tag:blogger.com,1999:blog-110275289113644752024-03-16T11:53:01.408-07:00EconomPicJakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comBlogger2621125tag:blogger.com,1999:blog-11027528911364475.post-6207209294616110412020-11-12T10:19:00.013-08:002020-11-12T20:50:57.385-08:00The Case Against Using the CAPE Ratio for Relative Valuation Across Markets<p>Bloomberg has an article <a href="https://www.bloomberg.com/opinion/articles/2020-11-12/personal-finance-will-u-s-or-foreign-stocks-perform-better-this-decade">You May Regret Staying Parked in U.S. Stocks</a> which made the case that there’s "widespread agreement" and "the answer isn’t in dispute" that foreign stocks will outperform going forward. </p><p>Simplified version of my view of that statement.... c'mon now. Extended version of my view of that statement is in line with what <a href="https://twitter.com/ajb_powell">Jamie Powell</a> outlines <a href="https://ftalphaville.ft.com/2020/08/17/1597668262000/Is-GMO-s-Montier-right-on--absurd--US-stocks-/">here</a>:</p><p></p><blockquote>So really, it’s hard to argue that US equities are any more expensive than their European counterparts. Sure, the States might have far more stocks at trading at rich prices, but that’s by virtue of its sectoral composition, rather than it being a uniquely American phenomenon. </blockquote><p></p><p>But the point of this post isn't to get into the relative fundamentals of US vs foreign stocks, but rather to outline how the author made a basic error with his choice of valuation metric.</p><p><br /></p><p><b>Cyclically Adjusted Price to Earnings Can Not Be Used to Compare Two Very Different Markets</b></p><p>The Bloomberg article states clearly that U.S. fundamentals have been superior over the last decade, which in their view is unlikely to repeat.</p><p></p><blockquote><p>The jaw-dropping earnings growth generated by U.S. companies in recent years — and which propelled U.S. stocks past foreign markets during the last decade — is unlikely to return anytime soon.</p><p></p></blockquote><p>Fair... but then the author uses the cyclically adjusted price-to-earnings ratio ("CAPE"), which averages the real EPS from the last decade, for the denominator in the price multiple used to compare markets.</p><p><br /></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiwyIobzw0SlAgtNmUcTku3i27VEox2xDJwhzYX2r2rA-FHhNQttOBjFCeAzY780bGAzv_W6p3bRk_UGSZc2lwQ57arLdYjCqbowcvX_TCfgtqoSIPbK4NKBLBJNFikXtzZtavjgd-IRw/s662/CAPEBLAH.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="372" data-original-width="662" height="360" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiwyIobzw0SlAgtNmUcTku3i27VEox2xDJwhzYX2r2rA-FHhNQttOBjFCeAzY780bGAzv_W6p3bRk_UGSZc2lwQ57arLdYjCqbowcvX_TCfgtqoSIPbK4NKBLBJNFikXtzZtavjgd-IRw/w640-h360/CAPEBLAH.png" width="640" /></a></div><p><br /></p><p>So what's the problem with the CAPE across markets? </p><p>The problem is the U.S. has experienced "jaw dropping" growth in EPS, while foreign stocks have not.</p><p>To the numbers... the chart below shows what the CAPE ratio would be for any given market assuming a constant trailing P/E over time (i.e. if a market traded at 10x, 15x, or 20x and it continued to trade at that exact multiple for the entire time frame). The only thing that changes in the below is the EPS growth from year 1 to year 10. Note I ignore inflation in the below, so assume growth rates are real instead of nominal.</p><p><br /></p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhB2E8fZ6fqgNyV20IQ7wgpAeXMu2RvYCKqfQs7jhdZjcGh6DGnjblaAEsuI53LUvau-IOiBd9ZaRNKjaGCX7NeRifrae26wKZgoxfEI7d5QUYSvChe15L2q9uhrJS_F_R9Vny8yD-BxQ/s569/CAPE2.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="400" data-original-width="569" height="450" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhB2E8fZ6fqgNyV20IQ7wgpAeXMu2RvYCKqfQs7jhdZjcGh6DGnjblaAEsuI53LUvau-IOiBd9ZaRNKjaGCX7NeRifrae26wKZgoxfEI7d5QUYSvChe15L2q9uhrJS_F_R9Vny8yD-BxQ/w640-h450/CAPE2.png" width="640" /></a></div><p style="-webkit-text-stroke-width: 0px; color: black; font-family: "Times New Roman"; font-size: medium; font-style: normal; font-variant-caps: normal; font-variant-ligatures: normal; font-weight: 400; letter-spacing: normal; orphans: 2; text-align: left; text-decoration-color: initial; text-decoration-style: initial; text-indent: 0px; text-transform: none; white-space: normal; widows: 2; word-spacing: 0px;"></p><p></p><p style="-webkit-text-stroke-width: 0px; color: black; font-family: "Times New Roman"; font-size: medium; font-style: normal; font-variant-caps: normal; font-variant-ligatures: normal; letter-spacing: normal; orphans: 2; text-align: left; text-decoration-color: initial; text-decoration-style: initial; text-indent: 0px; text-transform: none; white-space: normal; widows: 2; word-spacing: 0px;"><span style="font-weight: 400;"><br /></span></p>For a company with 0% EPS growth each year, it's easy... the starting and ending multiple is the CAPE ratio. But for a company with positive or negative EPS growth, the answer may be less intuitive. EPS growth makes the CAPE higher all else equal and EPS contraction makes the CAPE lower all else equal.<br /><br />So... if we assume:<br /><ul style="text-align: left;"><li>Stocks in a market with favorable sectors and growth prospects "should" trade at 20x (and do throughout) and have grown EPS at 10% / year, the CAPE is now ~30x. </li><li>Stocks in a market with less favorable sectors and growth prospects "should" trade at 15x (and do throughout) and have EPS that have contracted at 2.5% / year, the CAPE is now ~13x.</li></ul>Let me rephrase this to be clear... in this example the trailing P/E for the favorable market was at a 33% constant premium to the less favorable market (20/15 -1), but the end CAPE ratio of the favorable market appears as a premium of more than 100% to the less favorable market. <br /><div><div><br /></div></div><div><br /></div><div><b>Conclusion</b></div><div><br /></div><div>CAPE normalizes earnings when those earnings are cyclical. If your view is technology stock earnings are at a cyclical peak and industrial / banking earnings are at a cyclical trough then foreign <b><u>AND</u></b> US value stocks look cheap. If not, they very well may not be. </div><div><br /></div><div>That's your bet.</div><div><br /></div><div>Your bet is not that valuations are remotely as extreme the CAPE implies... and there's no disputing that. </div><div><br /></div><div><br /></div><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-18976013052104585112019-08-27T11:46:00.003-07:002019-08-27T12:53:21.477-07:00Mind the Gap? Rethinking the Investor Gap EquationMorningstar released the latest version of <a href="https://www.morningstar.com/articles/942396/mind-the-gap-2019">Mind the Gap</a>, an annual piece which shares with its readers analysis that "measures the costs of bad timing".<br />
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In this post I'll attempt to clearly explain the math behind the investor gap calculation, share a few examples of how flows impact the investor gap, and outline why I believe these flows (thus investor gap) have little (to no) relation to investor behavior.<br />
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The result of this analysis is potential good news for investors with implications for how money is managed as 1) advisors who market their value add as "fixing bad behavior" may be selling a fix to a smaller <a href="https://www.vanguard.com/pdf/ISGQVAA.pdf">problem</a> than thought and 2) this may help further explain the performance of factors that have struggled in recent years IF those factors rely on <a href="https://alphaarchitect.com/2019/05/02/deep-dive-into-the-value-factor%EF%BB%BF/">poor investor behavior</a> as some research believes.<br />
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<b>What is the "Investor Gap"?</b><br />
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<a href="https://www.morningstar.com/articles/810470/mind-the-gap-global-investor-returns-show-the-costs-of-bad-timing-around-the-world">Morningstar</a> shares the calculation:<br />
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To calculate fund investor returns, we adjust the official returns by using monthly flows in and out of the fund. Thus, we calculate a rate of return generated by a fund’s investors. As with an internal rate of return calculation, investor return is the constant monthly rate of return that makes the beginning assets equal to the ending assets, with all monthly cash flows accounted for.</blockquote>
In other words, the calculation shows "how did the average dollar in a fund do over a certain time period".<br />
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The table below walks through the internal rate of return “IRR” calculation for an investor in a fund with returns that perfectly match those of the S&P 500 for calendar years 2008-2017 with an initial $1,000,000 investment at the end of 2008 and $50,000 taken out each year (i.e. the fund had consistent outflows). I use the period ending 2017 as I want to align results with Mind the Gap analysis from 2014 (the first year published) through the end of 2017. I'll get to the period ending 2018 in a later section.<br />
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The IRR weights each years cash flow (the initial $1,000,000 put in, the $50,000 / year taken out, the final balance taken out) and calculates the constant return that would have matched the cash flows an investor would have received given those flows (i.e. it matches the same final balance with the same cash flows).<br />
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The table's far right two columns match in terms of beginning and ending balance at a constant 6.92% return (with the same $50,000 / year outflows), meaning this is the investors dollar weighted return assuming the returns of the S&P 500 and outflows in this specific period. Note in this example the investor return (i.e. the IRR) < time weighted return (also called the geometric return), which means Morningstar would bucket this as a fund with a negative investor gap for this period.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhp4jepYSxj6qGNux_vk-CfH56gk9vm9jUGuo_NHQHO8e9ztqxfo0Zl0Iaisi_WILHGJEmZztNmWd82lrGUVvDFFmwT2l5Zf18-soENZn6EhJYGzL9AknryiKcdrJEO6-w9DDacgj6ePg/s1600/SP2017.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="433" data-original-width="909" height="304" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhp4jepYSxj6qGNux_vk-CfH56gk9vm9jUGuo_NHQHO8e9ztqxfo0Zl0Iaisi_WILHGJEmZztNmWd82lrGUVvDFFmwT2l5Zf18-soENZn6EhJYGzL9AknryiKcdrJEO6-w9DDacgj6ePg/s640/SP2017.png" width="640" /></a></div>
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Conversely, a fund with $50,000 / year inflows in this same period would have an investor return (i.e. IRR) of 9.50%, which is greater than the time weighted return, thus this fund would now be bucketed as one with a positive investor gap for this period.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwhyphenhyphen8-pvW4yo3YXSnd0bI174E63Uj_2Ntb5W2mGut7xc17zKSf8uRfU5B21akYinkSfz-gbGFwundQgR3GN0qSZ-3EfV1PcdEBeq1NiE7kMWk2bqwVKMRLbtE1EfJ2XTQzEtmgHqB4Tg/s1600/2017OUT.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="432" data-original-width="943" height="292" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwhyphenhyphen8-pvW4yo3YXSnd0bI174E63Uj_2Ntb5W2mGut7xc17zKSf8uRfU5B21akYinkSfz-gbGFwundQgR3GN0qSZ-3EfV1PcdEBeq1NiE7kMWk2bqwVKMRLbtE1EfJ2XTQzEtmgHqB4Tg/s640/2017OUT.png" width="640" /></a></div>
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<b>How Do Flows and Returns Impact IRR?</b><br />
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Taking a step back, let’s first look at the weight of each year’s return if we were calculating the arithmetic return of a fund. In this case, each of the 10 years would have an equal 10% impact. In this example, the arithmetric return of the S&P 500 over the ten years ending 2017 would be 10.39% (the simple average return for each year in this period).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRUNz0RqmvV8_39tvoUNP347nznCbunzkgzz_VhDt8DzjKAkdkvJpfJ8qpcKfgoGIhXAmZmhTESJfVXqm0IeKZFdmKlBXQWY1ksTf_uxR7OJcXJK8nSIqbXS3GrLYUuOs1GmeO0X7N_A/s1600/Arithmetic.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="493" data-original-width="731" height="430" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRUNz0RqmvV8_39tvoUNP347nznCbunzkgzz_VhDt8DzjKAkdkvJpfJ8qpcKfgoGIhXAmZmhTESJfVXqm0IeKZFdmKlBXQWY1ksTf_uxR7OJcXJK8nSIqbXS3GrLYUuOs1GmeO0X7N_A/s640/Arithmetic.png" width="640" /></a></div>
But flows and returns impact the return an investor receives relative to the arithmetic return (note the arithmetic return is always at least as large as time weighted return given the old +50% / down 50% = 0% average return, but a -25% return in $$ terms ($1 x 1.5 x 0.5 = $0.75).<br />
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In the next example we show the weight of each year’s return over this same 10-year period, but now assuming the weights are impacted by S&P 500 returns even with no flows (this is as simple as taking each years ending asset level and weighting them relative to one another while capping all 10 years at 100%). The shift each year is driven by the performance of the S&P 500... you can see the drop off from 2008 to 2009 due to the 37% decline and the subsequent higher balance as the S&P 500 rallied back to new highs in later years.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhIzvkkz7jLjufCEhp9Q6Zycl7B8_BZEYwK3q9Zp7locOejHfSIhUGpnpLjBdACCKrsDQcP0AzMiTRbLy45bXt_p-dTJIIZIZ4D9WYXXNohjZhYlcjGATQV8ypqA0r_HaqoFNiEid9ZyA/s1600/Out1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="493" data-original-width="731" height="430" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhIzvkkz7jLjufCEhp9Q6Zycl7B8_BZEYwK3q9Zp7locOejHfSIhUGpnpLjBdACCKrsDQcP0AzMiTRbLy45bXt_p-dTJIIZIZ4D9WYXXNohjZhYlcjGATQV8ypqA0r_HaqoFNiEid9ZyA/s640/Out1.png" width="640" /></a></div>
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<span style="font-family: "times new roman" , serif; font-size: 12.0pt;">Now we'll look at how the above weights
change in this 10-year period assuming $50,000 in inflows or outflows each year. Given the material sell-off early in this 2008-2017 time
frame, an investor with outflows has a much higher exposure to the 2008 sell-off than an investor with inflows given flows and returns. <o:p></o:p></span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg5qvhm-e2K0SMsJ2OXWdaBQ-u_tFwb8RB-1KduNmQkzBjaYRaG0rW2Vr3GAsbo2DqMZbMsQrlr6AwADlNyVmFO42kGHshk-4YdOTKQbJPZIs2x9yXa2kACGxBYwoNH9i5KE8KdPQvRqw/s1600/Weighting2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="493" data-original-width="731" height="430" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg5qvhm-e2K0SMsJ2OXWdaBQ-u_tFwb8RB-1KduNmQkzBjaYRaG0rW2Vr3GAsbo2DqMZbMsQrlr6AwADlNyVmFO42kGHshk-4YdOTKQbJPZIs2x9yXa2kACGxBYwoNH9i5KE8KdPQvRqw/s640/Weighting2.png" width="640" /></a></div>
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The -37% market return in 2008 had an outsized negative impact to IRR for US equity funds with outflows (a headwind to investor returns) and an outsized positive impact to IRR for US equity funds with inflows (a tailwind to investor returns) during the 2008-2017 period. Given the path of returns within fixed income, the opposite was true for this period as absolute returns from 2008-2013 were higher than returns from 2013-2017. Below is a table summarizing the impacts to US equities and fixed income in more detail where "bad" = a headwind to investor returns and "good" = a tailwind to investor returns.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwMw0OvOqooKHH3S8nW0W_VCI6aDwMuKy6UUIZoD2m1D3VmcVTimKNUrLmBT5zXV70jcMtbQaYRjseSndD6tmXaJMKhTyvBxIexJZWduLRsyMverYb6uSe6I2xDGn-WUqvj3yDttMDXw/s1600/TABLEBLAH.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="541" data-original-width="627" height="552" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwMw0OvOqooKHH3S8nW0W_VCI6aDwMuKy6UUIZoD2m1D3VmcVTimKNUrLmBT5zXV70jcMtbQaYRjseSndD6tmXaJMKhTyvBxIexJZWduLRsyMverYb6uSe6I2xDGn-WUqvj3yDttMDXw/s640/TABLEBLAH.png" width="640" /></a></div>
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<b>Recent drivers of flows </b><br />
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Any dollar vs time weighted return analysis relies on the view that flows are driven mostly by investor behavior. My view is investor behavior ranks materially below each of the following in terms of aggregate impact:<br />
<ul>
<li><b>Rebalancing: </b>as stocks appreciate, investors sell stocks (selling stocks had a negative impact on investor gap in this window) to rebalance to bonds (buying bonds had a negative impact on investor gap in this window)</li>
<li><b>Demographics / cash demands:</b> investors may sell stocks (selling stocks had a negative impact on investor gap in this window) to derisk into bonds (buying bonds had a negative impact on investor gap in this window), while most investors also make ongoing deposits on the way in and outflows on the way out. Given the age of the US population, Federal <a href="https://fred.stlouisfed.org/series/BOGZ1FU103164103Q">data shows</a> households have been net sellers of equities for decades (selling stocks had a negative impact on investor gap in this window and older demographics were more likely to hold higher fee mutual funds).</li>
<li><b>Shift to passive / ETFs:</b> this causes outflows in active (selling stocks had a negative impact on investor gap in this window) and inflows to passive (buying stocks had a positive impact on investor gap in this window). </li>
<li><b>Shift to AUM advisors:</b> this shifts investors from various higher fee share classes (selling stocks had a negative impact on investor gap in this window) to low fee (buying stocks had a positive impact on investor gap in this window)</li>
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The chart below shows the cumulative flows in US equities and taxable bond mutual funds by active and passive... we can see there were materially positive flows in every area except active US equities and US equities mutual funds as a whole (the combined flows of active and passive).<br />
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<u>Summary:</u><br />
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<li>Returns and flows narrowed the investor gap in the 2008-2017 period for passive equity mutual funds </li>
<li>Returns + flows widened the investor gap in the 2008-2017 period for active equity mutual funds, active fixed income, and passive fixed income </li>
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<b>Real Life Example: The Case of the PIMCO Income Fund</b><br />
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The PIMCO Income Fund is a good example of this flaw in the investor gap calculation given it has been one of the top performing bond funds over the past decade, outperforming its aggregate bond index every single year from 2009-2018. This means an investor that allocated to the fund relative to an allocation to its core aggregate bond benchmark would have benefited if they made an allocation 1) in any year in this period, while holding for 2) any time frame in this period. Flows to this fund also happened to be positive EVERY single year from 2009-2018.<br />
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Yet this strong relative performance and timing translated to a HUGE negative investor gap given the absolute performance from 2009-2013 for the fund was larger than 2014-2018 (the latter period was overweight in the IRR calculation given the strong flows). Thus, despite the fund outperforming for EVERY single investor in dollar terms relative to its index, the investor gap was more than -4% / year. The table below uses the fund's real starting AUM and annual flows and gets to an investor gap result that is pretty close to reality.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhXePzOLeAlFiRCPS898q5yVcKOeyGOWRBKjNWgz2SF_BYxNnQwYWxmC-Qwj5tGKhyQkEnhjmS4j2ik2sh6Zg5OeL_aLc0iarPORjIAT0876VCncOTzH6Qkx8tsOi4Ae-ncUpgnygnNaA/s1600/PIMIX.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="430" data-original-width="913" height="300" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhXePzOLeAlFiRCPS898q5yVcKOeyGOWRBKjNWgz2SF_BYxNnQwYWxmC-Qwj5tGKhyQkEnhjmS4j2ik2sh6Zg5OeL_aLc0iarPORjIAT0876VCncOTzH6Qkx8tsOi4Ae-ncUpgnygnNaA/s640/PIMIX.PNG" width="640" /></a></div>
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<b>10-Year Period Ending 2018: Did Investor Behavior Really Improve?</b><br />
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Given the investor gap calculation had been weighed down by the return during the global financial crisis since Morningstar started putting together their Mind the Gap analysis in 2014, I have been anticipating the results for the period ending December 2018 given 2008 would roll off of the 10 year calculation. The table below shows that outflows for this period would now actually help the IRR calculation relative to time weighted returns given the lower return of US equities in more recent years in this more current 10 year window.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjdmHpjDJi3pZssxSPx3N8vr4-cVffLwjIVePaKbvt9Z5fZe9QmL3VjNm2HYR9utyxfhOJ-8IG4tEO5BL4ovwYwqHpD9TBLtG5o2khbSkfHqkXL8NgpfvMorvo-IoyX2CSyf4Zcm_mIKQ/s1600/SP0918.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="683" data-original-width="795" height="548" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjdmHpjDJi3pZssxSPx3N8vr4-cVffLwjIVePaKbvt9Z5fZe9QmL3VjNm2HYR9utyxfhOJ-8IG4tEO5BL4ovwYwqHpD9TBLtG5o2khbSkfHqkXL8NgpfvMorvo-IoyX2CSyf4Zcm_mIKQ/s640/SP0918.png" width="640" /></a></div>
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And here is an updated high level table outlining the expected impact.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiNgWECZTsnp20f-e1BPPWb9xVcd9y8EwVukZdQtWnW1Vu5-KV6lE4uDXDDzkTkYFaFWEfwgkPRi4_SsYu-DWJwV8d9BHRCVFophpL6ozlAT0JheLV0mh5w7oGeKDA0vBbC3IFjXV0TOA/s1600/TABLEBLAH2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="548" data-original-width="635" height="552" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiNgWECZTsnp20f-e1BPPWb9xVcd9y8EwVukZdQtWnW1Vu5-KV6lE4uDXDDzkTkYFaFWEfwgkPRi4_SsYu-DWJwV8d9BHRCVFophpL6ozlAT0JheLV0mh5w7oGeKDA0vBbC3IFjXV0TOA/s640/TABLEBLAH2.png" width="640" /></a></div>
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Given these expected results would seemingly invert many of the takeaways from the previous Morningstar reports (low fee, indexing, etc... investors had smaller investor gaps for a number of potential behavior reasons), I was interested to see how an investor gap that flipped for US equities would be evaluated.<br />
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But a change in <a href="https://www.morningstar.com/articles/942396/mind-the-gap-2019">methodology</a> of the calculation kicked that can a few years down the road given the analysis no longer looks at ten-year periods, but instead looks at the ten-year periods ending the previous 5 years. This effectively weights the studies ending 2014, 2015, 2016, and 2017 (i.e. periods positively impacted by flows) at 80% and the new period ending 2018 (that now favors outflows) at 20%.<br />
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<a href="https://twitter.com/syouth1">Jeff Ptak</a> (a great follow on Twitter not only for his investment takes, but also his music takes... and co-host of <a href="https://www.morningstar.com/articles/930834/the-long-view-podcast">The Long View</a> podcast) has been especially generous with his time responding to my questions over the years, as well as the change in methodology. He was gracious enough to share <a href="https://twitter.com/syouth1/status/1166185311870824448">what the results would have been under the old methodology for the period ending 2018</a>.<br />
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The following chart shows the investor gap by fee quintile for each of the 10 years ending 2014-2018 (the periods averaged for the new official investor gap measure) for US equities. Here we can clearly see the narrowing of the gap for all quintiles as the global financial crisis has rolled off 2018 figures, as well as the sharp reversal in terms of which investors have performed better on a dollar weighted basis by fee quintile (higher fee funds actually exhibited a positive investor gap as the analysis outlined above had expected).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEin68sbIkEoxyASD921XaZuuj__D-A0sNEx10l5-u1vcXxjNIZdOPyFBvJY8-1_i0lZWxWdoqZxs3ydmqWwEUazawcDJORfTzO67eQ0vHh0rzQ0XQEGc2o6pAzDpofOFhrsT1SAa12yWw/s1600/STOCKSM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="283" data-original-width="469" height="386" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEin68sbIkEoxyASD921XaZuuj__D-A0sNEx10l5-u1vcXxjNIZdOPyFBvJY8-1_i0lZWxWdoqZxs3ydmqWwEUazawcDJORfTzO67eQ0vHh0rzQ0XQEGc2o6pAzDpofOFhrsT1SAa12yWw/s640/STOCKSM.png" width="640" /></a></div>
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The question becomes... which time frames are right? Or (in my opinion), are any of the time frames right?<br />
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My take is 1) investors clearly haven’t suddenly (year over year) gone from bad behavior to good behavior, 2) if the investor gap can be positively correlated to poor behavior at certain times and negatively correlated to poor behavior at other times, then it should probably not be viewed as something besides noise, and 3) perhaps investor behavior has improved over time and we just haven't properly measured it (investors moving from high fee to low fee, shifting towards target dates funds / robos, rebalancing as stocks have moved higher, etc... all qualitatively point the right direction).<br />
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IF we have been overstating the poor behavior of investors and/or missed their improvement, this seemingly has material implications to the scale of the value proposition advisors often use to justify exorbitant advisory fees (i.e. the need for investors to have their hands held by advisors on a continuous basis). In addition, if certain investment factors have historically relied on poor investor behavior (in the aggregate) to outperform, perhaps improved investment behavior has contributed to what has been one of the more challenging time frames for these factors in history.<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-42329217095738703672019-05-07T11:02:00.002-07:002021-09-04T18:59:16.297-07:00F@ck Everything... We’re Going 120/80<a href="https://twitter.com/JeremyDSchwartz">Jeremy</a> had spent most nights over the previous 30+ years on this earth in search of the next big ETF. After all, you don’t “aspire to be at the forefront of innovative ways for marrying the benefits of the exchange-traded fund structure with goals that are associated with active managers” by sitting around and doing nothing.<br />
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The problem was for as much as he searched and probed, the same tired investment ideas presented themselves over and over again. Sometimes these offerings had catchy names. Other times they had ever reduced costs. But nothing brought Jeremy the joy that he was in search of.<br />
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Disgruntled and lonely, Jeremy needed a break from the madness. So on the fateful morning of November 18th, 2017, Jeremy logged into Twitter. And shortly thereafter, his life would never be the same.<br />
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<b>Making the Impossible, Possible</b><br />
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Based upon the now <a href="https://www.barrons.com/articles/whats-next-for-etfs-1510976833">infamous interview</a> with investment guru <a href="https://twitter.com/choffstein">Corey Hoffstein</a> in Barrons, the two users not so affectionately referred to as “trolls” that “lacked social skills” did what they did best.<br />
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<a href="https://twitter.com/EconomPic">Jake</a> and <a href="https://twitter.com/Nonrelatedsense">Unrelated Nonsense</a> argued. And argue they did.<br />
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But this argument was not like their previous arguments involving taxes or fast food. Rather, this argument was the FinTwit version of catching lightning in a bottle. You see… these two debated the merits of Corey’s idea of leveraged beta exposure by <a href="https://twitter.com/EconomPic/status/931965749819858944">coming up with a 90% stock / 60% bond strategy</a> that historically outperformed a 100% stock allocation with similar risk.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj7fDovkUFuLHEiMZmJ46WEd7aRAqnNygSa29uppLGWJbjDHUIBQE2AwWWoS1vCjg4vVAcIOhNY_xGn4uv1nBHUy78wWUfubRQ-JSFp644GqrDQqMTaouPk2VKA_YhgyrzNwvsT0LYAKw/s1600/1a.JPG" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="611" data-original-width="828" height="472" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj7fDovkUFuLHEiMZmJ46WEd7aRAqnNygSa29uppLGWJbjDHUIBQE2AwWWoS1vCjg4vVAcIOhNY_xGn4uv1nBHUy78wWUfubRQ-JSFp644GqrDQqMTaouPk2VKA_YhgyrzNwvsT0LYAKw/s640/1a.JPG" width="640" /></a></div>
