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The Big Picture

Summary US markets have surged in recent years. But this pattern has happened before. Foreign markets may present big opportunities. This is a shortened version of the latest Euro Pacific Capital’s Global Investor Newsletter . The past four years or so have been extremely frustrating for investors like me who have structured their portfolios around the belief that the current experiments in central bank stimulus, the anti-business drift in Washington, and America’s mediocre economy and unresolved debt issues would push down the value of the dollar, push up commodity prices, and favor assets in economies with relatively low debt levels and higher GDP growth. But since the beginning of 2011, the Dow Jones Industrial Average has rallied 67% while the rest of the world has been largely stuck in the mud. This dominance is reminiscent of the four years from the end of 1996 to the end of 2000, when the Dow rallied 54% while overseas markets languished. Although past performance is no guarantee of future results, a casual look back at how the U.S. out-performance trend played out the last time it had occurred should give investors much to think about. The late 1990s was the original “Goldilocks” era of U.S. economic history, one in which all the inputs seemed to offer investors the best of all possible worlds. The Clinton Administration and the first Republican-controlled Congress in a generation had implemented policies that lowered taxes, eased business conditions, and encouraged business investment. But, more importantly, the Federal Reserve was led by Alan Greenspan, whose efforts to orchestrate smooth sailing on Wall Street led many to dub Mr. Greenspan “The Maestro.” Towards the end of the 1990’s, Greenspan worked hard to insulate the markets from some of the more negative developments in global finance. These included the Asian Debt Crisis of 1997 and the Russian debt default of 1998. But the most telling policy move of the Greenspan Fed in the late 1990’s was its response to the rapid demise of hedge fund Long term Capital Management (LTCM), whose strategy of heavily leveraged arbitrage backfired spectacularly in 1998. Greenspan engineered a $3.6 billion bailout and forced sale of LTCM to a consortium of Wall Street firms. The intervention was an enormous relief to LTCM shareholders but, more importantly, it provided a precedent that the Fed had Wall Street’s back. Not surprisingly, the 1990s became one of the longest sustained bull markets on record. But in the latter part of the decade the markets really started to climb in an unprecedented trajectory. As the bubble began inflating in earnest Greenspan was reluctant to follow the dictum that the Fed’s job was to remove the punch bowl before the party got out of hand. Instead he argued that the Fed shouldn’t prevent bubbles from forming, but simply to clean up the mess after they burst. But while U.S. markets were taking off, the rest of the world was languishing, or worse: (click to enlarge) Created by EPC using data from Bloomberg All returns are currency-adjusted But then a very funny thing happened. In March 2000, the music stopped and the dotcom bubble finally burst, sending the Nasdaq down nearly 50% by the end of the year, and a staggering 70% by September 2001. When investors got back into the market their values had changed. They now favored low valuations, real revenue growth, understandable business models, high dividends, and low debt. They came to find those features in the non-dollar investments that they had been avoiding. Over the seven years that began at the end of 2000 and lasted until the end of 2007 the S&P 500 inched upwards by just 11%, for an average annual return of only 1.6%. But over that time frame the world index (which includes everything except the U.S.) was up 72%. The emerging markets, which had suffered the most during the four prior years, were up a staggering 273%. See table below: (click to enlarge) Created by EPC using data from Bloomberg All returns are currency-adjusted Not surprisingly, the markets and asset classes that had been decimated by the Asian debt and currency crises, delivered stunning results. South Korea, which was only up 10% in the four years prior, was up 312% from 2001-2007. Brazil, which had fallen by 4%, notched a 407% return, and Indonesia, which had fallen by 50%, skyrocketed by 745%. The period was also a great time for gold and gold stocks. The earlier four years had offered nothing but misery for investors like me who had been convinced that the Greenspan policies would undermine the dollar, shake confidence in fiat currency, and drive investors into gold. Instead, gold fell 26% (to a 20-year low), and shares of gold mining companies fell a stunning 65%. But when the gold market turned in 2001, it turned hard. From 2001 – 2007, the dollar retreated by nearly 18% (FRED, FRB St. Louis), while gold shot up by 206%, and shares of gold miners surged 512%. As it turned out, we weren’t wrong about the impact of the Fed’s easy money, just too early. 