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[johnhuber]

Buffett’s Comments on Why Airlines Are Bad Businesses

“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”

        – Warren Buffett, 2007 Shareholder Letter

Berkshire Hathaway’s latest 13-F filings show new investments in all of the major airlines ($AAL, $DAL, and $UAL, and Buffett mentioned in an interview that they also bought Southwest Airlines ($LUV) after the end of the quarter, which won’t show up until next quarter’s regulatory filings). This is very interesting because Buffett’s 2007 Shareholder Letter has some pointed language toward why he doesn’t (or didn’t) like airlines. Of course, it is widely presumed that these investments were made by Todd Combs or Ted Weschler, the two portfolio managers that Buffett hired a few years back. But regardless, it’s interesting that airlines are now part of Berkshire’s equity portfolio. 

The 2007 Shareholder Letter also discusses a topic that we’ve discussed quite a bit: the concept of return on capital, why it’s important, and how to think about it.

For those interested, you could review all the previous posts on the concept of ROIC here.

Basically, I just thought I’d make a few brief comments on Buffett’s ideas here, but largely just clip a few portions of the letter, since I think this is a really useful topic to think about.

In this 2007 letter, Buffett groups businesses into three general categories based on their ROIC profile, and explains the differences between those three categories.

Category #1—High ROIC Businesses with Low Capital Requirements

“Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

“Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

“At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.”

Buffett then talks about the return on incremental capital and how he thinks about ROIC:

“We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

“Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)”

I used this general back of the envelope math when thinking about return on capital (see this post for details on how I think about calculating incremental ROIC). It’s helpful to know roughly how much capital a business requires, how much of its earnings it can retain and reinvest, and what the returns from those investments will look like going forward.

So See’s invested an incremental $32 million over the life of the business which produced an additional $1.35 billion of aggregate profits over that time, an astronomically high return on capital. Obviously, See’s is a “capital light business” and the ROIC is high because the denominator is low. See’s couldn’t reinvest that cash flow at high rates of return, so it had to ship the cash to Omaha for Buffett to reinvest elsewhere.

Category #2—Businesses that Require Capital to Grow; Produce Adequate Returns on that Capital

Companies like See’s produce huge returns on the small amount of capital that it previously invested. These are rare businesses that can grow their earning power without capital investment. In See’s case, this was largely done through pricing power. But See’s is a rare business, and as Buffett points out, companies that can reinvest capital at high rates of return are still attractive businesses to own:

“There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

“A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

“One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

“Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

“Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.”

Category #3—Businesses that Require Capital but Generates Low Returns

Here he uses the often-cited airline business as one that requires a lot of capital but can’t generate a decent return on that capital:

“Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

“The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.”

He sums it up by using a savings account analogy:

“To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”

What’s interesting is that Buffett talks about See’s as the most attractive type of business in this example, and certainly a business that produces steadily rising cash flow on a very low capital base is a great business. But a business that has the ability to retain and reinvest a large portion of its cash flow at high rates of return is also a great business in my view.

See’s is great because it produces cash flow without the need for capital investments, and it can still grow its earnings through pricing power. So this is truly an exceptional business. Moody’s might be a similar business—the ability to grow without new capital, which in essence means an infinitely high return on capital.

But those companies are incredibly rare birds. The next best business (and depending on the rate of return maybe even a better business) is one that can reinvest lots of capital at very high rates. This is where the compounding machine kicks into gear.

I used the example of CMG in the previous post mentioned above. The company had incredible attractive restaurant-level economics: it could set up a new location for around $800,000 and in the first year that restaurant would generate over $2 million in sales and $600,000 in cash flow, or a 75% return on capital.

Combine these high returns, with a long runway to put lots of capital to work (it was able to maintain these returns while growing from 500 stores to over 2000), and you have a formula for a compounding machine of great proportions.

CMG invested $1.25 billion during the decade between 2006-2015, an investment that led to $435 million of incremental earnings, an outstanding 35% return on incremental capital:

These high returns on capital led to steadily rising intrinsic value for the business over that time. In these types of businesses, requiring a lot of capital is a good thing (or at least certainly not a bad thing if it can be reinvested at 75% cash on cash returns).

Another example is Markel, an insurance business that is obviously much more capital intensive than See’s Candy, but yet has been an incredible compounding machine over the years thanks to its ability to retain its earnings and reinvest them back into the business at high rates of returns. The result of these high returns on incremental capital has been a steadily rising intrinsic value per share (and stock price):

Buffett himself described this type of business in an earlier letter (1992) when he said:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

So we might think two categories of great businesses:

Those that can retain and reinvest most/all of its earnings at high rates of returns

Those that don’t have any reinvestment ability within the business but can still grow earning power with little to no incremental capital

In a durable business with predictable cash flows, the latter category leads to a compounding effect that sees earning power per share impacted by the absolute growth of earnings as well as the steadily shrinking share count.

Both types of businesses are rare birds, but I would say the second category (the See’s or Moody’s type businesses that can produce sizable free cash flow using very little capital and can grow its earnings through pricing power) is exceedingly rare, but probably the most valuable.

A Few Other Posts on the topic of ROIC:

Calculating the Incremental ROIC

Importance of ROIC: Compounding and Reinvestment

Reinvestment Moats vs. Legacy Moats

Capital Light Compounders

I also wrote a piece (Good Businesses Tend to Stay Good) on our new research site where Matt Brice and I discuss our investment ideas, share our research notes on the companies we follow, and discuss various investing topics with readers. That post discusses some research that (somewhat surprisingly) points to how high returns on capital are more sustainable than one might think, given the nature of capitalism.

Thanks for reading!

______________________________________________________________

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at [email protected].

[stefancheplick]

What generational breakouts mean and look like in the stock market

The stock market tends to move in cycles.

These cycles are influenced by tectonic shifts in supply and demand caused by new technologies and trend changes. But these shifts do not happen overnight. They evolve and expand over many years.

In the 1950s, for example, US stocks were the center of attention. There was a new global powerhouse, World War 2 was over, and the US was rebuilding and expanding after years of war. It was one of greatest economic expansions in history.

Another example is the 1990s. At that time technology was emerging at rapid rates and showing glimpses of its game-changing potential. It was at this time companies like Amazon, Microsoft, and Apple were all getting started or growing.

Both of these periods were huge generational breakouts for US stocks.They were some of the most powerful bull markets in history. They were generational breakouts that looked like this:

[thefatpitch]

About That "Secular Low in Yields"

Perhaps the most prevalent storyline in the markets over the past several years has been the long term secular decline in interest rates. Not just in the United States, but worldwide, low economic growth and persistently weak inflation has contributed to falling sovereign yields.

Interest rates have historically moved in cycles. On a relative basis, yields were as low as they are now for most of the period between 1900 and 1960 (the 10 year is currently 2.2%). Rates rose for 20 years until 1920 and then fell for 30 years into the 1950s. Then came a long secular rise in rates until 1980. That 30 year period has been followed by one even longer, as rates have cycled down over the past 4 decades. Enlarge any image by clicking on it.

Over the past several weeks (and especially since last week’s election), some smart money managers have declared that the secular decline in yields is now over and that rates are beginning a long term move higher. Read Ray Dalio’s views here.

They might be right. It is, objectively, too early to say.