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But that’s not where things ended.<br />
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This strategy also offered the flexibility to be held at a 2/3 weight, matching exposure of a traditional 60/40 portfolio and allowing the remaining 1/3 to be allocated to alpha strategies (click <a href="https://econompicdata.blogspot.com/2016/07/the-case-for-hedge-funds.html">here</a> for an older post outlining how a levered portfolio can make room for an alpha generating allocation).<br />
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<b>Better Act Fast </b><br />
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“I remember thinking this idea was just sitting there for the taking”, Jeremy is rumored to have remarked to his team back at Wisdomtree. “These idiots were just giving away their ideas for free. I had to act fast.”<br />
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And fast he acted. On August 2nd, 2018, less than one year from that fateful morning on Twitter, the ETF <a href="https://www.wisdomtree.com/etfs/asset-allocation/ntsx">$NTSX was launched</a>. Seven months later this ETF would be known as the <a href="https://twitter.com/JeremyDSchwartz/status/1111428882043826176">award winning ETF</a>, taking home the gold for best new allocation ETF.<br />
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<b>More Free Advice</b><br />
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If you think this is where the story ends, you would be wrong.<br />
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On May 6th, 2019, nine years to the day of the Flash Crash, investment legend Corey Hoffstein came out with a post outlining his tactical approach to the 90/60 concept, improving outcomes for investors further (side note I do highly recommend you <a href="https://blog.thinknewfound.com/2019/05/tactical-portable-beta/">check it out</a>). This was followed the very next day by the another approach I am about to share.<br />
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You see, an investor need not just use plain vanilla S&P 500 beta for the equity exposure within a 90/60 portfolio. In fact, an investor comfortable with a long-term volatility profile similar to equities could even ramp up the beta exposure past 90/60 if they could find an equity allocation that had lower volatility than the market.<br />
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<b>Introducing the 120/80 S&P 500 Low Volatility Strategy</b><br />
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Since its November 1992 launch, the S&P 500 Low Volatility index has a realized volatility of 10.9%, 23% less than the S&P 500 index. As <a href="https://twitter.com/lhamtil">Lawrence Hamti</a>l has <a href="https://www.fortunefinancialadvisors.com/blog/the-pain-of-low-volatility-investing/">pointed out in detail</a> in a variety of posts, while there have been moments of pain, this lower volatility has not required a sacrifice in return over the longer term.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjAkZ16f-g-errquyLfukzHnM3nTuRs0Hczd6jWTGRT5gCnJJUUdxJysy3LD8MoT_8EmsIb_l79vLSVEyN3lhHZrD1nP8WyGAId_R7VwBZl3de0JgB7YXh18mct1S5gCOC535ZhNp3bBA/s1600/2a.JPG" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="612" data-original-width="829" height="472" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjAkZ16f-g-errquyLfukzHnM3nTuRs0Hczd6jWTGRT5gCnJJUUdxJysy3LD8MoT_8EmsIb_l79vLSVEyN3lhHZrD1nP8WyGAId_R7VwBZl3de0JgB7YXh18mct1S5gCOC535ZhNp3bBA/s640/2a.JPG" width="640" /></a></div>
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As Twitter influencer <a href="https://twitter.com/MikeyDoh89">Michael Doherty</a> <a href="https://twitter.com/MikeyDoh89/status/1107686044382707713">pointed out</a>, a simple allocation that swapped the S&P 500 Low Volatility Index into the 90/60 framework results in improved historical performance. The strategy now has a historical volatility a full 30% lower than the S&P 500 since 1992. As a result, an investor can keep the same 1.5 (stock):1 (bond) ratio of a 60/40 portfolio intact, but given the reduced volatility of the S&P 500 Low Volatility / Treasury portfolio can lever up the exposure 2x to 120/80 with similar historical volatility of the S&P 500.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJRDLYt60ARxgVMI82GfHfb8BKVnkXb_W18R6MACNwo4ebvc2g3rpiTaovMIc8upbMc4etzAvAtj-GeR2JlOXxNdqFFerfa0kOPCDcUl1YNdErxoGIUS6e-G2X8uvWlnbd0vpLHsIAAg/s1600/3b.JPG" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="620" data-original-width="833" height="476" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJRDLYt60ARxgVMI82GfHfb8BKVnkXb_W18R6MACNwo4ebvc2g3rpiTaovMIc8upbMc4etzAvAtj-GeR2JlOXxNdqFFerfa0kOPCDcUl1YNdErxoGIUS6e-G2X8uvWlnbd0vpLHsIAAg/s640/3b.JPG" width="640" /></a></div>
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An equity curve shows there have of course been periods this strategy would have underperformed (and past performance yada yada yada the future), but the returns have largely been consistent and outsized.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuhcVrRUUDAYlo6Vieh0t9trfUKabd4f0OkeN-JE4Q2Jt_BVS6j2iI_Ar1qRUTrie5BzdZsfTCb_VKkhAvqNcrIXesYk2L8ds77tiREyGpUiOjwuR0N4oUMK_mcO3S6-vK5__Xcv4ElA/s1600/4a.JPG" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="596" data-original-width="831" height="458" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuhcVrRUUDAYlo6Vieh0t9trfUKabd4f0OkeN-JE4Q2Jt_BVS6j2iI_Ar1qRUTrie5BzdZsfTCb_VKkhAvqNcrIXesYk2L8ds77tiREyGpUiOjwuR0N4oUMK_mcO3S6-vK5__Xcv4ElA/s640/4a.JPG" width="640" /></a></div>
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In addition, the increased exposure to equities within the strategy means that a reduced allocation to this strategy can be utilized at the portfolio level to maintain stock / bond exposure; as an example as 50% weight to 120/80 = the 60/40 traditional stock / bond notional allocation, now leaving 50% of a portfolio to pursue alpha oriented strategies.<br />
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<b>Your move Jeremy.</b><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-27602697848738446402018-12-19T08:13:00.001-08:002018-12-20T22:53:48.102-08:00Cash or Bonds at Low Yields and a Flat Yield Curve?<div class="separator" style="clear: both; text-align: center;">
<b>The End of an Era?</b></div>
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While there have been a few cyclical periods of rising rates over the past 40 years, we've largely been in one large downtrend... meaning that it has consistently paid to own bonds vs cash<span style="font-size: xx-small;">**</span> or take duration risk for nearly my / many investment lives. </div>
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Now that we've moved away from a zero interest rate policy on cash in the U.S. and the yield curve is essentially flat, this post is an attempt to pose the question of whether it still makes sense own bonds at the same scale.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiRhyphenhyphen9N-55XCmGVhFTsmR4A6z2Ms55eHkcxfLkFqfDMmtRp232FsRL6V5hJ5AGi_dkY-5vTS4u7o2XriEdilj-vB_nvtJ8gZQrFTPXdCxSLgxytQtIbgV0GIySeEf9hVxvN_0sDSbOHVg/s1600/IMG_0604.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="507" data-original-width="869" height="373" id="id_fbd4_7965_9bec_f1a9" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiRhyphenhyphen9N-55XCmGVhFTsmR4A6z2Ms55eHkcxfLkFqfDMmtRp232FsRL6V5hJ5AGi_dkY-5vTS4u7o2XriEdilj-vB_nvtJ8gZQrFTPXdCxSLgxytQtIbgV0GIySeEf9hVxvN_0sDSbOHVg/s640/IMG_0604.PNG" style="display: block; height: auto; margin-left: auto; margin-right: auto; width: 616px;" width="640" /></a></div>
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<b>The Historical Benefit of Extending Duration</b></div>
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Mapping the forward 10-year return of t-bills, a constant maturity 5-year Treasury bond, and a 10-year constant maturity Treasury bond against the starting yield of the 10-year Treasury, it should come as no surprise that 1) higher nominal starting yields have led to higher forward returns and given the yield curve is <i>usually</i> upwards sloping, that 2) longer duration bonds have generally outperformed shorter-duration bonds given their higher starting yield. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgHI29xJKZTEFd4akjrrghAN9FAvXNbB7w1KkucHC8L0AbUOle9tvRK7QPy_2xykQFwc31563VYOhyXlS_o9ygnbu5Cbi1CnPOFek7deozRtFb6hJEX8VQ4LFp73lrYkOQQjNJTTwvN_A/s1600/IMG_0605.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="610" data-original-width="919" height="424" id="id_6494_1d5_ad7e_c4af" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgHI29xJKZTEFd4akjrrghAN9FAvXNbB7w1KkucHC8L0AbUOle9tvRK7QPy_2xykQFwc31563VYOhyXlS_o9ygnbu5Cbi1CnPOFek7deozRtFb6hJEX8VQ4LFp73lrYkOQQjNJTTwvN_A/s640/IMG_0605.PNG" style="display: block; height: auto; margin: 4px auto; width: 616px;" width="640" /></a></div>
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The data in the chart above may be more easily digested when the average forward returns are "bucketed" by the starting yields of less than 4%, 4-8%, and more than 8%. Here we can more clearly see that the benefit of bonds / duration historically occurred when rates were quite elevated. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhw7-bwJSVKbqRGSLpuXAkwV5ffKMLKqBQO8Iy06lXYKubEZv4fp1P7DuTuxz0pB8ce3MJVLuOA6ktl24No96w-xhGOIXkYTAhAkJJaVlKUa3vUl1LdQX_SjKEX3aAjLORkzyoh16duHA/s1600/2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="545" data-original-width="949" height="366" id="id_254c_b2ca_6bff_1c40" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhw7-bwJSVKbqRGSLpuXAkwV5ffKMLKqBQO8Iy06lXYKubEZv4fp1P7DuTuxz0pB8ce3MJVLuOA6ktl24No96w-xhGOIXkYTAhAkJJaVlKUa3vUl1LdQX_SjKEX3aAjLORkzyoh16duHA/s640/2.png" style="height: auto; width: 640px;" width="640" /></a></div>
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<b>Adjusting for a Flat Yield Curve</b></div>
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What the above chart does not account for is the relative starting yield of t-bills, the five year Treasury bond, and the 10 year Treasury bond. The below charts "adjust" the returns of t-bills and 5 year Treasuries to a yield equal to the starting yield of the 10 year Treasury. For example... if at T=0 t-bills yielded 1% and 10 year Treasuries yielded 3%, I added 2% / year to the t-bill ten year return. This is obviously inexact given it assumes the path of yield movements are identical in each situation despite the different yield levels.<br />
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And again... adjusted returns bucketed by starting yield of the 10 year Treasury. Now we can see the improved opportunity for cash / reducing duration; an investor can potentially (if history is a guide and this framework makes sense) reduce risk, while capturing similar (or potentially increased) return.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg63BDqmIJLQiZHnn4U82wI9GSSJkSjD4qDMoM33NOyuEakLh_jNAewEDX92To_6Isx6Pp6m0ho2oWZJ4HZ3Q1SM_OOYJKRn3Ahy-NHAq1ad2Olg7_NCV1qv9gSnnYdl5Nokr0S5-v9kQ/s1600/1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="563" data-original-width="943" height="382" id="id_228b_4dc_bddd_90f6" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg63BDqmIJLQiZHnn4U82wI9GSSJkSjD4qDMoM33NOyuEakLh_jNAewEDX92To_6Isx6Pp6m0ho2oWZJ4HZ3Q1SM_OOYJKRn3Ahy-NHAq1ad2Olg7_NCV1qv9gSnnYdl5Nokr0S5-v9kQ/s640/1.png" style="height: auto; width: 640px;" width="640" /></a></div>
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For those focused on tactical asset allocation, bonds are likely to outperform cash if we enter a deflationary / disinflationary environment, while cash will likely outperform if markets continue to normalize or if there are inflationary pressures. Rather than pretend to guess which situation is more likely, I would frame it as follows... are investors being fairly compensated for the increased volatility to own bonds vs cash?<br />
<br />
With cash, you know the value will increase by the short-term rate, you just don't know what that short-term rate will be in the future. Importantly, the daily volatility of cash can be assumed to be pretty much 0% irrespective of what happens in the market. With bonds, you know roughly what that the nominal return will be, but you don't know if that return will compensate you over cash. As important, the value of bonds will fluctuate daily (historical volatility has been ~6% for 10 year Treasuries).<br />
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So, while the risk of owning bonds has likely been exaggerated for longer-term holders, there is a real increased risk of ownership relative to cash. Whether it’s the risk of less proceeds available when it comes to reallocating to other opportunities / taking withdrawals or the behavioral impact of a fluctuating account value, it’s a risk. So, if you believe the return of cash / lower duration bonds will be the same (or more) than bonds, why take that risk?<br />
<br />
<br />
<i>** in the above analysis I considered t-bills as a cash equivalent because they are liquid and not subject to material fluctuations in value</i><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-25958377114216302002018-09-19T22:40:00.001-07:002018-09-20T06:10:41.336-07:00Market Timing The Credit CycleOver the last few years, you’ve likely heard the following competing narratives:
<br />
<ul>
<li>“Credit spreads are tight, a sign of exuberance among investors that are willing to overlook risk. This will end in tears.” </li>
<li>“Credit spreads are tight, reflecting an environment of high economic growth and low default rates. This supports risk assets.” </li>
</ul>
This post will outline why both of the above comments may be correct (or incorrect) by looking at asset class performance over various time frames / over recent credit cycles.<br />
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<div style="text-align: center;">
<b>THE CYCLICALITY OF CREDIT</b></div>
<br />
Corporate bond spreads can be thought of as an indicator of the overall creditworthiness of the private sector, with widening spreads either reflecting a difficult environment for companies to service their debt or the perception by investors that it may be difficult for these companies to service their debt. In this post, credit risk is defined as the difference in the option adjusted spread “OAS” (the difference in yield between a corporate bond and similar duration Treasury bond) between junk bonds and investment-grade corporate bonds, which I’ll refer to as “quality spread”. <br />
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The chart below outlines the month-end "quality spread" in percent terms going back to 1994, a time frame that goes as far back as I can get the high yield OAS data, as well as two bands reflecting one standard deviation above and below the three year month-end average spread.<br />
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<div style="text-align: center;">
<u>Quality Spread Since 1994 (as far back as Barclays reports High Yield OAS) - %</u></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgX9w3kVdj8tz6wa-3VlCELY6tac_i_Gm_rLsQLCFhm5tQJTmHCjR-HBhVHCo87JCsRJSGbkbvmC_FDhex0-dJvZjotBAnZZgnpRXQRrmBXWPnwbfilx-YZ-HUshBIe7fDVI2GtiljrLw/s1600/1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="765" data-original-width="1383" height="354" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgX9w3kVdj8tz6wa-3VlCELY6tac_i_Gm_rLsQLCFhm5tQJTmHCjR-HBhVHCo87JCsRJSGbkbvmC_FDhex0-dJvZjotBAnZZgnpRXQRrmBXWPnwbfilx-YZ-HUshBIe7fDVI2GtiljrLw/s640/1.png" width="640" /></a></div>
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As the chart above highlights, credit spreads can be highly cyclical, which I’ll bucket as:
<br />
<ul>
<li><b>Tight: </b>More than one standard deviation below average
</li>
<li><b>Normal: </b>Within a one standard deviation band
</li>
<li><b>Wide: </b>More than one standard deviation above average </li>
</ul>
Are tight or wide spreads a better indicator for forward risk taking? Let’s take a look. <br />
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<div style="text-align: center;">
<b>Credit Spreads vs Longer-term Returns </b></div>
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Bucketing each starting month-end period into tight, normal, or wide buckets, the forward five-year average performance of investment grade corporate bonds, high yield corporate bonds, and the S&P 500 for the 1997-2018 time frame is shown below (1997 is the first data point for the bands three years forward from the 1994 starting date).<br />
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The result is that while riskier asset classes returned more on average over the whole period:
<br />
<ul>
<li>Forward five year returns of all three asset classes were noticeably lower when the starting yield of the “quality spread” was low
</li>
<li>In fact, both high yield bond and the S&P 500 average returns were less over the subsequent five years than the returns on the Treasury index when the starting spread was more than one standard deviation below average</li>
<li>When the “quality spread” was elevated, average excess performance was exceptionally high in both absolute and relative terms five years forward</li>
</ul>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhYMUjjWBq-LI7VeyvxjHM_EvZyzhkIT_t7qVrsw9-c-N9P_pHHOa6P1qhqjPJ2gyrjs5Ea42_-9wUl4rRCix1RVeSZeC6UKYgGFo5QnzBsbAEB-emrH_uiei9WtLkOVD1kY4H5-coeWw/s1600/2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="527" data-original-width="1402" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhYMUjjWBq-LI7VeyvxjHM_EvZyzhkIT_t7qVrsw9-c-N9P_pHHOa6P1qhqjPJ2gyrjs5Ea42_-9wUl4rRCix1RVeSZeC6UKYgGFo5QnzBsbAEB-emrH_uiei9WtLkOVD1kY4H5-coeWw/s640/2.png" width="640" /></a></div>
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In summary… over these longer-term windows, a low spread = a lower return (which would seem to indicate longer-term investors may currently be taking excess / uncompensated risk).<br />
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<b>Credit Spreads vs Shorter-term Returns</b></div>
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Using the same 1997-2018 time frame and spread buckets, we can see that over the short-term (one-month forward time frame) the opposite narrative appears to be true:
<br />
<ul>
<li>Risk assets performed better when spreads were tight than when spreads were wide
</li>
<li>In fact, the best short-term period for stocks were when spreads were more than one standard deviation below their average
</li>
<li>Both high yield and stocks performed worse than Treasuries when spreads were wide </li>
</ul>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiG_4e5Uz0SgPI0TICxks_v5Ot0PWrZsaFVpEakFvht78BRTf9N9zLs4s9JxnHWznXMvSyBRZNgMtx5vy0dzNhbHU9IBNCkpagjV6H34TG3SKdQHj6ksAmuhL1UOENrQ-6zY84IfCoCgg/s1600/3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="513" data-original-width="1361" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiG_4e5Uz0SgPI0TICxks_v5Ot0PWrZsaFVpEakFvht78BRTf9N9zLs4s9JxnHWznXMvSyBRZNgMtx5vy0dzNhbHU9IBNCkpagjV6H34TG3SKdQHj6ksAmuhL1UOENrQ-6zY84IfCoCgg/s640/3.png" width="640" /></a></div>
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In summary… over the shorter-term, low spread seems to = a higher return (which would seem to indicate investors may be more than fairly compensated to take risk given current fundamentals).<br />
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<div style="text-align: center;">
<b>RISK / RETURN BY THE LEVEL AND DIRECTION OF SPREAD</b></div>
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The below charts break out investment grade bonds, high yield bonds, and S&P 500 further, charting the return (geometric one month forward annualized) and risk (standard deviation)
by:<br />
<ul>
<li>Spread levels (narrow, normal, or wide) </li>
<li>Spread direction (i.e. whether the "quality spread" has narrowed or tightened) </li>
</ul>
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<div style="text-align: center;">
<b><u>Investment Grade Corporates</u></b></div>
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<div style="text-align: center;">
<b>Geometric Annualized Forward One-Month Return vs Month-End Starting Yield / Direction of Spreads </b></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi1DjG_vLKqMPX_a4nA28oF9QFr_ir7JOVhNnjjt7_XEIkV76J1SMIR6W-6O7BzkSU02SuU8Jhy6Z5gIM1XO0m2ZoiIUeBAcBO1MKyJ1PWsywVH5Eah-IIiUEl8wCJ29tmOexTKqUcfOg/s1600/4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="749" data-original-width="1281" height="374" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi1DjG_vLKqMPX_a4nA28oF9QFr_ir7JOVhNnjjt7_XEIkV76J1SMIR6W-6O7BzkSU02SuU8Jhy6Z5gIM1XO0m2ZoiIUeBAcBO1MKyJ1PWsywVH5Eah-IIiUEl8wCJ29tmOexTKqUcfOg/s640/4.png" width="640" /></a></div>
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Investment grade corporates provided positive performance in all of the various environments in this time frame, but volatility did pick up when spreads were both elevated and widening (as a frame of reference, IG Corporate bonds did outperform Treasuries in all of these environments except when spreads were elevated and widening - a period where they underperformed by 6%).<br />
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<b></b><br />
<b><u></u></b><br />
<b><u>High Yield Corporates</u></b><br />
<b><u><br /></u></b></div>
<div style="text-align: center;">
<u>
</u>
<b>Geometric Annualized Forward One-Month Return vs Month-End Starting Yield / Direction of Spreads</b><br />
<b><br /></b></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiSF3JJquiRrmyuobKOM8048FnWBzsbzT9jN7yHtHIRvyeLQ7L0Z3PamQiekCAy4E4dfkZz7mE5EqMDYoATI9hGdgVqWCujg1EVpcJ3srkx9auXR8qWNootUEU53cLXVQA8qRVJtYBVJA/s1600/5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="739" data-original-width="1279" height="368" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiSF3JJquiRrmyuobKOM8048FnWBzsbzT9jN7yHtHIRvyeLQ7L0Z3PamQiekCAy4E4dfkZz7mE5EqMDYoATI9hGdgVqWCujg1EVpcJ3srkx9auXR8qWNootUEU53cLXVQA8qRVJtYBVJA/s640/5.png" width="640" /></a></div>
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The results for high yield seem more interesting. High yield returns were relatively steady in both low spread and “normal” spread environments, but the volatility of high yield was materially lower when spreads were narrow. Things were especially interesting at higher spread environments as there was: <br />
<ul>
<li><strong>Underperformance: </strong>when spreads were wide and widening (“catching a falling knife”) </li>
<li><strong>Outperformance:</strong> when spreads were wide and narrowing (an investor was able to successfully capture these higher than normal yields in this window) </li>
</ul>
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<div style="text-align: center;">
<b><u>US Stocks</u></b></div>
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<div style="text-align: center;">
<b>Geometric Annualized Forward One-Month Return vs Month-End Starting Yield / Direction of Spreads </b></div>
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<b><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJL4HRzZwkm7O1xCaLz9Bqu-GdIHIBoAj6EQ0mjbOowKWMZ-bYeqBtYFvQhcdnGp_EaVNNFN0dSXZf9BezQbLBfyTQqwf8JIaFdEArvytKqBwHw0hyphenhyphent0xOsEp64_CF7RQEqMNxgchMGQ/s1600/6.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="765" data-original-width="1299" height="376" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJL4HRzZwkm7O1xCaLz9Bqu-GdIHIBoAj6EQ0mjbOowKWMZ-bYeqBtYFvQhcdnGp_EaVNNFN0dSXZf9BezQbLBfyTQqwf8JIaFdEArvytKqBwHw0hyphenhyphent0xOsEp64_CF7RQEqMNxgchMGQ/s640/6.png" width="640" /></a></b></div>
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S&P 500 returns were especially strong when spreads were narrow, as well as when spreads were “normal” and moving wider (perhaps noise over the previous month presented a buying opportunity). What I found interesting was the linear relationship between the level of spread and volatility (narrow spreads = much lower volatility). Finally, I found it interesting that the performance of US stocks was poor when spreads were elevated (irrespective of whether spreads were narrowing or widening, unlike the divergence in performance within high yield).<br />
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<b>SUMMARY</b><br />
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The good news is the above analysis may provide some interesting signals for those with the flexibility to allocate tactically. <br />
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The bad news is that while I think the relationship between spread and the shorter-term performance outlined above makes logical sense, it may not work going forward. <br />
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So the next time someone asks for a quick answer as to whether tight spreads have been a sign of exuberance among investors who were willing to overlook risk (which will end in tears) or an environment of high economic growth and low default rates, supporting risk assets... you can now respond.<br />
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It depends.<br />
<img height="36" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiG_4e5Uz0SgPI0TICxks_v5Ot0PWrZsaFVpEakFvht78BRTf9N9zLs4s9JxnHWznXMvSyBRZNgMtx5vy0dzNhbHU9IBNCkpagjV6H34TG3SKdQHj6ksAmuhL1UOENrQ-6zY84IfCoCgg/s640/3.png" style="left: 219px; opacity: 0.3; position: absolute; top: 2037px;" width="96" /><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-71824354467912546492018-06-20T15:46:00.002-07:002018-06-20T23:36:32.981-07:00CAPE of Good Hope? P/E Divergence as a Performance Signal<div class="separator" style="clear: both;">
<a href="https://twitter.com/lhamtil/status/1007047856874774532">Lawrence Hamtil</a> recently shared a <a href="https://personal.vanguard.com/pdf/s338.pdf">Vanguard paper</a> with me that was surprising given it indicated the trailing twelve month price-to-earnings ratio "TTM P/E" was nearly as strong a predictor of forward 10-year equity returns as the cyclically adjusted price-to-earnings "CAPE" ratio going back to 1926. My assumption had been that the CAPE ratio (which uses smoothed 10-year real earnings) would be the much better of the two ratios given it reflects the longer-term earnings power of companies within the index, rather than the (potentially at times) cyclical peak. </div>
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This post will dig into:</div>
<ol>
<li>the historical relationship between the TTM P/E and CAPE ratios and forward returns</li>
<li>the historical relationship between the TTM P/E and CAPE ratios, and how that relationship has changed in recent years</li>
<li>how these ratios may potentially be used together to help predict shorter term market performance</li>
</ol>
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<strong>Backdrop: The Surprising Predictive Power of TTM P/E</strong></div>
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While perma-bears seem to enjoy highlighting metrics (debt, rates, growth rates, etc...) that have no predictive power for either short or long-term forward equity returns, valuations themselves have mattered. As I’ve <a href="http://econompicdata.blogspot.com/2016/12/a-long-term-position-in-s-500-is.html?_sm_au_=iHVD532VjkMM53VN">highlighted</a> in previous posts, higher valuations (as defined by an elevated CAPE ratio) have historically resulted in lower long-term forward returns. Vanguard replicated this result for trailing P/E, which surprised me given the backward looking / shorter-term / cyclical nature of the TTM earnings component in the denominator of the P/E ratio.<br />
<br />
Per <a href="https://personal.vanguard.com/pdf/s338.pdf">Vanguard</a>:<br />
<blockquote class="tr_bq">
We confirm that valuation metrics such as price/earnings ratios, or P/Es, have had an inverse or mean-reverting relationship with future stock market returns, although it has only been meaningful at long horizons and, even then, P/E ratios have “explained” only about 40% of the time variation in net-of-inflation returns. Our results are similar whether or not trailing earnings are smoothed or cyclically adjusted (as is done in Robert Shiller’s popular P/E10 ratio).</blockquote>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimTrWhe-hxcFMSLFK3NkCJKVEk5FvNpYy05HPaxGvZOIvNdyTeCmgj4eUZx0kTokKFwdnm4Fedd13jvZrU27jix6SEetk4GCVUAupAUT0BIB8aHxLjOKctsZrgo4f5lJnl6qqwi6MQ_28/s1600/Vanguard.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="611" data-original-width="861" height="454" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimTrWhe-hxcFMSLFK3NkCJKVEk5FvNpYy05HPaxGvZOIvNdyTeCmgj4eUZx0kTokKFwdnm4Fedd13jvZrU27jix6SEetk4GCVUAupAUT0BIB8aHxLjOKctsZrgo4f5lJnl6qqwi6MQ_28/s640/Vanguard.png" width="640" /></a></div>
