Tag Archives: management

Sector Investing: Why It Matters

This was originally published on December 29, 2015 Within the S&P 500, there are 10 sectors that comprise the key benchmark, and it remains my preferred way of dissecting the market for clients, and giving clients an orderly structure or framework to think about the giant morass that is the capital markets. The primary tool for analyzing sectors for clients remains the excellent sector earnings work done by Thomson Reuters and FactSet, as well as Howard Silverblatt of Standard & Poor’s, and Estimize (although Estimize has a narrower focus than the other firms) which is shared every week on this blog for readers. (Sam Stovall of Standard & Poor’s wrote a book on sector investing that was published in 1996. I just found the book on Amazon and bought it for some holiday reading this weekend.) Why worry about sectors? Well, give this a little thought: The bull market in the S&P 500 that ran from August 1982 to March of 2000 was dominated by two sectors: Technology and Financials. A lot of the old market pundits and the so-called gurus from the 1990s used to say that “The Financials are the market generals” and there was real truth to this. The Financials were the S&P 500’s primary market leader in the 1980s and 1990s. The S&P 500’s decade-long bear market from 2000 through 2009, the decade with the lowest average return for the S&P 500 since the 1930s, was a result of brutal bear markets in two sectors (guess which sectors): yes, Financials and Technology. Technology came first, with the Nasdaq correcting 80% from March 2000 through October 2002, and then the mother-of-all sector corrections with Financial stocks correcting (looking at the Financial Select Sector SPDR ETF (NYSEARCA: XLF )) from $38 to the $6 area from mid-2007, though late 2008, early 2009. Technology as a percentage of the S&P 500’s total market cap hit a peak of 33% in the first quarter of 2000 (really unbelievable when you think about it) and Financials hit their peak in mid-2007. I thought that Financials had gotten close to 30% as a percentage of the S&P 500’s market cap, but from looking at historical data, maybe Financials’ peak total of the S&P 500 was closer to 25% rather than 30%. The reason the Energy bear market hasn’t really impacted the S&P 500 like the Technology and the Financials’ collapse is that when crude oil started to fall from $110 to today’s $35-$37 per barrel, Energy as a percentage of the market cap of the S&P 500 was just 10%. It is now roughly 6.5% today. As the above implies, “Size (in terms of market cap) Matters”. Three bear markets: Technology, Financial and Energy – all sector-driven. Here is our latest spreadsheet where we updated sector weightings ( FC – marketcapvsearningswt ). As readers can see from this spreadsheet, Technology and Financials remain the two largest sectors within the S&P 500 at 37% of the S&P 500, and since they had their absolutely crushing bear markets in the last decade, what are the odds (in your opinion) that Technology repeats 2000-2002 or Financials’ 2007-2009? 20% corrections can happen at any time for a variety of reasons, but would a reader think that Financials and Technology could correct 30% or 40%? Here are the sector weightings for the S&P 500 as of late December 2015 (courtesy of Bespoke, rounded to the nearest 1%): Technology: 21% Financials: 16% Health Care: 15% Consumer Discretionary: 13% Industrials: 10% Consumer Staples: 10% Energy: 6%-7% Utilities, Materials, Telecom: 3% each The top 5 sectors of the S&P 500 are 75% of the market cap of the S&P 500. The top sectors which we’ve discussed at length are 37%. Consumer Discretionary’s 10% return year to date is heavily influenced by Amazon (NASDAQ: AMZN ) since the stock is a member of the Consumer Discretionary sector. Bespoke has noted that without Amazon’s 140% return year to date, Consumer Discretionary would be up just 2%-3% in 2015. Conclusions about 2016: Given the above, and the Technology and Financials’ weights, I just don’t think there is a sustained bear market in our future. Technology and Financials remain the largest sector overweights for clients coming into 2016. I’m leery of Health Care in a Presidential election year. I do like Industrials in 2016 IF the dollar can remain right where it is, or weaken a little. The biggest change to client accounts in the last 4 months has been adding the Energy Select Sector SPDR ETF (NYSEARCA: XLE ), and the iShares U.S. Energy ETF (NYSEARCA: IYE ) to client accounts with the market correction in August-September. We haven’t had any Energy exposure for years. There is more owned now than at any time in the last 5 years. Also bought in September, early October were the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ), and the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ), or the Emerging Markets ETFs. The underperformance of emerging markets relative to the S&P 500 the last 7-8 years has been remarkable. We have never owned Emerging Markets for clients before these positions. Finally, I took a shot at some Brazil (NYSEARCA: EWZ ), the last month. Brazil is the confluence of Energy risk, commodity risk, socialism, and inept incompetence, in one ETF. There is an approximate weighting of 5% in Energy, Emerging markets and Brazil in client accounts, depending on a number of other factors.

