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.

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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.

Morningstar Agrees With Me on Emerging Markets ETF

I wrote about alternative emerging maarkets ETF strategies emphasizing low volatility strategies here

Morningstar reached similar conclusions here:

Are There Better Emerging-Markets ETF Choices?

Rethinking A Bond ETF Allocation...The RIght Way and The Wrong Way

The March 11 WSJ features on of the almost endless stream of articles about preparing for the time when interest rates, rise. The articles range from sensible to apocalyptic with some predicting a quick and massive "bursting of the bond bubble".

First off its interesting to me that so many articles worry about the impact of a rise in interest rates on the bond market but seem to ignore it with regards to its impact on stock prices.

Thus the WSJ article starts out as follows:

"Don't fight the Fed" has been a market mantra for the past four years. But some bond investors are starting to lace on their gloves.

Figuring that the Federal Reserve won't be able to keep a lid on interest rates forever, large money managers such as BlackRock Inc., BLK -0.08% TCW Group Inc. and Pacific Investment Management Co. are getting ready for the day when rates take their first turn higher. 

It isn't coming anytime soon, these investors say. But when it does, they worry, the ascent will be swift and steep.

Of course the"don't fight the Fed mantra" is part of stock market lore too. And if there is one thing that pundits endlessly stress in their explanations of the stock markets rise it is the Fed policy of low interest rates which has pushed investors into riskier assets including stocks. In other words there is ample reason to be concerned that a change in interest rate policy will lead to a stock selloff that could be swift and steep as welll. And given that stocks are more volatile than bonds it is the stock market reaction to higher rates that may be more painful.

But back to bond allocations.

• In establishing a bond portfolio it is easier to pinpoint the risk factors and potential risk return of alternative scenarios. While it may not be possible to predict when interest rates will change it is relatively straightforward to predict how various types of bonds will react to changes in interest rates.
• Don't forget the total return: many articles on bonds focus solely on price changes ignoring the total return which is a product of price changes and interest earned. 

Despite the many words written on the bond market and the oft repeated warning of a "bond bubble" these same articles are very imprecise in explaining where exactly they see the "bubble" and therefore which bonds are at risk of big losses due to "bubble bursting". I have seen the term applied to high yield bonds, corporate bonds and treasury bonds often with little specificity as to maturity.

So here is an effort at clarity and specificity

Of course bond prices and yields move in opposite directions. And longer term bonds are more sensitive to changes in interest rates than short term bonds. The unprecedented declines in longer term interest rates has led to massive price increases. People have called the rise in prices in long term rates a "bubble" for several years but prices have continued to rise(yields fall). 

Unlike stocks which theoretically have unlimited upside bond prices cannot rise forever (interest rates can not fall forever). Therefore it is a simple mathematical certainty that long term bond investors will not experience the total return gains they have experienced in the last  years when for example 10 year treasury bond yields fell from over 5% to under 2.5%. Looking further back on the long term chart of bond yields below, it is clear that the gains to holders of bonds over the past decades will not be repeated in the future ...it is simply mathematically impossible, interest rates cannot fall below zero.

So from a strictly mathematical point of view the risk/return to holding longer term bonds is skewed negatively. The downside risk is greater than the upside potential for longer term bonds. 

Credit Risk: The other factor affecting bond prices is credit risk i.e. market perception of the potential inability of the issuer to pay back the bond holder. When using ETFs one is investing by asset class therefore diversifying away the individual company risk in the bond portfolio.

Investors can increase their credit risk and increase their yields through moving from treasury bonds to investment grade coporate bonds or even to riskier high yield bonds.

Spreads: the interest rate differential between treasury bonds and coporate bonds of both investment grade and high yield have narrowed at the same time that interest rates have declined. See chart. below.

But are high yield bonds in a  "bubble " ? Here is where I think alot of the analysis gets very sloppy. The Federal Reserve has told the world that it will only raise interest rates when economic conditions improve. But when economic conditions improve so should the fortunes of the financially weaker companies that issue high yield bonds. In other words their ability to repay their debt should improve...lowering the risk of default. Remember that in the beginnings of the economic crisis in 2008 as treasury bond interest rates fell, high yield bond interest rates moved up sharply (the spreads increased). Investors in the intermediate term HYG high yield bond ETF  suffered a loss of over 17% in 2008 while investors in intermediate term treasury ETF (ITE) had a gain of over 11%.

In other words better economic conditions lead to higher interest rates across the board lead to price changes which are greater as the maturity/duration increases. But there is no reason to assume they will affect high yield (junk) bonds more negatively than Treasury bonds.

 Long term bonds may be in a "bubble" or at least have poor risk reward characteristics but it is because of maturity not credit quality. 

In other words its the maturity/duration not the credit quality that should be the most important concern in establishing a bond etf portfolio.

A Better Way to Index Emerging Markets

A lot has been written about the "south korea issue" created by the largest emerging market ETF  Vanguard's VWO.

Vanguard announced last year that it was switching index benchmarks from MSCI  to FTSE which does not include South Korea as an emerging market. The transition is being made gradually. But for those looking to retain a significant South Korea exposure the search was on for a low cost alternative.MSCI has South Korea as its second largest country exposure at a bit over 15%. VWO is gradually transitioning to the new index and currently has a bit over 11% weighting in South Korea.

