Beyond the Fog of Daily Capital Markets

As an active manager one of the toughest psychological tasks is to invest for the long-term but have to deal with the daily noise and chatter of the markets. The unrealistic expectation of having superior performance over all measurable holding periods leads to behavior often inconsistent with the goal of prudent long-term capital accumulation.

Given the volatility of capital markets a lot can happen over the short-term that over time gets washed away and becomes a mere blip on the radar. Conversely, other things that in the hustle and bustle of the markets seem minor turn out to be much more impactful over the long-term. Empirical research shows that returns typically are more volatile in the short-term than warranted by changing fundamentals. The net result is a lot of noise that dissipates once investors take a longer term view.

Taking a Step Back. In recent years we have started thinking that stepping back a bit and watching the whole landscape unfold perhaps gives us a better sense of what really matters.

As archaic as this may sound to a high frequency trader in our research we have started focusing more on looking at company and capital market fundamentals over longer time periods. Looking for example at year by year annual company financials gives us a better sense where business fundamentals are going. Same with broad capital market relationships at the asset class level. Aggregating annual periods to look at secular trends gives us another way to process information in a manner that may seem old-fashioned but that hopefully removes some of the noise.

Shifting our Focus toward Long-Term Performance. We recently put together heat maps of annual performance for a variety of capital market breakdowns. We looked across the major asset classes as well as within each asset class. The results were revealing in each case. We found a lot of surprises especially when looking at cumulative returns over the last ten years!

In this note I will share the heat map for the ten major asset classes used in our asset allocation strategies. The returns for 2016 are as of January 22. All returns are in US dollars and correspond to commonly used indices.

What We Expected:

Lots of variability from year to year – this we expected. After all this is the point of creating a heat map.
We did not see a lot of relative mean reversion over one or two calendar years. Again this was expected given the strong empirical evidence that momentum persists for up to three years. We did not see a lot of “going from worst to best” or vice versa.
Not all higher risk categories outperformed lower risk assets – this we expected given the hits suffered by equity-oriented assets during the Financial Crisis. For example, US bonds have out-performed international equity investments over the last ten years. Needless to say this was achieved with much lower volatility.
US stocks had below average ten-year returns. The annualized return on US Large Caps (S&P 500) was 7.7%, more than 2% below historical averages. US Bonds (Barclay Aggregate) also had below average returns compared to history.

What Surprised Us?

A big surprise was the extremely poor performance of commodities (COM) – down 48% over the last ten years. For most investors the promise of uncorrelated returns to the stock market has come at a very high price. Bye-bye commodity super-cycle!
I was also surprised by the 2X out-performance of US stocks compared to international equity indices. Some was due to currency but not all. There were major geographic performance differences over the last ten years.
US REITS (RE) edged out US large cap stocks by a slight margin over the last ten years. We expected a larger margin of out-performance but we had forgotten that in 2007 REITS were a precursor to what would happen during the Financial Crisis.
Emerging Market Debt proved to be a revealing surprise with a 97% total return. Pretty close to US equity market returns and vastly superior to international equities. Much lower volatility too.
The 91.7% return to the 60% S&P 500/40% Barclay Aggregate portfolio. The balanced portfolio lagged the S&P 500 by only 0.59% on an annualized basis but with much lower short-term volatility. Not bad for such a simple portfolio.

Insights to Share:

The short-term noise in the capital markets can obfuscate long-term secular changes as well as disproportionally focus the mind on events that over the long-term have little to no significance.
Expect lots of variability from year to year in terms of performance but over longer-term periods asset values will converge toward the fundamental drivers of return – income generation, growth and valuation.
To reinforce the previous point, a lot of capital market volatility is just noise and should be ignored unless there is a change to fundamentals.
Simple strategies such as the annually rebalanced 60/40 portfolio can prove sometimes incredibly effective at managing through the daily fog of markets
Effectively distinguishing noise from fundamental signal is the key goal of capital market research. Capital markets are always evolving but the fundamental drivers of return and associated risk should be the backbone guiding your perspectives.

Sincerely,

Eric J. Weigel

Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

A Marriage of Necessity but with Benefits

One of the key underpinnings of modern-day investing is the concept of diversification. Adding assets to a portfolio will almost universally lower the overall volatility of a portfolio assuming that the correlation between the investment in question and the portfolio is lower than one. As the correlation falls the greater the drop in the volatility of the portfolio, i.e. the greater the diversification benefit.

Investors often fret about the lack of diversification opportunities in capital markets. The sentiment is especially pronounced during equity market selloffs such as what we have experienced this year.

Investors have been often discouraged by the high correlations observed among investments in the same asset class. For example, the early day (70’s and 80’s) arguments for increasing exposure to international equities hinged on the portfolio diversification benefits accruing from the low correlation between US and international stocks.

Sometimes expectations need to be re-adjusted. Unfortunately, as US investors increased their exposure to international investments and both US and foreign domiciled companies became more globally integrated the net result was a significant upward drift in correlations and a loss of diversification benefit.

The same story can be told about emerging market and even domestic small-cap investing. Investors looking for significant divergent behavior among equity sub-asset classes have been generally disappointed. Our latest estimates of the correlations of the S&P 500 to US Small Caps, International Stocks and Emerging Market Equity are all north of 0.7.