Does Low Growth Mean Lower Investment Returns?

Why U.S. potential GDP has declined. Investors should lower their expectations of future returns. Low growth comes with both higher opportunity and higher risk too. With little fanfare, the Federal Reserve recently reduced their estimate of the U.S. economy’s long-term potential growth rate. To be sure, the Federal Reserve has a less than enviable record forecasting GDP, or inflation for that matter. In fact, the Fed has systematically overestimated growth for many years now. In six of the past seven years, actual GDP growth has been outside the Fed’s central tendency or forecasted range. For 2015, real GDP is on track to increase at an annual rate of 2%, which is at the lower bound of the Fed’s initial estimate. This should not be a surprise to anyone. After all, forecasting is a tough science and there are few people that can boast of consistent success. We are all left to wonder whether the Fed’s reduction of potential GDP from a range of 2.0% to 2.3% to 1.8% to 2.2% is at all relevant. The cynics can rightfully be excused for believing that Fed’s action to trim potential GDP growth is a cherished signal that real growth is set to break out on the upside. It may be helpful to recall that GDP is simply a function of changes in two key variables: the employment participation rate and employee productivity. If we accept this premise, then the prospects for future GDP growth are indeed worrying. The civilian labor force participation rate, rather than increasing, has been decreasing at a rate of about 1% since 2008. Similarly, trend productivity, as measured by the Nonfarm Business Sector: Real Output per Hour of All Persons, is downward sloping as shown in the following chart: With both the employee participation rate and productivity declining, it is hard to see real GDP growth returning to the 3.5% to 4.0% range we enjoyed in decades past. Slow growth is now the new normal, which, if realized, has broad implications for investment returns over the medium to longer term. First, it should be no surprise that the iShares S&P 500 Growth Index ETF (NYSEARCA: IVW ) handily outperformed the iShares S&P 500 Value ETF (NYSEARCA: IVE ) by 9.24%. In a low growth environment, investors are sure to pay up for growth. Next, in a slow growth environment, companies will increasingly find it difficult to increase dividends, although they should be able to maintain current payouts, unless we face an earnings recession. However, as interest rates rise, as is currently the case, dividend payers will lose their luster relative to less risky alternatives like U.S. Treasury Notes. The two most popular dividend ETFs, the iShares Select Dividend ETF (NYSEARCA: DVY ) and the Vanguard Dividend Appreciation ETF (NYSEARCA: VIG ) , both sport small total return losses for the year. It is interesting to note that according to FactSet, “shareholder distributions for companies in the S&P 500 amounted to $259.8 billion in Q3 (October), which was the highest quarterly total in at least ten years.” Companies are paying out record amounts of cash via dividends or buybacks, yet investors are marking down theses shares’ prices due to lower expected future growth prospects. A dividend yield of 5% is not advantageous if the company’s stock price drops by 5% too. Reader of Thomas Piketty’s Capital in the Twenty First Century can take comfort in the fact that slow growth, circa 1.0% to 1.5%, is a much more the normal rate of growth over long periods of time dating back to the 1700s. Elevated GDP growth rates of say, 3% to 4%, are much more an aberration than the norm. The good news is that even at a growth rate of 1.5%, stock market returns should compound up to at least 45% over a generation, defined here by a period of thirty years. The bad news is that most investors are impatient and are unwilling to let the wonders of compounding work in their favor. So they are forced to take on an inordinate amount of risk to generate acceptable returns. That’s OK in my mind, as long as these investors have both the ability and willingness to take on such risk. Problems arise when investors possess a lot of willingness to take on risk but their ability is curtailed due their financial condition. In other words, most investors simply cannot afford to face big drawdowns that come along with upping the risk profile. What is to be done? The solution for many investors is to simply lower your expectations of returns, defer consumption in favor of savings and maintain a well-balanced disciplined portfolio approach. Granted nothing worked in 2015 – a traditional 60/40 portfolio using the Vanguard S&P 500 ETF (NYSEARCA: VOO ) and the iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ) barely returned 1% after