Tag Archives: history

Shifts In Leadership: Rules 3 And 4 For Investing

The stock market has moved towards new highs on the backs of the new leaders—the economically sensitive stocks. It’s not that the global economy has improved that much but it is that these companies have retooled to do better in a weaker environment. Expectations have been brought so far down and the stocks got so cheap that it has been easy to beat expectations with first quarter results. The market likes it when companies exceed expectations. Commodity prices, the bell weather for cyclicals, are increasing too, benefiting from a weaker dollar, which has now hit a multi-month low for reasons discussed in prior blogs and a somewhat stronger China. There has clearly been a mindset shift away from the old leaders towards the new and unless you recognize this shift, your performance will continue to lag behind the averages. Fortunately for our investors, we made these changes months ago beginning with covering our energy shorts, increasing our exposure to economically sensitive (especially commodity) stocks that are financially strong. We also are over-weighted banks and financials as discussed previously as a win/win proposition regardless of the economy. The best part about this change in leadership is that future earnings comparisons get easier for them as the year progresses as their results turned down dramatically beginning with the second quarter of 2015. Secondly, a weaker than expected dollar for 2016 has caused management to lift forecasts for this year. We made the shift in investment emphasis months ago aided in good part by utilizing our Rules #3 and #4 for investing. After looking at managements and strategies, we look for companies with rising incremental rates of returns and margins. In addition we are always searching for companies nearing their inflection point for earnings. Companies increasing their returns and margins are potential long investments as it tends to boost valuation and stock prices over time and it’s the reverse for the shorts. In addition, companies nearing an inflection point in earnings from negative to positive or visa versa as additional tools for investing. Anticipating with accuracy the inflection point as well as changes in incremental rates of returns are two of my time-tested rules for investing. These stocks tend to rise on a wall of worry or decline on a wall of exuberance… all the way to the bank. Patience is needed to let them unfold. None of these rules work in a vacuum. A successful investor needs a systematic approach combining a global macro-view for the proper asset allocation and risk controls with a bottom-up selection of each investment, which requires first hand research and and in-depth testing. While I agree with Warren Buffett that hedge funds have unperformed as a group over the last few years. It would be unwise to paint all managers with the same brush. A handful, who really understand what it takes to be a global investor today and abide by their time-tested methodologies, have done quite well and are worth every penny that they earn. Paix et Prospérité is one of them. Let’s take a quick look at the data points from last week and see if there were any changes in our core beliefs, asset allocation, risk controls and stock selection: The United States reported first quarter GNP increasing at an annual rate at 0.5% as we predicted down from a gain of 1.4% in the fourth quarter. Consumer spending led the way with a gain of 1.9% in the quarter down from 2.4% in the prior quarter; service spending rose by a healthier 2.7%; the trade gap widened reducing GNP by 0.34%; housing rose at a 14.8% rate; nonresidential fixed investment fell 5.9% and the GDP price index increased by only 0.7%. It was important to note that disposable income accelerated to a 2.9% gain in the quarter from 2.3% in the fourth quarter and the savings rate rose to 5.2% from 5.0% in the prior quarter. Growth in employment and wages combined with low inflation will result in more consumer discretionary income, which will support continued growth in consumer spending and the economy in 2016. The Fed also met last week and there was no surprise that the Fed policy was left unchanged. It is obvious why the Fed remains on hold: the U.S. economy weakened in the most recent quarter; inflation remains well below the 2% Fed target; problems abound abroad and finally fear of the ramifications of Britain potentially leaving as a member of the Eurozone. Economic activity and employment accelerated in the Eurozone in the first quarter with a gain of 0.6% from the fourth quarter and up 1.6% from a year ago. It was important to note that consumer prices reported for April were 0.2% below the prior despite all the actions of the ECB. Expect no changes in monetary and fiscal policies until after the Brexit vote at the end of June. China’s official manufacturers index was reported yesterday at 50.1 down from 50.2 the prior month. A number above 50 signals that the economy continued to expand after seven months of contraction. New factory orders and the production sub-index both fell slightly but also remain over 50 indicating continued expansion too. I remain confident that China will expand by at least 6-6.5% this year bolstering world growth. Japan remains the trouble spot amongst all major industrialized countries. The BOJ met and maintained its policies; the yen strengthened as investors sold risk assets and the stock market fell dramatically. Etsuro Honda, an advisor to Prime Minister Abe, raised concerns that monetary policy alone cannot lift the economy however the country’s debt situation precludes much stimulus. I remain cautious on Japan. Let’s wrap up. Events of the last week reinforced many of our core beliefs. One of my key beliefs, “This is a market of stocks, not a stock market”, was bolstered this week by a combination of disparate earnings reports and commentary by companies across a wide spectrum of industries but also by the clear shift in mindset from old leadership to new. This doesn’t mean that an Amazon, Facebook, Alibaba or a LinkedIn cannot still stand out, but I am suggesting that you need to recognize the changes occurring and invest stock-specific rather than by groups, regions or industries. In closing, review the facts, and then pause to reflect on proper asset allocation, risk tools, mindset changes by investors and managements. Lastly, do in-depth research on each investment… and invest accordingly!

