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The Fundamental Difference: Through A Lens Of Net Buybacks

By Jeremy Schwartz At WisdomTree, we believe that screening and weighting equity markets based on fundamentals such as dividends or earnings can potentially help produce higher total and risk-adjusted returns over a complete market cycle. One of the most important elements of a fundamental index is the annual rebalance process, where the index screens the eligible universe and then weights those securities based on their fundamentals. In essence, the process takes a detailed look at the relationship between the underlying fundamentals and price performance and tilts weight to lower-priced segments of the market. One way to illustrate the benefits of this approach for our earnings-weighted family is to compare the net buyback yield of the WisdomTree Earnings Index to a market cap-weighted peer universe. Below we look at how the net buyback yield changes when you screen and weight U.S. equity markets by firms’ profitability instead of market cap. Earnings Weighting vs. Market Cap Weighting Click to enlarge The WisdomTree Earnings Index consistently had a higher net buyback ratio than did a market cap-weighted universe consisting of the 3,000 largest securities by market cap. The WisdomTree Earnings Index averaged a net buyback yield of 2.2% over the period, compared to just 1.1% for the market cap peer universe. We believe that having an annual profitability screen for inclusion in the WisdomTree Earnings Index helps avoid speculative and unprofitable smaller-capitalization firms that have a tendency to raise capital by periodically issuing new shares. The earnings-weighted approach that tilts weight to more profitable firms can also be a reason the weighted average net buyback yield is higher. The chart below looks at the net buyback yield on a universe of the lowest price-to-earnings (P/E) ratio stocks within the 3,000 largest stocks by market cap and contrasts that with the net buyback yield on the highest P/E ratio stocks. Net Buyback Yield by P/E Ratio Click to enlarge If corporate America responds well to incentives, the higher-priced basket would issue more shares (given that their stocks are high priced and issuing more of them would be an effective way to raise growth capital) and the lower-priced basket would issue fewer shares or actually buy back shares to reduce their shares outstanding and thus power their earnings-per-share growth. What we see in the data is the higher-priced universe buys back fewer share, and instead issues more shares (having more companies with negative net buyback yields). Why Earnings Weight Going back to the WisdomTree Earnings Index in the first chart-weighting by Earnings Stream is essentially tilting weight from a market cap-weighted scheme to over-weight those companies with below average P/E ratios and to under-weight those companies with high P/E ratios. The Earnings Stream can be defined as earnings per share times shares outstanding or market cap x earnings yield (which is equivalent to 1/PE ratio). Tilting weight to the higher-earnings-yield stocks by earnings weighting thus is one effective way to tilt the net buyback yield balance in one’s favor. Companies reducing shares outstanding are essentially locking in earnings-per-share growth by reducing their share count, while companies that are issuing more shares are creating a higher hurdle to overcome to achieve earnings-per-share growth. There is a philosophical debate about the motivations for all the buybacks we are seeing today as well as fears that companies are failing to reinvest for future growth (or that they just see no growth opportunities, hence all the dividends and buybacks). One thing is clear to us from the data: the lower-priced stocks issue fewer shares, and the more expensive stocks issue more shares (and have lower net buyback yields). This can be especially true in the small-cap space, as we will discuss in a future blog post. The consistently greater-than 2% net buyback yields seen on the WisdomTree Earnings Index over the last five years, combined with 2% dividend yields on this basket today, provides critical valuation support and also helps explain why we think the earnings-weighted approach can add value over time. Jeremy Schwartz, Director of Research As WisdomTree’s Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel’s head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” and the Wall Street Journal article “The Great American Bond Bubble.”

The Great Temptation, Greatest Danger

“If we survive danger it steels our courage more than anything else.” – Reinhold Niebuhr I am often bewildered that what passes for analysis is really a focus on recent performance, rather than process. Yet, so little attention is given to the investor return/behavior gap, a well-documented phenomenon that proves that “on, average, investors sacrifice a substantial portion of their returns by incorrectly timing when to enter or exit investments”. In correct timing tends to come from chasing performance, getting in after a major up move has already taken place, and then, of course, exiting when the drawdown is likely near its end. The below chart sums up some of the research on this which, in my opinion, is a “must know” when considering where to put money to work. Click to enlarge The best returns in the future come from those parts of the marketplace that have not done well in the past. Yet despite the overwhelming evidence which supports this, strong recent performance is often the core catalyst to make an investment. In reality, it should be the exact opposite. High past performance and continuous visibility of that performance is a temptation too strong for many to ignore, and that temptation unequivocally results in sub-optimal returns going forward on average. Take that truism on mutual funds, and magnify it by a billion when it comes to Exchange Traded Funds (ETFs). Yes folks – I would argue to you that ETFs are the greatest danger to investors. Why? Because ETFs provide an even greater temptation to chase recent performance, day by day, hour by hour, and minute by minute. Overtrading is the ultimate source of the investor return gap, and the temptation to get “in and out” of the market has never been higher thanks to these investment vehicles. Now, don’t get me wrong here. We ourselves use ETFs to execute across our quantitative strategies in mutual funds and sub-advised separate account strategies we run. However, following a systematic, backtested, and quantitative approach using ETFs as the vehicle of choice for execution is NOT what the vast majority of ETFs “investors” do. The pattern of behavior remains the same. Assets for ETFs grow when the ETF has strong recent performance, and collapse after, with a lag, when losses have already occurred. In our case, we rotate based on leading indicators of volatility (click here to learn more). The majority rotate based on old leaders that have had continuously low volatility. The greatest danger is in using past strong performance to make an investment decision. ETFs like the S&P 500 SPDR ETF (NYSEARCA: SPY ) may be the greatest temptation of all that results in exactly that. *Join us this week for our live webcast on the 2016 Dow Award paper, hosted by the Market Technicians Association. Registration available by clicking here . This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. 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.