2010 – 2014 In recent years, investors who have looked to avoid the dollar and the high-debt developed economies have encountered many of the same frustrations that they encountered in the late 1990s. Foreign markets, energy, commodities and gold have gone nowhere while the dollar and U.S. markets have surged as they did in 1997-2000. (click to enlarge) Created by EPC using data from Bloomberg All returns are currency-adjusted It is said history may not repeat, but it often rhymes. If so, there may be a financial sonnet brewing. There are reasons to believe that relative returns globally will turn around now much as they did back in 2000. Perhaps even more decisively. Just as they had back in the late 1990’s, investors appear to be ignoring flashing red flags. In its Business and Finance Outlook 2015, the Organization for Economic Cooperation and Development (OECD), a body that could not be characterized as a harbinger of doom, highlighted some of the issues that should be concerning the markets. Reuters provides this summary of the report’s conclusions: Encouraged by years of central bank easing, investors are plowing too much cash into unproductive and increasingly speculative investments while shunning businesses building economic growth. There is a growing divergence between investors rushing into ever riskier assets while companies remain too risk-averse to make investments. Investors are rewarding corporate managers focused on share-buybacks, dividends, mergers and acquisitions rather than those CEOS betting on long-term investment in research and development. While these trends have been occurring around the world, they have become most pronounced in the U.S., making valuations disproportionately high relative to other markets. As we mentioned in a prior newsletter , looking at current valuations through a long term lens provides needed perspective. One of the best ways to do that is with the Cyclically-Adjusted-Price-to-Earnings (CAPE) ratio, which is also known as the Shiller Ratio (named after its developer, the Nobel prize-winning economist Robert Shiller).Using 2014 year-end CAPE ratios that average earnings over a trailing 10-year period, the global valuation imbalances become evident: (click to enlarge) As of the end of 2014, the S&P 500 had a CAPE ratio of well over 27, at least 75% higher than the MSCI World Index of around 15. (High valuations are also on evidence in Japan, where similar monetary stimulus programs are underway). On a country by country basis, the U.S. has a CAPE that is at least 40% higher than Canada, 58% higher than Germany, 68% higher than Australia, 90% higher than New Zealand, Finland and Singapore, and well over 100% higher than South Korea and Norway. Yet these markets, despite the strong domestic economic fundamentals that we feel exist, are rarely mentioned as priority investment targets by the mainstream asset management firms. In addition, U.S. stocks currently offer some of the lowest dividend yields to compensate investors for the higher valuations (see chart above). The current estimated 1.87% annual dividend yield for the S&P 500 is far below the current annual dividend yields of Australia, New Zealand, Finland and Norway. If a dramatic shock occurs as it did in 2000, will investors again turn away from high leverage and high valuations to seek more modestly valued investments? Then, as now, we believe those types of assets can more readily be found in non-dollar markets. Another similarity between then and now is the propensity to confuse an asset bubble for genuine economic growth. The dotcom craze of the 1990s painted a false picture of prosperity that was doomed to end badly once market forces corrected for the mal-investments. When that did occur, and stock prices fell sharply, the Fed responded by blowing up an even bigger bubble in real estate. When that larger bubble burst in 2008, the result was not just recession, but the largest financial crisis since the Great Depression. But once again investors have mistaken a bubble for a recovery, only this time the bubble is much larger and the “recovery” much smaller. The middling 2% GDP growth we are currently experiencing is approximately half of what we saw in the late 1990s. In reality, the Fed has prevented market forces from solving acute structural problems while producing the mother of all bubbles in stocks, bonds, and real estate. A return to monetary normalcy is impossible without pricking those bubbles. Soon the markets will be faced with the unpleasant reality that the U.S. economy may now be so addicted to monetary heroine that another round of quantitative easing will be necessary to keep the bubble from