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Do Hedge Funds Really Deliver Alpha?

"No matter how you "slice-and-dice the data,” hedge funds are struggling to meet their promise to clients to consistently produce high returns with low correlation to markets. It’s kind of: ‘I promise you a Rolls Royce and I give you a Honda.'" - Matt Granade, Chief Market Intelligence Officer, Point72 Asset Management

There are more Hedge Funds in the world than Dunkin' Donuts.

What does that statement have to do with negative alpha? Everything.

Too many funds + similar strategies + limited opportunity set + high fees = underwhelming returns.

Simply put: there’s not enough alpha to go around.

Back in the day, long/short equity funds (the largest hedge fund strategy by assets) actually used to hedge. They used to take risk. They used to look quite different than the overall stock market. And they used to deliver alpha.

How do they look today?

In aggregate, like a lower beta version of an index fund. With a correlation of 0.87 to the S&P 500 over the past few years, they pretty much move in lockstep with the market.

Note: the HFRI Equity Hedge Index is comprised of investment managers who maintain positions, both long and short, in primarily equity and equity derivative securities.

With such a high correlation, those using long/short funds to "protect" against the next bear market are likely to be highly disappointed when it comes.

How do we know this? We have a number of data points in recent years.

In 2008, when the S&P 500 lost 37%, long/short funds were down 26.7%. In 2011, when the S&P 500 dropped 16.3% from May through September (monthly closing basis), long/short equity funds lost 13.2%.

Since March 2009, the S&P 500 has had 29 down months with an average return during those months of -2.9%. Long/Short funds were down in 28 out of 29 of those months with an average return of -1.8%.

As long as their net exposure to the broad market remains high (not a lot of hedging), investors should expect the next downturn in equities to lead to a similar result.

This might be acceptable if long/short funds were "delivering alpha" as promised, but as you can see in the chart below, the only alpha delivered in recent years has been negative.

Investors who merely wanted a lower correlation equity option would have been better served with a simple combination of 50% Utilities/50% Consumer Staples (the 2 lowest beta sectors) than an exposure to long/short funds.

The returns since 2003 are not even close, and such a combination (Utilities/Staples) even outperformed in 2008. Beyond performance, there is no comparison in terms of increased transparency/liquidity and lower fees from Utilities/Staples ETFs versus a hedge fund.

Note: Many Hedge Fund Investors believe that the HFRI Equity Hedge Index overstates returns due to survivorship bias. As such, I have also included the investable HFRX Equity Hedge for comparison purposes. Actual performance is likely somewhere in between the two.

That’s not to say there aren’t unique long/short hedge funds out there that actually do something different and add value to a diversified portfolio over time. There certainly are, but not nearly as many as people believe and picking them before they exhibit strong performance is not nearly as easy as advertised.

Overall, long/short equity as an asset class has not been additive to portfolios in years. What could change that? Less funds chasing the same opportunities, with more alpha to go around.

On that front, the market finally seems to be moving in the right direction, on pace for a 3rd straight year of net hedge fund closures:

“Thus far this year (through the second quarter, the most recent date for which HFR has data available), 481 hedge funds have shut down, compared with the 369 that have been launched. 2017 is on track to be the third straight year that the number of liquidations have outpaced the number of funds coming to market.” – Source: HFR, MarketWatch

Is that enough for these funds to start delivering alpha again? Only time will tell, but as long as there's more hedge funds than Dunkin' Donuts, count me a skeptic.

***

Related Posts:

The Hedge Fund Myth

The Market Neutral Fantasy

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. Charlie holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and also holds the Certified Public Accountant (CPA) certificate.

In 2017, Charlie was named the StockTwits Person of the Year. He is a frequent contributor to Yahoo Finance and has been interviewed on CNBC, Bloomberg, and Fox Business.

You can follow Charlie on twitter here.

[charliebilello]

How Much Bitcoin Are You Willing to Lose?

Question: What do you call an asset that appreciates 5,555,456% in a little over 7 years?

Answer: Bitcoin.

In 2010, when Bitcoin was trading at $.09 that word meant nothing to most investors. Earlier this month when it crossed above $5,000, it was all investors wanted to talk about.

What changed? The price. It went up, and up, and up.

The thought of turning $10,000 into over $555 million is, needless to say, enticing to some.

As is the thought of owning something that seems to hit a new all-time high milestone nearly every single day.

At a certain point, the fear of missing out (FOMO) becomes palpable: many simply can't stand seeing Bitcoin go up any longer.

How do I know this is true? In late August, investors in the “Bitcoin Investment Trust” were paying $1,005 for Bitcoin assets worth $432, an incredible 132% premium to NAV. Why would a rational investor pay such a hefty premium? Simple: they think they will sell it to someone else at an even higher price. And besides, who said investors were rational?

Leaving aside whether FOMO is good reason to invest in something, what was the risk tolerance of an investor buying into Bitcoin at $5,000? In plain English: how much Bitcoin were they willing and able lose?

A simple question with a not-so-simple answer, especially after an asset class has gone parabolic. We tend to become blinded by such astronomical gains, failing to remember the risk part of the risk/return equation.

I know, I know, Bitcoin never seems goes down. It is the currency of the future. Why worry about risk in an asset that only goes in one direction?

Just humor me for a minute, and try to imagine a world in which Bitcoin drops 39%, 85%, or 94%.

Sounds crazy, I know. But you’ll notice in the table below that this is not a theoretical exercise. In 2011, it went from $32 to $2 in the span of 5 months, declining 94%. From late 2013 to early 2015, it went from 1,166 to $170, an 85% decline. And as recently as June to July of this year, it dropped 39% ($3,025 to $1,837).

In the past two weeks, Bitcoin has sold off 25% from its all-time high. Is that the end of the correction or the start of something much bigger?

I have no idea; nobody does. What I do know is that such a decline is far from atypical and investors in Bitcoin need to understand the risk they are taking.

Lost in the mania this year is the most critical question when it comes to portfolio returns: how much of an allocation are you going to give to each asset class. How much weight will you give to Bitcoin?

