2013 and Beyond – The Bad, and The Ugly

Negative ETF Ranking - 2013
9	-1.37% - shares International Treasury Bond ETF (IGOV)
10	-1.83% - iShares S&P GSCI Commodity-Indexed Trust (GSG)
11	-1.98% - iShares Core Total Aggregate U.S. Bond ETF (AGG)
12	-2.00% - iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
13	-3.44% - iShares National AMT-Free Muni Bond ETF (MUB)
14	-3.64% - iShares MSCI Emerging Markets ETF (EEM)
15	-6.09% - iShares 7-10 Year Treasury Bond ETF (IEF)
16	-6.73% - iShares Emerging Markets Local Currency Bond ETF (LEMB)
17	-28.33% - SPDR Gold Shares Trust (GLD)

Shockingly, not every asset class went up last year.  I say shocking because usually when stocks are hot nobody really cares what anything else is doing.

Last post I covered the ETFs that finished in the black last year and what we should expect moving forward.  This time I will cover the ETFs that finished in the red in 2013 (with the help of this file).  Again, when looking forward I am using this thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk.  Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat.  On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap.  The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

I will again mention the caveat that what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned and when things change portfolio and thesis adjustments will be made accordingly…

And now, the ETFs that had negative returns in 2013…

• IGOV – 2013:  International treasuries almost finished positive, but alas they finished with every other fixed income asset class.  They did finish the second half of the year very strong with the help of a weaker dollar.  Moving Forward:  While the US is pulling in the reins on QE – pushing our yields higher and bond prices lower – other countries are expected to remain easy or possibly become more accommodative (see Japan’s “success” with their own QE).  This would push their yields lower (or stable) and prices higher, but also cause their currencies to fall and thus washing out any positive.  Thus, an investment that is USD hedged could provide some boost.
• GSG – 2013:  The commodity chart looked a lot like USO last year, but worse as it includes agriculture and precious metals.  Commodities look to be in a range, and while that’s subjective the alternating black (Q1, Q3) then red quarters (Q2, Q4) would appear to validate that.    Moving Forward:  see USO (note: energy and industrial metals make up the bulk of index).
• AGG – 2013:   The pulse of the US bond market had its first negative calendar year return since inception and didn’t break its intermediate-term trend for the last eight months of the year.  Interestingly though it only had one negative quarter (Q2).  Moving Forward:  Assuming interest rates to continue to rise in 2014 it should yield another negative year for bonds.  While it appears interest rates may have hit a secular bottom in 2012, it’s important to remember that bonds hedge against a decline in risky assets (note: this has held as of late with equity markets off their highs and AGG moving up) and that they present much less risk (unless they are high yield or high duration) in terms of large capital loss.  Finding a balance between rising rates and the portfolio hedging benefits fixed income brings should be the goal.
• LQD – 2013:  See AGG, though the Investment Grade Corporate Bond LQD did break its intermediate-term downtrend at the end of the year.  Moving Forward:  See AGG.  There doesn’t appear to be much room for investment grade spreads to compress any further, so outside a 2008 credit event I would think they will have a high correlation with Treasuries.
• MUB – 2013:  Munis were hit harder than their taxable counter parts in 2013 with Detroit’s bankruptcy taking center stage.  While they did recover in the later part of the year, MUB like AGG finished the year below its intermediate-term trend for the last eight months.  Moving Forward:  Quick math, 3% yield on MUB equates to a tax effective yield at the 40% bracket of 5.00%.  AGG has a yield of 2.32%.  So if you are in a higher tax bracket, pick out some attractive munis, ladder them by maturity, hold to maturity, and you get a decent yield with not much interest risk. Note: as interest rates rise prices do fall, so prepare to watch your values drop, but if you hold to maturity you get the face value back.
• EEM – 2013: While EEM finished with two positive quarters and the last three months above the intermediate-term trend (barely), it still couldn’t overcome a poor start to the year as money moved out of Emerging Markets when our interest rates moved up.  EEM is also over 60% below its 2008 peak.  Moving Forward:  Even more so than developed markets, emerging markets appear to have an attractive relative valuation to our market.  Much of this is likely due to some longer-term demographic and geo-political issues and is especially true of the ones that got beat up last year (Russia, China).  Further, a sharp rise in US interest rates could continue the capital flow out of emerging markets.  Thus, while there are opportunities for upside until the trend reverses it’s hard to have much conviction.
• IEF – 2013: See AGG.  Moving Forward:  See AGG, though I think it makes sense to take a more tactical (over and under weighting when the market dictates) approach to the 7 – 10 year Treasury space.
• LEMB – 2013:  See EEM; rising domestics rates equates to capital moving from emerging markets local currency bonds back into US markets.  Moving Forward:  See EEM and IGOV.  While rising domestic rates would continue to be negative for emerging market bonds, a USD hedged exposure could be a nice boost.
• GLD – 2013: The gold chart for the year went pretty much straight down.  You can take your pick why: higher interest rates, decrease in systemic risk probability, lower inflation.  But at the end of the day you see three out four negative quarters, the whole year below the intermediate term trend, and down nearly 30%.  Moving Forward:  All three items I listed for gold’s 2013 decline are still in place.  Maybe one of those reverses and this turns into a great contrarian trade, but until the trend changes it’s difficult to allocate dollars to gold.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