deflating. The current rally in U.S. stocks has gone on for nearly four full years without a 10% correction. Given that high asset prices are one of the pillars that support this weak economy, it is likely that the Fed will unleash another round of QE as soon as the market starts to fall in earnest. The realization that the markets are dependent on Fed life support should seal the dollar’s fate. Once the dollar turns, a process that in my opinion began in April of this year, so too should the fortunes of U.S. markets relative to foreign markets. If I am right, we may be about to embark on what could become the single most substantial period of out-performance of foreign verses domestic markets. While the party in the 1990s ended badly, the festivities currently underway may end in outright disaster. The party-goers may not just awaken with hangovers, but with missing teeth, no memories, and Mike Tyson’s tiger in their hotel room. Read the original article at Euro Pacific Capital. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Coming Energy ETF Price Changes, As Seen By Market-Makers

Summary Transitions in energy economics continue as extraction technology of source fuels progresses, their transportation capacity to demand sites expands, conversion technology of sources to improved use forms evolves. It can’t happen instantly, so bets made on the rate and extent of advances are being made and modified daily in the convenient, diversified forms of Exchange Traded Funds, ETFs. Energy’s pervasive presence in contemporary civilization provides a wide range of opportunities for profit gains in investment capital. The choices are so overwhelming that focus is needed. ETFs do that. Investors must be careful about their energy ETF choices since progress prospects can be quite uneven in the common denominators of time required, odds of success, and extent of payoffs. Knowledgeable investment organizations, in their attempts at best choices, cause market-makers to put their firms’ capital temporarily at risk, facilitating volume trades. Risk-aversion measures reveal the players expectations. Observers can piggy-back on knowledgeable investor expectations Energy is an enormous, complex, evolving, opportune scene. Finding reliable guides to condense and focus attention and evaluation comparisons is a daunting task. Our strategy is to let large organizations, ones that are well-resourced in experienced people who are kept currently informed by extensive information gathering systems, do the heavy lifting research of developing and maintaining comparative data. These are the buy-side movers. That flood of essential minutia leads to value judgments about likely future prices of commodities and securities prices. Uncertainty infects all expectations, making ODDS of achievement an essential component in the valuation process. Scorekeeping in the investing competition is done by rate of return, making TIME a powerful element in the equation, potentially more important than size of PAYOFFS. The buy-side movers have their own conclusions about likely specific scores and attempt to implement them by changes in investment portfolio holdings. To have significant impact on their portfolios, the changes typically are too large to be accomplished in regular-way trades of single buyer confronting single seller. These volume trade programs pursue a variety of avenues, but the most significant price-setting ones are known as block trades. Block trades are single transactions typically involving one initiator and an anonymous group of “other side of the trade” reactors organized by a market-making [MM] negotiator, where a single per-share price is achieved for all participants, with a trade spread for the MM applied against the trade initiator’s receipt or cost. Usually markets do not provide the opportunity for a “cross” where available buyers equal sellers and the MM earns an effort-free spread. Instead, to achieve a price per share acceptable to the trade initiator, the MM usually must become party to the transaction, taking a position, long or short, to balance the volume of shares between buyers and sellers. That action puts the MM firm’s capital at risk of subsequent undesired price change until the acquired position can be unwound one way or another. Actual risk-taking is not the MM’s desired activity, nor practice. Their competitive skills are in risk avoidance – hedging and arbitrage – setting up combinations of securities positions that offset unwanted price changes in at-risk capital commitments. That intellectual art form tends to dominate the markets for many derivative securities. It usually can’t be done without cost because those markets are competitive in themselves. The MM seeking protection won’t get it for free, because the sellers of the price insurance are accepting their own risk exposures in the process, and insist on being