Even at its peak market cap of just over $80 billion, Bitcoin would represent less than a .02% allocation to a global market portfolio (click here for my post on this). Needless to say, such a small allocation today would have to have to experience unfathomable returns to make a dent in you overall portfolio returns. For instance, if Bitcoin went from $5,000 to $500,000 (a 10,000% return), it would contribute only 2% to overall returns.

Let’s say you don’t subscribe to traditional market-cap based weightings, and want to take a larger position of 5%, 10%, or more. You believe in Bitcoin and want its impact to be meaningful. That’s your prerogative, just be sure to know what you own, why you own it, and how long you plan on holding it for.

This is an asset with 72% annualized volatility over the past year and historical drawdowns that make the equity market look tame by comparison. Could you handle a 50-90% decline? Would you stick with it for years without making new highs? Can you sleep at night knowing that your account could be hacked into at any moment, losing all of your holdings?

If your answer to all of these questions is yes, how do you size such a position and how will you determine when to adjust that size?

These are just a few of the questions you need to be asking yourself - in advance - to have any chance in sticking with Bitcoin over time. I would spend less time predicting where Bitcoin is going (an impossible task) and more time figuring out how (if at all) it fits into your overall asset allocation plan.

***

Related Posts:

The Evolution of Money

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Put These Charts on Your Wall

Put these charts on your wall for reference the next time you think…

Something is “oversold” or “at support” and has to go back up…

Something is “overbought” and can’t go higher…

It can’t go to 0…

It is certain to default…

Interest rates can’t possibly go any lower…

Interest rates can’t possibly go any higher…

Housing prices only go up…

Valuation is a good reason to short something…

You can call a bubble/top without the benefit of hindsight…

Waiting for a correction will surely enable you to buy in at a lower price…

Volatility can’t possibly go any higher…

The Fed can prevent the stock market from going down…

Value investing is easy…

Following pundits/gurus is an effective investment strategy...

They say a picture is worth a thousand words but in investing it is worth so much more. Having a few extreme charts on your wall can be a helpful reminder that there is no such thing as “can’t,” “won’t,” or “has to” in markets. The market doesn’t have to do anything, and certainly not what you think it should do. The market doesn’t abide by any hard and fast rules; it does what it wants to do - when it wants to do it.

That's what makes it so hard and at the same time so interesting. And that's why listening to the endless prophesies of gurus and pundits can be so dangerous. They don't know anything more about the future than you or I, which is to say they don't know anything at all.

Find some charts that speak to you personally, and post them on your wall. Hopefully they'll serve as a constant reminder that the range of possible outcomes is much wider than you think. You will need to suspend your disbelief at times to succeed, because the market is forever doing things that it has never done before. There is no impossible in this wonderful game, only more or less probable. Truly understanding that can go a long way toward controlling your emotions and becoming a better investor.

***

Related Posts:

The Constants

10,0000 Hours or 10 Minutes: What Does It Take to Be a World-Class Investor?

Being Good at Suffering

Fat Tails and Expecting the Unexpected

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Will the Fed Reach 3% before the Cycle Turns?

The Federal Reserve is currently forecasting a “longer-term” Fed Funds Rate of 3.0%. Will they get there before the end of the current expansion? Let’s take look…

Back in December 2008, the Fed cut rates down to a range of 0% to 0.25%, the lowest level in history. For 7 years they held rates at this level, by far the longest time spent at a trough level in history.

In December 2015, December 2016, March 2017, and June 2017, they hiked rates by 0.25%, to a current range of 1.0% to 1.25%.

The market (Fed Funds Futures) is currently projecting the next 0.25% hike to occur in June 2018 and only one additional hike through July 2020.

The U.S. expansion is currently over 8 years in duration. The longest expansion in U.S. history was 10 years, from 1991 – 2001.

Given this backdrop, is 3% a realistic target before the cycle turns?

It doesn’t seem to be, unless a) the current expansion becomes the longest in history and b) the Fed significantly increases the pace of hikes, doing so against the expectations of market participants.

Observing the Fed’s behavior in recent years, this is unlikely. Their actual policy has been consistently more dovish than their own projected policy and much more in-line with the market:

In March 2012, the Fed projected a 2014 year-end rate of 1.0% (implying 3-4 hikes). The actual target rate at the end of 2014: 0% – 0.25% (no hikes)

In March 2013, the Fed projected a 2015 year-end rate of 1.0% (implying 3-4 hikes). The actual target rate at the end of 2015: 0.25% - 0.50% (1 hike).

In March 2014, the Fed projected a 2016 year-end rate of 2.25% (implying 8-9 hikes). The actual target rate at the end of 2016: 0.50% - 0.75% (2 hikes).

In March 2015, the Fed projected a 2017 year-end rate of 3.125% (implying 12-13 hikes). The current target rate is 1.0% - 1.25% (4 hikes) and is projected to remain there at year-end.

In March 2016, the Fed projected a 2018 year-end rate of 3.0% (implying 12-13 hikes). The market is currently projecting a 2018 year-end rate of 1.42% (5 hikes).

In March 2017, the Fed projected a 2019 year-end rate of 3.0% (implying 12-13 hikes). The market is currently projecting a 2019 year-end rate of 1.56% (6 hikes).

What if the Fed starts surprising market participants with hikes in upcoming meetings? Again, this is unlikely as there hasn’t been a surprise interest rate move in the current cycle. In an effort to squash volatility, the Fed has telegraphed each and every move far in advance and always met the market’s dovish expectations:

From January 2009 through November 2015, the Fed was never expected to hike rates going into a meeting and the Fed delivered as expected, keeping rates at 0% to 0.25%.

In December 2015, for the first time since 2006, the Fed was expected to hike rates. They did so and only hiked again in the December 2016, March 2017 and June 2017 meetings when they were expected to do so.

If this pattern continues, and the Fed is going to meet dovish market expectations, it will be extremely difficult to get to their 3% long-term target. They are much more likely to move their projections lower than to meet them. The Fed has already moved their long-term projections down from 4.25% to 3.0%, and when they meet again in September we should not be surprised to see this trend to continue.

Why?

1) Reported inflation remains subdued, below the Fed’s 2% target.

