv below returns top volatility below). 

The minimum volatility strategy has become available across for both US and international markets and there is a significant amount of research supporting that approach.

Monday, November 5, 2012

Sandy's Aftermath: Not Good for Utility and Telecommunications Stocks

Utility and Telecommunications stocks such as T (ATT) and VZ Verizon have been favorites of dividend and “dividend growth” investors. They have already been trading at high valuations. There is no doubt there will be costly damage to their infrastructure and earning along with the horrible human tragedy associated with Sands. In fact Verizon has aready acknowledged this.

Verizon says Sandy effects could be 'significant'
AP /  November 5, 2012

NEW YORK (AP) — Verizon says the effects of Superstorm Sandy on its fourth-quarter earnings could be ‘‘significant.’’
Verizon Communications Inc., whose downtown Manhattan facilities were flooded and are still without power, said Friday it is working to restore communications services to customers affected by the storm.
The hit to earnings would mean valuations like P/E will become even more lofty (after all the “E” will go down) and may increase the payout ration, also not a great sign.
It seems clear some market participants have already reacted to this possibility.
Here (above) is the chart of XLU the utilities ETF

Here is ATT (T)

And here is Verizon (VZ)

Monday, October 22, 2012

Shooting Stars...One has Flamed Out Already

On September 10 I discussed the phenomena of shooting star stocks and mentioned lululemon (LULU) as a candidate for that category. Here is the one year chart:

Another one that fits the mold is Chipotle. Those big lines at lunchtime dont always mean its a good investment....especially if too many people have reached the same conclusion.

Sunday, October 21, 2012

Words to Live By (Well At Least Your Investing Life)

Hat's off to Barry Ritholtz for his rules of investing
Here's some wisdom from his list:

Are you an active or passive investor: For the equity portion of your allocation, you must answer a crucial question: Do you buy indexes and garner market-level returns, or do you pick stocks (or sectors) and time the market in an attempt to beat the indices?
Those who try to beat the market have a tough road ahead: Each year, 80 percent of professional managers fail to beat their benchmark. Of the few who do, once you take fees and costs into consideration, less than 2 percent actually hit that bogey.
If you want to beat the market, understand the long odds that are working against you. That is why for most investors, indexing is a much better bet.
In conclusion, investors need to fully understand the challenges that face them: Capital markets are about making the best probabilistic decisions using imperfect information about an unknowable future.
Sometimes you have an embarrassment of riches to select from; other times you are choosing the “least-worst“ option. Either way, you will never have perfect information that allows you to bet on a sure thing. There is no magic elixir.

Friday, September 28, 2012

Price Only Charts Don't Show the Full Picture

Tip of the hat to the great new Amazon money and investing blog. A post there(via motley fool) noted the importance of looking at total returns including dividends while almost all charts and news reports show price only.

The article presents this graph comparing price only with total return(dividends+ price change)
The article notes that in the "lost decade" for stocks from 2000 -2010 an actual investor in the S+P would have had a total return of 20%.

I ran charts for the period since Jan 2007 for growth of 100,000 in total return=+15.3%
But the price only chart below shows a negative return of close to 5% for that period

Thursday, September 27, 2012

That Dividend Trade is Getting Very Crowded

If there is one current conventional wisdom in the investing world it's investing in dividend or "dividend growth" stocks. It's not hard to figure out why: dividend yields above treasury yields, a need for cash flow and disappointing returns on the US overall equity market over recent years.

In fact strategies represented based on dividend weighting with reliable data (such as backtesting of formulas used in etfs like VIG and SDY) show some outperformance vs market cap weighted indices, as does performance of some large cap stocks that frequently show up on dividend screens. Furthermore this has been the case in recent years, even the utility index (XLU) was a star last year top performing sector for the first time in the last 50 years.

And many investors seem to be using the dividend flows as a substitute for bonds in their portfolios. Despite the cogent arguments against equating dividend stocks with bonds (like this one from Vanguard) the view persists. As I will point out in a future article they might be much better up expanding their horizons and constructing a portfolio of bond ETFs covering a mix of durations and credit risk to create their cashflows...and diversification.

Beyond those factors is another issue...the trade is getting very crowded. I found this chart in a recent research piece from Fidelity. They used it as an argument for investors to continue to buy dividend growth stocks because of growing demand. I view it as a sign of a crowded trade.