paid. What cost can be paid comes back to the judgment of the trade originator, because the hedge is part and parcel of the market liquidity being provided by the MM and gets folded into the single per share price of the block trade. A small enough cost fills the trade, too big a cost kills the trade. This is the discipline of the marketplace. Live experience of market price changes subsequent to the implied price range forecasts by MMs verifies their ongoing judgments about what may be coming for energy ETFs. What Energy ETFs are Available? Over 30 actively-traded ETFs have a focus on the energy sector, more than in any other activity of the world economy. They are very diverse in nature, ranging from fuel producers with broad product lines to the commodity prices themselves, to electric Utility converters and distributors of energy, to explorers and developers of fuel resources, to transporters and in-the-field support service organizations . Figure 1 lists these ETFs, sorted by their principal holdings focuses. It further examines the size of investor capital commitments in each, and what kind of trading activity defines the liquidity of an investor’s ability to enter or exit from the game. Transaction trade spreads give further insights into the costs of participating. Figure 1 (click to enlarge) Source: Yahoo Finance For many of the sectors of interest there are multiple ETF choices available to the investor. As usual, those attracting the largest capital commitments, Assets Under Management, or AUM, tend to have the most liquidity in terms of turnover, and lowest cost in terms of bid-offer trade spreads. Negative or inverse-acting ETFs are indicated in red, as are costly trade spreads of 2% or more. Liquidity in ETFs is a major concern because of the huge number of ETFs that have small commitments and infrequent trading at large spread costs. A few of these are indicated here, but many hundreds more are extant. Investors should take care to be able to extricate their capital in short notice when things turn unpleasant by using ETFs with quicker turnover of AUM where alternative choices are present. From this list it is clear that XLE, XLU, and AMJ have the biggest investor commitments, but that AMJ is relatively illiquid. So are the two Vanguard ETFs, VDE and VPU. USO, UCO, XOP, and OIH, despite billion-$ commitments, have good AUM turnover. But how do these ETFs compare on Risk vs. Reward? Figure 2 provides a graphic comparison of MM upside price change forecasts (reward) with prior experiences of worst-case price drawdowns (risk) during holdings of forecasts similar to today’s. It is often at such points the need for cash or the confidence in price recovery is under most stress. Figure 2 (used with permission) In this picture higher rewards and lower risks are down and to the right, with the opposite up and to the left. Equal risk and reward, in percent price change terms, are along the dotted diagonal. The most favorable combination of prospects is for the Vanguard Energy ETF (NYSEARCA: VDE ) at location [16]. The market average proxy, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) is at [30] with the same upside prospect as VDE, but some larger drawdown exposure. Along with SPY is the First Trust Natural Gas Exploration and Production ETF (NYSEARCA: FCG ). Reaching out for higher rewards at the cost of larger risk exposure are the The United States Brent Oil ETF, LP ( BNO) [11], and the The United States 12 Month Oil ETF, LP ( USL) [10]. Big commitment ETFs, the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) [20] and the iShares U.S. Energy ETF ( IYE) [3] are on the wrong side of the R~R balance just above the diagonal. Fuller details on the comparative criteria of Risk, Reward, Odds, and Payoffs for this list of ETFs is contained in Figure 3. The historical experience data shown there is from hypothetical holdings at prior dates of forecasts similar to today’s, managed under our standard TERMD T ime- E fficient R isk M anagement D iscipline. Figure 3 (click to enlarge) What is important in the table is the balance of upside prospects (5) in comparison to downside concerns (6). That ratio is expressed in the Range Index [RI] (7), whose number tells what percentage of the whole range (2) to (3) lies below the then current price (4). Today’s Range Index is used to evaluate how well prior forecasts of similar RIs for this ETF have previously worked out. The size of that historic sample is given in (12). The first items in the data line are current information: The current high and low of the forecast range, and the percent change from the market quote to the top of the range, as a sell target. The Range Index is of the current forecast. Other items of data are all derived from the history of prior forecasts. They stem from applying a T ime- E fficient R isk M anagement D iscipline to hypothetical holdings