2) The rest of the developed world continues to maintain an extraordinarily easy monetary policies, with negative real interest rates across the board.

3) Most importantly: the Fed has never once expressed any real concern about unintended negative consequences from keeping rates artificially low for so long. They have only expressed their steadfast belief that easy money has been exceedingly positive for household wealth (higher stock prices/housing prices) and the real economy (via the “wealth effect”).

While some market participants are fretting about another Fed-induced “bubble,” this the last thing the Fed is concerned about. Quite the opposite is true, as stated plainly by Ben Bernanke in an Op-ed back in 2010. They want higher asset prices:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

If there are no negative consequences to easy money, then easy money becomes the default policy. If higher stock prices only lead to higher confidence, increased spending, and higher income, then a forever higher stock market becomes the default target. Any time stock prices go down, you ease (ex: a new round of quantitative easing) or slow the pace of normalization.

In a model that is optimized for asset price inflation, this is perfectly rational behavior. The question is whether a model optimized for long-term real economic growth would look the same. Put simply, is easy money as good for the real economy as it is for the stock market? As we cannot prove the counterfactual (normalized monetary policy years ago), that’s a question that can never really be answered. Which is another reason why the Fed is likely to continue to error on the dovish side, as they can take all of the credit for positive outcomes while arguing that any negative outcomes would be far worse but for their heroic easy money policies.

***

Related Posts:

Are Equity Returns Dependent on Easy Money?

Fed Hikes and Stock Market Returns

Stock Market Tail Wags the Fed Dog

To sign up for our free newsletter, click here.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Markets Don't Crash from All-Time Highs

“Markets don’t crash from all-time highs.”

This old saying is making the rounds again. Why?

The Dow just closed at an all-time high for the 8th consecutive trading day and 34th time in 2017.

That’s a lot of all-time highs, and it comes after the 122 all-time highs in 2013-2016. We haven’t seen this many all-time highs in consecutive years since the 1990’s.

Naturally, investors are feeling pretty good, with one prominent strategist proclaiming today that the bull market could “continue forever.”

Interesting, but what does the saying “markets don’t crash from all-time highs” actually mean? And why do people say it?

It’s supposed to imply that buying all-time highs is safer than buying on any other random day. That because tops are said to take time to build, so there will be plenty of time to “stop dancing” before the music stops. It also implies that the largest declines do not immediately follow all-time highs, because volatility tends to be lower on all-time high days than your average day. As volatility exhibits “clustering,” Benoit Mandelbrot observed that “large changes tend to be followed by large changes, and small changes tend to be followed by small changes.”

Are these assumptions supported by the data? Let’s find out…

First, we need to reaffirm that there is nothing inherently bearish about all-time highs. I’ve covered this many times in the past few years with the simple conclusion that “all-time highs tend to be followed by more all-time highs.”

That’s because, on average, forward returns are positive after all-time highs, meaning more all-time highs. The positive forward returns also happen to be a feature of any other random day, though marginally lower than all-time high days.

Note: all data herein are price returns only, not including dividends.

As for the percentage of positive returns, here too we find a likelihood of further gains, with a small edge to all-time highs in periods less than a year.

What about the risk of loss? An all-time high does not seem to preclude large future losses.

However, the largest losses following all-time highs pale in comparison to other days. Why is that? Because record highs tend to occur in periods of lower volatility. Since 1900, the Dow’s volatility on all-time high days was less than half of its average on all days.

It often takes some time for the market to transition from a period of lower volatility (where declines are small) to a period of higher volatility (where declines are large). Hence the saying: "markets don't crash from all-time highs."

But “some time” does not necessarily mean a long time. In fact, the worst crashes in the last 100 years, 1929 and 1987, both occurred within two months of an all-time high...

On September 3rd, 1929, the Dow hit its 33rd all-time high of the year. Over the next month, it would fall 10% and over the next 3 months it would fall 36%. On October 28 and 29, it fell 12.8% and 11.7% in back-to-back sessions. By the time it bottomed in July 1932, it had suffered an 89% decline. There wouldn’t be another all-time high until 1954.

On August 25, 1987, the Dow hit its 56th all-time high of the year. Over the next 3 months, it would fall 29%, with the largest one-day decline in the last 100 years occurring on October 19 (-22.6%). The Dow wouldn’t hit a new high again until August 1989.

Crashes get all of the attention, but most bear markets are not like 1929 or 1987.

On February 9, 1966, the Dow hit an all-time high. It declined 25% before bottoming that October. A new high was not reached again until 1972.

On January 11, 1973, the Dow hit an all-time high. Over the next 18 months, it would lose 45% of its value. The Dow did not register another new high until 1982.

On July 17, 1990, the Dow hit an all-time high, the same month the U.S. entered a recession. 3 months later, it stood down 21% from those highs.

On July 17, 1998, the Dow hit an all-time high. By, the end of August, it had fallen 20%.

On January 14, 2000, the Dow hit an all-time high. By October 2002, it had lost 38% of its value. The Dow did not register another new high until 2006.

On October 9, 2007, the Dow hit an all-time high. By March 2009, it had dropped 54%. A new all-time high was not hit again until 2013.

The point of this exercise is not to say that the all-time high on August 4, 2017 will join the lexicon of notable peaks, but to understand that it could. There’s nothing magical about an all-time high that prevents large declines from occurring. Indeed, by definition, every bear market in history was preceded by an all-time high.

While volatility clustering makes an imminent “crash” less likely, the environment can change quite rapidly, as we saw in 1929 and 1987. As Nassim Taleb has said, “don’t confuse a lack of volatility with stability, ever.” An all-time high is not without risk.

But the fact remains: stocks tend to go up on average, and as such new all-time highs tend to be followed by more all-time highs. That is as true today as it was on September 3, 1929, January 11, 1973, January 14, 2000, and October 9, 2007. Unfortunately, no one rang a bell at these all-time high tops, alerting you that there would be no new highs for years to come.

Unless this bull market goes on forever, the same will be true today. There will be another large correction. And it will start with an all-time high that looks and feels innocuous. No bell will be rung.

***

Related Posts:

The Best of Times

Is This 1929 or 1997?

