Monday, August 10, 2015

Death of (Plain Vanilla) Value - Long Live GARP

Warren Buffett made news this morning, not just for making the largest acquisition of his career, but for making it at a relatively lofty 22x earnings multiple.

Reuters reports:

Warren Buffett is paying a hefty price for the biggest acquisition of his career, now that his Berkshire Hathaway Inc has agreed to buy Precision Castparts Corp in a merger valuing the maker of aerospace and other parts at $32.3 billion. 
As for that valuation...
Buffett, known for buying undervalued and often unloved companies, acknowledged the high price. "In terms of price-earnings multiple going in, this is right there at the top," he told CNBC television. 

The Death of the (Plain Vanilla) Value Premium

Which brings me back to a chart from my March post outlining The Disappearing Value Premium since the seminal Fama French white paper.

More recent data outlining the relative performance of value vs. growth is even more striking, as growth has outperformed value across market caps (small through large) materially over five and ten years.

How Can Something Be Hated, Yet Receive the Bulk of Flows?

Value traditionally outperformed growth in large part because it was composed of the most hated, beaten down stocks. But over the last 15+ years flows have increasingly piled into "value stocks". How can something be hated, yet receive the bulk of flows? To put some numbers to this, $200 billion more has gone to large value vs. large growth in the last ten years alone. 

Growth at a Reasonable Price Matters

As Investopedia outlines, GARP is:
An equity investment strategy that seeks to combine tenets of both growth investing and value investing to find individual stocks. GARP investors look for companies that are showing consistent earnings growth above broad market levels (a tenet of growth investing) while excluding companies that have very high valuations (value investing). 
In other words, while value is by definition "cheaper" if you simply look at price multiples (such as price to book or price to earnings), it isn't necessarily cheaper once accounting for the underlying fundamentals of a business. Growth stocks should trade at a premium to value due to the underlying growth, the only question is by how much. 

Without getting into the "by how much question" at this time, there has been a material shift in relative valuations between value and growth since those flows have piled in, resulting in a dramatic decline in the growth premium (or the value discount if you want to think in those terms). In June 2000 (around the peak of the Internet bubble), the forward P/E of the Russell 1000 Growth (large growth) index was a whopping 118% higher than that of the Russell 1000 Value (large value) index, but by June 2005 it was down to 45%, and by June 2010 it was down to 19% (right about where it currently resides).

As the next chart highlights, the relative size of the growth premium matters; the starting level of growth premium and seven year excess returns have an r-squared of 0.67. When the forward premium has been less than 40% growth has outperformed value by almost 2% / year over the next seven years, when it has been between 40-60% value has outperformed growth by ~1.5% / year over the next seven years, and when the premium has been greater than 60% value has outperformed by a whopping ~8% / year over the next seven years (again... it currently sits at ~20%).

Going back to Buffett's acquisition of Precision Castparts Corp; a multiple of 22x certainly isn't cheap, but it may be reasonable for the underlying fundamentals of the business. If the company can continue to grow top and bottom line figures by double digits, it will certainly look a lot cheaper than the average company in the Russell 1000 Value index trading at 16x that has seen a decline year-over-year in earnings.

Monday, July 27, 2015

Are you a Gold Investor? You've Likely Underperformed Stocks

It's VERY easy to pile in on all the "gold sucks" posts that have flooded the blogosphere over the last few weeks, but I thought the below chart was interesting enough to share. My view of gold is that I don't think gold makes a ton of sense as a traditional investment as there is no way to know it's value (during the gold mania of a few years back, I used to ask prospective employees in interviews whether gold was cheap or expensive - whatever they answered, I would ask at what price it would be the opposite... rarely did I get a decent response). I do think it can make sense as a diversifier (in small amounts) and is a great way to play investor sentiment (see my post from early 2009 Ready to Ride the Golden Bubble that proceeded a more than doubling of the price).

The chart below shows the cumulative growth of $1 going back in time for an investment in gold or stocks (the S&P 500), in reverse order. For example, $1 invested in the S&P composite 1950 is worth ~$1000 today, while an investment in gold at that same date is worth only ~$30.

