Leaving Money on the Table? Time to Look at Taxes

Thinking about taxes implications for your investments often plays second fiddle in fast moving capital markets and for a large number of investors – pension funds and endowments/foundations the issue is moot given their tax exempt status.

But for many investor be they already wealthy or diligently saving for retirement on their own the issue of taxes is incredibly important. Proper tax management can dramatically alter financial outcomes especially over long periods of time.

Tax management can be complicated and should encompass the full financial and human capital picture and goals of the household or multi-generational family entity. Investments are one aspect of this view but properly evaluating the tax implications of different investment strategies is an important component to the long-term success of an entity’s financial plan.

Taxable investors are not generally able to capture the full potential return of an investment for a number of reasons

The most obvious and frequently discussed reason are fees and expenses
The second and often more significant drag on realized long-term strategy returns is due to taxes

While tax structure and rules vary across geographic domiciles (across countries but also by states ) there are generically speaking two types of taxes that subtract from investor returns – taxes on periodic income received (dividends and coupons) and taxes paid upon the sale of a security.

Measuring the tax bite of an investment strategy depends on individual circumstances but it is still useful to look for generalities to assess the likely impact of different strategies on after-tax portfolio returns

We resort to evaluating four different hypothetical strategies using the theory of tax management as outlined in Chincarini and Kim (Journal of Portfolio Management, Fall 2001).

The wealth path of the four strategies that we evaluate for tax implications are shown to the left.

All strategies assume an annual gross return of 8% and a management fee of 1% per year. The strategies vary by the type of trading incurred.

Main Conclusions:

The advantage of the more tax efficient strategies for creating wealth for investors are clear especially as one extends the holding period. Tax efficient strategies compound at a higher rate because of a smaller proportion of gains paid out as short-term taxes and the deferral of trading events leading to fewer taxable consequences.
Effective tax management requires an integrated approach to portfolio construction and trading that recognizes the potential returns, risks and tax implications of a strategy. Simply reducing turnover or matching winning with losing positions once a year yields some gains but leaves a significant portion of the potential tax alpha on the table.

Tax aware optimization techniques while complicated on the surface are commercially available but require customization to account for individual circumstances. In many instances such programs create voluntary losses to offset current investment gains and the more sophisticated applications encompass security positions across different asset classes. It is also very important to properly account for the intended final disposition of investment assets.

Finally, we would remiss to not point out that tax policy is not only highly specific to geographic areas (say countries and states) but also subject to significant rule changes over time.

If you would like to read our full report please fill out the information below and hit the Send button

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

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

Even A Wide Moat Won’t Save This Brexit

In the weeks leading up to the Brexit referendum vote our assumption was that while the vote would be close the “remain” side would eventually prevail. Our feeling was, I must admit, more based on our observation that under most circumstances electorates prefer to stay with the status quo.

My relatives in the UK had warned me against making such an assumption, but from a pure economic perspective the evidence seemed stacked in favor of remaining within the EU.

Now that we know the outcome of the vote and Brexit has become a reality it downs on me how out of touch we can sometimes be when dealing with unhappy electorates. The evidence is scant for any positive economic benefit for separation from the EU, but the hope for change is sometimes so strong so as to overwhelm rational thought. In my opinion, while the world may have recovered economically from the depths of the 2008 Financial Crisis the seeds of discontent are still alive within large segments of the population.

The rise of nationalism in many countries is tied to the search for simple solutions for promoting adequate growth in the face of weak labor markets and rising income inequality. These simple solutions are often expressed in the form of isolationist strategies with the underlying assumption being that inadequacies in economic growth are caused by outside forces.

But just as building a moat around one’s castle is a totally inadequate way in today’s world to keep outside influences at bay so are policies pretending that world economic forces can be neutralized at one’s door step.

Markets for goods and services today are truly global in nature and while pockets of every economy will remain domestically driven the vast majority of global economic activity takes place in the context of highly competitive supply and demand conditions involving companies frequently conducting business from multiple geographies. Borders don’t matter as much as the ability to offer a value proposition to both producers and consumers.