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

The Best of Times

It is the best of times.

The age of wisdom.

The epoch of belief.

The season of Light.

The spring of hope.

We have everything before us.

Source: Drudgereport.com

The financial markets have become a tale of one city, a utopia in which the streets are paved with risk-free reward. Try to remember the air of invincibility that abounds today, as we may not see anything like it for years to come…

The S&P 500 ended July up for the 9th month in a row and 16th time in the last 17 months.

The Volatility Index (VIX) hit its lowest level in history.

At 5.6%, annualized volatility in the S&P 500 over the last 12-month is just about as low as it’s ever been.

It’s been more than a year since the S&P 500 has suffered a 5% pullback, the 4th longest streak in history.

The Dow has hit 31 all-time highs in 2017 and has done so with no more than a 3% pullback.

Sentiment is ebullient, with 1) the S&P 500/Dow/Nasdaq 100 on pace for their 9th straight year of gains, 2) record-low volatility, 3) the U.S. economy in its 8th year of expansion, and 4) the Federal Reserve maintaining an extraordinarily easy monetary policy.

Inflation is tame, credit is loose, and any geopolitical concerns (Syria, Iran, North Korea, etc.) are quickly dismissed. Even Greece, who not long ago was said to be certain to default, is back out issuing bonds again. The bond offer was oversubscribed as Greek yields hit their lowest levels since 2009.

President Trump has taken to twitter on a daily basis to promote successes in the stock market, with the implication being that all-time highs are evidence of a booming economy and a direct consequence of his efforts.

If these are the best of times, we should certainly enjoy them, for they will not last forever. But we should also recognize that the best of times tends to mean poorer risk/reward, just at the worst of times coincides with opposite. When the streets appear to be paved with risk-free reward they are instead paved with reward-free risk...

10-years ago, you could have bought 3-month Treasury bills at a 5% yield. Today, U.S. Junk Bonds (HYG) yield less 5%.

European Junk Bond yields are at record lows.

Leveraged Loan (BKLN) yields are at record lows.

None of this matters in the short run. Markets can always go higher; we saw that in 1997 when the Shiller P/E Ratio (CAPE) was at the same level as today (above 30). Exuberance can always become more irrational and greed can always become greedier.

But the tranquility that exists in markets today – from stocks to bonds and everything in between - will be hard to surpass for some time. These are the best of times. Enjoy.

***

Related Posts:

Irrational Optimism

Is This 1929 or 1997?

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Irrational Optimism

In the months following the election, we saw optimism surge higher in a number of prominent indicators…

Homebuilder sentiment hit an 11-year high.

Small Business optimism hit a 12-year high.

Consumer confidence hit a 13-year high.

Philadelphia Fed Manufacturing survey hit a 33-year high.

The thinking was as follows: a new era of higher economic growth was about to take hold, driven by lower taxes, deregulation and massive infrastructure spending. It was said that 5% real GDP, a stronger U.S. dollar, higher long-term interest rates, and higher wage growth were coming.

Reinforcing this belief was the booming stock market in the U.S., hitting new all-time highs on a daily basis and doing so with just about the lowest volatility in history.

Fast forward to today and the stock market continues to hit all-time highs with record-low volatility, but something interesting is developing with respect to the aforementioned levels of optimism. They are starting to move back down…

Homebuilder sentiment has moved down to its lowest level since last November.

Small Business optimism has moved down to its lowest level since last November.

Consumer Confidence has moved down to its lowest level since last October.

Philly Fed Manufacturing Survey has moved down to its lowest level since last November.

But these are just surveys. Perhaps the real economic data is painting a different picture. Let’s take a look…

In the first quarter, Real GDP came in at 1.4%. In the second quarter the Atlanta Fed is projecting 2.5%. The average of the two, 1.95%, is below the expansion average of 2.2%.

In the first six months of the year, the U.S. added an average of 180,000 jobs per month (non-farm payroll report). In the prior five years, the U.S. added an average of 214,000 jobs per month.

In the first six months of the year, U.S. Retail Sales rose at an average pace of .07% per month. Over the prior five years, the average rate of growth was 0.29% per month.

In the first five months of the year, Real Personal Income grew at an annualized rate or 1.89% per year. Over the prior five years, it grew at an average rate of 2.28%.

Based on the data, it would be hard to argue that economic growth is improving, and certainly not supporting the belief that 5% real growth is attainable anytime soon. If anything, growth appears to be slowing down just a bit.

Meanwhile, the U.S. Dollar Index is at a 52-week low, down against every major currency in 2017.

And long-term bond yield have fallen in 2017 while the yield curve (10-year minus 3-month yields) is close to its flattest level of the expansion. The bond market certainly is not buying into a move to 3% real growth, let alone 5%.

But we still have the stock market, hitting new all-time highs on a daily basis with no volatility to speak of. In contrast to the economic surveys, sentiment there has certainly not waned. Is this a signal that 5% growth may indeed be coming? Only if you believe the stock market is the economy.

In recent weeks, the President has suggested as much. Mr. Trump, who called the entire stock market advance under President Obama a “big, fat, ugly, bubble,” has been touting it as a barometer of success…

It would be an understatement to say that there has been no President in history who has mentioned the stock market with greater frequency. This is interesting, for if the stock market is said to be a real-time reflection of his performance, what will the President say when it actually goes down (there hasn’t been a 5% correction since he was elected, one of the longest stretches in history)?

As most market participants understand, the President and their policies have very little influence on equity returns. There are a multitude of factors that drive the stock market (earnings, valuation, sentiment, economy, etc.), and the President is just one microscopic piece of that puzzle. This is as it should be in a free market economy, where no one person has undue influence.

Considering the growing divide between the stock market and the real economy, the question for investors is whether they still believe the post-election narrative to be true. Will the dream of 5% growth be realized and do they take Trump at his word when he says: “we’ve signed more bills – and I’m talking about through the legislature – than any President, ever”?

Rational optimism is the best default mindset to have in the long run. Put simply, things tend to get better over time. But there are times in the short run when optimism can reach a level that is simply not supported by the data, hence becoming irrational. After the election, the homebuilder/consumer/housing/manufacturing surveys were at such a point. In recent months they seem to be slowly coming back to reality, understanding that there was no paradigm shift on election day.

