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Value Stocks Are Still Not Attractive

There is no mystery in the ongoing behavior of value stocks against growth. It reflects a combination of low 10-year yields and a strong dollar, both of which are positive for growth stocks. As long as U.S. Treasury yields and the U.S. dollar will remain negatively correlated, value stocks may not outperform. Since the Fed started mentioning tapering, the relationship between the relative performance of value against growth and U.S. Treasury yields has broken down at least twice (see chart below). Episodes of higher yields should have benefited value stocks but did actually not. Yet, taking a long view, the long lasting underperformance of value is not really surprising – value stocks have suffered from the long decline in U.S. Treasury yields: conundrum, great recession, secular stagnation… Contrary to the late 1990s, the outperformance of growth is not linked to any bubble (Internet stocks in 98/99). From this perspective, only a significant reversal in U.S. long term yield would call for a structurally long position on value against growth. Once again the arbitrage for value when yields are going up is not linked to the growth expectations embedded in long term yields (which would call for growth stocks to outperform) but rather on the yield arbitrage (growth stocks have a much lower E/P hence a required price adjustment that is much significant than that of high E/P value stocks). The ongoing strength of the U.S. dollar also explains the relative strength of growth stocks. As can be seen below, bullish trends for the USD are generally positive for growth sub-indexes. On a three-month basis, the recent behavior of the USD would yet suggest either that growth-stock outperformance is overdue or that stocks are pricing a sharp rebound in the U.S. currency. Bottom Line: There is no mystery in the ongoing behavior of value stocks against growth. It reflects a combination of low 10-year yields and a strong dollar, both of which are positive for growth stocks (at least on a relative perspective). The question is therefore not about any “weird” behavior of value stocks but rather about the nature of the relationship between 10-year yields and the USD: how long will U.S. Treasury yields and the U.S. dollar remain negatively correlated? The chart below suggests that the correlation break is close to be the longest ever. As long as it lasts, value won’t be attractive. 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. Share this article with a colleague

The Importance Of Your Time Horizon

I ran across two interesting articles today: Both articles are exercises in understanding the time horizon over which you invest. If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets. Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell. Some people don’t have much choice in the matter. They have retired, and they have a lump sum of money that they are managing for long-term income. No more money is going in, money is only going out. What can you do? You have to plan before volatility strikes. My equity only clients had 14% cash before the recent volatility hit. Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened. That flexibility was built into my management. (If the market recovers enough, I will rebuild the buffer. Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.) If an older investor would be hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term. With a higher level of bonds in the portfolio, he could more than proportionately draw down on bonds during a crisis, which would rebalance his portfolio. If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then. That also would rebalance the portfolio. Again, plans like that need to be made in advance. If you have no plans for defense, you will lose most wars. One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time. When the time for converting assets to cash is far distant, using a single point may be a decent approximation. When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi) Monte Carlo simulations, and sensitivity analyses are done must reflect that. Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement. The same would apply to an early spike in inflation rates followed by deflation. The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes. If it doesn’t include the Great Depression, it is not realistic enough. Run them forwards, backwards, upside-down forwards, and upside-down backwards. (For the upside-down scenarios normalize the return levels to the right side up levels.) The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions. History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner. You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time. Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there. One more note: and I know how to model this, but most won’t – in the Great Depression, the returns after 1931 weren’t bad. Trouble is, few were able to take advantage of them because they had already drawn down on their investments. The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns. They had to be lower, because many people could not hold their investments for the eventual recovery. Part of that was margin loans, part of it was liquidating assets to help tide over unemployment. It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low. That’s not all that much different than some had to do in the recent financial crisis. Now, who is willing to throw *that* into financial planning models? The simple answer is to be more conservative. Expect less from your investments, and maybe you will get positive surprises. Better that than being negatively surprised when older, when flexibility is limited. Disclosure: None

