A Guide to Creating Your Own Smart Beta Fund

FT tries to define smart beta:

Smart beta is a rather elusive term in modern finance. It lacks a strict definition and is also sometimes known as advanced beta, alternative beta or strategy indices. It can be understood as an umbrella term for rules based investment strategies that do not use the conventional market capitalisation weights that have been criticised for delivering sub-optimal returns by overweighting overvalued stocks and, conversely, underweighting undervalued ones.

A pretty good definition, which is just broad enough to allow for anything and say it's a cure for almost anything. As a result, there has been a proliferation of smart beta ETFs and mutual funds that have, in many instances, gathered an absurd amount of assets from investors, often times with only backtested performance.

While no concept will work over every time frame, the more concerning aspect to me is that interesting concepts that backtested well in one category are being applied to other areas of the market irrespective of supporting analysis and/or whether there is proper liquidity. One highly regarded "fundamental" index provider now has a fundamental index not only within all major equity categories, but also across multiple areas of fixed income, including US high yield corporate bonds. While the 1.07% annualized underperformance of the "smart" index vs the Barclays US High Yield Index over the last 3 years is in itself an issue, the real concern is the incremental 1.10% of annualized underperformance the ETF has to its custom index due to fees + trading in an illiquid part of the credit market. This almost 2.2% annualized underperformance hasn't stopped this almost $700 million fund from taking in another $86mm in assets the first three months of the year!

So... lots of flows, based in large part on back-tested results, with actual results of only limited value. Let’s create our own…


Step 1: Find a Marketable Idea

Leveraging the work from my previous post Is there a Relationship Between the Economy and Stock Market?, let's create a systematic asset allocation index* and call it GDP Growth "Smart Beta". To sell a product, you need a concept that is unique, yet resonates with the masses:

Unique
I don't know of any ETFs that are systematically tied to short-term GDP growth as the main factor driving the stock / bond allocation decision

Resonates
Despite the fact that economists (even good economists) have no idea what's going on, everyone thinks they are an economist (including me... case in point - I started a blog called EconomPic Data)


Step 2: Create a Pitch

Using an exclusive signal, the strategy shifts capital to assets capturing the equity risk premium when deemed attractive and de-risks when valuations are deemed poor, while a proprietary macro overlay identifies periods of relative economic weakness. The resulting portfolio provides equity-like returns during strong market environments, with bond-like characteristics during periods of heightened market uncertainty.

Step 3: Show Backtested Results

Show performance in the best format possible. If total returns are similar, but a time series highlights long periods of underperformance vs the traditional asset class... then only show the time series of the "smart beta" index (and show a total returns comparison vs. the traditional beta separately in a table).

Step 4: Add Leverage

Show how much better returns would have been at similar levels of risk as the stock market, while ignoring the fact that there is no way to know in advance how much leverage you would need to have matched that standard deviation.

Step 5: Profit

Actually, I missed a step. I need a good ETF ticker. Perhaps Goodrich Petroleum would be willing to sell theirs?


Conclusion

Despite what I outline above, I think there is a huge opportunity for systematic / rules based ETFs. That said, I have a hard time understanding why many of these products, sponsors, and providers get a free pass (or in many cases are put on a pedestal) from the same guys that are railing against active management. Also... just because something has worked well in the past and there is academic support that explains (or tries to explain) why it has worked, it doesn't mean it will work in all markets or across all asset classes.


*Each quarter, if the latest one year nominal GDP > the yield to worst on the Barclays US Aggregate Bond Index... allocate the next quarter to stocks (S&P 500); otherwise to bonds (Barclays Aggregate Index). 

Is there a Relationship Between the Economy and Stock Market?

Long story short... yes, there appears to be a relationship between economic growth and stock market performance within the U.S. (and developed world), but that relationship holds only over longer periods of time and does not hold for all countries (less developed countries often "divert" growth to the political elite).

Also, for those interested in the relationship between long-term economic growth and returns across countries, Dimson, Marsh, and Staunton provide a ton of interesting analysis going back 100+ years within the Credit Suisse Investment Returns Yearbook (Figure 13 on page 28). The high level takeaway: "Though difficult for investors to capture in portfolio returns, strong GDP growth is generally good for investors."

Below are two pieces of analysis that outline what I feel drive the relationship between underlying economic growth and the U.S. stock market;

1. The economy's impact on valuation (economic growth provides a base for corporate earnings, which drives valuations, which drives returns)
2. Economic contractions that severely impact stock market performance

U.S. Economy vs. U.S. Stock Market - The Valuation Story

The best part about taking an almost 3 year hiatus from blogging is that I can recycle about 90% of my previous ideas and they will seem new. Here is one I initially ran in May 2010, then revised to the format below in February 2012. The background of this is that over the long run, equity valuations and earnings have both grown at roughly the same pace as nominal GDP. This makes intuitive sense... while earnings can absolutely grow slower than the economy (especially in emerging markets with less developed investor protection), if they consistently grew faster than the economy, then earnings would eventually become larger than the entire economy (not possible).