The picture is similar on the ETF side. Despite meager inflows into equity ETFs overall
Dividend ETFs remain popular as investors prefer funds that offer above-average yields and conservative strategies for exposure to the stock market.

A hot new dividend ETF from ishares HDV has amassed over $2 billion in assets in less than a year. A July Morningstar article noted the following...and there has been no sign the trend has slowed down since then.
Dividend-themed exchange-traded funds have been a popular choice among investors over the past year. The 42 dividend-themed ETFs that we follow raked in $16 billion in flows, nearly a third of every dollar going into equity ETFs, despite the fact that they make up just 5% by count of the 812 equity ETFs available. 

The above is a bit ironic since HDV uses a stock screen created by and licensed from Morningstart to pick its holdings.

What does that mean: a category that has been known for relatively low valuations (often considered "large value stocks) with low volatility has begun to carry valuations closer to that of "growth" stocks. Not surprisingly the very strong above market performance of last year has started to reverse itself, particularly during the market rally.

Here are returns for VTI (green,total stock market) and VUG (blue, large cap growth) vs  fast growing (in assets) Dividend ETF HDV (gold)year to date. Chart shows growth of $100,000.

  Ultimately dividends must come from either earnings growth or increasing the dividend payout. Based on the metrics below it seems that investors in some very popular dividend stocks are paying a very high price for those earnings. In fact those looking for dividends might well turn their sights outside the US...more on that in a future blog.

Here are some valuation measures of the top five holdings in HDV(courtesy of I'm not exactly how the current numbers can in some cases beabove the 5 year numbers. As a point of comparison the current p/e of the Vanguard large cap growth ETF has a p/e of 16, the S+P 500 14.
                      current p/e         5 yr p/e high      5yr avg p/e

ATT 51.5 48.4 20.5
Pfizer 18.4 19.3 13.4
JNJ 21.9 19.5 15.6
PG 18.9 17.9 15.2
Verizon 45.1 30.6 29.2

Tuesday, September 11, 2012

As I Was Saying...

Last week I noted the strong market rally on September 6 was likely due more to many portfolio managers returning from the beach vacation with performance anxiety more than any particular news item.

It seems I am not alone in my view. Raymond James analyst Jeffrey Saut wrote this in his September 10 commentary (after citing the same WSJ article I had noted):

In last week’s verbal strategy comments I suggested participants study the chart pattern of the S&P 500 (SPX/1437.92) and then think about what it would feel like if you were an underinvested portfolio manager (PM), or even worse a hedge fund that is massively short of stocks betting on a big decline. The concurrent performance anxiety would be legend because not only would you have performance risk, but also bonus risk and ultimately job risk. Accordingly, I have been opining that stocks were likely going break above the April highs (1420 – 1422) and then trade higher toward the 1450 – 1477 zone driven by what Dan Greenhaus said, “that pressure to try and play catch-up and not just merely play along but to gain some outperformance." Of course that performance pressure is magnified with end of the third quarter “report cards” due for PMs, followed by fiscal year-end, as many PMs close their books at the end of October.

I'm reminded of the story in Scott Patterson's book The Quants . He writes about how in the middle of the financial crisis major hedge funds unwound their positions in quantitative strategies leading to large moves in stocks in the absence of any fundamental news. One of the quants looked up at the reporters on the CNBC screen scrambling to give reasons for the moves based on fundamental factors. The hedge fund manager just looked up shook his head at the cluelessness of the reporters...they had no idea what was going on ...they were looking in the wrong place.