In the chart above, notice that the change from a secular decline to a secular rise in rates 60 years ago did not take place overnight. For some 15 years in the 1940s and 1950s, rates oscillated between 2-3% before finally moving sustainably higher.

If you’re thinking “but that was 60 years ago”, you have just put your finger on the main problem with trying to pin point a secular change. By definition, they don’t take place very often, during which time the world has massively changed.

We’ll know in hindsight, but if yields are now in a secular uptrend, the change in direction will probably once again take time to unfold. Right now, it suddenly looks like higher yields are a one-way bet. It’s probably a better bet that “the market” will obscure the change in the long-term trend through fluctuations in the short-term trend.

How so?

30 year yields are very much in a falling channel. In July, yields bottomed at 2.1%; they’re now almost 3%. They could rise further to 4% and still be in a declining secular pattern. If a nearly 200 basis point change seems like a lot, recall that yields fell by that amount (from 4% to 2.2%) during calendar 2014.

It’s also important to realize that the 1200 basis point rise in rates between 1960 and 1980 was extreme. Again, the secular rise in rates between 1900 and 1920 was a relatively minor 200 basis points. A secular rise now might be similarly minor. Overtime, it might just look like rates are moving within the yellow shaded band (first chart above).

The current rise in yields began this summer from the bottom of a 35 year declining channel (chart above). At that point, the momentum of decline had reached an extreme that had previously been close to a low in yields at least 7 other times in the past (in the chart below, top panel and green line). Like now, yields rebounded higher each time (arrows).

Objectively, yields could now just be reacting to an “oversold low” as they have many times before. It’s too early to say otherwise.

It’s worth pointing out the importance of investor psychology in the movement of rates over the short term (measured in months). Right now, the prevailing opinion is that a secular low occurred this summer. Well, what did money managers think about this at the time of that low? In short, they didn’t believe it at all.

In July when the 30 year dropped to 2.1%, fund managers surveyed by BAML had their highest exposure to bonds in more than 3-½ years. Just 2% believed that the global economy would improve over the next 12-months (chart below). In other words, they were convinced that yields would continue to move lower. Instead, they reversed much higher. That pattern of swinging investor psychology has played out consistently over the past decade and at each inflection point, yields have reversed (numbers in red are US 30-year yields). Read more about this in a post from July here.

Momentum has room to run higher, carrying yields higher. Momentum is just starting to reach an extreme now (red line and top panel). This has sometimes been the top for yields but yields have just as often continued higher. In the past 35 years, most of the move higher in yields has taken place by the time momentum reaches current levels. In mid-2013, yields moved 40 basis points higher over the next 6 months before turning lower. In other words, don’t count on a quick resolution to the debate about a secular low.

Investor positioning and sentiment suggests the change in the relative performance of bonds (down) versus equities (up) should continue longer.

Over the past 18 months, investors’ money has been flowing consistently out of equity funds. On a net basis, about $130b has left domestic equity mutual funds and ETFs. You can track that data every week here (chart below uses data from ICI).

The dates on the chart have been meaningful for SPX. The equity index fell about 17% in the 6 months following the April 2011 peak in equity flows. The index then rose about 50% from the November 2012 low in equity flows to the March 2015 high. Since March 2015, equity flows have been negative and the equity index has been oscillating near 2100, making little net progress.

Those fund outflows have recently become extreme. The 10-week moving average is the lowest ever. It’s a small sample, but after similar cases, SPX has always moved higher (arrows). The first arrow might look like it preceded a tiny rally, but SPX moved more than 8% higher in two months. A similar move now would put the index near 2275 (data from Lipper; chart from Sentimentrader).

Schwab looks at the same equity fund flow data but over a trailing 12 month basis (orange line). Again, the sample size is small but their view is that this correlates well with the next 5 year change in equity prices (blue line).

As an aside, the evidence suggests that equity outflows have been mostly due to retail investors exiting. Fund flows for institutional investors has been mostly flat since early 2015 (data from the Fed).

Where has the money that has left equity funds gone? Mostly to bond funds.

In the past 45 weeks, during which equity funds have seen outflows 82% of the time, bond funds have seen inflows 71% of the time. The data is even more skewed than that because in many of those weeks, equity inflows and bond outflows were tiny.

Until July/August, favoring bonds over stocks made sense as bonds had been outperforming since early 2015. Recall, the 30-year yield marked its low in July. But since then, equities have outperformed, and since the election, bonds have been routed.

Money usually follows performance. It’s a good guess that fund flows might soon begin to favor equities. If past is prologue, then equities should continue to gain and bonds should continue to sell.

The most recent data on fund managers’ investment allocations agrees with the fund flow data. Last month, allocations to equities relative to bonds, commodities and cash were near the lows formed in mid-2010, 2011 and 2012. Equities moved higher and bonds moved lower (yields moved higher) at those junctures. Read more on this here (data from BAML).

One final word on equity fund flows. We will know in hindsight, but it seems unlikely the recent equity fund outflows are due to demographics. Boomers reached retirement age starting in 2011 but there was a large increase in retirement age Americans starting already in 2005.  We should have seen equity outflows start earlier if demographic forces were predominant. More on demographic shifts in a new post here (data from Doug Short).

To summarize: In July, fund managers’ had their highest exposure to bonds in 3-½ years. In other words, they expected yields to keep falling. Instead, yields reversed higher and have since risen so sharply that several smart money managers now say that a new secular uptrend in yields is taking place. That is a big call, given that the foregoing secular downtrend has lasted more than 35 years.

Over the past 18 months, investors’ money has been flowing consistently out of equity funds. Where has that money gone? Mostly to bond funds. Money usually follows performance, so it’s a good guess that fund flows might soon begin to favor equities. If past is prologue, then equities should gain and bond yields should continue to rise. Whether that will constitute the start to a new secular uptrend for yields it is far too early to say.

[forcerank-blog]

Post-election, Health Care sees the biggest move in this week’s Forcerank Sector contest

After one of the biggest upsets in US presidential history last week, the election of Donald Trump has caused quite a bit of volatility in the markets. In this week’s Forcerank US Sector ETF competition, we see those sectors expected to gain the most under a Trump presidency rise to the top. Financials held onto their #1 spot from the prior week, Health Care rose to the #2 position from 8th in the previous week, and Industrials held steady at #3. 

Play in US Sectors contests now for next week »

It’s no surprise that Financials maintain their leading position, as the expectation of deregulation and a repeal of Dodd-Frank should help the banks.

Play in Financials contests now for next week »

Health Care reform is also high up on Trump’s priority list, including dismantling the Affordable Healthcare Act, although that language has softened a bit since last week. Insurers such as Aetna (AET) and UnitedHealth Group (UNH) are up around 10% since Wednesday. Pharma and biotech stocks have also been strong, breathing a collective sigh of relief as a Hillary Clinton presidency would have likely limited drug price gouging activities. 

Play in Healthcare contests now for next week »

Industrials are also receiving a boost. The need to rebuild American manufacturing and infrastructure were paramount to Trump’s campaign platform. Such efforts would boost names such as United States Steel (X) and Caterpillar (CAT) which have otherwise seen financial performance bottom out in recent years. Aerospace & Defense companies such as Lockheed Martin (LMT) and General Dynamics (GD) are also likely to surge as new defense contracts are expected to be doled out next year.