In addition to the outsized outperformance of stocks vs. gold going back in time, this chart outlines that an investment made in gold would have underperformed stocks over EVERY SINGLE PERIOD before 1997 and almost every period after 2002. So... unless you were one of the rare investors to make an allocation in the 1997-2002 window (i.e. pre gold ETF incepion), you've underperformed.

Wednesday, July 15, 2015

From Momentum to Mean Reversion: What the Heck Happened in 2000?

After reading about John Orford's Simplest Mean Reversion Strategy and Simplest Momentum Strategy, I decided to take a look at how the S&P composite would react going back to 1950 (as far back as I could pull daily index returns... note these exclude dividends, thus are not total returns).

The rules are simple
  • Daily Mean Reversion: if the previous day was positive, go short; if the previous day was negative, go long
  • Daily Momentum: if the previous day was negative, go short; if the previous day was positive, go long

Performance Results (excluding any transaction costs / ignoring dividends)
  • From 1950 - 2000 (50 years is a HUGE sample size), daily momentum compounded at a 22% annual rate, while daily mean reversion went straight to 0, losing nearly -20% per year.
  • Since 2000, daily momentum has lost -18% per year, while daily mean reversion has compounded at a 17% clip.

Source: S&P

Monday, July 13, 2015

Investing with Not-So-Perfect Economic Foresight

Following up on my previous post Is there a Relationship Between the Economy and Stock Market?, which outlined the relative performance of the U.S. stock market and underlying U.S. economy over time and market performance during economic expansions / contractions, the below provides further detail into performance of the stock market during periods of improving / declining underlying economic conditions.

GDP Growth and Stock Performance (real-time)
If you had perfect insight into whether underlying U.S. economic growth was improving or declining in real-time (or more realistically a view), then the first chart is interesting. It shows U.S. stocks have historically outperformed when economic growth was picking up (note this is not a measure of expansion vs. contraction, but rather a second derivative outlining whether the growth rate is improving / declining).

GDP Growth and Stock Performance (lagged)
Even without perfect foresight, if you had an opinion about the previous quarter's growth AFTER the quarter ended, the information remains valuable. The chart below outlines stock market performance against one quarter lagged economic growth (for example, if you knew on July 1st that the second quarter had improved from the poor first quarter). Note that the BEA releases quarterly real GDP stats about a month into the following quarter (and that information is revised for years), thus no perfect way to gather this information. Interesting none-the-less if you did have some insight...

GDP Growth and Stock Performance (lagged two quarters)
Economic improvement lagged two quarters actually has an inverse relationship with market performance (i.e. the stock market has underperformed after an improving quarter - two quarters lagged). My guess as to why is two-fold:
  1. Mean-reversion: following the outperformance during the "real-time" and "lagged" periods, markets takes a relative break
  2. Public knowledge: at this point the improving economy is well-known, thus individuals have likely over-reacted to it

GDP Growth and Stock Performance (linked quarters)
Knowing how the economy has performed in the past / in multiple periods also provides a potential opportunity for investors. The following 2x2 matrix outlines the possibilities:

The resulting performance is outlined below and highlights that if the previous quarter of economic growth was improving, you are relatively cushioned no matter how the underlying economy performs this quarter (a subsequent weakening economy has meant decent returns, an economy that continues to improve has meant monster returns), while a weakening economy in the previous quarter without a bounce back, has meant trouble for equity markets.

Source: BEA, Russell

Monday, July 6, 2015

Adding a VIX Signal to Momentum

Michael Batnick, Director of Research at Ritholtz Wealth Management, and blogger of the always interesting Irrelevant Investor, recently shared the historical performance of U.S. stocks when they fall below their 200-day moving average, something that occurred early last week (bold mine, quotes Michael's).

Increased odds at a material sell-off 
When bad things have happened, they tended to do so below the 200-day. Since 1960, 22 of the 25 worst days have occurred below the 200-day moving average. Of the 100 worst single days over the last 55 years, 83 of them happened while stocks were below the 200-day.  
Lower returns 
The average 30-day return going back to 1960 is 0.88%. The average 30-day return when stocks are below the 200-day is -2.60%. 
Higher risk
That’s 13.8% annualized for all periods and 18.4% for periods below the 200-day. 