With that in mind, the below chart shows:

• Blue: the S&P index
• Red: the ending 2014 value is set to the 2014 year-end value of the S&P 500 index, then brought back in time by the nominal GDP growth rate (GDP data is available at the Bureau of Economic Analysis) - 1929 is the first year the BEA produces annual GDP growth rate

This is an attempt to compare the S&P's historical valuation relative to the size of the US economy, relative to the current level of that relationship. When the S&P 500 (blue) is below the nominal GDP line (red), then the S&P 500 was cheaper on this relative measure than it is now (when the lines cross valuation levels were equal to those in place today).

The chart below shows the relative valuation for each year from 1929 through 2004 (relative to its current value of 0; again if less than 0, the S&P was cheaper by this measure), along with the subsequent 10 year forward change in the S&P 500 total return (annualized). This chart outlines that historically there has been a significant relationship between the underlying economy and stock market. When the S&P composite has grown at a slower rate than the U.S. economy, making it cheap, this has led to historical outperformance.

Of note... there have been many more periods when the stock market was less expensive than the current level, yet the trend-line goes through 0% (the current valuation) on the x-axis at roughly 7.5% annualized (noisy data, but it makes current valuations less stretched than some would think).


U.S. Economy vs. Stock Market - Avoid Economic Contractions if Possible

While the above analysis outlines that the relationship between the economy and stock market generally holds over longer time frames, there has been a relationship worth mentioning over shorter time frames. Going back to the first quarter of 1947 (as far back as the BEA releases quarterly real GDP) and separating quarterly S&P 500 performance when real GDP was either positive or negative, we see a pretty material difference in performance. Not only were returns much better when GDP was expanding vs. contracting (real returns have actually been negative during economic contractions), but returns were much more volatile when the economy was contracting.

While there is no real way for an investor to know in advance a contraction is coming (though a lot of investors think they can), the key is that if the underlying economy has strength, history points to stock markets as being supported.

The Disappearing Value Premium?

Eugene Fama and Kenneth French released their seminal white paper 'The Cross-Section of Expected Stock Returns' in June 1992 which added value (as well as size) as explanatory factors that drove market (out)performance. 

Per Investopedia:

Fama and French attempted to better measure market returns and, through research, found that value stocks outperform growth stocks.

Why does the value premium exist? There are broadly two explanations... an efficient market explanation and inefficient market explanation. Back to Investopedia:

On the efficiency side of the debate, the outperformance is generally explained by the excess risk that value and small cap stocks face as a result of their higher cost of capital and greater business risk. On the inefficiency side, the outperformance is explained by market participants mispricing the value of these companies, which provides the excess return in the long run as the value adjusts.

While I don't believe markets are completely efficient (too much proof outlining the opposite), I do believe markets are generally pretty darn good at eliminating blatant inefficiencies once discovered. 

What happens when inefficiencies are identified? 

Investor flows come in eliminating the inefficiency and the plain vanilla version of the value factor (price to book) appears to be no exception. Between 1995 and the end of 2014, the amount of money allocated to passive large value funds / ETFs grew more than 30% compounded / year, growing from slightly over $1 billion to more than $180 billion (and this doesn't include the MASSIVE amount of institutional separate accounts that went this direction), while small value went from literally $0 indexed to $18 billion in funds and ETFs. Including active managers, large / small value fund / ETF AUM grew from $86 billion to more than $1.1 trillion over that time frame.

The declining value premium

Below is a long term chart of the difference between the cheapest and richest stocks by book-to-market (the Fama French size factor) over rolling twenty year periods (20 years as this closely matches the time frame since the 3-factor white paper was published). While not necessarily completely dead, there is a material decline.

And how has this translated to index performance? Well, over shorter time frames, the results are even more striking (investor performance is similar in that the average "dumb" growth investor has outperformed the average value investor over these periods, despite a larger behavioral gap in growth than in value).

As of February 28, 2015

Even the best value investor of our time has seen massive compression in his ability to outperform (pulled from the always great blog A Wealth of Common Sense).

Is the value premium dead? 

Despite all of the above, in my view... absolutely not. What I feel is dead is an investor's ability to capture the value premium by simply allocating to companies with lower price multiples, ignoring all other fundamental aspects (growth, competitive landscape, etc...). In other words, like anything else in investing that becomes well known, the ability to outperform requires skill as the low hanging fruit of value may be dead.

Additional note: I find it utterly fascinating that those investors who believe active management is dead, pointing to the underperformance of passive over the last 5+ years as proof, are in many cases the same investors that believe value works, but it just needs "more time" or a different screen than book to price (the latter being an "active" decision). 

