Message From the Bond Market

In its' statements accompanying Wednesday's announcement of an interest rate hike the Federal Reserve indicated confidence in the growth of the US economy and the prospect for further interest rate hikes to limit potential inflation risks.The recent sharp drops in the stock market seems to indicate skepticism as to those prospects.

Over in the bond market the signals are fairly clear: the market sees little prospect for inflation,risk of recessionary conditions and consequently a negative view towards Federal Reserve policy as leaning too heavily towards tight money/higher rates.

A few graphs will give a snapshot of the bond market's message.

The Federal Reserve has been on the path of reversing the10 year period of zirp or near zirp= zero interest rate policy/quantitative easing which began in response to the 2008 financial crisis.The ostensible rationale for such hikes is to slow economic growth and  prevent inflation, On Wednesday the Fed raised rates by .25% and indicated further rate increases in 2019:

But the message of the markets indicates little fear of inflation.

This can be seen most clearly in the 10year breakeven rate for TIPs Treasury Inflation Protected bonds. The rate subtracts the rate on tips from the rate on conventional bonds of the same maturity. If inflation exceeds that number TIP holders profit. Below is a chart of 10 year breakeven rates for 10 year bonds.

 

Another measure of inflation expectations is the rate on conventional Treasuries. Despite the Feds inflation fears the market of late has brought 10 year interest rates down from a recent peak just above 3.2%. This indicates a reduced fear of inflation. No one would purchase a 10 year Treasury bond yielding if they expected future inflation to exceed that rate and produce a negative real return the recent decline in ten year Treasury yields indicates lower inflation fears.

Another indicator of market sentiment is the spread between short term rates and long term rates. The Federal Reserve can control the overnight Fed Funds rate but not longer term rates. The "spread" (differential) between short term and long term rates indicates the markets assessment of the extent to which Federal reserve tightening is sufficient or excessive.The current gap between Fed funds rates and ten year Treasury bonds is at the extremely low level of. The is indicates the market my feel the Fed has "gotten ahead of itself" with short term rates quite high relative to the market expectation of future inflation reflected in longer term interest rates.

Finally, there is the risk of recession, A widening of spreads between Treasury bonds and investment grade corporate bonds and between high yield (junk) bonds and investment grade Treasuries indicated increased fear of recession and defaults on credit bonds.

Inflation grade bonds vs Treasuries

High Yield Spreads:

It remains to be seen who is correct in their assessment of economic conditions, But it is clear at present there is a disconnect between the views of the bond market and the Federal Reserve.

Active vs Passive: It’s Worse Than You Thought

S+P has been publishing since 2002 its’ SPIVA report which compares the performance of actively managed funds as compared to their relevant indices. The results consistently show significant underperformance by actively managed mutual funds over periods of 5, 10 and 15 years, the results across virtually all categories of stock and bond funds particularly over longer time frames is for the active funds to underperform.

Many investors are interested not only in their investment returns but also the risk adjusted returns. In a recent study researchers at S+P examined the risk adjusted returns of actively managed stock and bond funds vs their relevant indices (for example large cap value funds vs the S+P500 value index).

The study found that the overwhelming percentage of actively managed stock funds underperformed their relevant indices over 5, 10, and 15-year periods. Not surprisingly, fees played a significant role in determining the underperformance. This can be seen in the tables below which show performance gross and net of fees.

In the case of fixed income funds fees were the key determinant of underperformance Bond funds in several categories outperformed gross of fees but when adjusted for fees their performance was much poorer.

The study destroys another of the myths peddled by the active fund management industry. The claim that indexing is “riskier” and that active managers can successfully reduce risk in portfolios compared to indices doesn’t stand up to scrutiny.

Rebound in Non US Markets

Emerging markets and European markets suffered large declines in the last 3 months in response to a litany of perceived problems: Turkey's currency and debt crisis, potential for trade wars, and sharp declines in markets in Argentina and Mexico. As can be seen in the charts below the selloffs were marked by large increases in volume at the low points with an extreme spike in volume at the mid August low. This is typical of non US markets, particularly emerging markets where there is considerable performance chasing. All of these declines occurred as the US markets were hitting record highs.

