Tag Archives: strategy

An Analysis Of A Long MSCI U.K./Short S&P 500 ETF Pairs Trade

While U.K. markets have been trading downwards in the past month over Greece concerns, I see this as temporary. However, I still maintain that the S&P 500 index is overvalued. I see potential value in a long EWU/short SDS ETF pairs trading strategy. In a previous article written on May 22, I argued that a significant pairs trading opportunity exists through taking a long position on the FTSE 100 and a short position on the S&P 500. The purpose of this article is to both review the performance of this strategy in light of developments in June, and further discuss the strategy in the context of specific ETF performance. On a one-month basis, the iShares MSCI United Kingdom Index ETF (NYSEARCA: EWU ), which approximates the returns on the MSCI United Kingdom Index returned -2.34 percent, which has been less severe than the -4.24 percent return on the FTSE 100 over the same period. On the other hand, the ProShares UltraShort S&P 500 ETF (NYSEARCA: SDS ) has returned 1.05 percent this month. On balance, this would have been a losing pairs trade based on lower than expected stock market performance in the United Kingdom. However, is there a prospect of reversal in this regard? In my opinion, economic fundamentals in the United Kingdom are solid and returns are being driven lower in tandem with European shares as a result of uncertainty in Greece, which has seen the FTSE 100 hit a three-month low. However, I had previously expressed my optimism that an upturn in property markets in the U.K. would lead the index higher over time, and while U.K. markets as a whole are lower, construction firms have bucked the trend with firms such as Berkeley, Persimmon and Barratt Developments all seeing gains this month. In this context, I expect that while U.K. markets may see volatility in the short-term as a result of the Greek crisis, long-run growth will ultimately push the index higher. On the other hand, we have seen that the S&P 500 has been falling as expected this month by -0.75 percent and the inverse ETF returning 1.05 percent accordingly. I still maintain that US stocks have little room left to run in terms of valuation, and this is evidenced not only by falling returns but also concerns of potential overvaluation among large consumer discretionary stocks. For instance, an article from ValueWalk makes the point that while the segment had expected a 16.9 percent growth rate at the beginning of the year, it has seen the fourth-biggest decline in earnings growth expectations. Moreover, I had also stated in the previous article that while the S&P 500 had trended upward until recently, US equity inflows had been falling which had raised concerns of a pullback which we now appear to be seeing. To conclude, I expect that U.K. stock markets may undergo some short-term volatility as a result of the Greek crisis. However, I still see potential for growth once the initial contagion subsides, and maintain my view on a long MSCI U.K./short S&P 500 trade. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Tactical Asset Allocation: Beware Of Geeks Bearing Formulas

By Wesley R. Gray, Ph.D. How Should I Tactically Allocate my Assets? A lot of investors ask this question as their wealth grows and the number of financial products grows exponentially. In order to generate a response, investors pay money to professional finance geeks who often present complex formulas as a solution to the asset allocation problem. Last year, when I was asked to present a seminar on the subject at the Morningstar ETF conference , I developed a tongue-in-cheek title for it: ” Beware of Geeks Bearing Formulas .” In this short research piece, we explore this seminar in detail. Our goal as evidence-based investors, and not story-based investors, is to set the record straight on the value of complexity in the context of asset allocation. Bottom line: simple seems to be better. Defining Tactical Asset Allocation (TAA) What exactly is tactical asset allocation? I like to work backward to forward, since it helps to build the concept. Allocation (A) : Our baseline, or static allocation to assets in our universe. E.g., 50% stocks, 50% bonds, rebalanced annually. Asset (A) : Financial assets that can be traded with reasonable liquidity. A key component of being “tactical” is being liquid, which implies that hedge funds, private equity, and other asset classes with limited liquidity rights should be avoided in the context of “tactical” asset allocation. E.g. Stocks, bonds, commodities, alternatives (if liquid). Tactical (T) : Changing our baseline allocation based on some tactical rules. E.g., 50% stocks, 50% bonds -> 30% stocks, 70% bonds based on a market valuation signal . So there you have it, tactical asset allocation is tactically investing in liquid assets in