Category Archives: Investing Strategy


Major Indicators Are All Positive, But Is It Time To Get Fearful?

  • Economic data is strong and positive.
  • Neither jobless claims nor consumer spending show signs of weakness.
  • The issues remain in valuations, optimism and low yields.


In the post-BREXIT world, there is a lot of speculation but no one knows what will happen. This article is going to provide a general outlook on how the economy is doing and try to extrapolate trends while ignoring the noise provided by the media.


As initial unemployment claims are reported on a weekly basis, the number can be used to forecast the monthly job report. On Friday the Bureau of Labor Statistics will release its job report for June. The previous report was scary with 38,000 jobs were added, but the number of initial unemployment insurance claims still remains at multi-year lows as well as the current unemployment rate, which sits at 4.7%.

figure 1 jobless claims
Figure 1: Initial unemployment insurance claims. Source: FRED.



figure 2 unemploment rate and claims
Figure 2: Unemployment rate and claims since 1990. Source: FRED.


By plotting the unemployment rate and claims we can see that the unemployment claims precede changes in the unemployment rate. Any increases in jobless claims are clues that there may be trouble brewing though the market may not recognize it yet. What’s most alarming about the above data is the impossibility for the unemployment rate to stay stable. As it is coming close to the natural unemployment rate, we should expect a trend shift in the coming years, though what we cannot know is if the unemployment rate will drop lower or if it will go up next month.

Consumer Spending

Consumer spending is growing and shows no indications of slowing down. A slowdown in consumer spending is also a leading indicator, and only after it begins to drop does it indicate trouble in the economy.

figure 3 consumer spending
Figure 3: Consumer spending and GDP. Source: FRED.


Similar to consumer spending, the consumer sentiment index is a great signal for forecasting a recession. The index hit its lows in the midst of 2008 while the deepest part of the recession was half a year later. It is now at its pre-recession highs, which would indicate there is no trouble for now.

Since consumer spending is still strong and consumer sentiment sits at its pre-recession highs, neither of these indicators point to trouble in the short term.

4 figure consumer sentiment index
Figure 4: Consumer Sentiment Index. Source: University of Michigan.



Inflation is tame compared to the 1980s, but it has picked up somewhat since the Great Recession indicating the economy is healthier.

Over the last 12 months, overall prices increased by 1%. Energy prices are at multi-year lows and favorable weather conditions have brought high crop yields which lowered food prices, therefore 1% inflation rate should be considered very good.

figure 4 consumer price index
Figure 5: Consumer price index (1984 = 100). Source: FRED.


Issues With The Above Data

With all of the favorable data, it might be tempting to pay higher prices for riskier assets, but that is exactly the biggest trap such economic indicators create.

A closer look at the above data shows that current indicator levels are similar to those from 2007, so even though they are all positive it might not be the best time to be heavily invested. Keeping in mind the essential investing quote of “being greedy when other are fearful and being fearful when others are greedy,” this might be the time to be fearful and wait for a future recession to be greedy.

figure 6 sandp gdp
Figure 6: S&P 500 and GDP since 2007. Source: Yahoo.


The market is far more volatile than the economy because investors tend to be overoptimistic in good economic times—as is the case now—and overly pessimistic in a recession. As all indicators are at their best levels, it is time to be fearful.

The issue here is that this is contrary to human nature as we are social creatures. Doing things differently than the rest of the pack makes us very emotional, but investors have to learn how to set emotions aside as markets and money have no emotions.


Except for the fact that the market is finding it very difficult to grow and all economic indicators are more likely to worsen than improve in the next few years, another important indicator—which is the result of the positive economic developments—are valuations. Simply put, relatively high valuations increase the risk of holding stocks and minimize long term returns.

With 7 years of positive economic developments, investors should carefully analyze growth and clearly separate the growth coming from the general high liquidity artificially created by the FED, and real business qualities. A good way to do that is to look at debt levels. If revenues increase slower than a company’s debt level it means that the return on capital is lower than the cost of capital. Such a situation can be sustainable in an economic growth cycle but comes to an abrupt end at the first signs of a recession.