The long-term performance of these equity sub-asset classes will naturally gravitate towards their fundamental value, but over shorter holding periods the pull of the broad equity market factor will be unmistakable. Style, market cap and sector membership are secondary to what happens to the broad equity market. The market effect dominates.

The same applies within other asset classes. For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds. Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods

So where does that leave investors looking for a little zig when their portfolio zags? The answer is so simply and obvious but the message is often ignored. Bonds, bonds and more bonds. In recent times investors have shown a strong dislike for fixed income especially in light of the low prevailing interest rates.The same applies within other asset classes. For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds. Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods

From a prospective return perspective we agree, but, in our opinion, investors are forgetting about the diversification benefits of bonds. Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets.

Our current estimates of the correlation of US stocks to high quality domestic and developed international debt markets are south of -0.3. Ok, correlations have been lower in the past, but they have also been higher. In fact the average correlation of US stocks and bonds over annual holding periods is indistinguishable from zero.

Is it a free lunch? No, not given the low interest rates on bonds today, but compared to the costs of using other forms of portfolio protection plain old bonds seem to offer the lowest opportunity cost with the lowest execution risk. The way we look at it is that the below normal yields are the premium you must pay to protect your portfolio.

Let’s look at a simple case using a portfolio composed 60% of the S&P 500 and 40% of the Barclays Aggregate. We are assuming that stocks have a volatility of 16% and bonds of 6% (these are currently our long-term normalized estimates).

The benefits depend on the volatility of stocks and bonds as well as their degree of co-movement. Historically, the correlation between stocks and bonds in the US has been about zero. Under such a scenario, the 60/40 portfolio would have a volatility of 9.9%.

There have been long periods of time, however, when the correlation has actually been positive. Stocks and bonds moving in the same direction either up or down. Let’s assume a modest correlation of 0.2. Under such a scenario the diversification benefits still accrue but at a lower rate. The 60/40 mix now exhibits a volatility of 10.4%.

What happens when the correlation between US stocks and bonds is actually negative? The simple answer is that the diversification benefits are significantly enhanced. Let’s assume a correlation of -0.2. This estimate is in line with our current estimate from our proprietary multi-asset class model. Now the 60/40 portfolio has a volatility of 9.4%, a full point lower than the earlier case.

Why stop there? Let’s push the envelope and assume a stock/bond correlation of -0.6. Quite dramatic for sure but not out-of-bounds from previous capital market experience. Now the benefits are further enhanced with the portfolio exhibiting a volatility of 8.4%

The role of bonds should be seen from the perspective of the total package of benefits. Historically, the role of fixed income has been income generation, but in today’s environment investors should focus as well on the diversification benefits created by mixing bonds with equity-like assets.

Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets. Incorporating bonds into the mix will be especially important in risk on/off markets such as those we expect to prevail over the next few years.

Let us hope that the marriage between stocks and bonds which at times has been a bit awkward remains beneficial as we transition into a low capital market return environment.

Sincerely,

Eric J. Weigel

eweigel@gf-cap.com

Managing Partner and Founder of Global Focus Capital LLC

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Is It Time to Get the Bear Market Cufflinks Out?

It’s been a while. In fact, I think I bought my cufflinks when there was no such thing as business casual. In other words, a long time ago!

I was in business school during the 1987 crash (so that does not count), went through the 2000-2002 bear market as a growth manager and hopelessly repeated the experience in 2008. I do not recall those markets with any fondness. Learning opportunities yes, but painful nonetheless. I still would have preferred watching a three day long cricket match!

It sure feels like we are entering one of these ugly markets again. I did not think that we were going to have such a nerve wracking start to the New Year, but Bear Markets are unpredictable.

While the warning signs were there for subdued equity market returns – high valuations, little to no EPS growth, collapsing commodity prices – our research still favored risky assets over safer investments such as Treasuries. Especially in a low inflation, accommodative monetary policy environment.

We have been in the “low return environment” camp for a while now, but have favored over-weighting equities and REITS over long-term horizons. But as Keynes once said “in the long-run we are all dead” so that leaves us to live our investment lives in the present. And that is precisely the problem.

With all this noise around us the fundamentals start looking fuzzy. We know it’s been bad but just how bad?

We use our Technical Classification system to learn about the positioning of the overall equity market.

Our system employs 50 and 200 day moving averages in relation to the current price and classifies each stock into one of six technical stages.

Currently, 60% of stocks in our global universe are in the Down Trend Stage – these are Bear Market numbers!

Bear Markets are typically categorized by a large proportion of stocks in the Down Trend Stage – typically 60% or more.

In the early stages of a Bear Market the next highest proportions tend to occur in the Deteriorating and Break Down Stages – these are stocks that most often were the last Up Trend stocks of the now gone previous Bull Market.

The situation as of mid-January resembles that of an early stage Bear Market.

60% of our global sample is in the Down Trend Stage.
18% are in the Break Down and 9% in the Deteriorating Stages.
Only 8% of our global sample is in the Up Trend Stage – as of a year ago that number stood at close to 60%.

