Tag Archives: finance

Un-Expectedly High Expected Return Of Global Equities

It seems just about everyone I talk to these days is underwhelmed by the long-term expected return of the global stock market. I too am more worried than normal about owning equities. However, my defensiveness arises from their negative momentum, not their valuation, which I see as surprisingly attractive. The valuation picture is blurred by the dramatic divergence between US and non-US equities. For the past four and half years, the US equity market has outpaced non-US equities by more than 10% a year. After that relative outperformance, US equities do appear overvalued, but the attractive valuation of non-US markets more than compensates in a global portfolio. The table below shows the cyclically adjusted earnings yields (using the past 10 years of earnings) of each regional equity market. The Baseline regional weights I’m using fall in between the weights published by MSCI and those calculated by Bloomberg using their WCAP function. 1 Click to enlarge The earnings yield of the global equity market is 6.6%. To get to an estimate of the long-term expected real return, I assume that 60% of earnings can be paid out in dividends (besides sounding like a reasonable assumption, it also happens to be the average payout ratio from 1915 to 2015 in the US), which will grow at about 1.5% above inflation in the long term. Many observers prefer the even simpler estimate of just using the earnings yield itself, which is 6.6%, but I prefer basing the estimate on cash flow to investors, which is generally more conservative. This results in 5.5% for the long-term expected real return for global equities (6.6% * 0.6 + 1.5%). 2 So how attractive is a 5.5% expected return above inflation? Here are four perspectives to consider: US equities returned 5.4% after inflation in the 50 years from 1965 to 2015, which many people view as having been a good time to be an equity investor (although not nearly as good as the 8.2% from 1915 to 1965). The chart below shows that 5.5% is well above the average expected return of 4.5%. It is in the top decile of expected returns calculated this way since 1985, a period of time longer than the careers of 80% of the people currently employed in the finance industry. 3 By contrast, other assets, such as fixed income and real estate, are currently offering low expected real returns in the bottom decile of expected returns over the past 30 years. It is difficult to come up with a simple prospective measure of expected real returns for alternatives such as hedge funds, but they certainly have been struggling recently to generate the attractive returns they produced in the ’80s and ’90s. Caution: Equities can get a lot cheaper, quickly. Just a month ago, global equities were more than 10% lower than they are now, in case we need any reminder. While 5.5% appears attractive as a long-term expected real return, we need to keep in mind that we may see much higher expected returns than that in the future. Bottom line: Global equities are pretty attractively valued, and when they enter a period of positive momentum, we’ll probably see very healthy returns. Click to enlarge Footnotes: MSCI bases its weights on strict investible market cap data while Bloomberg bases theirs on unrestricted market cap. The Baseline weights used here go beyond market cap, using other economically relevant data to compute weights. See this note for details, and here for a further comparison of weighting schemes. Based on the belief that earnings and dividends will grow at less than the rate of real GDP growth due to various slippages. For a more detailed discussion, watch this video , and read this short note . Furthermore, if we think of this as the central case in the return distribution, and if we believe the long-term return is distributed relative symmetrically around this value, then there is a convexity adjustment that makes investing in equities even more attractive. A back-of-the-envelope illustration is to note that if we thought there were two equally likely long-term (say 30 year) outcomes for the real return, of say 5.5% + 2% and 5.5% – 2%, we would see that the return associated with the expected value of equities would be 6.02%, or 0.52% higher than the 5.5% base case. From US BLS data, here . Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Fed Rate Hike On The Table Again: 5 Finance Mutual Fund Picks