One has the be foolish to look only at the positive economic indicators and assume that everything is good and being long stocks is the best option. Stocks will be the first to react if any of the forecasting economic indicators turn negative, so careful stock selection is the only option to preserve capital in these uncertain times. Other risks come from exuberant optimism which inflates asset prices as well as low yields, which pushes investors toward stocks in search of higher yield, but which also comes with higher risk.

As we do not know when the economic winds will change, the current market volatility gives great opportunities to increase portfolio returns with well placed trades and a more active investing strategy.


How Diversified Should You Be?

  • Extreme diversification is good but only provides ordinary results results.
  • Concentrated portfolios proved better in some cases as they allow investors to select the best companies.


A few days ago we discussed passive and active strategies given that there is a looming risk of a recession and that the markets are unable to break new highs which makes just holding stocks for the sake of holding stocks very risky. In this article we are going to discuss how diversified a portfolio should be as it is easier to pursue an active strategy with a concentrated portfolio of stocks.


Diversification is the process of allocating capital in a way that reduces the exposure to the individual risks of any particular asset. But the question is how much diversification is too much or too little?

On one side we have the “efficient market hypothesis” believers that promote a “market portfolio.” A “market portfolio” is a portfolio that holds every traded asset in the market in proportion to its market value. On the other side we have investors who meticulously search for one, two or three good companies and put “all their eggs in one basket.”

The debate is an ongoing one where Mark Cuban once claimed that diversification is for idiots while John Bogle, the father of the index fund business, adverts massive diversification through his Vanguard funds. As said on the Vanguard web page: “Each all-in-one fund invests in thousands of individual stocks and bonds to help reduce the risk to your investments.”

Let us see how this extreme diversification performed in the last decade.

NameTickerAsset ClassExpense RatioPrice As of 7/1/16
($ Change, % Change)
SEC YieldYTD As of 7/1/16Average Annual Returns: 1 YearAverage Annual Returns: 5 YearsAverage Annual Returns: 10 YearsSince Inception
Federal Money MarketVMFXXMoney Market0.11%$1.00 ($0.00, 0.00%)0.32%0.15%0.18%0.05%1.07%4.41%
GNMAVFIIXBond - Interterm Government0.21%$10.87 ($0.02, 0.18%)1.98%3.24%4.17%3.04%5.01%7.53%
Intermediate-Term Corporate Bond Index Admiral SharesVICSXBond - Interterm Investment0.10%$23.97 ($0.05, 0.21%)2.93%7.77%7.75%5.82%N/A6.43%
Target Retirement 2035VTTHXBalanced0.15%$17.38 ($0.05, 0.29%)2.13%3.21%-0.67%7.44%5.74%6.76%
500 Index Admiral SharesVFIAXStock - Large Cap Blend0.05%$194.08 ($0.42, 0.22%)2.11%4.04%3.95%12.06%7.42%4.88%
Developed Markets Index Admiral SharesVTMGXInternational0.09%$11.38 ($0.04, 0.35%)---1.96%-8.55%2.05%1.92%3.24%
Emerging Markets Government Bond Index Admiral SharesVGAVXInternational0.33%$20.01 ($0.11, 0.55%)4.47%10.45%8.18%----4.08%
Figure 1: Performance of Vanguard funds. Source: Vanguard.

All in all, the results are very positive over the long term. The Federal Money Market fund averaged 4.41% since 1981 but only 1.07% in the last 10 years. Bond funds had average returns of 7% since 1980 and 5% in the last 10 years. As for stocks, the 500 Index Admiral Fund managed to return 4.88% per year even if it was incepted in the midst of the dotcom bubble in 2000.