Your Bond Allocation Doesn't Matter as Much as You Think

Quick... which of the three allocations A, B, or C is 60% S&P 500 Index / 40% Barclays U.S. Aggregate Bond Index,  55% S&P 500 Index / 45% Barclays U.S. Corporate Bond Index, or 62% S&P 500 Index / 38% Barclays Treasury Bond Index going back all the way to the inception of the Barclays U.S. Aggregate Bond Index in 1976?

Tough right? How about a chart of a growth in $1 invested in each of the allocations

Still nothing? That's because you can access credit risk two main ways... through stocks or through spread, while rate exposure at the end of the day all comes back to rates on Treasury bonds. An allocation with a higher equity tilt, balanced with bonds with no credit risk (i.e. a pure Treasury allocation) provides the same exposure (and returns) over time as one with a lower tilt towards stocks with additional credit coming from spread.

So what?

While I do think there are times when there are more attractive means of gaining credit exposure through stocks, investment grade bonds, high yield bonds (a simple model I presented back in 2010 highlights how this might add value), you need to make a material reallocation to move the needle. On the other hand, a buy and hold investor can and should allocate to credit and rates in what is the most: (1) structurally efficient (i.e. minimal transaction costs), (2) cost effective (i.e. cheapest), (3) tax-efficient. 

1. Structurally efficient: stocks and treasury bonds both trade at much tighter bid/ask spreads than corporate bonds. More important, during periods of stress, treasuries are MUCH more liquid - winner: stocks and treasuries
2. Cost effective: interestingly enough, the cheapest treasury bonds ETFs are slightly higher in cost than the cheapest Aggregate Bond ETFs, but both are slightly higher than ETFs for the S&P 500; either way, we're talking bps here - a wash
3. Tax-Efficient: the more you are allocated to stocks, the more tax efficient you become as capital gains are taxed at a much lower rate than bond coupons - winner: stocks and treasuries

Takeaway... while stocks balanced with treasuries may have a slight edge in terms of implementation, at the end of the day, it really doesn't matter. If you are spending too much of your investment time trying to decide whether to slightly change your bond allocation away from treasuries to another duration sensitive area of the bond market given fears of a rate hike, please spend your time elsewhere.

Footnote: I initially listed what allocations A, B, and C were... then I remembered it doesn't matter.

Fearful of Rising Rates? Stocks Have You Covered

Josh Brown (i.e. The Reformed Broker) has a nice piece questioning the merit of unconstrained bond funds. Embedded within that article was this gem:

In fact, since 1976, U.S. stocks and bonds have not declined at the same time for more than two consecutive months. Over the last 60 years, there’s only been one year in which both stocks and bonds posted an annual decline (1969).

You can actually make a bolder statement than that given that the Barclays US Aggregate Index' inception wasn't until 1976. The S&P 500 and "Agg" have never declined at the same time for more than two consecutive months. As surprising to me was that stocks and bonds on a stand-alone basis have only declined more than two straight months about 5% of the time (i.e. once every year and eights months).

So if rates rise from here (negatively impacting bonds), how will stocks perform? I'm glad you asked.

Jeremy Schwartz (@JeremyDSchwartz) outlined a few months back during a back and forth that stocks (especially small cap stocks) have historically performed very well during periods of rising rates... going back all the way to the 1950's.

Taking that one step further, the below breaks out performance by small, mid, large across value and growth during periods of rising rates since 1994 (I can only get daily Russell data going back 20 years). In this case, rising rates is defined as periods where the 10 year Treasury rose more than 100 bps without a 50 bp decline (there have been 9 such periods since 1994). Not only have stocks broadly performed exceptionally well in these periods (with small caps outperforming), growth stocks have performed even better (the less "bond-like" the stocks, the better the performance in rising rate environments).

For those fearful of a sell-off in rates... what to do? Well, if history holds, simply hold a balanced portfolio consisting of stocks and bonds. Want to be bolder? Tilt slightly towards small and/or growth. As for unconstrained bonds... let investment managers fleece you somewhere else.


Source: Russell, S&P, Barclays

The Benefit of Slowing Down the Rebalancing Process

One of the top Google “rebalance free lunch” results is an article quoting one of the brightest minds in finance, Clifford Asness, that I think most investors would agree with:

"Rebalancing is one of the few free lunches out there," said Clifford Asness, managing principal of New York hedge fund AQR Capital, in a recent interview with the Online Journal. "You're generally selling things that have gone up the most and buying things that have gone down the most."

While the article is from 2004 (and he may have changed his tune), I like that he felt rebalancing was a free lunch despite the strong research he has done over the years specific to momentum, something he acknowledges the rebalancing process eliminates in the same article:

 "Someone who doesn't rebalance is a tacit momentum investor." 