While there is nothing magical about the 200-day moving average, I am a huge fan of momentum because it tends to result in improved risk-adjusted returns using any number of rolling periods (i.e. 100-day, 200-day, 300-day) and due to momentum's ability to cushion my own behavioral issues (I have a very difficult time doing nothing... something that can cause a material impact on my investment performance if not controlled). For me, momentum provides a systematic approach to protect my portfolio from myself. To keep myself busy (again... I have a very difficult time doing nothing), I have done quite a bit of work on momentum, specifically thinking about ways that may further enhance its outcomes. In this post I'll discuss one area I've looked into, which (in U.S. equity markets) happens to be sending a conflicting signal relative to the 200-day moving average.

Combining Momentum and Volatility Managed Portfolios

In a recent post, I outline the relationship between market volatility, the VIX, and future returns (see The Case for a Steady Volatility-State Managed Portfolio for high level details). The takeaway is there is valuable information contained within the VIX, specifically that it does a pretty good job of predicting future levels of volatility (due to the relationship between historical volatility and future volatility), which in itself has a strong relationship with future risk-adjusted returns (when volatility is high, risk-adjusted returns tend to be lower).

In this example, going back to January 19, 1993 (the first in-sample date of CBOE VIX index), I took forward S&P 500 returns and split them into the following four buckets:
  • When VIX > 20 and the S&P 500 TR Index > 200 Day Moving Average
  • When VIX > 20 and the S&P 500 TR Index < 200 Day Moving Average
  • When VIX < 20 and the S&P 500 TR Index > 200 Day Moving Average
  • When VIX < 20 and the S&P 500 TR Index < 200 Day Moving Average

As the chart outlines below, there is a strong relationship between momentum and implied market volatility; when momentum is strong (i.e. stocks are above their 200-day moving average), the VIX is below 20 seventy percent of the time and when momentum is weak (i.e. stocks are below their 200-day moving average), the VIX is greater than 20 eighty percent of the time. Of note (and what we'll focus on below), is when the market is below its 200-day while the VIX is less than 20 (a rarity at only 6% of the time).

Similar to what Michael pointed out in his analysis going back to the 1960's, when stocks are below their 200-day moving average, market risk is materially higher (28.4% annualized standard deviation vs. 18.9% for all days since 1993) and the Sharpe ratio is lower. BUT, in those 6% of days that stocks were below their 200-day moving average, while the VIX was below 20, not only was market volatility lower (13.6% standard deviation vs. the 18.9% for all days), excess returns to t-bills were materially higher (18.2% annualized vs. 6.4% for all periods), resulting in a Sharpe ratio 4x higher than the entire period.

Which brings us to the current period... despite all the noise currently in the market (China, Greece, my own personal nightmare of having my rent recently doubled), as I write this post the VIX is sitting below 17.5, well below the 20 threshold outlined above. Perhaps the VIX is providing investors with a signal that the market will bounce (mean reversion) vs. providing verification that the market is in a continued downtrend (momentum). In other words, a market that has recently underperformed, yet remains "calm", may in fact be a good buying opportunity.

Tuesday, June 23, 2015

Fad Investments (the Case of Good Harbor)

Investment News outlines an arbitration request by an investor seeking damages for being placed in two funds; one to F-Squared (an outright fraud) and another to Good Harbor's U.S. Tactical Core Fund (GHUIX).

The adviser placed approximately $900,000 of the investor's savings, which his lawyer said was the vast majority, in products managed by two so-called ETF strategists. More than half went into an F-Squared's AlphaSector Allocator Select, and the remainder went into Good Harbor Financial's U.S. Tactical Core product.
A quick look at the insanely good returns of the black box Good Harbor strategy prior to their fund launch (this was for Good Harbor's non-wrap and wrap accounts).

At roughly that time, a salesman at my former firm would rave about the returns of the strategy / drool at the commissions their quickly expanding distribution team was capturing (see fund flows below). I remember him sharing that flows were in the billion plus per quarter range (I can't verify that figure, but given the fund is only a fraction of firm's AUM that seems plausible).

