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Proof Positive That U.S. Stock ETFs Are Not The Only Place To Be

Financial professionals are blaming the latest round of risk asset uncertainty on a variety of factors, from the continuing sell-off in oil to the possibility of Greece being kicked out of the euro-zone. Still others are pointing to anxiety over the U.S. Federal Reserve’s intention to raise its overnight lending rate target in mid-2015 – the first move of its kind since December of 2008. Meanwhile, the biggest names in bonds have added fuel to the fire. Bill Gross at Janus has declared that the good times are over; he anticipates a plethora of “minus signs” in front of riskier asset classes by year-end. Similarly, Jeff Gundlach of DoubleLine believes the U.S. 10-year yield will test 1.38% from its 2.0% level. That is in sharp contrast to the unanimous verdict of economists that the 10-year would be sharply higher; the average expectation is 3.0% by December. Since the beginning of last year, I have argued the exact opposite and extolled the virtues of owning long-maturity treasuries via the Vanguard Extended Duration ETF (NYSEARCA: EDV ) and/or the Vanguard Long Term Government Bond Index ETF (NASDAQ: VGLT ). The yields on these safer havens have been more favorable than the sovereign debt of beleaguered foreign governments in the developed world. Even today, a 10-year U.S. Treasury at 2.0% compares quite favorably with German bunds (0.5%) and Japanese government bonds (0.3%). A wide variety of international and emerging market stock assets floundered in 2014, and they have continued to descend in the New Year. Yet it may come as a shock to some buy-the-dip enthusiasts that many U.S. stock ETFs have already broken below key support levels. The ones that I have identified in the chart below are currently below 200-day long-term trendlines (exponential). Paradise Lost? U.S. Stock ETFs Begin Falling Below Respective Trendlines % Below 200 Day SPDR Select Energy (NYSEARCA: XLE ) -17.1% Vanguard Materials (NYSEARCA: VAW ) -3.1% SPDR KBW Bank (NYSEARCA: KBE ) -2.0% Market Vectors Morningstar Wide Moat (NYSEARCA: MOAT ) -1.8% Guggenheim S&P 500 Pure Value (NYSEARCA: RPV ) -1.2% WisdomTree Small Cap Earnings (NYSEARCA: EES ) -0.9% RBS U.S. Midcap Trendpilot ETN (NYSEARCA: TRNM ) -0.9% Fidelity Telecom (NYSEARCA: FCOM ) -0.4% RBS U.S. NASDAQ 100 Trendpilot ETN (NYSEARCA: TNDQ ) -0.2% First Trust Internet (NYSEARCA: FDN ) -0.1% While nobody can predict whether the current flight from risk will be yet another head fake – investors have snapped up U.S. stock shares on every 4%-8% pullback since the winter of 2011 – extreme movements in both commodities and currencies in recent months do not bode well for the bulls. For example, dramatic falls in the price of crude oil historically correlate with an increase in geopolitical and economic crises. Does anyone believe that Wall Street can continue to ignore an uptick in overseas strife at the same time that the energy sector is reeling stateside? Similarly, the swift appreciation of the U.S. dollar and the quick depreciation of other world currencies over the last six months is likely to reduce the desire for carry trade activity and/or increase the desire to take some “chips off the table.” In other words, assets like the PowerShares DB USD Bullish ETF (NYSEARCA: UUP ) can be safe havens from stock turbulence, yet the ripple effects can create a desire for a reduction in risk taking across the board and an increase in desire for U.S. Treasury bonds. As an advocate for long-duration treasuries since the first week of January 2014 – as one who wrote at great length about the virtues of a barbell approach in a late-stage stock bull – I decided to investigate the unusually high positive correlation of two of my largest holdings, EDV and the Vanguard Dividend Appreciation ETF (NYSEARCA: VIG ). Historically speaking, treasuries and stocks have a slight positive correlation in good times and a strong negative correlation in bad times. That’s why 2014 represented an unlikely scenario where matching “risk-off” capital preservation with “risk-on” capital appreciation produced risk-adjusted gains that far exceeded stocks alone. Although CNBC would rather talk about the remarkable run in U.S. equities, there has been an unwillingness to address the extraordinary success of “risk-off” assets like EDV. On the contrary. The unanimous expectation for 55 of the leading economists in the country had been for the 3.0% 10-year yield to climb in 2014, with an average projection of 3.4%. It fell to 2.2.% The unanimous decision this time around is for the 10-year to rise from 2.2% to 3.0% in 2015. Alas, it is falling yet again here in the New Year. Granted, I may not be the only contrarian on middle-of-the-yield-curve rates, but I do not run a bond fund and I have plenty of stock exposure. I just know when and how to employ multi-asset stock hedging. Until we see a genuine bear scare, I do not expect tremendous coverage of the index that I helped to create with FTSE-Russell, the FTSE Custom Multi-Asset Stock Hedge Index . I affectionately refer to it as the “MASH” Index. Yet it should be noted that there are a variety of currencies, commodities, foreign bonds and U.S. bonds that have a history of exceptionally low correlations with U.S. stocks. What’s more, low correlations do not mean poor performance when stocks are soaring and great performance when stocks are struggling. It simply means that the assets move independently. That said, month-over-month, the FTSE Custom Multi-Asset Stock Hedge Index (a.k.a. “MASH”) is up 2.5% whereas the Dow logged -2.6%. Year-over-year? MASH gained 6.8% while the Dow picked up 6.3%. Granted, the last month demonstrates that multi-asset stock hedging works particularly well when stocks struggle, but it is hardly a prerequisite. The year-over-year results show that the index can garner admirable gains – better the t-bills or money markets – even in a stock uptrend. An investor can not invest in the FTSE Custom Multi-Asset Stock Hedge Index (MASH) directly yet, though an exchange-traded note is likely to appear in 2015. Do-it-yourself enthusiasts may acquire index components such as zero coupon bonds via the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ), the iShares National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) as well longer-dated Treasuries in the iShares 10-20 Year Treasury Bond ETF (NYSEARCA: TLH ). Currencies like the dollar and the franc can be acquired in the CurrencyShares Swiss Franc Trust ETF (NYSEARCA: FXF ) and UUP. The index also includes gold via the SPDR Gold Trust ETF (NYSEARCA: GLD ). Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships. Editor’s Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.

Risks And Avoidable Mistakes For 2015

Originally published on Jan. 4, 2015 Introduction For most dollar oriented investors 2014 was an “okay” year with a third year in a row of double digit gains for the S&P 500, but not for the bulk of institutional accounts. Consciously or not, many investors and managers were aware of the length of the present bull market having entered its 61st month. This has created twin dilemmas for the prudent management of responsible money. First dilemma – Large Cap over-ownership As regular readers of these posts recognize and true to my analytical history, I tend to view investments through the lens of mutual funds. When simplifying the fund performance data for 2014 by size of market capitalizations the following is revealed: Large Cap funds 11% Multi-cap funds (Unrestricted/ or “go anywhere” funds 9% Mid Cap funds 8% Small Cap funds 3% In a dynamic economy the rank order of operating earnings power generation would be in the opposite order, being led by Small Caps or possibly the successful “Go Anywhere” funds. Focusing on operational earnings, excluding foreign exchange benefits, I believe that the Large Caps were producing approximately 3 times the long-term growth of the Small Caps. The better market performance of the Large Caps, I believe, was a function of market structure changes. Some institutional investors being concerned with the duration of this bull market moved heavily into Large Cap stocks directly or more importantly through the use of ETFs invested in the S&P 500 and other indices. Because of perceived greater liquidity in Large Caps they were hiding out in what we used to call warehouses. With governments all over the world looking to Large Caps being “social progress” engines, I have some doubts as to the growth prospects for Large Cap companies. Second dilemma – Historical constraints As is often the case, apparent boundaries come with both hard data and locked-in thought processes. The data is the easy part. While as noted we are in the sixty-first month of the recovery, of the nine last market recoveries, four have been over 100 days in length with the longest being 181 days. Thus for a manager a possible career risk is exiting too soon which puts a premium on investing in liquid positions. Because so many others have made similar judgments as to the better liquidity in Large Caps, if there is a sudden drop in the market, I believe the excessive amount invested in Large Caps will find their exit liquidity either expensive or non-existent for those that are late. The biggest risk for investors and their managers are the biases that many of us labor with in making so-called rational decisions. The following are a list of these biases as listed by Essential Analytics. List of biases Outcome, herding, conviction (the curse of knowledge), recency, framing, band wagon effect, information, anchoring, optimism. I suggest that many of these biases find their way into reports; supporting in effect, the reasons we all have made decisions that haven’t worked out. The key for all of us is to understand our biases. Some biases we will be able to overcome. Others we will have to accept as immutable. This suggests that when putting together a portfolio of funds or managers, it would be wise to try to diversify the various biases of the hired portfolio managers as well as our own as the owners or fiduciaries of the capital being deployed. Overcoming biases I have a definite advantage in this task by personality. By nature I am both curious of what I don’t know and often a contrarian. As a contrarian again using the mutual fund microscope, the following may be useful thoughts: Looking to extremes one might wish to set up a pair trade of being long some of the components in the S&P Latin American energy index which declined -39% vs. the average Indian fund which was up 41% in 2014. In a similar fashion one might start to research funds in the following groups that declined in 2014: Energy Commodity funds -34% General Commodity funds -16% Global Natural Resources funds -15% Domestic Natural Resources funds -15% Dedicated Short-bias funds -15% I take some comfort in the contrarian thoughts contained in the headline to John Authers insightful Financial Times column: “The case for gently shifting money away from US.” I believe a well-reasoned portfolio should be looking for opportunities on a global basis both in terms of what companies do and where various securities are traded. Final thought Many year-end predictions are essentially extrapolations of existing market trends and this could be what will happen. However, I am searching for the beginnings of new trends that will produce +20% or -20% in a twelve month period. I would appreciate hearing your thoughts as to when and which direction (or both) you expect price movement. I firmly believe we will once again experience this kind of action.

