Category Archives: Investing Strategy

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How Dangerous Is Common Retirement Advice?


  • Things are much different than they were 10 or 20 years ago but everyone seems to follow the same retirement investing advice.
  • As retirees are in need of more security they are now forced into more risk as bonds have become riskier than stocks while also giving a lower yield.
  • If you’re looking for security, cash may be your best bet.

Introduction

You’ve likely heard the advice that as you get closer to retirement you should move toward having a bigger chunk of your portfolio in bonds rather than stocks. Most retirement funds are structured in that way. Vanguard Target Retirement Funds allocate 90% of assets in equities and 10% in bonds if you are going to retire between 2058 and 2062, thus 45 years from now. For those with 20 years until retirement, the division is 80/20. The ratio is 75/25 for those with 15 years, 65/35 for those with 10, 60/40 for those with only 5 years, and 50/50 for those of retirement age. For those in retirement, the division is 64% in bonds and 36% in equities if you’re younger than age 73, and 70% in bonds and 30% in equities if you’re older than 73. You can see this represented in figure 1 below.

figure 1 vanguard asset allocation
Figure 1: Vanguard Target Retirement Fund asset allocation per age group. Source: Vanguard.

The example above follows the standard and traditional retirement advice issued by the majority of financial institutions and retirement specialists. In this article we are going to analyze if that advice still holds up in the current financial environment, what the risks related to it are, and finally, what can be done differently.

Don’t forget that it is a given in the financial world that if an advisor gives the wrong advice but the advice is the same as what the majority does, there will be no negative implications for the advisor’s career if and when things turn for the worse. On the other hand, if you point out risks but nothing happens, your financial career is in jeopardy. Think of the movie The Big Short and the guys shorting A rated credit institutions.

What Has Changed In The Last Two Decades? Bonds.

The common advice outlined above comes from an environment that was significantly different than the one we have today. The first major difference is that yields have gone down and bond prices have gone up in the last 20 years.

figure 2 bond yields
Figure 2: Thirty-year treasury yield. Source: FRED.

The current yield on 30-year treasuries is 2.24%, which is a record low. What is significant is that yields have been declining since 1981 and before that yields had only been increasing.

The declining yields trend pushed bond prices upwards. The net asset value of the iShares 20+ Year Treasury Bond ETF (TLT) has gone from $103 at the end of 2013 to the current price of $140. This means that if yields go back to the levels they were at the end of 2013, of around 4%, the value of 20+ bonds will decline by 29%. It would take more than 10 years for the increase in yields to cover for the decline in value. So, by being long bonds, you are risking a loss of 30% for a yield of 2.24%.

Yes, bond prices can go higher if the U.S. becomes like Japan or Europe where negative interest rates are the new normal, but with the FED contemplating interest rate increases and an employment rate of 4.9%, which is half of Europe’s rate, we could say that the chances are more in favor of higher yields.

The retirement strategy that was formed a long time ago didn’t have to account for global negative interest rates, treasuries yields below 2.5% and the fact that bond yields could jump up or decline 50% in a matter of a year.

figure 3 volatility
Figure 3: Thirty-year treasury yield volatility in the last 5 years. Source: FRED.

What Has Changed In The Last Two Decades? Stocks.

Stocks are in the same asset bubble as bonds. Low bond yields push investors to seek better yields elsewhere. The S&P 500 has a PE ratio of 25.23 which implies a yield from stocks of 3.96% which is, the same as with bonds, the highest level ever reached if we exclude the 2000 tech bubble and the depressed earnings in 2009.

figure 4 s&P 500 multipl
Figure 4: S&P 500 PE ratio. Source: Multpl.

The Shiller PE ratio, which takes into account 10-year earnings averages in order to eliminate cyclical influences, is even worse and at 27.08.

figure 5 shiller
Figure 5: Shiller PE ratio. Source: Multpl.

To put it simply, if bond yields go to 4% and we attach the historical stock premium of 2.29% for stocks, the expected yield from stocks would be 6.29%. With current earnings, it would imply a PE ratio of 15.97 and an S&P 500 value of 1,380, or a decline of 37% from current values. This means that for the current S&P 500 earnings yield of 3.96%, you are risking 37% of your stocks portfolio if the FED reaches its 2% inflation target.

Conclusion

Given the risk versus reward outlined above for both bonds and stocks, one clearly has to be prudent with their savings, especially for those close to retirement. Many retirees watched their retirement savings get cut in half during the last financial crisis and unfortunately it looks like many will go down the same road again because they follow the same old rules without questioning them.

Low yields force investors to hold a greater percentage of their savings in assets that produce some form of yield in order to reach a satisfying retirement income, but if you look at risk as a function of price and not volatility you see that those assets become more and more risky as their prices go up and yield goes down. As we described in our article about Carl Icahn, smart investors continue to warn us about the long-term negative effects of low interest rates as they threaten to bankrupt pension funds and retirement incomes. Those low interest rates force people to save more as they will need more money to retire safely.

The main point of this article is to make investors think and to show them the risks they are running by just following the old investment dogmas in a different world. If you are close to retirement, assess your future needs, assess the risks you are currently exposed to and create a portfolio that you can sleep well with no matter what happens.

An asset that is pretty safe but that no financial advisor will ever recommend because you do not get any commission on it, is cash. Something to think about in this new world.

There is one additional strategy, which happens to be one of our favorites, where the bulk of your retirement savings sits safely in cash, yet still allows you to earn high double digit yields on your capital. Click here to learn more.

 

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The Future Will Blow Your Mind. How Can You Take Advantage Of It?


  • Global GDP has quadrupled in the last 35 years and will probably do so again in the next 35 years.
  • By 2050 it’s expected there will be 10 billion people on earth and most of them will be living a western lifestyle.
  • While the forecasts are pretty certain, the issue is that the way towards those forecasts will not be linear. Investors should be careful not to get excited and jump into bubbles.

Introduction 

Investing is both complicated and simple at the same time. Today we are going to show the simple side of investing by analyzing a few factors that are almost certain and that will have a huge influence on your investing returns. By analyzing a few global demographic and economic trends we can see where the world will be in the future and connect that with our investments pictures, a scenario that is actually mind-blowing. Keep reading…

Global Population & Economic Development

A number that is essential for investors is the following:

figure 1 global population
Source: Worldometers.

 

What is even more important is that the population is growing and will continue to grow. Global population is expected to reach 9.7 billion by 2050. The biggest expected growth is in Africa, followed by Oceania, the Americas and Asia.

figure 2 global population forecast
Figure 2: The World’s population. Source: The Economist.

 

This simply means that the global market for companies and global demand will be at least 31% larger in 34 years. On top of the increase in the global population, the economic structure and growth forecasts for the majority of the global population are astonishing.

The list below shows the current top 15 countries by population and their respective GDP per capita.

figure 3 data
Figure 3: Population and GDP per capita. Source: Worldometers, World Bank.