FEZ (Europe) YTD performance...not volume spikes (bottom scale) at the lows

IEMG Emerging Markets (note volume spikes at market lows)

The divergence in performance between emerging markets and the S+P 500 was the largest in over a decade.

Below is a 2 year chart of IEMG(emerging markets) FEZ(Europe) and SPY S+P 500 as can be seen the large divergence in performance between US and non US markets began in May as "headline risks" had impact on the markets.

This divergence in performance has created large valuation gaps between US and non US markets:
                                             


                                              p/e                         dividend yield


IEMG emerging markets       13.81                        2.66%
FEZ Europe                            15.09                       3.16%
SPY S+P 500                         23.45                        1.84%

Perhaps in reaction to a bit of a fading of the concerns mentioned above and the large divergence in the valuation measures non US markets have has a sharp rebound in the last two weeks perhaps overlooked as US markets keep moving to new highs: Most recently Europe has shown more positive economic surprises than the US and there are signs Germany will step in to give financial assistance to Turkey.

In the last 2  weeks IEMG has rallied 2.4%  FEZ 3.8% vs. a rise of   2.1% for SPY. The non US ETFs are still negative for the year IEMG -6.2 and FEZ -1.4% far underperforming the SPY rise of 9.6%.
Given the gaps in performance and valuation perhaps the recent moves are signs of closing of the performance gap between US and non US markets.

High Yield Bonds in Your Portfolio ?

High Yield bonds have proven to be an attractive addition to portfolios. They are not for the faint of heart however since they can be subject to large down years far in excess of those for investment grade. In fact, they have near zero correlation to Treasury bonds--not surprising since Treasury bonds benefit and high yield bonds take big losses during periods of extreme financial market uncertainty and the "flight to quality".

Their risk measures fall somewhere between stocks and treasury bonds and they have a relatively high correlation to US stocks. Nonetheless they show some attractive risk/return characteristics.

Ten Year data these include the worst year for high yield bonds in the last 20 years--2007 when high yield bonds fell 31%.

10 year returns Bond ETFs Hyg high yield gold vcit intermediate corporate green AGG aggregate US Bond (blue) VGIT Intermediate Corporate (Black)

There is considerable reversion to the mean in spreads (differentials) between high yield and investment grade bond yields with periods of financial crisis leading to the flight to safety and sharp widening of yields--as can be seen in the extreme move during the 2007-2008 financial crisis. Current spreads are low reflecting confidence in the US economy and low perception of financial risk.

 Investors looking to add high yield to their portfolios might consider a lower duration high yield bond ETF like SJNK which reduces duration risk=sensitivity to changes in interest rates. As can be seen below (SJNK short term high yield in green HYG intermediate term high yield in blue) during the last 2 years of rising rates short term has outperformed.

How is "Smart Beta/Factor Investing" Doing ?

We now have over 5 years of data of live trading from the ishares "smart beta/factor" ETFS VLUE(Value), MTUM (momentum),QUAL (quality) and USMV (minimum volatility).

Momentum has shown the most outperformance vs the S+P 500. But all of the ETFs have shown impressive results VLUE and QUAL have also outperformed the S+P 500 (SPY) with little or no increase in volatility and USMV has performed very much in line with its target : slightly lower return than SPY with considerably lower volatility. It is not surprising that in a market dominated by momentum, value would outperform.

5 year return Mtum(black) qual(green) USMV(blue),Vlue(gold),SPY(S+P 500 red) 

An equal weighted portfolio of the smart beta ETFs outperformed the SPY.Although the volatility was higher the increased return was far in excess of the added volatility The portfolio generated "alpha" the most widely used measure of portfolio perfomance.

EQUAL WEIGH SMART BETA ETFS (green) S+P 500 (blue)

Of course five years is too short a period to draw definitive conclusions and the results are someone skewed by the large outperformance of momentum during a massive bull market, yet the results are impressive.

Unusual Times in the Markets

This bloomberg article entitled

The Global Trading Map Looks Really Confusing Right Now

 explains several of them.