The 52% of voters in the UK that voted for pulling out of the EU are betting that the UK economy will be better off long-term not being part of the larger economic union. Stifling regulations imposed by the EU are one shackle that UK domiciled companies will no longer have to bear. Another, it is argued, will be removing the burden of subsidizing weaker members of the union.

But while the long-term ramifications of Brexit will not be known in totality for at least a decade or two the shorter-term issues are likely to wreak havoc with investor sentiment. “Risk-off” is likely is to stay with us for a bit longer than expected!

Another Brexit casualty will be sterling denominated assets. Not only will the British Pound depreciate significantly but the demand for UK domiciled stocks and bonds will decrease as well. Sellers will remain highly incentivized so prices will need to drop for buyers and sellers to meet. None of this is rocket science and markets on t+1 are already reflecting these negatives.

While the short-term implications for UK equity owners are negative we do not believe that Brexit will lead to the end of the world. After all our belief is that company fundamentals drive long-term investor rewards and spikes in investor sentiment both positive and negative appear as mere blips in long-term performance charts.

Especially for companies not directly tied to the regulatory consequences of Brexit the news may be good in the short-term as investors express an increased preference for lower uncertainty situations. Even for many UK companies the news does not constitute a death sentence as many already conduct operations in geographically diversified locales. For some export-driven companies the depreciation of the pound will provide short-term competitive advantages.

UK-domiciled assets will not doubt remain under pressure for the foreseeable future. Withdrawing from the EU bloc is fraught with technicalities and will require the negotiation of dozens of trade agreements. Article 50 of the Lisbon Treaty will have to be invoked which will then allow for a two year period of negotiation between the EU and the UK government. Pro-Brexit politicians have openly discussed delaying invoking Article 50 leading to most likely a period of 4 to 5 years of uncertainty. While the Brexit side rejoices today the withdrawal from the EU will not be immediate.

Most times when a political event such as Brexit occurs the size of the overall economic pie does not change materially at least over short and intermediate terms. What tends to happen instead is that the pie gets splits up differently creating losers and winners.

Capital markets are reacting post-referendum as if the size of the pie has permanently shrunk and everybody will go hungry. The reaction of global capital markets would suggest dire consequences for global growth. Risky assets are getting uniformly destroyed and investors are flocking to safe heavens such as the US dollar, long-term US government bonds and precious metals.

Our view is that while global economic growth will experience a hiccup the longer-term effect for global growth will not be significant. For long-term investors with multi-asset class portfolios we do not expect a lasting effect from Brexit but understanding the likely short-term winners and losers could actually yield some very rewarding tactical trades.

In many ways this crisis while most likely painful for the UK economy resembles other periods in history when political events led to a spike in capital market volatility and a rise in investor risk aversion. Such periods were uncomfortable for investors but also yielded tremendous opportunities to add value.

What can we reasonable expect over the next few weeks?

Investor risk aversion will remain elevated as investors seek to understand the long-term implications of Brexit
The US dollar, Swiss Franc and the Yen will strengthen at the expense of the Euro and the British Pound
Commodities apart from precious metals will face downward pressures as the US dollar appreciates. We, however, believe that oil will find its footing reasonable soon as supply/demand conditions seem to be close to equilibrium
Investors will increase the demand for high quality bonds leading to further interest rate decreases. Long duration bonds will benefit the most. Interest rate sensitive assets such as real estate will likewise benefit.
The US Federal Reserve will not raise rates in July and we would be surprised if they institute any hikes this year. The ECB and the Bank of England will cut rates and increase monetary stimulus. Global liquidity will remain plentiful.
Investors with short time horizons will flee risky assets en masse. We should expect outflows from equities to accelerate in the short-term. European and UK portfolios will see the sharpest outflows
Extreme contrarians will advocate buying into UK equities but there will be few takers. We would advocate passing on this trade for now
Contrarians will also advocate buying stocks domiciled in the US. Such a trade won’t require, in our opinion, as long as of a time horizon as buying UK stocks and it will thus entail less risk. Our two top equity tilts remain low valuation and above-average company profitability

In general, we would advocate making only small adjustments to multi-asset class portfolios. The adjustments would be more driven by risk management considerations as we expect asset class volatility to remain elevated for the remainder of 2016. Our risk aversion index (RAI) has also recently moved into the “extreme fear” zone thus calling for a more defensive risk posture.

