Category Archives: Stocks

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Sunday Edition: The Misunderstood Role of Stock Dividends


In Today’s reprint of Thomas’ Rebel Income newsletter ($1,164 annual subscription), he discusses the often overlooked but incredibly important role dividends play in your overall returns.  

As you’ll see, over the last 25 years, $1 invested in 1990 has grown to almost $10 today including dividends. Whereas that same $1 without dividends has only grown to $6. That’s a 40% difference in overall wealth creation.

In the Rebel Income picks, Thomas always looks to sell put options on fundamentally solid companies that pay strong dividends, since dividends are the single best indicator of true company strength.

Furthermore, a healthy dividend makes it much easier to hold onto stocks, which have been assigned, even if the stock price drops a fair amount below the strike price of the original put option.   

And finally, your overall long-term returns will be much higher once the stock price recovers, and the stock is either sold or called away because of a subsequent covered call trade recommended by Thomas on stocks which have been assigned.  

This three-prong approach is really what sets the Rebel Income system apart from just about any other income generation system. You have the opportunity to get paid 3 or more times on the same stock.  

First from the initial put sell, second from collected dividends, third from covered calls, and finally any capital appreciation on the stock itself.

I believe this is why Thomas has generated near 30% returns over the last two years turning every $100K into $171K as compared to only $112K investing in the S&P 500.

Here’s Thomas:


Week 5: The Misunderstood Role of Stock Dividends

If you’re a student of the stock market, you look for as much information as you can find about different investing methods and systems. Books, newsletters, videos, seminars, classes – you may not use them all, but even if you learn something you don’t end up using, it’s all useful, because it expands the scope of your knowledge, your perspective about the market’s many different possibilities, and your understanding of what fits you best.

One of the things I’ve found interesting over my more than two decades of studying and investing in the stock market is the role dividends can—and in my opinion, should—play in a successful investing system. Directional trading strategies, which usually emphasize relatively short-term trades based on price swings from low to high points that might last anywhere from a few weeks to a few months, tend to ignore dividends altogether, since in many cases you might not actually hold a stock long enough to be counted for a dividend distribution. The same is true of directional investing strategies that focus on equity options, since buying and selling call or put options on a stock will rarely translate to actual ownership of that stock.

Kinds of Stocks that Pay Dividends

Long-term investing concepts usually differentiate between stocks based on the underlying company’s size and scope of business, how much their business has grown in the past and what analyst’s forecast of future growth is likely to be. Large, established and easily recognized companies, like General Electric Co. (GE), Caterpillar Inc. (CAT), and Microsoft Corp (MSFT) among others are referred to as blue-chip stocks; these stocks are usually included in the major market indices including the Dow Jones Industrial Average and the S&P 500. Medium-sized businesses who have been successful at building their businesses but have not yet reached the status or size of a blue-chip stocks are usually called mid-caps, and smaller, up-and-coming companies are called small caps. Depending on how aggressive or conservative you want to be as a stock investor, these different categories present various levels of opportunity as well as risk. Small-cap stocks, who usually have the largest scope of opportunity to grow, generally provide the largest overall growth potential, with mid-caps coming in next, and blue-chips last, since these stocks already have become the 600-lb. gorillas in their respective industries and sectors. In the same way, blue-chips are usually considered to be the safest overall long-term investments, while small-cap stocks are far more speculative since a minority of these up-and-comers ever actually fulfill their potential.

One of the other reasons that blue-chip stocks are considered to carry a higher level of safety comes from the fact that most of them pay a regular dividend to their shareholders. Why do some stocks pay dividends while others don’t? Because companies are naturally allowed to decide what they want to do with their profits. What they actually do with those profits can tell you a lot about the strength of the business and what management thinks about the future. Dividends are one of the simplest and most transparent means companies have to return a portion of their profits back to their shareholders. Smaller, less-established stocks often don’t pay a dividend simply because their profitability can be widely variable from one year to the next. Dividends have to be approved by the company’s board of directors, and they won’t be likely to commit to pay out a portion of their profits if they don’t believe they will be able to maintain a level of profitability that is higher than the dividend.