Play in Industrials contests now for next week »

Check out the rankings for the other contests running on Forcerank this week!

Play in Consumer Discretionary contests now »

Play in Commodities contests now for next week »

Play in Energy contests now for next week »

Play in Forex contests now for next week »

Play in Global Indices contests now for next week »

Play in Technology contests now for next week »

Play in Catalyst contests now for next week »

(Photo Credit: Matt Johnson)

[kimblecharting]

Hot Banks, do not want to turn cold here!

Banks have had several extended periods of being “Hot & Cold” over the past 10-years. Since 2007, they have been much cooler than hotter. Over the past couple of months, they have been much hotter, than the broad market.

Are banks about to turn Cold again or become much much hotter? Below looks at Power of the Pattern thoughts on the question-

CLICK HERE TO ENLARGE CHART ABOVE

Banks have been much hotter than the S&P since hitting support at (1). Premium Members went long banks right after support was hit for the second time in a few months. What caught our eye, the ratio was near the 2009 financial crisis lows and was at the same prices as the lows back in 2011. Both times, banks had strong rallies.

While many say banks have rallied since the election was over, they actually started pushing higher, over 100 days ago.

In 2014 the ratio hit highs and Banks proceeded to under perform the broad market for nearly two years. Now the ratio is testing horizontal resistance at (2). The Risk On trade in Banks and the broad market wants/needs banks to remain hot and breakout at (2)! Biggest/most important risk on test for banks, in the past 24 months.

[jeffhirsch]

The Market Called the Election

Even with all the polling, prognosticating and predicting, the Electoral College delivered a surprise result late Tuesday/early Wednesday morning. Most polls were right as Hillary Clinton did in fact win the popular vote, but in the end Donald Trump took the votes on the Electoral College map. There were a poll or two that indicated Trump would win, but they were largely dismissed as outliers. Even the market was largely ignored even though its record of forecasting the winner is quite good, 15 of 18 prior to this year.

Including 2016 in the above table, S&P 500 has correctly predicted the outcome of the last 19 Presidential Elections 16 times. When the S&P 500 gains in the three months August through October, the incumbent party retained the White House 9 of 11 times. When S&P 500 was down during those three months the incumbent lost 7 of 8 times. S&P 500 was down for August to October in 2016 and the incumbent party lost. This next graphic plots past Incumbent Victories and Defeats alongside 2016. Despite the market’s “surprise” plunge on Election night, it had already indicated an incumbent defeat

[factorinvestor]

Five points of caution for dividend investors

At a time when demand for income generating assets is at an all-time high, the yields on income generating assets are at, or near, all-time lows. While the headlines often speak to the number of Baby Boomers entering retirement, the more important statistic is actually the amount of wealth entering retirement. According to the U.S. Census Bureau, of the 125 million households in the U.S., 32% fall between the ages of 55 and 70. That group also represents a disproportionate 57% of median household net worth. Assuming these retirees and near-retirees started saving around age 30, that would place the beginning of their “investment memory” somewhere between 1976 and 1991 and continuing to the present. That entire span was encapsulated by arguably the greatest bond bull market ever, and some of the most robust equity returns in history.

As this cache of wealth is in or approaches the distribution phase of the investment lifecycle, the thirst for income generating assets will be unquenchable. Most retirement models are predicated on a 4% annual withdrawal from retirement assets. In a world of sub-2% equity and bond yields, such a large annual withdrawal seems optimistic and susceptible to substantial sequence-of-return risk.

Though this cohort lived through a golden age of financial asset return, they have also experienced the most dramatic bear markets since the Great Depression. The tech bubble in the early 2000’s and financial crisis of the late 2000’s marks the first time two greater-than 40% downturns occurred in a ten year span, again since the Great Depression. An adaptation of the old adage, twice bitten thrice shy, may appropriately describe many investors.

McKinsey captured the outcome of this phenomenon in a recent report, which suggested that investors are laser focused on: 1) protecting principal, 2) hedging against severe downside risks, 3) minimizing volatility and 4) generating income. While the active management industry has been toiling to identify yet uncovered sources of alpha, investors seem to just want a reliable combination of principal protection and income generation at a reasonable fee. Investor sentiment has shifted, for now, from performance to solutions-focused objectives.

ETF assets confirm the popularity of at least two of these preferences (chart below). The most popular ETF categories, outside of the broad shift to market-cap weighted passive vehicles, are low volatility and dividend-focused.

While equity income could never be a substitute for the principal stability of fixed income, it does offer compelling long-term income generating potential. With equity yields at or higher than yields on most 10-year government bonds, they are no doubt becoming an increasingly popular component of retirees portfolios.

Five considerations for seeking dividend income

Dividend investing requires great care, particularly in the current environment. The combination of poor recent performance, elevated stock valuations, and uncertainty as to the path of interest rates are enough to perplex most investors. In speaking with advisors and clients across the country, we have identified five key considerations for equity income investors.

Dividends performed terribly in the years preceding 2016; that’s a good thing

We have just emerged from a period when stocks with strong dividend yield have struggled. As an investment theme, dividend yield found itself at the epicenter of three major events that conspired to drive lackluster performance—oil, the US dollar, and US outperformance. The crash in the price of oil in late 2014 took its toll on Energy firms. As oil recovered from its 2008 lows, profitability at large oil and gas exploration and production firms increased. They expanded their dividend programs and dividend investors found solace in the strong dividend yields offered. As oil declined in 2014, these previous darlings of the dividend space sold off. Because oil and the US dollar tend to be inversely related, the US dollar strengthened during this period. For global dividend investors, the strengthening of the US dollar served as an additional headwind to performance. Further compounding the performance issues for globally-oriented investors, persistent geopolitical concerns have resulted in dramatic underperformance of developed international and emerging markets. As of October month end, the S&P 500 was beating its developed and emerging counterparts by around 10% annualized over the trailing three years (even with the recent bounce in emerging markets).

Below is a snapshot of calendar year excess returns for stocks with strong dividend yield and dividend growth. Whether you favored dividend yield or dividend growth from 2012-2015, domestically or abroad, chances are high that performance has been challenged.

It would be easy to cast dividend payers aside for that reason, but know that historically it is very common for investment factors to come in and out of favor. So far in 2016, dividend yield has experienced a solid recovery. The chart below shows the rolling five year excess performance of stocks in the top quintile of dividend yield back to the 1970’s. Notice that periods of underperformance are followed by prolonged and/or significant periods of outperformance. If history serves as a guide, its possible the recovery of dividend yield experienced so far this year may continue for years to come.

Certain dividend payers historically buck the rising rate performance headwind

The fear of rising interest rates has been particularly alarming for some investors, most notably back in 2015 as the Fed wavered on when rates would increase. For the most part, the pain inflicted there was psychosomatic. The Fed had actually started tightening as far back as 2013 with the announcement of “taper” (when the Fed started reducing its monthly bond purchases). With some positive recent economic data, rates have again moved higher in anticipation of a hike. The concern now is that interest rate sensitive assets—Utilities in particular—will get torpedoed if the Fed starts raising in earnest.