2013 and Beyond – The Good

2013 is a wrap!  What a year it was if you invested solely in US stocks.  Just a guess, but I would wager some investors probably will think now is a good time to get undiversified.  That could work in 2014, maybe even longer, but ultimately other asset classes will begin to outperform and a diversified portfolio will provide good relative returns with lower volatility. 

But that discussion is for another day.  Below are some observations on ETFs (listed at the top) we look at that yielded positive returns last year.  I used this file to help make those observations.  For each ETF, I summarized 2013, and then outlined what should happen moving forward, based on the following thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk.  Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat.  On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap.  The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

Will all that happen?  Probably not, but these are my conclusions based on the current environment.  Of course as the markets and facts change so will the above thesis; in other words, as I have pointed out before, nothing is static.

Making predictions is a futile business, so what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned, with the caveat that when things change portfolio and thesis adjustments will be made accordingly… 

• IWM – 2013:  US Small Cap stocks were best in show and never came close to breaking their intermediate-term uptrend (roughly 10% above the 10-month moving average).  Small Caps leading Large Caps is a good sign to market observers, though they also lagged a bit (still up over 8%) in Q4 and is something to keep an eye on.  Moving Forward:  This equity market segment seems relatively pricey to others and above average.  While the environment is conducive toward continued appreciation, I prefer higher quality companies with strong balance sheets that tend to land in the large cap space (SPY) in case some of those conditions reverse or something unforeseen happens.  Still, the trend in US stocks (this includes SPY) is overwhelmingly positive and as a result our risk metrics have not been triggered, in fact IWM and SPY are far from them.  So until the environment changes or the risk metrics tell us otherwise it’s difficult to go against the market.
• IVW – 2013:  Growth had little difference from the Value stocks ETF, thus if you were invested in stocks it really didn’t matter much.  Moving Forward:  see SPY/IWM.
• SPY – 2013:  The S&P 500 ETF that everyone looks at really ripped and was up over 30% on a total return basis.   Q4 was also the strongest quarter of the year and the index hit its high in the last week of the year.  Like IWM, SPY never came close to breaking its intermediate-term uptrend.   Moving Forward:  See IWM, though valuations are more reasonable than small caps and probably at their average.  I will again note, I prefer the quality companies moving forward that capture part of the up move, but also avoid some of the down move in the event the market reverses course.  Lastly, a major fundamental equity concern is what happens as interest rates rise; however, in this environment rising interest rates have historically been a benefit to stocks.
• IVE – 2013:  see IVW.  Moving Forward:  see SPY/IWM.
• EFA – 2013:  Investing in developed international market stocks netted 20%+ though still had a decent lag relative to domestic stocks.  The ETF is also still below its 2007 peak, but it’s close to making a new high on a total return basis.  Moving Forward:  Looking at prior returns and research, these markets tend to be a better relative value than our own stock market.  What this doesn’t mean is that outperformance will happen overnight.  Further, the trend is NOT your friend.   What it does mean is that there are some opportunities here, especially as growth in those economies picks up. 