order to beat a static benchmark allocation. Basic Asset Classes: There is an old investor adage that you shouldn’t put all of your eggs in one basket. For my classes, I dive into correlation mathematics to prove this point (see below), but the conceptual benefit of diversification is grounded in common sense. (click to enlarge) But how do we identify the eggs that go into our diversification basket? Meb Faber highlights in his Ivy Portfolio book, and reemphasizes in his new book Global Asset Allocation , that you don’t need to get fancy when it comes to asset class selection. One can capture the big muscle movements of the world by simply allocating across 5 asset classes: Domestic Equity = S&P 500 Total Return Index International Equity = MSCI EAFE Total Return Index Real Estate = FTSE NAREIT All Equity REITS Total Return Index Commodities = GSCI Index Fixed Income = Merrill Lynch 7-10 year Government Bond Index (click to enlarge) We label the return series as follows throughout the analysis: S&P 500 = S&P 500 Total Return Index EAFE = MSCI EAFE Total Return Index REIT = FTSE NAREIT All Equity REITS Total Return Index GSCI = GSCI Index LTR = Merrill Lynch 7-10 year Government Bond Index Common Asset Allocation Techniques We discuss five common asset allocation techniques that are commonly utilized in one form or the other by academics and/or practitioners. 1. Tangency Portfolio/ Max Sharpe Portfolio Modern portfolio theory, inspired by Markowitz ‘s work on mean-variance-analysis in the early 1950s, identified the optimal trade-off between risk and reward for a portfolio. Of course, the underlying assumptions serving as the foundation for this so-called “optimal” algorithm stretch the imagination, but the intellectual construct and concepts are rock solid. The punchline from modern portfolio theory is the so-called “tangency portfolio.” This portfolio is identified by the “x” with a vertical line through it and sits on the CAL (capital allocation line). For those of you who haven’t taken an investment management course in a while, the CAL represents all combinations of risk-free rate and the tangency portfolio. These are “optimal” portfolios because there is no possible way to achieve a higher risk/reward. The optimal allocation weights for a 100% risk investor (i.e., no allocation to risk-free bonds) are the tangency portfolio weights. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. 2. Minimum Variance Portfolio Many readers are probably familiar with minimum variance portfolios. As the name implies, minimum variance portfolio weights are identified such that the portfolio’s expected variance is minimized. We can’t get too excited over the minimum variance portfolio – being low variance doesn’t necessarily mean something is a good investment. We need to consider expected return. In a modern portfolio theory context, the minimum variance portfolio (represented by the diamond below) is actually sub-optimal and should never be used. Instead, an investor can simply hold a small portion in risk-free bonds and the tangency portfolio to achieve a result with the same risk, but higher return. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Interestingly, even though there is no theoretical basis for its use, the minimum variance algorithm is often used in practice… 3. Risk Parity Portfolio Risk parity has been widely advocated recently, partly due to the success of the strategy’s largest proponent – Bridgewater Associates, LP. The basic concept behind risk parity is to equalize risk allocations across asset classes. For example, consider a traditional 60/40 stock/bond portfolio allocation. The “problem” with this allocation is that a large portion of the portfolio’s risk is driven by the stock allocation. Let’s say 90 percent of the risk is driven by the 60 percent allocation to stocks, and only 10 percent of portfolio’s risk is driven by the 40 percent allocation to bonds. Risk parity argues that we should allocate to stocks and bonds such that 50 percent of the portfolio’s risk is driven by the stock allocation and 50 percent is driven by the bond allocation. For example purposes, let’s say that a 50/50 risk contribution implies an 80 percent allocation to bonds and a 20 percent allocation to stocks. The figures below attempt to explain this via illustrations. Also, here’s a post that explains risk parity logistics. 4. Momentum Portfolio Momentum strategies overweight assets that have relative strength over the mid-term (e.g., 1 year) and underweight assets that have performed relatively poorly over the mid-term. This basic concept has been applied across asset classes, asset sectors, and on individual securities. As an example, the chart below shows the invested growth of high momentum portfolios and low momentum portfolios back to 1927. The data is from the French library . The historical performance of momentum strategies speaks for itself. In an asset allocation context, a momentum strategy will allocate more to relatively strong performing assets and relatively less to poor performing assets. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. 5. Simple Trend-Following Portfolios Simple moving averages represent a classic trend following strategy. The rule is simple: If the market is above the 200-day moving average rule, hold, otherwise go to cash. Wharton Professor Jeremy Siegel found that this simple technical rule outperforms a buy-and-hold approach, both in absolute terms and on a risk-adjusted basis. In general, while efforts to time the market should be viewed with skepticism, certain systematic timing strategies that have been explored in academia appear to reduce risk, without significantly impacting long-run returns. In particular, the application of simple moving average rules has been demonstrated to protect investors from large market drawdowns, which is defined as the peak-to-trough decline experienced by an investor. Siegel, in his book, “Stocks for the Long Run,” explores the effect on performance on the Dow Jones Industrial Average from 1886 to 2006, when applying a 200-day moving average rule. (click to enlarge) Red circles highlight episodes where the current market price breaks the 12-month moving average. The results are applied on the S&P 500. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Performance of Common Techniques Let’s run a horse race on the various asset allocation strategies described above. The back test period is from 1/1979 to 12/2013. Our core 5 assets are: S&P 500 = S&P 500 Total Return Index EAFE = MSCI EAFE Total Return Index REIT = FTSE NAREIT All Equity REITS Total Return Index GSCI = GSCI Index LTR = Merrill Lynch 7-10 year Government Bond Index (prior to 6/1982, Amit Goyal Data) Our back test asset allocation strategies are: RISK_PARITY = Risk parity on core 5 asset classes, 3-year rolling windows MOM_TAA = Relative momentum on core 5 asset classes, calculated using 12-month momentum MAX_SHARPE = Tangency portfolio weights on core 5 asset classes, 3-year rolling windows (weights constrained [-1,1]) MIN_VAR = Minimum variance portfolio weights on core 5 asset classes, 3-year rolling windows EW_INDEX = Equal-weight, monthly rebalanced across core 5 asset classes EW_INDEX_MA = Equal-weight, monthly rebalanced across core 5 asset classes, with 12-month moving average rule RANDOM = ¼ random chance of moving to risk-free rate, monthly rebalanced across core 5 asset classes Results are gross of management fee and transaction costs and for illustrative purposes only. These are simulated performance results and do not reflect the returns an investor would actually achieve. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Max Sharpe weights are constrained between -1 and 1. Data is from Bloomberg and publicly available sources. Summary Statistics: Benchmarks (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Over the time period, the S&P 500 and 10-Year bond exposures perform the best. It is no wonder that a 60/40 portfolio is so popular these days-the strategy cherry picks the best performing assets over the past 30+ years. Summary Statistics: Asset Allocation with Core 5 The EW_INDEX strategy and the RANDOM strategies serve as benchmarks for the tactical asset allocation models (their construction is outlined above). The results can be summarized as follows: The tangency portfolio, or “max-sharpe” method perform the worst and cannot even compete with the benchmarks. Minimum variance beats the tangency portfolio, which is ironic, given the theoretical underpinnings for the tangency portfolio. Nonetheless, the strategy, while risk-managed, does poorly on upside returns, underperforming the simply 10-Year bond CAGR. The risk parity methodology performs admirably, with strong risk-adjusted statistics and strong drawdown containment. Momentum also performs admirably, with the highest CAGR, however, the strategy has to contend with large drawdowns. The EW index with trend-following performs the best, capturing much of the upside, but preventing large drawdowns. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Overall, risk parity, momentum and EW w/ MA look like the top performers. Summary Statistics: Asset Allocation with Core 4 As a robustness test, we run all our tests for all tactical asset allocation models with and without 10-Year Treasury Bond exposure. We do these tests because the 10-Year has been on an epic tear over the past 30 years, which makes it challenging to ascertain whether a tactical strategy is lucky or good when a system chooses a large position in Treasury Bonds. If a tactical system is robust it should work on 2 assets, 4 assets, 5 assets, or 50 assets. Again, similar to the last table, we present the summary statistics for the EW_INDEX and RANDOM, which serve as benchmark performance guidelines when fixed-income is not included as an asset class. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. The results can be summarized as follows: Risk parity completely blows up and no longer works. Clearly, the results associated with risk parity are dependent on 10-Year Treasury exposure. Minimum variance and tangency portfolios do not beat the benchmarks. Momentum squeaks out a small gain on a risk-adjusted basis relative to the benchmarks, but the edge is much lower. The EW index with trend-following performs the best, capturing much of the upside, but preventing large drawdowns. We highlight the drawdowns associated with the top-performing asset allocation systems, but exclude 10 years as an allocation choice. The only system that provides robust drawdown protection is the trend-following system. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. So Trend-Following looks to be the winner – Time To Go All-In? Based on the results over the past 30+ years, trend-following looks to be the most effective and the most robust form of tactical asset allocation… But how has the trend-following system performed since the 2008 financial crisis? Well, in a word, terribly. The chart below highlights the performance path of the EW buy & hold strategy versus the EW w/ trend-following index. (click to enlarge) The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Conclusion There is no panacea when it comes to tactical asset allocation. The evidence seems to suggest that trend-following rules are the most effective and the most robust, but as the recent 5-year run highlights, NOTHING WORKS ALL THE TIME. Original Post

Bottom-Digging During Market Tops

Summary Finding investing opportunities when the market reaches all-time highs. What industries currently offer value in the market. Managing your portfolio. The S&P 500 has nearly tripled from a 2009 low of 735 to 2113 currently. Just as a rising tide lifts all ships, so too does a rising stock market lift all stocks. At greedy times like these, investors should be fearful and reexamine their portfolios. …if [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful. -Warren Buffett Now, I’m not saying the market has reached its peak (though some do make compelling arguments ). I am not a market timer. I’ve written about the folly of forecasting in the past. I’m merely saying a prudent investor should not let greed get the better of him. The following strategy is one that is more likely to be applicable during market highs as investors are more likely to have a preponderance of stocks trading at prices much higher than their actual values (aka, the rising tide theory mentioned above). So what to do? Well, I believe the prudent investor should lock in gains on stocks pushing well beyond their valuations (close to 52-week or all-time highs) and replace them with stocks trading at reasonable valuations. Mr. Market is offering attractive prices for your stocks, let him have them. But then we’re left with the problem of finding alternative investments. As markets keep pushing higher and higher, investors are often left scratching their heads wondering where to find value. Admittedly, this can be challenging, however, opportunities do still exist. One place to look as stocks reach all-time highs are stocks reaching new 52-week lows. Some noteworthy examples include PriceSmart (NASDAQ: PSMT ), SodaStream (NASDAQ: SODA ), Turtle Beach Corp. (NASDAQ: HEAR ), and Fossil (NASDAQ: FOSL ). PriceSmart is the Sam’s Club of Central America and the Caribbean. It’s trading at a small discount to its sales, has high insider ownership, and has consistently grown sales, 15% on average, over the past ten years. At its current price of $17.07 after-market, SodaStream trades at a large discount to sales (72% of sales) and is nearly trading at its book value of $16.59. Turtle Beach has near-total domination in the gaming headphone market with 50% of both the UK and US markets. It trades at 60% of sales (which it looks to nearly double sales this year) and is led by smart management with a solid near-term plan, and patents, to enter industries such as health, automotive, TV and mobile. I’ve already written my take on Fossil, you can read it here . The next place to look is at overlooked stocks (often smaller capitalization, less than $100m) in industries where there is a low supply of investment opportunities. One such industry is the coffee industry. Now, before going into individual companies, let me preface this discussion by first noting some interesting dynamics at place in this market. For one, coffee consumption is not nearly what it used to be. In fact, in 1946 consumers drank 46.4 gallons of coffee per person ( Figure 1 ). Today, even with a coffee shop on every corner, consumers drink