 

Of the 15 most populous countries, only the U.S. and Japan have a GDP per capita higher than $10,000. Countries like Indonesia, with 260 million people, have to grow 10 fold to reach the Japanese standard while India has to grow 20 fold. Thankfully, all of these currently underdeveloped countries are growing at amazing rates.

figure 4 global gdp growth
Figure 4: Global GDP growth. Source: The Economist.

 

If we look at where the global GDP per capita average was 35 years ago we can only imagine where the GDP will be in 35 years with the explosive growth in emerging markets.

figure 5 glboal GDP per capita
Figure 5: Global GDP per capital in current US$. Source: World Bank.

 

If GDP per capital quadruples in the next 35 years like it did in the last 35 years, in 2050 we will have an average global GDP per capita of $40,000, which is higher than what Japan currently has.

A higher GDP will make many things available that are currently unavailable. Many people will want a car and we can only imagine what will that do for the car industry. Of the 15 countries mentioned above, only the U.S. and Japan have reached a level of car per capita saturation.

figure 6 cars per capita
Figure 6: Global cars per capita. Source: Charts Bin.

 

Cars, homes, infrastructure, software, hardware, travel, fashion, medicine, food and who knows how many more things that we can’t even imagine at the moment will be a normal in 2050 for the majority of the global population.

How sure can we be that this will become a reality in the next 35 years? Facebook gives us a clue. Their data shows the fastest growth rates in the Rest of the World and Asia which means that people there are more and more informed about a western lifestyle which will encourage them to seek such a life.

figure 7 daily users
Figure 7: Facebook’s global growth in daily active users. Source: Facebook.

 

We can clearly conclude that the world will be a much different place in 35 years, especially when we look at how different the world is now compared to how it was 35 years ago. Just to gather the data I’ve listed above would have taken me a year or longer to gather 35 years ago, while today I can go online and have everything in front of me in an instant. Globalization, a larger population and inevitable economic development are the trends that will undoubtedly influence your investments in the next 35 years.

What Investors Should Do

If you’re in it for the long-term, you have nothing to worry about especially if you are well diversified and have made smart investments. What do we mean by smart investments? The global growth discussed above is pretty certain, but what is uncertain is the linearity of it. Going back to figure 5 we can see that from 1995 to 2002 there was very little improvement in global GDP.  Only after 2002 did it explode. This means that the road to quadrupling global GDP will not be smooth.

An investor has to be careful not to overpay for an investment. Many people see the above numbers and get very excited. This is what creates bubbles. As we will have many recessions in the next 35 years, it is wise not to get too excited about the numbers above but to invest at maximum pessimism. Currently there is excitement about healthcare, social networks, and consumer discretionary, and negativism in agriculture, food, energy, mining and shipping. With the growth described above, there is more certainty that demand will grow for commodities than for social networks which is a perfect example of how investors get carried away.

Charlie Munger, Buffett’s investment partner, continually restates that investing should be like watching paint dry and that if you want excitement, take $800 bucks and go to the casino. All the inevitable economic and demographic developments are pretty certain, but will slowly grow into the forecasted numbers. If your investment horizon is long you can afford to be invested in the sectors that will surely benefit from the structural trends and wait for the booms. What you should avoid is to be invested in bubbles because those are the destroyers of long-term returns.

For more specific information about a sector that we believe has just reached a point of maximum pessimism and is trading dirt cheap, but is sure to benefit from the massive future growth in global GDP, click here.

 

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Are You An Investing Optimist? Check Your Portfolio


  • Investors are very optimistic in bull markets and allocate much of their portfolio to stocks, increasing their risk.
  • Analysts and economists expect more spending which will consequently push GDP and inflation up, but low rates push people to save more for their retirement.
  • If the GDP and earnings don’t grow as expected, we could see a bear market in 2017.

Introduction

Stock markets keep going up while fundamentals keep going down and the economic situation isn’t that great either. The S&P 500 is dancing around new highs despite corporate earnings for Q2 falling by 3.6%, and the economy only growing by 1.2% on an annualized basis. Economic growth for the whole of 2016 is only at 1%.

So, what is pushing stocks higher? The simple answer is optimism. It is assumed that next quarter’s earnings will be exceptional and economic growth will blow off the charts. In this article we are going to elaborate on the forecasts and assess their probability in order to take a look at what optimism can do to investors.

About Optimism

Being an optimist is nice. Optimists are happier, have a more positive view of the world, are ready to take risks in life and optimism helps one to cope with life’s uncertainties. We can say that in life, it pays to be an optimist. On the stock market it also pays to be an optimist but it pays even more to be a rationalist.

An old research project (1999) by behavioral scientists Benartzi, Kahneman (Nobel prize) and Thaler explains perfectly how investors approach stock markets after a few years in a bull market. Based on 1,053 Morningstar subscribers of which 84% were male with annual household income averages of $93,000, they found that investors had an average allocation to stocks of 79%, and 95% of their pension contributions were directly allocated to stocks. This bullishness derives from investors’ optimism. When asked what they focused on when thinking about financial decisions, a staggering 74% of investors focused on positive returns.

figure 1 optimism survey
Figure 1: Thinking about potential return or potential loss. Source: Behavioral Finance.

By being an optimist, you make bold investment decisions, but investors should also think about risks. Don’t forget, one of the most quoted of Buffett’s pearls of wisdom is: “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1.” The reason behind this rule is that if you lose 50% of your investment, it takes a 100% return just to get you even.

Optimistic Forecasts

Yes, earnings have declined and the economy isn’t growing fast at the moment, but analysts are highly optimistic that in the next quarter or the one after that, everything will grow. On June 30, most analysts expected earnings to return to growth in Q3 2016.  Now analysts expect a 2% earnings decline in Q3 2016 and don’t expect earnings to return to growth until Q4 2016.

figure 2 earnings
Figure 2: Forecasted earnings growth for Q3 2016. Source: FACTSET.

The same analysts that consistently revise their estimations downwards as actual earnings results are released expect S&P 500 earnings to grow 13.3% in 2017. At the end of June, the expectation was at 13.5%.

figure 3 earnings growth 2017
Figure 3: Forecasted earnings growth for 2017. Source: FACTSET.

The expected increase in earnings comes from an expectation that oil and other commodity prices will inevitably increase and push earnings higher, and that no sector will see earnings decline.

Additionally, GDP is expected to grow at a rate above 2% from this quarter onwards. The current 1.1% yearly growth is just a temporary slowdown according to interviewed economists.

figure 4 wsj gdp
Figure 4: Forecasted GDP growth. Source: Wall Street Journal.

But not all economists agree on that rosy view. Economist Stephanie Pomboy stated that analysts and economists are wrong because they use pre-financial crisis frameworks to make their estimations and the world has changed a lot since then. Despite the fact that interest rates have severely declined, people spend less and save more. Less spending means inevitable declines or slower GDP growth.

figure 5 savings
Figure 5: Total saving U.S. deposits. Source: FRED.