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Given my need to replicate anything I see to personally believe, the below charts replicate this analysis with a scatter plot for each updated through May 2018 (the Vanguard piece is through 2011) using data from <a href="http://www.econ.yale.edu/~shiller/data/ie_data.xls">Shiller</a> (the dotted line shows the ratio as of May 2018). We see both relationships remain strong, though the CAPE’s predictive power has improved quite a bit (more on that below) since 2011.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEguX7IhOiGQut2N2PtMITZah9R0Ejx5_52kTJXg5pVnaIyQCHaDkYH_Cz1RIoQg_7ZR7rxcIiNDFLnQKTy9JkG_e4QKlqOX8sLvQV-eE4rZrsrg3Lza_4XEWNkDdA_owJNDOiGF-vsGZhc/s1600/IMG_7540.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="511" data-original-width="1172" height="275" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEguX7IhOiGQut2N2PtMITZah9R0Ejx5_52kTJXg5pVnaIyQCHaDkYH_Cz1RIoQg_7ZR7rxcIiNDFLnQKTy9JkG_e4QKlqOX8sLvQV-eE4rZrsrg3Lza_4XEWNkDdA_owJNDOiGF-vsGZhc/s640/IMG_7540.PNG" width="640" /></a></div>
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<strong>The Changing Relationship Between the CAPE and TTM P/E</strong></div>
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The reason the CAPE shows a higher predictive power in updated results is due to the divergence of the two ratios leading up to and through the global financial crisis “GFC” when earnings collapsed, causing the TTM P/E to spike, which in turn made the US equity market seemingly more expensive as it sold off. </div>
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Meanwhile the US equity market appeared quite cheap on a CAPE basis (it hit a ~30 year low), which turned out to be the correct signal. In the following chart we can see the close relationship between the two ratios following the Great Depression through late 1990’s, then the divergence seen first during and after the technology bubble (note the chart stops at 50 to show the data more clearly, but the TTM P/E spiked to 86 in October 2008).</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjlwaAP5zaePdqwfR1RQBTQEGM-w95wel8bSWmhbJNfb9N2vNFzV093WQIrmIComHTayKCD5avk9cQq8Uc-g_2UWkZ7g3JtNFB_5J3SCFt8HH6pxQbpf3usX1HLSsWgLdxrsbJO-Ga6DUI/s1600/IMG_7542.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="549" data-original-width="1057" height="323" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjlwaAP5zaePdqwfR1RQBTQEGM-w95wel8bSWmhbJNfb9N2vNFzV093WQIrmIComHTayKCD5avk9cQq8Uc-g_2UWkZ7g3JtNFB_5J3SCFt8HH6pxQbpf3usX1HLSsWgLdxrsbJO-Ga6DUI/s640/IMG_7542.PNG" width="640" /></a></div>
<div style="margin-left: 1em; margin-right: 1em; text-align: center;">
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<div style="text-align: center;">
<br /></div>
The impact of this divergence is especially clear in the rolling ten year correlation of the TTM P/E and CAPE ratios.<br />
<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiEjCtEtRN2unzr0exvHxz3dqjTV0N8JQOPCKV3553Ujn0z_XPY8z6v_YojTouI5dPT3DCueWU3iuI4uJd2g_A6FTIsAuZQ16S6aty6bur_5UM88eiInxTmf7Ha3Zu2YiJleC7WwTK_DBs/s1600/IMG_7539.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="535" data-original-width="910" height="374" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiEjCtEtRN2unzr0exvHxz3dqjTV0N8JQOPCKV3553Ujn0z_XPY8z6v_YojTouI5dPT3DCueWU3iuI4uJd2g_A6FTIsAuZQ16S6aty6bur_5UM88eiInxTmf7Ha3Zu2YiJleC7WwTK_DBs/s640/IMG_7539.PNG" width="640" /></a></div>
<br />
As a result, in the more recent periods that capture the Internet Bubble and/or GFC at the back, middle, or the front of a 10 year rolling period, the CAPE has been extremely predictive (89%), while the TTM P/E has been less so<br />
<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjuiAFAUMyWmke_niPsbereoZUOD9ard_LnU66BMthGdcp7OYyIU8WktNA7eC5qf7LJQJuGhyziRY7BVH8v8SAaTrIbW4DVPmlo7hvGzVxpSUdVDjLkvmtwYxEOoSZFIDlqlZuUfs6J4Y4/s1600/IMG_7541.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="514" data-original-width="1302" height="249" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjuiAFAUMyWmke_niPsbereoZUOD9ard_LnU66BMthGdcp7OYyIU8WktNA7eC5qf7LJQJuGhyziRY7BVH8v8SAaTrIbW4DVPmlo7hvGzVxpSUdVDjLkvmtwYxEOoSZFIDlqlZuUfs6J4Y4/s640/IMG_7541.PNG" width="640" /></a></div>
<br />
<strong>The Potential Use of the CAPE and TTM P/E to Make Allocation Decisions</strong><br />
<strong><br /></strong>
The following chart shows the difference between the two ratios over time. We can see that for a ~60 year window following the Great Depression to the beginning stages of the Internet Bubble they moved together closely. We can also see the more recent divergence.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjsSYG2xXseco543QSF0f8ZaY4EPZmFd5eOajaDNbuxJMLWrU0Yw-EPbVoEDpO3Cf8bZ-U-yuMyQ5TenUyywyXvK6myNtShJ9dtuAzJC1ZTQ8UwaoRKm5mjYruuhnEocX7YZz2lK81dkNA/s1600/IMG_7543.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="538" data-original-width="1069" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjsSYG2xXseco543QSF0f8ZaY4EPZmFd5eOajaDNbuxJMLWrU0Yw-EPbVoEDpO3Cf8bZ-U-yuMyQ5TenUyywyXvK6myNtShJ9dtuAzJC1ZTQ8UwaoRKm5mjYruuhnEocX7YZz2lK81dkNA/s640/IMG_7543.PNG" width="640" /></a></div>
<br />
And this is where I think things get interesting and potentially less intuitive.<br />
<br />
Historically, when the CAPE was elevated (meaning markets were potentially at risk from a valuation standpoint) and the CAPE > TTM P/E (meaning recent earnings in the TTM denominator are higher than the smoothed 10-year real earnings), forward short-term performance has been just fine. It's when the CAPE was elevated (again… meaning markets were potentially at risk from a valuation standpoint) and CAPE < TTM P/E (meaning recent earnings have lagged the smoothed 10-year real earnings) that short-term performance hasn't just been poor, but outright negative.<br />
<br />
In fact, looking back at the chart above we can see the CAPE ratio exceeded the TTM P/E by a substantial margin before the major market corrections of the Great Depression, Internet Bubble, and GFC, but when the CAPE flipped below the TTM P/E is when each sell-off really took hold. <em>Note that in the Great Depression the US equity market continued to sell-off even after the CAPE got to seemingly attractive levels.</em><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0luEmn9XWH9w7TmUu-3hX0C9oL3ZnirXbEJLNi823ENWJ21sEjVshTCE8imF-Xpdo3hAWUD1BUHcEWLYGy_vGVn_pFmUfYINaIDnofCmTHXE7JpVE7hxU3ho4yKrXsojqWEqHkb0TEqY/s1600/IMG_7544.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="559" data-original-width="799" height="444" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0luEmn9XWH9w7TmUu-3hX0C9oL3ZnirXbEJLNi823ENWJ21sEjVshTCE8imF-Xpdo3hAWUD1BUHcEWLYGy_vGVn_pFmUfYINaIDnofCmTHXE7JpVE7hxU3ho4yKrXsojqWEqHkb0TEqY/s640/IMG_7544.PNG" width="640" /></a></div>
<br />
My takeaway from all of this remains that forward long-term returns are likely to be low relative to history (both CAPE and TTM P/E point to that likelihood), while the shorter-term outlook looks better. Investors tactically holding US stocks may be well served by what has historically been strong equity performance in elevated valuation environments when current earnings remain strong and/or the <a href="http://econompicdata.blogspot.com/2016/06/the-case-for-momentum-in-expensive.html">upward trend of the market stays intact</a>. But buyer beware... should either earnings or the positive trend of the market shift, current valuations increase the risk that this may end up viewed as a period of calm before the storm.<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-44817333650859907772018-01-31T10:14:00.000-08:002018-02-03T23:16:22.582-08:00The Behavioral and Performance Benefits of Trend Following<i>When we tell our investors to invest for the long run, we have to
make sure the short run doesn’t kill them first… Investing for the long
run isn’t bad advice, it’s just unrealistic. It doesn’t take into
account human behavior.</i><br />
<br />
-Andrew Lo (HT: <a href="https://twitter.com/andrewthrasher/status/956897821445279745">Andrew Thrasher</a>)<br />
<br />
<br />
Trend following has <a href="http://econompicdata.blogspot.com/2016/06/the-case-for-momentum-in-expensive.html">historically provided strong long-term returns</a> with <a href="http://econompicdata.blogspot.com/2016/12/using-absolute-momentum-to-positively.html">materially reduced drawdowns</a> relative to a traditional buy and hold investment, but none of this matters if an investor cannot stick with the strategy through periods of relative underperformance. This “opportunity cost” is often felt the most during periods when more traditional allocations outperform.<br />
<br />
The consistency of a trend following strategy’s relative performance vs a 60/40 portfolio (impacting the ability for investors to stick with trend following) is the basis of an argument that’s taken place offline (yes, I also argue offline) with a FinTwit friend who is a huge proponent of buy and hold. It’s progressed to the point that we’ve discussed making a mini (very mini) Buffett style bet related to whether trend following or a 60% US Stock / 40% Bond allocation will outperform over the next five years (with money going to the winner's charity of choice).<br />
<br />
Given we've hit a dead-end due to his view that the result will be a coin flip (i.e. random whether trend or buy and hold outperforms, thus even if he were to lose it would be random as well), I thought I would put my case forward in this post outlining why I think trend following has a much higher probability of outperforming a 60/40 portfolio in most environments and especially in the current environment. <br />
<br />
<br />
<b>Backdrop: What is Trend?</b><br />
<br />
As outlined in a <a href="http://econompicdata.blogspot.com/2017/12/can-time-solve-issue-of-high-valuations.html">previous post</a>:<br />
<blockquote class="tr_bq">
In a nutshell, trend following is simply a means of determining if you will own an asset based on its recent price history. </blockquote>
<blockquote class="tr_bq">
One simple set of trend following rules are: <br />
<ul>
<li>If the S&P 500 Total Return Index > 12-Month Moving Average, Own Stocks </li>
</ul>
<ul>
<li>Otherwise Own Bonds</li>
</ul>
</blockquote>
<div class="separator" style="clear: both; text-align: left;">
The diagrams below depict how those without an understanding of trend following often believe it works vs how it really works. The original image on the left is used with permission from Carl Richards and outlines how poorly behaved investors often act, while my revised version on the right outlines what trend followers attempt to do (follow Carl on Twitter <a href="http://behaviorgap/">@behaviorgap</a>).</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYCc5NWQmBLo_pNByra9o5i-y2xXwjwCy4Nk2BQjUhzIr7sJkQXncXAlt7lo1lT28d8bnjNZipPRyQOG6P-NM-Ze5iwQr6qobmtu99LCX3qvk0Pbv9M39GfnKpwby0KbgTmDXaLKTixw/s1600/TREND99.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="456" data-original-width="1092" height="266" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYCc5NWQmBLo_pNByra9o5i-y2xXwjwCy4Nk2BQjUhzIr7sJkQXncXAlt7lo1lT28d8bnjNZipPRyQOG6P-NM-Ze5iwQr6qobmtu99LCX3qvk0Pbv9M39GfnKpwby0KbgTmDXaLKTixw/s640/TREND99.png" width="640" /></a></div>
<div class="separator" style="clear: both; text-align: center;">
</div>
<br />
Buy and hold
investors seem to perceive trend followers in a similar light as these poorly behaved investors, chasing strong returns higher and selling out once markets have completely rolled over. In practice, trend following buys / sells after major turning points, thus gets back into markets once a new trend forms and holds until there is another turning point... often much later than when the investor would have otherwise preferred to sell. The opportunity cost of trend following is the willingness to miss initial turns and to be wrong over many intermediate periods until a new long-term trend emerges. <br />
<br />
<div>
<br /></div>
<div>
<b>How Often Does Trend Following Outperform?</b></div>
<div>
<br /></div>
<div>
As the chart below shows, trend-following outperformance has occurred at a much higher rate than a coin flip and that beat rate has increased over longer periods. This specific 12-month trend model outperformed a 60/40 portfolio over ~80% of rolling 60-month time frames since 1926 and 90%+ of the time over 10 and 15 year periods. </div>
<div>
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhzlpcX_yXhcbj_qOYTYctPx1bTZ27IPklJcdOdHx66YPcML4DJR_MYKRXaGqpi3X9mX9l1VgqJKMtuovUJm5m8DEt_DQ-H-36v4doXaQhI9YmiCh-PL7SW0x4W9tyF5GCbSADkOTZy0g/s1600/new9.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="553" data-original-width="838" height="422" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhzlpcX_yXhcbj_qOYTYctPx1bTZ27IPklJcdOdHx66YPcML4DJR_MYKRXaGqpi3X9mX9l1VgqJKMtuovUJm5m8DEt_DQ-H-36v4doXaQhI9YmiCh-PL7SW0x4W9tyF5GCbSADkOTZy0g/s640/new9.png" width="640" /></a></div>
<div>
<br /></div>
<div>
To get a better sense of when these periods of outperformance and
underperformance occurred, the following chart breaks out when trend following outperformed a 60/40 portfolio (blue) and when it did not (white) over rolling 60-month time frames. </div>
<div>
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6AigVOK8h6R9Ak_lNmmzDTrh99HBvu1ARYaOwzN1rGlx5rS12Wei3bRq79ca7vqhNBWTP9J7yPeXzKW6NiBPSACtlOKDRaL2qabiUWrI4jhvDkN5dzdzP5HLViepowEaSrCiDlcuq-A/s1600/new10.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="613" data-original-width="874" height="448" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6AigVOK8h6R9Ak_lNmmzDTrh99HBvu1ARYaOwzN1rGlx5rS12Wei3bRq79ca7vqhNBWTP9J7yPeXzKW6NiBPSACtlOKDRaL2qabiUWrI4jhvDkN5dzdzP5HLViepowEaSrCiDlcuq-A/s640/new10.png" width="640" /></a></div>
<div>
<br />
A
few things to note:<br />
<ol>
<li>the trend following model outperformed a 60/40 portfolio consistently</li>
<li>the trend following model outperformed over extended periods of time</li>
<li>periods of trend following underperformance were short lived and clustered</li>
<li>periods of relative underperformance
were more likely to occur when the opportunity cost associated with moving away from a
60/40 portfolio were high</li>
</ol>
</div>
<div>
Specific to point #4, the chart below shows the historical yield of a 60/40 portfolio (i.e. what can be viewed as the likely opportunity cost of trend following). We can see that a high starting yield that compressed quickly in the mid 1930's coincided with the underperformance that took place in the late 1930's / early 1940's, while the huge yield
compression of a 60/40 portfolio in the mid 1980's coincided with the challenging relative performance in the late 1980's / early 1990's.<br />
<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqnl-Fp9-UC6UYeYUQ_55phrkUBHwmsWuz1B0oBXSwwBhyRdaiTx4pPhMNQv-KPOADNCHQkQXxjEJl87AwU653zTaVNkKMErVE5m8DQNvK75f4_js8ldQjFqYCPL90F5wQXU_zjI0FZw/s1600/new2.png" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="554" data-original-width="766" height="462" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqnl-Fp9-UC6UYeYUQ_55phrkUBHwmsWuz1B0oBXSwwBhyRdaiTx4pPhMNQv-KPOADNCHQkQXxjEJl87AwU653zTaVNkKMErVE5m8DQNvK75f4_js8ldQjFqYCPL90F5wQXU_zjI0FZw/s640/new2.png" width="640" /></a></div>
<br />
<br />
<b>Current Expectation</b></div>
<div>
<br /></div>
<div>
Simply put, the starting yield / opportunity cost of a 60/40 portfolio is extremely low at ~3%. Historically, when
we split the universe into buckets when the starting 60/40 yield was
above or below the long-term 6% average (3% higher than the current level), we can see the increased likelihood a trend following strategy outperforms at lower starting yields. In fact, the historical beat rate over rolling 5
year time frames moves up to 85%.<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtoXwxvcoI42PBEW34YIPLbpUK6rr562ZLg0swbeD5Vlx0k_ZvXQBRoJlA6IdSg2fCUn_t0pwrbdbQuX6QAhYnBccHXvjHdWIbYDyeYoEY4tEm89LKv_0eBCH6h56rlThD6-W684GxPA/s1600/new4.png" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="559" data-original-width="831" height="430" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtoXwxvcoI42PBEW34YIPLbpUK6rr562ZLg0swbeD5Vlx0k_ZvXQBRoJlA6IdSg2fCUn_t0pwrbdbQuX6QAhYnBccHXvjHdWIbYDyeYoEY4tEm89LKv_0eBCH6h56rlThD6-W684GxPA/s640/new4.png" width="640" /></a></div>
<br />
<b>Conclusion</b><br />
<br />
I really like the way my friend Wes from <a href="https://twitter.com/alphaarchitect/status/954125605511065600">Alpha Architect</a> framed this decision: <br />
<blockquote class="tr_bq">
Flip
it and make trend following the benchmark and consider buy and hold.
Works sometimes, doesn't work other times, but you eat massive tail risk
with buy and hold, therefore isn't worth the risk/effort.</blockquote>
</div>
<div>
In other words, if trend following is your base allocation, would
you as an investor allocate to a different strategy that underperformed at a 70%+ rate over 3-5 year rolling time frames and 90-100% of rolling 10-15 year time frames, and had materially more downside risk? Not only would I not make that allocation, I'd love to bet someone with proceeds going to charity that trend following would outperform.
<br />
<br />
<br />
<br />
<b>Appendix: Tax Efficiency of Trend Following</b><br />
<br />
A common question that comes up related to trend following is its tax efficiency. The reason I ended up ignoring the tax issue as a detriment to trend following in the analysis is that trend following may actually be more tax efficient than a buy and hold allocation that includes taxable bonds.<br />
<br />
A few reasons: <br />
<ol>
<li>A trend following solution can be structured utilizing futures, which are taxed at 60% the long-term rate and 40% the short-term rate, making it pretty similar to a 60/40 portfolio</li>
<li>Even with cash holdings, trend following can be tax efficient as the large gains in stocks are often held much longer than 12 months (i.e. are taxed at the long-term rate). The chart below shows the length of each past isolated trend, along with the gains earned in these trends showing that significant gains were often taken years after the initial trend signal.</li>
</ol>
<br /></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgM91VWjXWEJu9mYNgObR2BLyo2ZOzTbj3Q05c_ZS3hSJBpqHdDGTwdFQg8tIvzFBlHSZ5Yd9DMg90j7XDaydkk4X2DIwc-6nlC9ENDtx0ZVaK0A9jWUvsW9W6Coq1IRcTY978zLI0Uag/s1600/new12.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="602" data-original-width="857" height="448" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgM91VWjXWEJu9mYNgObR2BLyo2ZOzTbj3Q05c_ZS3hSJBpqHdDGTwdFQg8tIvzFBlHSZ5Yd9DMg90j7XDaydkk4X2DIwc-6nlC9ENDtx0ZVaK0A9jWUvsW9W6Coq1IRcTY978zLI0Uag/s640/new12.png" width="640" /></a></div>
<br /><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-4800819674702966382017-12-05T10:43:00.000-08:002017-12-26T19:01:00.719-08:00Can Time Solve the Issue of High Valuations?<i>“Time solves most things. And what time can't solve, you have to solve yourself.” - Haruki Murakami </i><br />
<br />
<a href="http://econompicdata.blogspot.com/2017/08/us-stock-multiples-properly-reflect.html">Recent research by GMO</a> outlined that wide profit margins, low levels of inflation, subdued economic volatility, and low 10 year treasury rates have led to high valuations for both U.S. stocks and bonds. Yet irrespective of why valuations are high relative to history, what an investor pays for a dollar of earnings or a dollar of bond coupons directly impacts the forward return they receive. This is generally understood by investors who have accepted the likelihood that returns will be low over the next five or even ten years. What has been discussed less, or often dismissed outright by buy-and-hold long-term investors, is the similar challenge investors may face over much longer periods of time given high starting valuations.
<br />
<br />
<div style="text-align: center;">
<b><br /></b></div>
<div style="text-align: center;">
<b>The Issue: Annualized Returns Can Mask the Effect of Compounding </b><br />
<br />
<div style="text-align: left;">
Annualized returns are commonly used to compare asset class performance over various time frames. The issue is annualized returns trivialize the effect of compounding, especially over longer periods. As an example, the following chart compares annualized returns for:</div>
<div style="text-align: left;">
<ol>
<li>an investment that is down -50% in year 1, which then returns 10% each year for the next 29 years</li>
<li>an investment that returns 10% each year for the full 30 years </li>
</ol>
</div>
<div style="text-align: left;">
We can see the large return gap between the two investments in year 1, as well as what appears to be a narrowing of that gap over time from a 10% annualized differential in year ten to a 3% annualized differential in year thirty. </div>
<br />
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<b><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEizsmfYi-MRANbaur6alZhzJJ-MQMxlV1nlLRXL-FF6hTCoro0NY0oChKz-sOeUzHxGHCKDKlWsln5Rn7wOLdS0UWqJBG2fQtWcYldW6LfCfDU2CVwZPTjh003jhc7eK-GVRI6nCogBDA/s1600/Annzld1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="652" data-original-width="918" height="454" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEizsmfYi-MRANbaur6alZhzJJ-MQMxlV1nlLRXL-FF6hTCoro0NY0oChKz-sOeUzHxGHCKDKlWsln5Rn7wOLdS0UWqJBG2fQtWcYldW6LfCfDU2CVwZPTjh003jhc7eK-GVRI6nCogBDA/s640/Annzld1.png" width="640" /></a></b></div>
<br />
<div style="text-align: left;">
<br />
<div style="text-align: left;">
In reality, the return gap is getting larger in dollar terms as the same 10% earned each year after year one is from a much larger base for the investment that was not dragged down by the initial 50% decline.</div>
</div>
<div style="text-align: left;">
<div style="text-align: center;">
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<b>A Revised Perspective</b></div>
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One way to view valuation of the U.S. stock market is the cyclically adjusted price to earnings “CAPE” ratio (a measure of the price an investor pays for each $1 of historical normalized earnings). This ratio can be converted to a yield by inverting it (i.e. a CAPE of 30x = 1/30x or a roughly 3% yield) as a means of making it more comparable with current bond yields. We can then calculate a yield for a traditional balanced 60% stock / 40% bond portfolio “60/40”, by using the formula ‘60% CAPE yield + 40% bond yield = 60/40 yield’.<br />
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This 60/40 yield has provided strong explanatory power for forward annualized ten year real (after inflation) returns going back to 1926 (Ibbotson data inception).
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This 60/40 yield has also provided strong explanatory power for much longer 30-year forward annualized returns. The issue is annualized returns makes it appear that the range of outcomes, relative to starting valuations, narrows over longer periods of time, an argument commonly used by buy-and-hold investors. In reality, the comparison of annualized returns over different time frames masks the compounding effect of these seemingly small return differences.</div>
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The following chart removes this effect by showing the real growth of $1 for each these starting valuations over 10 and 30 years instead of annualized returns. We can clearly see that the gap in dollar terms widens significantly over longer periods, as the compounding effect has more time to work its magic. </div>
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The “we are here” line in this chart highlights how extreme current stock and bond valuations are relative to history, creating an environment where time itself may not be a solution to the valuation challenge.<br />
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<b> What Can an Investor Do? </b></div>
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For an investor looking to improve their outcome, there are a variety of options available, including:
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<ol>
<li><b>Search for Value:</b> reallocate capital to segments of the US equity market (or outside the US equity market) that may be more attractive
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<li><b>Identify Alpha Opportunities:</b> rethink the value proposition of active management, especially within less efficient areas of the market
</li>
<li><b>Follow the Trend: </b>utilize trend following to manage equity exposure </li>
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The first two options are familiar to most investors, but trend following may be less so. In a nutshell, trend following is simply a means of determining if you will own an asset based on its recent price history. One simple set of trend following rules are:
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<ul>
<li>If the S&P 500 Total Return Index > 12-Month Moving Average, Own Stocks
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<li>Otherwise Own Bonds </li>
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Given this simple trend following model can never result in monthly outperformance vs the S&P 500 when the market is up, as the most it can own is 100% stocks, it will underperform during most bull markets relative to the S&P 500. However, it may still outperform a 60/40 portfolio in these environments as it is not weighed down by an allocation to bonds. Conversely, the strategy will outperform the S&P 500 in down markets over time and, importantly, it has the potential to side step a major market correction that impairs the compounding effect that has historically impacted long-term returns when valuations have been elevated (more on why trend / momentum works <a href="http://econompicdata.blogspot.com/2016/07/what-drives-momentum-performance.html">here</a>).<br />
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The below chart updates the 30 year real growth of $1 with returns for this basic trend following strategy, comparing the returns generated to the original 60/40 buy-and-hold portfolio over similar periods.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0Q2e-6ehYCgZnEOn9hvM097A63mXK0j0VA2p_OalzU23jaNhZ4UeDAmAya73K_wsBzj2ZkghMzK4uo_KgRjZpzn8RCmld-VJvAash9fdwx-i5sGJJJZ1iA_0iy-W1mW61tu84fkofHQ/s1600/3233.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="681" data-original-width="890" height="488" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0Q2e-6ehYCgZnEOn9hvM097A63mXK0j0VA2p_OalzU23jaNhZ4UeDAmAya73K_wsBzj2ZkghMzK4uo_KgRjZpzn8RCmld-VJvAash9fdwx-i5sGJJJZ1iA_0iy-W1mW61tu84fkofHQ/s640/3233.png" width="640" /></a></div>
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While there are still material differences in the historical growth of $1 depending on the starting valuation, the trend following strategy generated dollar growth that was consistently higher than that of a 60/40 strategy and produced returns that were higher even at low starting yields than that of a 60/40 portfolio at much higher starting yield levels.<br />
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<b>Conclusion </b></div>
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Buy and hold strategies work best when stocks and/or bonds are cheap. When valuations are extended and starting yields are low, an investor should look to allocate to cheaper areas of the global market, rethink the value proposition of active management, and/or be prepared to reduce stock market exposure if profit margins, inflation, volatility of GDP, or 10 year treasury rates (that pushed valuations higher) reverse course.</div>
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<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-8581163938624593742017-11-28T13:41:00.001-08:002017-11-28T23:13:42.802-08:00Volatility May Feel More Painful the Next Time AroundStock and bond markets have been extraordinarily quiet since February 2016 lows. How quiet? A 60/40 portfolio consisting of the S&P 500 and the Bloomberg Barclays Aggregate Bond Index has a 12-month standard deviation of (wait for it)… 2.2% ending October 2017. This is the lowest period of volatility since the inception of the aggregate bond index back in 1976.<br />
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My own behavior has been impacted by just how boring markets have been, as I’ve slowly seen my own risk tolerance ramp up. In addition to thinking that I really need to rebalance, I’ve been thinking about the consequences of a world in which many investors haven’t experienced a material drawdown in many years / potentially in their entire investment lifetime. For those of us that are relatively young, even if we've lived through the 2000-01 dot com bust or the 2008-09 global financial crisis, it’s likely many of us haven’t experienced any material loss of wealth.<br />
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<b>Viewing Market Volatility Through a $$ Lens</b></div>
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Let me explain with an example….