initiated by the MM forecasts. That discipline requires a next-day closing price cost position be held no longer than 63 market days (3 months) unless first encountered by a market close equal to or above the sell target. The net payoffs (9) are the cumulative average simple percent gains of all such forecast positions, including losses. Days held (10) are average market rather than calendar days held in the sample positions. Drawdown exposure indicates the typical worst-case price experience during those holding periods. Win odds (8) tells what percentage proportion of the sample recovered from the drawdowns to produce a gain. The credibil(ity) ratio (13) compares the sell target prospect (5) with the historic net payoff experiences (9). These ETFs have been ranked by (15) an odds-weighted blend of reward and risk in light of the frequency of opportunities in the sample, as a figure of merit [FOM] to include the results of prior relevant experiences. Averages of the 10 best FOM-ranked ETFs and of the set of 32 have been compiled for comparative purposes with the market proxy SPY, and with the day’s equity population average of some 2500 stocks and ETFs. Conclusion The best ten Energy ETFs as a subset offer poor comparisons to the market proxy SPY, with slightly larger upside prospects but markedly worse price drawdown experiences. Their drawdown recovery back to profitability of 79 out of 100 positions was worse than SPY’s 86 of 100. Their forecast credibility was just as poor as the market average, but with a much worse reward-to-risk ratio. Looked at as the larger set of 32, these ETFs have a pretty horrible comparison with the overall equity population. But that should not be much of a surprise, given a 50% drop in the common denominator for the entire sector, the price of crude oil. Still, there is recent hope that we may be seeing a bottom area in that price of $50-$65 per barrel. We will be producing a series of single ETF analyses on those energy ETFs where the present and coming better investment prospects may lie. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

How To Find The Best Style ETFs: Q2’15 In Review

Summary The large number of ETFs hurts investors more than it helps as too many options become paralyzing. Performance of an ETFs holdings are equal to the performance of an ETF. Our coverage of ETFs leverages the diligence we do on each stock by rating ETFs based on the aggregated ratings of their holdings. Finding the best ETFs is an increasingly difficult task in a world with so many to choose from. How can you pick with so many choices available? Don’t Trust ETF Labels There are at least 65 different All Cap Blend ETFs and at least 289 ETFs across twelve styles. Do investors need 20+ choices on average per style? How different can the ETFs be? Those 65 All Cap Blend ETFs are very different. With anywhere from 4 to 3775 holdings, many of these All Cap Blend ETFs have drastically different portfolios, creating drastically different investment implications. The same is true for the ETFs in any other style, as each offers a very different mix of good and bad stocks. Large Cap Value ranks first for stock selection. Small Cap Blend ranks last. Details on the Best & Worst ETFs in each style are here . A Recipe for Paralysis By Analysis We firmly believe ETFs for a given style should not all be that different. We think the large number of All Cap Blend (or any other) style ETFs hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many ETFs. Analyzing ETFs, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each ETF. As stated above, that can be as many as 3775 stocks, and sometimes even more, for one ETF. Any investor worth his salt recognizes that analyzing the holdings of an ETF is critical to finding the best ETF. Figure 1 shows our top rated ETF for each style. Note there are no ETFs currently under coverage in the All Cap Growth or All Cap Value Styles. Figure 1: The Best ETF in Each Style Sources: New Constructs, LLC and company filings How to Avoid “The Danger Within” Why do you need to know the holdings of ETFs before you buy? You need to be sure you do not buy an ETF that might blow up. Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. No matter how cheap, if it holds bad stocks, the ETF’s performance will be bad. PERFORMANCE OF ETF’S HOLDINGS = PERFORMANCE OF ETF If Only Investors Could Find Funds Rated by Their Holdings The Arrow QVM Equity Factor ETF (NYSEARCA: QVM ) is the top-rated Large Cap Blend ETF and the overall best ETF of the 289 style ETFs that we cover. The worst ETF in Figure 1 is the SPDR S&P 600 Small Cap Growth ETF (NYSEARCA: SLYG ), which gets our Neutral rating. One would think ETF providers could do better for this style. Disclosure: David Trainer and Max Lee receive no compensation to write about any specific stock, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.