Why are people saving more? Well, with lower interest rates you need to save more to reach a satisfying level of income for retirement. As the population is getting older, they will save more and more. This speaks to how low interest rates have been beneficial for businesses but very detrimental for savers and an aging population.

In such an environment we cannot expect GDP growth and earnings to increase just because interest rates are low as it is clear that low interest rates have not worked thus far to stimulate economic growth.

If the GDP does not reach the expected 2% growth rate and corporate earnings continue with their decline, Pomboy sees a bear market in 2017, especially in discretionary stocks.

Discretionary stocks have really high PE ratios and, yes, if the growth from the past 5 years continues, those ratios might be justified, but any kind of bad news could quickly send those stocks down. Amazon (AMZN) has a PE ratio of 188.4, Home Depot (HD) 23.8, Starbucks (SBUX) 30.9, and Nike’s (NKE) is at 27.3. All these stocks could easily fall more than 50% if a recession comes along or people spend less because of their high valuations based on optimistic future projections.

Conclusion

It is good to be an optimist, but in investing it is also good to be a realist, or a diversified optimist. A diversified optimist is an investor that is positive about his returns, fully invested but well diversified among various uncorrelated assets and prepared for any economic environment.

The main point of this article is for you to assess your optimism and look at the risks in your portfolio. When you look at each component of your portfolio, ask yourself how much you can lose. Write that number down and then go through the list again and ask yourself how much you can gain. Where the potential risk is much higher than the gain you might want to look for other assets.

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The U.S. Dollar: Should You Stick To It Or Diversify Now?


  • The dollar has been positively correlated with stocks for the last 4 years which is unusual.
  • Potential FED interest rate increases don’t make international diversification a great idea right now.
  • Any sign of a U.S. recession should be a good time to think about international diversification with emerging markets.

Introduction

On big news sites like Bloomberg you often come across headlines related to the movement of the U.S. dollar. The headline below is a good example.

figure 1 bloomberg news

Such headlines relay what has been going on in the few hours before publication but are completely irrelevant for investors that aren’t trading pips on forex. This article is going to investigate the longer term relationship between the dollar and stocks, and discuss the best option for maximum return with minimal risk.

Recent Dollar & Stocks Movements

Before 2012, as the dollar strengthened, stocks went down and vice versa. The reason was simple, a strong dollar meant U.S. exports were less competitive and businesses suffered, while a weak dollar made U.S. goods cheaper across the world and increased corporate earnings. Since 2012, however, the story has been a little bit different. The dollar has gotten stronger and stocks have gone higher.

figure 2 fred dollar stocks
Figure 2: U.S. dollar vs. S&P 500. Source: FRED.

The reason behind this is the fact that no matter what we think of the FED, it is the most globally coherent financial institution. In an environment where the European central bank is continuing with stimulus and the Japanese think about printing money for direct spending, the FED is the only institution that contemplates raising interest rates. So the positive correlation between the U.S. dollar and the S&P 500 comes from the relative success of the U.S. economy and the global faith in the U.S. dollar as the only safe currency.

On one hand, the strong dollar lowers corporate revenue. But on the other hand, it also lowers corporate costs, something CEOs never talk about when reporting earnings. As the U.S. has a net trade deficit, the strong U.S. dollar makes everything around the world cheaper and therefore expenses should also be much lower. Don’t forget this in the next earnings season.

Long Term Dollar Strength

The long term perspective is a little bit different than the above. Since 1975, the dollar has slowly but consistently weakened in relation to foreign currencies.

figure 3 long term dollar
Figure 3: Dollar index since 1975. Source: FRED.

The slow decline of the dollar means that global trends are shifting, which is also normal given the development in China and other countries. As the rest of the world is expected to grow at a faster rate than the U.S., the long term trend for the dollar is clearly and slowly downwards. This point is essential for international diversification. We have discussed many times how ChinaIndia and other fast growing emerging markets are essential for healthy diversification.

Forecasts & Economic Factors

In the short to medium term, it looks like the dollar is going to continue to strengthen. If the FED increases interest rates and others continue with their stimulus, the dollar will surge even higher. The most recent FOMC minutes clearly indicate that we could see a rate hike by the end of the year. But, eventually the strength of the dollar will kick back as exports will be more expensive and the trend will turn and continue to follow the declining line seen in figure 3 above.

What To Do

There are two options with currencies. They go up or down and do so for longer periods until the structural influences rebalance on a global scale. With interest rates low and good news from the U.S. economy, the FED will eventually raise interest rates and send the dollar higher. The moment of maximum strength of the U.S. economy and the dollar will be the time to diversify to other currencies but until then, sticking to the dollar is not a bad idea, especially for the majority of our readers who are living in the U.S. If the U.S. economy slows down and the dollar weakens, you will still have most of your assets in your home currency which will not represent a real change to your portfolio. But if you are exposed to other currencies and the dollar gets stronger, you will have to look at losses, which is never pretty.

Conclusion

U.S. investors have the benefit that if the dollar gets weaker, international diversification is just a missed opportunity while if the dollar gets stronger, it was a good idea to stay at home. International investors have to play it differently. With the FED eventually increasing rates, the dollar has no other direction to go than up which is a great diversification play when looking at the stimulus in Europe and Japan which weakens their currencies.

In the long term, it pays to be exposed to the currencies of the countries that are going to grow at a faster pace than the U.S. economy, i.e. emerging markets. We have seen the Chinese Yuan get weaker in the past two years due to some fears about China slowing down, but the longer term trend is clear.

figure 4 cny usd
Figure 4: Chinese Yuan per 1 USD. Source: XE.

With the economy expected to grow at a pace of above 6% in the next 10 years and the Chinese getting richer, there is only one way for their currency, up. Think about international diversification, but only when the dollar strength reaches its structural limits and the U.S. is close to a recession.

 

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Small Cap Value Stocks Have The Best Returns, But Can You Stomach The Catch?


  • Historically, small cap value stocks are the best performers.
  • They don’t trade in sync with the market and often are waiting to be discovered.
  • The “waiting to be discovered” period can last for a few years.

Introduction

Almost a month ago we discussed how, from a risk-reward perspective given current valuations and historic performance, it isn’t a smart idea to invest in small cap growth stocks at the moment. Today we are going to discuss small cap value stocks to see if they will fare better on our long-term risk-reward scale.

Small Cap Value

In order to be categorized as a small cap value stock, a company has to have a market capitalization below $2.5 billion and its stock price has to trade below its book value (where possible, or have the lowest book value).

There are several benefits to having a small market capitalization. One is that a company is then always a takeover target and as we discussed last week, that can bring about instant returns when an acquisition is announced. Other benefits include growth prospects as it is easier to grow when you are smaller. For stock pickers like us, it is always a benefit when a company is a small cap because it is less frequently, or even not, followed by analysts, and thorough due diligence pays off as sooner or later the market recognizes good companies even amongst small caps.