I graduated from college in May 2000, thus the below drawdowns are what I would have experienced in a 60/40 portfolio since I started my working career.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxu8MNp-0SYJosmwYR5omanGAHbGTfmg0mVDOr6cnrUvPannChUXFVwNXmDWhVeEkCr2u3I0CDhfgrGUOzVKRWXGX9zlN8gqrzSDojN5JMKob-Bb03qziufg4IMkffAF3lnj8PzMbF5w/s1600/Drawdown.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="607" data-original-width="954" height="406" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxu8MNp-0SYJosmwYR5omanGAHbGTfmg0mVDOr6cnrUvPannChUXFVwNXmDWhVeEkCr2u3I0CDhfgrGUOzVKRWXGX9zlN8gqrzSDojN5JMKob-Bb03qziufg4IMkffAF3lnj8PzMbF5w/s640/Drawdown.png" width="640" /></a></div>
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A well weathered investor I must be having faced two of the largest drawdowns in US history? Well... let’s take a look at this return history from a different perspective.<br />
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Rather than in percent terms, let’s look at the drawdown in dollar terms assuming an investor put $1000 in the market at time = 0 and added an incremental $1000 more than the previous year... each year (i.e. $1000 at time = 0, $2000 at T + 1, $3000 at T +3, etc…).<br />
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We can see from the above chart that the 2000-02 downturn may have seemed painful, but may as well not have existed in terms of consequence to an investor this early in their wealth accumulation (not to mention this investor was much less likely to have the stress of providing for a family). Even the 2008/09 downturn was quite minor in the grand scheme of things, matching the dollar drawdown of the tiny 5% drawdown experienced in late 2015. <i>In addition, during the early stages of wealth accumulation, the ability for contributions to materially make up for market declines helps with the mental issue of otherwise seeing the value in your investment account fall (i.e. $10k is a huge contribution when your balance is $50k, $20k is much less so when your balance is $300k).</i><br />
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And where do many of us sit now?<br />
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For those of us fortunate to have accrued wealth over the last 10-20 years, we should anticipate a high likelihood of experiencing the largest dollar downturn of our lives at some point in the near future. In fact, in the scenario outlined above, a 15% drawdown from here would result in a loss ~4x larger than that experienced during the global financial crisis.<br />
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The implications to me are as follows:<br />
<ul>
<li><b>Reevaluate your risk tolerance:</b> not by the comfort level experienced over the past few years or even your entire investment life, but by what you should expect in the years to come given your current financial and life situations </li>
<li><b>Create a game plan:</b> for how you should / will react when market volatility “normalizes” (trend can be your friend)</li>
<li><b>Prepare for market volatility that doesn’t just “normalize”</b>: but instead overshoots to the upside if / when markets do correct</li>
</ul>
We have a lot of market participants (myself included) that have never experienced any real turmoil and poor behavior always follows.<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-64458958678929941082017-09-22T12:01:00.002-07:002017-09-22T15:48:58.046-07:00Compound Your Face OffMy buddy <a href="https://twitter.com/alphaarchitect">Wes Gray</a> shared one of my favorite investment mantras when he was interviewed on <a href="https://twitter.com/patrick_oshag">Patrick O’Shaughnessy's</a> stellar podcast <a href="http://investorfieldguide.com/podcast/">Invest Like the Best</a>. Simply put... the goal for investors should be to:<br />
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"Compound Your Face Off" </blockquote>
There is a lot of content outlining just how powerful compounding is on the interweb... <a href="https://www.blogger.com/Compounding%20is%20the%20process%20of%20generating%20more%20return%20on%20an%20asset's%20reinvested%20earnings.%20To%20work,%20it%20requires%20two%20things:%20the%20reinvestment%20of%20earnings%20and%20time.%20Compound%20interest%20can%20help%20your%20initial%20investment%20grow%20exponentially.%20For%20younger%20investors,%20it%20is%20the%20greatest%20investing%20tool%20possible,%20and%20the%20#1 argument for starting as early as possible. Below we give a couple of examples of compound interest. Read more: Investing 101: The Concept Of Compoundi">Investopedia</a> summarizes it well (bold mine):<br />
<blockquote class="tr_bq">
Compounding is the process of generating more return on an asset's reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. Compound interest can help your initial investment grow <b>exponentially</b>. For younger investors, it is the greatest investing tool possible, and the #1 argument for starting as early as possible. </blockquote>
This post will outline the benefit further, as well as show some examples of how large this benefit can be when an investor is focused on maximizing their compounded return. I'll then finish with some thoughts on how investors can more effectively compound their returns through tax aware investing.<br />
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<b>BACKDROP: THE MATH BEHIND COMPOUNDING</b></div>
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The compounding formula is straight forward enough:<br />
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Ending $$ = Beginning $$ * (1 + return) ^ total time frame of compounding</blockquote>
The most important aspect of this formula is the exponential benefit of time (i.e. compounding shifts gains from a linear path to one that becomes more and more rapid in dollar terms). The result is that the level of annual return can matter less to long-term results than the ability to reinvest at that level of return.<br />
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Example: Growth of $100 assuming 6% / 8% returns with no reinvestment and with reinvestment.</div>
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Example Cont'd: Difference in the growth of $100 at 6% and 8% returns with no reinvestment and with reinvestment</div>
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<b>CAPTURING THE IMPACT OF COMPOUNDING</b></div>
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This isn't to say that the level of return doesn't matter. Not at all. While most investors can grasp that limiting the impact of taxes can increase the level of total returns captured, I am not as sure many investors truly understand how this benefit can increase over time. The below chart is my attempt to clearly articulate how tax efficient investing can increase the rate of return that becomes embedded in the compounding machine <i>(I used lots of simplifications in the below including no dividends to deal with and assuming all gains are long-term at the highest 20% tax bracket)</i>. </div>
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<ul>
<li>The line corresponding to no tax is straight forward enough. If an investment returns 8% annualized, there are no taxes, and you reinvest all proceeds... you receive 8%. </li>
<li>If you sell at the end of each year and are taxed at a 20% rate, you receive 8% * (1- 20%) = 6.4%... also straight forward. </li>
<li>Where things get interesting are for those that can postpone taxes in the 'sell at the end' line. Here the annualized figure starts in a similar situation as sell annually (i.e. if your holding period is 1 year it is identical), but for each year you postpone the payment of taxes, the more returns can compound before paying them out. </li>
</ul>
Thus, the annualized return captured by an investor shifts higher, getting closer to the return for an investor with no taxes at all than those taxed annually (in this example, the sell at end annualized return is 7.3% in year 30, closer to the 8% return of no taxes than the 6.4% return if taxed annually).<br />
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In each case, the investor is avoiding short-term capital gains (i.e. keeping their tax rate at the minimum level), but the result is still material. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjbNb5s4q0ukGcShaXwmaJhXhmtol4U_ToXuBPbOvuVrDpChlpm3fXrtqJbOoXfStB4jVRHI_VG3OnqZbqXHo3pi_7UxkROPZ1VW3ktiErZIITodHKpxtePLayEHdcfUZ5hE4JLMWISeg/s1600/gro3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="429" data-original-width="693" height="396" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjbNb5s4q0ukGcShaXwmaJhXhmtol4U_ToXuBPbOvuVrDpChlpm3fXrtqJbOoXfStB4jVRHI_VG3OnqZbqXHo3pi_7UxkROPZ1VW3ktiErZIITodHKpxtePLayEHdcfUZ5hE4JLMWISeg/s640/gro3.png" width="640" /></a></div>
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<b>THE IMPACT IS LARGER PER UNIT OF RETURN IN BONDS</b></div>
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Stocks happen to be a very tax efficient asset class if done right. An owner of a stock for more than a year pays "only" 20% at the highest current tax rate. Things are much less reasonable in other areas of the market... notably with taxable bonds where all income is taxed at the investor's income tax rate. The chart below is an example of the impact for an investor assuming high yield bonds return the current yield to worst (5.5%) for the foreseeable future and that the returns are taxed at the top 39.6% tax bracket (5.5% return becomes a 3.3% return after taxes - and the taxes cannot be postponed for bonds in a taxable account). In this example, the impact of taxes on bonds is greater on a dollar per dollar basis than it is for stocks despite lower returns... in the stock example above, stocks returned 8% while in this example bonds returned 5.5%, but the variance moved from a $185 difference to a $232 difference.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimGIQ2WmNdn58G4SyT-34hWoa2k2yTKicci3pzIMWSkCunnVhTgSaWbaxgzWEMsZ6EVdrr4Y9H5XX27ac2PklSs44GflikkyoNNBhzlCZNuqR7I1LQ8jOm-RNIQQO5tjKj33rcWOWgHQ/s1600/5.5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="498" data-original-width="851" height="374" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimGIQ2WmNdn58G4SyT-34hWoa2k2yTKicci3pzIMWSkCunnVhTgSaWbaxgzWEMsZ6EVdrr4Y9H5XX27ac2PklSs44GflikkyoNNBhzlCZNuqR7I1LQ8jOm-RNIQQO5tjKj33rcWOWgHQ/s640/5.5.png" width="640" /></a></div>
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The interesting comparison thus becomes stocks vs bonds. A buy and long-term hold investor only needs a 3.9% pre-tax annualized return in stocks to get to the same 3.3% after-tax compounded return over 30 years. <u>In other words, at the highest tax bracket, the pre-tax returns for a long-term investment in taxable bonds needs to be 30% higher than for stocks to get the same after-tax return.</u></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimgLcYzoVC52qroEhkNLwD-lm6PwvT5YUphyVLg0b87UZRKql2OerVPXe8WGtygYCSZQ7x0Z0abMt1b95JQ6FWYjW02i2GVYpl9RRR62ugCtJtl9nKELvvi8YNehfbEg1Qc0XY05go6Q/s1600/39.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="590" data-original-width="791" height="476" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimgLcYzoVC52qroEhkNLwD-lm6PwvT5YUphyVLg0b87UZRKql2OerVPXe8WGtygYCSZQ7x0Z0abMt1b95JQ6FWYjW02i2GVYpl9RRR62ugCtJtl9nKELvvi8YNehfbEg1Qc0XY05go6Q/s640/39.png" width="640" /></a></div>
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<b>SOME INITIAL TAKEAWAYS</b></div>
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<ul>
<li><b>Postpone gains:</b> Do you really need to sell? If not... don't</li>
<li><b>Rebalance efficiently</b>: Rather than sell gains (tax event), perhaps just allocate future proceeds into holdings that have underperformed</li>
<li><b>Use favorable structures:</b> ETFs are a GREAT way to delay tax events for stock holdings (not so much for bonds)</li>
<li><b>Put money into tax efficient accounts: </b>Deferring taxes or paying all taxes up front (i.e. Roth) in a retirement account or utilizing a 529 plan for your kid's education expenses allows your money to compound at a higher rate</li>
<li><b>Put tax inefficient assets /strategies in retirement accounts:</b> if you're going to own tax efficient assets or strategies that require frequent rebalancing, put them in your retirement account </li>
<li><b>Allocate to tax efficient areas of the market: </b>muni bonds are underrated for after-tax returns relative to both cash accounts and taxable bonds, while real estate allows the postponement of tax events forever (if you roll gains into new property), while reducing taxes on current income given interest deductions for residential property</li>
<li><b>Exposure replication: </b>I hope to share some ways to replicate tax inefficient structures using more tax efficient structures at some point in the near future</li>
</ul>
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<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-78876370333775572312017-08-04T09:44:00.003-07:002017-08-04T10:02:12.996-07:00US Stock Multiples Properly Reflect Sentiment, But It Doesn't Make Them AttractiveGMO's latest <a href="https://www.gmo.com/docs/default-source/public-commentary/gmo-quarterly-letter.pdf?sfvrsn=46">quarterly commentary</a> is a must read, especially the second half where Jeremy Grantham attempts to model / answer the question "Why Are Stock Market Prices So High?". His first bullet point in the whole piece provides a good summary:<br />
<blockquote class="tr_bq">
Contrary to theory, the market P/E level does not primarily reflect future prospects. It reflects current conditions.</blockquote>
Go read the whole thing, but inputs into the model include profit margins, inflation, volatility of GDP, a reflection of recent market performance, and 10 year treasury rates. The more investor friendly these inputs have been, the higher the multiple of the market. Given where we are in the cycle (high margins, low economic volatility, strong recent performance, low rates) investors have pushed multiples to elevated levels.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhC4-DxFkHKr1f0TKm-4WlR-NXLBrLN3TRJ4CHWDizl0aGDvRQFQ_KfEkcdjmCG8PuNNsFxjrE34Wt-U1t6t5Vfuq0RFlzJ6-s5yH2hrO5oGe6rrBWvaZpuB_7oTcyfD6XmRton4nmG4w/s1600/GMO.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="441" data-original-width="964" height="292" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhC4-DxFkHKr1f0TKm-4WlR-NXLBrLN3TRJ4CHWDizl0aGDvRQFQ_KfEkcdjmCG8PuNNsFxjrE34Wt-U1t6t5Vfuq0RFlzJ6-s5yH2hrO5oGe6rrBWvaZpuB_7oTcyfD6XmRton4nmG4w/s640/GMO.png" width="640" /></a></div>
<br />
GMO has not attempted to predict future prices or performance with this information.<br />
<blockquote class="tr_bq">
Our model does not attempt to justify the P/E levels as logical or deserved, nor does it attempt to predict future prices.</blockquote>
So this is where I come in...<br />
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<div style="text-align: center;">
<b>WHAT TO DO WITH EXPENSIVE MARKETS</b></div>
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Rather than rely on their model which I don't have access to, I simply used the CAPE (cyclically adjusted price to earnings) given the strong enough 0.9 correlation to their model (which was only off during the late 90's bubble when the model underestimated investor risk appetite and interestingly enough a few years back when it overestimated investor sentiment).<br />
<br />
Using S&P composite stock market data going back to 1926, I divided the data into 5 specific valuation buckets (starting CAPE of less than 15, 15-20, 20-25, 25-30, and 30+) and split this further by whether the CAPE itself was higher (multiple expansion) or lower (multiple contraction) than where it was 12 months ago. <i>This is going to be VERY similar to trend analysis, but there can be differences (i.e. there is the possibility that multiples can contract even if returns are positive, especially at low valuations when earnings yield is so high). </i>I then took a look at the next month's performance and annualized the applicable returns for these buckets.<br />
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<i>The resulting returns in chart form</i><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgFAPzzCXejLahkcNUI0HIQVhJf5YdWHgXqBfDm55kgVpSBECwmsTWi90idlLdZwoPyjqX0dRlLsPt5y39DkpWa5T3AMJaLRxEvpFiFeflux6f3fQ8IOecoHanyMgqno7J1ogDgSKR2Ag/s1600/CAPE.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="511" data-original-width="788" height="414" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgFAPzzCXejLahkcNUI0HIQVhJf5YdWHgXqBfDm55kgVpSBECwmsTWi90idlLdZwoPyjqX0dRlLsPt5y39DkpWa5T3AMJaLRxEvpFiFeflux6f3fQ8IOecoHanyMgqno7J1ogDgSKR2Ag/s640/CAPE.png" width="640" /></a></div>
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<i>The resulting returns / standard deviation in table form</i><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8sckKX9XK-oChIJ0uh6z4Y46P0JmgQFGEF0dme2o91dDmBglR9dWxA-eM8kTaK0EnLlB9NSb37vRwTqKWRrwXxc7IgLL4qWYWYbi8_b2ABgx1xV5MXBuc9XsRQJif6CxlZIuCHPdjkw/s1600/CAPE2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="468" data-original-width="693" height="432" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8sckKX9XK-oChIJ0uh6z4Y46P0JmgQFGEF0dme2o91dDmBglR9dWxA-eM8kTaK0EnLlB9NSb37vRwTqKWRrwXxc7IgLL4qWYWYbi8_b2ABgx1xV5MXBuc9XsRQJif6CxlZIuCHPdjkw/s640/CAPE2.png" width="640" /></a></div>
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The takeaways are pretty clear to me. Invest in stocks when they are cheap or multiples are trending higher and when rich (i.e. at current levels) tread carefully, look to allocate to cheaper areas of the global market (GMO's commentary had a great case for emerging markets), and get the hell out of the way when profit margins, inflation, volatility of GDP, or 10 year treasury rates reverse course and multiples start to contract.<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-6255310351070657472017-07-27T09:42:00.002-07:002017-09-11T16:24:06.671-07:00When Big Numbers Attack: Corporate Defined Benefit Plans are Not the ProblemI started my career working closely with corporate pension plans, thus when I saw the following article in my twitter feed causing alarm I thought there might be an interest in some context and a reality check into the supposed corporate pension crisis. Note that state and local pensions are a completely different story.<br />
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Let's go to <a href="https://www.bloomberg.com/graphics/2017-corporate-pensions/">Bloomberg</a>'s article titled 'S&P 500’s Biggest Pension Plans Face $382 Billion Funding Gap':<br />
<blockquote class="tr_bq">
People who rely on their company pension plans to fund their retirement may be in for a shock: Of the 200 biggest defined-benefit plans in the S&P 500 based on assets, 186 aren’t fully funded. Simply put, they don’t have enough money to fund current and future retirees.The situation worsened for more than half of these funds from fiscal 2015 to 2016. A big part of the reason is the poor returns they got from their assets in the superlow interest-rate environment that followed the financial crisis. It’s left a hole of $382 billion for the top 200 plans. </blockquote>
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The reality is corporate pension plan participants are completely fine and the article simply regurgitates a straw man argument that has cost employees the security that a defined benefit "DB" pension provides.</div>
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<b>HOW DO CORPORATE PENSION PLANS WORK</b></div>
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I'm going to oversimplify things a bit, but at a high level corporate pensions have assets (straight forward - they are what they are) and liabilities which are the benefits that participants have earned and are owed. These liabilities are a bit more complex because even if you know roughly what is owed in the future, you don't know exactly what those liabilities will cost in today's dollars. </div>
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The way a corporate pension backs into this value is through a discount rate. The end result is liabilities are worth less today than in the future given the present value of a dollar today is worth more than in the future. An example... assuming liabilities for a plan are $100 / year for 25 years discounted at 4.3% (more on that later), they are worth $1614 (less than $100 x 25 = $2500) as seen below.</div>
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<b>Cash Flows Discounted Back to a Present Value at a 4.3% Discount Rate Each Year</b><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_QMOEaN8Eq9vZhNyO3_F7R0gQFRZp5rMFUg1RrNJkEfSupWgS7R2bUy_DJ2gtUowy314wenyAjheI3nLiOiYPkkWgxqL9LQFfxFtNaxN0Nqdi045F0jRf7ZHPoFSEX9S2PGRfduP82Q/s1600/intel2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="574" data-original-width="888" height="412" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_QMOEaN8Eq9vZhNyO3_F7R0gQFRZp5rMFUg1RrNJkEfSupWgS7R2bUy_DJ2gtUowy314wenyAjheI3nLiOiYPkkWgxqL9LQFfxFtNaxN0Nqdi045F0jRf7ZHPoFSEX9S2PGRfduP82Q/s640/intel2.png" width="640" /></a></div>
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<b>Total value of 25 years of $100 / year discounted back at 4.3%</b><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPrq_FMw8NzxQD-MzezoEYoGNf3cGhMkVCWSFNkrC0nwTTaU6YDLrAwhOiZbOgFtwLHiLbfr3d_mKcmfAKoEHQnTcQ46e_f8AytvlKaFHdPd-WKmyrnqFkYaQcOHq2VK-O9ahB0Q1YMw/s1600/intel3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="474" data-original-width="804" height="376" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPrq_FMw8NzxQD-MzezoEYoGNf3cGhMkVCWSFNkrC0nwTTaU6YDLrAwhOiZbOgFtwLHiLbfr3d_mKcmfAKoEHQnTcQ46e_f8AytvlKaFHdPd-WKmyrnqFkYaQcOHq2VK-O9ahB0Q1YMw/s640/intel3.png" width="640" /></a></div>
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<b>BUT THAT BIG NUMBER IN THE HEADLINE IS SCARY</b></div>
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$382 billion!!!! </div>
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That number seems big, but notice there is no mention of the relative scale of that. According to <a href="http://www.pionline.com/article/20170206/PRINT/302069976/assets-of-top-funds-up-62-to-94-trillion">P&I</a> as of 9/30/16:</div>
<blockquote class="tr_bq">
Among the 200 largest retirement plans, assets totaled $6.79 trillion as of Sept. 30, up 6.2% from the year earlier. Of this, $4.83 trillion belonged to DB plans (up 5.5%) and $1.96 trillion to DC plans (up 8%).</blockquote>
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So that big $382 billion number was ~8% of total plan assets as of 9/30/16 (global stocks have also happened to go up ~17% since that time so the funded status has likely improved quite a bit since). </div>
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<b>BUT PLANS WOULD NEVER USE A 4.3% DISCOUNT RATE... MORE LIKE 10%, RIGHT?</b></div>
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Corporate pensions are required to discount liabilities at a rate roughly equal to a corporate bond of similar duration as their pension liabilities. The rationale being that's the rough rate a debtor would require, but also because when a plan is fully funded (i.e. 100% assets to cover future liabilities at this discount rate) the plan could simply invest the proceeds in long corporate bonds and call it a day (it's more complex than that, but close enough for this post - it also happens to be the basis of liability driven investing "LDI" and why pensions own a lot of long bonds). The discount rate is extraordinarily low right now given where market rates and spreads are and can be thought of how much it would cost a corporation to fund their underfunded status. So a big part of the reason some plans are underfunded hasn't been due to their asset performance in the "superlow interest-rate environment that followed the financial crisis" per Bloomberg, but rather because their liabilities have increased in present value terms due to the superlow interest-rate they are discounted by.<br />
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Looking at Intel's latest <a href="https://www.intc.com/investor-relations/financials-and-filings/annual-reports-and-proxy/default.aspx">annual report</a> (the poster child in the article as they are the most underfunded plan in % terms), we see they used a 4.3% discount rate at year-end. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhb1PSwBgANZ76TV7TRnmR-oANhN2IYC08aZCRleLfQH02olNgC3sTNzLj58kKyCrXrkUUh7tpcOhB9Se8EEOieWebrncf2YlZiy_OZFkWodfslhB1AuwTTmpjg4Yc_W2a5oKTxmvW5QA/s1600/Intel.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="251" data-original-width="720" height="220" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhb1PSwBgANZ76TV7TRnmR-oANhN2IYC08aZCRleLfQH02olNgC3sTNzLj58kKyCrXrkUUh7tpcOhB9Se8EEOieWebrncf2YlZiy_OZFkWodfslhB1AuwTTmpjg4Yc_W2a5oKTxmvW5QA/s640/Intel.png" width="640" /></a></div>
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This rate has huge implications for the liability calculation. Assuming a move up in rates to just 5%, we can see that the present value of liabilities in the previous examples goes down more than 6%. In reality, assuming pensions have a duration of ~20 years, a ~40 bp higher rate as of 9/30/16 would have pushed the underfunded status of pensions to $0 without a change in asset valuations.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj-13FHBZw-aN_5RCYkfWDQpph2vT_MrdxmPxKMxhCVBzKfJGnp6pDXlzeQn5ZX_pL5ZaNAcifr41P4QXRcITzAIUmlkoTmWiSgn1NQtlv4KyXtJpGNZzQ6XhNE8vlGnJCPoePXNc_ePw/s1600/intel4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="483" data-original-width="771" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj-13FHBZw-aN_5RCYkfWDQpph2vT_MrdxmPxKMxhCVBzKfJGnp6pDXlzeQn5ZX_pL5ZaNAcifr41P4QXRcITzAIUmlkoTmWiSgn1NQtlv4KyXtJpGNZzQ6XhNE8vlGnJCPoePXNc_ePw/s640/intel4.png" width="640" /></a></div>
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<b>POOR ANECDOTES DON'T HELP</b></div>
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<div>
Back to Bloomberg:</div>
<blockquote class="tr_bq">
Last month, the 70,000 participants in the United Parcel Service Inc. pension plan learned they won’t earn increased benefits if they work after 2022. Late last year DuPont Co. announced it would stop making payments into its pension plan for 13,000 active employees, and Yum! Brands Inc. offered some former employees a lump-sum buyout to offload some of its pension liabilities. General Electric Co. has a major problem. The company ended its defined benefit plan for new hires in 2012, but its primary plan, covering about 467,000 people, is one of the largest in the U.S. And at $31 billion, GE’s pension shortfall is the biggest in the S&P 500.</blockquote>
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Now the reality of what this means...</div>
<div>
<ul>
<li><b>UPS / DuPont: </b>these moves have nothing to do with past pension liabilities or risk to participants. That has to do with corporations de-risking their balance sheets by moving future benefits from defined benefit (they have the obligation to pay an amount) to defined contribution (a one off payment into a 401k). Benefits that have already been earned are not changed.</li>
<li><b>Yum! Brands: </b>this is an option for employees to leave their plans at the current present value of their liabilities. Options have positive values for option holders, so this is a good thing.</li>
<li><b>GE:</b> $31 billion is certainly GE's problem, but it is not their employees issue unless the company goes bankrupt, cannot make the payment in bankruptcy, and the participant is above the threshold guaranteed by the PBGC (a government agency that backstops corporate pensions for a fee - and is required). None of this likely matters as GE has an equity cushion for participants of $222 billion (i.e. their market cap) and if GE wanted, they could simply add $31 billion in debt to fund their plan and make this optical issue go away (something they may be forced to do down the line in increments given rules)</li>
</ul>
<div>
As for Intel (the poster child as the least funded pension), they have unfunded obligation of $2 billion or less than one quarter of earnings.</div>
</div>
<div>
<br /></div>
</div>
</div>