Will the stock market be next?

***

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Innovate or Die

Back in January 2007, Netflix announced a bold plan to bring internet video to television sets. At the time, few believed they would be successful, but such skepticism was nothing new.

The “death” of Netflix was predicted first in late 2002, not long after its IPO. Wal-Mart was entering the DVD-by-mail business, and who could ever compete with the all-powerful Wal-Mart? In 2006, its “death” was again predicted, when both Apple and Amazon announced plans to start movie-downloading services. Surely Netflix could not survive such a threat.

But survive they did, only to find new doubters after announcing their plans for streaming video. Netflix shares had dropped 12% by mid-January of 2007 and analyst downgrades ensued. The streaming video service would cost Netflix an estimated $40 million in 2007, and such a hefty sum was deemed “too much. “

“There’s clearly a strong demand for watching movies,” said Brian Pitz, an analyst with Banc of America Securities. “But the company’s earnings are going to be more negatively impacted,” said Mr. Pitz, who has a sell recommendation on Netflix shares.

At the time, Netflix’s biggest threat was said to come from (don’t laugh) Blockbuster. Blockbuster’s online rental service was “taking off,” adding over 700,000 subscribers in the prior 2 months.

Blockbuster’s CEO had this to say about their closest competitor: “We have everything that Netflix has, plus the immediate gratification of never having to wait for a movie.”

What happened next?

Just 3 years later, Blockbuster would file for bankruptcy protection. Netflix stock has advanced over 5,500% since their streaming video service was announced in January 2007, versus a loss of 99.8% for Blockbuster.

Since its IPO in 2002, Netflix is up over 15,000%, an annualized return of over 40%.

At $79 billion, Netflix is now valued at more than Time Warner, an incredible statistic considering it was less than $5 billion just a few years ago.

Netflix’s rapid ascent in recent years seems easy and inevitable in hindsight, but in truth it was anything but. There were many struggles along the way, and many more doubters than believers. Innovation may be inevitable at the macro level, but at the micro level it is a conscious decision that is fraught with difficulty. For innovation is inherently risky - it must be made with the knowledge that 1) short-term results are likely to suffer and 2) it may take much longer than you think to payoff.

But to maximize long-term growth, and to remain competitive, innovate you must. If you don’t continually disrupt yourself someone else surely will. Innovate or die.

***

Related Posts:

Being Good at Suffering

Big Winners, Big Drawdowns

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Should Investors Fear Rising National Debt?

U.S. National Debt continues to rise and many investors are afraid. This fear is nothing new; it has been around for decades.

Is it rational for equity investors to fear rising debt levels? Let’s take a look.

First, some background.

Since 1966, the U.S. National Debt has risen in each and every calendar year. Through Democrat and Republican administrations - the one constant has been more debt - from $320 billion in 1966 to nearly $20 trillion today. With a current budget deficit north of $600 billion, the national debt clock continues to tick higher.

National Debt as a percentage of GDP is moving higher as well, most recently coming in at 104%. Just 10 years ago this ratio stood at 62%. You have to go back to 1995-2000 to find a period where the ratio was trending lower for any sustained period of time.

Why is the ratio moving consistently higher? For the last 16 years, National Debt growth has outpaced Nominal GDP growth every in every single quarter (on a year-over-year basis). This has been true during both recessionary and expansionary environments, and both Democratic and Republican administrations.

So, were equity investors justified in being concerned with rising National Debt over the years?

Not exactly. U.S. National Debt has increased by 8.4% per year since 1966 and over that time the S&P 500 has advanced 9.7% per year. Clearly rising debt levels by themselves are not an impediment to equity returns.

What about rising Debt as a percentage of GDP?

Again, not exactly. From 1982 to 2016 this ratio moved from 32% to 105%. Over this time period the S&P 500 gained 11.7% per year.

What about large spikes in the debt level. Is that a bearish omen?

Not exactly. The two largest year-over-year increases in National Debt occurred in early 1983 and early 2009 (both >20% increases). Two of the strongest and longest bull markets in history followed.

Interestingly, the National Debt has gone negative year-over-year in only one quarter since 1966. That was in the 3rd quarter of 2000, near the start of the 2000-02 bear market. By the time the bear market ended in the 3rd quarter of 2002, National Debt was once again on the rise (up 7.8% year-over-year).

But isn’t there a breaking point at which National Debt could be a problem for stocks?

Yes, if the National Debt reached a level at which default risk was a real concern, that would be worrisome as it would likely coincide with severe economic weakness. The only problem is no one knows what that level is or when it will occur. We just know we haven’t yet come close to reaching that "breaking point" in the United States.

In 2015, Moody’s developed a “Fiscal Space” metric which attempts to measure the “difference between a nation’s sovereign debt-to-GDP ratio and the limit beyond which the nation will default unless policymakers take unprecedented steps.”

If you trust their analysis, the U.S. is still in the “safe zone,” and far from any significant risk of default.

Japan on the other hand, is in Moody's “grave risk” zone. With an astronomical Debt-to-GDP ratio of over 250%, this isn't exactly surprising.

What may be surprising, though, is that Japanese stocks (EWJ ETF, total return) recently hit a 21-year high.

And at the same time, Japanese yields remain near all-time lows. Even at 250% of GDP, Japan's National Debt still seems to be below its "breaking point."

Japan may be a unique situation but it’s an instructive one nonetheless. There are no hard and fast rules regarding stock market performance and National Debt. In fact, the two variables have had literally zero correlation historically in the United States. National Debt is likely to continue to rise in the foreseeable future and at some point stocks will go down, but that doesn't mean stocks will be going down because of National Debt. Don't confuse short-term correlation with causation.

If you are worried about rising National Debt, that may or may not be a valid concern as it pertains to the economy (many have argued that higher debt levels will impede future growth), but when it comes to the stock market and investing in general such fears do not seem warranted. The stock market is not the economy and it certainly isn't the national debt. Your best protection against the risk of a debt crisis in the future? Diversification, diversification, diversification.