On the value side, when a company is trading below its book value it means that the risks of investing are limited because in the case of a business liquidation or bankruptcy, there are enough assets to cover all stakeholders. However, proper due diligence here is essential as there is a big difference between having lots of fixed assets on your balance sheet and having lots of goodwill. In difficult times, goodwill is impaired as the acquisition that created it was obviously a mistake while fixed assets like real estate are of real value on the balance sheet. Researching beyond the balance sheet can bring further benefits as by understanding the story behind a property, plant and equipment account, one can discover that some buildings are completely depreciated and not even on the balance sheet. Such a situation with no analysts following a company is a real gem, but it takes a lot of research of diligently going through every single small cap in the stocks universe.

Small Cap Value – Historical Performance

For those investors who don’t have the time to research small caps in detail, diversified investing into small cap value stocks has been the best thing to do over the past 40 years. Investing into U.S. small cap value stocks would have outperformed all other investment options.

figure 1 size and value
Figure 1: Investing by size and value – performance since 1979. Source: Author’s calculations.

 

$100 invested into small cap value stocks at the end of 1979 would have returned $11,027 today, while investing in mid cap value stocks would have returned $9,605 in the same time frame, in the S&P 500, $5,199, and in small cap growth stocks only $3,216.

This outperformance is nothing new. Back in 1992, Fama and French developed their famous three factor model—which earned them the Nobel prize (French, unfortunately passed away and was not formally awarded a Nobel)—where they found that value and size give the highest premiums to stock returns. Twenty-four years later, the story should be the same. The iShares S&P Small-Cap 600 Value ETF (IJS) has had an average return 9.48% since its inception in 2000, thus no matter when the measuring started, this strategy outperforms other strategies.

The current PE ratio of the iShares S&P Small-Cap 600 Value ETF is 19.21 which is the same as the iShares Core S&P 500 ETF (IVV), but the difference lies in the price-to-book value which is 1.64 with small cap value stocks, 2.88 with the S&P 500 and 2.92 with the small cap growth ETF. From a fundamental perspective, this is where the difference lies.

Why Do Small Cap Value Stocks Outperform? 

The are many answers to this question. To find them, you have to dig in the dirt and not many analysts are willing to do that as it is easier to follow the crowd with big names. Big investment funds have to wait for a company to reach a large market capitalization to invest in it, but by then the major profits have already been accounted for. If you are an investment manager and you make a mistake by overpaying for a large cap, there will be no hard feelings as everybody else did so as well, but if you recommend a small cap and the story doesn’t end well, you will probably be fired.

The last reason is that value lowers investing risk. If the business doesn’t end well, there are always assets to sell to cover the losses. Therefore, small cap value stocks trade at a premium which ultimately delivers higher returns.

What’s The Catch?

Investing in small cap value stocks comes with a catch that many investors don’t have the stomach for. The catch is that small cap value stocks tend to have a mind of their own and don’t move in sync with the S&P 500. For example, in 2015 the S&P 500 returned 1.3% while small cap value stocks had a return of -6.84%. The same was true in 2014 when the S&P 500 was up 14% while small cap value stocks were only up 6.5%. In 2007, the S&P 500 was up 5% while small cap value stocks lost 8%. How would you feel if when talking to your neighbor, they are up more than 20% in the last two years while you have a negative return?

The thing is that small cap value stocks have to first be discovered by the masses, and only then, when they become trendy, do they boom by getting a fair market valuation. Therefore, an investor may wait for a long time and underperform—like in 2014 and 2015—but sooner or later things change. Year-to-date, small cap value stocks are trendy again and are up 13.6% compared to the S&P 500’s 6.5%.

Conclusion

Investing in small cap value stocks is not for everybody but it delivers the best returns in the long term. The low liquidity, higher uncertainty and general unwillingness to research small caps means a higher premium which in the end, brings about higher returns. Investors who are ready to invest in small cap values will be rewarded in the long term.

In an environment like we’re in now with lots of monetary stimulus, value might be the way to go as assets increase in value in inflationary times. We don’t see inflation yet, but it is bound to happen sooner or later. Growth stocks with high debt levels will be the first ones to suffer when higher interest rates arrive, and historically are the worst performers. Therefore, look into your portfolio and if you don’t have small cap value stocks, be sure to include some.


On Friday we attempted to send you a report Sven had written but had some issues with the links. It just so happens the company featured in this report happens to be a small cap value stock in the metals and mining space that we believe has yet to be discovered by the market. To access this free report ($49 value) click here, and to access the most recent update on the featured company click here.

Many of you also may not have received yesterday’s Sunday Edition featuring a reprint from Thomas Moore’s Rebel Income newsletter. In yesterday’s issue, Thomas discussed why stock assignments aren’t a bad thing and how to take advantage of them. To access the Sunday Edition, click here.

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Minimize Risk Without Sacrificing Returns? Sven Tells You How


  • By dissecting the S&P 500 per valuation quintiles we see that only parts of the market are overvalued.
  • Historically, buying the lowest PE quintile stocks has increased annual returns by 360 basis points.
  • High PE stocks have large market capitalizations which force you to own more of them through index funds, increasing your risks and lowering your returns.

Introduction 

Beyond the top news stories about central banks increasing stimulus to fight the BREXIT or sluggish economic data with high hopes for the future, there is one recurrent theme that still flies under the radar. The recurring theme is that financial markets are overvalued.

As we all know, bull markets climb a wall of worry. Investors who sold everything in 2011 believing markets were overvalued were happy for a while, but are probably still crying now as, if they had not gotten back in the market, they missed a huge upside. We might be in a similar situation where selling now would mean losing much upside, but there is another option.

Figure 1 S&P 500 last 10 years
Figure 1: S&P 500 chart for the last 10 years. Source: 5yearcharts.com.

Today we are going to discuss the alleged market overvaluation and dissect it into overvalued and undervalued segments. This is possible as the market is currently all over the place. We are going to end with an example of potential irrational exuberance, social network stocks, and show how such investments can be avoided even when allowing for a high level of diversification.

Dissecting Market Overvaluation

The PE ratio of the S&P 500 is 25.24 if you calculate it by using S&P 500 earnings. By changing methodology, you can get to other averages, but we believe this one to be the most accurate as it looks at aggregate earnings and not stock PE ratios with a lot of negative inputs that skew the result. The average PE ratio for all S&P 500 stocks with negative ratios included ends up at around 19, so don’t get confused by the difference.

In any case, the expected returns with a PE ratio of 25.24 are below 4% per annum, and as corporate earnings are not growing we cannot expect much more. If you hold a diversified ETF or mutual fund that tracks the market, you can’t expect more than 4% returns in the long run, but you should be able to lower your risks and even increase your long term returns if you choose not to include irrationally overvalued companies in your portfolio.