<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-7033414687485645302017-07-24T10:39:00.002-07:002017-07-24T12:13:41.702-07:00The Case for the Harmonic Mean P/E CalculationThe most recent "analysis" seemingly spreading like wildfire across the perma-bear community was performed by <a href="http://horizonkinetics.com/">Horizon Kinetics</a> in their most recent <a href="http://horizonkinetics.com/wp-content/uploads/Q2-2017-Commentary_APPROVED_FINAL.pdf">quarterly commentary</a>. Their claim is that the price-to-earnings of the Nasdaq (or any index really) is much higher than reported because we are being fed a manipulated harmonic mean rather than arithmetic mean for the price to earnings ratio (don't worry, I'll explain the difference). While the piece also claims excluding non-earners from the calculation is wrong (something I also don't agree with), I'll ignore that portion for now* as it is more nuanced, a separate argument in their piece, and because their specific argument for the arithmetic mean is so clearly wrong.<br />
<br />
<b><br /></b>
<b>CASE STUDY #1</b><br />
<b><br /></b>
Let's start with a case study Horizon Kinetics provides outlining how they believe the P/E for an equal weighted three stock portfolio (with an investment of $1 million to each) should be calculated.<br />
<blockquote class="tr_bq">
One business earns $100,000 per year, so it has a price‐to‐earnings ratio of 10x; the second earns $50,000, for a P/E ratio of 20, and the third earns only $20,000 and so has a P/E of 50. This last one is probably situated on a high‐ growth street corner. Averaging the three P/E ratios of 10, 20 and 50 means that the average P/E of the 3‐ company portfolio is 26.7x. So far, so good.</blockquote>
<div class="MsoNormal">
Not a good start...<br />
<br />
The 3-company portfolio clearly does not have a P/E of 26.7x when you take a step back and think about what you as an investor own in aggregate. The companies in the case study earn $100,000 (10% yield on $1 million) + $50,000 (5% yield on $1 million) + $20,000 (2% yield on $1 million) = $170,000, which is a 5.7% yield on $3 million total investment. A $3 million total investment divided by $170,000 of earnings = (1/ 5.7% yield) = a P/E of 17.65x, which is <b>66% LOWER than their calculation</b>.<br />
<div class="separator" style="clear: both; text-align: center;">
</div>
<br />
The easy way to view the correct harmonic mean calculation is to think about what you own in terms of earnings yield (getting to an average earnings yield and then backing into the P/E is the harmonic mean calculation). In this example:<br />
<ul>
<li>Company A: 10x P/E = 10% earnings yield (1/10)</li>
<li>Company B: 20x P/E = 5% earnings yield (1/20)</li>
<li>Company C: 50x P/E = 2% earnings yield (1/50)</li>
</ul>
(10% + 5% + 2%) = average yield of 5.67%. 1/5.67% = the correct 17.65x aggregate P/E.<br />
<br />
Visualizing this makes it clearer. The left-hand chart shows the earnings yield for each company, while the right hand chart shows the contribution from each company in total (the earnings of each company divided by the whole $3 million investment - then stacked). We'll revisit the right hand chart to show how an extreme multiple can overly influence the arithmetic mean of the P/Es when we review their second case study.<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhp5BpINuCQBd9dQVAJec6nOYIPXjwd6p2lCzGDldQWrFU52GEN2X9oBkgCXPKRRLGIIFYkeTTMSIi1a0Y9waE3BbcnUiNqLNMO91SdfydeO7DiAp2dOIowBjCs1E4OwgK1Duz9EghfNw/s1600/Earnings+Contr.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="396" data-original-width="1152" height="220" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhp5BpINuCQBd9dQVAJec6nOYIPXjwd6p2lCzGDldQWrFU52GEN2X9oBkgCXPKRRLGIIFYkeTTMSIi1a0Y9waE3BbcnUiNqLNMO91SdfydeO7DiAp2dOIowBjCs1E4OwgK1Duz9EghfNw/s640/Earnings+Contr.png" width="640" /></a></div>
<br />
<o:p></o:p></div>
<br />
<b><br /></b>
<b>CASE STUDY #2</b><br />
<b><br /></b>
Horizon Kinetic's next case study is worse because the error in the result is so obvious as it includes a company with an extreme high P/E ratio.<br />
<blockquote class="tr_bq">
Observe the following hypothetical equal‐weighted 4‐stock portfolio consisting of a range of low, somewhat high and egregiously high‐valuations, ranging from 10x to 300x. A simple average results in a portfolio P/E of 90x.</blockquote>
<ul>
<li>Company A: 10x P/E or 10% yield</li>
<li>Company B: 20x P/E or 5% yield</li>
<li>Company C: 30x P/E or 3.3% yield</li>
<li>Company D: 300x P/E or 0.33% yield</li>
</ul>
An average P/E of (10x + 20x + 30x + 300x) / 4 = 90x implies an earnings yield of just over 1% (1/90). Compare this to the average earnings yield of 10% + 5% + 3.3% + 0.33% = 4.67% average, which gets you to a correct aggregate portfolio P/E of 21.4x (1 / 4.67%).<br />
<br />
Visualizing this case study again shows their error more clearly. On the right hand side we can see that the earnings contribution of a 25% weight to the first three stocks alone yields more than 4.5% (10% x 25% + 5% x 25% + 3.3% + 25% = 4.575%), so by their rationale the earnings of company D contributes -3% to the overall portfolio (i.e. something akin to company D losing $140,000 on their $1,000,000 investment instead of having small, but positive earnings).<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjFWrFNJNJPmxA4oCf2j4GGDGp61NWBa2HJyOekf1BqAG3qDmxssI8GUYLlu9R6Mv7HS8pHdfrKq4nPtYqqpm-THebjGsS1xU-dLklXysbQiCvfABbWkcgeJ83MxV7lBhMmJhhnK_nRBA/s1600/yield2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="396" data-original-width="1142" height="219" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjFWrFNJNJPmxA4oCf2j4GGDGp61NWBa2HJyOekf1BqAG3qDmxssI8GUYLlu9R6Mv7HS8pHdfrKq4nPtYqqpm-THebjGsS1xU-dLklXysbQiCvfABbWkcgeJ83MxV7lBhMmJhhnK_nRBA/s640/yield2.png" width="640" /></a></div>
<div class="separator" style="clear: both; text-align: center;">
</div>
<br />
And of course, their ridiculous conclusion.<br />
<blockquote class="tr_bq">
That completes the strange journey
of transforming a fairly understandable, if alarming, P/E of 90x into the more
comforting Harmonic Mean P/E ratio of only 21.5x.</blockquote>
<div class="MsoNormal">
And the even more bearish takeaway of an investment in the Nasdaq 100.</div>
<div class="MsoNormal">
<o:p></o:p></div>
<div class="MsoNormal" style="margin-left: .5in;">
<o:p></o:p></div>
<blockquote class="tr_bq">
No
active manager would be permitted to manage a concentrated, high‐P/E portfolio
for an institutional client.</blockquote>
<br />
<i>* you are paying a price to own the lack of historical earnings (which is a case for including these companies), but the fact is these non-earners have often been the fastest growing companies in the Nasdaq, thus including their negative historical earnings ignores their future potential (a case for excluding these companies from the valuations calculation)</i><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-19463862817432133462017-07-18T10:26:00.001-07:002017-07-18T21:06:07.865-07:00EconomVIX...A Summary of Past VIX PostsRCM Alternatives has a <a href="http://info.rcmalternatives.com/hubfs/VIX_whitepaper_J.pdf">great piece</a> (HT <a href="https://twitter.com/abnormalreturns/status/887348401712627717">Tadas</a>) outlining what the VIX is, the market for VIX related products, and how to think about volatility as an asset class. It also happens to contain my new favorite quote for anyone thinking about trading volatility:<br />
<blockquote class="tr_bq">
Still, if you cannot see the VIX futures curve in your head, burning $100 bills is probably more profitable than trading them.</blockquote>
I'll piggyback on the RCM piece given the interest in volatility trading strategies (due to the <a href="https://www.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1500408000000&chddm=98532&chls=IntervalBasedLine&q=NYSEARCA:SVXY&ntsp=0&ei=K0NuWbClGMaQmgGy-6z4AQ">remarkable run of some of the short VIX ETPs</a>) and link to old posts that I've previously done on the subject that I thought might be helpful.<br />
<br />
<br />
<br />
<a href="http://econompicdata.blogspot.com/2015/10/what-exactly-does-vix-tell-us.html">What Exactly Does the VIX Tell Us?</a><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEin3E0cU7O_wPkdsw0rjQP3ijOh3UdSK6DU8gcOB7Jth4zcbpI_UvQ0Z0MK3AmIe3oP1SBE5Dmnzun-LVgsMglIdkY3crMNkkrXso2ktR7ZRsfBRnPChaBYvpaAdMs_-dEzcTJNo8BXtg/s1600/2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="506" data-original-width="706" height="458" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEin3E0cU7O_wPkdsw0rjQP3ijOh3UdSK6DU8gcOB7Jth4zcbpI_UvQ0Z0MK3AmIe3oP1SBE5Dmnzun-LVgsMglIdkY3crMNkkrXso2ktR7ZRsfBRnPChaBYvpaAdMs_-dEzcTJNo8BXtg/s640/2.png" width="640" /></a></div>
<br />
<a href="http://econompicdata.blogspot.com/2016/09/how-low-vix-can-remain-expensive-hedge.html">How a Low VIX Can Remain an Expensive Hedge</a><br />
<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjS1xPHJfkKYSyeISTrEtshpAMXN10YoKEM9E2ryZJOGSxJWDFYmob9qa1bSeDxRybKw_dg9jmmFIhnEDyTKjyZjqtaCawnxujd0WvVv5TYurammgvhxlIg75RNNF1a0SH64GCWQhZlvQ/s1600/4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="617" data-original-width="916" height="430" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjS1xPHJfkKYSyeISTrEtshpAMXN10YoKEM9E2ryZJOGSxJWDFYmob9qa1bSeDxRybKw_dg9jmmFIhnEDyTKjyZjqtaCawnxujd0WvVv5TYurammgvhxlIg75RNNF1a0SH64GCWQhZlvQ/s640/4.png" width="640" /></a></div>
<br />
<a href="http://econompicdata.blogspot.com/2016/10/the-case-for-swapping-stocks-into-vix.html">A Framework for a Short VIX Allocation</a><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgR2JfLDfT5LW363hO7Yq8nKIKeTWhYpBQw0Uhlyu1WqDeMB5RqSXlYy6EJnFeP_JsomZliod3TV3MAthsrnEYVHx8Cs5svXvdKooKphVhBMnAjqo62AaJEjGC_UJOlIJk51738ApvdOQ/s1600/8.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="621" data-original-width="843" height="470" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgR2JfLDfT5LW363hO7Yq8nKIKeTWhYpBQw0Uhlyu1WqDeMB5RqSXlYy6EJnFeP_JsomZliod3TV3MAthsrnEYVHx8Cs5svXvdKooKphVhBMnAjqo62AaJEjGC_UJOlIJk51738ApvdOQ/s640/8.png" width="640" /></a></div>
<br />
<a href="http://econompicdata.blogspot.com/2012/07/breaking-down-volatility-of-vix.html">Breaking Down Volatility of the VIX</a><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiQ3MtGlCqZVlHeEh-ieQdvPmgwMzSkruhyetwexzPR93l-YuQ1q4nyd8lPDo8ERCScLOr34mEJTwtpGjCcfYQ_ZnMdf1dc0c8QaPKMETbBjiLMNfTOfDVpT0Ew8MbLmYcT-CITha6HyQ/s1600/7.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="728" data-original-width="963" height="482" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiQ3MtGlCqZVlHeEh-ieQdvPmgwMzSkruhyetwexzPR93l-YuQ1q4nyd8lPDo8ERCScLOr34mEJTwtpGjCcfYQ_ZnMdf1dc0c8QaPKMETbBjiLMNfTOfDVpT0Ew8MbLmYcT-CITha6HyQ/s640/7.png" width="640" /></a></div>
<div>
<br /></div>
<a href="http://econompicdata.blogspot.com/2015/09/utilizing-money-sucking-uvxy-to-improve.html">Utilizing the Money Sucking $UVXY to Improve Risk Adjusted Returns</a><br />
<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHPd08hfXNHFMgwowEpbRA7uuC0J9vd1f1UglDVxPbTHxSGMFNtTOsFTPFRoRwRv2duEEJY1CMPLSlpu2jH66SZ7aeVxLtjG0L2FD6m-r2S138aoeko4vhebvWCFxLy7GOtqb6zsnyrA/s1600/3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="601" data-original-width="947" height="406" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHPd08hfXNHFMgwowEpbRA7uuC0J9vd1f1UglDVxPbTHxSGMFNtTOsFTPFRoRwRv2duEEJY1CMPLSlpu2jH66SZ7aeVxLtjG0L2FD6m-r2S138aoeko4vhebvWCFxLy7GOtqb6zsnyrA/s640/3.png" width="640" /></a></div>
<br />
<a href="http://econompicdata.blogspot.com/2015/09/using-vix-futures-term-structure-to.html">Using the VIX Futures Term Structure to Reduce Equity Exposure</a><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiRP-2o8-g9LxQxRpHm6WY3ArLakP8FhBKAOxiKeVM__OEQqwPqNyx9G671fQsimTcoAvFQiO_9Fe8_um2CG08KX-b6bGnUF5Q44Y_zIFyN6LHpEBx-GAJK5KiupmndVp4iHc_s40o0lQ/s1600/1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="395" data-original-width="518" height="305" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiRP-2o8-g9LxQxRpHm6WY3ArLakP8FhBKAOxiKeVM__OEQqwPqNyx9G671fQsimTcoAvFQiO_9Fe8_um2CG08KX-b6bGnUF5Q44Y_zIFyN6LHpEBx-GAJK5KiupmndVp4iHc_s40o0lQ/s400/1.png" width="400" /></a></div>
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<br /></div>
<a href="http://econompicdata.blogspot.com/2015/07/adding-vix-signal-to-momentum.html">Adding a VIX Signal to Momentum</a><br />
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<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9iP9BE2l4S7X_zvTys4HK2qXPTRIBMRyPB6bLQRKtxUcreA6CkR5m07pCDJL_U_H1qP-OKfPjj6sW1_tguc2oRXl2DxyFlpH1RutWCXTk9_Wxkz-MYENMGVxDNfsHyYzl5shbE1PNQA/s1600/5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="699" data-original-width="929" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9iP9BE2l4S7X_zvTys4HK2qXPTRIBMRyPB6bLQRKtxUcreA6CkR5m07pCDJL_U_H1qP-OKfPjj6sW1_tguc2oRXl2DxyFlpH1RutWCXTk9_Wxkz-MYENMGVxDNfsHyYzl5shbE1PNQA/s640/5.png" width="640" /></a></div>
<br />
<a href="http://econompicdata.blogspot.com/2015/06/the-case-for-volatiltiy-managed.html">The Case for a Steady Volatility-State Managed Portfolio</a><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifMj8ablREqwwheVtFTVRUpjCuVANIRYB5yaa1BO4vBqzZnTUETINoyjtpYqudaZUR1RAjgLxsVbSwR8LmPD_5ZkSKAIN0_4lUzPopt6ZB2RHSlZ_viR6VrV3rApC7p3WuqO4qyXnZjQ/s1600/6.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="535" data-original-width="716" height="478" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifMj8ablREqwwheVtFTVRUpjCuVANIRYB5yaa1BO4vBqzZnTUETINoyjtpYqudaZUR1RAjgLxsVbSwR8LmPD_5ZkSKAIN0_4lUzPopt6ZB2RHSlZ_viR6VrV3rApC7p3WuqO4qyXnZjQ/s640/6.png" width="640" /></a></div>
<br />
<br />
<br /><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-59384003936871459262017-05-25T09:44:00.003-07:002017-08-24T22:57:08.020-07:00Yes. Demographics and Economic Growth Matter for Equity Returns<div class="tr_bq">
<i>Quick note... for those not already listening, my buddy <a href="https://twitter.com/patrick_oshag">Patrick O’Shaughnessy</a> has one of the (if not the) best investing podcasts out there with his podcast <a href="http://investorfieldguide.com/podcast/">Invest Like the Best</a>. Each week he sits down with some of the best capital allocators, investment thinkers, etc... in the world and really allows his guests to share deep insights. I highly recommend it to anyone reading this who isn't already doing so.</i></div>
<br />
<b><br /></b>
<br />
<div style="text-align: center;">
<b>"Real GDP Growth Doesn't Matter for Equity Returns" is Wrong </b></div>
<br />
Patrick's guest this week was David Salem, the founding president and CIO for The Investment Fund for Foundations. The discussion was great as always, but I would like to focus on one small aspect related to where in the world he currently finds value. He specifically makes the case for Asia ex-Japan ex-China for a number of reasons I agree with (value and alignment of management with shareholders), but he seemingly gets one aspect (which he views as a negative) wrong based on his view of what historical analysis reveals. The point of this post is to outline this flaw with supporting data because it's a common theory and one that can seemingly be dismissed when the data itself is viewed. It also happens to makes his case for an allocation to Asia ex-Japan ex-China even stronger.<br />
<br />
<br />
First to David (bold mine):<br />
<blockquote>
We also have some money allocated under present conditions to I’ll call it Asia ex-Japan ex-China. Here’s where a careful study of long-term capital market history will tell you, and my favorite source of this is of course is Elroy Dimson, Paul Marsh, and Mike Staunton’s book Triumph of the Optimist and all the sequels to it, <b>will tell you that high growth economies that are flattered by relatively high growth rates of the GDP level and by favorable demography tend to generate surprisingly, perhaps to many people, sub-par returns. </b>
So. You’re a value guy, I’m a value guy. We get that. </blockquote>
<blockquote>
So, why would we be chasing return for long-term capital in Asia ex-Japan and even ex-China, and it’s because I’d say almost <b>notwithstanding the favorable demographics</b> and the relatively favorable debt profile the prices, the current prices at which interest can be acquired in well managed businesses where the managements have a sufficient, not perfect, but sufficient alignment of interest with outside shareholders, they tend to be family controlled and family dominated.</blockquote>
<div class="MsoNormal">
To summarize… he has found value in Asia ex-Japan ex-China
DESPITE its favorable growth and demographics. To be blunt… this appears to be a common
mistake and one that is likely flat out wrong. Here are other heavy hitters quoting Dimon, Marsh,
and Staunton making the same case.</div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<o:p></o:p></div>
<div class="MsoNormal">
</div>
<div class="MsoNormal">
<o:p></o:p></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
The Financial Times, <a href="https://www.ft.com/content/8b5ae298-a065-11e2-a6e1-00144feabdc0">Rising GDP not always a boon for equities</a> (bold mine):</div>
<blockquote class="tr_bq">
Analysis by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School of 19 major countries between 1900 and 2011 shows that the <b>correlation between the compound real rate of return on equities and the compound growth rate of real per capita</b> GDP is minus 0.39. Investors would have been best off investing in the most sluggish economies. </blockquote>
<blockquote class="tr_bq">
Similar analysis of 15 major emerging markets between 1988 and 2011 produces a remarkably similar negative correlation of minus 0.41. To be fair, some other combinations produce correlations nearer to zero. </blockquote>
<blockquote class="tr_bq">
But, to the chagrin of emerging market bulls, whichever way the data are interrogated, a meaningful positive correlation between GDP growth and equity returns remains elusive.</blockquote>
<div class="MsoNormal">
<br />
The Economist, <a href="http://www.economist.com/blogs/buttonwood/2014/02/growth-and-markets">A Puzzling Discrepancy</a>:</div>
<blockquote class="tr_bq">
The annual report on markets by Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School (produced in association with Credit Suisse) is always good value and this year's effort is no exception. The main theme is related to emerging markets and will be the focus of this week's column. But one oddity emerged in the course of the report that is quite difficult to explain and is worth exploring in more detail. </blockquote>
<blockquote class="tr_bq">
An oft-quoted argument for investing in emerging markets is their superior economic growth. But the professors have pointed out in the past that economic growth and equity returns are not correlated at all. </blockquote>
<div class="MsoNormal">
This Economist article was in reference to the 2014 Credit Suisse Yearbook (which contains all the pertinent data) and is fortunately still available <a href="http://doc.xueqiu.com/14cdbae48e74653fe7546fe0.pdf">online</a>. Let's take a look. <i>The data for the following charts were all pulled from Table 1 in the <a href="http://doc.xueqiu.com/14cdbae48e74653fe7546fe0.pdf">pdf</a> (reproduced below for any of you nerds that wants easy access).</i></div>
<div class="MsoNormal">
<br />
<b>Decomposition of Real GDP Growth and Economic Returns (1900-2013)</b><br />
<br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; text-align: center; width: 452px;">
<colgroup><col style="mso-width-alt: 3218; mso-width-source: userset; width: 66pt;" width="88"></col>
<col span="4" style="mso-width-alt: 3328; mso-width-source: userset; width: 68pt;" width="91"></col>
</colgroup><tbody>
<tr height="40" style="height: 30.0pt;">
<td class="xl65" height="40" style="height: 30.0pt; width: 66pt;" width="88"></td>
<td class="xl67" style="width: 68pt;" width="91"><b>Real GDP</b></td>
<td class="xl67" style="width: 68pt;" width="91"><b>Population Growth</b></td>
<td class="xl67" style="width: 68pt;" width="91"><b>Per Capita Real GDP</b></td>
<td class="xl67" style="width: 68pt;" width="91"><b>Real Return on Equitie</b>s</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Canada</td>
<td class="xl66">3.63%</td>
<td class="xl66">1.65%</td>
<td class="xl66">1.95%</td>
<td class="xl66">5.75%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Australia</td>
<td class="xl66">3.35%</td>
<td class="xl66">1.61%</td>
<td class="xl66">1.71%</td>
<td class="xl66">7.37%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">USA</td>
<td class="xl66">3.29%</td>
<td class="xl66">1.27%</td>
<td class="xl66">1.99%</td>
<td class="xl66">6.45%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">South Africa</td>
<td class="xl66">3.20%</td>
<td class="xl66">2.08%</td>
<td class="xl66">1.10%</td>
<td class="xl66">7.39%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">New Zealand</td>
<td class="xl66">2.89%</td>
<td class="xl66">1.53%</td>
<td class="xl66">1.34%</td>
<td class="xl66">6.01%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Mean</td>
<td class="xl66">3.27%</td>
<td class="xl66">1.63%</td>
<td class="xl66">1.62%</td>
<td class="xl66">6.59%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Ireland</td>
<td class="xl66">2.83%</td>
<td class="xl66">0.05%</td>
<td class="xl66">2.77%</td>
<td class="xl66">4.09%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Portugal</td>
<td class="xl66">2.70%</td>
<td class="xl66">0.61%</td>
<td class="xl66">2.08%</td>
<td class="xl66">3.66%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Sweden</td>
<td class="xl66">2.70%</td>
<td class="xl66">0.54%</td>
<td class="xl66">2.15%</td>
<td class="xl66">5.77%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Spain</td>
<td class="xl66">2.66%</td>
<td class="xl66">0.82%</td>
<td class="xl66">1.82%</td>
<td class="xl66">3.62%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Switzerland</td>
<td class="xl66">2.16%</td>
<td class="xl66">0.80%</td>
<td class="xl66">1.36%</td>
<td class="xl66">4.41%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Mean</td>
<td class="xl66">2.61%</td>
<td class="xl66">0.56%</td>
<td class="xl66">2.04%</td>
<td class="xl66">4.31%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Japan</td>
<td class="xl66">3.68%</td>
<td class="xl66">0.94%</td>
<td class="xl66">2.71%</td>
<td class="xl66">4.11%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Norway</td>
<td class="xl66">3.19%</td>
<td class="xl66">0.70%</td>
<td class="xl66">2.47%</td>
<td class="xl66">4.26%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Finland</td>
<td class="xl66">3.04%</td>
<td class="xl66">0.63%</td>
<td class="xl66">2.39%</td>
<td class="xl66">5.31%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Netherlands</td>
<td class="xl66">2.83%</td>
<td class="xl66">1.06%</td>
<td class="xl66">1.75%</td>
<td class="xl66">4.95%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Italy</td>
<td class="xl66">2.71%</td>
<td class="xl66">0.53%</td>
<td class="xl66">2.17%</td>
<td class="xl66">1.91%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Denmark</td>
<td class="xl66">2.49%</td>
<td class="xl66">0.70%</td>
<td class="xl66">1.78%</td>
<td class="xl66">5.21%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">France</td>
<td class="xl66">2.30%</td>
<td class="xl66">0.43%</td>
<td class="xl66">1.87%</td>
<td class="xl66">3.17%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Belgium</td>
<td class="xl66">2.25%</td>
<td class="xl66">0.43%</td>
<td class="xl66">1.81%</td>
<td class="xl66">2.63%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Austria</td>
<td class="xl66">2.21%</td>
<td class="xl66">0.31%</td>
<td class="xl66">1.89%</td>
<td class="xl66">0.67%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">Germany</td>
<td class="xl66">2.03%</td>
<td class="xl66">0.37%</td>
<td class="xl66">1.66%</td>
<td class="xl66">3.23%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15.0pt;">UK</td>
<td class="xl66">1.84%</td>
<td class="xl66">0.39%</td>
<td class="xl66">1.45%</td>
<td class="xl66">5.33%</td>
</tr>
</tbody></table>
</div>
<div class="MsoNormal">
Source: Dimson, Marsh, and Staunton</div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<b><br /></b></div>
<div class="MsoNormal">
<b><br /></b></div>
<div class="MsoNormal" style="text-align: center;">
<b>The Issue: Per Capita GDP is the Wrong Measure</b></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
The first chart is a reproduction of the chart from the yearbook that is commonly shared to make the case that real GDP and real equity returns have a limited or negative relationship. Even Dimson, Marsh and Staunton state investors do not capture economic growth (bold mine) based on the downward slope and r-square of 0.10.</div>
<div class="MsoNormal">
<blockquote class="tr_bq">
The horizontal axis measures the growth in per capita real
GDP, while the vertical axis displays the annualized real return, including reinvested
dividends, from each equity market over the entire period since 1900. In the
cross section of countries, it <b>appears that equity investors do not capture
benefits as a result of economic advancement, as measured by per capita real
GDP.</b></blockquote>
<div class="MsoNormal">
<o:p></o:p></div>
</div>
<div class="MsoNormal">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhSHaUTHk6uSEay9rq7l9nOrNtDcaa17l7NplKsLabbdspBvb6yCp8s8WXUYcnPHe_hUe79XJvw3groydO_QqM8vWU-wHYl7T-iXvXqi0xYtJYCu2YcnZleKMOz-YKrdgSBL_O7MXUsIQ/s1600/percapita.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="676" data-original-width="922" height="468" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhSHaUTHk6uSEay9rq7l9nOrNtDcaa17l7NplKsLabbdspBvb6yCp8s8WXUYcnPHe_hUe79XJvw3groydO_QqM8vWU-wHYl7T-iXvXqi0xYtJYCu2YcnZleKMOz-YKrdgSBL_O7MXUsIQ/s640/percapita.png" width="640" /></a></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
Let's think about the apples to oranges issue here. Per capita GDP is the level of GDP per person, whereas equity growth is the equity returns in aggregate. This would be like wondering why you can't lose weight after eating a full pizza every night because it only has 300 calories per slice. What matters isn't the calories per slice, its what is the calorie level (economic output) in aggregate for the full pie.</div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<b><br /></b></div>
<div class="MsoNormal" style="text-align: center;">
<b>Real GDP Accounts for THE Most Important Piece... Population Growth</b></div>
<div class="MsoNormal">
<b><br /></b></div>
<div class="MsoNormal">
Now let's take a look at an apples to apples comparison... the total real economic output produced (real GDP) vs the total real equity return over the same period. We now see a scatter plot that moves up and to the right (vs down to the right). I would note that this exact chart is produced ON THE SAME PAGE as the above chart in their 2014 yearbook, but has seemingly been ignored.</div>
<div class="MsoNormal">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjNRpVeEX_C0jYGbsqZFaZz2PezPM6R3HbO0_ITzOYhCGsabLHSHX2cFPGrxj0lL-i-KMONVmmT4_GfwvR-yL6uzbv_JfhKvT0EFE3q9lFHn39HAVJQ288vexa8lSEURtyQTo4sJNbKg/s1600/realgdp.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="677" data-original-width="974" height="444" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjNRpVeEX_C0jYGbsqZFaZz2PezPM6R3HbO0_ITzOYhCGsabLHSHX2cFPGrxj0lL-i-KMONVmmT4_GfwvR-yL6uzbv_JfhKvT0EFE3q9lFHn39HAVJQ288vexa8lSEURtyQTo4sJNbKg/s640/realgdp.png" width="640" /></a></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
Despite the stronger relationship between real GDP and real equity returns, there is an even stronger relationship out there... population growth (i.e. the piece REMOVED from the per capita GDP calculation). I have not found this specific chart produced anywhere else in their yearbooks, but at a 0.56 r-square it is clearly the strongest relationship of the three (despite the lowest r-square result most often quoted), thus explains when you remove it why you get a non-existent relationship.</div>
<div class="MsoNormal">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj76LkEQwTcDRuOP5pFzWfzg1I1o4_NR7wekdsnPjSkgmanDX9ERMd3UCCJ5mrBzXbBQ616QMnKu3ra8aNb20VUBPshPJh2YvMDhhcDRAWTAi0Mqpl_C6CuWjT7dwk1PlPfrujIFI35Dg/s1600/Popgrowth.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="683" data-original-width="945" height="462" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj76LkEQwTcDRuOP5pFzWfzg1I1o4_NR7wekdsnPjSkgmanDX9ERMd3UCCJ5mrBzXbBQ616QMnKu3ra8aNb20VUBPshPJh2YvMDhhcDRAWTAi0Mqpl_C6CuWjT7dwk1PlPfrujIFI35Dg/s640/Popgrowth.png" width="640" /></a></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
<b>Summary: The Case for Asia ex-Japan ex-China is even Stronger</b></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal">
To bring this full circle, David Salem outlined that he has found value in Asia ex-Japan ex-China despite its favorable growth and demographics. Instead, there is a case to be made that the allocation may make sense ONLY due to the favorable growth and demographics (it certainly does not appear to be a reason not to own this region). Combined with the attractive valuations in these markets, especially relative to the developed world, there is a very strong case to be made for diversifying to emerging / high growth countries.</div>