5 Lessons From The S&P 500 Market Crash For ETF Portfolios

Summary ETFs tracking the S&P 500 index had down-side tracking error. Other ETFs based on value, low volatility, dividend payers or equal weight fell more than the S&P 500 Index. Gold, bond and exotic ETFs provided down-side protection during the sell-off. These lessons can be used to build better portfolios. Introduction We review the past few trading days and try to draw some lessons from the rapid expansion in volatility. Naturally, it is still very early, and this edition of the crash is yet to run its course, and more lessons surely wait in the wings. However, we can draw a few lessons about portfolio construction that this market stumble has revealed. S&P 500 ETFs had down-side tracking error We measure the decline in the S&P 500 Cash index (SPX) from the Wednesday, August 19, close to the Monday, August 24, low. We want to check how well the S&P 500 ETFs did in tracking this downdraft. In Figure 1, we show that amplitude of the move from the Wednesday close to the Monday low. There was significant tracking error, particularly for the IVV ETF, which seemed to lost its bearings altogether. Hence, in designing portfolios, one should recognize that the down-side risk could be greater than that experienced by the index itself. (click to enlarge) Figure 1: There was significant down-side tracking error among popular S&P 500 tracking funds. Value, Dividend, Equal Weight Alternatives to SPX Fared Worse One of the portfolio construction principles suggested to reduce volatility and give down-side protection is to use a value approach, or have high dividend payers or change the weighting scheme. We show in Figure 2 that none of these alternatives gave any meaningful down-side protection. So, from a portfolio design perspective, it might be better to just use a good SPX ETF. (click to enlarge) Figure 2: ETFs focused on value, dividends and alternate weights fared worse in the sell-off then the SPX. Data courtesy ETFmeter.com. Low Volatility Funds Were Volatile Low volatility funds were supposed to bounce around less than the typical market ETF. However, these funds crashed harder than the S&P 500 index itself (Figure 3) calling into question their benefit within a portfolio. (click to enlarge) Figure 3: Many ETFs designed with volatility screens were more volatile on the down-side than the S&P 500 index itself and might add little value in a crisis. Data courtesy ETFmeter.com. Long-term bond ETFs and Gold ETFs provide small offset The traditional way to offset weakness in equities is through diversification into long bonds. We show in Figure 4 that the large bond fund provided a small positive offset during this major decline. Since bonds are rising while equities are falling, we measure the performance from the Wednesday close to Monday’s high. . As a store of value in a crisis, some money flowed into gold funds, and gold ETFs provided good diversification during the equity sell-off (see Figure 4). So, the gold related funds could be a source of diversification when one is constructing portfolios, though their long-run trends could dictate the size of the position. (click to enlarge) Figure 4: The major bond and gold ETFs were positive, providing diversification, but the bond ETF amplitude of the move was small compared to the declines in the equity ETFs and the expansion in the VIX index ETFs. Data courtesy ETFmeter.com. Exotic ETFs such as Leveraged Inverse ETFs Provided Diversification Lastly, we look at exotic ETFs, such as leveraged inverse ETFs and long/short strategy ETFs. By design, such ETFs should rise when the market falls, though their leverage means they are probably not the preferred choice for all investors. These inverse ETFs provided excellent on-demand down-side protection as they should, by design. The long/short strategy ETF also did well. So, for those who understand these strategies and the perils of leverage, these may be alternatives to consider during portfolio construction. We emphasize that these ETFs may not be the best alternative for everyone due to the leverage involved. (click to enlarge) Figure 5: The more exotic ETF strategies, such as inverse SPX ETFs, provided much-needed on-demand down-side protection, but due to their leverage, and other complexities, may not be the best choice for all portfolios. Data courtesy ETFmeter.com. Summary A number of lessons could be drawn from the market action so far during this sell-off, and more will surely follow. Perhaps the most important are that all S&P 500-tracking ETFs are not created equal, and that value, dividend, alternate-weighting schemes and low-volatility ETFs fared worse than the index itself. Some of the tracking errors could be attributed to the weak opening in the market, and ETF prices could have fallen more than the prices of the underlying stocks, i.e. to poor quotes in a “fast market”. However, this is a significant risk that should be factored into the portfolio construction process. Reference [1] Tushar Chande, “Eight lessons from the S&P 500 stumble to build better portfolios”, www.etfmeter.com/blog.aspx?id=4425 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.