***

Related Posts:

When Home Bias Helps

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Fast Food and Thinking Slow

Investing: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” – Charlie Munger

Over the past 2 years, McDonald’s stock is up over 70% while Chipotle’s is down 38%.

Was this expected to happen? Not exactly.

In July 2015, Chipotle’s stock had advanced 70% over the prior 2 years while McDonald’s gained only 4%.

At the time (2 years ago), most everyone was bullish on Chipotle and bearish on McDonald’s. A few reasons why, beyond the wide differential in recent stock market performance:

A customer satisfaction survey of fast food chains ranked Chipotle #2, trailing only Chick-fil-A. In the same survey, McDonald’s was ranked #17, dead last.

Another prominent survey at the time reported that “Americans trust Chipotle, but not McDonald’s.” Only 30% of respondents said they would invest in McDonald’s, down almost 10% from the year prior.

A headline from business insider read as follows: “McDonald's CEO has a misguided obsession with Chipotle that could drive business into the ground.” The article noted that same-store sales at McDonald’s had fallen for six straight quarters while Chipotle’s business was “booming” with same-store-sales growth of 17%.

Another publication asked: “Does McDonald’s have a Plan for Growth?” The article called the new McDonald’s CEO’s plan for a turnaround a “fiasco” which “doesn’t change the long-term issues the company faces: perceived low-quality food that consumers are increasingly rejecting, and bloated menus that slow food delivery and escalate tensions with franchisees.”

Moody’s downgraded McDonald’s debt, following similar moves from S&P and Fitch.

First-level thinking in July 2015 would have consisted of the following:

Chipotle is great company and McDonald’s is bad company.

I think Chipotle’s earnings will rise and McDonald’s will fall.

I want to buy Chipotle and sell/short McDonald’s.

Second-level thinking in July 2015 would have consisted of the following:

Chipotle is a good company but everyone thinks it’s a great company. I think Chipotle’s earnings will rise less than people expect. By extension, Chipotle’s stock is overloved and overvalued.

McDonald’s is a good company but everyone thinks it’s a bad company. I think McDonald’s earnings will fall less than people expect. By extension, McDonald’s stock is underloved and undervalued.

I want to buy McDonald’s and sell/short Chipotle.

With the benefit of hindsight, selling Chipotle and buying McDonald’s in July 2015 may have seemed like an easy decision. In reality, it was anything but. As Howard Marks wrote:

“Anyone who thinks it is easy is a first-level thinker …  first-level thinkers see what’s on the surface, react simplistically, and buy or sell on the basis of their reactions … the first-level thinker simply looks for the highest-quality company, the best product, earnings growth or the lowest p/e ratio. He’s ignorant of the very existence of a second level at which to think, and of the need to pursue it.”

Contrast this with the thought-process of a second level thinker…

“Is it good? Do others think it’s as good as I think it is? Is it really as good as I think it is? Is it as good as others think it is? Is it as good as others think others think it is? How will it change? How do others think it will change? How is it priced given: its current condition; how I think its condition will change; how others think it will change; and how others think others think it will change? And that’s just the beginning. No, this isn’t easy.”

The next time you are ready to make a change in your portfolio, ask yourself whether you are being a first-level thinker or a second-level thinker. Ask yourself whether you are thinking fast or slow, and if you have any valid reason to expect a superior return than the market.

***

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Will There Ever Be Another Correction?

Will there ever be another correction?

An absurd question to be sure, but one I’m fielding with increasing frequency these days.

Why?

It’s been more than a year since the S&P 500 declined as much as 5% from a prior high. That’s quite a long time, now the 5th longest period without a correction in history. With recency bias in hand, investors are starting to forget that corrections are a normal occurrence in markets.

We haven’t seen such a prolonged stretch of calm in U.S. equities in over 20 years. One could argue that 2017 thus far has been the most peaceful market in history, as measured by record-low volatility and unfathomably low drawdowns.

So will there ever be another correction?

I think it’s a safe bet that there will be, unless the laws of risk and return have been repealed. We just don’t know when, we don’t know why, and we don’t know how deep it will be.

That uncertainty can drive one crazy, but it is that uncertainty which is necessary for the risk premium to exist. For without the prospect of risk in equities there would be no reward. It is not another correction that we should fear, then, but instead the widespread belief that there may never be another one.

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

What Happens When the Nasdaq 100 Lags?

Over the past month, the Nasdaq 100 ETF (QQQ) is down 3.7% while the S&P 500 (SPY) is up 0.01%.

Is this a good, a bad thing, or a “nothing burger” for markets?

Let’s take a look at the data to find out.

First, it’s important to note that such a wide divergence in performance is relatively rare. Out of 4,573 trading days since the inception of the Nasdaq 100 ETF, there were only 73 instances where QQQ was down more than 3% over the prior month while SPY was positive.

In those 73 instances, the forward S&P 500 returns have been below average in all time periods from 10 days through 12 months. The percentage of positive returns is also below average.

On average, it seems that Nasdaq 100 weakness in the face of a resilient S&P 500 tends to be a negative factor for the market ahead. When the Nasdaq 100 lags, the S&P 500 tends to follow that weakness, particularly over the subsequent month.

Will that be the case today? I don’t know. These are only averages; there have been many times where the Nasdaq 100 has been weak and nothing bad occurred.

But with the S&P 500 up 8 straight months and 15 out of the past 16 entering July, it is certainly something to consider.

With the Nasdaq 100 leading to the downside and Technology representing the largest sector in the S&P 500 (at 22%), a larger drawdown (than the near record low of 2.8%) in the coming months would not be surprising. It would be more surprising if such a drawdown did not occur.

***

Related Posts:

What Happens When a Long Uptrend Ends?

From Silver Linings to Gray Skies

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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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Picking Up $100 Bills

If you saw a nickel on the ground, would you pick it up? Would your answer change if it was a $1 bill? How about a bag of $100 bills?

Thus far in 2017, short volatility traders have been picking up the equivalent of industrial-sized garbage bags filled with $100 bills. In shorting equity volatility - via ETFs, futures, or options – they have been earning what seems like a risk-free reward. Volatility has never been this consistently low for so long, and shorting it has therefore never been easier.

