#portfolio positioning

[shannoninvestment]

Trouble With the Curve

Past newsletters have discussed recent efforts by the Federal Reserve to hike the Fed Funds Rate (and thus short-term rates) while many other articles have focused on how the yield on the 10-year U.S. Treasury bond (UST) remains stubbornly low in an economy with near-full employment. The relative yield across varying maturities (please see Financial Jargon elsewhere in this issue) is watched closely for signs of economic turns. Trouble With The Curve isn’t a reference to Clint Eastwood’s 2012 baseball movie but rather addresses what happens when these or similar measures of short vs long-term yield converge or even invert.

The adjacent graph depicts the difference between the yields on 10-yr and 2-yr debt over 40 years. The blue line falling below the black horizontal line at 0.0 are points below which these yields have inverted.

The shaded vertical areas represent when the U.S. economy was in recession. What markets have noted and as evidenced in the graph, there is a consistent record of recessions being preceded by an inverted yield curve. What’s troubling markets is that this curve has steadily flattened and is as close to inversion (25 bps between 2-yr and 10-yr) as it has been in 10 years.    

That all being said, while all recessions may be associated with inverted yield curves, not all curve inversions are followed by recession (notably a 10-yr vs Fed Funds curve). The curve doesn’t cause the recession but rather reflects market conditions and sentiment that may be in place around or in anticipation of economic slowdowns. And (at the risk of ridicule) this time may be different as the 10-yr UST yield might naturally be higher if not for low global rates suppressing UST yields. Finally, equity investors have observed lags between initial inversion and stock market peaks which suggest patience to avoid panic selling in anticipation of curve inversion. Investors need to be familiar with the shape of the curve and its implications for their fixed income and equity portfolios.

[shannoninvestment]

Back to the Future

“The success and timing of any administration’s policies is difficult to track (not to mention predict) and could result in investor paralysis. Though politics, policies and taxes all have an impact, a more useful focus for investors might best be on the economy and company earnings.”

The above quote was from last year’s Spring 2017 SIM Newsletter (You Never Can Tell) and might serve to remind us of the uncertainty and challenges currently facing the markets and this administration. When writing the above twelve months ago, the post-election stock market appreciation had stalled, the prospects of renewed economic growth were unclear, Treasury yields were in decline, legislative progress was then uncertain, fractures were growing within a unified House, Senate and White House, and abroad concerns with Russian influence, North Korean aggression and Syrian use of chemical weapons were increasing. While the geopolitical issues remain or have grown, other concerns now include a trade war, ethical distractions, a growing U.S. deficit, new Fed chairman, administration turnover, elevated tech valuations, special counsel investigations, social media privacy issues and the impacts from the fall elections.

That all being said, the 4/04/18 Wall Street Journal stated: “Boosted by a recent corporate-tax overhaul and a strengthening global economy, S&P 500 firms are forecast to report profit growth of 17% in the first quarter of 2018 from a year earlier, according to reported results and analysts’ forecasts compiled by FactSet.” I would note that geopolitical eruptions or trade wars could still derail the equity markets and that some commentators note the strong expected earnings are factored into the current market levels. Still, investors with a long-term horizon need not run from this stock market. As I also wrote last year:  

“Since you never can tell the direction of politics or markets, investors might better focus on understanding their own risk tolerance, asset class returns, asset class volatility, investor goals and investment time frames.”

[shannoninvestment]

Careful What You Wish For

Calm investment markets seem appealing but they can create their own problems.

A lack of inflation contributed to the Fed keeping interest rates so low for so long. This remains an issue abroad where central bank accommodation contributes to the yield on 2-yr government bonds still being negative in France, Germany, Italy, Japan and Spain. Last month, the Federal Reserve hiked U.S. short-term rates to a 1.5- 1.75% range, yet rates on Treasury securities remain too low for some. But a search for higher yielding securities can lead some toward riskier assets offering either exotic structures, longer terms or lower credit quality. The August debt issuance by Tesla may be an example of such (please see Zero to 60, elsewhere in this issue). It’s true individual borrowers may have benefited from the associated lower rates, particularly on secured debt like mortgage and car loans, but some argue the availability of consumer debt fell amidst the lower rates. However, many corporate borrowers have been able to feast on low-rate debt available to them, but could that leave these firms over- leveraged if economic expansion slows?

Maybe more prominent has been the calmness in the equity markets. “According to the WSJ Market Data Group, the absolute daily percentage change for the Dow Jones Industrial Average was 0.31% in 2017. It was 0. 3% for the S&P , and in both instances, that represents the smallest absolute daily percentage since 1964. For the Nasdaq Composite Index, the absolute daily percentage change was 0. 44%, the smallest since 1989.” This market calm has however left some investors and portfolio managers longing for greater volatility (please see Financial Jargon– Winter 2018, Issue 12). The notion is that with the market moving in unison and volatility at record lows, active managers haven’t been able to outdo passive investment (think indexed) styles. Maybe all they need is for individual stocks to no longer be indistinguishable so they can demonstrate their stock picking skills? In early February, calm left the market – at least temporarily.