The most common line of thought suggests that a stock shouldn’t begin to pay a dividend until the business has reached a size and scope of business that makes a dividend easier to maintain. Microsoft Corp, for example, didn’t pay a dividend to its shareholder for almost 20 years after their initial public offering in 1986 despite their domination of the software industry and the mountains of dollars they held in cash. When they finally declared their first dividend in January 2003, MSFT held more than $43 billion in cash; their initial dividend payout was only $864 million of that amount, or about 1.8% of their total cash. To me, this is a good example of why identifying stocks that pay a dividend—even a small one—is so important; it says a lot about management’s confidence in their business as well as recognizing the important role shareholders play in their overall success.

Another interesting aspect of dividends is that while blue-chip stocks are the most likely places you’ll find attractive dividends, it also isn’t unusual to find mid-cap and in some cases, even small-cap stocks that have committed to a consistent dividend payout. I think there is a lot of power in finding these types of stocks, which are even more in the minority than their larger brethren; most of these companies prefer instead to reinvest their profits in their business to keep driving growth. Those that do decide to pay a dividend, in my opinion, are communicating a different level of confidence in themselves and future of their business than those that don’t. They are using the dividend payout to attract shareholders that can buy in to their long-term plan and prospects, which I think is a smart thing. That’s why you’ll see me write about stocks like SLCACBIGME and others as I find them and they meet my other fundamental criteria.

The Real Impact of Dividends Over Time

The fact of the matter is that on an historical basis, dividends have always made up a significant piece of the overall returns the stock market has achieved for decades. As of now, the average dividend yield for all stocks that make up the S&P 500 is 2.02%; the average yield for the past 25 years isn’t too far from that same level, at 2.07%. Over the same period, the index itself has returned an average 11.29% return. If you take dividends out of the equation, that annual return lowers to only about 9.22%. What does that mean in real dollars? Including dividends, $1 invested in January 1990 would grow to almost $10 today; but without dividends, it only grows to a little less than $6. That’s a 40% difference over the last 25 years, and it’s a major reason I include dividends in the criteria I apply to my income generation system.

I get emails quite often from subscribers asking me when I’m going to get out of a stock I’ve been assigned from a put sale that has seen a major drop from the price I was assigned at. My general answer has always been that as long as I see the stock’s fundamentals holding, I will continue to wait for the stock’s price to recover back to my assignment price; my analysis of the company’s business strength still confirms my belief that the value of the stock should be higher than my assignment price. I also want to continue to hold the stock because when it does recover, I should be able to find opportunities to generate even more income with covered calls. Both of these statements are true; but another reason I don’t mind holding these stocks even for an extended period of time is because of the fact I can draw dividend payments from them. Those dividends are extra income I don’t have to do anything to get except to hold the stock before and through the announced ex-dividend date.

It’s true that in general, I don’t expect to hold a stock long enough to see an entire year’s worth of dividend payments on it; even so, the fact that I can enhance my ability to generate income—even if by just a few cents per share—by doing nothing more than emphasizing dividend-paying stocks in my screening process is more than worth the trouble. It is also one more layer of protection I can add to my system, since I can also lower my overall cost in a stock by the per share amount of the dividend.

Dividends vs. Stock Buybacks

Tech stocks, in particular have historically chosen a slightly different tack over paying dividends, which is to implement a large-scale stock buyback program. The result is that shareholders hold fewer shares than before, but also see an increase in the stock price; the increase in buying activity over time will also often create an extra wave of bullish enthusiasm for the stock that inflates the price even higher than the buyback alone would yield. I prefer to look for stocks that pay a regular dividend because it signifies a greater commitment to return value to shareholders on a consistent basis; stock buybacks are really about letting the company maintain flexibility and control over your shares, since the timing of buybacks, how large they are, and what they mean to you is at their complete discretion. With a dividend, you get to decide what to do with the money; you can spend it at your discretion, or you can invest in back in the stock or the market at large.

Another element that can also make a company more attractive from a fundamental standpoint is whether their dividend payout has grown over time, remained static, or decreased. Ideally, dividends should grow as profitability does, and more proactive companies do this either by increasing their regular dividend or by issuing a special dividend on an annual basis. If I’m trying to decide between two different fundamentally strong stocks, this can be a way to delineate between them. Be aware, though that the dividend itself is the main criteria for my income trading system, even if the company has not increased its payout. I also don’t place a lot of emphasis on the size of the dividend, again unless I’m trying to differentiate from multiple candidates.