Quiet Week For Equities Doesn’t Stop Equity Fund Redemptions

By Jeff Tjornehoj Equity markets were flat for the fund-flows week ended Wednesday, April 27. The Dow Jones Industrial Average moved only a little more than 100 points between its highest and lowest closes and finished the week down 55 points (or minus 0.3%). This past week equity exchange-traded fund (ETF) authorized participants were responsible for sending about $3.2 billion into SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and $487 million into the iShares Russell 2000 ETF (NYSEARCA: IWM ) while pulling $675 million from the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ). As is their habit these days, equity mutual fund investors pulled $4.5 billion (net) from their funds and brought the year-to-date equity mutual fund outflows to $18.3 billion. High-yield fund investors were of different minds this week: High-yield mutual funds saw net inflows of $555 million, while high-yield ETFs saw net outflows of $258 million. Bond ETFs gathered $260 million of net inflows. The week’s biggest individual bond ETF net inflows belonged to the iShares Core Total U.S. Bond Market ETF ( AGG , +$242 million). Municipal bond mutual fund investors added a whopping $1.1 billion net to their accounts, which was the highest amount since the last week of 2015. As seasonal tax payments ebbed, money market funds saw net inflows of $5.0 billion for the week.

How Scared Should We Be About Future Returns?

McKinsey had a really nice piece this week on the future of financial market returns. The basic conclusion – lower your expectations and hunker down for some lean years in the financial markets. McKinsey says that equities have benefited from unusually favorable conditions in the last 30 years such as low valuations, falling inflation, falling interest rates, strong demographic growth, high productivity gains and strong corporate profits. Specifically, they say: ” Despite repeated market turbulence, real total returns for equities investors between 1985 and 2014 averaged 7.9 percent in both the United States and Western Europe. These were 140 and 300 basis points (1.4 and 3.0 percentage points), respectively, above the 100-year average. Real bond returns in the same period averaged 5.0 percent in the United States, 330 basis points above the 100-year average, and 5.9 percent in Europe, 420 basis points above the average .” That’s a nice clean view of the future relative to long-term returns. I think McKinsey is dead right – the last 30 years were unusual and something closer to the 100-year average is probably reasonable. I’ve stated in the past that the math here isn’t terribly controversial (or shouldn’t be). If a 50/50 stock/bond portfolio has generated 30-year average returns of 9.5%, then we should expect the future returns to be lower or more volatile. In other words, you can, with near certainty, expect that the high risk adjusted returns of the last 30 years are gone. Why is this a certainty? Well, it’s a simple function of the current interest rate environment. Because the post-1980 era involved a huge bond bull market, the risk adjusted returns of a balanced portfolio were unusually high. For instance, from 1985-2015 a 50/50 stock/bond portfolio posted returns of about 9.5% with a Sharpe ratio of 0.7 and a Sortino ratio of 1.5. That’s because the bond piece, which is inherently more stable, generated average annual returns of 7% with a Sharpe ratio of 0.76 and an eye popping Sortino ratio of 2.12, while the stock piece generated annual returns of 12.5% with a Sharpe ratio of 0.5 and a Sortino of just 0.92. In other words, bond investors have done extraordinarily well over the last 30 years thanks to the favorable tailwind of falling inflation and falling interest rates. And those outsized bond returns had a hugely positive impact on diversified investors. We also know that the best predictor of future bond returns is current yields so, do the math on the 1985 starting overnight interest rate of 7.5% versus today’s rates of 0%. A bond aggregate held for the next 10 years is unlikely to outpace the current yield of 2.25% by much. So, we know for a fact that the bond piece won’t generate anything close to the types of returns it did in the last 30 years. But there’s also good historical precedent