Ishares emerging markets ETF (EEM) retains the MSCI benchmark but at a management fee of .69% quite an increase for those previously paying .18% for VWO.

But Ishares has stepped up with a very attractive new emerging markets ETF: IEMG which has a management fee of

IEMG as other attractive aspects as well: it has larger number of holdings and thus more exposure to small and mid cap stocks.

Recently another interesting alternative has debuted among emerging markets ETFs. The low volatility strategy (which I described here) is now offered in an ishares ETF EEMV.

Adding EEMV to an emerging markets allocation is particularly interesting because it is weighted in different industries than IEMG (or VWO or EEM). The low volatility screen reduces the weighting to natural resource based holdings and shifts towards those more linked to the local economies.

Here is a comparison by industry of the emerging market ETFs As can be seen the only significant difference among the ETFs is EEMV (minimum volatility) vs. the others.

	IEMG	VWO	EEM	EEMV
Basic Materials	11.63%	12.06%	11.78%	5.39%
Communication Services	6.97%	8.67%	8.00%	12.74%
Consumer Cyclical	9.27%	8.70%	8.57%	6.05%
Consumer Defensive	8.33%	8.20%	8.56%	14.34%
Energy	9.69%	11.59%	10.84%	6.62%
Financial Services	23.32%	22.84%	24.29%	24.92%
Healthcare	1.65%	1.11%	1.08%	4.77%
Industrial	8.55%	7.58%	7.67%	8.25%
Real Estate	3.15%	1.65%	1.89%	1.69%
Technology	14.42%	14.49%	14.32%	9.08%
Utilities	3.02%	3.11%	2.99%	6.16%

As a consequence the EEMV returns have been strikingly different than other the other ETFs listed above.  Although of course one should not draw too many conclusions from the short trading history of EEMV.

EEMV is below in green EEM in gold  VWO in blue

This chart shows growth of 100,000

And below the top bar chart is returns and the bottom is volatility

So far an impressive performance for EEMV with far higher returns at significantly less volatility. It would be too early to declare an absolute preference for EEMV but the data certainly argues for including it in a portfolio.

( I left out IEMG here because it has been on the market for such a short period of time but at least for now it trades in line with EEM and VWO)

This Makes Me A Little Nervious

• The stock market is basically impossible to forecast in the short term 
•  I am a big advocate of not market timing by going "all in" any single asset class.
• There is a well known document momentum factor in short term market movements.
• But in the short term price can deviate from value and there is a reliable pattern of prices reverting to the mean (closer to value)

On the Other Hand... Remember that stock prices can move higher only one of two ways: p/e (or other multiple )expansion ( a higher valued stock market ) or  higher earnings (which keeps the p/e growth minimal, nil or even can push it lower) Right now we are in a p/e expansion mode on historical short and long term earnings measures meaning that the expansion is based on increasing enthusiasm for future earnings (if price is keeping base with value). Or the move up is based on too rosy a forecast for the future=pure momentum and price is deviating from value.

One of the fewer macro indicators with some medium to long term efficacy is the  Schiller p/e ratio based on Long Term Normalized Earnings.(more explanation here). And that indicator is at a minimum flashing a warning signal.

Current Shiller PE Ratio: 23.75 +0.03 (0.11%)

4:35 pm EST, Wed Mar 6

Mean:	16.46
Median:	15.87
Min:	4.78	(Dec 1920)
Max:	44.20	(Dec 1999)

And Here is the P/E most analysts and journalists commonly refer to:price to earnings ratio, based on trailing twelve month “as reported” earnings.

Current PE is estimated from latest reported earnings and current market price.

Current S&P 500 PE Ratio: 17.53 +0.02 (0.11%)

4:35 pm EST, Wed Mar 6

Mean:	15.49
Median:	14.49
Min:	5.31	(Dec 1917)
Max:	123.79	(May 2009)

Price to earnings ratio, based on trailing twelve month “as reported” earnings.

Current PE is estimated from latest reported earnings and current market price.I would regard a third measure of p/e based on forecasted earnings as of little use, considering the unreliability of earnings forecasts 

Looking at this S+P 500 chart above (total return) and especially the pattern of last  3 years with major rallies in the first quarter followed by sharp declines through the middle of the year and strong annual performance one might conclude it is worh looking into some rebalancing to return portfolios to target allocations by selling some stocks.

One the other hand many might look at the 45% total return and conclude that despite the roller coaster ride it was worth simply ignoring the selloff and not making any adjustments.

I tend to favor rebalancing.

No Suprise Here..

Barron' cover story Feb 9 issue

All in the Family

By LAWRENCE C. STRAUSS | MORE ARTICLES BY AUTHOR

The Barron's/Lipper one-year ranking of fund families offers some dramatic moves and big surprises. Putnam, Pimco and Hartford top the list, while last year's winners slid to the bottom.

How We Invest A Presentation of My Approach to Investing

I put together a fairly comprehensive review of my investment strategy. You can find it here.


One more part of my investment approach not in the presentation: I never watch this guy....or anything else on CNBC.

But you can find Cramer's appearance on Jon Stewart..it is fantastic.