Dividends provide a strong reason to hold stocks even when they might be in a downward trend. If the company’s fundamentals remain strong, the dividend adds an element of income above and beyond my ability to write covered calls. While there certainly are undervalued, fundamentally strong stocks out there that don’t pay dividends, the presence of a dividend says a lot about that company’s management, their management style, and the relationship they maintain with their shareholders. That’s why dividends are a big part of my system.


As you can see, dividends are critical to achieving long-term returns that far outpace other investing strategies which ignore this important source of income and overall return.  

Thomas’ subscribers recently got paid 9 different times on Archer Daniels Midland (ADM), by selling puts, writing covered calls and collecting dividend income.  

The total cumulative return on this one trade was 15.38% in only 7 months. In today’s zero yield world, those kinds of returns are nothing short of spectacular.  

We understand that at $1,164 per year, Thomas’ Rebel Income newsletter is out of reach for many investors.

That’s why a little over a year ago we asked Thomas to launch a second newsletter called Retirement Revival as a way to introduce investors to income generation through selling puts, writing covered calls and buying high dividend paying undervalued companies.

Retirement Revival is a monthly rather than weekly publication. Each issue contains one put sell recommendation and one undervalued stock pick.

As of now there are 12 open stock positions with the average gain per trade of 9.56% with one stock up more than 38% in less than a year.  

Eight of these stock picks are still in our recommended buy range with several paying dividends between 4% and 5%.

The average gain per put sell has been 2.54% in less than 30 days. Compounded and annualized that works out to be 35.12%.

Thomas is currently offering new Retirement Revival subscribers a 1-year subscription at an introductory rate that’s less than you’d pay for dinner for two at a modest restaurant.

To learn more, click here.  

Regards,

Shane Rawlings
Co-founder, Investiv

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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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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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Signs of Fragility in the Economy Point to an Impending Bear Market. What To Do Now To Protect Yourself.


  • The last jobs report was good news but it also indicates higher costs and full employment.
  • An “easy to hire, easy to fire” mentality is in the air.
  • Healthcare, cash or short term trades should be the best options in this situation.

Introduction

Last week the Nasdaq and S&P 500 reached yet another record high. Aggressive central bank stimulation pushes investors to disregard risks and look for any kind of yield or growth. Not looking at risk is the worst thing an investor can do, but they also shouldn’t fight the trend.

Even from a long term perspective the market is irrationally valued, and no one can know how long it will stay that way. Being in cash might seem logical but a 0.1% return looks much worse than the S&P 500’s 8.9% year-to-date return.

Today, we are going to analyze earnings as 86% of S&P 500 companies have reported them, but first take a look at Friday’s jobs report which sent mixed signals.

The Jobs Report

On Friday, the U.S. Bureau of Labor Statistics reported an increase in total non-farm payroll employment of 255,000 in July. The unemployment rate was unchanged at 4.9 percent which is great news for the economy but not so much for investors because it indicates that we are close to full employment. The unemployment rate has stabilized at 4.9% and wages have started to increase (2.6% over the year). Higher wages mean higher costs which have a negative effect on margins and earnings.

figure 1 unemployment rate
Figure 1: Unemployment rate. Source: Bureau of Labor Statistics.

Apart from the reach of full employment and higher wages, the fact that businesses prefer to hire more than to invest in equipment signals that corporations are not so optimistic about the future. They easily hire but know that they can fire with the same ease, if necessary. If you buy equipment, you are stuck with it in most cases.

figure 2 employment equipment
Figure 2: Lower equipment spending in favor of labor. Source: Bloomberg.

The “easy to hire and fire” effect is even more pronounced by the increase in the number of people forced to work part-time for economic reasons, which rose from 5.84 million to 5.94 million.

All of the above means that job numbers are fragile and can quickly shift in the opposite direction. This, along with slow GDP growth, will probably keep the FED on hold or result in minimally increased rates to hold off inflation.