here. In the 1940s, rates were as low as they are today. So, how did the bond market do? It did okay, but it certainly wasn’t anything like the post-1980 period. From 1940-1980, bonds posted annual returns of 2.75%, but were very stable (much more stable than is commonly believed in a rising interest rate environment). The stock piece, however, performed very similarly to the post-1980 period, with rates of returns from 1940-1980 at 12.4% vs. 12.5% for the 1985-2015 period. As a result of this, a balanced portfolio from 1940-1980 generated an average 8% return with a Sharpe ratio of 0.58, significantly lower than the average 10% return with Sharpe of 0.7 that we experienced in the last 30 years. In other words, in the only reasonable historical precedent a balanced portfolio generated lower nominal and risk adjusted returns than the post-1985 period. Now, I think backtests and historical references are a bit dangerous and overused by the financial community, but I also don’t think we need these historical precedents to establish a reasonable probability of future returns. All we need is a little common sense when comparing the next 30 years to the last 30 years. After all, we have empirical proof that most of those tailwinds are in fact waning. For instance: Current interest rates are the best predictor of future returns in the bond market, and this period is certain to be a low return period for future bond holders. Valuations, which have a strong tendency to correlate with future equity returns, are high historically. Demographic trends have shifted substantially in the last few decades from a world of higher growth to a much more modest pace of growth. High productivity gains have waned and have now become an area of great concern for economists. Corporate profits, as a share of national income, have never been higher as they rode the back of the liberalization of tax rates and regulation and could come under pressure given the anti-corporate climate we are entering. I don’t think any of this should be terribly controversial, and you don’t have to be an expert forecaster to see what’s coming. At the same time, we shouldn’t panic as some people have implied . If the aggregate stock and bond markets generate anything close to that 8% return of the 1940-1980 period, then most investors will still generate positive real returns. However, there are a few key takeaways here: It is crucial to understand the most important principles of portfolio construction so you can grow comfortable with a process and a plan. See Understanding Modern Portfolio Construction . It’s time to temper expectations in the markets. The future is likely to be an era of lower returns and potentially bumpier returns; however, it doesn’t mean returns are going to be catastrophic. It’s time to hunker down on your taxes and fees in your portfolio. As a % of assets, these frictions will become increasingly important in a lower return environment. See, Understanding your Real, Real Returns . Be patient! Find a good plan and learn to stick with it. The lower and bumpier returns will create periods of frustration for most investors. The grass will always look greener somewhere else. Switching in and out of plans and chasing the next hot guru will very likely result in higher taxes and fees, leading to lower average returns. See, How To Avoid the Problem of Short-Termism . Invest in yourself, continue to save and pour that savings into your portfolio. You might not get world beating returns from your portfolio in the coming 30 years, but we know cash will be the riskiest asset in the future as it will guarantee a negative real return in such a low interest rate environment. See, Saving is not the Key to Financial Success . Be careful reaching for yield. All safe assets aren’t created equal and reaching for yield in the wrong places could create more volatility without the guarantee of stable income. See, Reaching for Yield or Reaching for Risk? Don’t let the scaremongers get to you. If the future is one of lower returns and bumpier returns, there will be lines of people trying to sell you something in exchange for your fear. These people should not be trusted. The world of the future might not be the gangbusters growth period of the 80s and 90s, but it also won’t be the end of times either.