Is the whole global equity market in the Down Trend Stage? Let’s look at some equity markets around the world.

In the US things have been nasty (only 6% in Up Trend) but things have actually been worse north of the border in Canada where 81% of stocks are in the Down Trend Stage.

In China 62% of companies reside in the Down Trend Stage.

Among the largest markets only Germany and Japan enjoy less than 50% of stocks in the Down Trend Stage. All of these numbers are significantly higher than 30 days ago!

The highest pain market is Brazil. Somehow, I doubt that the “Olympic Games” effect will be sufficient to offset the downturn in equity values.

Is this the beginning of a Bear Market or just a Correction?

Equity Market turning points are, in our opinion, impossible to predict with any reasonable amount of confidence. Our approach examines the weight of the evidence and as of now we still believe that we are in a correction rather than in the early stages of a Bear Market.

Our perspective is that equity markets are in for a long-period of below average returns, but not a Financial Crisis type of meltdown. In a slow growth, low cost of money environment our research still favors risky assets such as equities. We would view the current period of market stress as an opportunity to deploy capital at more favorable return-to-risk terms.

Eric J. Weigel

Managing Partner

eweigel@gf-cap.com

It’s Already Been a Stomach Churning Ride!

Hope you’re buckled up

Who would have expected this start to the New Year? After a fairly humbling 2015 most investors were looking for a bit of a break heading into this year.

Yes, equity markets, especially the US looked expensive when judged relative to history using traditional metrics such as P/E and P/B.

But in the context of low interest rates and relative to other major asset classes our research was more consistent with a “dull” equity market offering below average returns, not a meltdown off the bat.

Of course we have also been saying for a while now that capitalmarket volatility is too low and that a whole generation of investors has become hyper sensitized to the smallest blip in uncertainty.

The memory of 2008 unfortunately still permeates our thinking. Investors as a whole have forgotten that while equities tend to out-perform safer assets occasionally you have to go along the ride and find yourself holding on for dear life on a roller coaster.

While everybody has already heard all the usual explanations for the correction, in all honesty, we have been taken aback by the suddenness and magnitude of the equity market downdraft. Let’s briefly review.

High Quality Fixed Income Has Been the Only Place to Hide

Fixed income strategies have been the only true hedge for equity market risk
Superior fixed income performance has been associated with higher credit quality and extended maturity
US small caps have dropped the most, down over 8% (as of 1/11)
Precious metals have behaved like in the old days, i.e., as a safe haven asset during periods of market stress

All Equity Regions, Industries and Styles Have Suffered

All major global regions have suffered with Latin American equities down the most
China is YTD the worst performing equity market
Energy and Materials have once again been the worst hit sectors
Some “smart” beta tilts such as Low Volatility and Dividend Growth have delivered smaller losses than core indices

Mixing and Matching Asset Classes Has Not Immunized Investors From Pain

Of the six multi-asset class strategies that we track, only our All Fixed Income strategy is in positive territory for the year
The more equities in the mix the more pain investors have felt
Even the plain vanilla 60/40 strategy was down more than 3% last week

Equity Downdrafts Create Some of the Best Stock Picking Opportunities

Early in my career I used to hear how corrections were healthy for investors. However I never felt that corrections did anything but make my stomach churn. Corrections have always made me nervous, but with the benefit of experience I have come to see corrections as often ideal starting points for picking up beleaguered stocks assuming an unchanged fundamental picture.

Our view at Global Focus Capital is that equity market fundamentals have not materially deteriorated thus creating additional opportunities for stock selection. The list above highlights some stocks ranked by market cap deemed as attractive by our stock selection methodologies. All these stocks have had losses exceeding 10% YTD.

We offer this list purely as an illustration of possible attractive stock selection opportunities and make no representation as to the suitability of the stocks in an investor’s portfolio. We view such a screening exercise the same way a fisherman uses a fish finder – it alerts you to opportunities but you must still exercise judgment and possess skill to make the catch!

Sincerely,

Eric J. Weigel

Managing Director and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

(617) 529-2913

The Equity Observer – Issue 1

This month, you can download the first issue of my monthly equity-oriented publication, The Equity Observer, for free.

In this issue, we thoroughly examine the global equity markets by breaking down performance along region/country, sector/industry and style factors. Our goal is to identify pockets in the markets with attractive reward to risk opportunity both from top-down as well as bottom-up perspectives.

Taking a holistic view of the global capital markets, The Equity Observer answers the critical questions that impact forward looking portfolio returns.

What is the current state of investor risk aversion? What regions or industrial sectors show the greatest potential for attractive returns? What does this mean for long-term and short-term oriented investment strategies? What equity styles are being currently rewarded and are there any nascent emerging trends?

Monthly Archives: January 2016

What We Expected:

What Surprised Us?

Insights to Share:

Is It Time to Get the Bear Market Cufflinks Out?

High Quality Fixed Income Has Been the Only Place to Hide

All Equity Regions, Industries and Styles Have Suffered

Mixing and Matching Asset Classes Has Not Immunized Investors From Pain

Equity Downdrafts Create Some of the Best Stock Picking Opportunities