One stood out to me the volatility of emerging markets stocks is lower than that of developed markets (which is of course largely made up of the US).

Beware "Thematic" (trendy) ETFs

One of the ETF strategies least likely to succeed is one based on a theme. A recent case in point  is the eventshares Republican Policies ETF

According to the sponsors:

The EventShares Republican Policies Fund’s investment objective is to seek capital appreciation by investing in market segments that the Advisor believes will be impacted by the enactment of Republican Policies.

The fund gives:

Access to a diversified basket of companies and industries aimed to benefit from Republican Policies. The portfolio is rebalanced to maintain its tailored exposure around political narrative changes.

To say the least the "political narrative" of the current administrations political/economic policy is not exactly consistent. So its not surprising that the current focus towards trade policy has left the people at eventshares scrambling to respond.

Bloomberg (via Financial Advisor Magazine) Investment News)

Confused by the Trump trade policies? You’re not alone.

An ETF that’s designed to own stocks affected by Republican policies sees more risk than opportunity in the president’s tariff showdown with China and is taking cover -- just like most of the rest of the market....

The ETF hasnt exactly been attracting assets...it holds under $1 million

And if you think the Democrats will take over the House and be able to push their policies you can "flip" your trade and buy the eventshares Democratic Policy ETF.

No they are not offering an eventshares political stalemate ETF.

First Quarter 2018 Review

Market Review First Quarter 2018

Both equity and bond markets showed negative performance for the quarter. The bond market continued to show response to the Federal Reserve policy of raising interest rates. Equities showed the impact of both higher interest rates and uncertainty over future economic/political policies.

Equity markets:  Stock markets showed extreme volatility as market participants displayed uncertainty towards future fundamentals. But just as important was the consequence of the large concentration of the market increases in the past year of a handful of stocks particularly those referred to as FAAMG (Facebook, Apple, Amazon, Microsoft and Google.

The concentration of this movement means that the S+P 500 has an extremely large weighting in these stocks. Furthermore, stocks in the technology sector have also increased in weighting over the past years. The large holdings in these stocks also come from holders of sector ETFs and actively managed funds chasing performance. The consequence is that when there is a selloff in these stocks there is a cascade of selling followed in turn by momentum traders.

Among these stocks Facebook and Amazon (and perhaps Google) may face regulatory challenges that may justify some revaluation of their stock value. Otherwise the overall earnings prospects for the technology sector remains in place.

The fundamentals of the US economy also  remain in place. But the potential challenges from poorly thought out trade policies hang over the market.

In sum, greater volatility can be expected and further declines in the market not unexpected particularly given the tendency of the market to develop a momentum of its own.

Among “smart beta” factors momentum continued to show outperformance despite the selloff in technology in March. Value and Quality showed strong relative performance in March.

Major US Market Indices

Symbol	Category	1Q 2018	1 year	3 year
SPY	SP 500	-1.0%	13.8%	34.3%
Mtum	Momentum	3.0%	29.6%	54.5%
Prf	US Large Value	-2.7%	9.8%	27.4%
QUAL	US Quality	0.2%	15.7%	36.3%
USMV	US Minimum Volatility	-1.2%	10.8%	32.9%
VBR	US Small Value	-2.1%	8.3%	25.5%

International Stocks

Influenced less by changes in US bond markets Asian markets continued their trend of outperformance vs.US stocks. Emerging markets and particularly Asia based on current market conditions are attractively valued vs the rest of the world…. but of course, the future of US Asian trade policy makes forecasts difficult at best.

The overall European Union stocks continued recent outperformance vs the US. Changes in trade policy, albeit to a lesser extent impact outlooks here as well. The European Central Bank has not moved to a tightening mode which is a positive. Germany underperformed the overall European Union likely due to domestic political developments. European stocks have continued to perform the index of all deloped markets. Emerging Asia has continued to outperform the rest of emerging markets.