When we looked at the 12 environments where the 10 year US Treasury rose by 1.0% or greater over a 12 month period, we found evidence to support that suspicion. The Utilities sector underperformed in ten of the 12 environments and had an average underperformance of -8.5% on an annualized basis. Real Estate (REITs) underperformed, but robust data only covers three of the rising rate environments so it’s challenging to draw inference. Beyond REITs, Financials are the second worst performer with banks underperforming by 5% on average across all the periods. On the positive side, Energy and Info Tech did exceptionally well, outperforming by 6.1% and 7.4% on average, respectively. Energy outperformed in eight of the 12 environments while Info Tech outperformed in nine. It’s important to note that these are averages across some very unique periods in market history—from the inflationary death spiral of the 1970’s to the tech bubble of the late 1990’s.

Be wary of dividend ETF’s; they offer less diversification than investors are led to believe

Financial innovation is a wonderful thing. ETF’s are a wonderful thing. But, investor assets are becoming more and more concentrated in specific investment themes, and specific investment vehicles. While I have my own thoughts on the concentration in passive investment vehicles, I’ve found a few assessments to be particularly provoking, such as the one below which discusses the implications of passive investing on corporate competitive behavior.

The dividend theme may be particularly susceptible to this phenomenon of concentration into investment vehicles. In a recent analysis, we analyzed the four most popular dividend ETFs to see what names they hold in common. The results are summed up in the graphic below. The largest circles represent an ETF. Each of the spokes is an individual stock holding and is scaled to its weight across the ETFs. The spokes connect each stock to the ETFs in which it is held. For the sake of simplification, only underlying holdings with a greater than 3% weight receive a ticker label.

Notice that the largest names tend to be those that are held in common between all of the ETF's—those stocks in the middle of the map. The stocks that are unique to an ETF tend to be the smallest weights and line the periphery. We found it quite surprising how similar the ETF’s are; only 20% of the total weight across the 4 ETF’s is unique. 80% of the assets have at least one holding in common with the other three ETF’s. 30% have two holdings in common. And 9% of the assets are held in common across all four ETF’s.

Here’s why that matters. Individual investors should realize that when owning the most popular investment products, their fate is tied to the whims of the masses. These vehicles provide near instant liquidity, which can result in massive and rapid flows out of the ETFs and their underlying stocks. Because the ETF’s have similar underlying holdings, sales out of one ETF can result in price declines for holdings in the other ETF’s, creating a downward spiral in a panic scenario. When the Fed did raise rates in December 2015, fearful investors withdrew $30 billion in assets from dividend ETF’s in the two months following the hike.

Yet, short-term trigger-happy speculators often tend to be wrong. From December 15, 2015 when the Fed raised rates through 9/30/2016, stocks with strong dividend yield delivered an 18% total return. Many a crisis negotiator will impart the advice of “slow it down” in times of stress. We may have gotten to the point where financial innovation, ETF’s, have made it a little too easy to hit the sell button. Let’s slow it down a notch.

Dividend growth on its own is not an effective strategy

As valuations have risen on the highest yielding stocks, dividend managers are seeking dividend stocks with modest valuations. As an alternative to pure yield, dividend growers provide ready access to income and the perception of safety. Unfortunately, they fall short on performance. Quite simply, stocks with the best dividend growth have actually underperformed the market since the mid 1970’s on average. There are bright spots in that nearly five decade span, but since the credit crisis, dividend growth has muddled along.

The chart above looks at the total annualized excess return of various dividend growth metrics—1, 3, 5 and 10 year annualized dividend growth. What we found was that stocks with high dividend growth really don’t offer much on the performance front. Take, for example, stocks with high 10 year dividend growth, they actually underperform the market by 0.7%, while stocks with low 10 year dividend growth outperform. Further, stocks with low 5 year dividend growth counter-intuitively outperform the market and those stocks with high dividend growth. Dividend growth may expand the opportunity set for income investors, but it is not a panacea. 

Valuation trumps dividends

Valuations are rising across the board. The market is nowhere near the single digit price to earnings ratio we saw in mid-2009. Today, it is not uncommon to find investment strategies that aspire to a “value-based” investment philosophy carrying a PE ratio greater than 20x. Unfortunately, a lot of those strategies also fall in the dividend space. A byproduct of the massive flows (about $90 billion since 2009) into dividend focused strategies is that valuations have been pushed higher. In the analysis of popular dividend ETFs above, we found that stocks receiving a disproportionate amount of those flows—stocks with the greatest weights in the ETFs—were more expensive than the lower weighted holdings. Underlying stocks with a greater than 1% weight were more expensive than stocks with less than a 1% weight on average by between 17% and 37% depending on the value metric used—price to sales, price to earnings, price to cash flow, or price to book.

This positioning runs contrary to what we know from the historical record. From 1975-2016, a focus on discounted valuation within the dividend yield theme meant the difference between outperforming the market and underperforming. Below, we narrow the investment universe to dividend stocks falling in the highest-yielding third and then subdividing further to create three high-yielding portfolios differentiated by valuation. These portfolios share one thing in common, high dividend yield, but are differentiated by another—valuation. High yield and discounted valuation outperform high yield and expensive valuation by 5.4% annualized. The price you pay is an all important constant in investment success. 

A few suggestions

Thinking about the five considerations outlined above, we have outlined some suggestions for seeking equity income allocations.

Flows into equity income are not likely to stop anytime soon. There is too much demographic demand for income producing assets. It is important to recognize, however, that there are only so many large high-quality dividend paying firms. The trends towards ETF’s has concentrated flows into a relatively small swath of the overall market. At some point, even the best companies can become bad investments due to high valuations. Be cognizant of the price you are paying for dividend income, and seek discounted pricing even if you have to sacrifice yield.

Ensure that there is low overlap across dividend-focused portfolios you hold. This means diving into individual ETF’s and mutual funds to make sure they don’t hold the same investments. One way to do this is to hold strategies with different objectives within the dividend space: US dividends, global dividends, small cap dividends, etc.

As we move into a rising interest rate cycle, it may be prudent to consider shying away from the sectors (Utilities and REITs) that have done poorly in those environments. However, as evidenced by the performance of yield after the December 2015 rate hike, don’t underestimate the total return potential of the dividend theme. Sometimes markets become too pessimistic, which breeds opportunity, as was the case late last year.

Recognize that dividend yield and dividend growth on their own are not the most effective stock selection factors. Dividend yield does better than dividend growth, but valuation reigns supreme historically. Pair yield and valuation with quality considerations like balance sheet strength and cash-based earnings to insure the dividend is sustainable.

Calculated based on the number of households by age cohort and their share of the weighted median net worth for households across age cohorts.

“The $64 trillion question: Convergence in asset management”. Pooneh Baghai, Onur Erzan, and Ju-Hon Kwek. Feb 2015.

OSAM calculations, top quintile of dividend yield for global large capitalization stocks.

[stefancheplick]

Did Someone In The Stock Market Know Trump Was Going To Win?

The following chart will have you thinking.

Did someone know Trump was going to win? Or was it a calculated risk-reward investment? Or just pure coincidence?

Hillary Clinton once made waves, during her campaign, with the following sentence:

“We’re going to put a lot of coal miners and coal companies out of business.”