dividends. Alternative, higher risk portfolios fared much worse and may bounce back – which is fine unless you cannot afford to lose a large amount of money now, which few people can. Of course, higher returns are available with higher risk. The PowerShares QQQ Trust ETF (NASDAQ: QQQ ) had a 9.45% total return in 2015 and both European and Japanese equities had high single-digit returns, at least in local currency terms. All three alternatives experienced higher volatility (risk) than the S&P 500. Certain financial institutions, with powerhouse investment banking franchises, should benefit in a low growth environment. It’s no wonder that investment bankers feast on low growth. After all, mature companies with muted growth prospects focus on industry consolidation (M&A), capital structure (buybacks financed with debt) and tax management (inversions). Well-heeled bankers are ideally placed to lend a helping hand and the Financial Select Sector SPDR ETF (NYSEARCA: XLF ) is likely to outperform the broader market in 2016. Slow GDP growth is likely to be an enduring feature of the investment landscape for many years to come. It is not realistic to expect eight to ten percent annual returns when interest rates remain at extraordinarily low levels. Low or negative interest rates are the result of low growth expectations and intense risk aversion, not as popularly believed, an exclusive consequence of muted inflation. Setting accurate investment return goals, based upon current conditions rather than on historical precedent, is the surest way to avoid nagging disappointments.

8% Current Income And Stable Principal From A Portfolio Of Closed-End Funds

Summary This High-Income, Stable-Capital CEF portfolio is designed to generate current income with reasonable tax efficiency. The portfolio’s second, and equally weighted, objective is long-term sustainability of capital. The objectives are addressed by entering positions in quality funds when their discount status is attractive. This article summarizes the final quarter of 2015. High Current Income and Capital Stability from CEFs At the end of 2015’s gut-wrenching third quarter (chart at right) I took note of the sharp declines in closed-end funds and considered that an opportunity was at hand. I proposed a portfolio of CEFs ( A CEF Portfolio For High Current Income With Capital Preservation ) designed to generate high current income with capital sustainability: The Stable-Capital, High Current-Income Portfolio. With the fourth quarter in the books, it’s time to review the results. I’ll not spend time here rehashing the details of the portfolio; interested readers should refer to the article cited above. But I will say that one incentive for building this model grew from my frustration with the performances of ETFs, ETNs and CEFs that offer portfolios of CEFs. As the name implies, the model has three objectives: First is high yields for current income. I’ve targeted 8% for taxable funds and 5% for tax-free municipal bond funds. Any excess is to be reinvested. Second is sustainable principal value. Capital growth is not an explicit objective, but maintaining a sustainable principal while withdrawing income at approximately 7.6% will obviously require periods of capital growth to offset inevitable periods of capital erosion. Third is tax efficiency. I wanted a manageable portfolio, so I limited the selections to 15 funds and equally weighted them. The portfolio is diversified across income asset classes. The funds selected are: Equity (40%) Dow 30 Premium & Dividend Income Fund Inc. (NYSE: DIAX ) Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (NYSE: ETW ) Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE: ETY ) Tekla Healthcare Investors (NYSE: HQH ) NASDAQ Premium Income & Growth Fund Inc. (NASDAQ: QQQX ) Columbia Seligman Premium Technology Growth Fund, Inc. (NYSE: STK ) Real Estate (6.7%) Cohen & Steers Total Return Realty Fund Inc. (NYSE: RFI ) Preferreds (13.3%) Flaherty & Crumrine Preferred Securities Income Fund Inc. (NYSE: FFC ) First Trust Intermediate Duration Preferred & Income Fund (NYSE: FPF ) Fixed Income – Taxable (26.7%) Western Asset Mortgage Defined Opportunity Fund Inc. (NYSE: DMO ) PIMCO Strategic Income Fund, Inc. (NYSE: RCS ) AllianzGI Convertible & Income Fund (NYSE: NCV ) PIMCO Dynamic Income Fund (NYSE: PDI ) Fixed Income – Tax-Free Municipal Bond (13.3%) Eaton Vance Municipal Bond Fund (NYSEMKT: EIM ) MFS Municipal Income Trust (NYSE: MFM ) Comparables The comparables I’m using for this portfolio are: Cohen & Steers Closed-End Opp (NYSE: FOF ), an unleveraged closed-end fund of funds with 85 CEFs in its portfolio. PowerShares CEF Income Composite (NYSEARCA: PCEF ), an unleveraged ETF holding 147 closed-end funds. UBS E-TRACS