The key points in my mind as to why rebalancing may not be a free lunch:

1. Momentum works: much research exists outlining that momentum can improve risk-adjusted performance (here is a great white paper by Cliff Asness himself)
2. Relative outperformance doesn’t equal a relatively more expensive asset: quite simply, stocks SHOULD outperform over time as they can grow their earnings, while bonds pay a static coupon. So rebalancing doesn't always mean selling high and buying low.

It would be good enough if slowing down the rebalancing process did not materially hurt performance, as there are significant benefits associated with slowing down (lower transaction costs, tax benefits through delayed capital gains, and any behavioral benefit of looking at your account less often), but rebalancing less has actually improved average results specific to a 60% S&P 500 / 40% Barclays Aggregate Bond index since the latter’s 1976 inception with seemingly more potential outperformance than underperformance over any 36-month iteration.

Source: S&P, Barclays

Employment Survey's Diverge

The Washington Post details:

One is called the payroll survey. It asks mostly large companies and government agencies how many people they employed during the month. This survey produces the number of jobs gained or lost. In July, the payroll survey showed that companies added 172,000 jobs, and federal, state and local governments cut 9,000.

The other is the household survey. Government workers ask whether the adults in a household have a job. Those who don’t are asked whether they’re looking for one. If they are, they’re considered unemployed. If they aren’t, they’re not considered part of the work force and aren’t counted as unemployed. The household survey produces each month’s unemployment rate.

In July, the household survey showed that the number of people who said they are unemployed rose by 45,000. In a work force of155 million, that doesn’t make a big statistical difference. But it was enough to raise the unemployment rate to 8.3 percent from 8.2 percent in June.

Unlike the payroll survey, the household survey captures farm workers, the self-employed and people who work for new companies. It also does a better job of capturing hiring by small businesses.

But the household survey is more volatile from month to month. The Labor Department surveys just 60,000 households, a small fraction of the more than 100 million U.S. households.

Looking at the data, the household survey was even worse than that. Not only did the number of unemployed rise by 45,000, the number leaving the workforce spiked (resulting in the number employed dropping significantly), resulting in the unemployment rate rising despite the better headline number.

Source: BLS

GDP Expands 1.5% in Q2

Bloomberg details:

The U.S. economy expanded at a slower pace in the second quarter as a softening job market prompted Americans to curb spending.

Gross domestic product, the value of all goods and services produced, rose at a 1.5 percent annual rate after a revised 2 percent gain in the prior quarter, Commerce Department figures showed today in Washington. The median forecast of economists surveyed by Bloomberg News called for a 1.4 percent increase. Household purchases, which account for about 70 percent of the world’s largest economy, grew at the slowest pace in a year.

Consumers are cutting back just as Europe’s debt crisis and looming U.S. tax-policy changes dent confidence, hurting sales at companies from United Parcel Service Inc. (UPS) to Procter & Gamble Co. (PG) Cooling growth makes it harder to reduce unemployment, helping explain why Federal Reserve Chairman Ben S. Bernanke has said policy makers stand ready with more stimulus if needed.

Looking at the data, we see the declining contribution by consumption, offset in part by a quarter over quarter (small) rise in investment and a less negative impact from government cuts (i.e. addition by the elimination of subtraction). Overall, considering what was going on during Q2 this report isn't awful, but certainly isn't encouraging considering we are now three years out of the recession.

Source: BEA

Leading Economic Indicators Decline by Most Since Last September

Bloomberg details:

The index of U.S. leading economic indicators fell more than forecast in June, a sign the U.S. economic expansion is slowing.

The Conferences Board’s gauge of the outlook for the next three to six months decreased 0.3 percent after a revised 0.4 percent increase in May, the New York-based group said today. Economists projected the gauge would drop by 0.1 percent, according to the median estimate in a Bloomberg News survey.

Source: Conference Board

Consumer Credit Jumps... a Good Thing?

Bloomberg details:

Consumer credit climbed more than forecast in May, led by the biggest jump in credit-card debt in almost five years that may signal Americans are struggling to make ends meet.

The $17.1 billion increase, exceeding the highest estimate of economists surveyed by Bloomberg News and the largest this year, followed a $9.95 billion gain the previous month that was more than previously estimated, the Federal Reserve said today in Washington. Revolving credit, which includes credit card spending, rose by $8 billion, the most since November 2007.

In a "normal" mean-reverting downturn, an increase in consumer borrowing is a good sign as it allows a consumer to maintain their purchase level (even without the current income to pay for it), with the expectation that they can cover their borrowing when their wages "revert" higher in the future.

A quote from someone who believes we are still living in the old world (we may be, I'm just not so certain):

“When the economy’s not doing well, that’s when you want the consumer to spend, and if it means borrowing to do that, then that certainly would be encouraged,” said Millan Mulraine, a senior U.S. strategist at TD Securities in New York, who projected credit would rise by $15 billion.