You might think quotes like this would have hurt coal stocks and the entire coal sector. But let’s take a look at what the market did despite this quote. What you’re about to see is the largest coal ETF in the stock market and how it performed over the last year, heading right into the election:

[dragonflycap]

What to expect from the stock market this week

A weekly excerpt from the Macro Review analysis sent to subscribers on 10 markets and two timeframes.

Last week’s review of the macro market indicators noted that heading into the first full week of November and with the US elections Tuesday, the equity markets were weak and hemorrhaging. Elsewhere looked for Gold ($GLD) to continue higher in the short term while Crude Oil ($USO) continued to move lower.

The US Dollar Index ($DXY) looked to continue to the downside while US Treasuries ($TLT) were biased lower but consolidating. The Shanghai Composite ($ASHR) continued to drift higher while Emerging Markets ($EEM) were biased to the downside. Volatility ($VXX) looked to remain elevated keeping the bias lower for the equity index ETF’s $SPY, $IWM and $QQQ. Their charts agreed and looked better to the downside on both the daily and weekly timeframes.

The week played out in two phases with the pre-election drift higher and then post election rotation. Gold started higher and then reversed to end at 6 month lows while Crude Oil also started higher and then fell later in the week. The US Dollar moved higher all week while Treasuries continued lower, accelerating after the election. The Shanghai Composite pushed higher, with a bit more gusto post election, while Emerging Markets started higher but reversed and dropped quickly, ending at 4 month lows.

Volatility pulled back slightly to start the week and crashed post election back to the normal range. The Equity Index ETF’s started the week drifting higher into the election. Election night saw limit down moves in the futures markets and then a full recovery and more the following day. Then came the rotation as the small cap IWM continued to rocket higher and the QQQ moved lower, while the SPY marked time. What does this mean for the coming week? Lets look at some charts.

SPY Daily, $SPY

The SPY started the week with a gap higher off of its 200 day SMA, and ran to its 20 day SMA. It continued Tuesday into the election and up to short term resistance. Wednesday saw an open at the low after overnight futures had been limit down, and then a drive higher all day, erasing the drop and adding significant upside. Thursday saw it stall at prior important resistance/support levels after a small rise, and then held there with a small body candle Friday.

The daily chart shows the RSI stopped just shy of 60, and a move into the bullish zone, with the MACD rising though and the Bollinger Bands® opening to the upside. A good week that will frustrate some as it could not clear resistance. The weekly chart shows a strong move higher. The RSI on this timeframe is moving up off of a lower low, with the price moving up off of a higher low, creating a Positive RSI Reversal.

This one targets a move to 229.33. The MACD is turning back up as well. There is resistance at 217 and 218 before 219 and 219.50. Support lower comes at 215.70 and 214 before 212.50 and 210.20. Uptrend Resumes with Possible Short Term Consolidation.

SPY Weekly, $SPY

With the election in the rearview mirror and heading into the last full week before Thanksgiving and the holiday season begins, equity markets are looking a bit mixed but positive. Elsewhere look for Gold to continue lower while Crude Oil moves lower in the short term as well.

The US Dollar Index looks strong and ready to challenge the 2015 highs while US Treasuries are biased continue lower. The Shanghai Composite is looking strong as it continues higher while Emerging Markets are at key support and looking weak if it does not hold. Volatility looks to remain at lower normal levels now that the election has passed keeping the bias higher for the equity index ETF’s SPY, IWM and QQQ.

Their charts are a bit mixed though with the IWM leading a charge higher towards new all-time highs while the SPY stalls just below highs and the QQQ struggles in consolidation. Use this information as you prepare for the coming week and trad'em well.

Join the Premium Users and you can view the Full Version with 20 detailed charts and analysis: Macro Week in Review/Preview November 11, 2016

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[chrisciovacco]

Does The Trump Rally Look Sustainable Or Vulnerable?

Exploring A Wide Range Of Post-Election Outcomes

As Brexit reminded us, the initial reaction from markets is often not the longer-term reaction. We have all seen predictions with markets crashing and a global recession under the “Trump is elected” scenario. While the bearish case has merit, it is always prudent to explore a wide range of possible economic and market outcomes. From A Wealth Of Common Sense:

The recession/crash scenario is certainly one to consider. But here’s one scenario not many people will be talking about — it’s possible that within the next couple of years we could see a melt-up in the markets. No one really knows what Trump’s policies will be (possibly not even him yet) but he has stated numerous times that he plans on doing massive infrastructure spending. He’s always promised tax cuts and isn’t afraid of large budget deficits. If anything like this were to happen, we could see much higher corporate profits and higher inflation. If this were to occur I think it’s possible that we could see a massive shift in investor allocation preferences which could potentially take the stock market into bubble territory.

This Is What Risk-Off Looks Like

Investor preferences allow us to better understand the stock market’s risk reward profile. When economic fear was high in 2008, the performance of growth-oriented stocks (SPY) was weak relative to defensive-oriented bonds (AGG).

This is What Risk-On Looks Like

When fear started to subside in March 2009, equities started to outperform bonds, telling us the risk-reward profile of the general stock market was improving.

This Is What Today Looks Like

How does the same stock/bond ratio look after election week is in the history books? If we compare and contrast the three periods (2007 peak, 2009 bottom, and 2016 post-election), the present day looks more like the favorable risk-on period in 2009 than the unfavorable risk-off period in 2007-08.

Investment Implications - The Weight of The Evidence

Is it possible the 2016 stock/bond ratio is skewed by the expectation the Fed will raise rates in December? To address that question and examine the weight of the evidence, this week’s video presents numerous risk-on/risk-off ratios, including long vs. short, retail vs. bonds, total stock market vs. defensive consumer staples, base metals vs. bonds, small caps vs. bonds, junk bonds vs. Treasuries, and materials vs. bonds. The video also looks at the market’s reaction to Trump’s platform and anticipated policies.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

After reviewing the video above, you can draw your own conclusions about the odds of the Trump rally being sustainable relative to a bearish reversal. Time will tell.

[frankzorrilla]

Epic Week

It was an unforgettable week for Wall Street and Main Street. It all started Tuesday night, as Trump chances of winning was becoming clearer the dimmer the Futures were looking. At around 11 pm when it was almost clear that he would be the new President the SP500 futures were limit down -5%

One has to wonder if Hillary had won if the reaction would’ve been the exact opposite; limit up first and then limit down. Leading up to the elections there was a lot of put buying, and one can argue that many were caught off guard on the short side and then were forced to cover.

Small caps, Biotechnology, Industrials, and Copper were the standouts on the positive side. FANG (Facebook, Amazon, Netflix, Google, Apple, and many other technology stocks were the clear losers, along with Gold, Gold Miners, Bonds, and Emerging Markets. The huge moves in the winners and losers this week probably was overdone. These are ‘bigly’ moves are based on hope and possibilities of what can change with the new administration, changes that may or may not happen, and regardless it’s way too soon. Suddenly, a couple of legendary (Carl Icahn, Stanley Druckenmiller) investors who have been bearish for years turned bullish and are now confident about the market/economy and our new elect President. In hindsight, their bearish view now looks more like it was political more than anything else. Three days in and suddenly a Trump presidency detoured the U.S economy for these guys? By looking at Icahn’s stock any change is good, look below.