S&P 500 Earnings

The second quarter of 2016 is the fifth consecutive quarter with a decline in earnings.

figure 3 earnings growth
Figure 3: S&P 500 earnings growth rate. Source: FACTSET.

The S&P 500 reported sales were flat in comparison to Q2 2015 which means that the increased hiring does not create growth but is necessary to merely keep up with the competition.

Analysts have postponed expected earnings growth to Q4 2016, which doesn’t mean much as they had expected earnings growth for this and for the next quarter. So, as always, analysts’ expectations have to be taken with a grain of salt.

From a sector perspective, consumer discretionary was the best performer with earnings growth of 10.7% which is logical seeing that consumer spending is the only growth segment of the U.S. GDP. But as consumer discretionary is not essential, any kind of bad news or tightening credit might quickly turn this trend around.

For investors interested in not taking on much risk if a bear market hits us, the healthcare sector continued its good news. Healthcare earnings grew 4.9% and revenue grew 9%. As we know that the global population is getting older, especially in the developed world we can expect demand for healthcare to stay stable, or fall the least in a recession or bear market. Therefore, finding good healthcare investments is essential for a defensive portfolio that is still open to growth in this bull market but limits the potential downside if things take a turn for the worse.

figure 4 sector
Figure 4: S&P 500 Earnings growth by sector. Source: FACTSET.

All other sectors are exposed to negative volatility because consumers are going to save on all things except for food and healthcare. With oil prices around $40 we cannot expect an earnings pickup in the energy sector.

The most important factor for long term investors is valuation. Lower earnings and higher prices have brought the current S&P 500 PE ratio to 25.25. If the FED is forced to increase rates due to high employment rates, corporate earnings will be further pressured downwards by the high debt levels and tightening credit will lower consumer spending.

figure 5 multpl
Figure 5: S&P 500 PE ratio continues to grow. Source: Multpl.

Conclusion

We are in a situation where the S&P 500 is consistently breaking new highs while there have been 5 consecutive quarters of declining earnings, slow GDP growth, lower productivity and where bank credit, the main factor for GDP growth, is about to tighten due to increased interest rates and full consumer indebtedness.

We cannot know for how long such a surreal situation will last, but as smart investors we have to be prepared for the worst and still try to grasp the benefits of the upside. As Warren Buffett has $66 billion in cash on his balance sheet, we might to also want think about having cash on hand just in case a bear market comes that will enable us to buy the bargains. As earnings yields are at 4%, that would be the opportunity cost for holding cash but we can hold cash for 5 years and still break even if a bear market comes along. It is difficult to mentally accept such a strategy as we are in the 7th year of this bull market, but some returns have to be sacrificed in order to lower risks.

Another option for diversification is to use a part of your portfolio for well-placed short term trades. The S&P grew minimally in the last two years but in the meantime it gave great trading opportunities. With stop losses and by knowing what you are doing, you can limit the time you are invested, thus lower the risk of being caught in a bear market while still creating healthy returns on the liquid part of your portfolio.

Investiv has developed a robust stock screening tool which analyzes over 15,000 US and Canadian stocks and ETFs and generates reliable short-term swing and position trading buy and sell signals. To take a free, no credit card required 14 day trial, with no obligation to continue, click here (no long, annoying video).

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Euphoria & Denial Point to the Last Days of the Bull Market


  • Risks are cumulating and getting bigger.
  • U.S. GDP growth is slower than expected, earnings and oil prices continue to decline.
  • Japan is unable to grow while BREXIT risks are still unfolding.

Introduction

It is difficult to find good news lately. The last really good news was the June jobs report when 287,000 jobs were added. Since then, most of the news seems dismal, however, it has yet to have a negative impact on financial markets. It’s as though investors are just hoping for something good to happen in the future. As hopes are an immaterial human feeling, they should not be the base for investment decisions.

In this article we are going to analyze what’s pushing the S&P 500 to new highs. Are we in a state of euphoria about stocks or are the valuations and price increases rational?

GDP News

The U.S. economy was expected to grow 2.5% in Q2 2016, but it only grew 1.2% (seasonally adjusted). U.S. economic growth for 2016 is currently at 1% which is the weakest start of a year since 2011. Saving the economy from a recession is consumer spending which increased by 4.2%.