• USO – 2013:  This is the first significant relative underperformance as the oil ETF’s return was a tad under 6%.  Moving Forward:  Typically cyclical commodities tend to rally more late equity cycle (see big Oil rise in 2007 and 2008 before it cratered), so assuming the equity market rally still has legs, I would expect the lag to continue.  Further, many investment based countries (e.g. China) are trying to shift to a more balanced economy.
• HYG – 2013:  Only bond asset class up for the year, which isn’t surprising given high yield is more correlated with equities and has minimal duration risk.  Moving Forward:  Environment should still be supportive.  However, while spreads (the difference between Treasuries and a similar high yield bond) have been narrower before, I do wonder how much juice is left in the squeeze?  Just be careful as high yield bonds won’t provide a hedge if riskier assets stumble.
• IYR – 2013:  Logic would dictate real estate would perform better given a big bullish economic story last year was the increase in home prices, but IYR barely finished the year in the black.  The chart looks eerily similar to the Treasury ETF, so there appears to be a correlation with interest rates.  Plus REITs outperformed stocks every calendar year since 2009 except last year, so maybe much of those gains were priced in.  Moving Forward:  The correlation between real estate and stocks broke down for much of 2013, but did move together prior to that.  Still, steadily rising interest rates with minimal inflation should result in lackluster performance and a loose correlation with bonds. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

The 10-2 Indicator Says No Recession, Market Collapse

A popular indicator is the 10 Year Treasury yield less the Two Year Yield.  When the number is positive or upward sloping, that is typically indicative of a growing economy.  The short version is that the Fed heavily influences the short-end of the curve, so when investors are confident about the economy they sell the long-bond pushing the yield up. 

Now the Fed can and will, as evident by quantitative easing (the Fed buying longer dated bonds), control the long-end too.  Thus, even though we have an upward sloping curve now there is still some heavy Fed influence as they are keeping short-term rates very low.  Further, the drawing down of quantitative easing (no longer buying longer dated bonds) expected Q1 next year should push up the long-end of the yield curve.

Still, even with that caveat I found the chart below pretty fascinating.  The blue line is the 10 Year yield less the 2 Year yield and the red line is the S&P 500.  

A few things stick out:

1. A negative sloping yield curve has ALWAYS led to a recession.  There all no false positives.
2. We have never had a recession since 1976 (from when the data was available) where the yield curve did NOT turn negative beforehand.
3. The last two major markets tops in 2000 and 2007 coincided with a negative yield curve.
4. We don’t have anything close to a negative curve now.  In fact, the slope is moving higher.  

While the sample size is small and everything works until it doesn't, it bares extremely well for the economy.  This has important stock market implications.  I have noted before that even if earnings lag (say the economy is weaker than expected or the record high profit margins come down) we can still have multiple expansion to push the market higher given short-term valuations are not at extreme levels.  That isn't to say the market can’t or won’t have a hiccup or pullback around 20% or so, just that a larger bottom doesn't appear to be in the cards unless that 10-2 indicator reverses. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Can Deflation Stop the Rally?