To no surprise of anyone that knows me, I tried to figure out what they were actually doing, using the following Good Harbor objectives as my starting point.
  • Long-only stock exposure with reduced beta
  • Seeks to outperform the Standard & Poor's 500 Total Return Index by allocating investments tactically across various asset classes
  • Designed to align with US stocks during sustained bull markets
  • Designed to move defensively to US Treasuries during sustained bear markets
  • Use of leverage

Through a bit of trial and error, I backed into results that looked awfully similar using the following simplistic rules:
  • 3 and 6 month rolling returns (i.e. 2 paths)
  • If S&P 500 > Long Treasuries, allocate to the S&P 500
  • If S&P 500 < Long Treasuries, allocate to the Long Treasuries
  • 1.2x leverage

I hadn't thought about the above model (or Good Harbor for that measure) in more than 2 years, but when I came across the article I thought it would be interesting to dust off the model and compare the results of Good Harbor's strategy vs. my own (in the below, returns past January 2013 are the institutional fund). 

The results are pretty brutal; either their model's signal(s) were tied to momentum and that relationship broke down or... well, they simply changed how they followed the model (perhaps behavioral issues tied to managing billions vs millions). Either way, returns since January 2013 were 65% for the EconomPic replication model, 55% for the S&P 500, and -3% for the Good Harbor strategy.

As for the investors that piled in billions of dollars, this is seemingly yet another example of performance chasing. In this specific case by an advisor who should have known better than to chase returns with the majority of a client's portfolio (concentration that should not be done irrespective of past performance or future performance expectations). 

What's interesting to me is that performance chasing is especially prevalent for investments that are too good to be true, either with the potential of a new technology (biopharma comes to mind), the superiority of an investment manager (the case of Marketfield comes to mind), or (in this case) in the form of a black box that always beats the market (hedge funds also come to mind). 

In this specific case, you add in the 5.75% load of the A-share and this may be a situation where past performance is not the only issue:
The claim said that Wells Fargo earned about $19,000 in fees for recommending the products, eroding potential capital gains. According to a copy of the claim reviewed by InvestmentNews that created "a conflict in recommending such high commission investments.”
Source: S&P, Barclays

Monday, June 15, 2015

The Case for a Steady Volatility-State Managed Portfolio

The always interesting quant aggregator Quantocracy linked to an interesting post by John Orford (follow John on Twitter at @mmport80) outlining a 'Steady Volatility Strategy' that targets a constant volatility target based on the most recent VIX index as follows:

Stock weight = Target volatility / VIX 
For example, if an investor is targeting a portfolio volatility of 10% and the current VIX is 20, then the investor would weight stocks at x = 10 / 20 = 50% weight.
I've actually been working on something similar (actually... almost exactly the same thing), thus I thought it might be helpful to share some thoughts on why this strategy likely leads to a portfolio with an improved Sharpe ratio over time relative to the S&P 500.

Market Volatility is Sticky

High levels of market volatility tend to lead to continued high levels of market volatility (at least over short periods of time before mean-reversion does its magic). As the chart below highlights, higher levels of the VIX have largely been the result of high market volatility over the previous month, while high levels of VIX tend to lead to higher levels of market volatility over the next month. Putting the old A = B and B = C, so A = C thought process to work, we get to high levels of historical market volatility leading to high levels of future market volatility.

Sharpe Ratios are Higher During Low Volatility Environments

While returns have in fact been a bit higher when volatility is elevated, the relationship has been much weaker than the relationship between historical and forward volatility. As a result, the S&P 500 has had a Sharpe ratio almost 2x higher when the VIX was less than 20 than when it was above 20. As a reminder, Sharpe ratio is excess performance to cash over standard deviation. The lower denominator when volatility is low more than offsets the impact of slightly lower returns on the Sharpe ratio calculation.