The concern is that we are now in year 4 year of the muddle through recovery, thus some concern that people are spending money on goods via debt that they may have trouble repaying. Back to Bloomberg:

A pickup in borrowing coincides with a slowdown in hiring and declines in consumer confidence that indicate the job market is failing to spur enough gains in wages to cover expenses. Employers added fewer workers to payrolls than forecast in June while the jobless rate stayed at 8.2 percent.

Regardless, overall nominal debt (even excluding student loans) is once again rising. A bullish sign for the short run. Mixed (in my opinion) for the longer run.

Source: Federal Reserve

Gaming the System... Disability Edition

In my post outlining the decline in employment (excluding teens), reader Mike pointed out another interesting phenomenon:

One of the stories I read about this month's BLS report dealt with the rise in people on disability. I thought charting this over a few dozen years and several recessions might tell an interesting story.

Unfortunately, the BLS only reports this data going back to 2008, but the most recent data shows an interesting trend. From the looks of it, we have what appears to be a not-so-coincidental mirror image between the decline in those unemployed with the rise in the number of people not working via claims of disability. I know next to nothing about disability, but my guess is individuals whose employment benefits have run out, have been increasingly taken advantage of disability (or tried to) as a replacement.

Source: BLS

Employment (Excluding Teen Hires) Turns Negative

Peter Boockvar provides details of the ugly job report:

June Payrolls totaled 80,000, 20,000 less than expected and well below the ADP whisper. The two prior months were revised down by a net 1000. The private sector added 84,000 jobs (13,000 from goods producing, 71,000 from services) vs expectations of a gain of 106,000. The unemployment rate held steady at 8.2% as the 128,000 increase in the household survey was basically offset by the 156,000 increase in the size of the labor force.

Below is an updated chart of the stagnant unemployment rate and slightly up ticking broader unemployment measure.

Unfortunately, things were even worse than that. When looking at the household survey, we see that the headline measure of unemployment doesn't account for the fact that teen employment (likely low pay part-time workers on summer break) accounted for more than 100% of all new jobs. Excluding teens (the second bracket from the left in the chart below), we can see that negative employment number. In addition, individuals over 20 continue to flee the workforce (more than 150,000 more 20+ year olds were classified as "not in the labor force").

A truly ugly report on first glance.

Source: BLS

Breaking Down Volatility of the VIX

I had never heard of the VVIX index (the volatility of the stock market's volatility "volatility of VIX") until a week back when Bill Luby from the always insightful 'VIX and More Blog' posted about the recent gap seen between the historical volatility "HV" of the VIX (i.e. the trailing volatility of the VIX index) and the implied volatility "IV" (i.e. what was currently priced in as the forward expected volatility of the VIX index).

To Bill:

Much to my surprise the current 20-day HV is 144, while the current IV is only 98. In other words, the markets expect the VIX to be considerably less volatile in the month ahead than it has been over the course of the last month.

But as we'll see, based on the historical relationship between the VIX and VVIX, the pricing wasn't all that unexpected. Over the previous month, the VIX index had fluctuated between roughly 17 and 26, so (ignoring any opinion of the market for a moment) the reading of 98 was actually right in the heart of where one would expect it based on historical data since the VVIX index 2007 inception.

And this is where things get interesting.

The historical chart shown above makes the assumption that the volatility of the VIX index is lower when the VIX index is lower, which would have been my first guess had I not really thought about it. When I did think about it, that actually makes no sense whatsoever.

Why?

• Volatility is a measure of change in percent terms
• A change from a low starting value is a much higher percentage change than an equivalent unit change from a high starting value (i.e. a 2 point change from 10 is a 20% move... a 2 point change from 80 is a 2.5% move)

With that understanding, the chart below showing the realized one month change from various VIX starting points shouldn't be too surprising because a 15 point move higher in the VIX from a starting value of 15 is much more likely than a 40 point move higher in the VIX from a starting point of 40.

The interesting thing is that this conflicts with how the VVIX (vol of VIX) has been priced. At low levels of VIX, the VIX is MORE likely to have wide outcomes (in percentage movement) while at high levels the mean reverting characteristic of the VIX has made a move down from high levels much more likely.

A chart attempting to summarize the first two charts is shown below. It shows the realized one-month forward volatility of VIX resulting from various starting VIX and VVIX index values. Interestingly enough, it shows that realized volatility of VIX spikes when the VIX index is low, but only when the market isn't pricing it in.

Potential thoughts from the above to consider further...

• When the VIX and the implied volatility of the VIX are low, buy options on the VIX (i.e. calls / puts)
• When the VIX is high and implied vol on the VIX is high, sell calls on the VIX

Source: CBOE

Common Investor Errors...

