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Monday, April 22, 2013

Top Performing Sectors = Telecom and Utilities and The Are Expensive

The always sharp folk at Bespoke Investments posted this interesting  article and the graph below:

Clients and regular readers of this site know that we have had a longstanding preference for US stocks with domestic exposure over stocks that generate the bulk of their revenues outside of the United States.  A look at the chart below shows just how well that strategy has been working over the last year.  In the chart, we compare the one-year performance of all ten S&P 500 sectors (y-axis) to the percentage of domestic revenues for the average stock in the sector (x-axis).
As shown, Technology is the only S&P 500 sector that is down over the last year, and it also happens to be the only sector where the average stock generates less than half of its revenues in the United States.  On the opposite end of the spectrum, stocks in the Telecom Services sector generate the largest percentage of their revenues in the United States, and Telecom has seen the best performance over the last year.  Besides these two sectors, if you look at the rest of the sectors in the S&P 500, there is a clear trend between percentage of domestic revenues and performance over the last year; the more the better.
I would give an additional..or alternative explanation. The stocks in those sectors carry high dividends. And the conventional wisdom" or even, judging by the blogosphere investing craza is dividend ("dividend growth") iinvesting.
Here are the current p/es and yields for the sectors  (all via
XLUutilities p/e 16 yield 3.72%
XTL telecom p/e 24.7 yield 3%
S+P 500  p/e 14 yield 2%
VTI total US market p/e 13.57  yields 2%

Stocks in the above sectors generally trade at a valuation discount to the overall market

Thursday, April 18, 2013

Q 1 2013 Credit Market Review and Strategy

If there was a message of the fixed income (bond) market this quarter it was that investors have finally decided that the risk return on intermediate and longer term bonds has tilted away from bonds. This triggered a small selloff in intermediate and longer term bonds in anticipation of an eventual end to Federal Reserve’s easing policy if not through outright interest rate increases at least in the form of an end or reduction in bond buying (“quantitative easing/QE). Nonetheless, with economic data mixed there is certainly no decisive “bursting” of the bond bubble.
It seems as if the close to 20 years of largest in history declines in interest rates (see below for 10 year treasury and corporate investment grade bonds since 1963 ) is running to a close. Simply on the basis of arithmetic, since rates cannot go below zero, the gains of previous years simply cannot be replicated.
Intermediate Term Bonds (Treasuries Blue, Corporates Red)

Nonetheless as of this writing (April 16)recent economic data still point to weakness in the economy and low near term inflation giving some gains to intermediate and longer term bonds. We still see the risk/return as with one exception—Build America Bonds—as unattractive.
Treasury bonds:                         
Treasury bonds carrying the lowest yield of all sectors of the bond market performed the worst of the key bond sectors as seen below The low yields were not enough to offset much of the price changes.

Investment Grade Corporate Bond
Investors willing to take moderate credit risk were rewarded for taking the risk with modest gains.

High Yield (junk bonds) Investors in search of yield have invested record amounts into high yield bonds pushing yields and credit spreads to record lows. The conventional wisdom is full of talk of a high yield bond “bubble”.  I view that analysis as simplistic. If the major cause for higher interest rates is an improved economy than it doesn’t follow that high yield bonds will suffer more than other bonds of similar maturity in the treasury and investment grade sectors. After all the low rates mean  that companies have refinanced at lower rates that factor and an improved economy would mean better prospects for the weaker credits that issue high yield debt.

Strategy: Finding value in the bond market.

Risks of price declines in bonds that reduce or erase total returns (interest earned + price change) come in two types: credit risk and interest rate risk.

Interest rate risk: Higher market interest rates cause declines in the bond market and the longer the maturity (or more precisely duration) of bonds the greater the price declines. Based on current market levels the risk return of intermediate and long term bonds argues for shortening maturities despite the lower yields.

Credit Risk: In terms of risk/reward tradeoff taking on a higher credit risk seems a better way to pick up yield. As noted an improved economy reduces credit risk and short term bonds carry minimal interest rate risk as their price sensitivity to interest rate changes is far lower than on intermediate or long term bonds.

This would argue for looking at the following mutual funds and ETfs s as components of a bond market allocation. '

In a conservative allocation such  one is just looking for minimal price fluctuation such that total return = yield for the short term bonds and a price risk that is high enough to offset price fluctuations for the intermediate term bond fund…with some potential for upside.