Low interest rates create cheap money which fuels two trends, growth in both consumer spending and the S&P 500. Consumer loans have increased at a faster pace than consumer spending which makes it clear that spending growth is fueled by debt.

figure 1 consumer loans
Figure 1: Consumer loans at all commercial banks (blue) and consumer spending (green). Source: FRED.

Anyone who has studied economics will tell you that the economy works in credit cycles, when money is cheap and prospects good, people take on credit and spend it. But one can only take on so much credit, and all banks want their money back sooner or later. When sentiment shifts, a credit contraction arises and consumer spending falls. As this is inevitable, the only justification for the current hope of increased GDP growth can be explained with the most dangerous words for investors: “this time is different.”

figure 2 credit cycle
Figure 2: Credit cycle. Source: Loomis Sayles.

As we are in the expansion part of the credit cycle, a recession is going to hit us as soon as we reach the downturn part of the credit cycle because consumer loans are the only thing still boosting growth.

figure 3 gdp contributors
Figure 3: Contributions to Q2 economic growth. Source: Wall Street Journal.

If it wasn’t for consumer spending fueled by cheap loans, the U.S. economy would most likely already be in a recession.

The S&P 500

With economic growth largely missing expectations you would assume the S&P 500 would tank, but that’s not what happened Friday when the economic data was released. On the contrary, the S&P 500 reached a new intraday high at 2177 points. The main reason for the new S&P 500 high is hope of future economic growth, the same economic growth that didn’t realize itself in this quarter.

Another reason stocks have continued to rise has been the Q3 2016 expected corporate earnings growth, but that also vanished like the above described economic growth. As most companies have issued negative guidance we cannot expect higher earnings in Q3 2016.

figure 4 positive guidance
Figure 4: Q3 2016 earnings guidance for the S&P 500. Source: FACTSET.

The FED

It would appear the FED is also somewhat in denial about the true state of the U.S. economy and S&P 500 earnings, and is holding on to the hope of increasing interest rates as soon as the economy shows signs of strength, be we’ve been hearing the same story for a while now.

Last week the FED left the door open for interest rate increases as the economy seemed to be improving, but this was before Friday’s GDP debacle. With growth being lower than expected, the FED will probably continue with its status quo policy. As we now know that the only thing pushing the economy higher is consumer spending fueled by consumer debt, any interest rate increases would be detrimental for the economy and push it into the downturn part of the cycle because higher interest rates would increase the cost of debt.

Data on jobs, consumer spending and inflation will be available before the FED’s next meeting in September so we will closely watch that in order to see if the FED will eventually move, highly unlikely after the latest GDP debacle.

Global Situation

The BREXIT had only a short-term effect on markets as investors soon focused on other things and hoped that it would not have any long term effects. But any BREXIT effects won’t be seen in economic data for a few years as it will take the UK at least two years to exit the EU, if not four.

figure 5 brexit
Figure 5: Soon forgotten BREXIT. Source: Google.

News from Japan was also not that good. As economic targets have not been reached, the Bank of Japan decided to double the annual amount it uses to buy exchange traded funds, from ¥3 trillion to ¥6 trillion ($57 billion). This is only a modest increase to Japan’s easing policy, measured in hundreds of trillions, and brings us to the conclusion that Japan is out of monetary policy ammo. Even with constant increases in monetary easing, Japan has experienced a 0.5% deflation in June and slower consumer spending. This should be a warning sign for the U.S. as it is clear that easing has its limits.

Conclusion

All the above indicates that we are currently in the denial phase of a stock market cycle. We have had a bull market for 7 years now and no one wants to look at the above data as it indicates a turn in the credit cycle, lower business spending and earnings, a strong dollar and global uncertainties with the UK, Japan and China. We will analyze the situation in China soon as it requires a special article.

figure 6 stock market cycle
Figure 6: Stock market cycle. Source: The Gold and Oil Guy.

Not to mention oil prices coming close to $40 dollars per barrel, which will push energy earnings down, again.