Early last week, Barry Ritholtz outlined what he believed were the top ten most common investor errors:

Here is my short list:

1. High Fees Are A Drag on Returns
2. Mutual Fund Are Inferior to ETFs
3. Reaching for Yield is Extremely Dangerous
4. Asset Allocation Decisions matter more than stock selection
5. Passive is usually better than Active Management
6. You must understand “The Long Cycle”
7. Behavioral Issues Are Costly
8. Cognitive Errors as well
9. Understand your own risk tolerance
10. Pay Guys Like Me For the Right Reason

While I think this is an interesting / solid list, I don't necessarily agree with a number of them. In his post I responded with the following:

Can we disagree on some of these?

2. Mutual Fund Are Inferior to ETFs: Too broad a statement. Some mutual funds are great (inexpensive, track indices almost exactly, prevent owners from day trading [see your #7] behavorial issues being costly), while many ETFs are very poor (broad tracking error, expensive, leveraged inverse ETFs)

3. Reaching for Yield is Extremely Dangerous: Everything is based on appropriate compensation for the risk an investor takes… 5 years ago an investor sitting in cash received [a 4-5%] risk-free return. 0% [yielding] cash is now return-free risk. An investor “reaching for yield” now may actually now be a risk reduction exercise.

4. Asset Allocation Decisions matter more than stock selection: agree, but by definition asset allocation decisions are “active” decisions, hence….

5. Passive is usually better than Active Management: seems in conflict with #4

Diving right into my point #2 (because ETFs seem to be uniformly praised these days) is that mutual funds are not all inferior to ETFs (stating ETFs are superior is too broad of a statement). This is especially true for sectors / asset classes where the underlying securities are less liquid and the ETF itself trades with minimal volume (volume isn't nearly as important if the underlying securities are liquid... a point for another day). In these instances, it is more likely that the price of the ETF can move significantly from the ETF's net asset value "NAV" (the actual value of its holdings) and the bid/ask spreads widen, both of which can be negative to an investor.

One example can be seen year-to-date with Muni ETF MUB performance relative to that of a muni mutual fund. I am not vouching for the Fidelity fund below (it was the first to come up when I looked for a national muni fund with roughly 7 years of duration).

In addition to the underperformance of MUB, the volatility is 3x higher at 6.8% vs 2.2% due to the widely fluctuating ETF price vs the underlying NAV which hit a 4% premium in February (i.e. someone buying that day paid 4% more than the securities were worth).

Source: Yahoo Finance

(Almost) All Assets up in the First Half

Despite a volatile second quarter, risk assets (actually all assets with the exception of commodities) performed quite well in the first half. Leading the pack were REITs (up both quarters) on demand for income, a potential inflation hedge, and CHEAP real estate financing.

Source: Yahoo

More on Corporate Profits

Back in September of last year, I showed this chart outlining that corporate profits as a percent of GDP were approaching a three-standard deviation event. Since that time, the relationships has gotten even more extended hitting an all-time high.

Which brings me to this morning's tweet from PIMCO's Bill Gross:

Simple formula: US profit growth rate = (real GDP x 5) – 10. No “ka-ching” at 2% or less GDP growth.

I appreciate the insight that profits can be thought of as being leveraged to economic growth (hence the wide fluctuations), but struggling to see why nominal profit growth would have a relationship with a real (after inflation) economic growth or why those specific numbers (why 2% real and not 2.5% real?) were used.

Anyhow... I was interested enough to see what this equation looked like using actual data, so I put together the below chart going back 60 years against corporate profits, as well as against my old simple standby of using nominal economic growth (my preferred long-term measure for corporate profits as simple math tells you that corporate profits can't grow faster than the economy over the long term or else they'd be bigger than the economy itself - hence profit growth tends to mean revert relative to nominal growth).

The chart...

What do we see?

Well corporate profits are basically right on trend (a surprise to me), but nominal growth is well below trend and the PIMCO formula (the formula based on 2% real growth) is WAY below trend, indicating corporate profits are significantly above trend (by that record 30% level relative to nominal growth and an off the charts 200% relative to the PIMCO formula).

Seems like the old nominal GDP standby has historically been more reliable, but I will be thinking more about the insight that corporate profits are leveraged to (and in need of) specific levels of economic growth. If anything, this may indicate earnings are potentially more stretched than I previously thought.

For those interested, there was a great piece by GMO on the topic of extended profits a few months back.

Source: BEA

Leading Indicators Up in May

Marketwatch reports:

The risk of a downturn in the second half of this year is relatively low, the Conference Board said Thursday as it reported that its index of leading economic indicators rose 0.3% in May. "Economic data in general reflect a U.S. economy that is growing modestly, neither losing nor gaining momentum," said Ken Goldstein, economist at the Conference Board.

Update: while leading economic indicators held up in May, first signs of June are UGLY.