Allocating More to Equities when the Sharpe Ratio is Higher = Improved Return Profile

As a result of a higher Sharpe ratio when the VIX is less than 20, an investor could produce higher risk-adjusted returns by allocating more to stocks when the VIX is less than 20 and less when the VIX is above 20. In the example below, stock weights were increased 50% to 150% when the VIX was less than 20 and decreased 50% to 67% when the VIX was above 20 (financed by 3-month t-bills when levered / allocated to 3-month t-bills when unlevered).

While the introduction of leverage brings in a whole assortment of other risks I'll ignore here, the result of the steady volatility allocation over the above time frame is a portfolio with:
  • More consistent year-to-year performance: 12-month standard deviation ranged from 11% to 31% for steady volatility vs. 8% to 45% for the S&P 500
  • Lower drawdown: -47% for steady volatility vs. -55% for the S&P 500
  • Lower overall volatility and higher returns: see above

Source: CBOE, S&P, Federal Reserve

Wednesday, June 10, 2015

The Relationship Between TIPS, Treasuries, and Inflation

TIPS "treasury inflation protected securities" currently provide very little upside (return), but that exact statement can be made about just about any area of the fixed income market. Where they do present a potential opportunity is in relative terms against traditional Treasury bonds. Regardless, this post is less about the opportunity within TIPS and more about the return profile they provide. For a deeper dive into how TIPS function, I recommend this Vanguard piece.

What are TIPS?

TIPS provide an investor with real (i.e. after inflation) returns guaranteed by the U.S. government. You buy TIPS at a real rate, which is lower than traditional Treasuries by a 'break-even' inflation rate determined by the marketplace. For example, in the below post I will assume the nominal rate on a Treasury bond of 2.5% and a break-even inflation rate of 2.0%, resulting in a TIPS real yield of 0.50% (all relatively close to current levels for bonds with a 10 year maturity).

Return Profile of Treasuries vs. TIPS

The below chart is without a doubt an oversimplification, but the most important aspect is that nominal bonds (i.e. Treasuries) provide a nominal return (over a time frame equal to their duration) that is extraordinarily close to their yield to maturity. For this exercise we will ignore the path of returns (i.e. how they got there... which is important), so that we can focus solely on the relationship between inflation and returns (nominal and real).

Treasury Bonds

At the current yield of 2.5% and an 8-year duration, a 10-year maturity Treasury bond WILL provide an investor a nominal return very close to 2.5% over the next 8 years regardless of inflation. As Treasuries do not adjust for inflation, assuming an inflation rate at a constant level over the life of the Treasury bond, the real return of a Treasury bond is simply the nominal rate less the inflation rate. For example, if inflation is 3% and the Treasury bonds only return 2.5%, then real returns are negative -0.5%. On the other hand, if there is deflation, then the real return moves higher. For example, if deflation is -1% and the nominal yield is 2.5%, then the real return is 3.5%.


Inflationary Environment
At a real yield of 0.5%, TIPS provide an investor with a real return equal to 0.5% if there is inflation, while the nominal return will increase by the rate of inflation. For example, if the inflation rate is a constant 2%, then TIPS provide the same nominal return as Treasuries (the fact they are the same, means the break-even is 2%). If inflation is above 2%, then TIPS provide a greater nominal return than Treasuries... if less, they provide a smaller nominal return than Treasuries. 

Deflationary Environment
A TIPS investor is guaranteed to receive PAR at maturity, thus is given an embedded "deflation floor" option. As outlined in this Vanguard piece:
TIPS also provide some deflation protection to the principal (but not to the coupon payments). At maturity, if consumer prices have fallen so much that the inflation-adjusted principal would be below par, the Treasury will repay the principal at par value. In this manner, TIPS provide a “deflation floor.”
As a result, while nominal bond real returns move in a linear fashion to changes in inflation rates, TIPS cannot move negative (unless the real yield at purchase was negative) in nominal terms, thus the real return also increases in a deflationary environment (a ~0% nominal return when deflation is 3% = to a 3% real return). 


In normal market environments when inflation is relatively stable, long-term returns tend to be similar for both Treasuries and TIPS. However, TIPS materially outperform in an inflationary environment, while Treasury outperformance is capped by a rate roughly equal to the break-even inflation rate in a deflationary environment. Thus, assuming a view that an inflationary and deflationary scenario are equally likely, the unlimited potential outperformance of TIPS vs. Treasuries in an inflationary environment and limited upside of Treasuries vs. TIPS in a deflation environment would sway an investor towards TIPS.