But the word around town is finally getting out. It is hard keep traders quiet for long when they are picking up bags filled with $100 bills.  Non-commercial futures traders have built up their largest net short volatility position in history. Every one, it seems, is lining up to receive their free bags of money.

What could go wrong here? Nothing at all, I’m sure, unless by some freak occurrence there happens to be a bulldozer or steamroller passing by.

For a long time the geniuses at Long Term Capital Management (LTCM) picked up nickels in what seemed to be a risk-free arbitrage. With annualized returns of almost 40%, those nickels added up to a nifty sum. And then, just like that, it was gone. A steamroller passed by in May 1998, and then another in June, and then a few more in July and August.

By September 25, 1998, LTCM’s equity moved down to $400 million. With liabilities of over $100 billion, they were leveraged 250 to 1. The partners of LTCM once had $1.9 billion of their own money invested in the fund, all of which was wiped out. A bailout by the Federal Reserve Bank of New York was organized to prevent a wider financial collapse.

It’s been almost 20 years since LTCM and nearly 10 years since the 2008 financial crisis. Memories fade and new traders without that emotional baggage have entered the markets.

How many of these traders today have leveraged short volatility positions on, operating under the assumption that volatility will stay low forever? I don’t know, but we’ll find out soon enough. The names change but the moral of the story never does. If you pick up nickels long enough you will one day look up to find a steamroller inches away.

Think you can move out of harm’s way in time? Indeed, as does everyone else.

***

Related Posts:

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To sign up for our free newsletter, click 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.

CHARLIE BILELLO

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Tall Tales and Transports

“The Transports are rallying, hitting new all-time highs. That’s extremely bullish for the broad market.” - Pundit

One of the tallest of tall tales in markets is the myth of all-powerful Transports. When Transportation stocks are hitting new highs, as they are today, all is said to be well in the world. Investors can safely buy the broad market with an expectation of nothing but blue skies ahead.

Back in July 2011, we heard the same fable from a renowned pundit. Transports were hitting new highs with the S&P 500 still below its peak in April. "Bullish," he said.

What followed? A sharp sell-off and 20% decline until a bottom was hit in October.

I can still recall the days in early June 2008 when the Transports rallied to hit new highs. “The Bear Market is over,” I remember one so-called “Technician” declare without an ounce of reservation.

What followed? The worst declines since the Great Depression, in a bear market that took the S&P 500 down 57% before bottoming in March 2009.

This should not have come as a surprise. Indeed, we had seen this movie before. In January 2001, the Transports hit a new all-time high, leading many to say that the broad market declines which began in March 2000 were over.

What followed?  The sharpest losses bear market that took the S&P 500 down 51% before bottoming in October 2002.

Should we conclude from these examples that Transports hitting new all-time highs without the S&P 500 is actually a bad thing? No, certainly not. The average forward returns from this scenario, while slightly below average, are still positive.

What we can say, though, is there’s nothing in the data to suggest that Transports hitting new highs are an unusually bullish signal. And as we saw in 2001, 2008, and 2011, there’s nothing to suggest that sharp declines can be ruled out when Transports are strong. To the contrary, the last 3 bear markets all saw Transports hitting new all-time highs just prior to the steepest losses.

***

Related Posts:

First, Do No Harm

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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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

What Happens When a Long Uptrend Ends?

The Nasdaq 100 ETF is in the midst of its longest uptrend in history: 138 consecutive trading days above its 50-day moving average.

On CBNC today (click here to view) I discussed a number of factors that are signaling a potential end to this historic run (click here for my recent post on gray skies). If the streak is indeed coming to an end, what does that mean for the market? Is it a signal of a top, a bottom, or nothing at all?

To answer that question, let’s take a look back in history at the end of prior uptrends in the Nasdaq 100 ETF (QQQ).

2010 – 2011

Streak ends with an 8% correction. New highs soon follow.

1999 – 2000

Streak ends with a 36% correction, marking the start of the 2000-2002 Bear Market.

2003

Streak ends with a 7% correction. New high soon follow.

2014

Streak ends with an 8% correction. New highs soon follow.

2006

Streak ends with a minor 4% pullback. New highs soon follow.

2004-2005

Streak ends with a 14% correction. New highs are not hit until November 2005, 11 months after the prior high.

2007

Streak ends with a 10% correction. New highs soon follow, culminating in the bull market peak in October 2007.

What Happens When a Long Uptrend Ends?

Most of the time, there’s a pullback/correction which is followed shortly thereafter by new highs. We saw this in 2011, 2003, 2014, 2006, and 2007. Why does this tendency to run right back to new highs occur? One theory: the many participants who missed out on the uptrend finally get their chance to buy the dip, and once it starts moving higher again they jump on board. This is what seems to happen most of the time.

But most of the time is not always. In 2005, a deeper correction of 14% ensued which took some time (11 months) to reach new highs again. The most bearish example was after the 1999-2000 uptrend which saw an initial 36% correction that marked the start of a devastating bear market.

Which will occur this time around? I don’t know. Nobody does. The only thing I would say is that such a break will likely coincide with higher volatility in markets. We illustrated the relationship between moving averages and volatility in a research paper last year, showing that volatility tends to increase when indices are trading below commonly referenced moving averages such as the 50-day and 200-day.

Over the past two months, the Volatility Index (VIX) has seen 9 out of its 19 lowest closes in history. Given the mean-reverting nature of volatility, we should expect to see higher levels in the back half of the year. A break below the 50-day moving average would only strengthen that case.

***

Related Posts:

From Silver Linings to Gray Skies

Is This as Good as It Gets?

Leverage for the Long Run

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

Is This 1929 or 1997?

The CAPE Ratio or “Shiller PE” just crossed above 30.

In layman’s terms, what does that mean?

Stock valuations in the U.S. are high.

How high?

Going back to 1871, the only periods in history with a CAPE above 30 were as follows (data from Robert Shiller):

August to September 1929

June 1997 to March 2002

Today

In August 1929, the CAPE ratio moved above 30 for the first time in history. A month later the S&P 500 would hit a generational high. From there, it would fall over 86% before bottoming in June 1932.

