Challenging Conventional Wisdom

Transcription

1 with Rick Golod GLOBAL INVESTMENT INSIGHT August 7, 2015 Challenging Conventional Wisdom Rick Golod Chief Global Strategist It wasn t just a difficult month for investors; it s been a difficult year. Perhaps it s time to challenge conventional thinking and change the way we invest? Overview July was a volatile month for global equities. Investors had to deal with the Greek bailout uncertainty earlier in the month, and the bursting of China s stock market bubble towards the end. The positive resolution in Greece (at least for now) led to positive equity returns for the major developed regions in July. S&P % MSCI-Europe +3.1% Nikkei +0.5% MSCI-EM -7.3% China -10.9% However, these returns masked the large disparity between regional and sector performance for the month. European equities outperformed emerging market equities by more than 10%. The retailing sector outperformed the energy sector by almost 13%. China s market turmoil also spilled over into the commodity markets over concerns of slower economic growth; the Jefferies/CRB index was down % for the month, and Brent crude prices fell -16.3%. It wasn t just a difficult month for investors; it s been a difficult year. Investors who own an S&P 500 Index fund are up 2.6% in price. Long-term Treasury bonds remain slightly negative for the year. Investment grade corporates are barely breaking even. Commodities are down 37%, and gold is down more than 8%. Large cap growth is outperforming large cap value by 770 basis points. Investors that have a well-diversified portfolio have probably made little-to-any progress building wealth this year. Conventional wisdom on how to invest isn t helping. Investors have been convinced to: buy no-load index funds, equally weight growth and value, remain fully invested, stay short duration and rebalance allocations every year to agreed-upon levels. Perhaps it s time to challenge conventional investment thinking and change the way we invest? Consider the following: Should you always stay fully invested? We ve all heard, it isn t timing the market, it s time in the market. Tell that to someone who owned the market from: , , or In each of those cycles, the market traded at the same level in the end year as it did in the beginning year. Dow Jones Industrial Average Log Scale /29/06 10/31/16 10/31/26 10/31/36 10/31/46 10/31/56 10/31/66 10/31/76 10/31/86 10/31/96 10/31/06 SOURCE: Bloomberg Page 1

2 Page 2 Owning a no-load index fund from May 1, 1997 to March 18, 2009 made zero returns. Beware of absolutes. Don t equally weight growth and value. Over the past 145 years, there have been long stretches when the equity market traded sideways where it made little sense to be fully invested in U.S. stocks. I m not talking about moving in and out of the market multiple times per year. I m talking about avoiding the big down-turns. Investors should identify whether the equity market is in an uptrend or a downtrend. In a bull market, buy the dips. In bear markets, sell the rallies. Key market levels are also well known by market technicians, for short-, mid- and long-term investors; signals on when to raise cash or change strategies. When the market reaches a key inflection point, then it would be time to change the way to invest; raise cash, utilize defensive strategies or own concentrated stock portfolios. There are always stocks that go up in a down market but not if you own an index fund. It s not time in the market; it s avoid the big down years. Avoid no-load index funds active managers DO add value, despite fees. The academic studies are pretty clear on this issue. Trading costs and fees make it difficult for active managers to outperform the market over time. That is, for most managers, not all managers. Beware of absolutes. Owning a no-load S&P 500 index fund from May 1, 1997 to March 18, 2009 made zero return except for dividends. After almost twelve years in the market, a $100,000 investment would have been worth the same $100,000. However, if an investor had purchased a fund offered by one of the largest mutual fund companies and paid the highest fees (8.5% front-end load), that same $100,000 would have been worth $168,700, net of fees. This wasn t even one of the better-performing funds. Yes, I specifically picked the timeframe in order to prove the point. As I said to my ex-financial advisor who felt active managers couldn t outperform index funds, Perhaps you should spend more time on how to select managers; then I transferred my account. Yes, it has been more difficult for active managers to outperform the market index, certainly since the recovery began in The easy answer is fees. But, perhaps there s another reason. Perhaps the answer also lies in the way portfolio managers buy equities. Most, if not all, active portfolio managers try to buy quality companies at low valuations that are growing earnings. Since QE, the best-performing stocks have been lower priced companies with low quality balance sheets. Expensive stocks continue to get more expensive. There has been little benefit in owning undervalued companies with quality balance sheets. Portfolio managers have also not benefitted from worrying about the potential downside in the market. The S&P 500 Index hasn t had a 10% correction or greater since It would appear that active managers placed too much importance on quality earnings growth, buying stocks with low valuations relative to their sector or the market with manageable debt levels. In other words, most portfolio managers placed too much importance on good fundamentals. Shame on them! All I know is that the 1% 2% savings in fees from owning an index fund isn t going to help much in a bear market or a market that trades sideways for an extended period. At the beginning of a bull market, buying a no-load index fund is acceptable. Buying an index fund in the later stages of a bull market will make it difficult to build wealth, in my opinion. Finding good managers has always been difficult and requires hard work. There are numerous mutual funds that outperformed the S&P 500 Index over the past five years, net of fees. Perhaps we should spend time on how to identify the future outperformers instead of using an investment approach that buys stocks based on size, i.e., index funds. Don t equally weight growth and value. In the mid-to-late 1990s, every time investors took money out of large cap growth stocks to rebalance their portfolio into value, they reduced their returns. In fact, during that timeframe, rebalancing portfolios out of large cap growth into anything else, lowered returns for the most part. It didn t pay to diversify and I saw no sell signals to get out of growth, except valuations, which have almost no predictive ability. In the past five years, the Russell 1000 Growth Index is up 108% and the Russell 1000 Value Index is up 81%. Just in the past seven months, the growth outperformance over value has gotten more extreme, 770 basis points. In this age of information and analysis, I believe investors could build more wealth if they made asset class and/or sector tilts (overweights/underweights) using factors with high probability outcomes. There are a number of factors that show when growth or value outperforms. Currently there are more than seven different factors that all point to growth continuing to outperform value stocks. Growth tends to outperform value stocks when: global growth is slowing or below average, the dollar is strengthening, interest rates are rising, global PMI is rising, or the U.S. economic surprise index is outperforming the international economic surprise index, to name just a few.