The small-cap index had a helluva week, the type of rally it had this week typically only happens when you are in a deep bear market. It seems like they try to price in 4-years of a Trumpstatic economy in 3 days.

The overly enthuse will think this will be a non-stop move higher, but the tendency of the last few years has been for the market to stall and turn down after touching highs.  Here you have the stats when the Small Cap index has had a winning streak of 5-days or more. Courtesy of Schaeffer’s Research

The case for the move higher in biotechs/pharma this week was the fact that the Republicans won the house and that Hillary lost, maybe the new administration won’t come down as hard on them for price gouging.  Another reason for the bullishness this week might be the fact that U.S. based pharma companies have $98-billion overseas that might have to come back into the U.S. and that could lead to significant acquisitions in the sector. For more on this click here. The fear in the FANG stocks might come from comments Trump made during his campaign. Fear that they may have to bring back all the cash they have overseas and pay a massive tax bill, or it could just be a huge rotation into stocks that might benefit more under the new elect, I think it is way too early to come to a conclusion. The market is very dynamic, and it never pays to have firm opinions based on what you think is going to happen. Here is a possible playbook based on previous presidential cycles;

Frank Zorrilla, Registered Advisor In New York. If you need a second opinion, suggestions, and or feedback in regards to the market feel free to reach me at [email protected] or 646-480-7463.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

[thefatpitch]

The Boomers Have Already Been Overtaken By The Millennials

Nearly 20 years ago, investors started becoming concerned about the aging demographic profile in the United States. The concern was understandable: the largest birth cohort in the nation’s history was close to entering retirement. Between 1940 and 1950, the number of births per year in the US increased by a massive 45%, and that group would begin retiring in 2005. Enlarge any chart by clicking on it (data from Doug Short).

An aging population consumes and produces less, draws down savings and equity holdings and requires greater publicly-funded services. Japan had already started feeling the ill affects of a rapidly aging population and the fear was that the US was destined to be next.

What happened instead was this: an average of 3 million Boomers entered retirement every year starting in 2005, but the population of the country grew by nearly the same amount. Between 2005 and 2015, the total population of the US increased by more than 25 million.

As a proportion of the total, retired Americans has increased. That should surprise no one. Not only are Boomers reaching retirement, but successive birth cohorts are living longer. But the impact has been relatively minor. Retirement-age Americans have increased from 12.3% of the population in 2005 to 14.8% in 2015.

Importantly, the working-age population in the US increased by 7% (15 million workers) during the past decade. In Japan, the working-age population declined by 10%.  The two countries had the same dependency ratio (proportion of retirement age to working age populations) in 1991. By 2015, the dependency ratio had more than doubled in Japan, to 43%; in the US, it barely increased, from 19% to just 22%.

Immigration accounts for some of the differences. The more important aspect is this: the Millennial and Gen Z birth cohorts (those born after 1980 through early 2000s; definitions are not universally agreed on) are as large as the Boomers. About 4 million were born in each cohort each year. Starting this year, Millennials are the largest living cohort in America, overtaking the remaining Boomers (data from Pew).

Consequently, as late Boomers enter retirement-age over the next decade (left-side in chart below), nearly the same number of Millennials and Gen Z'ers will be entering the working-age population (right-side). These will not be perfectly offsetting (again, successive generations are living longer), but the burden of supporting an aging population will fall on a working population that is also growing (data from Doug Short).

None of is to say that the US will not become older. It will. But the US is not like many other advanced economies and the impact will likely be far less. The cohort following the Boomers (Gen X) is a much smaller group than that following the Millennials (the appropriately named “Post-Millennials”). Gen Xers start to retire in 2030 but Post-Millennials already begin to reach working age in the next few years (data from Pew; article here).

American’s aged 20 to 39 declined in the mid-1990s until about 2010. Since then, that age group has been growing strongly. Based on the birth cohorts presented above, the 20 to 39 age group will continue growing strongly past 2060. Not only is this a prime working age group but one which heavily consumes housing and other goods as they pass through their reproductive and household formation years (data from Calculated Risk, here).

The upshot, to paraphrase Bill McBride, is this: “Demographics is a key driver of economic growth. Most people focus on the aging of the baby boomer generation.  But by 2020, eight of the top ten largest cohorts (five year age groups) will be under 40, and by 2030 the top 11 cohorts will be the youngest 11 cohorts. The movement of these younger cohorts into the prime working age is a key economic story in coming years.”

[stefancheplick]

Did Donald Trump Just Change The Entire Market? Two Charts To Think About

Let’s look at two of the biggest sectors in the market and what they did after the election.

These two sectors are tech and industrials.

The first chart shows XLK. This is one of the largest technology sector ETFs. Its holdings include Apple, Microsoft, Facebook, and Google. The red arrow shows what this sector did after the election. Not much. It actually dropped from its all-time highs:

Now let’s look at the next chart.

This chart shows one of the largest industrial ETFs. It holds stocks like General Electric, Boeing, and 3M. This chart, in particular, really stands out. Look what happened:

The Industrials ETF hit new all-time highs following the election.

The election may have just changed the course of the market by putting one sector in favor and the other out of favor.

[stefancheplick]

Did Someone In The Stock Market Know Trump Was Going To Win?

The following chart will have you thinking.

Did someone know Trump was going to win? Or was it a calculated risk-reward investment? Or just pure coincidence?

Hillary Clinton once made waves, during her campaign, with the following sentence:

“We’re going to put a lot of coal miners and coal companies out of business.”

You might think quotes like this would have hurt coal stocks and the entire coal sector. But let’s take a look at what the market did despite this quote. What you’re about to see is the largest coal ETF in the stock market and how it performed over the last year, heading right into the election:

[factorinvestor]

Five points of caution for dividend investors

At a time when demand for income generating assets is at an all-time high, the yields on income generating assets are at, or near, all-time lows. While the headlines often speak to the number of Baby Boomers entering retirement, the more important statistic is actually the amount of wealth entering retirement. According to the U.S. Census Bureau, of the 125 million households in the U.S., 32% fall between the ages of 55 and 70. That group also represents a disproportionate 57% of median household net worth. Assuming these retirees and near-retirees started saving around age 30, that would place the beginning of their “investment memory” somewhere between 1976 and 1991 and continuing to the present. That entire span was encapsulated by arguably the greatest bond bull market ever, and some of the most robust equity returns in history.

As this cache of wealth is in or approaches the distribution phase of the investment lifecycle, the thirst for income generating assets will be unquenchable. Most retirement models are predicated on a 4% annual withdrawal from retirement assets. In a world of sub-2% equity and bond yields, such a large annual withdrawal seems optimistic and susceptible to substantial sequence-of-return risk.

Though this cohort lived through a golden age of financial asset return, they have also experienced the most dramatic bear markets since the Great Depression. The tech bubble in the early 2000’s and financial crisis of the late 2000’s marks the first time two greater-than 40% downturns occurred in a ten year span, again since the Great Depression. An adaptation of the old adage, twice bitten thrice shy, may appropriately describe many investors.

McKinsey captured the outcome of this phenomenon in a recent report, which suggested that investors are laser focused on: 1) protecting principal, 2) hedging against severe downside risks, 3) minimizing volatility and 4) generating income. While the active management industry has been toiling to identify yet uncovered sources of alpha, investors seem to just want a reliable combination of principal protection and income generation at a reasonable fee. Investor sentiment has shifted, for now, from performance to solutions-focused objectives.