The Monday after the January jobs report (released 1st Friday in February) stocks tumbled, with the benchmark S&P 500 index and the Dow Jones Industrials suffering their biggest percentage drops since August 2011. For the Dow, the fall at one moment of nearly 1,600 points was the biggest intra-day point loss in Wall Street history. The volatility index (VIX) ended up 20 points at 37.32, its highest close since August 2015.

An interesting side story has been the growth of the “volatility trade”. Those wishing to hang on to stock market gains “bought volatility” to protect asset values – but paid what’s essentially an insurance premium that ate into returns. On the other side of the bet were those “selling or short volatility” wishing to profit on the absence of volatility and collect a premium. That short bet blew up in February (please see What Were You Thinking?, elsewhere in this issue).

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Markets Could Move 50% Up...or Down

Robert Shiller is a Noble Prize winner in economics and serves as an economics professor at Yale University and frequent contributor to televised business shows. Last May, he generated significant attention by stating: “I would say have some stocks in your portfolio. It could go up 50 percent from here. That's what it did around 2000, after it reached this level, it went up another 50 percent.”

 People unfamiliar with Mr. Shiller might welcome his enthusiasm for equities and be comforted by his claim. But like some others familiar with Mr. Shiller’s work and his typical caution around the markets, I was surprised by the quote and searched for the video. I found the above May 23, 2017 quote as well as his follow-up interview with CNBC the next day. In the latter, he additionally stated: “For a long-term investor…there should be a place for stocks in a portfolio and they could go up a lot from where they are now. They could also go down a lot and that’s the problem.”

 Whether it was only to sell the news or save ink, it seems his more-cautionary tone in the follow-up interview got little coverage. So the stock market could go up, or it could go down. But where did he get the 50% number?   

In addition to developing a popular index tracking home prices, Mr. Shiller may be best known for his cyclically adjusted price-to-earnings ratio (CAPE), which is a broad market valuation measure that uses historical 10-year earnings and adjusts for inflation. It’s true that the CAPE ratio had initially peaked at 30 in the 1930’s but re-visited the 30-times multiple in 1998 only to shoot up to 45-times in 2008 – the 50% increase Mr. Shiller referenced. The current CAPE ratio is again at 30-times and what Shiller’s headline grabbing declaration pointed to was the simple mathematical possibility of getting to 45 times, having once done it before. What is not discussed is that the long-term average CAPE ratio is closer to 17 and the last two times the CAPE ratio hit 30 ended with the Great Depression and the popping of the “Tech Bubble”.  Not a great end to those stories.   

 What was also lost behind attention-grabbing headlines actually was Mr. Shiller’s rather tame view of the markets and his general support of stocks as part of a long-term asset allocation decision. His recommendation of equities incorporated a relative value analysis – particularly versus bonds. He stated that “stocks have generally outperformed other investments through history”. Sure a 50% move up or down is possible (with the government’s successful implementation of an agenda supportive of growth) but he views either 50% price move as “extreme outcomes”. Mr. Shiller rather sees (over the long-term) annual 5% stock market returns as more likely (which would infer a 7 to 7.5% total return when including dividends). Further, he views such as favorable relative to expected fixed income returns and would venture abroad for a significant part of any equity exposure.  

In the end, the story was not about a traditionally pessimistic economist suddenly calling out the market opportunity of a lifetime. Behind the headline, it was rather a story about the mundane process of understanding expected returns, making relative value assessments and building portfolios using a long-term perspective.   

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Financial Jargon - Balanced Fund

Some believe the most important decision in investment management is asset allocation – which involves the percentage of money allotted to various asset classes. Traditionally, the asset classes under consideration are simply stocks, bonds and cash. A broader approach to asset classes would introduce alternative assets such as commodities, real estate or private equity. The goal is to spread the amount to be invested across differing assets types to gain the benefits of diversification and help manage the risk profile. This is most successful when the assets considered are uncorrelated (one “zigs as the other zags”) to some degree. The notion is to establish the appropriate mix to meet the investor’s risk and return requirements over an extended period of time. Separately, it can also serve as the benchmark for performance analysis.      

With this in mind, a simple and common asset allocation is to have 60% of the money in stocks (equities) and the remaining 40% in bonds (fixed income). An alternate division might be 35% U.S. stocks, 15% foreign stocks, 40% bonds and 10% cash or short-term Treasuries. Once the targeted allocations are decided, investors or advisors could shop for the individual securities, mutual funds or exchange traded funds to construct the portfolio. To make it easier, some investment companies have built and offer single funds to meet the targeted equity, fixed income, cash or alternative asset mix. These blended asset pools are known as balanced funds or hybrid funds. Examples of these are Vanguard Balanced Index Fund Investor Shares (VBINX) which has the 60/40 split discussed above or Fidelity Asset Manager 50% (FASMX) that targets the 35/15/40/10 allocation from above.