Mthly Pay 2x Closed End ETN (NYSEARCA: CEFL ), an ETN (Exchange Traded Note) indexed to a 2x leveraged portfolio of 30 closed-end funds. YieldShares High Income ETF (NYSEARCA: YYY ), an unleveraged ETF that holds a portfolio of 30 closed-end funds using the same index as CEFL. Fourth Quarter Results Income The first objective is current income, so let’s start with a look at distributions for the funds. Recall that any distributions for the quarter over 2% (8% annualized) for 13 taxable funds and over 1.25% (5% annualized) for two tax-free, muni-bond funds are retained for reinvestment. (click to enlarge) Total distribution was $3430.00, a return of 3.26% for the quarter. The return is enhanced by three funds posting special distributions. PDI added $2.61/share for $608.13; DMO added $1.20/share for $322.80; and RCS added $0.04/share for $32.28. Thus, special distributions put an extra $963.21 or 28.08% to the quarter’s yield. When only the regular distributions are considered, the portfolio paid $2466.79, which exceeds the anticipated $2,372.43 by 4% (see previous article for a discussion of anticipated yields). Distributions for all but three funds met the 8%/5% target. The shortfalls were minimal and were anticipated at the onset: DIAX -$10.60, FPF -$31.10, and QQQX -$14.62. Overall, the 8%/5% target objective was exceeded by $1,428.03, which is available to reinvest. At the quarter’s close, yields for the funds are as shown in this next chart. (click to enlarge) As we see, a few have increased but most now have decreased yield percentages, reflecting changes in market prices. This leads to discussion of the next objective: stability of principal. Price Performance and Capital Stability It was a good quarter for the portfolio. Somewhat surprisingly so, in fact, considering the generally poor performance of equity and fixed-income markets. Here is the market price performance for the portfolio’s funds. (click to enlarge) Only four funds had price declines. For two of these, PDI and DMO, the declines were partially a consequence of their high special distributions. One, FPF, is essentially flat. And one, NCV, is the portfolio’s big loser having given up 4.5%. I added NCV to the portfolio because I felt that it was due for a move up. It had just come off a large dividend cut and moved from a perennial premium to a discount of -15%. The fund was paying a 13.44% yield. I anticipated the discount would be reduced and the fund would stabilize at a somewhat higher valuation to NAV. This has happened; the discount is now -11.2%, but NAV has been falling along with the rest of the high-yield bond market. The fund does, however, continue to pay an exceptional distribution (14.1%). Two funds that have been long-time favorites of mine, STK and HQH, had stunningly good quarters; they’re up 13.8% and 12.1%. I’ve written on both of these several times over the past couple of years, and regular readers are aware of my high regard for both of them. HQH had been unduly beaten down. As the biotech sector dropped mid-year, HQH dropped even further. This is yet another example of the exaggerated panic selling so often seen in closed-end funds. STK was also oversold in response to the summer’s market upheavals in technology. It fell to a -6.2% discount at one point, but was back up to a 2.4% premium when I began this portfolio. Anyone who was quick enough to grab that -6% discount gets my admiration and compliments. Premiums and Discounts Let’s look at the changes in discount/premium status for the funds which provides a bit of an object lesson in CEF investing. (click to enlarge) In large measure I felt that these funds were undervalued and oversold at the end of September. As such they offered especially attractive entry points. As we see here, only one fund (NYSE: DMO ) has not gained value from a favorable move in the discount/premium. Two, FFC and RCS, have grown from moderate-to-modest discounts to substantial premiums. I held both of these at the time I started this exercise. I’ve since sold FFC (and anticipate replacing it with FLC or, perhaps, another preferred share fund) to take advantage of that profit and have been considering doing the same for RCS. RCS is a fund that has run a perennial premium. It dropped to a discount after PIMCO cut distributions on several of its high flyers (not, however, RCS). I felt that RCS’s drop was unwarranted at the time and it quickly turned around. I will likely echo my real-money swap of FFC for another preferred shares fund in this model portfolio once I’ve reviewed the space. It could be FLC here as well, but there are other strong contenders which may be a better fit. Preferred shares are presently a bit of a hot asset class, so everything out there (except FPF which