All of the cumulating risks we’ve discussed send a strong message. Investors have to start thinking about risks and rewards. In the late stage of a bull market, many are overweight stocks, which means they can expect a beating if any of the above mentioned risks trigger a bear market. The options are to increase one’s cash in order to have liquidity when a market decline comes, or to own more uncorrelated asset classes. I’ve written more on this in our recent article on Ray Dalio’s strategy.

For stocks, simply ask yourself, how much are you willing to risk for a 4% long term expected yield?

 

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Corporate Earnings of the S&P 500’s Top 10: Why It Is Important for You


  • Corporate earnings and fundamentals are variable, pick the stocks that best suit you.
  • There are low PE ratio stocks, high growth stocks, and high dividend yielders – anything you might want.
  • But be aware: some companies engage in buybacks that are detrimental to shareholders’ value.

Introduction

When you add up the top ten companies by weight, they account for 17.7% of the total weight of the S&P 500. For investors who are heavily invested in the S&P 500, following the earnings of its top ten companies is essential in order to understand the risks and rewards of being invested in the index. In this article we are going to assess the current market situation by looking at what has been going on with the 10 biggest companies in the S&P 500 index.

Apple

Apple (Nasdaq: AAPL) reported earnings after hours on Tuesday. Q2 2016 revenue declined 14.4% year-over-year and earnings per share declined 27% to $1.42 from $1.85. Those results were better than expected, and AAPL jumped 7% in after-hours trading.

AAPL isn’t a standard company, its revenue is highly dependent on iPhone sales which fell due to customers awaiting a new generation iPhone to be announced in September. If the same trend holds true as it has in the past with new iPhone generation sales, AAPL’s sales will increase when it releases the new phone. In the meantime, perhaps the most important thing from this earnings report is the fact that AAPL returned $13 billion to investors through dividends and repurchases.

The dividend yield is 2.38% annually but when we add in the repurchases, it comes to a staggering 2.3% quarterly yield, making AAPL’s dividend yield quite a bit higher than the S&P 500 average of 2.05%.

In total, the S&P 500 buybacks were $161 billion in Q1 2016,—interestingly, Apple alone makes up about 8% of this total— second only to Q3 2007 when the buybacks reached $172 billion. The most important thing with buybacks is the question: is buying your own stock the best use of cash at that point in time? Yes, companies protect and increase their share prices, but at what cost? We all know what happened in the two years after Q3 2007 when repurchases reached record highs…

Another company that is strong in repurchases in Microsoft (Nasdaq: MSFT).

Microsoft

MSFT also saw its revenue decline, by 6%, and earnings per share declined 23% (GAAP results), but nevertheless returned $2.8 billion in dividends and $3.6 billion in repurchases, giving a dividend yield of 2.54% and a 3.1% indirect yearly repurchase yield.

The decline in revenues and earnings further exacerbates the above mentioned buyback issue, but even more alarming is the fact that MSFT is buying its stock despite their PE ratio of 27.7, while AAPL’s is at 11. This is where alpha kicks in because good stock picking can make you avoid such bad cash investments.

Exxon Mobil

The consensus earnings per share for Exxon Mobil (NYSE: XOM) is $0.64 for Q2 2016 which is 34% below the earnings per share in the same quarter last year.

XOM’s share repurchase program is another crazy example of ill-timed purchases. In February, XOM stopped its buyback program after spending $210 billion over the last decade. The craziness lies in the fact that the company has stopped buying back stocks despite the price being at multiyear lows.

figure 1 xom buybacks
Figure 1: XOM’s stock price movement in the last 2 years. Source: Yahoo Finance.

This falls perfectly in line with what usually happens as managers time buybacks poorly. When stocks are cheap, management doesn’t buy them. When they are expensive, buybacks explode, eroding shareholders’ value.

figure 2 total buybacks
Figure 2: Quarterly share repurchases and number of companies repurchasing shares. Source: FACTSET.

Johnson & Johnson

Johnson & Johnson (NYSE: JNJ) is continuing on its wonderful ascent despite revenues and earnings per share not growing since 2014. JNJ has a $10 billion share repurchase program that is being financed by debt. The current enthusiasm is of course backed by global monetary easing which pushes future expectations higher.