less than half as much at only 20-25 gallons of coffee per year as coffee was replaced predominantly by soda. As consumers become more health-conscious, pop consumption should decrease and coffee, as a viable, healthy alternative, should have an increased level of consumption. Secondly, there is a shift taking place where high-quality shade-grown coffee (high cost to grow) is being overtaken by the rise of poorer quality shade-free coffee (cheaper to grow). This makes coffee plants much more susceptible to climate change and topsoil erosion. As climate change concerns begin to grow, the downfall we’ve seen in coffee prices from $300 in 2011 to a current 52-week low of $140 is not likely to last. Figure 1 Now, opportunities in this market surely exist in the form of large companies. There is, of course, Green Mountain Coffee Roasters (NASDAQ: GMCR ) and Starbucks (NASDAQ: SBUX ), but investors in those companies will soon bail when they see these companies for what they are-overvalued. Starbucks trades at an all-time high ($94.30) and the highest price-to-sales ratio it has ever seen in the last ten years of 4.12. Starbucks also trades inversely to coffee prices. Green Mountain Coffee Roasters ($124.10) shares trade even higher at a price-to-sales of 4.31 and, like Starbucks, it is also inversely correlated to coffee prices. As coffee prices rise investors will bail on these two companies (and valuations will come back down to earth). So when investors bail, where will they look? On the conservative end is Coffee Holding Co. (NASDAQ: JVA ), trading at 28% of its total sales. This company is well-managed by its owners, experienced coffee industry veterans who have a 10% stake in the company’s shares. They also support and believe in sustainable practices. These beliefs lead to production of higher quality coffee (shade grown) that is not as susceptible to soil erosion and climate change. Furthermore, as experienced coffee experts, they are well-hedged against fluctuating prices. On the risky end is Jammin Java ( OTCQB:JAMN ), better known by its Marley Coffee, which is trying to force itself to turn things around before it does a complete nose-dive. If company-estimated year-end sales are to be believed, the company trades at a 10% discount to expected year-end sales. However, this company is only for high-risk-oriented individuals who don’t mind getting cleaned out if things turn south. Then, there’s the oil industry. I don’t think I need to go into this as many have already witnessed the price collapse at the pumps, so suffice it to say that there are many opportunities to be had in this sector, both large cap and small, and everything in between. (Check out Cale Smith’s recent notes about the oil price phenomenon). I’m pretty sure you could throw 10 darts at oil stocks right now and make at least 8 solid investments. Another interesting idea is James O’Shaughnessy’s strategy of looking for stocks that he calls Reasonable Runaways . These are stocks that have a high relative strength, greater than $150m in market cap and trade at a price-to-sales ratio less than 1. I’ve modified this strategy a little bit by including companies that have large amounts of cash in excess of debt. Some notable examples include FreightCar America Inc. (NASDAQ: RAIL ), BeBe Stores (NASDAQ: BEBE ), Men’s Wearhouse (NYSE: MW ), LSI Industries (NASDAQ: LYTS ) and FujiFilm Holdings ( OTCPK:FUJIY ). While I have not had time to look into each of these companies it doesn’t matter- the theory of the Reasonable Runaways strategy is one of investor agnosticism. The theory says that you are buying $1 worth of sales for less than a dollar (low P/S) just as investors are realizing the company is undervalued (high relative strength). You simply run the screen, buy agnostically, and diversify your portfolio by giving equal weight to the top 20 or so companies with the highest price appreciations. Sell after a year then repeat the process. Since 1951 this strategy had a compound annual growth rate of over 18%. While the S&P 500 may have reached its top, your portfolio doesn’t have to top out. You can simply shift your current best performers to companies that offer greater opportunity and more attractive valuations. Employing several different search techniques, such as those mentioned above, can get you on the right track to optimizing your portfolio towards value and thus reducing your overall risk by increasing your margin of safety. But don’t forget to hold on to a fair amount of just in case cash for when the market does plummet. You’ll want to have that cash in your back pocket to snatch up undervalued companies when the falling tide lowers all the ships again and more opportunities abound. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: The author is long FOSL, JVA. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.