From a tactical perspective we see opportunities emerging more from bottom-up stock selection activities rather than from sector or country allocation decisions. When whole markets sells off as we saw on the day after Brexit the good gets thrown out with the bad.

In a crisis company fundamentals are often ignored as investors are forced to sell their most liquid holdings first. Market turmoil tends to create attractive entry points for investments with robust long-term fundamentals. We expect global equity markets to remain under pressure next week and we would thus advocate waiting a bit longer to put any excess cash to work.

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Migration Patterns in Company Profitability

ROE’s Tend to be Pretty Stable

Firm profitability is a characteristic highly sought out by investors in private market transactions. In public markets firm profitability tends to be frequently lumped together among “quality” factors.

Over the years I have always thought that “quality” is very much in the eye of the beholder while profitability as a concept can be measured in an unambiguous manner and stand on its own feet.

That is why in our stock selection and top-down sector and country allocation models we treat profitability as a separate conceptual category.

After all what more powerful combination can one have for long-term value creation than a company that is growing and doing so in a profitable way. Some of the best known stocks in the world such as Apple and Google are living proof that a combination of growth and profitability is highly rewarding for long-term investors.

While market-wide ROE’s tend to be pretty stable across time we would expect some variability caused by the business cycle, the degree of leverage in the system, changes in the cost of money and tax rates among others. The above chart shows the year-to-year median ROE along with points along the 3^rd and 1^st quartiles. The average calendar year ROE in our global sample is 11.2 with a standard deviation of 2.1.

The conventional wisdom holds that in a competitive economy it is virtually impossible to remain a highly profitable company over the long-term.

In the case of a frictionless free market system, companies should all gravitate long-term to an economy-wide level of profitability. The idea is that companies that are currently below a normal level of profitability will restructure and/or change their business strategy thus hopefully improving profitability. Conversely, companies with above average levels of profitability will face increased competitive forces and revert back over time to a normal level of profitability.

In a free market open economy company profitability will exhibit a mean reverting pattern. That is in theory. In the real world of partially competitive markets we would still expect to see mean reverting levels of profitability but with a lot more noise. We would also expect to see stronger mean reverting patterns over longer holding periods while in the short-term we would expect to see minimal competitive re-alignment.

In this note we present some high level findings on how Return on Equity (ROE), a common measure of firm profitability, evolves over time. ROE is calculated as Net Income / Shareholder Equity. For some background on what motivated our interest in profitability factors please take a look at a recent video Eric J. Weigel – The Manual of Ideas Interview available on YouTube.

What does the data show in terms of how companies migrate between profitability stages?

Note: Decile 1 contains the highest ROE stocks in our balanced panel global equity sample

Some high level conclusions:

ROEs do not fluctuate that much over time and there is a high persistence in relative universe profitability rankings. We call this the “status quo” effect
- Mean reversion in ROE (estimated over a five year window) is best found in the middle portion (Deciles 4-6) of the profitability spectrum

The highest ROE stocks tend to, over the subsequent five years, remain in the higher portions of our sample profitability at a greater rate than expected.
- Buying a high ROE stock and five years down the road ending up with a company in the bottom end of profitability occurs with a frequency less than expected by pure chance
- Deciles 2 and 3 appear to be the place for finding companies with high sustainable levels of relative profitability

The greatest rate of improvement in relative profitability rankings occurs in Decile 10 comprising those companies with the lowest ROEs, but the rate of improvement fails to beat expectations. Going long Decile 10 stocks is fraught with significant risk of disappointment

A contrarian investor investing in low relative ROE stocks such as those in Deciles 7-9 is taking a bet with unfavorable odds of success. The improvement rate of these ROE laggards tends to fall below expectations

As a final note, our view is that stock picking is a multi-dimensional endeavor balancing among others valuation, profitability, and growth concepts. The behavior of any one factor should always be viewed in the context of the current capital market environment. Our current view on the attractiveness of stock factors augurs well for favorable returns to stocks with high sustainable levels of company profitability.

To read the full report please click here Migration Patterns In Company Profitability

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Apples to Oranges – The Case Of Commodity Indices

Commodity investing dramatically increased in popularity with both institutions and retail investors in the last decade as it became cheaper and easier to invest in the asset class.