Should You Short S&P 500 With ETFs This Summer?

It seems that the S&P 500 has left its sunny days behind! This key U.S. index last hit a record high of 2,131 on May 21, 2015, and lost about 4.3% in the last one year (as of the May 19, 2016). As a matter of fact, the index suffered corrections ( down over 10% from previous highs) during this timeframe and could not really regain its lost ground. The hollowness of this one year becomes more prominent when you look at 45 record highs in 2013 and 53 in 2014, as per Wall Street Journal. Though the start of 2015 was equally grand with 10 highs till May 21, the journey afterward was simply lackluster. This makes it imperative to understand investors’ perception on the S&P 500 before it approaches its anniversary of highs on May 21, 2016. What’s Behind This Decline? There are plenty of reasons. One of the main factors is the global market crash that was induced by the Chinese currency devaluation and extreme plunge in oil prices last summer. Since then China and oil have been a pain in the neck. In addition to this, earnings recession, overvaluation concerns, Fed liftoff in December and ambiguity over the Fed’s next moves amid global growth issues challenged the broader market. If this was not enough, when market watchers were almost sure about a delayed policy tightening in the wake of threats to the stability of the U.S. economy, the latest Fed minutes hinted at the possibility of a June hike. As an instant reaction, the S&P 500 fell to its lowest level since March on May 19. The reason for this fall was the fear of shrinkage in liquidity in the stock market. Turbulent Times Ahead for S&P 500? A volley of upbeat data released lately on retail, housing, inflation and consumer sentiments may boost the Fed’s confidence that the economy can now digest an additional hike. Then again, the global market is still edgy and has all the power to derail the U.S. index if the Fed acts alongside. In today’s concept of an open economy, it is hard to bet on a large-cap stock index just on the basis of domestic market recovery. First, if the Fed strikes, the greenback will jump hurting the profitability of companies with considerable exposure in foreign lands. More than 30% of the S&P 500 revenues depend on international economies. Plus, investors should note that IMF, while slashing global growth forecasts recently, reduced the U.S. growth forecast for 2016 too from 2.6% to 2.4% . After all, though inflation is rising, it is yet to reach the level where it can digest further hikes comfortably. In April 2016, American inflation was at 1.13%. Notably, a rise in rates lowers inflation. Also, uncertainties regarding election in November flares up risk in the S&P investing. Earnings of the S&P 500 index are likely to decline 6.7% in the first quarter of 2016 while revenues are expected to fall 1% as per the Zacks Earnings Trends issued on May 18. Though the trend looks up from the second quarter onward with expected earnings reduction of 6% for the ongoing quarter, earnings growth of 0.4% in Q3 and again growth of 7.3% in Q4, it is less likely for the S&P 500 to jump before late second half. Analyst Bearish on S&P 500 In March 2016, Goldman commented that the index in overvalued. It recently noted that “the forward P/E multiple of the S&P 500 index ranks in the 86th percentile relative to the last 40 years. They note that the median stock in the index trades at the 99th percentile of its historical valuation on most metrics.” Goldman also noted that historically the S&P 500 index is fairly range-bound until November in a presidential election year. Bank of America believes that the S&P 500 could slip to its February lows, while Morgan Stanley has applied the famous maxim “Sell in May and go away” to stocks at least till November. All in all, no great news is expected from the S&P 500 in the coming summer. Short via ETFs? Going by the above thesis, the S&P 500 will likely see rough trading ahead, but investors could easily profit from this decline by going short on the index. There are a number of inverse or leveraged inverse products in the market that offer inverse (opposite) exposure to the index. Below we highlight those and some of the key differences in each: ProShares Short S&P500 ETF (NYSEARCA: SH ) This fund provides unleveraged inverse exposure to the daily performance of the S&P 500 index. ProShares UltraShort S&P500 ETF (NYSEARCA: SDS ) This fund seeks two times (2x) leveraged inverse exposure to the index. ProShares UltraPro Short S&P500 (NYSEARCA: SPXU ) Investors having a more bearish view and higher risk appetite could find SPXU interesting as the fund provides three times (3x) inverse exposure to the index. Direxion Daily S&P 500 Bear 3x Shares (NYSEARCA: SPXS ) Like SPXU, this product also provides three times inverse exposure to the index. Bottom Line We would also like to note that the relative strength index of the S&P 500 based ETF (NYSEARCA: SPY ) is presently 43.92. This indicates that the fund is yet to enter the oversold territory. Original post