Of course, complete S&P 500 diversification is then out of the question, but here is why. When buying an index, the most expensive stocks have the largest weights because as they get more and more expensive, their market capitalization increases and the fund manager is forced to buy more, which further increases the price and forces the asset manager to buy even more creating a vicious circle that leads into irrational exuberance.

But by looking at quartile valuations of expected forward PE ratios, we see that the market is overvalued only within the highest PE quintile.

figure 2 quintile expected forward PE
Figure 2: S&P 500 PE ratios by quintile. Source: Smead Capital Management.

As historically stocks with the lowest PE ratios have outperformed all other groups, we can limit the risks of a market downturn by shifting our portfolios towards low PE ratio stocks. Those who did that in the last 40 years achieved above market returns of 360 basis points (market average 11.7%, lowest quintile PE stocks 15.3%).

figure 2 PE ratio returns
Figure 3: Returns by valuation quintile. Source: Smead Capital Management.

To give some research aid, here are the 25 S&P 500 stocks with the lowest PE ratios. Be careful because low PE ratios don’t always mean high earnings. Special events like divestitures or future imminent costs can skew PE ratios.

CompanyTickerPE Ratio
Delta Air Lines Inc.DAL3.87
Noble Corp.NE6.44
Yahoo! Inc.YHOO6.64
Valero Energy Corp.VLO7.03
American International Group Inc.AIG8.91
AFLAC Inc.AFL9.26
Assurant Inc.AIZ9.42
Danbury Resources, Inc.DNR9.50
Unumprovident Corp.UNM9.59
Deere & Co.DE9.69
Travelers Companies Inc.TRV9.94
CF Industries HoldingsCF9.94
Lincoln National Corp.LNC10.04
Ford Motor Co.F10.23
Hess Corp.HES10.36
International Business Machines Corp.IBM10.39
Verizon Communications Inc.VZ10.48
Lyondellbasell IndustriesLYB10.52
Masco Corp.MAS10.55
Murphy Oil Corp.MUR10.69
Chevron Corp.CVX10.72
AT&T Inc.T10.88
Capital One Financial Corp.COF10.91
Allstate Corp.ALL10.92
Goldman Sachs GroupGS10.95
Figure 4: S&P 500 lowest PE stocks. Source: The Online Investor.

Digging into such a list can give you companies that have stable businesses and low valuations despite any market whim.

High Valuation Example

Not taking anything away from Facebook (FB) or giving any investment analysis, we are going to use it as an example of how a high PE ratio stock can influence our long term investment.

FB’s current weight in the S&P 500 is 1.53% which means that the average Joe that only invests in the S&P 500 has 1.53% of his portfolio in FB. This might be a good thing as FB has had an extraordinary performance since its IPO, but it also means you are paying $125 a share for something that has a book value of $17.54 and EPS of $2.09.

FB will probably continue on its growth path in the future, but investors must understand such a situation carries more risk and the risk can be explained with the huge fall other social networking stocks have witnessed.

figure 5 FB LNKD
Figure 5: Facebook’s, Twitter’s and LinkedIn’s performances in the last 4 years. Source: Yahoo Finance.

LinkedIn has fallen from a price of above $250 per share at the end of 2015 to a price near $100 earlier this year due to lower growth. It was saved by Microsoft which bought it for $26.2 billion, or $196 per share.

Twitter didn’t find any suitors, so its price is still 55% below IPO.

Any change in FB’s growth trajectory, which is bound to arrive sometime as no corporation can grow forever, can have a LinkedIn effect on Facebook which will mean that half of the 1.53% of one’s portfolio would be wiped out.

Another example of high PE ratios and low returns could be Microsoft which bought LinkedIn despite the company not being profitable. Microsoft’s PE ratio is currently around 28 which puts it into the higher valuation quartiles. Microsoft’s weight in the S&P 500 is 2.41%.

Conclusion

The main message of this article is that you can choose where to be invested and you can minimize long term risk and, from an historical perspective, you do not even have to sacrifice your returns. By buying the stocks that are suitable to your investing goals you can achieve better returns and avoid the market risks you don’t like. Those can be social networking stocks, money-losing car makers, or oil companies. Because in order to have a well-diversified portfolio, you only need about 20 stocks.

figure 6 portfolio risk
Figure 6: Number of stocks needed in order to eliminate market risks. Source: Investopedia.

As index funds are created for long-term investors that want to be well diversified, if you want something other than that, you can lower your risk and achieve better returns by buying stocks that have higher earnings as in the long term, stock returns and earnings are perfectly correlated.

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Sunday Edition: Setting Reasonable Investing Expectations


The story of the tortoise and the hare teaches us that the prize doesn’t always go to the swift, who are sometimes easily distracted, but often ends up in the hands of the one who perseveres regardless of speed.

This apologue is even more true when applied to investing. Many investors are too easily lured by “get rich quick” investing schemes and strategies, rather than safe and consistent compounding month after month, using what some might consider a boring strategy.

I shudder at the thought of comparing Thomas’ nearly 30% annual returns over the last two years to the tortoise. Especially when his returns exceed those of investing greats Buffett, Ichan, and Tepper. But when compared to the pipe dream some investors have of earning 100% + annual returns buying options and futures contracts, then it most certainly appears “boring.”

Sure, some investor might have a banner year buying leveraged options and futures contracts, but lets see him string together two, three, or four years of similar performance. Any trader who more than doubles his account in a year, or even 18 months for that matter, will have been helped by lady luck much more than he cares to admit.  

The fact is, for every gunslinger who doubles, triples, or even quadruples his trading account in less than 18 months, there are 50 other traders who attempted the same thing, and completely blew up their trading account. You don’t want to be one of them.

In today’s reprint of Thomas’ Rebel Income newsletter (annual subscription $1,164), he talks about his own experience trading leveraged futures contracts and why he is sticking to the more “boring” strategy of selling put options.


Week 2: Setting Reasonable Investing Expectations

“How much money can I expect to make if I use your system?”

This is a question I often see from new potential subscribers. It’s essentially the same question I used to deal with on a daily basis when I worked for a major mutual fund in the 1990s. It’s a natural question that many of us ask when we’re thinking about putting our hard-earned money into an investment.

The natural answer, of course, is to point to previous results. I make my trading log available through the Investiv website so you can see my trading results almost as quickly as I make trades, and I’ve used it quite a lot in customer communications to illustrate what I think is a reasonable example of what is possible using the Rebel Income system. At the same time, though, I remember that I got tired very quickly of telling potential customers to look at the historical returns of the funds I was trying to get them to put money into. I came to realize why every performance graph I could show people included the disclaimer “past performance is not a guarantee of future results.”