The two primary indices for commodity investing have been the S&P GSCI and the Bloomberg indices. These indices are dramatically different in terms of weighting structure with the S&P GSCI being very energy heavy (63% weight) while the Bloomberg index tends to be more balanced across the primary commodity sectors. As a consequence both indices can have significant performance differences.

Both indices aim to cover the broad spectrum of most actively traded commodities. Commodity pricing is primarily determined by global supply and demand conditions, but that is where the similarities among commodity sub-groups often end.

When investors think of constructing their portfolios usually the starting point are broad asset classes such as stocks and bonds. Asset classes tend to possess fairly well defined risk and return characteristics and represent aggregations of “similar” investment types.

As an example, stocks are usually broken down into economic sectors but most investors would agree that stocks are driven to a large extent by what happens to the broad equity market. Similarly, while fixed income investments are frequently broken down by maturity and credit worthiness, the key driver of fixed income returns tends to be the general direction of government bond rates. In general, return correlations within asset classes such as stocks and bonds tend to be high and frequently exceed 0.8.

When evaluating investment returns within the commodity complex the high within asset class correlations typically seen among stock and bond investments are absent. More common are correlations in the 0.2 to 0.4 range.

The low correlation among commodity groups is a manifestation of a less homogeneous asset grouping than typically seen for other broad asset classes such as equities and bonds. Given that each commodity group has its own supply and demand dynamics and the vastly different swing pricing factors this result is to be expected.

Thinking of commodity investing as a broad concept has been useful for investors as a way to get their feet wet, but given the current depth of commodity markets, the variety of liquid investment vehicles available, and most importantly the dissimilar behavior within the commodity complex we think that looking at the space as one homogeneous asset class is like comparing apples to oranges.

Other sections in this report include:

Thinking of commodity return behavior in terms of risk exposures
What do the risk estimation exposures tell us about commodity sub-group behavior?
What does our research imply for commodities in the context of a multi-asset portfolio?

Download The Full Report Below

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

Feeling Unsettled – An Update on Investor Risk Aversion

Investors have been feeling a bit unsettled this year. Right off the bat risky assets fell off the cliff only to recover strongly in March. Since then financial markets have felt like a typical spring day in New England –at times warm and sunny followed by cold winds and clouds.

Investors have become highly sensitized to changing capital market conditions – one moment feeling upbeat and confident and the next being rife with doubt and stress.

Back in 2009 Mohamed El-Erian then at Pimco described the changing mood swings of investors using the risk on/risk off label.

While the risk on/off concept makes a lot of sense to truly grasp the investment implications of such mood swings one needs an objective yardstick to properly identify these periods of euphoria and sheer despair.

At Global Focus Capital we measure investor sentiment using our Risk Aversion Index (RAI). The higher the RAI the more fearful investor are, or in other words the more risk averse. As a reminder to readers we classify investor risk aversion into three zones – Extreme Risk/Risk Allergic, Neutral, and Risk Loving/Seeking.

Thus far in 2016 we have spent most of our time in the Extreme Fear/Allergic and the higher end of the Normal Zones. Investors are clearly nervous.

The chart shows the ten day moving average of our daily risk aversion index. During the early part of the year risk aversion was in the very high end as global stock and commodity markets were tumbling.

As risky assets found their footing in mid to late February so did investor risk aversion. After almost reverting back to the Extreme Fear/Allergic Zone in mid-April, investor risk aversion has been trending down while still remaining in the high end of the Neutral Zone. Investor sentiment remains fragile.

What does it mean to be in each one of these risk zones? Without going into all the portfolio construction issues let us just focus on returns. A separate note will explore the risk management aspects of each risk regime.

We illustrate average monthly returns since 1995 for the major asset classes typically part of our asset allocation strategies at Global Focus Capital. Among equities and fixed income we split the asset classes into domestic and international and also include alternatives such as real estate and commodities.

Periods of capital market stress such as those when the RAI is in the Extreme Risk/Allergic Zone (red bars) are difficult for investors holding risky asset classes such as equities. In line with conventional wisdom the higher the perceived risk the more negative the average returns. When the RAI is in this zone all equities suffer but emerging markets takes the biggest hit (down 2.3% on average). Our two alternatives (Real Estate and Commodities) also take a hit but the overall negative effect is dampened due to their exposure to non-equity risk factors.