My Investment Worries: The Dollar, Large Caps, And More

Originally published on Dec. 28, 2014 Introduction Essentially investment risk is not a number. The price of risk failure is the foregoing of important funding plans. In that light your risk is not the same as my risk. Not only because we have different financial and personality resources, but also different time frames, which is why I developed the TimeSpan L Portfolios. These help isolate the impacts of risk failures; e.g., a disappointing short-term portfolio is different than one to help fund future generations. No matter what the planning time horizon of a portfolio, there is another major difference between two similar portfolios. In this age of optimization many portfolios project funding out of resources with little to spare for unexpected mistakes. For many there are no reserves for mistakes because the investor or his/her manager has supposedly identified all possible disruptions. Thus, they have created an expectation risk and need to examine what could go badly wrong with their expectations. I suggest the biggest impact of an expectation risk is likely to be found in the very assets that most investors have the highest level of confidence. Not only by nature I am a contrarian, I am a student of history that gets uncomfortable when there is excessive enthusiasm. My current worry risk is as follows: The US $ Large Cap Stocks Treasuries-US and some Others ETFs and other market structure changes These worries are not generally recognized in market prices, which I think they should be. Therefore I perceive significant market price distortions that don’t recognize that in the future something could go wrong in most portfolios. The worries Part of my worries is that few if any professional investors are publicly concerned about the concerns that are on my list. The (mighty) US Dollar For those of us who live in a competitive price environment we are very much aware of the price spread for similar, usually not truly identical, items. There are always reasons why the bulk of buyers and sellers can identify with the current price; e.g., availability, ease of transaction, easy to service, and other qualities of merit. As an entrepreneur I always wanted to be the high priced service sold to discriminating, great capital sources. My approach was that my successful pricing was a badge of high quality. I was conscious that this policy was holding up an umbrella over cheaper competition, but in the institutional world quality usually trumps price, within reason. Turning to the current valuation of the US$, the widening price spread versus all other major currencies suggests to me a leaky umbrella. Our current exalted position is not due to our virtuous qualities of protecting the purchasing power of our currency but rather it is due to the perceived decline in the value of other currencies. Some of the weaknesses in other currencies are self imposed by the deliberate mercantile policies of governments to help sales of their exports to the US. In a period of increasingly unpopular governments within their countries and with their neighbors, people are choosing to store some of their wealth in the US, behind its supposed two ocean fortress sitting on valuable natural and human resources. Because the US monetary leadership is having enough trouble attempting to manage the domestic economy and a current Washington political establishment that would like to isolate the US from others’ problems, there is no desire to establish the US dollar as the single world currency. Thus, at some future point the unannounced but real weaker US dollar policy is likely. In the future, various economies will start growing again and become attractive places for investment both by the locals and those from outside. Therefore it would be wise to hedge one’s longer term portfolio against continued dollar strength. A number of mutual fund investors have been doing this for some time. With the exception of the five trading days ending December 24th, traditional US mutual fund investors have been adding to their non-domestic holdings while redeeming some of their domestic fund holdings. (The latter move could very well be a normal pattern of mutual fund investors exiting for retirement and other needs. In most cases the domestic funds are the oldest of their holdings.) The leaky large-cap house If the US dollar is being held up by a potentially leaky umbrella, the investment houses holding large caps may start to leak soon. We acknowledged in last week’s post that in general large cap mutual funds in 2014 were performing materially better than smaller market capitalization funds. At present and historically there is no solid evidence that large cap companies will do better than smaller caps. The foreword of Charlie Ellis’s book, What it Takes , states that “None of the ten largest corporations in the U.S. economy in 1900 still ranked in the top ten 50 years later and indeed only three actually survived as companies.” In addition there is an article by JP Morgan Asset Management that since 1980 the S&P 500 has dropped 320 stocks or roughly 10 per year due to mergers, low volume, and an inversion of their tax headquarters. The problems that caused these results were more widespread with numerous large companies losing their advantage. Some possible victims of these deteriorations today might well be General Motors (NYSE: GM ), IBM (NYSE: IBM ), and Citigroup (NYSE: C ) among others. Turning to the large-cap stocks as distinct from the companies themselves, there are significant changes occurring. First the surge of stock price performance above the level of earnings progress may well be a warehouse effect. In the past when investment managers were concerned