Major International Indices

Symbol	Category	1Q 2018	1 year	3 years
VWO	Total Emerging Markets	0.9%	21.6%	24.5%
EFA	Total Developed Markets	-0.2%	14.9%	18.0%
GMF	Emerging Asia	2.0%	25.2%	30.6%
EZU	European Union	-0.1%	17.4%	18.8%
EWG	Germany	-3.0%	13.8%	12.4%

Bond Market

The Federal Reserve raised interest rates for the fourth time this year on March 21, the first time umder the new Fed Chairman Powell. While it seems near certain further hikes will occur this year the pace is uncertain much dependent on future data on inflation and the overall economy. The yield on the ten-year Treasury bond hit 2.95% at the end of February the high for 2018. It ended 2017 at 2.45%. At the end of the quarter it fell a bit to 2.74%. Shorter term rates have risen as well in what is called a “flattening/flat yield curve (narrowing of the differential between 2 years and 10-year interest rates) the two-year treasury reached a high 0f 2.30% on March 19, up from 1.88% at the end of 2017 and ended the quarter at 2.25%

Even with this development in the yield curve the bond allocation in portfolios benefitted from the strategy of keeping maturities/duration short. Short term high yield continued to perform strongly reflecting positive prospects for the economy.

Major Bond Market Indices

Symbol	Category	1Q 2018	1 year	3 years
AGG	Aggregate US Bond Index	-1.5%	1.1%	3.6%
BSV	Aggregate Short-Term Bonds	-0.5%	0.1%	2.1%
VCSH	Short Term Corporate Bonds	-0.7%	0.7%	4.4%
vgsh	Short Term Government Bonds	-0.2%	-0.1%	1.0%
SJNK	Short Term High Yield Bonds	0.2%	3.7%	10.8%

Looking Forward

As JP Morgan was famously said to have replied when asked for his market forecast his response was “they will fluctuate”.

It seems highly likely that those fluctuations will continue to be above historical levels going forward. The concentration of holdings in a few stocks and in the technology, sector will have an outside impact on returns. The growth of momentum traders both institutional and individual (many using ETFs) will be a short-term factor. More fundamental factors such as the uncertainties over trade policy and future interest rate changes will affect markets as well. A year of low single digits or negative returns should not surprise investors given the outsize gains of recent years.

Of course, the fundamental advice to investors is, as always to be comfortable to the level of risk in their portfolio and to stay the course. Given that short term fluctuations are best ignored.

I'm Still Confused by Wealthfront's Direct Indexing and Tax Harvesting

Robo advisor Wealthfront makes much of its strategy of direct indexing" purchasing individual stocks instead of broad ETFs which in turn allows more opportunities for tax loss harvesting as individual stocks fall..rather than only making exchanges between broad ETFs that have essentially the same index (total stock market ETFs ITOT and VTI for example).

As Wealthfront describes the strategy:(my bold)

Wealthfront 100 (WF100), Wealthfront 500 (WF500), and the Wealthfront 1000 (WF1000)

We call the up to 100 individual stocks owned as part of our Direct Indexing service the Wealthfront 100. When Direct Indexing employs 500 or 1,000 individual stocks, we refer to that collection of stocks as the Wealthfront 500or the Wealthfront 1000 respectively.

The individual stocks we buy are always selected to minimize tracking error with Vanguard’s Total Stock Market ETF, VTI, not based on their fundamentals or any perspective on whether they are fairly valued by the market. We harvest losses on individual stocks based on a threshold and use the proceeds to purchase other highly correlated stocks within the appropriate US stock index.

In some cases, we may purchase more of an existing holding. For example, if Coca-Cola misses an earnings estimate and drops precipitously in value we would sell Coke and use the proceeds to buy more PepsiCo to maintain the correlation with VTI in the absence of Coca-Cola.

The above may sound nice in theory but I am confused about how it would be implemented even in the case of Coca Cola and Pepsi other than that they make some competing soft drinks they are quite different companies with a large part of Pepsi's earnings from snack foods.

But that is trivial compared to week the one the market had last week. Facebook, the second  largest holding in the total stock market index

Here is Facebook stock over the last week (a 14% fall). It's hard to imagine how a strategy of direct indexing and daily (or even intraday) would work with Facebook. Which stock would reliably be chosen that had the same correlation with Facebook ?