General Electric

General Electric (NYSE: GE) has survived terrible times in the last 7 years. GE’s revenue is currently just 64% of its 2008 revenue, but the company finally managed to increase earnings and revenue in the last quarter. The PE ratio is still high at 24, and J.P. Morgan warns that GE will face bad times again due to the volatility in the economy and other internal issues.

Amazon and Facebook

Amazon (NASDAQ: AMZN) and Facebook (NASDAQ: FB) have the growth that the companies discussed above are missing, but it comes at crazy valuations.

AMZN’s PE ratio is 303, while FB’s PE ratio is 74.5. We cannot know if AMZN will manage to grow its earnings by more than tenfold in order to reach a more normal valuation or if it will forever stay the mega growth company.

Holding the S&P 500 gives you diversification, the unfortunately you gain exposure to companies after their initial growth cycle has passed. AMZN’s weight in the S&P 500 was only 0.46% in 2009 when its price was about a tenth of its current price.

Berkshire Hathaway

Berkshire Hathaway (NYSE: BRK.A, BRK.B) hasn’t yet release its earnings but what is significant and different from the above companies is that buybacks are limited. BRK will buy back its own stocks only if the price falls below 1.2 times book value. Warren Buffett believes that buying back the company’s own shares above book value is a disservice to shareholders. This might be one of the reasons why BRK has by far outperformed the S&P 500 in the last 30 years.

figure 3 brk vs sandp
Figure 3: BRK vs the S&P 500. Source: Yahoo Finance.

AT&T

AT&T (NYSE: T) doesn’t have comparable earnings as it recently acquired DirectTV, however it is a company that keeps on growing, has a high dividend yield of 4.53%, and has had minimal share repurchases when compared to other companies in the last 4 quarters.

JPMorgan Chase & Co

The last company on our list is JPMorgan Chase & Co (NYSE: JPM). JPM reported revenues up by 4% and net income up by 5%, and has a PE ratio of 10.87 with a price to book ratio of 1.0, making it the company with the best fundamentals on our list and a great introduction to our conclusion.

Conclusion

Most great investors would advise the average investor to hold the S&P 500 for the long term, but the analysis of the 10 companies we’ve discussed and the variety of their revenue growths, earnings, and management buyback policies suggest something different.

Being long the S&P 500 just because that’s what everyone else does means also having managers destroy shareholder value by excessive and poorly timed buybacks, or it means paying high valuations for companies with no growth or exorbitant valuations for growth companies. On top of that, the risks of just owning the S&P 500 are increasing as its valuation is higher and is at levels only seen twice historically, in the dotcom bubble and just before the 2009 crisis.

figure 4 s&P 500 pe ratio
Figure 4: S&P 500 PE ratio. Source: Quandl.

Investors should assess their own needs and financial requirements. There are plenty of relatively safe high dividend yielders on the market, value companies, growth companies and declining companies from which to build your portfolio.

 

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The Economic News is Very Good, But Keep An Eye On the FED and GDP This Week


  • Housing is showing inflationary signs but still offers an opportunity to profit from the rising trend as a downturn is unlikely and not expected in the short term.
  • Amidst all the positive news, manufacturing turned negative. Yet despite this, stock valuations keep going up, increasing the risk.
  • In the week ahead: the FED’s decision and GDP data. It looks like stable weather in the near future.

Introduction

The last sequence of economic data was very positive. In this article we are going to discuss the important data coming out this week and analyze the information released last week. Then we’ll combine it with the current situation on the market and, as always, analyze the risks and rewards.

Housing

Existing home sales came in at 5.5 million which is the highest in the last 10 years. This is great news and indicates a continuation of the positive trend in the real estate market. Distressed sales from foreclosures are at 6%; down from last year’s 8%.

figure 1 home sales
Figure 1: Existing home sales since 2013. Source: FRED.

Some might think that a new housing bubble is being created. Unfortunately, a clear answer to that can only be given in hindsight. There are several worrying factors, but every bull market climbs the wall of worry. The most alarming factor is that the number of people renting is growing which may indicate that many are already priced out of the market.

In support of a continued uptrend is that fact that home inventory is low as housing starts are at 1.18 million, which is still subdued when compared to the historical average of around 1.5 million, but much higher than it has been over the last 7 years.

figure 2 housing starts
Figure 2: Housing starts. Source: FRED.