Fixed income on the other hand tends to exhibit positive average returns during this high risk aversion phase. In fact, the highest average returns of all asset classes correspond to government bonds (US and Non-US developed market). US Government bonds for example show an average monthly return of 1% in the Risk Allergic Zone.

Let’s see what happens when the RAI falls in the Risk Loving/Seeking Zone (green bars). Here the situation is reversed. Asset classes with higher perceived risk tend to do better. Emerging market equities do best on average and small caps outperform large cap stocks. Real estate also does well. Within fixed income emerging market bonds do best, but in general the performance of safer assets lags significantly behind that of riskier investments.

When in the Risk Loving/Seeking Zone it pays to be aggressive, but one must also be mindful of taking on too much risk in exchange for less and less potential reward. Both the Long Term Capital Management implosion in 1998 and the 2008 Financial Crisis debacles occurred on the heels of investors being highly dismissive of the risks involved. In both cases investors were taking on a disproportionate amount of risk for smaller amounts of potential return.

Finally when evaluating returns in the Neutral Zone (orange bars) it is interesting to note that, on average, equities tend to exhibit the best monthly returns when in this risk phase. All four equity classes show this tendency. Likewise real estate also shows the highest average returns in the Neutral Zone. Interestingly, the highest perceived risk asset within fixed income – Emerging Market Debt – also shows this characteristic.

Where is the RAI now and what should we be doing? Our barometer is currently entrenched in the Neutral Zone with a reading in the 59^th percentile. The RAI has been trending down (becoming a bit less risk averse) but remains in the higher end of the Normal Zone. Pick your poison – low global growth, negative policy rates, disappointing corporate earnings, Brexit, a Greek default – investors are finding lots of reasons for remaining nervous.

In looking at the pattern of how investor risk aversion typically evolves our research has found that investor risk aversion tends to be sticky over the short-term

There is about a 65% probability of remaining next month in the current risk zone, a 25% chance of moving to the contiguous zone (say from Neutral to Extreme Risk) and only a 10% chance of moving from one extreme to the other (say Risk Seeking to Risk Allergic).

Our current reading of 59^th percentile is on the high side for the Neutral Zone. Coming off the Extreme Risk/Allergic Zone at the beginning of the year the portfolio implication is a lowering of tracking error and an increase in investment volatility. We are thus advocating becoming less dissimilar from the benchmark if a relative return orientation is applicable.

When investor risk aversion is in the Normal Zone, low volatility strategies lose their effectiveness and we, therefore, do not recommend a low volatility tilt anymore.

Should investors get spooled again and our RAI return to the Extreme Fear Zone our recommendation would be to tilt toward lower volatility investments and sectors. Such a set of moves would increase deviations relative to the benchmark and we would expect to observe higher levels of strategy tracking error.

What could sour the mood of global investors leading to a jump up in risk aversion? Potentially a whole host of issues frequently best understood in hindsight. But on a more practical note we would highlight three areas of concern. First, should the UK vote to withdraw from the European Union we would expect a large spike up in investor risk aversion. Risky assets such as stocks and commodities would likely take a big hit should this event occur. We think that investors will react extremely negatively to Brexit especially in terms of their European stock and bond holdings.

The second concern involves contagion effects should a Greek default occur. At the very least the interest spread between safe and riskier debt should jump up. This would lead to a higher RAI and riskier investments will likely bear the brunt. Haven’t we seen this movie before? Yes, too many times but unless debt relief is in the cards we will we seeing another re-run this summer.

Finally, a Chinese growth scare could also trigger investor fears and bring about very negative consequences for emerging market equities and commodities. The official target growth rate is between 6.5 and 7% with a focus on internal consumption and services growth.

The wildcards remains the health of the real estate market and the credit worthiness of off-balance sheet financing. According to the IMF China currently accounts for over 16% of Global GDP when adjusted for purchasing power parity. The US accounts for a similar fraction of global growth. A significant negative revision to growth in either country would no doubt roil equity and commodity markets while leading monetary authorities to expand their loose monetary policy further into the future.