<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-61453040451308195372017-03-20T11:53:00.004-07:002017-03-22T16:57:41.797-07:00Capturing Mean Reversion Via Momentum<a href="https://twitter.com/awealthofcs">Ben</a> from <a href="http://awealthofcommonsense.com/">A Wealth of Common Sense</a> recently <a href="http://awealthofcommonsense.com/2017/03/updating-my-favorite-performance-chart-for-2016/">posted</a> an update of his "favorite chart", which stacks the calendar year performance of a variety of asset classes.<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
</div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjd5yC5PrR4MZhp2FW53qbYDj2wHz5opb_ruuVd7qbCWvzKwOlPpY1V55tsdjE1qq58z2sL7UFaLI9GYrP4pDoQx_0x5wN70XJ60o8z16kK1osWZN4XxnR655tGzTMxeIHj_n_7rE-e9g/s1600/SOIL.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="314" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjd5yC5PrR4MZhp2FW53qbYDj2wHz5opb_ruuVd7qbCWvzKwOlPpY1V55tsdjE1qq58z2sL7UFaLI9GYrP4pDoQx_0x5wN70XJ60o8z16kK1osWZN4XxnR655tGzTMxeIHj_n_7rE-e9g/s640/SOIL.png" width="640" /></a></div>
<br />
As Ben points out:<br />
<blockquote class="tr_bq">
There’s little rhyme or reason for how these things play out from year-to-year so it provides a good reminder for investors to understand that any single year’s performance in the markets is fairly meaningless.</blockquote>
While the year to year performance is rather random, this post will weigh the benefit of mean reversion (allocating to risk assets that have underperformed and stack low on the quilt) vs momentum (allocating to risk assets that have worked well and rank high on the quilt).<br />
<br />
<br />
<b>Asset Class Performance Over Longer Time Frames</b><br />
<br />
The chart below shows the same asset classes that Ben highlighted, but rather than rank the asset classes by calendar year performance, it ranks them by rolling five year returns as of the end of February for each year (I picked end of February simply because that was the last data point).<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjm0rQN9RW4zJEUg-VnTqVP6NOfeCuGPE11AZneKKZIhWgCPcoD1R-YOUNp3CvtDY7y-g9y7VxvxqIcHYlA6eVO-SNgiWEtx9cld3xJoIdn2yJZ7B1_t-LsrPT6mSLfI5Actzm_i3AWlQ/s1600/5yrsoil.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjm0rQN9RW4zJEUg-VnTqVP6NOfeCuGPE11AZneKKZIhWgCPcoD1R-YOUNp3CvtDY7y-g9y7VxvxqIcHYlA6eVO-SNgiWEtx9cld3xJoIdn2yJZ7B1_t-LsrPT6mSLfI5Actzm_i3AWlQ/s640/5yrsoil.png" width="640" /></a></div>
<br />
There is a lot of interesting information here. One of the more interesting aspects is how mean reversion AND momentum can be seen over various time frames. Asset classes appear to be mean-reverting over longer periods (note the strong relative performance of US equities at the beginning of the 2000's, the poor relative performance through the mid to late 2000's, and the strong relative performance we are currently experiencing - while EM and international stocks were the opposite) and asset classes that have done well continue to do well (momentum) over shorter periods (note that if something did well the previous five years, it tended to stick around in the years to follow).<br />
<br />
<br />
<b>Allocating by Mean Reversion and Momentum</b><br />
<b><br /></b>
Using the February 1997 data as a starting point, we can look at the performance over several different time frames to determine whether mean reversion or momentum makes more sense. In this example I narrowed the universe down to equity-like holdings (US - small, mid, large-, International, EM, and REITs) as I personally don't necessarily believe commodities, cash, or even bonds should always be long-term strategic <i>investment</i> holdings (a conversation for another day).<br />
<br />
<b>Five year allocation:</b> In this example, an allocation to the worst two performing asset classes over the last 5 years (mean reversion) and the best two performing asset classes (momentum) are held for the next five years. There is a HUGE caveat in this analysis as since 1997 there have been only 3 periods of rebalancing (so take the exact results with a grain of salt, though this has been verified in past research performed by <a href="http://mebfaber.com/2015/11/11/why-you-should-ask-for-coal-stocks-in-your-stockings-this-holidiy-season/">Meb Faber</a>).<br />
<br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 286px;">
<colgroup><col style="mso-width-alt: 4315; mso-width-source: userset; width: 89pt;" width="118"></col>
<col span="2" style="mso-width-alt: 3072; mso-width-source: userset; width: 63pt;" width="84"></col>
</colgroup><tbody>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15pt; text-align: center; width: 89pt;" width="118"></td>
<td class="xl63" style="text-align: center; width: 63pt;" width="84"><b>Mean Reversion</b></td>
<td class="xl63" style="text-align: center; width: 63pt;" width="84"><b>Momentum</b></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15pt; text-align: center;">2002-2007</td>
<td class="xl66" style="text-align: center;">21.10%</td>
<td class="xl66" style="text-align: center;">10.81%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15pt; text-align: center;">2007-2012</td>
<td class="xl66" style="text-align: center;">1.80%</td>
<td class="xl66" style="text-align: center;">2.30%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15pt; text-align: center;">2012-2017</td>
<td class="xl66" style="text-align: center;">8.67%</td>
<td class="xl66" style="text-align: center;">6.80%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15pt; text-align: center;"></td>
<td class="xl66" style="text-align: center;"></td>
<td class="xl66" style="text-align: center;"></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl65" height="20" style="height: 15pt; text-align: center;"><b>Geometric Return</b></td>
<td class="xl66" style="text-align: center;"><b>10.24%</b></td>
<td class="xl66" style="text-align: center;"><b>6.58%</b></td>
</tr>
</tbody></table>
<br />
<br />
<b>One year allocation:</b> The reason I didn't bother to build out the five year allocation analysis further (to remove the issue outlined above) is that it doesn't really matter once you see the shorter-term results. In this example, we allocated to the bottom two / top two performing asset classes from the previous five years, but held on for the following 12-months (more data points than above, but we'll have a lot more below).<br />
<div>
<br /></div>
<div>
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 286px;">
<colgroup><col style="mso-width-alt: 4315; mso-width-source: userset; width: 89pt;" width="118"></col>
<col span="2" style="mso-width-alt: 3072; mso-width-source: userset; width: 63pt;" width="84"></col>
</colgroup><tbody>
<tr height="40" style="height: 30.0pt;">
<td class="xl66" height="40" style="height: 30pt; text-align: center; width: 89pt;" width="118"></td>
<td class="xl67" style="text-align: center; width: 63pt;" width="84"><b>Mean Reversion</b></td>
<td class="xl67" style="text-align: center; width: 63pt;" width="84"><b>Momentum</b></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2003</td>
<td class="xl68" style="text-align: center;">-15.3%</td>
<td class="xl68" style="text-align: center;">-19.9%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2004</td>
<td class="xl68" style="text-align: center;">64.5%</td>
<td class="xl68" style="text-align: center;">50.9%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2005</td>
<td class="xl68" style="text-align: center;">13.3%</td>
<td class="xl68" style="text-align: center;">21.0%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2006</td>
<td class="xl68" style="text-align: center;">13.9%</td>
<td class="xl68" style="text-align: center;">21.3%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2007</td>
<td class="xl68" style="text-align: center;">16.9%</td>
<td class="xl68" style="text-align: center;">23.5%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2008</td>
<td class="xl68" style="text-align: center;">-8.1%</td>
<td class="xl68" style="text-align: center;">4.4%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2009</td>
<td class="xl68" style="text-align: center;">-43.0%</td>
<td class="xl68" style="text-align: center;">-53.0%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2010</td>
<td class="xl68" style="text-align: center;">76.9%</td>
<td class="xl68" style="text-align: center;">73.7%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2011</td>
<td class="xl68" style="text-align: center;">30.8%</td>
<td class="xl68" style="text-align: center;">26.2%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2012</td>
<td class="xl68" style="text-align: center;">-1.1%</td>
<td class="xl68" style="text-align: center;">1.4%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2013</td>
<td class="xl68" style="text-align: center;">15.2%</td>
<td class="xl68" style="text-align: center;">7.8%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2014</td>
<td class="xl68" style="text-align: center;">7.0%</td>
<td class="xl68" style="text-align: center;">18.7%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2015</td>
<td class="xl68" style="text-align: center;">2.9%</td>
<td class="xl68" style="text-align: center;">17.1%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2016</td>
<td class="xl68" style="text-align: center;">-19.0%</td>
<td class="xl68" style="text-align: center;">-7.8%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;">2017</td>
<td class="xl68" style="text-align: center;">23.1%</td>
<td class="xl68" style="text-align: center;">22.0%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;"></td>
<td class="xl65" style="text-align: center;"></td>
<td class="xl65" style="text-align: center;"></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15pt; text-align: center;"><b>Geometric Return</b></td>
<td class="xl68" style="text-align: center;"><b>8.0%</b></td>
<td class="xl68" style="text-align: center;"><b>9.7%</b></td>
</tr>
</tbody></table>
<br />
<div>
</div>
</div>
<div>
<b>Monthly allocation: </b>In this case we allocated to the bottom two / top two performing asset classes from the previous five years, but held on for the following one month (performance is shown for the 12-months ending February of each year).<br />
<br />
<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; text-align: center; width: 286px;">
<colgroup><col style="mso-width-alt: 4315; mso-width-source: userset; width: 89pt;" width="118"></col>
<col span="2" style="mso-width-alt: 3072; mso-width-source: userset; width: 63pt;" width="84"></col>
</colgroup><tbody>
<tr height="20" style="height: 15.0pt;">
<td height="20" style="height: 15.0pt; width: 89pt;" width="118"></td>
<td class="xl67" style="width: 63pt;" width="84"><b>Mean Reversion</b></td>
<td class="xl67" style="width: 63pt;" width="84"><b>Momentum</b></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2003</td>
<td class="xl65" style="text-align: center;">-15.2%</td>
<td class="xl65" style="text-align: center;">-14.7%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2004</td>
<td class="xl65" style="text-align: center;">48.7%</td>
<td class="xl65" style="text-align: center;">57.4%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2005</td>
<td class="xl65" style="text-align: center;">13.2%</td>
<td class="xl65" style="text-align: center;">12.3%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2006</td>
<td class="xl65" style="text-align: center;">13.9%</td>
<td class="xl65" style="text-align: center;">34.9%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2007</td>
<td class="xl65" style="text-align: center;">14.1%</td>
<td class="xl65" style="text-align: center;">23.9%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2008</td>
<td class="xl65" style="text-align: center;">-8.2%</td>
<td class="xl65" style="text-align: center;">5.4%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2009</td>
<td class="xl65" style="text-align: center;">-42.1%</td>
<td class="xl65" style="text-align: center;">-56.1%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2010</td>
<td class="xl65" style="text-align: center;">78.8%</td>
<td class="xl65" style="text-align: center;">73.1%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2011</td>
<td class="xl65" style="text-align: center;">35.5%</td>
<td class="xl65" style="text-align: center;">24.4%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2012</td>
<td class="xl65" style="text-align: center;">-1.2%</td>
<td class="xl65" style="text-align: center;">1.6%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2013</td>
<td class="xl65" style="text-align: center;">17.4%</td>
<td class="xl65" style="text-align: center;">5.7%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2014</td>
<td class="xl65" style="text-align: center;">4.4%</td>
<td class="xl65" style="text-align: center;">24.3%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2015</td>
<td class="xl65" style="text-align: center;">3.0%</td>
<td class="xl65" style="text-align: center;">13.8%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2016</td>
<td class="xl65" style="text-align: center;">-18.9%</td>
<td class="xl65" style="text-align: center;">-9.8%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;">2017</td>
<td class="xl65" style="text-align: center;">23.2%</td>
<td class="xl65" style="text-align: center;">23.6%</td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td height="20" style="height: 15.0pt;"></td>
<td></td>
<td></td>
</tr>
<tr height="20" style="height: 15.0pt;">
<td class="xl66" height="20" style="height: 15.0pt;"><b>Geometric Return</b></td>
<td class="xl68"><b>7.5%</b></td>
<td class="xl68"><b>10.1%</b></td>
</tr>
</tbody></table>
</div>
<div>
<b><br /></b></div>
<div>
<b>Mean Reversion Captured via Momentum</b></div>
<div>
<b><br /></b></div>
<div>
Asset classes mean revert over longer periods, but this analysis provides a good starting point for the hypothesis that it can can be captured more effectively through momentum than by allocating to a down-an-out area of the market. The chart below shows that the best performing asset class was emerging markets for an extended period roughly 5 years after being the worst ranked asset class in 2002, REITs in 2012 were the best after being the worst ranked asset class during the financial crisis, and US stocks more recently were the best after ranking poorly for much of the period following the financial crisis.</div>
<div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifxOJxVWQhTuFknPiXUAcY97YNHTLkvhDhJBy8hCltIBeywbWs0usfyZf2CyGAphVwRqoaqR9U3N-zcPAbeZ3GJwD_Y8p3rtKxA30PCB29-r6zqNvN15en772O89F49DmlN6Bm2VGjpw/s1600/Best+perf.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="392" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifxOJxVWQhTuFknPiXUAcY97YNHTLkvhDhJBy8hCltIBeywbWs0usfyZf2CyGAphVwRqoaqR9U3N-zcPAbeZ3GJwD_Y8p3rtKxA30PCB29-r6zqNvN15en772O89F49DmlN6Bm2VGjpw/s640/Best+perf.png" width="640" /></a></div>
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<div>
For an investor the takeaway is good news... rather having to allocate to an underperforming asset class over the past x years, simply wait for that underperforming / cheap asset class to start performing well. While you may miss the exact turn, you may be able to capture the longer run success when the asset class starts working without having to deal with the pain that created the opportunity. </div>
<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com1tag:blogger.com,1999:blog-11027528911364475.post-6395989622375363552017-02-23T12:31:00.001-08:002017-02-23T16:03:45.127-08:00The Potential Return-Free Risk of BondsI've read too many posts / articles that outline why a rise in rates is good for long-term bond investors (as that would allow reinvestment at higher rates). While this can be true depending on the duration of bonds owned and/or for nominal returns over an <i>extended</i> period of time, it is certainly not true over shorter periods of time and absolutely not true for an investor in most real return scenarios... even over <i>very</i> long periods of time.<br />
<br />
<b><br /></b>
<b>BACKDROP</b><br />
<br />
I'll take a step back and go to an interesting question posed by <a href="https://twitter.com/pearkes/status/834226633569660928">George Pearkes</a> the other day (abbreviations removed for clarity):<br />
<blockquote class="tr_bq">
Anyone care to estimate how big losses would be if you rolled 10 year US Treasuries at constant maturity for next 10 years w/ 25 bps of rate rise per quarter?</blockquote>
My <a href="https://twitter.com/EconomPic/status/834239754807840770">response</a> (completely translated from Twitter speak for clarity) was:<br />
<blockquote class="tr_bq">
<ul>
<li>A 25 bp move per quarter is roughly a 2% loss per move given the current duration of around 8 years (0.25% x 8 = 2%).</li>
<li>So an investment would lose money each quarter until the yield (currently 2.4%) is greater than 8% (8% / 4 quarters in a year = 2%, which would offset the loss from the rate hike). </li>
<li>Given an 8% yield would happen during year 6 (6 years x 4 quarters x 0.25% = 6% hike + current 2.4% = 8.4% at the end of year 6).</li>
<li>Year 6 is around midway of the 10 year horizon, so total return would be close to 0% cumulative over the ten years.</li>
</ul>
</blockquote>
This was pretty close to being correct. The chart on the right shows the path of rates assuming a 0.25% rise per quarter, while the chart on the left shows the cumulative return for an investor (slightly above 0% over this period).<br />
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<br />
In the above example, a 0.25% rise per quarter (1% per year) is pretty extreme, but even a smaller 50 bp / year rise would result in lower returns (~10%) than no move (1.024^10-1 = ~27%).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWXsRbCmJHg-84f17YQuEkU5HJpB0YFnvGrUPub3hkGP3r5F7CGNWICeArxIFR0ZewTMe8J6M6G9tXRIB6OQqzegN6Mg5NWBO8e78ahOHQKE5u3HmAg5JWxCi9f-hnGe1XrWcaCZZYlw/s1600/1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="300" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWXsRbCmJHg-84f17YQuEkU5HJpB0YFnvGrUPub3hkGP3r5F7CGNWICeArxIFR0ZewTMe8J6M6G9tXRIB6OQqzegN6Mg5NWBO8e78ahOHQKE5u3HmAg5JWxCi9f-hnGe1XrWcaCZZYlw/s640/1.png" width="640" /></a></div>
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<br />
<b>YOU CAN'T EAT NOMINAL RETURNS</b><br />
<br />
Another problem for investors is that a rise in nominal rates does not occur in isolation. A rise is typically a function of a credit concern (much more likely with corporate / muni debt than treasuries), supply / demand imbalance, or inflation. For this exercise, I'll focus on the impact of inflation.<br />
<br />
Nominal rates moved relatively closely with inflation from the late 1980's until the global financial crisis as investors demanded a real rate (nominal rate less inflation) of ~2% over that period (the recent period of QE pushed them much lower). It's the 1970's that highlights the real risk of inflation in a rising rate scenario; inflation overshot expectations, which created an environment in which inflation pushed real rates into negative territory (bond investors lost from rising rates and negative real carry).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjVa-UOmQ0zQHnwH_6uh1Il4huiQ65PsZHioc5Uj_L6HY37IAo7v5Ecf5-JCyk-ZIudmfaS30sAgjzjk3aqoMmh_T9GHZQE33cgRoaNt2g3ugY_IzlGs_x5XO_e8BzaBTi9iqjAdA4ZJQ/s1600/hist.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="430" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjVa-UOmQ0zQHnwH_6uh1Il4huiQ65PsZHioc5Uj_L6HY37IAo7v5Ecf5-JCyk-ZIudmfaS30sAgjzjk3aqoMmh_T9GHZQE33cgRoaNt2g3ugY_IzlGs_x5XO_e8BzaBTi9iqjAdA4ZJQ/s640/hist.png" width="640" /></a></div>
<br />
Back to the scenarios... taking the same 0.25% rise in rates per quarter (1% / year) shown above and applying two alternative inflation paths, the left hand chart below shows the return profile if real returns were a constant 5% (i.e. inflation was consistently 5% below nominal treasury yields - in itself very optimistic for investors), while the right hand chart shows the return profile if real returns were a constant 2% (i.e. 3% higher inflation on the right hand side than left). In either scenario, the returns are decimated (not surprisingly... when inflation is higher, they are decimated more).<br />
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If you think the nominal return paths are too pessimistic (likely), let's take a look at a few scenarios that seem like pretty realistic possibilities based on market expectations for both rates and inflation. On the left hand chart we show a 20 bp rise per year with 1.5% real yields (settling at ~4.5% yields with 3% inflation) and on the right hand chart we show a 15 bp rise per year scenario with 0.5% real yields (settling at ~4% yields with 3.5% inflation). In each of these scenarios there are cumulative losses over ten years in real terms.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgI1xD_GHpTOquRgZQ6Chtugg4wbmdn4thjyUMRKcUbNId6C8TabHxFG7JyQg81Vx5bnQDJfXH-QyHORPKvwP9gIVdQ9CA5ihG7BIccEbuMW-RwOWVOGZkO4jCJpi6o7ifrvewtpET44g/s1600/newb.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="484" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgI1xD_GHpTOquRgZQ6Chtugg4wbmdn4thjyUMRKcUbNId6C8TabHxFG7JyQg81Vx5bnQDJfXH-QyHORPKvwP9gIVdQ9CA5ihG7BIccEbuMW-RwOWVOGZkO4jCJpi6o7ifrvewtpET44g/s640/newb.png" width="640" /></a></div>
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My takeaway... if you think rates are poised to rise in the future... think twice about owning them. While the risk-free return of cash is hard to accept at current levels, that return may end up being more attractive than the return-free risk of bonds if rates do rise.<br />
<script async="" charset="utf-8" src="//platform.twitter.com/widgets.js"></script><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com0tag:blogger.com,1999:blog-11027528911364475.post-36955658644358351592017-01-09T10:49:00.000-08:002017-01-12T23:38:43.868-08:00The Asymmetry of Reaching for Yield at Low SpreadsBloomberg Gadfly's <a href="https://www.bloomberg.com/gadfly/columnists/AQJIVP98p_c/lisa-abramowicz">Lisa Abramowicz</a> (follow her on twitter <a href="https://twitter.com/lisaabramowicz1">here</a>) outlined in a recent piece <a href="https://www.bloomberg.com/gadfly/articles/2017-01-06/insatiable-appetite-for-corporate-debt-keeps-boom-alive">The Credit Boom that Just Won't Die</a> the insatiable demand for investment grade credit.<br />
<blockquote class="tr_bq">
Last month, bankers and investors told Bloomberg's Claire Boston that they expected U.S. investment-grade bond sales to finally slow after six consecutive years of unprecedented issuance. But the exact opposite seems to be happening, at least if the first few days of 2017 are any guide. The debt sales are accelerating, with the biggest volumes of issuance ever for the first week of January, according to data compiled by Bloomberg.</blockquote>
Lisa followed up this morning with a <a href="https://twitter.com/lisaabramowicz1/status/818508595205701632">tweet</a> outlining similar demand within high yield pushing the spread to treasuries to 3.83%, the lowest level since September 2014. That 3.83% option adjusted spread is the excess yield a high yield investor demands above a treasury bond of similar duration. Note that I did not say to be paid above a treasury bond of similar duration. The reason is historically high yield bonds have (on average) returned ~3.5% less than their yield going back 30 years due to credit events (the chart below is from a previous post <a href="http://econompicdata.blogspot.com/2015/05/the-case-against-high-yield.html">The Case Against High Yield</a>).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjEfK_Ah6ZfRoh4TVUrf2MTf1Bd1kKLQVIbW7lIdjzpxsHRVZ-R9QQ-WAeUukJ_AIqIjrixkcpRig5-SdvVYvHwpq_4qLWS4Mul4RULztvp5aswyjuG9uJf8mBFGkv7PD8W6TuqH6GiXw/s1600/HY1+%25281%2529.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="270" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjEfK_Ah6ZfRoh4TVUrf2MTf1Bd1kKLQVIbW7lIdjzpxsHRVZ-R9QQ-WAeUukJ_AIqIjrixkcpRig5-SdvVYvHwpq_4qLWS4Mul4RULztvp5aswyjuG9uJf8mBFGkv7PD8W6TuqH6GiXw/s640/HY1+%25281%2529.png" width="640" /></a></div>
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As a result, with a current option adjusted spread of 3.83%, if high yield bonds returned what they have returned relative to their spread ON AVERAGE since 1986, high yield bond investors should only expect a forward return that matches that of a treasury bond with similar duration (with a whole lot more risk).<br />
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<b>But things can get worse</b><br />
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The next chart compares the option adjusted spread "OAS" of the Barclays High Yield Index relative to the forward excess performance vs treasury bonds of a similar duration since 1995. <i>Note that yield to worst data goes back to the mid 1980's, whereas OAS only goes back to the mid 1990's hence the different time frame than the example above. </i>The chart clearly shows the strong relationship between the two, but note that the upside potential of high yield is much more symmetrical at higher OAS levels, whereas there is more downside when starting OAS is at lower levels. This is driven largely by where in the credit cycle we are when OAS is low (often near the end) vs when OAS is high (often near the beginning).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiZzToltaFfg_PDrfAkFYmY75yyuknr0I_bMJf2RbshWTHNNFfHD_ugT1q8X1DPlYbOnTwRzUJkGiZdE5DYEpTwBFZ6_1yq9oOz3RUb_7rAFjqm2kGR12t2ykexIgBCUMyCNCkdRtAdVw/s1600/HY+Update.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="472" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiZzToltaFfg_PDrfAkFYmY75yyuknr0I_bMJf2RbshWTHNNFfHD_ugT1q8X1DPlYbOnTwRzUJkGiZdE5DYEpTwBFZ6_1yq9oOz3RUb_7rAFjqm2kGR12t2ykexIgBCUMyCNCkdRtAdVw/s640/HY+Update.png" width="640" /></a></div>
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In fact, we can see in the chart above that when we were at similar levels of OAS as we currently sit, high yield has never provided excess returns to treasuries more than its starting OAS. In fact, the chart below breaks out each of these ~80 starting periods when OAS was less than 4% and we can see that not only did high yield bonds underperform their starting OAS in every instance, the likelihood of underperforming treasuries has been much more prevalent (and with a higher degree of underperformance) than the likelihood of outperforming treasuries (the red line shows that on average high yield bonds underperformed treasuries by 2% at similar levels).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEhw1TzMYzl6P4fzge9XWMBAb-1ZQ54RQk8t-KBDbTYrAC2Bhf5XgJ14Dgoph9GrFBHFaUNn7GRcpADAtwneMCrJoo2bvY8w6fxr3zvfwJASw6At8zwM8CmDtFN4YKVRNTQxB_EkNdrA/s1600/Less4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="462" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEhw1TzMYzl6P4fzge9XWMBAb-1ZQ54RQk8t-KBDbTYrAC2Bhf5XgJ14Dgoph9GrFBHFaUNn7GRcpADAtwneMCrJoo2bvY8w6fxr3zvfwJASw6At8zwM8CmDtFN4YKVRNTQxB_EkNdrA/s640/Less4.png" width="640" /></a></div>
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So if you are looking at the low yields of treasury bonds and searching for an alternative or believe that the spread of high yield may help cushion performance from any further rise in treasury rates, I would tread very carefully.<br />
<script async="" charset="utf-8" src="//platform.twitter.com/widgets.js"></script><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-87031503521952546732016-12-22T23:13:00.000-08:002016-12-22T23:36:49.390-08:00Using Absolute Momentum to Positively Skew Calendar Year ReturnsThere are instances where I "borrow" an idea from someone (actually... most of my posts were at a minimum inspired by someone else). In this case, I am stealing the initial concept from <a href="https://twitter.com/RyanDetrick">Ryan Detrick</a> who <a href="https://twitter.com/RyanDetrick/status/811249298616815616">posted</a> the following chart of annual U.S. stock returns going back ~200 years as there is a lot of interesting information in his chart. As Ryan <a href="https://lplresearch.com/2016/12/20/long-term-look-at-recessions-and-returns/">pointed out</a> in a supporting post most returns were between 0% and 10%, but returns varied pretty broadly during recessions:<br />
<blockquote class="tr_bq">