Wednesday, June 3, 2015

An Improved High Yield Alternative

I really don't like the high yield asset class. Not just in the current environment with near-low historical yields and the potential for material liquidity issues, but in general. As an asset class, I think high yield:

  1. Often caters to unsophisticated investors that only look at the yield
  2. Is riskier than its returns suggest due to an opaque credit market that doesn't as regularly reprice bonds (as they do within equities)
  3. Has unfavorable tax consequences relative to stocks as coupons are taxed at a much higher rate than the capital appreciation of stocks

Historical Performance Comparison to Stocks

One draw of high yield is the view that its performance is from a known yield (vs. the less guaranteed market appreciation of equities). In addition, the Sharpe ratio of the asset class has historically been superior to stocks (i.e. more return per unit of risk). The counter points to that argument is that the Sharpe ratio is overstated as volatility of high yield is under-reported (see point 2 above), as well as the fact that high yield returns are the result of two factors (credit and rates) that can be replicated with an allocation to stocks and bonds (thus a high yield vs. stocks comparison is apples to oranges). Case in point being that a 54% S&P 500 / 46% treasury portfolio since the Barclays High Yield 1983 inception has the same standard deviation and higher returns vs high yield... thus a higher Sharpe ratio. 

Decomposing High Yield Returns

Before getting into details of a high yield alternative, let's decompose historical high yield returns to get a better sense of what an investment in high yield actually provides. 

High yield benefits from the return of two main factors, credit and rates (actually as we'll see it mainly benefits from rates). As the chart outlines below, the credit (spread) component of high yield and the rates component are often well balanced, making high yield a "risk-parity" like allocation between the two factors. As a result, comparing high yield to a blended stock/bond allocation rather than a stand-alone stock or bond allocation makes sense. Or as we'll outline below, there may be an opportunity to replace one of the factors with a more efficient / more liquid component. The below charts break down the returns into these two factors over the past 25 years (as far back as Barclays reports them separately).

Despite a higher contribution to portfolio level risk from the credit (spread) component...

Credit (spread) has provided a materially smaller contribution to the long-term performance of high yield

Swapping in Credit Risk via Equities vs. Bonds

If high yield is a sub-optimal way to access credit risk an investor utilizing leverage can replicate high yield via treasuries for the rate factor and the S&P 500 for the credit / spread factor.

The below chart shows the equity curve of two such options going back to 1983...
  • High Yield Alternative A: scale stocks to provide similar return as high yield: 100% treasuries, 24% S&P 500 financed at 3-month t-bills 
  • High Yield Alternative B: scale stocks to provide similar risk as high yield: 100% treasuries, 46% S&P 500 financed at 3-month t-bills

The Results

Historical results are certainly promising on an absolute and relative basis. Not only were Sharpe ratios improved, drawdowns were materially reduced. In addition, a portfolio consisting of treasuries and the S&P 500 will likely be MUCH more liquid than high yield during periods of turmoil.

Sources: S&P, Barclays, Federal Reserve

Monday, June 1, 2015

Ignore the Margin Debt Alarm

The margin debt alarm has seemingly been sounded every few months when investors realize absolute levels of margin debt have reached new all-time highs (inferring that risk taking has too reached all-time high levels). This brief post highlights why any such alarm (and any future margin debt alarm) should likely be ignored.

Oversimplified Analogy

Absolute levels of debt simply don't matter. As anyone who took an accounting or corporate finance course in high school or college understands, what is relevant are levels of debt relative to asset and equity levels. Taken to the extreme... does someone worth $2000 with $5000 of credit card debt have the same debt problems as someone worth $2 million with $5000 of credit card debt? Of course not. What matters is the level of debt to the assets that debt is supporting.

Relative Margin Debt is the More Appropriate Calculation

Doug Short put together the below chart outlining NYSE debt and S&P 500 equity levels going back 20 years. When viewed in isolation, NYSE Margin Debt levels (red) have risen sharply since 2009 lows. What has also risen sharply since 2009 are equity valuations.