Will deflation doom stocks?  If prolonged logic dictates it will.  Lower cost = lower earnings = lower prices AND higher real rates = good alternative to stocks = lower valuations.  This is why looking at the latest CPI numbers it’s at least a tad concerning:

The chart shows disinflation and is getting worse -- see the arrow.  Currently inflation is running a little under 1%; thus, we are currently not in deflation, but disinflation.  An article in FT highlights the concern moving forward:

“’The lesson of the past, [CLSA], is that the three previous times the US rate of inflation dropped below 1 per cent since 1957 — 1998, 2001-02, and 2008-09 — stock market investors suffered significant losses.’ … 

In 2002, during the period when Ben Bernanke made his infamous helicopter money speech, stocks fell by almost a third after US inflation dropped below 1 per cent. 

Also, in 2008, inflation fell through that 1 percent line days before Lehman Brothers filed for bankruptcy.”

I decided to dig a bit deeper and put together my own data table – here.  I was looking for points in time when inflation for all items (there appeared to be little link between inflation ex. food and energy) was lower than both our current level of inflation and subsequent one year returns.  Here is the summary:

To me the data and subsequent analysis shows the following:

• First there is a small sample size, so certainly findings should be taken with a grain of salt.
• Returns are lower and the probability of a negative return over the next 12 months is elevated.
• But the lowest return, while large, still isn’t a bear market and I wouldn’t consider it catastrophic, especially with diversification and risk control.
• And there are still positive returns with some large ones even.
• What’s also interesting is the negative correlation (lower inflation number = higher forward returns), which on the surface seems counter intuitive…
• Until you take into account that as these numbers worsen the Fed will ease more and thus provide a bump to the markets.
• When you look at the 2009 data, this illustrates that.  The big fall in the market coincided with disinflation/deflation; however, once we fell below 1% the 12 month forward returns on the S&P were all positive.
• Thus, my view is even if disinflation persists, based on recent history the Fed will step up and pump up the inflation number, and subsequently the market.  Now if the Fed doesn’t step up or their efforts no longer work, then the risk of negative returns on stocks is elevated.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

By Definition, Black Swans Can’t Go Away

If everyone can quantify the risk that the world will burn, then if it goes up in flames it’s now allowed to count as a black swan (or blind tail risk) event. 

The term black swan, made famous by Nassim Nicholas Taleb, refers to a phrase from a time London when they wore funny clothes, and powdered wigs.  At the time everyone thought a swan was white, thus a black swan was viewed as impossible or at least improbable.  Without getting too philosophical, the phrase refers to risk to which the consensus is totally blind, either because their premise or their process is wrong.  Basically a black swan risk is a huge catastrophic risk not many see coming - the unknown unknowns (i.e. we don’t know the risk or the outcome).

As outlined by Business Insider, large scale risks are off the table in 2014:

“Betting against a U.S. financial collapse was a great call. Betting against a Eurozone crash was a great call. Betting against a Chinese hard landing that threatened the whole world was a good call. Betting against a debt ceiling default was the right call.”

Those assessments were totally correct.  Further, the risks of those events moving forward have been substantially diminished; however, those were all known unknowns (i.e. we knew the risk, but not the outcome).  A common misconception is that risks like the aforementioned are black swan events: they are not, and the reason is the consensus at the very least saw these coming head on.  On the surface this seems like a debate in semantics, though it’s more practical to one’s portfolio than that. 

While it’s true those aforementioned risks are now less likely than before, as the article points out the market has probably priced that in by now.  Thus, our conversations with clients on risk are shorter, our bullish thesis is stronger, and our asset allocation observations are lower on conditionals (e.g. stocks will have a good year if various European countries don’t replay the French Revolution). 

Therein lies the issue, investors are now more confident that those large scale risks are diminished.  This is true for what everyone can see, but can NEVER be true for actual black swan events.  Further, as the known risks seem to evaporate the probability of being oblivious to a true blind tail risk event inherently becomes greater.

All of this is a nice way of saying be prepared for anything, never be too strong in your investment convictions, or dismiss anything outright.  The ways to accomplish this are through proper diversification, discipline, the use of out-of-the-money put options, and other prudent risk management techniques.  This is also why I have been bullish, but never omniscient.    

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.