Yes, more recessionary years saw negative returns more often than not, but surprisingly there have been some strong equity returns during years that had an official recession take place. Obviously most of these big gains took place as the recession was ending; still, this is eye-opening and reinforces not focusing too much on just fundamentals, but also incorporating valuations and technicals.</blockquote>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWQp2vaQsXkDRjpMhENPq4C01kXw_pG_7VdOeK7fa7QCRGorZ9BbCKt30M9BqYVowcN2WV5DkeXGdf5sQDyhUoVz2vHFfDWfnAzgVkvdTKmnkdUntWsldwQFEWjazYTrs9VpXlo3AxgA/s1600/12-20-16_blog_fig1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="580" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWQp2vaQsXkDRjpMhENPq4C01kXw_pG_7VdOeK7fa7QCRGorZ9BbCKt30M9BqYVowcN2WV5DkeXGdf5sQDyhUoVz2vHFfDWfnAzgVkvdTKmnkdUntWsldwQFEWjazYTrs9VpXlo3AxgA/s640/12-20-16_blog_fig1.png" width="640" /></a></div>
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I recreated his chart below using Ibbotson data going back to 1927 (the data goes back to 1926, but you'll see shortly why I selected 1927) and to highlight his point on recessions, I added yellow cells to show final years of a multi-calendar year recession to clearly show the strong performance available for investors that owned stocks after the stock market was already crushed during the initial stages of the recession. <i>Note there are some differences in which years we show as being recessionary. I am not sure of Ryan's source, but I just went to <a href="https://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States">Wikipedia</a>.</i><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiGndH-3YhBMtqAb3R0rGrB9HTr_KWK7x9IgnaQgHmdAi9-5wZTRSGU0kJR9uDHi-FxH9GoUUWAKBA24uMKmTEbm2Zzh2-z1O_UbaLUCOgDU22FXbS5rBp9EInjV0-TfPHXx1Yydcb9gA/s1600/ibbot999.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="336" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiGndH-3YhBMtqAb3R0rGrB9HTr_KWK7x9IgnaQgHmdAi9-5wZTRSGU0kJR9uDHi-FxH9GoUUWAKBA24uMKmTEbm2Zzh2-z1O_UbaLUCOgDU22FXbS5rBp9EInjV0-TfPHXx1Yydcb9gA/s640/ibbot999.png" width="640" /></a></div>
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<b>Avoiding the Downturn and Capturing the Upturn</b></div>
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So is it possible to avoid much of the drawdown at the start of a recession and capture the rebound? </div>
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Fortunately, it might just be. </div>
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The below recreates the above table, but with one slight twist. Instead of a buy and hold allocation to U.S. stocks, the below utilizes the following allocation rules:<br />
<blockquote class="tr_bq">
At each month-end, if the total return index is greater than the 10-month moving average of the total return index stay in stocks... otherwise buy U.S. treasuries.</blockquote>
<i>The 10-month moving average calculation pushed the first calendar year of the strategy to 1927, hence the 1927 start in both charts.</i><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDx2UAYxCmExH1wbVseyciGENLY_unaROqeo4flNrrUWxePPtTl4lwiEjc6j21y1nhmHsnZe8ZyTYS18HZIecTNlo49KRa-B9ZVAd2n5XmKSN6LWf-sKpM-PyQhu8Gq98HKZJUhcqDng/s1600/momo99.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="342" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDx2UAYxCmExH1wbVseyciGENLY_unaROqeo4flNrrUWxePPtTl4lwiEjc6j21y1nhmHsnZe8ZyTYS18HZIecTNlo49KRa-B9ZVAd2n5XmKSN6LWf-sKpM-PyQhu8Gq98HKZJUhcqDng/s640/momo99.png" width="640" /></a></div>
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Remarkably, while this simple model did reduce some of the strongest calendar years, it resulted in no calendar year return of less than -25% and "converted" most of the tough recession years to much more manageable down years. As remarkable, this simple momentum model was able to capture most of the rebound years (i.e. the yellow cells showing the last year of a multi-year recession), as well as the strong performance of the two positive returning recessions (1945 and 1980).<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-69891349640371821262016-12-13T22:27:00.003-08:002016-12-14T06:30:52.215-08:00Betting on PerfectionTo earn a decent return going forward, how reliant on multiple expansion are buy and hold investors in the S&P 500? Let's take a look at one measure.<br />
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The first chart plots forward 10-year returns for the S&P 500 at various starting 5 point <a href="https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=3&cad=rja&uact=8&ved=0ahUKEwjMo6Wb9_LQAhVX8GMKHahiDNgQFggoMAI&url=http%3A%2F%2Fwww.econ.yale.edu%2F~shiller%2Fdata%2Fie_data.xls&usg=AFQjCNHIO1L5UxO3l2vTz6RPRnYvePMf9Q&sig2=k4Bz-VXGz5JtfB540MFV_Q&bvm=bv.141320020,d.cGc">"CAPE"</a> valuation buckets (i.e. less than 10x P/E all the way through above 30x) against the change in the starting P/E relative to the P/E in ten years (i.e. whether the P/E multiple expanded or contracted) going back to Ibbotson data inception in 1926. The chart shows the strong relationship between forward performance and the change in the multiple, as well as the impact of the starting valuation (the cheaper the starting valuation, the higher the <a href="http://econompicdata.blogspot.com/2016/11/predicting-forward-6040-returns.html">returns</a> and the more likely the index will exhibit multiple expansion, whereas the more expensive the starting valuation, the lower the returns and the more likely the index will exhibit multiple contraction).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglWP4iAcYYPkTSWbBYw6RxQZqHhh6qM0vnJCV8AqKlSGWGxx45280ToXs_3QukC6LfhJdAyQ8ZiES6PIY7OCijBED0en9qHSWB_h-gXsHAZ0n91AemHuERrK33AJCcMBlIXL1Q2-kOrw/s1600/nomnom.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="486" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglWP4iAcYYPkTSWbBYw6RxQZqHhh6qM0vnJCV8AqKlSGWGxx45280ToXs_3QukC6LfhJdAyQ8ZiES6PIY7OCijBED0en9qHSWB_h-gXsHAZ0n91AemHuERrK33AJCcMBlIXL1Q2-kOrw/s640/nomnom.png" width="640" /></a></div>
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The next chart plots the same information, but uses forward real returns (i.e. adjusted for inflation). It is interesting to see the tight convergence of returns during periods of P/E multiple contraction irrespective of starting valuation, indicating that some of the decent nominal returns during contractionary periods in the first chart at lower starting valuations occurred during inflationary environments (mainly the 1970's).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEilnRxXAOU0vcPG6I4Axadb5kz2Q26hi-zzkODduskpaL2E2KfNFQYjVIdzp4c0rrD7xw6-vOzzz1mD0PuZM8uX8WDJG16ZMx4zcyYHoClB69NDCUBgWkKzaP9m2GS37oedqpVXf9yckA/s1600/RealReal.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="486" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEilnRxXAOU0vcPG6I4Axadb5kz2Q26hi-zzkODduskpaL2E2KfNFQYjVIdzp4c0rrD7xw6-vOzzz1mD0PuZM8uX8WDJG16ZMx4zcyYHoClB69NDCUBgWkKzaP9m2GS37oedqpVXf9yckA/s640/RealReal.png" width="640" /></a></div>
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So where do we currently sit... at the current 28.3x CAPE, decent forward returns will require the multiple remaining elevated (or becoming more elevated) as no change would equate to a roughly ~4% real return in the model. While no change is certainly a possibility, the below chart shows the CAPE has declined in all previous 67 ten year periods since 1926 when the CAPE was greater than 28x, with an average and median decline of around 40% (which would take us right back to the historical average of ~18x), which at the current valuation models out to a roughly 0% real return over 10 years.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFC7ApAMbi76EqH-Z-9l5s5oCOERZKM0WxucGlh7sGnKIpO0yHnZoiA1mBcl_LrmIDVOojRyahNbHzR_kMWADNBk21TS47DVMcnnnwLMrN9NNvr5ywT-gxS2erTd0mLaWrme_zuBYDow/s1600/change+in+cape.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="448" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFC7ApAMbi76EqH-Z-9l5s5oCOERZKM0WxucGlh7sGnKIpO0yHnZoiA1mBcl_LrmIDVOojRyahNbHzR_kMWADNBk21TS47DVMcnnnwLMrN9NNvr5ywT-gxS2erTd0mLaWrme_zuBYDow/s640/change+in+cape.png" width="640" /></a></div>
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None of this is a sure thing, especially over the short-run. Despite being expensive three years ago, the S&P 500 has returned 10% annualized since. It just happened to have benefited from moving from the 15th percentile of most expensive CAPE to the 6th most expensive. While it absolutely can get more expensive from here, that's simply not the long-term buy and hold bet I would want to make when there are cheaper opportunities available outside and <a href="http://econompicdata.blogspot.com/2016/06/the-case-for-momentum-in-expensive.html">within the U.S.</a>.<br />
<br /><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-43988769887131737252016-12-12T13:15:00.000-08:002016-12-12T22:49:24.081-08:00A Dynamic Approach to Factor Allocation<a href="http://www.etftrends.com/2016/12/low-volatility-is-not-a-buy-and-hold-strategy/">ETF Trends</a> (hat tip <a href="http://thereformedbroker.com/2016/12/11/chart-o-the-day-factor-performance-by-year-quilt/">Josh</a>) showed the following "quilt" of large cap factor calendar year returns in the post <a href="http://www.etftrends.com/2016/12/low-volatility-is-not-a-buy-and-hold-strategy/">Low Volatility is Not a Buy and Hold Strategy</a>.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghsrfxGFZegLoBNlzbLdXfTvbyY5YmQ0FbEsB98DVFSuad8Exgr4FEWkln9Ut82IhpXhkRmgfIsTrPcU8MC-iF7OywsiF1xNtVazL-8T9zOWuv1HSgjMzhqZmzgf_j5qZcAZ8SCeeoRw/s1600/Factor-Quilt.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="276" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghsrfxGFZegLoBNlzbLdXfTvbyY5YmQ0FbEsB98DVFSuad8Exgr4FEWkln9Ut82IhpXhkRmgfIsTrPcU8MC-iF7OywsiF1xNtVazL-8T9zOWuv1HSgjMzhqZmzgf_j5qZcAZ8SCeeoRw/s640/Factor-Quilt.jpg" width="640" /></a></div>
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Author <a href="http://www.etftrends.com/author/johnlunt/">John Lunt's</a> takeaway (bold mine):<br />
<blockquote class="tr_bq">
It is reasonable to conclude that low volatility is not a buy and hold strategy. This is not because it is unlikely to outperform over the long term, but rather because few investors are likely to survive multiple years of underperformance. Recent months have witnessed money flowing out of the low volatility and minimum volatility ETFs. Is this money flowing into different factor ETFs, or is it moving back to the market cap-weighted ETFs? <b>Rather than abandoning factors during their periods of underperformance, investors may want to consider the opportunities that exist in factor blending and in factor rotation.</b></blockquote>
I agree completely and in this post I'll outline one potential framework to allocate to factors that diversifies across a few approaches and across time. <i>Update: following my publishing of this post I received a comment that a lot of the work in the below was built out in further detail in a white paper by Ronald Balvers and Yangru Wu titled <a href="http://andromeda.rutgers.edu/~yangruwu/MOM_MR_JEF.pdf">Momentum and Mean Reversion Across National Equity Markets</a>. I recommend anyone interested in the framework to take a deeper look there.</i><br />
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<b>QUICK BACKDROP</b></div>
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For simplicity, I used the same indices outlined in the ETF Trends post with the exception of the below two tweaks:<br />
<ol>
<li>I added a small cap index (S&P 600 Smallcap Index)</li>
<li>I swapped out the S&P 500 Dividend Aristocrat Index for the MSCI USA High Dividend Yield Index; the issue with the <a href="http://us.spindices.com/indices/strategy/sp-500-dividend-aristocrats">S&P 500 Dividend Aristocrat Index</a> for this analysis is that it has a size tilt (it's equal weighted) and a momentum / quality tilt (it holds companies that have increased dividends every year for the last 25 consecutive years built in as well). Neither are a bad thing at all, just not the pure dividend exposure I want for this analysis.</li>
<li>I went back another five years (which does bring up an important boom / bust regime for the analysis)</li>
</ol>
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Similar to what was outlined in the ETF Trend piece, certain factors had more favorable long-term returns over 15 and 20 years (small cap, low volatility, momentum, and high dividend), while high beta and value (of all things) weighed on performance (note that the Russell 1000 Value Index outperformed the S&P 500 Value Index used in the analysis by 100 bps, which shows that getting the factor right may not be enough if you get the implementation part wrong - but I'll save that for another day). </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj0FDfPiz59uPW9f8qIwXdanalg27MhdkcRcCPH7oYksxfJlcUSutN3aFwcV_hyphenhyphenx0tIrGHN8gtD2P7_Ary8is-2QjGyfVE_fi9qRGZk_QSS5FkGhIlFRtCTf_FMc0CYUlSP-UN-gdM1LA/s1600/1520.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="464" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj0FDfPiz59uPW9f8qIwXdanalg27MhdkcRcCPH7oYksxfJlcUSutN3aFwcV_hyphenhyphenx0tIrGHN8gtD2P7_Ary8is-2QjGyfVE_fi9qRGZk_QSS5FkGhIlFRtCTf_FMc0CYUlSP-UN-gdM1LA/s640/1520.png" width="640" /></a></div>
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The below shows the updated factor quilt. Note the quality index only went back 15 years, hence the blank 1996-2000 data.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNqP3VJ7j5ouGxwsMDxOfZ3EdnhNOdVOdGxulJastf4xiFPqQSuH2a5RcoemSEX2UIwlW5_z0kP_oy-Ok4udPRJbWoIFT_mwOlXwRvLmbVnz3TyG6yfb3b-xoR3wuGNPqA9xWPIeLs8w/s1600/quilt2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="324" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjNqP3VJ7j5ouGxwsMDxOfZ3EdnhNOdVOdGxulJastf4xiFPqQSuH2a5RcoemSEX2UIwlW5_z0kP_oy-Ok4udPRJbWoIFT_mwOlXwRvLmbVnz3TyG6yfb3b-xoR3wuGNPqA9xWPIeLs8w/s640/quilt2.png" width="640" /></a></div>
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<b>FACTOR ROTATION: MOMENTUM OR MEAN REVERSION? YES AND YES.</b></div>
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<b>Intermediate Time Frames: Momentum is the Winner</b><br />
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Momentum tends to work better over shorter periods of look back periods (6, 9, 12 months). The chart below shows momentum and mean reversion using 12-month returns for the indices and one can see that momentum outperformed over the longer time frame. That said, note that almost all of the outperformance came in the first 10 years as a relative momentum strategy was able to cruise through the dot.com bubble.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjMLOOkhi3F838cjj8t-ONwCHukgJojw36ZNBOu7MpCsqNIu7IXJgYDUc_-XpumcBr3qRTRk0ZgzYjXbzSIb_noUOG6kCN9wJREQ6jqfRoZ8XsRxhT7DH6z-p2YZN5LMR7nqlfw69HjQ/s1600/meanmomomonthy.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="464" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjMLOOkhi3F838cjj8t-ONwCHukgJojw36ZNBOu7MpCsqNIu7IXJgYDUc_-XpumcBr3qRTRk0ZgzYjXbzSIb_noUOG6kCN9wJREQ6jqfRoZ8XsRxhT7DH6z-p2YZN5LMR7nqlfw69HjQ/s640/meanmomomonthy.png" width="640" /></a></div>
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<b>Longer Time Frames: Mean Reversion is the Winner</b><br />
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Mean reversion on the other hand tends to work better over longer look back periods, in part because <a href="http://econompicdata.blogspot.com/2016/06/the-case-for-momentum-in-expensive.html">valuations tend to matter more over longer time frames</a> (while sentiment is a shorter term signal). We can see that momentum continued to outperform the index over this twenty year period, but not nearly to the extent it had using a shorter signal.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPSCV72rUbya8vh8t6lXqlcPP9Pqcdj07TwooOpcF76H7dI9cdNewWG27IynI6IEicREQLRdgj4DU3VzGYGDxT7heXItEmmk1Mco4if-s1ENQM6cairqonTQCCkw_tVA7Gjgti6HQJqg/s1600/36m.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="446" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPSCV72rUbya8vh8t6lXqlcPP9Pqcdj07TwooOpcF76H7dI9cdNewWG27IynI6IEicREQLRdgj4DU3VzGYGDxT7heXItEmmk1Mco4if-s1ENQM6cairqonTQCCkw_tVA7Gjgti6HQJqg/s640/36m.png" width="640" /></a></div>
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<b><br /></b>
<b>Combining Signals</b><br />
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Given momentum works better over shorter periods and mean reversion works better over longer periods, we can combine the two to diversify allocations by the momentum factor and by time. The result is a portfolio with similar returns, but much more consistent tracking to the S&P 500 (tracking error goes from 9.5% for mean reversion and 8.3% for momentum, to 5.8% for the combination).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiPvercmnfFMg7n3wFwWL433MpwrcZiCsotpoAb1ORR9-ysZ_cdMblhltCIX06DTcHh5LaBQxeRQMFVVATovr7Fi1Eq-tEGN6qtk-aSKqt4PnIYkbD9rzQiP1c7-yDOf-JO2cmIRPEfvw/s1600/Blend.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="450" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiPvercmnfFMg7n3wFwWL433MpwrcZiCsotpoAb1ORR9-ysZ_cdMblhltCIX06DTcHh5LaBQxeRQMFVVATovr7Fi1Eq-tEGN6qtk-aSKqt4PnIYkbD9rzQiP1c7-yDOf-JO2cmIRPEfvw/s640/Blend.png" width="640" /></a></div>
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<div>
Taking it one step further, the below adds cash as an allowable asset class for momentum (i.e. an allocation can only occur if the twelve month return outpaced cash), turning momentum into a more absolute return oriented strategy (mean reversion continues to exclude cash as an asset class).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh1gKNWFsHM6HogdT60Y6MwOgwZgcES9tTFdmwzu5soSX491t-iCnC41aAgzMDKJvBQnDnRJhC8LnyB1SYDWr8ohpGyVTRBFzyCnZvC6Wj8bQAsmxDDI9Iu02748RD15Lkeij3JfG1cZg/s1600/cashbal.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="452" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh1gKNWFsHM6HogdT60Y6MwOgwZgcES9tTFdmwzu5soSX491t-iCnC41aAgzMDKJvBQnDnRJhC8LnyB1SYDWr8ohpGyVTRBFzyCnZvC6Wj8bQAsmxDDI9Iu02748RD15Lkeij3JfG1cZg/s640/cashbal.png" width="640" /></a></div>
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There are still shorter periods of time in which the blend will underperform, but the blended strategy (with the ability to go to cash) has provided consistent outperformance over three year periods (85% of the time over the last twenty years). In addition, the relative performance has tended to have a linear relationship with starting valuation (i.e. it tends to outperform going forward when stocks appear relatively expensive) in part because of the ability to move to cash in the case of momentum and in the likelihood of allocating to a less frothy segment of the U.S. stock universe in the case of mean reversion. Something to keep in mind given the current cyclically adjusted P/E "CAPE" has crossed 27x.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiPATKavVJrOJKJd2x8UHDR3IhBNPUKlJaqaX_mVmvMyVGQL4CenBWUsRS93Zoj7qU7uSMfpKqttTe5ikCtjayn8oxk6MDSCTqAn1A426to09pUkOy88E7WAYgofxTuwK_DYzMJNAl6vA/s1600/blurp.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="436" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiPATKavVJrOJKJd2x8UHDR3IhBNPUKlJaqaX_mVmvMyVGQL4CenBWUsRS93Zoj7qU7uSMfpKqttTe5ikCtjayn8oxk6MDSCTqAn1A426to09pUkOy88E7WAYgofxTuwK_DYzMJNAl6vA/s640/blurp.png" width="640" /></a></div>
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<b>CONCLUSION</b></div>
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Certain factors have shown the ability to outperform over longer periods of time, but can and do underperform over shorter periods. These periods can be challenging for investors that cannot remain disciplined. As a result, a strategy that consistently follows a set of diversified rules to allocate across factors may help reduce behavioral issues of holding onto a strategy that differs from the S&P 500. Given the historical performance of this sort of strategy tends to do relatively better when market valuations are expensive, it may be an interesting approach to allocate across factors going forward.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh-hX3JVGsg8_of-twf5HBonBbF5uiNrsfLqFPTHrZHwNsEyMYgaKJVFzux9tTg6hUTa9a24J37gvfzl_GfP4vSe3P8VexBo5PxlDjH-gqIy0lpoOndQv7gvPxlHqNoOfQm-sFYz4VgSA/s1600/strat4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="478" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh-hX3JVGsg8_of-twf5HBonBbF5uiNrsfLqFPTHrZHwNsEyMYgaKJVFzux9tTg6hUTa9a24J37gvfzl_GfP4vSe3P8VexBo5PxlDjH-gqIy0lpoOndQv7gvPxlHqNoOfQm-sFYz4VgSA/s640/strat4.png" width="640" /></a></div>
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<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-17064902825623876722016-11-30T12:31:00.001-08:002016-12-13T13:57:55.062-08:00Predicting Forward 60/40 ReturnsIn a recent post, <a href="http://www.fortunefinancialadvisors.com/blog/long-term-bonds-behave-more-like-stocks-than-you-might-think">Long-Term Bonds Behave More Like Stocks Than You Might Think</a>, <a href="https://twitter.com/lhamtil">Lawrence</a> via Fortune Financial fame outlined:<br />
<blockquote class="tr_bq">
It shouldn't be surprising that long-term Treasurys exhibit almost the same degree of volatility as equities. After all, as we discussed in <a href="http://www.fortunefinancialadvisors.com/blog/a-better-way-to-think-of-cash-bonds-and-stocks">A Better Way to Think of Cash, Bonds, and Stocks</a>, stocks are essentially high-duration instruments, or perpetuities. The further out on the duration scale you go with bonds, the more likely they will behave like equities, even if they are of the highest quality.</blockquote>
The longer duration means that forward long-term nominal returns of long bonds are much more predictable than those of intermediate-bonds (after all, you are locking in a nominal return over that longer time frame). Similarly, stock valuations tend to be much more predictive over longer time frames than shorter time frames, which are driven more by sentiment.<br />
<br />
Following Lawrence's lead (and given that few investors invest in long bonds or invest only in stocks or bonds in isolation), I thought it might be of interest to see if we can "calculate" the historical duration of a U.S. 60/40 portfolio and then use this information to try to predict where we are headed. The goal of this is not to scare investors (it may / will), but rather to show that simply investing in a U.S. only balanced portfolio may not cut it going forward.<br />
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<div style="text-align: center;">
<b>DURATION OF A 60/40 PORTFOLIO</b></div>
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Using S&P 500 and Barclays U.S. Treasury data going back to 1973 and Ibbotson data going back pre-1973 to 1926 (as far back as that data goes), I attempted to solve for the best fitting relationship of forward returns relative to the starting yield of a 60/40 portfolio over various time frames. My methodology for starting yield was as follows:<br />
<ul>
<li><b>Stock Yield:</b> I first calculated the Cyclically Adjusted P/E "CAPE" for each time frame using a backward looking time frame equal to that used in the calculation of the forward return analysis (for example... the <a href="http://www.econ.yale.edu/~shiller/data/ie_data.xls">standard CAPE formula</a> smooths after inflation earnings over a 10 year time frame - for the 5 year time frame in my analysis, I created a 5 year CAPE - for the 20 year time frame, I created a 20 year CAPE), then I turned the CAPE into a yield by taking 1 / CAPE (i.e. a CAPE of 20 = a yield of 1/20 or 5%)</li>
<li><b>Bond Yield:</b> U.S. 10 Year Treasury Rate</li>
<li><b>60/40 Yield:</b> Simply 60% the Stock Yield + 40% the Bond Yield</li>
</ul>
The below chart shows the fit between starting yield and forward returns over times frames from five to twenty years, with the tightest fit being a time frame of 14 years.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjGFKz-KD145w_rFRO9tJRt7UPuQ1kkHE4QWdqevG2Ygf5RhuRHqjzNg50z3DPzUcJZgY7fXnprYxpq92yz4wGup4YlQuZB-QMW_Ar7v7et56SbCi8S_gr2eIgLVE1aUFBYYHTG-4edBw/s1600/6040.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="472" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjGFKz-KD145w_rFRO9tJRt7UPuQ1kkHE4QWdqevG2Ygf5RhuRHqjzNg50z3DPzUcJZgY7fXnprYxpq92yz4wGup4YlQuZB-QMW_Ar7v7et56SbCi8S_gr2eIgLVE1aUFBYYHTG-4edBw/s640/6040.png" width="640" /></a></div>
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The chart below shows how the analysis looked for a sampling of these times frames.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRtYTGOb_r8_7sD-SwDanvd3GzJV44psv40B2qVGr6K9lP2uBkzotZm1svNuR09XdrXgZxha_wUcoXqQt3MNPB22ed-BbkAq_q8xglefnfaBz6DHqC1Qox59M5YevD9lcItP57PZ-emw/s1600/startingy.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="537" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRtYTGOb_r8_7sD-SwDanvd3GzJV44psv40B2qVGr6K9lP2uBkzotZm1svNuR09XdrXgZxha_wUcoXqQt3MNPB22ed-BbkAq_q8xglefnfaBz6DHqC1Qox59M5YevD9lcItP57PZ-emw/s640/startingy.png" width="640" /></a></div>
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<div style="text-align: center;">
<b>PROJECTING NOMINAL 60/40 RETURNS GIVEN STARTING YIELD</b></div>
<div style="text-align: center;">
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The full equation for the tightest fit of starting yield and forward nominal returns for a 60/40 portfolio over a 14 year time frame was as follows:<br />
<blockquote class="tr_bq">
Forward Annualized Returns = 1.246 x Starting Yield + 0.0118</blockquote>
We can see in the following chart that this ex-post calculated formula did a great job at predicting future returns given starting yield. Forward returns were +/- 1.5% of actual annualized returns in 2/3 of all time frames and 80% of all time periods since 1950.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgwJWqPmdfu_Y8ixKo8FNyocxBijLcg9EXqp8IaqgJdI-7kpP4uB37gkx2Y-Av8OAwJmfF8J_X8i2cF9T78s71XwbHsS4PhvicivMjsgkk9LfweJmNaAHiMlJY8bicYwDkRCgZMspq-WA/s1600/Nominal.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="454" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgwJWqPmdfu_Y8ixKo8FNyocxBijLcg9EXqp8IaqgJdI-7kpP4uB37gkx2Y-Av8OAwJmfF8J_X8i2cF9T78s71XwbHsS4PhvicivMjsgkk9LfweJmNaAHiMlJY8bicYwDkRCgZMspq-WA/s640/Nominal.png" width="640" /></a></div>
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My main takeaway is how amazing the fit has been without any knowledge (ex-ante) of a wide range of inflationary and economic environments. Over any given 14 year window the main driver of performance was the nominal yield of the 60/40 portfolio, while the inflationary / economic environment seemingly only impacted things on the margin (something to keep in mind for those that think a huge economic rebound will solve current valuation issues).<br />
<br />
In addition, one can see that excluding the very high starting yields of the 1970's / early 1980's (driven by cheap stocks and high interest rates following a period of very high inflation), the nominal starting yield of a 60/40 portfolio was relatively consistent hovering above / below 6-7% in most instances. Unfortunately, the current period appears to be an outlier to the low-end given high multiples for stocks and low yields for bonds, resulting in a starting yield at a 90+ year low.<br />
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<div style="text-align: center;">
<b>PROJECTING REAL RETURNS</b></div>
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The below chart takes all of the nominal yields / returns in the chart above, but reduces the starting yield and forward returns by the forward 14 year inflation rate (a figure that was known only after the fact). To project future real returns, I show two paths... one assuming 2% inflation and one assuming 4% inflation.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEipae4CWIg4bneEACXo8X5FIhTtWgGLp8Ej7Eg3zawLsX49uXnR-sRtAfsAd7aAgT6Dr8sCj37Da5dV0lwLC8MiwFQVFKgokrddMZuXmYGZ-V081uW4z7Ybs6AWpOx_7MtDCjGUutuNWg/s1600/real6040.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="438" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEipae4CWIg4bneEACXo8X5FIhTtWgGLp8Ej7Eg3zawLsX49uXnR-sRtAfsAd7aAgT6Dr8sCj37Da5dV0lwLC8MiwFQVFKgokrddMZuXmYGZ-V081uW4z7Ybs6AWpOx_7MtDCjGUutuNWg/s640/real6040.png" width="640" /></a></div>
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You can infer that realized real returns will be worse if inflation moves higher and I have a hard time imagining inflation moving lower in the years to come (I very well may be wrong, but I don't know how our system would handle disinflation given the high levels of nominal debt that would be difficult to pay back without inflation). The result are likely forward real returns for a 60/40 portfolio in the 0-2% range pre-tax with more downside in my view than upside (post-tax - you can take off another 1-2%).<br />
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<div style="text-align: center;">