In June 1997, the CAPE ratio moved above 30 for the second time in history. From there the S&P 500 would gain an additional 80% before peaking in March 2000 at a CAPE ratio of 43. From the peak in March 2000 to the low in October 2002, the S&P 500 would give back all of those gains, declining over 49%.

Is this 1929 or 1997?

Neither. This is 2017. No one knows what will happen from here because every time is different. Stocks could fall starting tomorrow or they could run for a few more years, going from “overvalued” to more overvalued. Or they could trade in a sideways range for years to come, frustrating bears and bulls alike. Anything can happen in the short-run and we should be surprised by none of it.

With the CAPE ratio above 30 (>96th percentile), what should investors be prepared for in the longer-run?

Below average forward returns.

Above average forward volatility.

Above average forward maximum loss.

These are probabilities, not predictions. Objectively, the risk/reward in U.S. equities is less favorable today than it has been in some time. That says nothing about what will happen tomorrow, but if the price one pays for something still matters, will be a factor weighing on returns for years to come.

After the CAPE ratio hit 30 in 1929, the S&P 500 would trade at the same level 25 years later, in 1954 (note: price only, not including dividends).

After the CAPE ratio hit 30 in 1997, the S&P 500 would trade at the same level 12 years later, in 2009 (note: price only, not including dividends).

With the CAPE ratio above 30 once again, how many years into the future will the S&P 500's current level of 2450 be revisited?

***

Related Posts:

Valuation and Volatility

Valuation, Timing, and a Range of Possible Outcomes

To sign up for our free newsletter, click 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.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

[charliebilello]

From Silver Linings to Gray Skies

“I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, “Well, you know this is a bull market!” he really meant to tell them that the big money was not in the individual fluctuations but in the main movements – that is, not in reading the tape but in sizing up the entire market and its trend.

And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! “

    – Reminiscences of a Stock Operator

Since I penned the “Silver Linings Playbook” for markets on February 11, 2016, the “main movements” have been up. Thinking has been a liability. Brexit, the U.S. elections, Syria, North Korea, and Comey - all reasons to think - and all distractions from the primary trend. Sitting has earned the “big money,” as it always does during long uptrends.

And a long uptrend it has become, with the S&P 500 holding above its 200-day moving average for 242 straight trading days, one of the longest runs in history.

The Nasdaq 100 Index ETF (QQQ) is currently tied for the longest streak above its 50-day moving average in history, at 130 consecutive trading days.

Above the surface, all seems to be well in the world, as I outlined recently in “Is This as Good as It Gets?” It has rarely been easier to sit still and enjoy your gains than it has been in the first half of 2017. Every minor drawdown has been met with strong buying, soon followed by new all-time highs. Equity returns with bond-like volatility – what’s not to like?

But all good things come to an end. There comes a time when thinking is necessary and dare I say prudent. Is now such a time?

You be the judge…

1) With the Dow at an all-time high, the yield curve is aggressively flattening, nearing an expansion low of 80 basis points.

2) With the Fed hiking today to a range of 100 to 125 bps (its 4th hike since December 2015), short-term yields are at their highest level since 2008. Meanwhile, long-term yields (10-year and 30-year) are at 7-month lows.

3) Credit, which had been a bastion of strength since February 2016 is starting to show some signs of weakness. Energy spreads, which caused problems for markets back in 2015-16, are at their widest levels in more than 6 months.

4) The spread between low volatility (SPLV) and high beta (SPHB) stocks has been widening, with defensive names hitting new highs while cyclical names are struggling to remain positive on the year.

5) Momentum stocks, which have been leading all year, are showing their first sign of weakness. The fact that Goldman Sachs is “mulling the death of value investing” is an interesting aside.

6) Talk of a pickup to 5% real GDP growth after the election is not being confirmed by inflation expectations, which are hitting 7-month lows.

7) Speculative fever seems to be waning in other asset classes, as evidenced by the 38% drop in the Bitcoin Investment Trust (GBTC) over the last 6 trading days. In early June investors were paying a 133% premium to buy this trust. Today that premium is down to 42%.

8) Jeremy Grantham, who has been forecasting low U.S. equity returns for the past seven years based on elevated valuations, is throwing in the towel. “This time seems very, very different,” he wrote in a recent piece arguing why higher equity valuations will persist.

9) The Nasdaq 100 ETF (QQQ), which as mentioned earlier is in the midst of a record uptrend, is showing higher volatility on higher volume. For the first time in a long time, there at least appears to be some uncertainty as to its near-term direction.

From Sitting to Thinking

As I write, all is calm in the world. After the Fed hike and announcement of future plans for a balance sheet reduction, the S&P 500 finished down only 2 points. The Dow hit a new all-time high. The Volatility Index (VIX) remained at one of its lowest levels in history (10.64).

It is the complete opposite of the backdrop on February 11 of last year. This has me thinking, about the risk/reward in a market (S&P 500) that has risen over 35% since that time. The above factors (some objective, some subjective) are not by any means absolute, but taken together point to a less favorable position.

Whether that less favorable risk/reward manifests itself in a 5% correction, a 10% correction, or no correction at all remains to be seen. Just because the skies are gray doesn’t mean it will actually rain. But it does mean that if you don’t bring your umbrella and it does rain, you will get wet.

Depending on your time frame, you may or may not care about getting wet. Most investors can handle getting a little wet. Fewer investors can handle a downpour. Fewer still can handle a hurricane.

The problem is that no one rings a special bell ahead of a hurricane in markets.  There is no way to tell, in advance, the difference between a drizzle, a downpour and a flood. As such, if you want to manage risk and can’t handle a large drawdown, you have to behave the same the same way every time the evidence points to a less favorable risk/reward. Because you just don’t know when the next flood is coming.

If you want to protect on the downside, you have to be willing to be wrong, early and often. There is no other way. You have to accept that the rain may never come.

***

Related Posts:

Is This as Good as It Gets?

Silver Linings Playbook

To sign up for our free newsletter, click 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.

CHARLIE BILELLO

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.