  • GNMA bond funds: these funds are short duration and the instruments carry the full faith and credit of the US Government but have yields above treasuries. Although recent total return has been hurt by the vagaries of Fed purchases of mortgage securitie they still merit considering in asset allocation.  Current 30 day sec yield is 1.69%
  • Short term investment grade corporate bonds…a little more credit risk than the above  for a bit higher yield  and a bit more price volatility 
  • Short term high yield bonds. For those willing to take on more credit risk short term high yield (SJNK) looks quite attractive. The yield is around 4.25% and the price has proven to be very stable. All an investor is looking for in this area of the bond market is minimal price movement allowing the investor to capture the yield.
  • Intermediate term bonds. For those willing to take on a bit of interest rate risk as a “hedge” against going all in on a view of rates going higher in the near term there is one sector of the intermediate bond market where risk/return look reasonable. Build America Bonds essentially muni bonds with the Federal government assuming partially the cost of debt payments. In other words these bonds offer a cushion against possible price declines due to higher interest rates and good potential for price increases should rates move down a bit  BAB currently yields a bit over 4%/
  • Treasury bills instead of money market. Investors who currently have some holdings in money market funds might consider a tbill etf like SHY as an alternative.  Money market funds are not credit risk free in 2008 a major money market fund “broke the buck” fell below $1 in net asset value. Although the Fed effectively bailed out the fund and its investors to protect the $1 net asset value, there is no guarantee this will occur in the future. On the other hand treasury bills are a crisis hedge.                                                                        Despite their near zero current yield they are likely to rise in price in a financial crisis. In 2008 SHY had a total return of 6%  while money market returns guaranteed no price fluctuation but paid virtually zero interest  making total return = yield . And  money marke funds carry more credit risk than treasury bills. Thus treasury bills act as a bit of a “crisis hedge”. 
  • ” Combining some treasury bills with short term high yield in their portfolio. This would be a “barbell strategy “with regard to credit risk while retaining low interest rate risk. As rough example a 50/50 split between SJNk and SHY would yield  a bit over 2.55%    Of course increasing the weighting of SJNK would raise yield--(and increase credit risk—risk and return are (almost) always linked at the hip.

Thursday, April 11, 2013

Q1 2013 Equity Market Review and A Look Ahead:

The first quarter was a very strong one for US equity markets with far weaker performance outside the US:
US total stock market (ETF VTI)                                       11%
Developed International Markets (EFA)                      3.7%
Emerging Markets (VWO)                                           + 3.7%
If the  US market rally continues at this rate for the entire year it would mean  increase would represent a 40% + gain for 2013 which Is to say the least highly unlikely.  
We remain skeptical of the recent price increases and within the discipline of our long term strategy have reduced our exposure to US stocks.
What are the common explanations for the market rally?
 Here is a rundown of the “conventional wisdom” and my skeptical response
·         Because of low interest rates and uncertainty outside of the US investors have “no place else” to put their money.
True, US interest rates are at record lows and the high valuation of many high dividend stocks that considered stable but low growth indicates many investors are ---erroneously in my view—looking at dividend stocks as a substitute for bonds.  Indicative of this is that consumer defensive stocks considered slower growing, but higher dividend stocks and utilities are top performing sectors year to date. These stocks generally trade at a valuation discount to the SP 500 but are now trading at premium of over 10%.

The curious part of this explanation is that the bond market as reflected in market prices —and the conventional wisdom of the bond market analysts—is that the end of the Feds aggressive easing policy is nearing. So if the equity rally is because of low interest rates and bonds are  highly risky due to the prospect of higher  interest rates it seems that low interest rates are a thin reed upon which to base a 10%+ rally over 3 months…the message of the bond market that the major declines in interest rates are behind us.
·         A “great rotation” is occurring in which investors are returning to stocks after missing most of the markets recovery
Great rotation is too strong a term particularly if it represents the beginning of a long term major return of individual investors into the stock market. Anecdotal and fund flow data definitely do show movement of individual investors back into stock funds and ETFs. But individual investors (and the fund managers who try to “catch up” with the market to avoid outflows and attract inflows) can be a fickle lot and many of them will likely flee from the market at the first sign of a selloff.
·         Price Momentum: Markets definitely have a momentum factor in which short term trends are self-reinforcing. That makes market timing –trying to pick tops and bottoms—virtually impossible. But high returns make markets more risky, price can deviate from value in the short term and markets tend to revert to the mean. High current returns and valuations portend lower returns in the future. All this means that rebalancing  makes sense in response to large market moves (in this case selling stocks and readjusting allocations) but moving all in or all out is  not a path for long term investing success
·         Improved economic outlook in the US.  At the end of the 2012 all the conventional wisdom was forecasting a reversal of the modest of the emerging economic recovery due to the sequester, payroll tax increases and assorted other woes. None of this has changed since the turn of the year , yet the market has shown the strong performance. Macro-economic data particularly in housing show the economy has likely bottomed. But the growth prospects are still modest at best, the employment data and consumer spending and confidence data don’t point to anything close to economic growth above 2.5 -3% with the potential for negative surprises  larger than those for unexpectedly good news.  The anemic employment figures released on April 5 are a good sign of how fragile the recovery is.