It can be concluded that there is nothing wrong with extreme diversification. Over the long term it will earn single digits returns, similar to the earnings of the underlying assets. With the current S&P 500 PE ratio at 24, diversified investors can expect returns of around 4% from stocks and 2% to 3% from bonds in the long term. Such returns will for sure beat inflation and keep capital well preserved.

Portfolio Concentration

Diversification opponents state that an investor is limited to mediocre returns if he buys the market, and that much better returns can be expected if the best assets available are selected and nothing is bought just for the sake of buying because it makes up part of the market.

Two great promoters of carefully choosing where to put your eggs are Berkshire Hathaway’s managers, Warren Buffett and Charlie Munger. They state that excessive diversification is madness and because it includes investments in mediocre businesses it only guarantees ordinary results. A look at Berkshire Hathaway’s performance since 2000 will prove that concentration outperforms diversification.

figure 2 berkshire hathaway
Figure 2: Berkshire Hathaway since 2000. Source: Yahoo Finance.

Berkshire Hathaway went from $51,200 in 2000 to the current $216,298. That gives a compounded annual return of 9.4% which beats the returns of all the Vanguard funds. The main ideology behind Buffett and Munger is don’t just buy something because everyone else is. This slight difference is the reason for the few extra percentage return points that create a huge difference in the long term. And still now, Berkshire has a PE ratio of 14.5 which will create better returns in the long term than the general market.

As Berkshire holds companies like Geico, Fruit of the Loom, Dairy Queen, Nebraska Furniture Mart, Benjamin Moore, See’s Candies, Burlington Northern and has investment positions in Wells Fargo, Coca-Cola, American Express, IBM and Heinz, it provides good diversification but not too much.

Buffett’s strategy is in line with the academic market portfolio theory that 20 stocks from various sectors is enough to eliminate stock specific risk from your portfolio and leave you with only market risk. As 20 stocks is not many, and many fewer than the thousands of stocks in the Vanguard funds, you might as well chose the best ones which will bring you additional returns with the same amount of risk.

figure 3 stock market risks
Figure 3: Number of stocks needed to eliminate stock specific risks. Source: Investopedia.

Of course, this does not mean that you can buy 20 different airlines and sleep well, the stocks should be from various sectors and have uncorrelated returns.

No Diversification At All

Some advocate a strategy where you put all your eggs in one basket, but a big survival bias holds this theory afloat. We constantly hear about the various Gates, Zuckerbergs or Ortegas that made huge fortunes by betting on one horse. But that was mostly their horse and we do not hear about the millions that lost it all by betting on themselves in the same way.

In Bloomberg’s billionaire top ten list there are two who arrived there by diversifying, Buffett and Slim.

figure 4 bloo
Figure 4: Bloomberg Billionaires list. Source: Bloomberg.


Let us start with saying that every strategy should outperform holding your capital under the mattress in the long term. Extreme diversification will achieve stable but ordinary results while less diversification and choosing the best companies at the best prices will help your portfolio outperform. On top of that you can be more active with a 20 stock portfolio and buy the cheaper stocks and sell the overvalued ones.


Should You Switch to a More Active Investing Strategy?

  • Passive investing has been excellent in the past decade but has gone nowhere in the last two years.
  • Higher valuations are increasing volatility and risk which gives opportunities for more active strategies.
  • Due to the high valuations in 1968, only an active strategy would have produced positive returns in the period up to 1982.


The S&P 500 has gone nowhere since December 2014. Several reasons have influenced such a performance, but the most impactful factors seem to be market fundamentals deteriorating while central banks keep limiting the downside by increasing available liquidity. The FED was supposed to begin raising interest rates, but the 0.25% hike was insignificant, and now there is even speculation that the FED could lower interest rates again.

In such an environment you might wonder if the old buy and hold strategy is the best or if you should be more active and seize the opportunities given by the volatility in the market.

figure 1 active vs passive
Figure 1: S&P sideways movement in last 12 months. Source: Bloomberg. Annotations: Author’s own.

This article is going to analyze the benefits and risks of both a passive and active strategy, and relate them to the current market.

