From the High

The S&P hit its high for the year May 21^st and then pulled back -3.61% through June 5^th.  Such a small pullback in such a small time frame is no reason to sound the alarm unless it shows signs of morphing into a more pronounced move.  Currently, none of my quantitative screens exhibit more vulnerability to a sustained downside move. 

Still I wanted to look at this move and see what provided a good hedge against this decline.  The short answer – nothing except Gold.

May 21st to June 5th
S&P 500	-3.61%
Bond Index	-1.50%
Developed Intnl Stocks	-7.00%
Emerging Market Stocks	-6.80%
Gold	2.00%
USD Index	-1.60%

What’s interesting here is that stocks and bonds moved down together.  The last time the S&P had a pronounced move down in the summer/fall of 2011, bonds provided a decent hedge and were up close to 5%.  Also of note was that the dollar was positive, all of which indicate deflationary concerns taking precedence.  Gold was also positive, which can fit into the deflationary narrative depending on one’s perspective about how that shiny metal operates.

When gauging the current numbers, I initially thought inflation concerns helped drive these moves; in theory such concerns should cause bonds and the dollar to fall and gold to rise.  Equities are a mixed bag, depending on the type of inflation.  For example, strong recovery causing inflation = good, while too much money without offsetting production = bad.  This would lead to the conclusion that too much money is forcing the dollar, bonds, and stocks down at the same time.  Except…

Inflation isn’t a concern at all, in fact inflation expectations actually fell during the period.  So what happened?  My wild guess is a combination QE tapering and Japanese market volatility, which was not unexpected.  

The point of the post is not to breakdown market moves and assuage cause and effect.  The point is that every market environment is different.  While the current time frame is short and for now insignificant, it does help illustrate that markets change and the past correlations and subsequent hedging strategies may not work in the future.  So the takeaway is:

• Portfolio construction must evolve to meet current conditions
• Investors must look to intermediate market moves to remove the noise
• Investors make sure their portfolio doesn’t stray from their comfort zone
• As always, moderate and contain portfolio risk

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. 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.  

Macro Musings via El-Erian

Josh Brown recently wrote a blog post highlighting what Mohamed El-Erian said at the PIMCO Investment Conference.   Since my invitation got lost in the mail, I had to settle for reading his summary, which was quite good. 

Like Mr. Brown, I think that Mohamed El-Erian is not only a great macro thinker, but communicates his/PIMCO’s views as clear as anyone.  Further, their track record has been extremely solid since before the financial crisis despite the occasional misstep.   I doubt you could find much better.

Three things really struck me.  For ease, the big bullets are Josh’s notes along with El-Erian’s quotes.  The highlights are mine to add emphasis.  My comments are in italics under their respective bullets.

