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Why Popular Investments Are Usually Wrong

By Alan Gula Oscar Wilde, the 19th century poet and playwright, once said: “Everything popular is wrong.” The Irish wordsmith wasn’t referring to the financial markets, but he may as well have been. That’s because investors should be very wary of the popular stocks, sectors, and exchange-traded funds (ETFs) du jour. While it’s true that momentum can persist, more often than not, popularity is the kiss of death. In finance, the degree of popularity is typically referred to as sentiment. Fundamentals matter in the long term, but sentiment is what really drives short- and intermediate-term moves in the financial markets. Caution is, therefore, essential when sentiment reaches a bullish extreme. The Texas Hedge It was a no-brainer, can’t-lose trade. Pundits on CNBC and Bloomberg TV were supremely confident in the outcome. Fund flows poured in to take advantage of its inevitability. This was a “layup” – a sure thing. The Bank of Japan (BOJ) was going to depress the value of the Japanese yen, and Japanese equities would rise due to exporters benefiting from a cheap currency. Naturally, everyone wanted to be long Japanese stocks, but short the yen, and the WisdomTree Japan Hedged Equity ETF (NYSEARCA: DXJ ) provided an easy way to do just that. Except now investors are realizing that they aren’t hedged at all. Ironically, the yen has gone through the roof ever since the BOJ implemented a quasi-negative interest rate scheme. The U.S. dollar/Japanese yen exchange rate (USD/JPY) recently hit its lowest level since October 2014 (a decline in USD/JPY represents dollar weakness, yen strength). Thus, anyone betting on a decline in the yen is getting bludgeoned in the market. Not only that, Japanese equities are, unsurprisingly, falling in tandem with USD/JPY. This is a lose/lose situation for DXJ holders. Since April 2015, when I warned that investors in currency “hedged” ETFs were essentially speculating on currency movements, DXJ has lost 26% of its value (including distributions). Going back even further to early 2014, DXJ has produced a total return of negative 6%. Alas, it was so popular! Over the same time frame, the S&P 500 has returned a positive 16%. Shifting Sentiment To be sure, DXJ now offers a far better risk-reward proposition than it did a year ago. Basically, the fund may excel because the trade is not nearly as popular. We’re even seeing currency futures speculators, in aggregate, bet on yen appreciation . The last time this group had a net long position in the yen was 2012, right before the yen plummeted as “Abenomics” was introduced. In other words, the sentiment of this crowd is a contrarian indicator. Sentiment notwithstanding, the fundamentals for Japan, in general, remain poor. Japan has a shortage of the most precious natural resource on the planet: children. Do the central planners really think that burning their currency at the stake is going to solve anything? Well, they certainly shouldn’t. Nonetheless, the short-term swings will continue, as prices are determined – at the margin – by human behavior and emotions. This is why serially buying the most popular investments is a great way to destroy wealth. Meanwhile, the fundamentals for U.S. Treasuries remain strong. The real trick, however, will be knowing when they, too, have become overly popular. Original Post

The V20 Portfolio #27: When To Rebalance

The V20 portfolio is an actively managed portfolio that seeks to achieve an annualized return of 20% over the long term. If you are a long-term investor, then this portfolio may be for you. You can read more about how the portfolio works and the associated risks here . Always do your own research before making an investment. Read the last update here . Note: Current allocation and planned transactions are only available to premium subscribers . After a volatile week, the V20 Portfolio declined by 3.2% while the SPDR S&P 500 ETF (NYSEARCA: SPY ) declined by 1.2%. The underperformance can once again be attributed to the largest holding, Conn’s (NASDAQ: CONN ). When To “Average Down” Recently our cash balance has grown as a percentage of the overall portfolio, which can be primarily attributed to the decline in portfolio value as opposed to strategic shifts in allocation. As mentioned earlier, the biggest laggard is Conn’s. You may recall that the V20 Portfolio will continue to purchase shares of a company if fundamentals have not deteriorated, even if price has dropped. In 2016, we did exactly that. Conn’s position would have been 42% smaller had we not made any purchases in 2016. But as share price has continued to drop since the last transaction, I have not yet made any additional purchases for Conn’s, which is a part of the reason why cash allocation has swelled to one of the highest levels since the portfolio’s inception. Why did I make that decision? The truth is that I’ve been looking for the opportunity to “pull the trigger” so to speak. This relates to my rebalancing philosophy. There are many ways to rebalance, but I break them down to systematic and discretionary. The former style follows a predetermined method (e.g. once every quarter according to some specification). As you probably guessed already, the V20 Portfolio’s rebalancing method is discretionary. I believe that too many factors are shifting to warrant a systematic method. However, discretion does not imply randomness. The V20 Portfolio seeks to allocate more capital to stocks with the highest expected rate of return while accounting for the possibility of permanent capital loss . I believe that the smallest position in the portfolio right now, Dex Media, actually has the highest expected return; but due to the high risk of shareholders being wiped out in the restructuring deal, it is not prudent to allocate a significant amount of capital to the stock, no matter the expected return. Bringing the discussion back to the topic of rebalancing; a position essentially shifts between “no exposure” to “too much exposure” at any given time. However, there is no specific number associated with these two groups. Let’s suppose that the ideal allocation is 10% for a certain stock. Should you rebalance when it falls to 9.99%? Or what if it rises to 11%? There is no good answer. However, if we examine the extremes, the answer can become clearer. Using the same example, I don’t think anyone will disagree that rebalancing would be appropriate if the allocation falls to 1%, assuming no changes in fundamentals. There are also short-term considerations. While the focus should be long-term, short-term fluctuations are very real. Each time you place a trade, you are implying that prices shouldn’t go lower, or else you would have waited. This implication exists even if your investment horizon is long-term . There are numerous factors that could lead to sustained mispricing. For Conn’s, the general macro picture for retail has been soft and the credit division’s results may not improve for a while. Both of these factors could put more pressure on the stock, providing better opportunities to accumulate shares. In conclusion, there is no “perfect” time to rebalance. I believe that Conn’s current allocation remains large enough to capture the stock’s significant upside. The allocation could be larger, it could be smaller. However, one thing is certain: if shares continue to fall in the future, there is no doubt that more capital would be allocated to the position. Performance Since Inception Click to enlarge Disclosure: I am/we are long CONN. 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.