about not being invested in a market that was gently rising to flat before a perceived decline, they hid from their clients by investing in stocks of very large companies. AT&T (NYSE: T ) was the best of the warehouses with its $9.00 predictable dividend which hadn’t changed for about 40 years. Today, many of the tactical players have shifted to using Exchange Traded Funds (ETFs). In the week ending Christmas Eve approximately $1 billion flowed into two S&P 500 ETFs (net of their redemptions) out of $23.7 billion. Some of the inflows could be covering shorts. As of December 15th the SPDR S&P500 ETF (NYSEARCA: SPY ) had the second largest short position of 240 million shares. (The largest was our old warehouse name but applied to a different company, AT&T.) More on the changing market structure through ETFs and other derivatives below. The current market sentiment may well be changing from complacency to belief in a general recovery starting in the US and haltingly going global. One clue that this could happen would be that in 2015 small market capitalization stocks once against perform better than larger caps. We could even see some flows from the larger caps into smaller cap funds. Due to ETF players who are mostly faster trading institutions, we could see redemptions in various index funds as sentiment shifts from avoiding losses to picking exploding winners. Treasuries discipline Surprising the US deficit is declining due in part to the sequester in 2013, but it is still a deficit which does not include the off-balance sheet liabilities for various government programs. We have not taken the pledge that except in times of war to produce surpluses to retire our debt. One also needs to recognize our twin infrastructures in terms of roads and bridges as well as our growing educational deficit. We are not alone in our lack of discipline; most other countries are similarly addicted to deficit spending. For those of us who can choose not to invest in various governments’ securities, this lack of discipline is an additional imponderable. However, for our banking institutions it should be a considerable issue as banks in most countries must own local government paper. Often the various authorities treat government paper more favorably than commercial paper in terms of the level of reserves required. Thus, to some extent our whole financial system is exposed to the level of discipline applied to our treasury deficit machine. ETFs and other market structure changes Students of warfare often note that changes of weaponry change how battles are fought and won. Clearly the introduction of the English Long Bow and the Aircraft are two examples. In the investment marketplace battles, some rely on the most current weapon which is often not fully tested. The 1987 market fall is a good example of a market collapse that was not tightly tied to an economic collapse. In a somewhat overpriced market after a multi year rising market, many institutional investors felt secure because of their newly acquired weapon of “portfolio insurance.” This procedure was based on locked-in trades of securities and derivatives largely executed in Chicago. If markets were functioning normally with other investors using the various tactics of the past, a limited amount of portfolio insurance transactions apparently worked. However, as the decline accelerated, many institutions and some trading organizations withdrew from the market and so the locked-in derivative trades were working against each other in driving prices into a free fall. In 2014 and beyond, the popularity of derivatives, particularly ETFs, have grown and now often represent the bulk of trading in an emotional period. To put the size of the ETF power into perspective, the following points are worth noting: While the estimated net inflow into traditional US mutual funds for the Christmas Eve week was $12.8 billion, the highest since March of 2000, almost twice as much ($23.7 billion net) came in through ETFs. As Blackrock’s Larry Fink has been warning for some time, institutions are using ETFs instead of futures to speculate. There are roughly 250 authorized participants in the creation and redemption of ETFs. In many if not most cases these participants are acting for institutional clients. Some of the participants’ purchases may be to aid in setting up short positions or providing securities to meet share lending requirements. To put the importance of the shorting of ETFs shares in perspective, it is worth noting as of December 15th seven of the largest forty short positions on the New York Stock Exchange stocks were ETFs. As of the same day, nine of the thirty largest changes in short positions were for ETFs. Because of particular interest in the S&P Biotech ETF, the short position would take 17 days to cover. The use of derivatives in both fixed income and currency trading is extensive. Some of the regulators and I are wondering whether several of these new weapons will blow up certain users and possible counterparties in the heat of battle. How does one live with the worries? One must recognize that probably there has never been or never will be a period without worries. Long-term investors need to be both flexible and diversified. In our four timespan portfolio structure, I suggest that the Operational Portfolio (1-2 years) stay tactical and not take large losses. In the Replenishment Portfolio (2-5 years) one should develop both tactics that can tolerate at least one to two poor years. The Endowment portfolio (5-10+ years) should shift to a more strategic view to take advantage of periodic declines. The Legacy Portfolio, needed to feed multiple future generations, has a need to separate current fashionable thinking for expected future changes.