Passive Strategy

A passive strategy is one that promotes “buy and hold no matter what” because stocks should always outperform all other assets. Passive strategies include investing in mutual funds or reinvesting your dividends in the stocks that issued them and not thinking much about what is going on in the market, the valuation you are paying, or the risks.

The passive strategy has been developed from the Efficient Market Hypothesis which states that it would be impossible to know something about a security that would improve your returns as the current price already incorporates all available information about the security, and only by knowing something that no one else knows would it be possible achieve extra returns.

This idea has been promoted in the last few years as the S&P 500 bull market created a situation where over the five-year period, 84.15% of large-cap managers, 76.69% of mid-cap managers, and 90.13% of small-cap managers lagged their respective benchmarks in the U.S. You might wonder, if more than 80% of the professional managers did not manage to beat the market, why should you try? Well, passive strategies are good, but the only return in the S&P 500 since December 2014 would be coming from the dividend yield, which is currently at 2.12%.

But the Efficient Market Hypothesis would have you buy without thinking about what might be the cause of such an historic rise in stock prices, which has been the high liquidity provided by the FED. Buying without thinking makes investors disregard valuations, and high valuations bring much higher risks and lower yields.

Figure 2: S&P PE ratio since 2011. Source: Quandl.

As you can see, the S&P 500 PE ratio went from below 13 in October 2011 to the current 24 which is an 84% increase. At the same time, the S&P 500 increased by 82% which means that there were no fundamental changes and investors are now willing to pay almost double the price they were paying 5 years ago for the same yields.

figure 3 5 years sandp
Figure 3: S&P 500 since 2011. Source: Bloomberg.

You should ask yourself if you are happy just doing what the crowd is doing, or if you want to have your risks properly assessed and maybe even outperform the market in the next few years. As the current bull run is mostly influenced by optimism and higher risk acceptance, we can only imagine what would happen if the risk perception changes and all of these passive investors start selling.

We have seen a few glimpses of what can happen in the three sharp declines we have witnessed in the last 12 months. If you think the current market is overvalued or going nowhere for a longer period of time, you could think of an active strategy. Don’t forget that stocks do not always go up, from 1968 to 1982 the stock market also moved sideways due to the high valuations reached in 1968.

Active Strategy

In a flat market, investors are tempted to do something in order to increase their returns. This does not mean that investors should take crazy risks like shorting or trading options, active investing could also just mean to reallocating your portfolio weights in relation to the risks those assets carry.

You might wonder how to assess the risk. Well, the usual academic option is to calculate an asset’s volatility, but the logical way is just to check the yield of the asset and its price. If we start from the premise that risk is a function of price and not volatility, the higher the price of an asset is, without any changes in underlying fundamentals, the riskier the asset. As the S&P 500 has seen only deteriorating fundamentals in the last two years and earnings did not grow as much as asset prices, we could say that stocks are much riskier now than they were 7 years ago, even if they were much more volatile in 2009.

Cyclical stocks are a great example of how and active strategy can seize the opportunities given by the market. Daimler, the company that manufactures Mercedes luxury cars and other vehicles, is the perfect example.

figure 4 daimler
Figure 4: Daimler (OTC: DDAIF) price movements since 1998. Source: Yahoo Finance.

The long term swings are very clear and those are swings of more than 100% up or 75% down, so they give plenty of opportunity. Now, if you think that such a company will be around for a longer time you do not have to just buy and hold, you can buy more and increase your exposure when prices are down, and lower your exposure when prices are high. This is difficult to do as you have to do the opposite of what fear and greed are telling you, but in the long term such a strategy would decrease your risks and probably also increase your returns.


There will always be a debate between active and passive managers about which strategy is better. As a smart investor you might want to be passive when valuations are low and more active when valuations are high in order to minimize your risks and maximize your returns. It takes some effort and a correct mindset to sell when everyone is buying and buy when everyone is selling, but such a strategy will create the extra returns.