is already in the portfolio) is above its mean discount status. I’ll add here a view of the Z-Scores for the funds from the beginning and end of the quarter because I think it helps to reinforce the emphasis I’ve been putting on moves in discount/premium status relative to mean discount/premiums. (click to enlarge) On the whole, the 29 September Z-scores were indicating reasonable entries for most of the funds. As I noted at the time DMO, EIM, PDI and STK were exceptions, but I wanted those high-quality funds in here despite those apparently unattractive valuations. Notice too, how frequently the Z-scores predict reversion to mean values. By these indicators, HQH remains an especially attractive opportunity (especially so if, like me, you’re inclined to think biotech is due for a recovery), but little else in the mix is. Indeed, I would not be surprised to see some corrections in the other direction in the coming months. As I noted above, RCS and FFC look ripe for profit taking. The equity option-income funds, DIAX and QQQX, which I also suggested were good buys because of their unjustified under-valuations have moved to highly positive Z-scores as well. The problem with trading out of these funds is that one needs to find a replacement. I’ll be working on that as time allows and as I go through a similar exercise for my own portfolio which shares many of these positions. Performance Summary Fourth quarter performance is summarized in this table. (click to enlarge) As shown, the portfolio is up $5,550.27 (5.5%) on market price. Results for the quarter for some asset-class benchmarks are seen in this chart. (click to enlarge) The portfolio performed well relative to these benchmarks. On price returns it lagged the S&P 500, Russell 3000 index and the Dow Jones REIT index, but it beat corporate and high-yield bonds and preferred stocks. Consider that the 5.5% price return does not include the 3.3% distribution yield, a yield unmatched by any of these benchmarks, and it’s clear that it was a good quarter for the HI-SC portfolio. The next chart summarizes the total returns for combined market price and distribution yields for each fund. (click to enlarge) Only NCV is negative for the combined values. Comparables As noted earlier, there are products that offer exposure to CEFs. I’ve not been a big fan of these, but I know many readers are. Here’s how they stack up for the quarter. Each is based on a $100K investment at the quarter’s start. The table that follows shows percentage return for combined market value and distributions. The chart says it all, in my mind. CEFL, true to its charge and 2x leverage, generated remarkable income. But, true to its ongoing track record, that income has come at a substantial capital cost. It does beat FOF and YYY, as it should with its 2x leverage, but it lags PCEF. The lag is trivial but PCEF is an unleveraged product, so in an up-trending quarter, one would have certainly expected a better showing from CEFL than an essentially even run with the ETF. None of these comes close to the HI-SC returns. I’ll be the first to admit here that the model had an unfair advantage in that it was selected at the beginning of the quarter with valuation as a high priority. But I’d also argue that the model portfolio has a much higher quality of funds than any of the comps here and that is also a consideration. We’ll continue following these funds as I do quarterly updates to see if the outperformance trend continues. Updating the Portfolio As it stands there is $1,428 in excess distribution returns to reinvest. One possibility is to add them to the funds that are the greatest distance from the equal-weighted goal. My typical target for rebalancing a portfolio is more than 10% out of balance. This table shows none at that level, but three over 9% out of balance. If I add a third of the reinvestable capital to each of DMO, PDI and NCV it would bring them closer to equal weighting. A good case can be made for this. DMO and PDI are top-of-their-class funds, but their valuations look pricey at the moment. NCV has, as I noted, been hit hard by the flight from high-yield. Is that due to turn around? I think it might to some extent, but I’m not anticipating a good year for that asset class. And when an asset class falters, the CEFs for that asset class almost invariably exaggerate the declines. The fact that NCV has such a high yield argues in favor of bringing it up to near balance. I also am considering taking some profits and swapping out of some funds. I should have some clarity on that in the coming weeks, so I’ll be holding off on the re-investment until I make those decisions. I’ll update on changes when I make them. If you have suggestions, I’d love to hear your opinions in the comments.