ETF assets confirm the popularity of at least two of these preferences (chart below). The most popular ETF categories, outside of the broad shift to market-cap weighted passive vehicles, are low volatility and dividend-focused.

While equity income could never be a substitute for the principal stability of fixed income, it does offer compelling long-term income generating potential. With equity yields at or higher than yields on most 10-year government bonds, they are no doubt becoming an increasingly popular component of retirees portfolios.

Five considerations for seeking dividend income

Dividend investing requires great care, particularly in the current environment. The combination of poor recent performance, elevated stock valuations, and uncertainty as to the path of interest rates are enough to perplex most investors. In speaking with advisors and clients across the country, we have identified five key considerations for equity income investors.

Dividends performed terribly in the years preceding 2016; that’s a good thing

We have just emerged from a period when stocks with strong dividend yield have struggled. As an investment theme, dividend yield found itself at the epicenter of three major events that conspired to drive lackluster performance—oil, the US dollar, and US outperformance. The crash in the price of oil in late 2014 took its toll on Energy firms. As oil recovered from its 2008 lows, profitability at large oil and gas exploration and production firms increased. They expanded their dividend programs and dividend investors found solace in the strong dividend yields offered. As oil declined in 2014, these previous darlings of the dividend space sold off. Because oil and the US dollar tend to be inversely related, the US dollar strengthened during this period. For global dividend investors, the strengthening of the US dollar served as an additional headwind to performance. Further compounding the performance issues for globally-oriented investors, persistent geopolitical concerns have resulted in dramatic underperformance of developed international and emerging markets. As of October month end, the S&P 500 was beating its developed and emerging counterparts by around 10% annualized over the trailing three years (even with the recent bounce in emerging markets).

Below is a snapshot of calendar year excess returns for stocks with strong dividend yield and dividend growth. Whether you favored dividend yield or dividend growth from 2012-2015, domestically or abroad, chances are high that performance has been challenged.

It would be easy to cast dividend payers aside for that reason, but know that historically it is very common for investment factors to come in and out of favor. So far in 2016, dividend yield has experienced a solid recovery. The chart below shows the rolling five year excess performance of stocks in the top quintile of dividend yield back to the 1970’s. Notice that periods of underperformance are followed by prolonged and/or significant periods of outperformance. If history serves as a guide, its possible the recovery of dividend yield experienced so far this year may continue for years to come.

Certain dividend payers historically buck the rising rate performance headwind

The fear of rising interest rates has been particularly alarming for some investors, most notably back in 2015 as the Fed wavered on when rates would increase. For the most part, the pain inflicted there was psychosomatic. The Fed had actually started tightening as far back as 2013 with the announcement of “taper” (when the Fed started reducing its monthly bond purchases). With some positive recent economic data, rates have again moved higher in anticipation of a hike. The concern now is that interest rate sensitive assets—Utilities in particular—will get torpedoed if the Fed starts raising in earnest.

When we looked at the 12 environments where the 10 year US Treasury rose by 1.0% or greater over a 12 month period, we found evidence to support that suspicion. The Utilities sector underperformed in ten of the 12 environments and had an average underperformance of -8.5% on an annualized basis. Real Estate (REITs) underperformed, but robust data only covers three of the rising rate environments so it’s challenging to draw inference. Beyond REITs, Financials are the second worst performer with banks underperforming by 5% on average across all the periods. On the positive side, Energy and Info Tech did exceptionally well, outperforming by 6.1% and 7.4% on average, respectively. Energy outperformed in eight of the 12 environments while Info Tech outperformed in nine. It’s important to note that these are averages across some very unique periods in market history—from the inflationary death spiral of the 1970’s to the tech bubble of the late 1990’s.

Be wary of dividend ETF’s; they offer less diversification than investors are led to believe

Financial innovation is a wonderful thing. ETF’s are a wonderful thing. But, investor assets are becoming more and more concentrated in specific investment themes, and specific investment vehicles. While I have my own thoughts on the concentration in passive investment vehicles, I’ve found a few assessments to be particularly provoking, such as the one below which discusses the implications of passive investing on corporate competitive behavior.

The dividend theme may be particularly susceptible to this phenomenon of concentration into investment vehicles. In a recent analysis, we analyzed the four most popular dividend ETFs to see what names they hold in common. The results are summed up in the graphic below. The largest circles represent an ETF. Each of the spokes is an individual stock holding and is scaled to its weight across the ETFs. The spokes connect each stock to the ETFs in which it is held. For the sake of simplification, only underlying holdings with a greater than 3% weight receive a ticker label.

Notice that the largest names tend to be those that are held in common between all of the ETF's—those stocks in the middle of the map. The stocks that are unique to an ETF tend to be the smallest weights and line the periphery. We found it quite surprising how similar the ETF’s are; only 20% of the total weight across the 4 ETF’s is unique. 80% of the assets have at least one holding in common with the other three ETF’s. 30% have two holdings in common. And 9% of the assets are held in common across all four ETF’s.

Here’s why that matters. Individual investors should realize that when owning the most popular investment products, their fate is tied to the whims of the masses. These vehicles provide near instant liquidity, which can result in massive and rapid flows out of the ETFs and their underlying stocks. Because the ETF’s have similar underlying holdings, sales out of one ETF can result in price declines for holdings in the other ETF’s, creating a downward spiral in a panic scenario. When the Fed did raise rates in December 2015, fearful investors withdrew $30 billion in assets from dividend ETF’s in the two months following the hike.

Yet, short-term trigger-happy speculators often tend to be wrong. From December 15, 2015 when the Fed raised rates through 9/30/2016, stocks with strong dividend yield delivered an 18% total return. Many a crisis negotiator will impart the advice of “slow it down” in times of stress. We may have gotten to the point where financial innovation, ETF’s, have made it a little too easy to hit the sell button. Let’s slow it down a notch.

Dividend growth on its own is not an effective strategy

As valuations have risen on the highest yielding stocks, dividend managers are seeking dividend stocks with modest valuations. As an alternative to pure yield, dividend growers provide ready access to income and the perception of safety. Unfortunately, they fall short on performance. Quite simply, stocks with the best dividend growth have actually underperformed the market since the mid 1970’s on average. There are bright spots in that nearly five decade span, but since the credit crisis, dividend growth has muddled along.

The chart above looks at the total annualized excess return of various dividend growth metrics—1, 3, 5 and 10 year annualized dividend growth. What we found was that stocks with high dividend growth really don’t offer much on the performance front. Take, for example, stocks with high 10 year dividend growth, they actually underperform the market by 0.7%, while stocks with low 10 year dividend growth outperform. Further, stocks with low 5 year dividend growth counter-intuitively outperform the market and those stocks with high dividend growth. Dividend growth may expand the opportunity set for income investors, but it is not a panacea. 