With mutual funds, performance often varies wildly from one year to the next for any number of reasons. For example, we had a very high profile manager managing our flagship fund who decided to retire. His replacement was highly intelligent, educated and groomed in the same basic approach his predecessor had used to beat the market year after year, and was this manager’s first choice as his successor. And yet in the first few years after the switch, the fund lagged its previous performance in glaringly obvious ways. The fact is, the new guy wasn’t the old guy, and so thinking their approach was going to be the same—and that the fund would just keep chugging along the same way it had—wasn’t actually very realistic. Through it all, the instructions I kept getting from management was to rely on the fund’s average historical numbers, which tended to obscure the more recent data (with the new manager) because the older performance (from the old manager) had been so strong. This was one of the first ways I learned to distrust funds that trumpeted their historical returns for everybody to hear.

Where does that leave individual investors? As you’re trying to make investment decisions that will provide for current or future needs, what are you supposed to hang your hat on? Marketing material out there tends to work with the most impressive numbers they can come up with, because nobody is going to pay attention to an ad promising conservative results. We are all cursed by the the consumption-based society we live in; we want maximum benefit/pleasure/entertainment value with minimum work/effort/money spent. It makes it easy to pay attention to the shiniest, newest, and best-looking thing out there, and hard to care about anything that is dressed up in any other way.

Several years ago, I had a good friend who was achieving some really spectacular investing results as a day trader. He had begun trading futures, which were highly leveraged contracts on commodities like gold, oil, and even on the broad stock market indices. He was doing so well in just a few months of time that he had paid off the mortgage on his house, his college student loans, and every other debt he had, and was living almost entirely off of his trading income. Naturally, I was impressed and asked him to show me what he was doing. His approach seemed simple enough, and so I decided to give it a try. I thought I had everything to gain and little to lose, especially since I started my trading with just a few thousand dollars that wouldn’t have gotten me into trouble to lose.

For about the first six weeks, I did okay; I almost doubled my account value by applying a similar method that my friend showed me with some rules that I customized for my own purposes. I was having a lot of fun, telling people I was a day trader and bragging about how astute I was. After that sixth week, though, the market shifted, and I didn’t shift with it. The thing about futures trading is that the leverage that pays you so well when you’re right takes it away from you even more quickly when you’re wrong. I saw my profits evaporate within days, and didn’t have the sense to stop what I was doing to figure what I needed to change. I was so upset about how things had turned against me that I was convinced I just needed to keep trying. I watched my account drop all the way to $0, and then put in a few thousand dollars more and tried again. Within weeks, all of the money I could put towards futures trading was gone. All I had to show for it were a lot of lumps, a big slice of humble pie and a very hard lesson learned.

As time passed and I was able to think more rationally about my experience and my failure, I realized that one of the problems was that I went into futures trading with guns blazing; I relied on the experience and knowledge I had built by investing in stocks and trading options to make my futures trading decisions. I didn’t take the time to really study and learn about the futures market first. It’s true that futures form trends just as stocks do, but it’s also true that futures behave in ways that are very different from anything I was used to at that time. My ignorance about that reality kept me from recognizing trouble when it was in front of me.

I also learned an important lesson about expectations. I assumed that because my friend had achieved such fantastic results, I could too. I’m not saying that setting ambitious goals is a bad thing – but when you base your expectations of your own success or failure on what somebody else has done, you’ll usually end up disappointing yourself. I was so determined to prove to myself that I was just as good as my friend that it blinded me to the need to apply what I was seeing in the market properly for my own trading system. I stopped thinking about the fact that we were different people, with different perspectives, experiences, and investing styles. My expectations became completely unrealistic because I was trying to be like my friend instead of just being myself.

In the years since that experience, I’ve stayed away from the futures market. I’ve decided that part of what makes me successful as an investor is to work with investments that make it easy for me to stay grounded – not only to what I know works, but also to what I know I can manage effectively and rationally for my own purposes. I’ve realized that I don’t have to trade the coolest, sexiest markets to get what I need out of my investments. My expectations are simpler, and because of that, the system I use is more effective and easier to manage.

The purpose of Rebel Income is to highlight income-generating trades each week that you can use to provide for your own needs; so what does everything I’ve just said about my expectations mean to you? My system is based on my own study and experience of what a fundamentally strong stock with a great value proposition is. I’ve worked hard to ground that system in principles and concepts that have been proven by time and by the wisdom of other investors. Even so, I don’t believe you should take the things I write about in this Rebel Income on blind faith. That’s why we’ve provided a lot of educational resources for you, in the form of the Homestudy Kit (my e-book and training video library) and the videos available in the Getting Started area of the site to Rebel Income subscribers. It’s also why when I write about subjects like position sizing and diversification, or trading based on overnight information, I tell you about what I do. I don’t necessarily want you to do the same thing, but if you know how I approach those concepts, you can decide for yourself if my logic makes sense or whether you need to apply a different method that works better in your case.

Setting expectations isn’t really about how much money you can make with a given investment or system, even though that’s naturally the way we all tend to think about it. Setting expectations  is really about thinking about a given investment or system in the most practical terms you can, against what your own investing style, risk tolerance, and needs look like. In my case, I decided that the futures market didn’t offer the right fit for my investing style or my needs. That doesn’t mean it’s a bad investment, or even that I might not use it at some point in the future, only that I decided it would be easier for me to not spend more time, energy or money on trying to make it fit when I already had a system in place that did. If you work with the Rebel Income system, make sure that you’re evaluating it based on how easily it fits, or can be adjusted to fit into your own preferences and needs. That’s really the only way you’ll be able to get what you want from any system or investment in the long run.


Through his own market experience, Thomas has gained a unique perspective on investing expectations, and has most certainly carved out a niche selling put options to generate income.

Quite frankly his track record is unheard of in the financial publishing business. He’s closed exactly 101 trades, of which 98 have been winners with only 3 small losers.

To become a tortoise and finish the race, we’ve arranged for you to follow Thomas’ put selling income picks for the next 30 days for only $9, with no obligation to continue, and get two incredible bonus items free, click here.

Regards,

Shane Rawlings
Co-founder, Investiv 

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Can Your Portfolio Withstand Any Economic Environment? See What Ray Dalio Has To Say


  • With 86 months of economic growth and growing money supply, the current economic environment might soon change.
  • On top of the beta returns, specific alpha asset allocation can further increase your returns.
  • In this article you will find a strategy that works at all times.

Introduction

Ray Dalio is the most successful hedge fund manager by net gains. His Bridgewater Pure Alpha fund reached $45 billion in net gains in 2016 beating George Soros with $42.8 billion in gains since inception. What’s even more impressive is that Dalio has reached such a performance with only 4 negative years in the 40 year period.

Dalio is also famous for a simple, yet insightful video explanation that every investor should watch on how the economy works entitled “How The Economic Machine Works by Ray Dalio.”

In this article we are going to analyze his strategy and way of thinking, and see how it can be applied to an individual portfolio.

All-Weather Strategy

Dalio managed to achieve 36 out of 40 positive yearly returns by using the all-weather strategy. The strategy was born in 1971 when president Richard Nixon suspended the convertibility of the dollar into gold, an action that made Dalio look at markets from a broader perspective. Rather than look at the markets from a perspective of one’s lifetime, his strategy expects surprises that are beyond one’s experience.