Estimating Future Stock Returns

Click to enlarge Idea Credit: Philosophical Economics , but I estimated and designed the graphs There are many alternative models for attempting to estimate how undervalued or overvalued the stock market is. Among them are: Price/Book P/Retained Earnings Q-ratio (Market Capitalization of the entire market / replacement cost) Market Capitalization of the entire market / GDP Shiller’s CAPE10 (and all modified versions) Typically these explain 60-70% of the variation in stock returns. Today I can tell you there is a better model, which is not mine, I found it at the blog Philosophical Economics. The basic idea of the model is this: look at the proportion of US wealth held by private investors in stocks using the Fed’s Z.1 report. The higher the proportion, the lower future returns will be. There are two aspects of the intuition here, as I see it: the simple one is that when ordinary people are scared and have run from stocks, future returns tend to be higher (buy panic). When ordinary people are buying stocks with both hands, it is time to sell stocks to them, or even do IPOs to feed them catchy new overpriced stocks (sell greed). The second intuitive way to view it is that it is analogous to Modiglani and Miller’s capital structure theory, where assets return the same regardless of how they are financed with equity and debt. When equity is a small component as a percentage of market value, equities will return better than when it is a big component. What it Means Now Now, if you look at the graph at the top of my blog, which was estimated back in mid-March off of year-end data, you can notice a few things: The formula explains more than 90% of the variation in return over a ten-year period. Back in March of 2009, it estimated returns of 16%/year over the next ten years. Back in March of 1999, it estimated returns of -2%/year over the next ten years. At present, it forecasts returns of 6%/year, bouncing back from an estimate of around 4.7% one year ago. I have two more graphs to show on this. The first one below is showing the curve as I tried to fit it to the level of the S&P 500. You will note that it fits better at the end. The reason for that it is not a total return index and so the difference going backward in time are the accumulated dividends. That said, I can make the statement that the S&P 500 should be near 3000 at the end of 2025, give or take several hundred points. You might say, “Wait, the graph looks higher than that.” You’re right, but I had to take out the anticipated dividends. Click to enlarge The next graph shows the fit using a homemade total return index. Note the close fit. Click to enlarge Implications If total returns from stocks are only likely to be 6.1%/year (w/ dividends @ 2.2%) for the next 10 years, what does that do to: Pension funding / Retirement Variable annuities Convertible bonds Employee Stock Options Anything that relies on the returns from stocks? Defined benefit pension funds are expecting a lot higher returns out of stocks than 6%. Expect funding gaps to widen further unless contributions increase. Defined contributions face the same problem, at the time that the tail end of the Baby Boom needs returns. (Sorry, they *don’t* come when you need them.) Variable annuities and high-load mutual funds take a big bite out of scant future returns – people will be disappointed with the returns. With convertible bonds, many will not go “into the money.” They will remain bonds, and not stock substitutes. Many employee stock options and stock ownership plan will deliver meager value unless the company is hot stuff. The entire capital structure is consistent with low-ish corporate bond yields, and low-ish volatility. It’s a low-yielding environment for capital almost everywhere. This is partially due to the machinations of the world’s central banks, which have tried to stimulate the economy by lowering rates, rather than letting recessions clear away low-yielding projects that are unworthy of the capital that they employ. Reset Your Expectations and Save More If you want more at retirement, you will have to set more aside. You could take a chance, and wait to see if the market will sell off, but valuations today are near the 70th percentile. That’s high, but not nosebleed high. If this measure got to levels 3%/year returns, I would hedge my positions, but that would imply the S&P 500 at around 2500. As for now, I continue my ordinary investing posture. If you want, you can do the same. Disclosure: None