Source: Conference Board

Fed's Ugly Forecasts

Over the past two months, the Fed's FOMC has:

• Reduced forecasts for growth in 2012, 2013, and 2014
• Increased expectations of unemployment in 2012, 2013, and 2014
• Reduced inflation expectations (from a level already below the 2% target) in 2012, 2013, and 2014

Source: Calculated Risk

Financial vs. Capital Expenditures and Equities

Yesterday, I made a bullish case for equities over the long run (especially when compared to bonds), today I will outline one of the reasons I am a bit concerned over the intermediate time frame.

Meb Faber (via a paper by Mauboussin from Legg Mason) shows a table that outlines:

How companies have spent their cash over the past 25 years. Interesting to note is that they spend on average, about 60% of their total spend on capital expenditures, 20% on M&A, and about 10% each on dividends and executed buybacks. The total amount of spend bounces around a bit but is a fairly consistent 20% of market capitalization. Note that buybacks exceeded dividends in 7 out of the past 10 years

Along with the market cap of these corporations, the table shows (as part of a broader paper outlining the benefits and analysis of each) the amount corporations spent on:

• Dividends
• Share buybacks
• M&A
• Capital expenditures

I'll simplify things and group the first three as "financial expenditures" (or at least spending that isn't used for organic growth) and compare this figure with capital expenditures.

The first chart I'll show compares historical capital expenditures and financial expenditures, normalized as a percent of GDP. While Meb outlines the averages for each category above, what we see is financial expenditures have been trending higher while capital expenditures (as a percent of GDP) have been trending lower. This despite slower underlying economic growth (i.e. slowing growth of the denominator in the capital expenditure to GDP ratio), in part caused by a slowdown in (you guessed it)... capital expenditures. Some thoughts on why financial expenditures have increased in relative importance include the boom in private equity and financial engineering, the shorter-term focus of investors, and a lack of perceived opportunities to deploy cash on projects. Also note how volatile financial expenditures (mainly buybacks and M&A) have been.

The next chart shows the ratio between the two expenditures (financial expenditures divided by capital expenditures). In the late 1980's / early 1990's the ratio was consistently at or below 0.4 (meaning for every $1 spent on dividends, buybacks, and M&A they spent $2.5 on internal growth opportunities), whereas since the late 1990's the ratio has gone above 1 almost 50% of the time (i.e. corporations are now more interested in financial management then building their business through organic growth).

So what does this mean for an investor? Well, returned cash sounds good, but taking the above ratio and comparing it to the three year forward change in market cap (i.e. the value of corporations three years forward) we see a relatively strong (negative) relationship. Unfortunately (and not too surprising when you think about it), when corporations don't put money back into their businesses, the value of these corporations is negatively impacted (they are essentially liquidating vs reinvesting).

I'll leave with one additional point... this all likely reduces the impact of monetary policy (if a corporation is returning cash even at these low rates, why would they borrow more?).

Source: BEA / Meb Faber

Valuation Matters.... Equity vs Bonds Edition

I've shown that valuation matters numerous times over the years when it comes to long-term equity returns (see here, here, and here for some of my favorite examples). The below post uses the same concept in that it compares valuation (i.e. yields) with forward returns, but in this version we compare the relative performance of equities vs. bonds.

The first chart shows the factor that serves as our starting point for valuation... earnings yield of the S&P composite (i.e. the inverse of the P/E ratio) and the yield of the ten year Treasury bond going back 100 years. What we see is a relationship between the two starting about 50 years ago that was non-existent the previous 50 (and the recent divergence that is the widest in almost 40 years).

But the lack of a relationship from 1912-1962 doesn't mean it the relationship wasn't always important. The next chart outlines the forward ten year return differential (annualized) for each starting point against the starting excess yield (the equity earnings yield less the bond yield). Interesting to note that we can easily see the unwarranted excess return that equities saw over bonds starting in the 1980's (i.e. the equity bubble), that was given back over the past ten or so years.

To summarize the above, the next chart outlines the forward ten year return differential (annualized) for each starting point by "bucket" (note that at current valuations we just made it into the 5-7.5% bucket, hence the yellow highlight). The takeaway is that starting yield differentials matter... a lot. To be more specific, the current 5-7.5% bucket means that for every period over the past 100 years when the yield differential was between 5-7.5%, the average annualized ten year forward return differential was a bit more than 8% (8% over the current 1.5% ten year would be 9.5% absolute returns for equities).

While I refuse to state that returns will be anywhere near this 9.5%, by almost all measures stocks appear cheap on a relative basis to Treasury bonds. Unless earnings collapse back to a "normal" percent of the overall economic pie abruptly (definitely possible, but in my view not likely) or the economic pie contracts abruptly, stocks are going to outperform bonds over the next ten years.