3 Page 3 Don t stay short duration. The real question is to what degree should income oriented investors own fixed income? Implementing an overweight and underweight tilt builds wealth faster than using an equally weighted approach. For long-term investors, consider making one adjustment a year, no more than two, and only if the data suggests making an adjustment. Portfolio rebalancing shouldn t occur on a specific date, but rather when the decision makes sense and only when based on factors with high probability outcomes. Investors should consider rebalancing their portfolios based on factors that have predictive power in asset class or sector outperformance. For instance, when the book to price ratio for the Russell 2000 (small caps) relative to the Russell 1000 (large caps) is less than 1.29X, large cap stocks tend to outperform. I believe this would be one of the inflection points an investor could use to determine when to shift an overweight into large cap stocks. Don t stay short duration. Investors should NOT shorten duration when the output gap (excess capacity) is closing slowly. In simple terms, there don t appear to be any imbalances between supply and demand in: labor, manufacturing or capital that would drive interest rates significantly higher. Fed Chair Janet Yellen is likely to move the Fed Funds Rate higher on a slow and measured pace to 2% and hold for an extended period. Interest rate volatility is likely to increase, but settle in the 3% range for 10-year Treasuries and 4% for 30-year Treasuries. The yield on long duration bonds should more than compensate for slightly higher interest rates and outperform short duration paper on a total return basis, in my opinion. However, we are talking about relative performance to other fixed-income vehicles. The real question is to what degree should income oriented investors own fixed income? Emerging market debt is highly correlated to oil prices, which will likely continue to put downward pressure on this asset class. The U.S. high yield corporate bond market just broke below three major support levels, suggesting further weakness ahead for this asset class. Ten-year Treasury yields remain in an uptrend despite recent declines. It would take a break below 2.14% before we might see 10-year Treasuries trade in the 1.63% 1.85% range. Based on current and forward-looking data, technical analysis and proprietary quantitative models, investors should consider overweighting/underweighting the following asset classes: Equities United States Large cap growth Large cap value Small cap growth Small cap value International Europe Japan Emerging Markets China India Fixed Income Treasuries IG Corporates HY Corporates HY Minus EM Debt Specialized Investments Senior loans/clos Global Macro L/S Managed Futures L/S Neutral + ++

4 Page 4 The problem is, when China sneezes, other emerging-market countries catch a cold. Emerging markets Underweight Emerging market earnings are declining at a rate we haven t seen in five years: down 10% since the beginning of the year. The problem is, when China sneezes, other emerging-market countries catch a cold. Margin debt still remains 300% above year-ago levels and 30-day market volatility has surged to the highest levels since the Asian crisis back in These metrics suggest further downside risk. Chinese margin debt still triple from a year-ago levels Mar Jun Sep Dec Mar Jun SOURCE: Thompson Reuters Datastream United States Neutral The U.S. economy lacks a certain degree of vitality. But, analysts have upgraded earnings four consecutive months, which has brought forward price multiples below cautionary levels (17X). Currently, companies with quality balance sheets with low default risk are outperforming, which means: growth stocks with pricing power are likely to continue to outperform. The Value Index is rife with economically sensitive companies with high fixed costs. A weaker euro/dollar exchange rate should continue to move European equity prices higher. Europe Overweight If it wasn t for China, European equities would be trading at higher levels. The firewall that Draghi built prevented a massive tightening in financial conditions, which was one of the problems in 2010 and A weaker euro/dollar exchange rate should continue to move European equity prices higher. Japan Overweight The Japanese equity market is likely to continue to move higher on massive quantitative easing, a weaker yen/ dollar exchange rate, continued upward earnings surprises, and a gentle upward move in core inflation. Targeted Opportunities Overweight There are a number of investment vehicles that provide bond-like income with little to any interest-rate risk which would likely provide a better risk/return outcome than fixed income. Final Thoughts Quantitative easing has made it difficult to consistently make money using active managers, or making sector and/or asset class overweights over the past six years. Investors were better off just buying a no-load index fund, but that is about to change. QE tends to reward risk-taking and momentum investing, trumping fundamentals. Macro events had more impact on stock prices than a company s balance sheet or income statement. Liquidity has distorted traditional asset class and sector outperformance driven by fundamentals. As we move farther away from QE in the U.S., fundamentals will matter more in driving stock prices and more active managers will outperform their benchmarks because quality balance sheets will matter. Some of the consensus thinking on how to invest appears to be flawed. Building wealth is never easy, especially buying an index and forgetting about it. As financial advisors, I believe we need to consider all options in meeting clients investment objectives. Most importantly, making high-probability decisions and using those probabilities to overweight and underweight asset classes will, in my opinion, increase wealth over a shorter period.

5 Page 5 The opinions referenced are those of Rick Golod and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and/or views of other Provasi Capital Partners LP professionals. The comments should not be construed as recommendations, but as illustrations of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions. There can be no assurance that actual results will not differ materially from expectations. Past performance is neither indicative nor a guarantee of future results. Provasi Capital Partners LP and/or its affiliates may sponsor, co-sponsor, and/or distribute securities in investment sectors reviewed in this material. Published 7/ Provasi