The Federal Reserve had raised interest rates for the first time in almost a decade in December and assured that it would hike rates four times this year, provided there are signs of a strengthening labor market, inflation rises to the target level of 2% and the financial markets remain strong. However, the continuous slump in oil prices, weak global economy and volatile financial markets since the beginning of the year raised doubts as to whether the Fed will be able to fulfill its commitment. Nevertheless, Friday’s upbeat jobs report reinforced the notion that the labor market is firming, which puts Fed rate hikes in play. An uptick in inflation data and rise in consumer spending levels also kept rate hikes in the cards. Additionally, the broader markets regained momentum in the last three weeks after a rebound in oil prices from its 12-year low ebbed deflationary concerns. China’s stimulus measures, on the other hand, raised hopes of a much stable global economy, which would, in turn, contain the volatility in the broader markets. While these encouraging facts aren’t probably enough to push the central bank to raise rates this month, it could bolster the case for a rate hike in the upcoming meetings this year. A large number of economists and some Fed officials also expect the central bank to continue hiking rates this year. Given these positive vibes, it is profitable to invest in financial mutual funds that are positioned to benefit from subsequent lift-offs. These funds also boast strong fundamentals and solid returns. Upbeat Jobs Data The jobs data painted a solid picture of the labor market. The U.S. economy added 242,000 jobs in February, handily beating the consensus estimate of 194,000, according to the Bureau of Labor Statistics (BLS). The tally was also considerably higher than January’s upwardly revised job number of 172,000. Meanwhile, the unemployment rate in February remained unchanged at 4.9%. Further, the unsparing U-6 rate that includes the unemployed, the underemployed and the discouraged dipped to 9.7% in February from 9.9% in January, its lowest level since May 2008. The labor force participation rate also increased to 62.9% last month, the highest level in almost a year. Moreover, the report found that wages went up 2.2% in the past 12 months. Even though it increased at a slower pace compared to the previous month, it is still consistent with a tightening labor market that is viewed by the Fed as one of the major criteria for a rate hike. Underlying Inflation Picks Up, Spending Rises This surge in hiring followed the Commerce Department’s report that showed a rise in inflation. The Fed’s preferred gauge, the personal consumption expenditures index (PCE), increased 1.3% in January from year-ago levels. The so-called “core” inflation that excludes food and energy prices came in at a solid 1.7%, much closer to the Fed’s desired target. Moreover, consumer spending levels increased at the fastest pace in eight months this January. Retail sales are also off to a good start this year, indicating strength in consumer spending, which accounts for more than two-thirds of U.S. economic activity. These reports increase the likelihood of a rate hike soon. Broader Markets Rally The markets have also showed signs of stability in recent times. Oil prices bounced back from their record low in mid-February, which eventually boosted the broader markets. Signs of decline in U.S. production and continuous talk about freezing output by the major oil producers were cited to be the reasons behind the oil price surge. Positive developments in China also fueled investor sentiment. The recent stimulus measures by the People’s Bank of China (“PBOC”) to address concerns over the country’s recent economic slowdown boosted investor sentiment. The PBOC reduced the reserve requirement ratio by 0.5% to 17%. 5 Finance Mutual Funds to Invest In If the broader markets continue their winning streak, the Fed will have to raise rates this year. Additionally, a pick-up in the inflation rate, rise in consumer spending levels and encouraging nonfarm payroll reports are also paving the way for a rate hike as early as possible. Fed Vice Chairman Stanley Fischer had already told the National Association for Business Economics on Monday that inflation may be “stirring,” which suggests that he might want rates to increase in the near future. Richmond Fed President Jeffrey Lacker had also said that ongoing strength in the labor market warrants rate hikes this year. A survey by the National Association for Business Economics on Monday showed that almost 80% of economists expect a Fed rate hike this year at least once. The CME Group’s FedWatch tool expects that there is a solid 53% chance a hike could come as soon as November, while it projects that there is almost a 50% chance of a rate hike in September. Separately, the Bank of America Merrill Lynch Global Research stated last Friday that Americans can witness two interest rate hikes this year and three more next year. Given that there is a fair chance of a rate hike this year, it will be prudent to invest in finance mutual funds. Financial companies, including banks, insurers and brokerage firms, are likely to be among the biggest beneficiaries of the rate hike. Here, we have selected five such finance funds that boast a Zacks Mutual Fund Rank #1 (Strong Buy) or #2 (Buy), have positive 3-year and 5-year annualized returns, offer minimum initial investment within $5000 and carry a low expense ratio. John Hancock Regional Bank Fund A (MUTF: FRBAX ) invests a large portion of its assets in equity securities of regional banks. The fund’s 3-year and 5-year annualized returns are 12.1% and 10.1%, respectively. Its annual expense ratio of 1.26% is lower than the category average of 1.54%. FRBAX has a Zacks Mutual Fund Rank #1. Fidelity Select Banking Portfolio No Load (MUTF: FSRBX ) invests a major portion of its assets in securities of companies principally engaged in banking. Its 3-year and 5-year annualized returns are 8.7% and 7.9%, respectively. The annual expense ratio of 0.79% is lower than the category average of 1.54%. FSRBX has a Zacks Mutual Fund Rank #2. Schwab Financial Services Fund No Load (MUTF: SWFFX ) invests the majority of its assets in equity securities issued by companies in the financial services sector, which includes commercial banks, insurance and brokerage companies. The fund’s 3-year and 5-year annualized returns are 7.8% and 7.1%, respectively. Its annual expense ratio of 0.9% is lower than the category average of 1.54%. SWFFX has a Zacks Mutual Fund Rank #1. Fidelity Select Insurance Portfolio No Load (MUTF: FSPCX ) invests a large portion of its assets in securities of companies principally engaged in property, life or health insurance. Its 3-year and 5-year annualized returns are 12.8% and 11.4%, respectively. The annual expense ratio of 0.81% is lower than the category average of 1.54%. FSPCX has a Zacks Mutual Fund Rank #1. Franklin Mutual Financial Services Fund A (MUTF: TFSIX ) invests a major portion of its assets in securities of financial services companies. The fund’s 3-year and 5-year annualized returns are 8.9% and 7.4%, respectively. Its annual expense ratio of 1.44% is lower than the category average of 1.54%. TFSIX has a Zacks Mutual Fund Rank #1. Original Post