1. Risk management: People used to think that diversification was good enough, but no more. "Diversification is necessary for any investor but it is not sufficient when central banks have distorted prices."  He says the way to think about insuring tail risk is the same as you would car insurance. You maintain it at all times, not try to guess when you'll need it. He is talking about far-out-of-the-money options that hedge against unforeseeable outlier events, which is what his fund does.
• I totally agree that diversification is no longer adequate to control risk, given how correlations move to 1 and -1 in times of stress.  Tail risk insurance, using momentum to move risk on/off, and/or stop-losses at waterlines are good ways to contain risk.  Diversification only manages to moderate risk.  That is an important distinction.
2. Beta heavy lifting:  He thinks the beta heavy lifting is probably over in asset markets. In bonds, he says the capital appreciation returns from treasuries, corporates and high yield bonds are done too.  Lastly, someone asked him a Vanguard-related passive indexing question. Mohammed tells a killer anecdote from early in his career about how EM bond indexes were once made up of 22% Argentinian bonds pre-default, and that the other managers who were hugging that index got hammered. He says that passive makes sense only if you'll be driving in reverse up a road that is completely straight. Because you're essentially looking at snapshot of the way things were.
• Passive is less preferable to active in this environment.  Again, I think he is spot on here, though PIMCO would have this view given they are an active shop.  This is especially true on the Fixed Income side.  I will say the caveat is finding the right active managers, which is more of a qualitative function and can prove to be difficult.
3. Central Bank Brand Management:  He says basically a brand is like a wedge you can shove in between fundamentals of your company or product and raise prices. But that brand wedge is finite and cannot keep things apart or elevated indefinitely, there is a limit to what a brand can do… Central banks are also a brand. The brand is "we can deliver outcomes today to improve the future."  Right now people believe in the central bank brand, watch out for when that belief in the brand turns. Right now the psychology about the Fed's brand is positive, "but psychology goes both ways."
• What if Central Bank psychology in regard to the market reverses?  Admittedly this is something I need to look into more.  He elaborated more on that thought recently.  His basic point is that even powerful brands can only continue for so long until fundamentals justify (or on the negative side, no longer justify) the price (e.g. he mentions APPL).  In this specific instance, it’s that central bankers are hoping that in increase in financial market prices will filter down to the real economy.  El-Erian is skeptical this will work, and notes risks about the unintended consequences. He wonders what happens if investors no longer believe the fundamentals justify the financial market prices, even if central bankers continue their current policies.  All of these are legit concerns; however, in my opinion they are all fixable.

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. 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.  

QE Taper or Not… and What Happens if it Does Occur?

When will the Fed taper its purchases of Treasuries and mortgage backed securities as part of its Quantitative Easing?  That seems to be the biggest discussion going on at all the hottest clubs.  The chief economist from my favorite econ research team (Goldman) said “A September tapering is certainly possible”.

In an economic sense, QE is more debated than JB at the Heat Game 7.  Regardless of whether QE works, is destructive long-term, neither, or both, I want to focus on its impact on equity markets where I see 3 common reasons why it’s bullish:

1. Higher earnings of companies through refinancing as interest rates are pushed down.
2. Low bond yields force investors into higher yielding assets (e.g. stocks), which in turn forces up stock prices and valuations.
3. QE creates liquidity (e.g. I hold a bond, the Fed buys it, I now have cash), which has to be put somewhere.  One of those places is the equity market.

Ipso facto, QE tapering would be bearish for equities.  I do believe that is a risk, but at least for now under the current facts and circumstances – facts and circumstances which can and do change – I am less concerned, and here is why:

1. Econ Data Still Not There:  from the same article “I think that is going to depend on the data… Chairman Ben S. Bernanke expresses caution over trimming the program too soon… The likelihood that the economy will continue to grow about 2 percent over the next couple of quarters with inflation ‘well below’ target will probably stay the Fed’s hand until December”.
2. Closer to End of Recovery Cycle: Cullen Roche at Pragmatic Capitalist elaborates on the last bullet: we’re in the backstretch of the recovery, unemployment is still way too high, corporate revenues are starting to falter.
3. Tapering Not Huge Anyway: if they do taper, consensus isn’t exactly a large change to the Fed’s balance sheet.
4. Good Economic News Drives This Decision: as insinuated earlier, if the Fed is tapering then economic data is good.  If economic data is good, then stocks should do well.   

That last bullet is the key.  If economic data falters as the Fed tapers their purchases then equity markets will be in trouble.  A good article at Learning Bonds points out that fact QE and equity prices is even a conversation points to artificially inflated equity values.  Thus, if data comes in weak stocks would be more likely to revert to their fundamental value. 

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. 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.  

Max Pain – Investing, not the Awful Movie

When I get bored I crunch numbers and build spreadsheets just like everyone else.  This time I wanted to see the maximum amount of money an investor would have lost over the last 40 or so years.

It’s an important number to me for 2 reasons:

1. How far is the deviation from what one would expect given the historical average and standard deviation (i.e. variance around the average)?
2. Investors tend to panic when the losses get really bad.  The results in a sell at the bottom mentality, locking in the already large loss.