 Furthermore, the stronger the economic data the greater the prospects for a change in Fed policy….and higher rates are unlikely to be good for stocks.
·         Improved corporate profitability: corporate profitability has improved led largely by the recovery of the devastated housing and financial sectors. Consumer spending has not shown a major upturn. 
Furthermore, investors have been bidding up the prices of stocks of large cap high dividend payers many of which are major multinationals with large portions of their revenues coming from outside the US. If the message of the European and Emerging economy equity markets is for slow growth and profitability among those companies there has to be a limit to the prospective profit growth of US multinationals like Procter and Gamble, Ford and McDonalds who depend on foreign markets for a large portion of their profits.
·         US markets attractive vs. the rest of the world:  The situation in Europe and slower growth in emerging economies certainly raise the risk levels in these markets…but in a global economy does that mean that equity holdings in non US economies justify the divergent performance and valuations are likely to continue? 
·         Valuations are reasonable:  At the end of the day stock prices can go up one of two ways: increased profits or higher valuations (i.e. one dollar invested buying a smaller portion of future earnings because of optimism about the future).
The best long term measure of valuation is the CAPE or Schiller P/E ratio which is based on the average of 10 years of earnings.  Markets with high valuations as measured by CAPE have shown to have poor investment returns going forward. The current US S+P 500 P/E are 23.18 well above the historical mean of 16.47. The Price earnings P/E ratio based on 12 month trailing earnings is 17.93 vs. a long term mean of 15.49. In other words the market is anticipating a sustained recovery in earnings….despite economic uncertainty around the world. It is hard for to see the US market as undervalued.

Based on most valuation measures the US market is highly valued although certainly not at “bubble” levels Despite  appearances …the higher the market returns the higher risk and the lower the prospective returns indicating   caution is in order and the prospects of a “correction” in the near term is high. 

Will the pattern of recent years with a selloff after a first quarter (see below) repeat itself? With the large price indices of the past quarter….it seems a reasonable scenario.


Investment implications   my general investment approach   makes use of portfolio rebalancing, but large scale market timing and believes that “price and value” can deviate in the short term but revert to the mean in the long term.  My current outlook and strategy is based upon:  Rebalancing between asset classes has been shown to increase return modestly and at lower risk (volatility)

Rebalancing portfolios A rebalancing strategy would take some profits on equity positions and  moving to fixed income (more on fixed income strategy in my next email) in order to keep portfolios slightly underinvested in equities vs. target allocations. Of course investing this way goes the opposite of the tendency to buy into momentum. That strategy runs the risk of buying high and selling low. Although rebalancing certainly runs the risk of missing out on some of the moves due to momentum…as has likely been the case for rebalances that have missed the most recent part of the market’s strong rally.

Global Allocations

With global valuations as follows (relevant ETF listed in parentheses) price/prospective earnings

US S+P 500 (SPY) 13.5
Europe (VGK) 11.3
Germany (EWG) 12.8
Emerging Markets (IEMG) 10.95
Emerging Asia (11.38)

It is hard to find a rationale for favoring US over non US stocks for the medium to longer term.

The major US and European indices are heavily weighted with global multinationals that compete with each other around the world; it is hard to rationalize European multinationals trading at a 15% valuation discount to the US peers.

Emerging market economies have slowed from their very rapid growth of previous years but still have stronger long term growth prospects than the US.  These indices include both major multinationals such as Samsung as well as domestically oriented companies like China mobile.   Growth has slowed significantly in China, India, South Korea and Brazil but longer term growth prospects and demographic trends remain positive.

Ironically one of the hot “new ideas” for investing is to invest in merging market corporate government and corporate bonds because of the better economic fundamentals vs. the US. If that is the case and if the major growth market for US multinationals is in the emerging economies then a longer term perspective would see emerging market stocks trading at a 20% discount to US stocks as a buying opportunity.

A valuation based investor looking to initiate new equity positions would likely look outside the US and rebalancers might wind up selling US stocks and adding to their international allocation.