The main question an investor has to ask themselves is “what kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different?” There are a few economic environments that repeat themselves in an economic cycle and are related to economic growth and inflation, either of which can be rising or falling. The goal is to balance asset classes in a portfolio in order to minimize the effect of economic surprises.

figure 1 environments
Figure 1: Investment scenarios. Source: Bridgewater.

Rising Inflation

For such an environment Ray Dalio suggest owning inflation linked (IL) bonds like Treasury inflation protected securities (TIPS) and commodities. As the typical investor has a small percentage of his assets exposed to commodities or IL bonds, they risk to lose a significant part of their investments if inflation rises. As the money supply is constantly increasing, we are already in an inflationary environment, though the consumer price index doesn’t reflect it yet. Therefore, investors should think about allocating higher percentages of their portfolios to inflation protective assets.

figure 2 us money supply
Figure 2: U.S. M2 money supply. Source: FRED.

Falling Inflation

As the money in circulation continues to increase, inflation will eventually hit us but we cannot know when, therefore a 100% inflation protective strategy would be detrimental if low inflation continues. Assets that perform well in deflationary periods, as we have witnessed in the last 7 years, are equities and nominal bonds.

Economic Contraction

We have had 7 years of economic growth, but sooner or later a recession will come along. According to the National Bureau of Economic Research we have had 11 economic cycles since 1945 with the average expansion period at 59 months and the average contraction period at 11 months, so the probabilities of a recession are increasing from an economic cycle point of view. In the last two recessions stocks fell 49% (2001) and 56% (2009), so portfolios overweight in stocks are exposed to the risk of recession. In order to protect a portfolio from such a risk, Ray suggests owning nominal bonds and inflation linked bonds which always give you a return and protect you from heavy volatility.

Economic Growth

The fourth scenario is one in which most things do well so a portfolio should also always be exposed to equities, commodities, corporate credit and emerging market credit.

In the end, a portfolio should be constructed in such a way that it does not bet on future economic situations and trends but has consistently positive returns no matter the environment.

figure 3 porfolio allocation
Figure 3: All-weather portfolio allocation. Source: Bridgewater.

As one of the primary investing rules is not to lose money, the all-whether strategy is a good one to follow. Your returns will be lower in bull markets but the loses will be much smaller in bear markets.

figure 4 portfolio risk and rewards
Figure 4: Cumulative total returns and drawdowns of global equities vs all-weather portfolio. Source: Bridgewater.

Conclusion

The main thesis behind the all-weather portfolio is that investors are prepared for everything. A decade ago no one expected close to zero interest rates and those who expected them certainly didn’t expect they’d last for 7 years. Similarly, in 2007 the 2009 crisis seemed like something very unlikely, and the same stands for the amazing bull market we have witnessed since 2009.

The all-weather portfolio enables an investor to grasp rewards and minimize risks from all possible economic environments. As all the assets in the portfolio have betas, which means they will give positive returns in the long term, the total return of the all-weather portfolio is positive, but as assets have uncorrelated returns and behave differently in different economic environments, the downside is minimized.

In order to further increase returns, an investor can choose specific assets in the above asset risk weights. As there is a higher risk of stocks experiencing a sharp decline due to their current high valuations, more defensive stocks could be an option. Stay tuned to Investiv Daily to learn more about such investing opportunities.

 

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Beware of “Thinkless” Investing


  • Passively managed funds do offer the lowest fees but invest in stocks without “thinking”.
  • High positive net inflows into passively managed funds push large caps higher regardless of fundamentals.
  • If non “thinking” investors panic when things turn, large caps will be the worst performers.

Introduction

Today we are going to discuss two related topics: fees and the general market consequences of passively managed investing funds.

Fees are charged by funds for their services, be it active or passive management. Passively managed funds, which have the lowest fees, merely track an index. Over the last several years a trend has developed toward lower fees and passively managed funds which may also be creating a growing risk that equities are held by “weak” hands.  If panic comes, and investors pull their money out, passive fund managers will be forced to sell, creating further market havoc.

We will start by explaining the current situation and trends, and finish with an analysis of what is best for more sophisticated investors.

Current Fees and Trends

In 2015 the average assets-weighted expense ratio was 0.64% for all funds. The expense ratio includes distribution commissions, management, administrative, operating and all other asset-based costs incurred by the fund but it does NOT include transaction fees which are charged directly to the fund’s assets. These transaction fees are not reported and do lower your returns, but if you manage your own portfolio you incur in the same fees so we are not going to account for those.

If we take the current S&P 500 expected average compounded return of 4% and calculate the value of a $100,000 portfolio for the next 30 years with and without fees, the difference comes to a staggering $56,825.

figure 1 difference
Figure 1: $100,000 portfolio with and without fees. Source: Author’s calculations.

 

These fees, that at first look innocuous, contribute to a total income for the industry of $88 billion (2014) per year. The good news is that passive funds charge lower fees with an average of 0.2%, but they still charge a fee and offer only market-like performance, minus fees.

figure 2 expense ratio
Figure 2: Asset-weighted expense ratios. Source: Morningstar.

 

The low fees and strong marketing, and the fact that active management has significantly underperformed over the last several years, has attracted lots of capital inflows into passively managed funds. In the past 10 years, the lowest cost quintile funds attracted an aggregate of $3.03 trillion while the other four quintiles attracted only $160 billion. This has several consequences and creates opportunities for the astute investor. In the last 10 years, 18% of actively managed funds did beat their benchmark which means that over-performance can be found if searched for.

Consequences and Opportunities

As 95% of capital flows go into passively managed funds that simply track an index, this also means that 95% of the money in the markets does not “think.” Funds that track an index simply buy stocks according to their weight in an index and continue buying or selling in relation to their inflows or outflows. As passively managed funds have had constant positive net inflows, the stocks with the largest weights in an index will get the most funds and their share price will grow even higher.

figure 3 net inflows
Figure 3: Net inflows by expense ratio (lowest quintile are passively managed funds). Source: Morningstar.

 

The consequence of so much money going into passively managed funds is that the stocks with the largest weights will go up regardless of their fundamentals. If we check the performance of the top 10 S&P 500 constituents, we will see that their stock prices have gone up in the last 10 years. Of the top 10 (all excluding dividends), the best performer in the last 10 years was Amazon with a 2,318% return, followed by Apple with a 931% return and Facebook with a 311% return. The worst 3 stocks were General Electric with a negative return of -3%, AT&T with a return of 37% and Exxon Mobile with a 38% return.