Shannon Investment Management (SIM) is not endorsing the asset allocations or specific funds discussed above but presents the balanced fund concept to inform and introduce the notion that balanced funds may serve as a benchmark for performance analysis and comparison. While a balance fund may provide both multiple asset class exposure and simplicity, SIM favors a more customized and granular approach that provides opportunities for tactical positioning of a portfolio for both performance and risk management.

[shannoninvestment]

The Times They Are A-Changin’

Like a lot of people, I was shocked at what unfolded last fall – and who honestly saw it coming? How does a 70-year old man, who never directly participated in that field, suddenly win it all? But when the votes were counted he came out on top – Bob Dylan shocked the world and won the Nobel Prize for literature! The New York Times reported on 10/13/16, “Mr. Dylan, 75, is the first musician to win the award, and his selection on Thursday is perhaps the most radical choice in a history stretching back to 1901.”

It seems a lot of change is “blowing in the wind.” There will also be a new President of the United States. Importantly, the Republican party will additionally control both the House and Senate and could institute changes that have been difficult to achieve in a “divided” Capitol Hill. What is expected to be a business-friendly Trump administration combined with existing hints of a rebounding economy could serve to jump start what has been a slow-growing U.S. economy – or it could also overheat it. These turning points can be difficult to manage and investors will need to navigate:

A surging currency that is up to a 13-year high against one popular index

Rising U.S. interest rate policies in a stagnant global economy

Overstimulating a U.S. economy now finally showing year-over-year earnings growth

Intense job-creation focus in a near-full employment environment

Balancing unfunded tax cuts and big infrastructure spending

These turning points can lead to large and unexpected swings such as: 

When in the first 12 days of 2016 the stock market delivered the worst      start since 1897 but ended the year with a big post-election bounce

When healthcare is up 13% in 6 months thru July but then fell 9% over next 5 months

When energy stocks fell 24% in 2015, but posted a 25% jump in 2016    

When concerns of post-Brexit global slow down drives 10-yr US Treasury rates to 1.36% but ends 2016 at 2.45% (80% higher)

When defensive plays like utilities rises 21% in the 1st half of 2016 only to fall 7% in the 2nd half

When financial stocks were dead money in 2015 but jumped 24% in ‘16

These unexpected reversals might continue in the new year and investors need to be on guard as such dramatic swings are predicted by few. But one might note that our new Nobel laurate once declared, “For the losers now will be later to win, ‘cause the times they are a-changing.” Maybe Bob Dylan’s victory should not have been such a surprise – or maybe it should’ve been for economics. 

[shannoninvestment]

Portfolio Positioning in the Current Market

Portfolios should be designed to meet the specific objectives, risk tolerances, tax, timeframe and special circumstances of each individual - though investors might generally consider:

·      US equities for exposure to a possibly strengthening economy

·      Developed market equities for appealing foreign market valuations

·      Currency-hedged positions in the face of a potentially stronger US dollar

·      Dividend paying equities to replace foregone fixed income - though use caution with high dividend payers in rising rates era

·      Small and mid-cap equities for lesser foreign currency exposure

·      Equity exposure to sectors that benefit in rising rate environments

·      Floating rate notes to combat rising interest rates

·      Shorter duration securities should fixed-income assets be desired

·      Cash to provide flexibility in an uncertain market

[shannoninvestment]

Financial Jargon - Rule of 20

“THE RULE OF 20” is a rule of thumb used to assess how “rich or cheap” the stock market may be at any given time. The measure simply holds that the stock market is fairly valued when the sum of the market’s price-earnings ratio plus the inflation rate equals 20. A number less than 20 would suggest the market is cheap while a number in excess of 20 suggests the market is expensive.

The appeal of the measure includes the simplicity of calculation (P/E + inflation rate) and interpretation. But while the calculation is simple to perform, the inputs – notably the “earnings” number – is less clear. One would need to decide* between forward (projected) or trailing (historic actual) numbers or the use of GAAP numbers, adjusted (non-GAAP) or even a “Shiller P/E”.

What is less ambiguous about the formula is the merit of introducing a market valuation measure that factors in inflation (and indirectly addresses the current low rate environment). As discussed in AN INTRODUCTION TO TINA (Summer 2015), in the absence of fixed rate investment products with attractive yields, some investors increasingly focus on equities and alternative assets. Application of “the rule of 20” can help explain (justify) the seemingly bloated price-earnings ratios in times when inflation is subdued or absent. Underlying support for the rule’s equity valuations comes: from simple supply-demand dynamics when fixed income assets have lesser appeal; from using lower equity premiums or from reduced discount rates in a low interest rate environment. While the formula is helpful in putting historic P/E ratios into context, it risks misguiding based on overly pessimistic (in 2009?) or optimistic (now?) earnings estimates.

*Personally, I would use the 52-week forward (estimated) earnings of the S&P 500. Applying The Wall Street Journal-reported forward P/E of 18.37 and an inflation rate at 1.0% (per US Inflation Calculator), the resulting 19.4X suggests the market (as represented by the S&P500) is fairly valued.