Context matters... while debt levels did rise more quickly than equity valuations from 2001 through 2007, since 2007 margin debt has moved in complete unison with stock valuations; margin debt has consistently stayed between 2.0% and 2.5% of the value of the S&P 500 index. This means margin debt has not increased at all when you account for assets that margin debt is supporting.

Do Absolute or Relative Margin Debt Levels Even Matter?

The only thing an increase / decrease in absolute margin levels tells you is how the stock market has done in the past. As markets rise, margin levels rise. As markets fall, margin levels fall.  This can be seen in the bottom left chart (red), where 46% of the relationship over the past 20 years (the time frame in Doug's chart) has been driven by market movements.

As all the other R-square levels attest, there has been very limited relationship with changes in margin levels and future market movements over the last 20 years and absolutely no relationship between historical or future market movements with the very small changes that have occurred in the relative levels of margin debt to S&P 500 valuations.

Returns vs. Margin Debt (1995-2015)

So next time you hear anything about absolute levels of margin debt... ignore it.

Sources: NYSE Data / Yahoo Finance

Tuesday, May 12, 2015

The Case Against High Yield

Following up on my post The Relationship Between Stocks and Bonds, which outlined why it is probable that stocks will outperform Treasury Bonds over the next 10 years, let's take a look at another expensive area of the bond universe... high yield U.S. corporate bonds.

High yield bonds: Where's the high yield?

As the right-hand chart below highlights, the 5.95% yield to worst of the Barclays U.S. High Yield Index (as of 4/30/15) is near its all-time low. Due to defaults, this yield should be thought of as the best case return that can be expected over a 5-10 year period, rather than the likely forward return.

Why? Over ten year periods since 1986 (the furthest back I could gather yield to worst data):

  • The forward ten-year return of the Barclays U.S. High Yield Index has under-performed its yield 93% of the time
  • The forward ten-year return of the Barclays U.S. High Yield Index has under-performed its yield by an average of 3.5% / year (with a 3.5% standard deviation) 

While there are certainly no guarantees, given the 5.95% yield, history "implies" a ten year forward annualized return of 2.5% with a one-standard deviation range of -1% to 6%.

High yield vs. stocks: The story gets worse

While U.S. stocks appear expensive by most measures, they have nothing on high yield. Using the same format as above, the below compares the excess yield of high yield relative to stocks vs. the excess return of high yield relative to stocks.

The first thing you may notice in the right-hand chart below is that high yield's excess yield vs. stocks is only slightly above 2%, well shy of the 7% average from 1987 through 2005 and not even in the same ball park as the 15% level reached during the early 1990's and financial crisis. Note... the below uses the CAPE yield (more details here); using the S&P 500's current earnings yield gets you to a sub 1% figure, slightly above the negative level that occurred in 2013.

Relative performance results look even worse than high yield in isolation:
  • High yield's forward ten-year relative performance vs. stocks has under-performed its excess yield 100% of the time
  • High yield's forward ten-year relative performance vs. stocks has under-performed its excess yield by an average of 8.3% / year, with a 5.2% standard deviation 

Given the current 2.2% excess yield of high yield bonds vs. stocks (as of 4/30/15), history "implies" a -6% ten-year annualized underperformance vs. stocks with a one-standard deviation range of annualized underperformance of -11% to -1%.

"History doesn't repeat itself, but it does rhyme" - Mark Twain

Looking back at the performance of high yield corporate bonds since the crisis, we see remarkably strong performance among the lowest credit quality segments of the market. It wasn't long ago that we found ourselves in a similar situation of lower quality outperformance; the chart below highlights the almost five year run from late 2002 through mid-2007 that looks awfully similar to the returns we've experienced since the end of 2008. In between these two time frames was a massive flight to quality / junk sell-off that took place during the financial crisis, which created the opportunity for the most recent period of junk outperformance (and NOBODY wanted to allocate to high yield in early 2009).

There are times when high yield bonds present an attractive opportunity in absolute or relative terms. Today does not appear to be one of them.