StockCurrent S&P 500 WeightTotal 10-Year ReturnRevenue GrowthEPS Growth
AAPL2.91%930%1100%2800%
MSFT2.22%117%100%10%
XOM2.08%38%-33%-50%
JNJ1.83%93%40%47%
GE1.61%-3%-28%-74%
AMZN1.52%2318%1100%537%
FB (4 year data)1.48%311%380%250%
BRK1.46%128%218%100%
T1.40%37%150%20%
JPM1.24%109%50%50%
Figure 4: S&P 500 top 10 constituents by weight. Source: Author’s calculations from Yahoo and Morningstar.

The interesting thing is that only AAPL had returns lower than its revenue and earnings per share growth. All the other stocks have seen their prices increase at a much higher rate than their fundamentals. The high net inflows in passive funds pushed the largest weighted stocks higher since passive funds buy regardless of the underlying fundamentals.

Over the same time period the S&P 500 only grew by 66.62%, which is much lower than the above averages. This proves another important point: passively managed funds are forced to have their largest weighting in companies when their share price is at or near a high point and completely skip being invested during the growth period. As a good example, Facebook had its IPO in May 2012 but was only included in the S&P 500 in December 2013 when its stock was already 100% up since the IPO.

Conclusion

Fees should be assessed constantly since high fees are severely damaging to portfolio returns in the long run as they limit the magic of compounding.

One solution is passively managed investment funds that replicate an index performance, minus a small fee. A fee nonetheless, which should still be considered, especially since passively managed funds do not “think” when buying the biggest companies which proportionately constitute the largest weighting in their portfolios. Furthermore, their growth in share price has less to do with strong revenue and earnings growth, and more to do with a passively managed investing trend that attracts lots of capital.

But what happens when the tide eventually turns? A halt in net flows into passively managed funds would force them to sell assets. And since the current net inflows are much higher than those in 2007, the downside risk is also much higher.

Until a recession hits the economy, why fight the trend when you can outperform the S&P 500 by just following the biggest companies of the index as all the passively managed funds buy stocks according to their weight in an index. However, when a recession comes and people start to panic, the same stocks will see the biggest declines due to forced asset sales in proportion with their weight, and the best option will be to “think” by sticking with companies with the best fundamentals.

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As The S&P 500 Reaches New Highs, Asset Inflation Continues


  • All factors are indicating an artificially created asset inflation.
  • Earnings are expected to decline with economic outlook being constantly revised downwards.
  • Gold is gaining alongside stocks which confirms that all assets are inflated.

Introduction

Amidst all the turmoil from BREXIT, negative interest rates and global downward economic growth forecasts, the S&P 500 has reached a new high. On Monday it closed at 2,137.16 points, overtaking the previous high of 2,130.82 from May 21, 2015. The Monday record was surpassed again on Tuesday and Wednesday, with Wednesday closing at 2,152.43.

figure 1 s and p 500
Figure 1: S&P 500 in the last 5 years. Source: Bloomberg.

This new high isn’t significant in terms of real returns as the market hasn’t really gone anywhere in the last 14 months, but it is significant from a psychological and confidence perspective. In this article we are going to look for the breakout reasons and fundamentals, and analyze potential risks.

Fundamentals

It’s pretty straightforward: if earnings grow then the S&P 500 is also supposed to grow, if earnings decline and the S&P 500 grows we can assume we are in a bubble. At the moment, earnings are not growing and this earnings season will probably be the fifth consecutive quarterly earnings decline. In total, net income is down 18% since its 2014 high.

figure 2 earnigs
Figure 2: S&P 500 index and earnings. Source: Bloomberg.

The 18% decline isn’t that bad when compared to the average 36% earnings decline in recessions since 1936, but currently we are not even close to being in a recession.

Investors seem optimistic and willing to pay a hefty premium for stocks. The current S&P 500 PE ratio is approaching 25 and it has been higher than 25 on only two occasions in the last 100 years, in the dotcom bubble and in the midst of the Great Recession when earnings plunged.

figure 3 S&P 500 pe ratio
Figure 3: S&P 500 PE ratio. Source: Multpl.

As earnings are not growing and fundamentals are deteriorating, there must be something else that creates investor optimism.

Economic Data

As stock prices reflect future expectations, a look at GDP forecasts will give a good perspective on the rationality of the above valuations. In June, well before the BREXIT vote, the World Bank lowered its global growth forecast from 2.9% to 2.4% indicating more trouble for corporations. The International Monetary Fund has cut its forecast for the U.S. from 2.4% to 2.2% for 2016 but expects a pickup to 2.5% in 2017, while the FED expects moderate and stable economic growth at 2% for the next few years. In greater detail, the media highly promoted the 287,000 new jobs added recently but failed to focus on the increased unemployment rate from 4.7% to 4.9%.

One might wonder if the above mentioned data is enough to sustain a PE ratio of 25 as historically the economy has grown faster than 2% and the S&P 500 has had lower PE ratios, again an indication that asset prices are inflated.

Low Bond Yields 

The inflation in asset prices is especially visible in fixed income investments. With 30% of global sovereign debt charging a negative yield, investors push bond prices higher and higher in a desperate search for positive yields. This is further enhanced by the central banks of Europe and Japan actively buying corporate bonds on the market, and even stocks for the latter. As long as central banks relentlessly continue buying securities, it is very difficult for stock markets to experience substantial declines which means that small risks are being smoothed out by monetary policies while the big black looming risk grows bigger and bigger.

Not only that, but capital flows toward fixed income funds are reaching record highs.

figure 4 etf flows
Figure 4: Cumulative fixed income ETP flows in billions. Source: Bloomberg.

S&P 500 Sector Performance

One could argue that the above mentioned corporate earnings decline is mostly the result of lower commodity prices and declining earnings in the energy sector, but only 4 of 10 sectors will see earnings growth in the coming earnings season.

figure 4 earnings per sector
Figure 5: S&P 500 expected earnings growth per sector. Source: FACTSET.

Despite that the energy sector is expecting the worst decline in earnings, its performance in the last 6 months has been the best as things have stabilized a bit. On the other hand, the fact that utilities, energy and materials were the best performing sectors in the last 3 months shows that investors are looking for investments that protect against inflation and have constant, recession-proof yields.

figure 5 sector spdr
Figure 6: S&P 500 sector performance in the last 6 months. Source: Sector SPDR.

The same conclusion related to the search for inflation protective assets can be reached by the looking at the continuing surge in gold prices.

figure 6 gold prices
Figure 7: Gold prices in the last 12 months. Source: Bloomberg.

Gold is usually not correlated with stocks, but from the chart above we can see that both gold and stocks are increasing which again leads toward the conclusion that all asset prices are inflated.

What To Do

It is difficult to be smart in such an artificially created situation, but stock picking and “stick to what you know” might be the best option. You must evaluate the companies in your portfolio and identify how they will perform in the uncertain times that are ahead as asset inflation, possible real inflation in the future, and higher rates will wreak havoc among securities.

Now is the time to be smart. Investors should grasp the opportunities given by the high liquidity but at the same time think of the potential risks if anything changes in the current financial monetary easing system.