Valuation trumps dividends

Valuations are rising across the board. The market is nowhere near the single digit price to earnings ratio we saw in mid-2009. Today, it is not uncommon to find investment strategies that aspire to a “value-based” investment philosophy carrying a PE ratio greater than 20x. Unfortunately, a lot of those strategies also fall in the dividend space. A byproduct of the massive flows (about $90 billion since 2009) into dividend focused strategies is that valuations have been pushed higher. In the analysis of popular dividend ETFs above, we found that stocks receiving a disproportionate amount of those flows—stocks with the greatest weights in the ETFs—were more expensive than the lower weighted holdings. Underlying stocks with a greater than 1% weight were more expensive than stocks with less than a 1% weight on average by between 17% and 37% depending on the value metric used—price to sales, price to earnings, price to cash flow, or price to book.

This positioning runs contrary to what we know from the historical record. From 1975-2016, a focus on discounted valuation within the dividend yield theme meant the difference between outperforming the market and underperforming. Below, we narrow the investment universe to dividend stocks falling in the highest-yielding third and then subdividing further to create three high-yielding portfolios differentiated by valuation. These portfolios share one thing in common, high dividend yield, but are differentiated by another—valuation. High yield and discounted valuation outperform high yield and expensive valuation by 5.4% annualized. The price you pay is an all important constant in investment success. 

A few suggestions

Thinking about the five considerations outlined above, we have outlined some suggestions for seeking equity income allocations.

Flows into equity income are not likely to stop anytime soon. There is too much demographic demand for income producing assets. It is important to recognize, however, that there are only so many large high-quality dividend paying firms. The trends towards ETF’s has concentrated flows into a relatively small swath of the overall market. At some point, even the best companies can become bad investments due to high valuations. Be cognizant of the price you are paying for dividend income, and seek discounted pricing even if you have to sacrifice yield.

Ensure that there is low overlap across dividend-focused portfolios you hold. This means diving into individual ETF’s and mutual funds to make sure they don’t hold the same investments. One way to do this is to hold strategies with different objectives within the dividend space: US dividends, global dividends, small cap dividends, etc.

As we move into a rising interest rate cycle, it may be prudent to consider shying away from the sectors (Utilities and REITs) that have done poorly in those environments. However, as evidenced by the performance of yield after the December 2015 rate hike, don’t underestimate the total return potential of the dividend theme. Sometimes markets become too pessimistic, which breeds opportunity, as was the case late last year.

Recognize that dividend yield and dividend growth on their own are not the most effective stock selection factors. Dividend yield does better than dividend growth, but valuation reigns supreme historically. Pair yield and valuation with quality considerations like balance sheet strength and cash-based earnings to insure the dividend is sustainable.

Calculated based on the number of households by age cohort and their share of the weighted median net worth for households across age cohorts.

“The $64 trillion question: Convergence in asset management”. Pooneh Baghai, Onur Erzan, and Ju-Hon Kwek. Feb 2015.

OSAM calculations, top quintile of dividend yield for global large capitalization stocks.

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The Market Called the Election

Even with all the polling, prognosticating and predicting, the Electoral College delivered a surprise result late Tuesday/early Wednesday morning. Most polls were right as Hillary Clinton did in fact win the popular vote, but in the end Donald Trump took the votes on the Electoral College map. There were a poll or two that indicated Trump would win, but they were largely dismissed as outliers. Even the market was largely ignored even though its record of forecasting the winner is quite good, 15 of 18 prior to this year.

Including 2016 in the above table, S&P 500 has correctly predicted the outcome of the last 19 Presidential Elections 16 times. When the S&P 500 gains in the three months August through October, the incumbent party retained the White House 9 of 11 times. When S&P 500 was down during those three months the incumbent lost 7 of 8 times. S&P 500 was down for August to October in 2016 and the incumbent party lost. This next graphic plots past Incumbent Victories and Defeats alongside 2016. Despite the market’s “surprise” plunge on Election night, it had already indicated an incumbent defeat

[jlfmi]

Traders Breathe Unprecedented Sigh Of Relief Following Election

Stock market volatility expectations saw the biggest drop on record following the election.

In the buildup to the presidential election, we queried whether “Investors Were Over-Prepared For Election Volatility?”. The reason behind that observation was that near-term (e.g., 9-Day) volatility expectations, via the VXST, had jumped to the 3rd highest level ever relative to the 1-Month VIX. This was despite just moderate stock declines at the time. It was obvious that they were nervous about something, i.e., the election, other than mere price declines. But had they gone overboard with their volatility bets?

We looked back at similar historical extremes and came to a somewhat surprising discovery. As we stated in that November 1 post:

Now, normally our inclination upon seeing a sentiment reading at an extreme would be to fade it. After all, the crowd is notoriously wrong at extremes. However, the funny thing about this VXST/VIX indicator (and much of the volatility trade in general) is that the extremes are often warranted, at least in the short-term.

And:

That is, more often than not, a spike to an extreme in the VXST/VIX ratio initially led to short-term weakness, prior to a rebound.

This short-term weakness played out again as stocks would continue to sell off for another 3 days before bouncing. Furthermore, on election night, some equity futures actually went limit down before recovering prior to Wednesday’s open. Thus, the relative spike in short-term volatility expectations once again led to further selling in the interim prior to the big bounce of the past 2 days.

Now, we find the shoe on the other foot (sort of). That’s because, the day after the election, relative shorter-term volatility expectations (this time, the 1-month VIX versus the 3-month VXV) dropped from 1.04 to 0.88, or a decline of 14%. Since the inception of the VXV in 2007, that is the largest single-day drop in the VIX:VXV ratio on record.

Is this action also characteristic of “smart money”, if just temporarily? Or is this a sign of complacency to be faded? We looked at the limited precedents that even approached today’s 14% drop in the VIX:VXV. Specifically, we found 8 instances of 10% daily drops in the ratio. These were the dates:

10/20/2008 10/27/2008 1/21/2009 5/7/2010 5/10/2010 8/9/2011 10/16/2013 8/27/2015

While these episodes were all unique, most of them saw somewhat similar circumstances around the signal, i.e., a drop in the VIX:VXV from elevated levels due to recent stock market weakness.

What did the stock market do following these signals? In the very short-term, there was some evidence that such a drop in volatility expectations was warranted. 1 week after the signals, 5 of the 8 events were higher. And within a week, 6 of the 8 saw the S&P 500 higher by at least 1% at some point. After one week, the volatility selloffs did not look so smart.

By the 2-week mark, 6 of the 8 had turned negative, all by at least -1%. One month following the signals, 5 of the 8 were negative, with a median return of -4.9%. 5 of 8 were still negative after 2 months. Beyond that, returns normalized. Here are the stats:

One potential bit of good news for bulls is the similarity between the current signal and the 2013 episode. That is because they are the only 2 instances showing a positive 1-week or 1-month return at the time of the signal. And that 2013 signal saw the S&P 500 show positive returns over every subsequent time frame out to a year.

So what’s our take? We would probably designate this data point a “slight negative” for stocks given the precedents’ poor median returns in the weeks and months following the signal. In other words, after becoming overly prepared for post-election volatility, traders may now be just a little too comfortable that the stock market is out of the woods.

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More from Dana Lyons, JLFMI and My401kPro.

The commentary included in this blog is provided for informational purposes only. It does not constitute a recommendation to invest in any specific investment product or service. Proper due diligence should be performed before investing in any investment vehicle. There is a risk of loss involved in all investments.