Source: Irrational Exuberance

Retail Sales Sluggish

BusinessWeek details:

U.S. retail sales declined in April and May, pulled down by a sharp drop in gas prices. But even after excluding volatile gas sales, consumers barely increased their spending.

The Commerce Department said Wednesday that retail sales dipped 0.2 percent in May. That followed a revised 0.2 percent decline April. The back-to-back declines were the first in two years.

The weakness reflected a 2.2 percent plunge in gasoline station sales. Still, excluding gas station sales, retail spending rose just 0.1 percent in May. And it dropped 0.1 percent in April. That left retail spending roughly flat outside of gas sales for the two months, a sign that slower job growth and paltry wage increases may be leading consumers to pull back on spending.

The one thing not mentioned above that I find interesting is that furniture and motor vehicles (i.e. large purchase retail items) are #1 and #2 respectively in terms of strength. Perhaps (though not certain) people are just putting other items on hold as they make these purchases.

Source: Census

The End of the Middle Class

The NY Times details:

The recent economic crisis left the median American family in 2010 with no more wealth than in the early 1990s, erasing almost two decades of accumulated prosperity, the Federal Reserve said Monday.

A hypothetical family richer than half the nation’s families and poorer than the other half had a net worth of $77,300 in 2010, compared with $126,400 in 2007, the Fed said. The crash of housing prices directly accounted for three-quarters of the loss.

Families’ income also continued to decline, a trend that predated the crisis but accelerated over the same period. Median family income fell to $45,800 in 2010 from $49,600 in 2007. All figures were adjusted for inflation.

The chart below outlines median family net worth among different percentiles. While all wealth brackets have witnessed a hit since 2007, the wealthier you are... the less you've likely been impacted in percent terms (they were less levered / more diversified in their investments and are less reliant on income from a job for their wealth). Since 2001, it is even more divergent as the only bracket to have seen an increase in wealth are those in the top 10% decile of all wealth.

Source: Federal Reserve

Drop the Inflation Concerns

As I've outlined before, wages tend to be the one of the better predictors of inflation (or deflation) out there as wages tend to be very sticky and stable (so when they move, it tends to mean there is a new underlying trend).

So how are wages currently holding up?

Well, earlier this week, the BLS released compensation figures for Q1 and even with negative real interest rates and multiple quantitative easings, there is absolutely no wage inflation in the pipeline. In fact, the year-over-year change in nominal wages came in at just 1.3% at the end of March and 0% over the last six months, the lowest since the crisis and below the rate of inflation.

Even more concerning (to me) is that these figures are as of March, before business sentiment took a turn for the worse on renewed European concerns.

With no inflationary pressure and limited growth potential, a low yielding Treasury bond almost appears justified.

Source: BLS, BEA, Fed

Dividend vs. Treasury Yields

The dividend yield of the S&P 500 is above that of the ten year Treasury for the first time since the financial crisis. Before that we have to go all the way back to the 1950's to find a time when this was the case.

The kicker... stock dividends have only made up about 45% of total S&P composite stock returns over the past 100 years, while Treasury bond coupon payments have made up north of 96% of Treasury bonds returns over that same period (see below). What this means for an investor is unless you think dividends will be cut and/or capital appreciation will be negative (i.e. corporate America will shrink in terms of nominal value), stocks are poised to outperform.

My take... stocks appear to be very cheap relative to bonds for investors with a long-term investment horizon, while near term investors need to be careful as we seem to be in a world that is likely to have binary outcomes (i.e. either a boom or an absolute collapse).

The remaining 55% of S&P stock returns have been in the form of capital appreciation, which has become increasingly important since the 1950's (see above), as corporations reinvested earnings back into their businesses / bought back shares (vs paying out dividends), while investors evaluated the relative merits of equities relative to bonds (see the much tighter relationship to bonds, which ratcheted up P/E multiples).

Source: Irrational Exuberance

Europe's Core / Periphery Imbalances Going Parabolic

George Soros' recent speech on what created the Euro bubble (and how it will need to play out) is making the rounds (although he deleted the speech from his personal site for some reason, a pdf version is here). While I strongly suggest reading the whole thing, a key takeaway is that:

The authorities didn’t understand the nature of the euro crisis; they thought it is a fiscal problem while it is more of a banking problem and a problem of competitiveness.

The result is that the issues have not been addressed and problems have only gotten worse.

The real economy of the eurozone is declining while Germany is still booming. This means that the divergence is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. So something has to give.

Which can be easily seen in a variety of metrics, including unemployment which is shown in the below chart and is simply unbelievable. It shows the current unemployment rate of Spain (currently an unreal 24.3%) divided by Germany's (less than half 2005's level at 5.4%) going back to 2000. It was only 5 years ago that Spanish unemployment was actually lower than Germany's (though that employment coincided with a massive housing bubble in Spain funded by cheap German financing from excess German savings).

Source: Eurostat