At Global Focus Capital we continue to believe that investment risk has been underpriced for a while and that there is no better time than now to evaluate one’s willingness to trade off risk in relation to potential reward.

Monetary authorities have provided investors with a nice safety cushion and allowed aggressive investors to benefit disproportionally. Lackluster global growth and seemingly high absolute valuation levels for stocks and bonds are likely to lead to a decade of lower than average capital market returns where many investors will struggle to meet their stated target portfolio returns.

A proper understanding of realistic sources of potential returns and associated risks together with a willingness to remain tactically flexible with a portion of the overall portfolio will reward investors with a higher likelihood of achieving their goals without going too far out on the risk curve.

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Should Inflationary Expectations Be So Sticky?

Capital markets have brought lots of surprises this year. Two developments especially – recovering commodity markets and a falling US dollar – have important implications for future consumer prices.

Capital market participants do not seem overly sensitive to these two developments in terms of expectations of future inflation. Commodity prices are for the most part an “input” into the type of goods and services consumed. The US dollar on the other hand acts as a translator of value between goods produced abroad and domestic consumers.

Recent consumer price changes have been muted in the last few years. Monetary authorities in the US as well as abroad seem particularly troubled by the prospect of deflation and have in some cases even resorted to the use of negative policy rates to revive growth.

The April 14 BLS Report on the CPI-U estimates year-over-year inflation at just 0.9%. This number is welcome news after near zero inflation for most of 2015, but still lags the historical norm of 3% annual inflation by a wide margin.

A quick glance at the latest report provides interesting clues. Two of the four main categories of consumption categories – Food, Energy, Commodities Less Food & Energy, and Services – exhibit price depreciation over the last year.

The biggest deflationary force has been the Energy category with a 12.6% price drop. The other deflationary category is Commodities Less Food & Energy with a -0.4% year-over-year price change.

Federal Reserve members seem concerned with the possibility of deflation in the US, but what about market participants? We evaluate two measures – the breakeven rates from TIP prices measuring the expected inflation over the next 5 years (orange line) and the so called 5-over-5 rates measuring inflation expectations five years from now over the next five years (green line). To provide context we also illustrate the rolling year-over-year CPI-U inflation.

Capital market participants are expecting an uptick to inflation, but in light of this year’s commodity price increases and the depreciation of the US dollar do these expectations need to be revised? Yes, the market implied inflationary expectations seem low in relation to the resurgence in commodity prices and the depreciation of the US dollar.

Where do we see inflationary expectations heading to? Our research based on our econometric model of 5 year inflationary expectations calls for steady but moderate upward revisions.

The latest market-based estimate of 1.61% is expected according to our model to rise to 1.7% by the end of Q2 and to 1.9% by the end of the year.

We are not expecting a huge bump up yet in inflationary expectations in large part due to the fact that rising commodity prices and a depreciating USD have only been in place for a short period of time.

Many strategists are still skeptical that these two trends have legs. Our view is that even if there is no further change for the remainder of the year inflationary expectations have been too low and will slowly drift up.

What are the implications for investors of slowly rising inflationary expectations? For now the more direct impact for investors of rising commodity prices and a falling US dollar is being felt through the rise of previously unloved sectors such as Energy and Materials as well as the revival of Emerging Market Equities.

The transmission mechanism from higher commodity prices and changes in the value of the US dollar to actual inflation pressures is not immediate of for that manner always straightforward as many other forces such as demographics and the overall health of the global economy come to bear.

Rising inflationary expectations would according to our risk management methodology benefit holders of risky assets such as equities, commodities and real estate. Safer assets such as bonds would suffer as we would expect higher inflationary expectations to translate to higher nominal interest rates. The effect would obviously be greater the longer the duration of the assets.

Click here to download the report: Should Inflationary Expectations Be So Sticky

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Is it Really All About Oil?

A large number of stories in the financial press this year have revolved around the relationship between equity prices and oil. In fact some commentators have focused on a recovering oil price as the key lynchpin for rising equity prices.

As an example, the Wall Street Journal published an article this year “Oil, Stocks at Tightest Correlation in 26 Years”. Many other publications and strategists have written pieces this year noting the close relationship between oil prices and equity index performance.