<b>IMPLICATIONS</b></div>
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Perhaps a separate post for another day, but some initial thoughts:<br />
<ul>
<li>Diversify equity exposure to cheaper markets abroad</li>
<li>Rethink the value proposition of active management in inefficient markets</li>
<li>Look for an alternative anchor to bonds, such as managed futures</li>
<li>Look outside traditional stocks and bonds with regards to asset classes</li>
<li>Diversify by time, not only asset classes (i.e. momentum)</li>
<li>Be very tax aware (put more money in your retirement accounts)</li>
<li>Save more</li>
</ul>
<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-56028866741608758262016-10-26T13:08:00.000-07:002016-10-26T17:07:43.412-07:00A Framework for a Short VIX AllocationIt has <a href="http://econompicdata.blogspot.com/2016/10/the-case-for-put-writing-in-expensive.html">historically paid to be a seller of volatility</a> for at least two reasons...<br />
<br />
<b>1) Volatility is typically overpriced relative to realized volatility</b><br />
<blockquote class="tr_bq">
The chart on the left shows the VIX index (predicted volatility) relative to the forward realized volatility of the S&P 500, while the chart on the right shows the variance between the two (anything > 0 means the VIX index was higher than the realized volatility)</blockquote>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh15x6YEcysKH22me0Bx1oYq_1l2pgnaJStDD0hWISFkKgQWO2FDOoyfqwGNHhWssfeETqpbhHSGNRh8FXUzIyCStWoJietUUnx3-JF2JqRgK2cBc3qJ1Bp2agfzhWzVTVN1ObA_xOOIZQ/s1600/sellvol.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="345" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh15x6YEcysKH22me0Bx1oYq_1l2pgnaJStDD0hWISFkKgQWO2FDOoyfqwGNHhWssfeETqpbhHSGNRh8FXUzIyCStWoJietUUnx3-JF2JqRgK2cBc3qJ1Bp2agfzhWzVTVN1ObA_xOOIZQ/s640/sellvol.png" width="640" /></a></div>
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<b>2) VIX futures typically price the cost of longer dated contracts higher</b><br />
<blockquote class="tr_bq">
The chart below shows the steepness of the <a href="http://vixcentral.com/">VIX futures term structure</a>. Anything below 100 means the value of the CBOE 1-Month Volatility Index (<a href="http://www.cboe.com/micro/vix/vixintro.aspx">VIX</a>) is less than the CBOE 3-Month Volatility Index (<a href="http://www.cboe.com/micro/vxv/">VXV</a>). This is typically the case to compensate the seller for uncertainty, which benefits a short VIX position (all else equal).</blockquote>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFSRqjq5uN-Axp8uTNsAGtCc_kV3ZdBo6KnvHsE5b0T7NJZOQKkiO-pvm0_RRpTbZLiz3cYZXBqMelJape3LkqD3vt_J8_nC1ybhoJep6ckdvIsgteQxsoiEHx_xpwx7Law237UF8nDM4/s1600/shortvix.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="468" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFSRqjq5uN-Axp8uTNsAGtCc_kV3ZdBo6KnvHsE5b0T7NJZOQKkiO-pvm0_RRpTbZLiz3cYZXBqMelJape3LkqD3vt_J8_nC1ybhoJep6ckdvIsgteQxsoiEHx_xpwx7Law237UF8nDM4/s640/shortvix.png" width="640" /></a></div>
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<div style="text-align: center;">
<b>Creating a Model</b></div>
<br />
Given these historical structural advantages of a VIX short, I thought it would be of interest to share how one might make an allocation within a portfolio to capture these benefits while maintaining characteristics of a long stock position. The below analysis goes back roughly to the inception of VIX futures and carves out a portion of a stock allocation for a short VIX position via the <a href="http://us.spindices.com/indices/strategy/sp-500-vix-short-term-futures-inverse-daily-index-tr">S&P 500 VIX Short-term Futures Inverse Index</a> (the index for ETPs <a href="https://www.google.com/finance?q=xiv&ei=btEPWNmPDYb6mAHK37lI">XIV</a> and <a href="https://www.google.com/finance?q=svxy&ei=WdEPWIGFKImKmAHKzajwCA">SVXY</a>). An investor can simply carve out a percentage of their allocation (call it 10% or 20%) and call it a day, but a risk weighting scheme has historically added about 1% to returns per year, while reducing risk, and it provides a framework for how one might add additional asset classes to the mix (also shown below).<br />
<br />
<b>The Equal Risk Weight Methodology Used Below is as Follows:</b><br />
<blockquote class="tr_bq">
Weight next month exposure to the S&P 500 and S&P 500 VIX Short-term Futures Inverse Index by risk weighting based on historical 6-month standard deviation (using month-end data) and rebalance monthly.</blockquote>
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<div style="text-align: center;">
<b>Model Version 1.0 (Stock / VIX Short, Equal Risk-Weighted)</b></div>
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<b>Example Weights</b><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhlfJ5Ay4CHfEOqpPuY59THN-8VimDIu3QdlbW5_3pzfO_CKPjpulhTZ7M9pn4-sl_07J4zn9zhWiQnxi-kPMxSdjFPVKn8Tcnhh7NhuZ2qAMKmZDWWYRvVLu_srZD_fKOXNidQlzWY0Zw/s1600/vweight.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="470" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhlfJ5Ay4CHfEOqpPuY59THN-8VimDIu3QdlbW5_3pzfO_CKPjpulhTZ7M9pn4-sl_07J4zn9zhWiQnxi-kPMxSdjFPVKn8Tcnhh7NhuZ2qAMKmZDWWYRvVLu_srZD_fKOXNidQlzWY0Zw/s640/vweight.png" width="640" /></a></div>
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Note that this framework resulted in higher modeled performance with better risk-adjusted returns (higher sharpe ratio), though it did come with higher risk in the form of higher standard deviation and higher drawdown.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh9gPSFK5fwQl7sgmRr3vP0TnxRqkl0AIz70Wu6Tyc4S1ms_HsQ1FpINmOnsS7GZuXDNbYagLrMR9Q-TNT_xeX0AmbEN7KZ7Dao2kLUIzc2SuyR3H-Zj7r_w5jER_fHuAnC32Mb4V5wWg/s1600/swap0.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="464" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh9gPSFK5fwQl7sgmRr3vP0TnxRqkl0AIz70Wu6Tyc4S1ms_HsQ1FpINmOnsS7GZuXDNbYagLrMR9Q-TNT_xeX0AmbEN7KZ7Dao2kLUIzc2SuyR3H-Zj7r_w5jER_fHuAnC32Mb4V5wWg/s640/swap0.png" width="640" /></a></div>
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<b>Model Version 2.0 (Stock / Dynamic VIX Short, Equal Risk-Weighted)</b></div>
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Instead of a static short to VIX futures, version 2.0 allocates to the short VIX position only when the term structure favors a short on a daily basis (i.e. when the previous close was in contango - see chart above or <a href="http://econompicdata.blogspot.com/2015/09/utilizing-money-sucking-uvxy-to-improve.html">here</a> for more about investing based on the term structure - the weight remains determined by the previous month-end). The modeled results are improved (higher return, higher risk-adjusted return, and lower drawdown), but overall risk in terms of standard deviation remains higher as well.</div>
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<div style="text-align: center;">
<b>Model Version 2.1 (Version 2.0, but Scaled Down): </b></div>
<b><br /></b>
This iteration takes the rules from version 2.0 and waters down the weight of both stocks and bonds with cash to match risk profile of the S&P 500 (note - this is absolutely data mined or I wouldn't have known a ~70% weight to the results from version 2.0 and 30% to t-bills would have resulted in the 14.3% standard deviation of the S&P 500). The modeled portfolio is improved in just about every manner and has an additional 30% of the portfolio now sitting in cash that is <a href="http://econompicdata.blogspot.com/2016/07/the-case-for-hedge-funds.html">available for an alternative allocation</a>. <i>Note a 37.5% weight gets to the same 7.6% return and results in a standard deviation of almost 1/2 that of the S&P 500 and drawdowns of only 1/3 that of the S&P 500. </i><br />
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<b>Model Version 1.1 (Add Bonds to Version 1.0): </b></div>
<b><br /></b>
This iteration takes the rules from version 1.0 (a static VIX short, even if the VIX term structure is in backwardation), but throws long bonds in the mix. This is more akin to traditional risk parity, so I included the performance of a stock / bond risk parity iteration in the performance chart below as well (i.e. an allocation excluding the VIX short).<i> </i><br />
<i><br /></i><b>Example Weights</b><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbqluQjsaYAN_wn-Azhyphenhyphenq-eO6qtAO7VZxjkkXkszvVnqqPfVSNRUwYTLnu8i4emy2n2esvO6ESXQcgnBk4ZgooA9VSp1KQFax2vg6tRhdKH6_8T4c91lVbJfw5f9g5CGGksWadg31xdQ/s1600/weightbond.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="440" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbqluQjsaYAN_wn-Azhyphenhyphenq-eO6qtAO7VZxjkkXkszvVnqqPfVSNRUwYTLnu8i4emy2n2esvO6ESXQcgnBk4ZgooA9VSp1KQFax2vg6tRhdKH6_8T4c91lVbJfw5f9g5CGGksWadg31xdQ/s640/weightbond.png" width="640" /></a></div>
<b><br /></b>The result is an improved sharpe ratio, largely due to the negative correlation of bonds with stocks over this time frame, and more "bang for your buck" that even a small unlevered allocation to a high volatility VIX short provides (more was written on that feature <a href="http://econompicdata.blogspot.com/2016/01/the-case-for-high-volatility-strategies.html">here</a>). <i>Please note this has been the <a href="http://econompicdata.blogspot.com/2015/04/looking-back-at-risk-parity-golden-age.html">golden age of risk parity</a>, thus this level of performance is unlikely to continue.</i><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjghHZCRtc4nQrsRGdtggGbOBDi_aOziCWn8o5OyEkKpEiMUa9lyBvEfgky1mlqkqw4BXZKq23GOiaDXgsHmqzbRuW07EjsgaRBRtIKESXG6FtlaGRRVR32zmyAGKnNOy_xxceLb9_XSw/s1600/rpbondperf.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="482" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjghHZCRtc4nQrsRGdtggGbOBDi_aOziCWn8o5OyEkKpEiMUa9lyBvEfgky1mlqkqw4BXZKq23GOiaDXgsHmqzbRuW07EjsgaRBRtIKESXG6FtlaGRRVR32zmyAGKnNOy_xxceLb9_XSw/s640/rpbondperf.png" width="640" /></a></div>
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See also:<br />
<ul>
<li style="color: #333333; font-family: Georgia, serif; font-size: 13px;"><a href="http://econompicdata.blogspot.com/2015/10/what-exactly-does-vix-tell-us.html" style="color: #999999; font-family: georgia, serif; font-size: 10pt; line-height: 18pt; text-decoration: none; text-indent: -11.25pt;">What Exactly Does the VIX Tell Us?</a></li>
<li style="color: #333333; font-family: Georgia, serif; font-size: 13px;"><a href="http://econompicdata.blogspot.com/2015/09/utilizing-money-sucking-uvxy-to-improve.html" style="color: #999999; font-size: 10pt; line-height: 18pt; text-decoration: none; text-indent: -11.25pt;">Utilizing the Money Sucking $UVXY to Improve Risk-Adjusted Performance</a></li>
<li style="color: #333333; font-family: Georgia, serif; font-size: 13px;"><a href="http://econompicdata.blogspot.com/2015/04/looking-back-at-risk-parity-golden-age.html" style="color: #999999; font-size: 10pt; line-height: 18pt; text-decoration: none; text-indent: -11.25pt;">Looking Back at Risk Parity's Golden Age</a></li>
<li style="color: #333333; font-family: Georgia, serif; font-size: 13px;"><a href="http://econompicdata.blogspot.com/2016/01/the-case-for-high-volatility-strategies.html" style="color: #999999; font-size: 10pt; line-height: 18pt; text-decoration: none; text-indent: -11.25pt;">The Case For High Volatility Strategies</a></li>
<li style="color: #333333; font-family: georgia, serif; font-size: 13px;"><a href="http://econompicdata.blogspot.com/2016/10/the-case-for-put-writing-in-expensive.html">The Case For Put Writing in an Expensive Market</a></li>
</ul>
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<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-47640561635761862672016-10-03T21:52:00.000-07:002017-01-14T22:27:38.121-08:00The Case for Put Writing in an Expensive MarketPensions and Investments wrote about the interest pension plans have shown in put writing (seemingly one of the more misunderstood investment strategies out there) in a recent article <a href="http://www.pionline.com/article/20161003/PRINT/310039982/funds-go-exotic-with-put-write-options-to-stem-volatility">Funds Go Exotic with Put-write Options to Stem Volatility</a>. I thought the article did a nice job of outlining the case for the strategy as a risk reducing equity alternative. In this post I'll outline why current valuations among U.S. stocks may actually make the trade-off even more interesting (than normal) relative to an allocation to the S&P 500.<br />
<i></i><br />
<div>
<i><br /></i>
<i>For a deeper dive into what put writing entails, including how they have the same economic exposure as covered calls... see past posts <a href="http://econompicdata.blogspot.com/2015/09/the-case-for-put-writing-further.html">here</a> and <a href="http://econompicdata.blogspot.com/2016/05/the-smoother-path-putwriting-at-high.html">here</a>.</i></div>
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<br />
<b>But Shorting Naked Options Sounds Scary... How Can They Reduce Risk Relative to Stocks?</b><br />
<br />
I regularly see articles / posts / tweets outlining the "complexity" and/or "danger" of put writing.<br />
<br />
Example 1) The WSJ reported on the same topic <a href="http://www.wsj.com/articles/pensions-play-with-puts-for-protection-1471777202">In Scramble for Yield, Pension Funds Will Try Almost Anything</a>:<br />
<blockquote class="tr_bq">
Pension funds in Hawaii and South Carolina are plying an arcane options strategy called cash-secured put writing.</blockquote>
Example 2) AAII published an article <a href="http://www.aaii.com/files/investorupdate/20160825.html?a=update082516">Taking on Risk and Hoping the Strategy Doesn't Backfire</a> where <a href="https://twitter.com/CharlesRAAII">Charles Rotblut</a>, the editor of the investment association, reveals the mistaken belief that covered calls provide a different exposure than put writing (click <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQdLoe07SCWl52OMRH18Kog_QyNVWvUyHn38h89wg9R-RgRzwQpUaStUKPh6mpFXb7BS3LxG2GN_WvBH1Q8vHadheu2CCchyphenhyphenM_N3TU9SfHdvQSZHlYb6SlW0LGSL3D1aCCqP-LcRSyhA/s1600/Payoff.png">here</a> for a chart showing they are identical):<br />
<blockquote class="tr_bq">
If an investor holds a stock and writes call options (a strategy referred to as covered calls), the investor gives up potential upside if the option is called. Assuming the investor wrote the contracts with a strike price above what the stock cost to acquire, a profit is made, though a smaller profit than could have been made if the contract hadn’t been written. </blockquote>
<blockquote class="tr_bq">
Conversely, all of the stock’s potential downside is taken on by the investor writing the put. Assuming the investor wrote the contracts with a strike price below what the stock cost to acquire, a profit can only be made if the premiums received and the proceeds from selling the stock exceed the loss incurred from being forced to buy the stock at a price below the put’s strike price</blockquote>
In reality... writing puts simply converts the upside potential of the stock market to a premium collected up front, while the downside (excluding the premium collected) remains the same. The result is a more consistent return stream (the premium collected cushions / offsets the downside when markets sell-off) while it has kept up with the S&P 500 since inception (despite the lower risk profile), given volatility is routinely overpriced by the market. In addition, puts tend to be priced more expensively than calls (in part) because they are less understood by investors, thus put writing has historically outperformed covered calls.<br />
<br />
In other words, I largely agree with the P&I article that shifting equity exposure to put writing can reduce risk in any market environment:<br />
<blockquote class="tr_bq">
The put-write strategy serves both as protection against downside risk and volatility but has the added bonus of providing income, said Frank Tirado, vice president of education, Options Industry Council, Chicago.</blockquote>
<b></b><br />
<div>
<b>The Current Relative Opportunity for Put Writing Appears Greater than Normal</b></div>
<div>
<br />
The current opportunity to shift a long position in the S&P 500 to put writing may be greater than normal given current extended valuations. The reasoning is as follows: </div>
<ul>
<li>The opportunity cost of writing puts relative to owning stocks is the upside of the market (the upside is capped by what is collected as a premium when writing puts, but unlimited for stocks)</li>
<li>The upside of the market is greater when valuations are lower (and expected returns are higher) and lower when valuations are higher</li>
<li>With the S&P 500's cyclically adjusted P/E "CAPE" at 26.5, the market appears relatively expensive, thus upside potential / opportunity cost of stocks are very low vs history (another way of saying forward returns are likely lower than normal)</li>
</ul>
The data bears this out... going back to the CBOE PutWrite Index' 1986 inception, the S&P 500 has outperformed put writing when valuations were cheap and has underperformed put writing when valuations were expensive. In fact, while the S&P 500's forward return has varied by almost 8 points when the CAPE was below / above it's current 26.5 level, the forward seven year return of put writing has hardly varied when below / above this same 26.5 level.<br />
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Scatter plot of starting CAPE vs forward seven year CBOE PutWrite and S&P 500 returns.<br />
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Starting CAPE vs forward seven year CBOE PutWrite and S&P 500 returns.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjvglnclg5GvdFYgbpVWo7i90r3gvesZGpY9kaCSEAI0U0iFC1FCdumIijeBurJujut1OLLqX_49ddmpggCz22u9BN2Tn8800oRls2nx8GhFSJ-S0VM5LWhIWODTti2rF4Hdxp8Pk8bzA/s1600/CAPE+SP500.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="456" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjvglnclg5GvdFYgbpVWo7i90r3gvesZGpY9kaCSEAI0U0iFC1FCdumIijeBurJujut1OLLqX_49ddmpggCz22u9BN2Tn8800oRls2nx8GhFSJ-S0VM5LWhIWODTti2rF4Hdxp8Pk8bzA/s640/CAPE+SP500.png" width="640" /></a></div>
<br /><div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.comtag:blogger.com,1999:blog-11027528911364475.post-5553791688284024492016-09-13T23:41:00.004-07:002016-09-16T23:27:23.979-07:00Off Point: The Case for Home Loans<b>UPDATE:</b> I had a nice discussion with <a href="https://twitter.com/arampell">Alex Rampell</a>, partner at VC firm a16z, who provided me with a material detail that I missed that is both positive and negative. I greatly appreciate his time and while it does change the value proposition for homeowners, it remains unclear to me that the new benefit outweighs the new cost for most homeowners. That said, with the new information I can see where a homeowner with a sizable equity stake could value the flexibility it may provide and I do see where this could become a viable product a few iterations down the line.<br />
<br />
<br />
<u>What did I miss?</u><br />
<br />
I missed that Point does in fact share in the downside with the homeowner if the home price falls below Point's "<a href="http://help.point.com/article/29-how-is-the-propertys-value-determined">risk-adjusted value</a>" (and the loss has not eaten away all of the homeowners equity). Point places a risk-adjusted value on each home at the time they take a stake (i.e. if the home has a market value of $1,000,000, it sounds like they'll typically strike a risk-adjusted value at some price below that). Once the home declines below that risk-adjusted price, Point shares in the loss at their ownership stake (i.e. if they took a 10% equity stake in the home, they share in 10% of the losses below that risk-adjusted value).<br />
<br />
I would note that the risk-adjusted value is also an incremental cost to the homeowner that I initially missed. If a $1,000,000 home has a Point risk-adjusted price of $900,000 and is sold the very next day at $1,000,000, then it sounds like Point is entitled to a 20% cut of the $100,000 "gain" even though the market didn't move.<br />
<br />
Where I personally can see this eventually being a viable product is for an individual that bought low (likely a long time ago), is now sitting on a house worth a LOT of money, and is liquidity constrained (i.e. cannot afford the monthly interest payments associated with a HELOC). Retirees planning to move in the next ten years (Point requires they are paid out of their equity stake within ten years) would be one demographic falling into this camp, as would technology folk who have been buying up property all over San Francisco when we hit our next tech recession (please please please happen sooner than later).<br />
<br />
My dialogue with Alex also made it pretty clear to me that the longer term goal of Point is to build a platform where all these details would more dynamically sort themselves out. For now, the initial analysis below does understate the downside (i.e. the amount captured by Point is actually higher given the risk-adjusted price), but also understates the upside (i.e. the homeowner can benefit by more than the interest savings if prices move lower). For those with a high LTV (loan-to-value), thus lower equity cushion, I believe the initial analysis remains a good enough proxy for the payout structure as the benefit of the put received (i.e. the loss Point offsets in a market decline) is only there until the total equity is wiped out (banks get paid back first).<br />
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<br />
<br />
<br />
<b>ORIGINAL POST</b><br />
<br />
I am pretty sure there will be a ton of other posts tomorrow about <a href="https://point.com/">Point</a> (a "home equity partner") given the huge response to Marc Andreessen's tweet (if not... check out the responses <a href="https://twitter.com/pmarca/status/775806121592299520">here</a> - UPDATE: the great Matt Levine has a take <a href="http://www.bloomberg.com/view/articles/2016-09-14/home-equity-and-bad-apples">here</a>). As a result, I'll skip whether or not the fractional home equity investor is really just a predatory lender, how they will / won't disrupt the mortgage industry, or whether it marks the VC top. Instead I'll focus on the investment case against swapping out of a traditional mortgage loan and "selling" Point a fraction of your home equity. I make a lot of assumptions in the below, but if anything looks off, please let me know. TLDR: don't do it.<br />
<br />
<br />
<b>Swapping from a Loan: A Homeowner's Perspective</b><br />
<b><br /></b>
The real benefit of fractional equity for homeowners will be for those that cannot afford the initial 20% down payment and cannot borrow from family. Unfortunately, Point will not solve this issue as:<br />
<blockquote class="tr_bq">
To be eligible for Point, you’ll need to retain at least 20% of the equity in your home after Point's investment.</blockquote>
As a result, this is a pretty straight forward swap for a homeowner that is otherwise reliant on borrowing. The homeowner is simply swapping out the cost of interest payments for the opportunity cost of the housing appreciation associated with whatever equity stake is sold should markets rise.<br />
<br />
In the below analysis, I assume a $1,000,000 home where an investor swaps out 10% ($100,000) from a ten year interest only loan and instead "sells" that 10% stake to Point.<br />
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Assuming a 3% interest only loan for ten years and a 33% tax rate for interest deduction benefits, we get a 2% / year after-tax savings (3% x [1 - 0.33%] = 2%) for the homeowner due to the reduced notional loan. This comes out to $2000 of savings per year or $20,000 over a ten year period. In return, the homeowners gives up <a href="https://twitter.com/matt_levine/status/775819002413191168">200% of the upside</a> on the stake sold and is charged <a href="https://point.com/how_it_works">3% up front</a>. Unfortunately, the homeowner doesn't appear to receive any incremental benefit should markets fall as the homeowner takes first loss on the minimum 20% equity stake homeowners are required to retain. Andreessen's VC firm <a href="http://a16z.com/2016/09/13/point/">a16z</a> outlines:<br />
<blockquote class="tr_bq">
Point gets paid back after the bank, but before the homeowner,</blockquote>
Given Point gets paid back before the homeowner, this capital structure provides a huge benefit to Point at the expense of the homeowner (i.e. heads Point wins, tails the homeowner loses). There could be examples where Point also takes a hit, but the homeowner appears to have already been wiped out an amount equal to Point's stake at that point.<br />
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<b><br />Payout Diagram</b><br />
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The below payout diagram assumes an investor doesn't pay back the loan for the max 10 years (the longest period of time before Point is owed their investment back) and that the increase in home value comes solely from market appreciation (i.e. no upgrades paid for by the homeowner). The dotted line represents the starting house price and we can see that the homeowner is better off if the price does not move or if the price declines, as they pocket the $20,000 they would have otherwise paid in after-tax interest. In return, the homeowners break even if the market rises a bit more than 1% a year, given the interest savings and 3-4% up front cost, a rate that is forecast to be less than the rate of inflation.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhH7_tSqMhkla14jcgm7XmIjPPfpMasCF451gPuY5-S_fUt_XEaqINnuOfMsJKrq5bq4n8J78jBGMsGeawvFptbUU5FyPOFjBT-1InIVExROVv8gytU3tK6FrPKaxOnCi1lyc7mZbDpvw/s1600/Home1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="430" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhH7_tSqMhkla14jcgm7XmIjPPfpMasCF451gPuY5-S_fUt_XEaqINnuOfMsJKrq5bq4n8J78jBGMsGeawvFptbUU5FyPOFjBT-1InIVExROVv8gytU3tK6FrPKaxOnCi1lyc7mZbDpvw/s640/Home1.png" width="640" /></a></div>
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Unfortunately it gets worse if the homeowner <a href="http://help.point.com/article/25-can-i-remodel-the-home-at-any-time">remodels</a> (one of the benefits of owning a home). Per point:<br />
<blockquote class="tr_bq">
Many homeowners use Point funds to pay for remodeling costs. You can remodel your home but there are limits on adding additional debt to the home to pay for remodeling. Please also note that Point will share in any increase in property value due to remodeling changes you might make.</blockquote>
Let's be clear... if a homeowner sells a $100,000 stake in order to invest in a new kitchen, increasing the value of the home by $100,000, Point captures 20% of that $100,000. Note that $20,000 ($100,000 x 20%) equals the entire benefit of avoiding the interest payments <u>for the full ten years</u>, meaning there is no longer any net upside of choosing Point vs a loan at time = 0. The dotted line represents the new starting point assuming the $100,000 was used to upgrade the home (note the green line cross at ~$0).<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjCrxyfSgofgB2t6P1Ii2OulI9WNiMPatAivlzQNomvj73QsakWN8ffbUg-NQ1KnJfourZXW-PVlvJ3oLXQV_M-kc8IgQMbhuJVB5mH4u4-bHTzzCjwjaSPPWsReo0KFSliNze1A0DQg/s1600/Home2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="434" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjCrxyfSgofgB2t6P1Ii2OulI9WNiMPatAivlzQNomvj73QsakWN8ffbUg-NQ1KnJfourZXW-PVlvJ3oLXQV_M-kc8IgQMbhuJVB5mH4u4-bHTzzCjwjaSPPWsReo0KFSliNze1A0DQg/s640/Home2.png" width="640" /></a></div>
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As for the cost at inception, these payoff diagrams are classic naked call payoffs and the interest savings can be viewed as the premium collected for selling those calls (i.e. the $20,000). Assuming these calls expire in 10 years, we can try to value them using the Black-Scholes formula. Using the assumed inputs:<br />
<ul>
<li>Notional: $200,000 (200% upside of $100,000)</li>
<li>Strike: $1,000,000</li>
<li>Current (Remodeled Home) Spot: $1,100,000 </li>
<li>Risk free rate (assumed 2%)</li>
<li>Volatility (the annual volatility from 2006-2016 for the <a href="http://us.spindices.com/indices/real-estate/sp-corelogic-case-shiller-20-city-composite-home-price-nsa-index">Case Shiller</a> index was 9%)</li>
</ul>
We get a value of roughly $60,000. Assuming any home price movement will be on top of 2% / year inflation, these calls move up to a rough value of $100,000. All for $20,000 in saving.<br />
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Keep the loan.<div class="blogger-post-footer">EconomPic Data: Darn Nice Economic Eye Candy</div>Jakehttp://www.blogger.com/profile/07946497592651234440noreply@blogger.com