Monday, September 10, 2012

IPOs and Shooting Stars...Not Healthy For Your Portfolio

Shooting Stars and Ipos

As an investment advisor there are two categories of stocks I most frequently get asked about. IPOs and shooting stars.
These categories share 2 things in common high visibility (everyone seems to be using their product), often it’s in the news and it seems like a “sure thing’  Potential investors also suffer from two well known characteristics now part of the textbook list of pitfalls of behavioral finance and in fact decision making in general. The brilliant and highly readable book on this subject is by Daniel Kahneman: Thinking Fast and Slow. Kahneman was the first and only winner of the Nobel prize in economics to come from Psychology and I think the first Nobel Prize winner in the field without a degree in economics (there have been other social scientists since). 
Kahneman’s work is important for learning about the sometimes irrational behavior of the markets when price differs from value. In other words markets can be irrational and cause bubbles and busts. But I think there is merit to the critique: no one has shown a systematic way to make money off behavioral finance.
But I think there is a way to avoid losing a lot of money through investing avoid IPOs and shooting stars. And avoid falling into the biases of paying attention to a selective sample of information which reinforces confirmation bias. You think the product is ubiquitous therefore it is a good investment and you know people that have made a lot of money IPOs picking hot stocks or buying the individual stock in question. In fact as a group IPOs and shooting stars are as a group the worst category of stocks.
IPOs (initial public offering).  This one may be more obvious due to the largest and most publicized IPO…facebook.  Nevertheless before the IPO many investors were salivating at the prospect (investment professionals(mutual and hedge fund managers) were included in the group. Relatively unusual this time was that some retail investors got access to the IPO …that in itself not a good omen.
Why were they interested in facebook ? Because they only remembered and/or remember about the big money made in some IPOs…and didn’t hear (especially at cocktail parties) of the larger percentage of duds.
What were they looking at something like Google (of course ignoring the jaw popping 50% drop.

But they failed to think about IPOs  such as Groupon

Therefore they looked at Facebook with optimism. As a wiseguy (not me of course) would say: how did that work out for you:

Shooting Stars: shooting stars are attractive for some of the same reasons: I see someone using all of the product, therefore it must be a successful company and a good stock. In addition since the stocks are already on the market.  The stocks also share:
They are usually small growth stocks (small companies with forecasted high growth) in general the worst category of stocks in the traditional market  cap (large/small) and growth/value division. Think of a quadrant dividing the market (small value large value large growth large value)
They trade at a very high (P/E) price earnings valuation (as well as other metrics) indicating high optimism of continued high growth.
Because stock prices have had tremendous gains they have heard from or read about some investors/traders making big money.
Often the stocks will become “short positions” for professional aggressive investors. Therefore if they were early and the numbers temporarily remained positive..they may wind up buying back the shares (short covering) and the stock will have a sharp move up.
The problem because the forecasted high growth is factored into the price  bad news about prospective growth falls and the stock price takes a big drop as the “shooting star” falls to earth.
Why is this: often the shooting star is related to a consumer (often fashion/fad) product that seems ubiquitous, is premium priced for it’s uniqueness. But it is usually a product that can easily be knocked of appear in a cheaper person in a mass market retail outlet (think Target). The number of people willing to pay the premium price drops as does the stock.
An example would be Deckers the importer of those UGG boots that seemed to be on the feet of every trendy young person. To put it bluntly when the popular shoes were available at Nordstrom  or the UGG stores at a premium price and the knockoffs at places like Target…there were only a limited number of people to buy the original. Despite the effort to broaden the brand the anticipate earnings…and stock price as dropped like a rock. 

Another would be Crocs

Two Shooting Stars That Earn a Yellow Light

Two stocks that fit the characteristics of shooting stars but have not(yet ?)  fallen to earth:

Lululemon: This is the seller of yoga pants and other hot products sold at their own stores at premium prices. Knockoffs that are priced at a far lower price are prominently displayed at Target and elsewhere. Is there a limit to the number that can be sold at the premium price. The market seemed to think so, although good news last week created a big (I think short covering) rally. The stock carries a P/E of 57.

Underarmour: the hot athletic wear premium priced product. It’s current p/e is an eye popping  128.

 As a point of comparison Nike trades at a P/E of 21 and sells products competing with both Lululemon and Underarmour

What is my answer to clients interested in buying IPOs and shooting stars: I make the points above and suggest if they want to buy them they open an account I don’t manage and purchase it there.

Interestingly a company/stock that doesn’t fit the characteristics of a shooting star is Apple. Apple does have a unique premium priced product but they are difficult (and given recent court rulings perhaps even more difficult) to copy.
Apple of course is the world’s largest company, it’s large cash position makes bankruptcy virtually impossible.  And interestingly relative to earnings it doesn’t seem expensive. the p/e is 16.  A new iphone is to be unveiled this week and a smaller cheaper Ipad is in the works. Is the stock worth buying on price dips  ? I’ll leave you to judge.