The human mind is conditioned to look for patterns and in the tumult of early 2016 the oil market meltdown started playing a leading role in explanations of why global equity markets were under stress. But as any econometrics professor will say “correlation is not causation“.

In this note we look at the sensitivity of asset class returns to changes in the price of oil. We take a risk management perspective and find that while oil price sensitivity is significant when analyzing one-on-one relationships, the effect is close to zero and statistically insignificant in a multivariate context.

What you see is not always what you get. We conclude that rising oil prices have little long-term significance for broad equity market prospects and that a rising oil price is more of a reflection of supply curtailment efforts.

The key lesson to us from our analysis is that commonly heard explanations for asset return drivers are often incomplete and in some cases highly misleading.

Every market environment has its own context and no single factor in isolation will ever be able to fully explain the complexities of market behavior. Even in hindsight it is often hard to pin down a story that holds up to serious scrutiny.

Best to stay humble and realize that over shorter time periods capital markets will always be subject to a lot of noise of no material significance to long-term investors.

Click here to download the report: Is It All About Oil

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Low Volatility – One Factor or Several?

Once a month in our Equity Observer publication we share our analysis of what stock selection factors are working. This year the best performing factor in our global sample is “low volatility”.

The issue of what constitutes a factor will be endlessly debated, but while “low vol” does not quite rank up there among academics with the original Fama-French-Carhart variables (market, size, value, momentum) there is nevertheless a growing investor demand for lower volatility strategies.

The growing demand for “low vol” strategies does not seem entirely driven by the performance of these strategies relative to core benchmarks. For example over the 2015-2013 period the S&P Low Volatility Index under-performed the S&P 500 core index by 3.4% annualized. Yet demand for these strategies appears to have grown as manifested by the large number of new ETF’s launches in this space.

Investors seem particularly interested in the capital preservation characteristics of “low vol” strategies and appear willing to sacrifice returns during the good times in return for less pronounced equity market downdrafts.

Low volatility strategies seem here to stay. Given their market beating returns thus far in 2016 it is reasonable to expect growing interest. We therefore analyze our global sample of 13,000 stocks to ascertain the basic characteristics of low volatility stocks.

Stocks in the lowest volatility decile have an average return volatility of 20%

Higher volatility stocks exhibit low levels of market sensitivity (beta)

During periods of equity market stress ‘low vol” strategies should out-perform broad market indices

The lowest volatility decile enjoys the highest current yields while the “high vol” names in Decile 10 barely register for income

Lower volatility stocks have lost their historical valuation advantages. The growing demand for ‘low vol” and its close cousin dividend income have eroded the typically lower valuations seen in lower volatility sectors and stocks.

Even after adjusting for sector and region/country effects we observe a strong monotonic relationship in YTD returns across volatility deciles.

The lowest volatility stocks (Decile 1) have had the highest 2016 returns while the highest volatility stocks have shown the greatest losses.

Our general conclusion is that “low volatility” strategies play a useful role for investors looking to provide short-term downward protection in their equity portfolios. However, we think of “low vol” as part of a package of stock attributes designed to lessen market exposure during periods of equity market stress. These strategies along with lower betas, higher yields and exposure to more stable sectors should exhibit lower levels of downside capture.

Investors worried about equity market downturns should not view these strategies as a substitute for properly assessing and managing the risk of their overall portfolios.

Click here to download the report: Low Volatility – One Factor or Several?

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Less Bunny, More of a Rocky Balboa Market!

Rocky Balboa View

The start of the year felt like a Rocky Balboa fight. Risky assets were absolutely pummeled during the first 6 weeks of the year and were down for the count.

Most investors were taken by surprise by the strength of the first punch and the retail section started emptying out early. White towels were being thrown about but out of nowhere equity markets started gathering strength.

Just like a fighter on the ropes biding time equity markets started little by little chipping away. By the end of February stocks had stabilized and the first real signs of a competitive fight emerged during the first week of March. The point count had evened out and by the end of the month the count had swung around in many categories. At the end of Q1 world equity markets were essentially flat but there were surprises galore.

The biggest surprise by far this year has been the re-emergence of Emerging Market Equities. The asset class had been left for dead after many years of disappointing returns, but this year the asset class is punching above its weight – already up 4.4% (MSCI EM).