Here is what we got:

Let’s breakdown US Stocks (i.e. S&P 500 month-end values, dividends reinvested) because that is what most people care about: 

• From 1970 through April of this year stocks had an annualized return of 10% with a standard deviation of 16%. 
• To elaborate, that means 95% of the time we can expect stocks to fall between -22% and 42% return in a 12-month period. 
• While the max drawdown was 51%, over a full 12 month period that number drops to 41% (not shown).
• During that time frame, the lowest return over a 10 year period for stocks was -29% (also not shown).  This sticks out as there have been 10 year holding periods where investors could lose money by holding equities.  There were 24 times this happened; however, they were all consecutive and took place between 2008 and 2010 corresponding with high equity values (e.g. the start date) prior to the tech bubble.

Risky assets (stocks, REITs, commodities) all have large drawdowns and are relatively correlated (again, not shown) with the exception of maybe commodities.  Thus, diversifying from just US Stocks to other risky assets will most likely not be an adequate hedge in the event of a large drawdown in US Stocks.  The addition of bonds helps; however, from my data is no panacea. 

 Note: Portfolios are rebalanced annually.  For a breakdown of the allocations and the indices used please email me for details.

The above numbers indicate that portfolio diversification can lessen risk (i.e. standard deviation) without sacrificing much, if any, return.  However, the max drawdowns are still large and well outside 2 standard deviations.  So while a diversified portfolio can mitigate maximum drawdown risk, it doesn’t necessarily restrict it.   This leaves the investor with 2 choices:

1. Mentally prepare himself or herself for a large drawdown so that if it does happen he or she doesn’t liquidate at the bottom and lock in a devastating loss.
2. Put risk control measures in place so the max drawdown is limited.  

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. 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.  

Bonds Aren’t as Stupid as Their Yields Indicate

Buying and holding bonds in the current environment might make you ill.  If you hold a Treasury Bond for 10 years you receive roughly 2% on that money annually for the next 10 years.   That’s in nominal terms too.  If inflation averages a little more than 2% that you essentially get 0%.  Higher quality corporate bonds aren’t much better.

Note: Left graph is based on 10-year Treasury bond coupled with inflation expectations.  Right graph is AA Corporate effective yields.

To summarize the graphs – buying and holding a Treasury or high quality corporate bond for 10 years is the investing version of Chinese water torture.   So why invest in bonds at all?

• They still will likely provide the best hedge against a declining equity market.  From November 07 to March 09 S&P 500 declined 44% with the Aggregate Bond Index was up 7%.
• Smart money is on Fed staying loose and keeping interest rates low for some time.  Even if they taper bond purchases later this year or early next year.
• Demographics and risk aversion provide a market for higher quality bonds. 
• Yields can stay low for a long time.  Ask Japan.
• Since 1976 the Aggregate Bond Index max loss over a 12 month period has been 9%.  Not what I would call a catastrophic loss so your principal probably won’t be decimated. 
• The world bond market is $90 trillion (compared to equity market size of $40 trillion), so there are a lot of places to seek out return (i.e. there are more than just Treasuries and Corporates out there).
• There isn’t a bubble, at least anecdotally.  How many investors you know brag about their bond portfolio over the past few years and compare that to their real estate portfolio in 2007 or their tech stock portfolio in 1999.
• Check this out:

That shows the 10 Year bond going from 2% to about 1.60% in a little less than 2 months.  It also shows the long bond ETF going up in value.  Point being, bond trades can capitalize on these quick moves in yield.

I take all of the above and come up with the following bond investment cocktail.

1. While the risk of buying and holding is probably low, the upside is muted when it comes to quality bonds.
2. Still given the depth of the bond market and short-term moves in yields, returns can be had.
3. Thus, move away from more passive buy and hold bond investing to quality managers who have the leeway and skill to navigate the fixed income space.

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. 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.