According to Bloomberg, another worry is that many homes are being purchased by “mom and pop” investors with less experience, while institutional investors are ducking out of the market. Institutional investors used to account for 50% of investor foreclosure purchases, but in June that number fell to 38%. More troublesome is institutional investors now only make up 2.5% of the market, down from 9.8% in 2013.

Similarly to the situation we had in 2007, more and more foreclosed homes are bought by amateur speculators, which may be over-inflating the market.

figure 3 third party investors
Figure 3: Third-party investors auction home purchases. Source: Bloomberg.

Housing is cyclical and at some point in the future we will see another down market, but the above mentioned worries do not indicate an immediate decline, which means there is still money to be made in the uptrend. Investors might want to look at building and building materials companies that are trading below their real values and still feeling the consequences of the great recession. But beware of the risks, the downturn will eventually arrive. It might be a soft landing as more new homes are built which smooths out the price increases, or a hard landing similar to the one we saw in 2009.

The S&P/Case Shiller home price index will be published today, and prices are still expected to grow at 5.5% year over year which is very high for housing markets, but if low interest rates continue we might see a few more years of such increases.

The S&P 500

The recent S&P 500 breakout is strengthening on the positive housing data and jobless claims at 43 year lows.

figure 4 jobless claims
Figure 4: Jobless claims. Source: FRED.

So far, 25% of S&P 500 companies have reported positive earnings surprises, further fueling the stock market. Earnings are not growing, but 68% of companies have reported earnings above estimates. As of this weekend, the S&P 500 earnings decline for Q2 2016 was expected to be at -3.7%, and unfortunately, expectations for earnings in Q3 2016 have been constantly falling over the last several months.

According to Factset, Q3 2016 will be the sixth consecutive quarter with declining earnings (-0.1%). Positive analysts don’t expect a return to earnings growth until Q4 2016, but the below figure shows how quickly analysts’ forecasts can change.

figure 5 expected earning growth rate
Figure 5: Expected S&P 500 Q3 2016 earnings growth rate. Source: Factset.

With positive economic news and declining earnings, it is difficult to know where the market goes from here. From a fundamental perspective, the market is getting riskier and investors are paying more for lower returns. The current S&P 500 price earnings ratio has now surpassed 25, indicating that in the long term you should not expect stock returns to be higher than 4%.

figure 6 multpl
Figure 6: S&P 500 PE ratio. Source: Multpl.

Reaching full employment means that companies will have to pay more for employees, and thus have higher costs, which should put more pressure on earnings. This should spur inflation, but we will know more on Wednesday when the FED issues its Monetary policy statement.

The Real Economy

As always, life for the FED will be difficult. Low jobless claims, higher house prices and a higher S&P 500 are all good, but there is always the fear that those are just asset inflation repercussions.

The Philly Fed Manufacturing business outlook survey has turned negative again. As manufacturing is the basis of a healthy and sustainable economy, this might push the FED to postpone rate increases, but we might hear a more positive tone.

figure 6 diffusion index
Figure 7: Current and future general activity indexes. Source: Philadelphia FED.

No matter what the FED says, the week will be overshadowed by Friday’s publication of the preliminary data on GDP. A big rebound is expected given the positive economic activities happening in the last few months. GDP is forecasted to grow at 2.5% in Q2 2016.

figure 7 forecasted gdp
Figure 8: Forecasted GDP. Source: Wall Street Journal.

Conclusion

The current environment is one full of positive news and positive expectations which is very good, but as savvy investors we must always look at ways to protect ourselves. More and more indicators are signaling that we are getting closer to the end of the real economic growth period and entering a bubble period.

House flippers are inflating house prices, stocks are reaching new highs even as earnings are declining—and still expected to decline further—while the real manufacturing economy is not growing. All this mixed data indicates that we are close to a recession and a bear market, but the good times could still last for a while as the FED continues to keep interest rates low. We will watch this week’s news releases and earnings carefully and update you on the new developments. Stay tuned.

 

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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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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.

Introduction

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.

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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.

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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.

Conclusion

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.