Q1 2016

EM equities have vastly out-performed developed markets especially those in Asia and Europe. A 9% gap has developed between developed and emerging international stocks (MSCI EAFE).

Despite the poor showing of the average Chinese stock how is it possible that EM equities as a whole are up for the year? No doubt investors are somewhat stunned by the YTD eye-popping returns to resource-oriented markets such as Brazil and Russia.

In our sample of global equities the average Brazilian stock is up over 24% while the average Russian equity is up about 16%. South Africa, another major EM market, punches in at an average stock return of close to 14%. Other emerging markets with average YTD returns exceeding 10% include Indonesia, Turkey, Chile and Malaysia.

Commodity markets have no doubt recovered, but is the strong performance of EM simply due to a recovering commodity market?

Precious metals have done very well this year with gold up 15% and silver up 9%. While $20 oil is still mentioned from time to time, energy markets have had a tenuous recovery but still show losses close to 10% for the year. Smaller components of commodity indices such as grains, livestock and industrial metals are all only slightly above water this year. Our conclusion is that there is more to the re-emergence of EM equity markets than simply a direct benefit from recovering commodity markets.

While broad based equity indices have gyrated at times like a punch drunk Rocky Balboa behind the scenes we have been witnessing a strong rotation toward out of favor sectors such as Energy, Materials, Utilities and Telecom. Momentum sectors of the past few years such as Health Care and Technology have receded.

The country and sector performance numbers indicate to us that global investors have been quietly changing their stripes. Glamour sectors and equity markets with the best post-Financial Crisis performance are being re-priced.

Part of this shift toward more value-sensitive sectors and regions may be driven by a desire to better protect the downside and capture yield in what most strategists would agree is a low capital market return environment.

We perceive that investors are changing their stripes. Valuation levels are being more carefully examined. Investors are also showing a desire for lower risk both from a return as well as financial statement perspective. Momentum strategies have lost their punch as have sell-side analyst recommendations.

Many of the characteristics typically associated with larger capitalization companies such as lower volatility, higher yields, stock buybacks and higher levels of profitability seem to be gaining favor among global equity investors.

We see global markets being more similar to Rocky Balboa – at times exhausted and bloodied but despite great hardships triumphant in the end. For the foreseeable future we see ourselves living in a risk on/off world with investor preferences increasingly tilted toward capital preservation strategies.

Click here to download the report: Less Bunny, More of a Rocky Balboa Market

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

From Bear Market to Sector Rotation – It’s All a Bit Confusing Now!

This year has been a roller coaster for global equity investors. From the weak start to the year to the recovery in early March it has left investors with more questions than answers. Are we in a bear market? Are we just pausing until global growth resumes?

Lots of questions and few answers, but maybe we can distill some useful information from the recent price action of global equity markets. In a world where the headlines revolve around broad market indices such as the S&P 500 or the Nikkei 225 much is left unexplored.

In this note we look at the technical characteristics of our global equity sample (13,000 stocks) for clues as to what may be going on behind the scenes. We search the readings from our Technical Stage Model for clues. For further details on our methodology please read our post Getting All Technical

What we find is great investor indecision – over 40% of stocks in our global sample reside in the Improving Stage.

While historically one would expect these stocks to keep on moving up higher to the Break Out Stage there is also a non-trivial probability of regressing to the Down Turn Stage hence our characterization of the Improving Stage as indecisive.

We also find a strong rotation away from sectors and equity styles that out-performed last year toward much maligned resource-oriented sectors and countries.

Is the current technical picture more consistent with a Bear Market or an ongoing strong sector rotation toward out-of-favor sectors? Will the recovery in resource- oriented sectors last?

Click here to download the report:Strong Sector Rotation or a Bear Market?

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Insights That Matter

But just as building a moat around one’s castle is a totally inadequate way in today’s world to keep outside influences at bay so are policies pretending that world economic forces can be neutralized at one’s door step.

Most times when a political event such as Brexit occurs the size of the overall economic pie does not change materially at least over short and intermediate terms. What tends to happen instead is that the pie gets splits up differently creating losers and winners.

What can we reasonable expect over the next few weeks?