When Lower for Longer is Not Enough

For years now, U.S. equity markets have rejoiced each and every time expectations for the first Federal Reserve rate hike have been pushed back. Mr. Zero interest rate policy has been the best friend of the stock market bar none. “Lower for longer” has been so ingrained into our psyche that anytime there is a hint of negative news we expect calls for the Fed to remain on hold to ensue.

And on hold they will stay, if the futures market is correct. After tepid wage growth in the most recent employment report and continued worries about Greece, the odds of a 2015 rate hike have dipped below 50%. The market is now expecting the first rate hike to occur in January 2016. At that point, it will have been seven years of 0% interest rates.

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Normally, we would see stocks surge higher on such a development but the behavior seems to be changing of late. As I wrote a month ago, there’s been a stalemate between bulls and bears in 2015. Two consecutive quarters of negative earnings growth, declining revenues over the past year, and median valuations at all-time highs have left the market in a more vulnerable position.

Thus far, the Fed remaining on hold and the 48 other central banking easing measures have been enough to keep the sellers at bay.

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But momentum is waning here and market participants seem increasingly indifferent to these dovish actions. The S&P 500 is very close showing a negative return over the prior six months for the first time since early 2012. This is important because there are many new investors who have come to view the S&P 500 as a risk-free instrument. How will they react when they find out it is not?

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When Lower for Longer is Not Enough

If it is indeed the case that lower for longer is not enough to support the markets, then we will need to see one of two things occur: 1) earnings improvement or 2) more Fed action.

By my calculations, earnings are likely to decline for a third consecutive quarter with the announcements starting next week. That leaves markets with the hope of more Fed action six years into an economic expansion. Back in 2010 and 2011 after the end of QE1 and QE2, we saw stock declines of 17% and 21% before new Fed programs. Today, the S&P 500 is only 3% off of its all-time high. It should be an interesting summer.

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New York

 

 

 

 

 

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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The S&P is not a 6-month CD

This may come as a surprise to new investors, but the S&P 500 is not a risk-free certificate of deposit (CD). For more than three years, though, it has been behaving as one. Had you purchased the S&P 500 (SPY) at the end of any week since August 2011 and held for six months, you would have ended up with a positive return 100% of the time.

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For 179 consecutive weeks, this has been true, marking the second longest stretch in history. Only the mid-to-late 1990’s (1994-1998) had a longer streak of positive 6-month returns.

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What does this mean for investors going forward?

This has been one of the greatest periods for buy-and-hold investors in history. As a by-product, many investors have developed unreasonable expectations for their equity holdings – that they have no risk. These investors are likely to be disappointed and with S&P 500 up only up 1% over the past six months, this disappointment may come sooner than most expect.

Historically, the odds of a positive 6-month return in equities is only 67%. Thus, in one out of every three 6-month periods an investment in the S&P 500  would have lost money. Using equities as a substitute for a savings account or  short-term certificate of deposit – money you need available in within the next year – has never been a wise idea. The recent past doesn’t change that fact even though the outcome would have been favorable in hindsight.

On a broader note, the period of nearly unrelenting advance in U.S. equities has not been lost on investors. We now live in a world where everyone wants higher beta and correlation to the S&P 500 because that is “what has worked.” This is the polar opposite sentiment to March 2009 when everyone wanted low correlation and beta to stocks.

Prudent investors today will be positioning for the future, not the recent past. For if trees don’t grow to the sky, the next few years will look markedly different. If now is not the time to prepare for that eventuality, when is?

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New York

 

 

 

 

 

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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Gold: What is it Good For?

In a world increasingly focused on the short term, five years can seem like an eternity. How many among us would stick with an investment that has gone nowhere for five years? That is precisely the question Gold investors are faced with today, with a return of -7.4% over the past five years.

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The case for buying Gold five years ago was seemingly obvious. The Federal Reserve was embarking on a second round of quantitative easing and continuation of 0% interest rates. This was supposed to lead to higher inflation, a collapse in the U.S. Dollar, and increased demand for the “other” currency: Gold.

Fast forward five years and we have seen continued central bank easing, not only in the U.S. but across the globe. While we did see inflation in housing and stocks prices, what we did not see was a collapse in the Dollar or a spike in reported inflation. We also did not see an increase in the demand for Gold.

The past five years have not been a straight line, though. Gold prices initially surged higher in 2011 and money flowed in as investors chased returns. For a brief period of time the SPDR Gold Shares ETF (GLD) stood as the largest ETF in the world. Since then, Gold prices have fallen (-36%) and assets in GLD have fallen more, declining over 65% from their 2011 peak.

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So the answer to the above question about how many of us would stick with an asset that has declined over the past five years is … not many.

Still, there remains $27 billion of assets in the Gold ETF, not a small sum. Those sticking with the yellow metal today argue that Gold is not just an “inflation hedge,” but also acts as an insurance policy of sorts. It is supposed to provide an uncorrelated alternative to stocks that proves valuable during times of stress.

Fair enough. There has been no stress to speak of in recent years and thus no need for any uncorrelated exposure or diversification in hindsight. But eventually we will enter another volatile period in equities where gold will prove valuable – or so goes the argument.

Let’s examine this thesis, looking at the period from 1976 through today.

First, Gold is indeed uncorrelated to stocks, with a monthly correlation of .02 to the S&P 500. Second, it has acted as a hedge on average with a -7.7% down capture to the S&P 500, meaning it tends to rise when the S&P 500 falls. During months in which the S&P 500 has finished lower, Gold has risen 53% of the time.

Lastly, introducing Gold into a stock portfolio has also improved risk-adjusted returns (return/volatility). A 60/40 portfolio of Stocks and Gold slightly underperforms Stocks alone (9.5% vs. 10.7%) but does so with lower volatility (-11.9% vs. 14.9%) and lower drawdowns (-29.9% vs. -50.9%) than an all-stock portfolio (see Table 1).

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Based on these stats, a reasonable case can be made that Gold can add value to an all-stock portfolio. But this conclusion is one made only in isolation, failing to consider other competing investments. Gold is not the only asset class with a low correlation to equities that can mitigate volatility in a portfolio.

There are also Bonds. Since 1976, the Barclays Aggregate Bond Index (AGG) has a correlation of .22 with the S&P 500 and the Merrill Lynch 15+  Year Treasury Index has a correlation of .07. Both bond indices have a down capture ratio that is more negative than Gold (-10.0% and -15.9%) with a higher percentage of positive returns during down months for the S&P 500 (61% and 55%). They also tend to perform better during up months for the S&P 500, with up capture ratios of 22% and 21% versus 16% for Gold.

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An additional factor favoring Bonds over Gold is their lower volatility. A portfolio of Stocks and Bonds produces a significantly higher risk-adjusted return than a portfolio of Stocks and Gold (see Return/Vol in Table 3 below). Adding Gold to a portfolio of Stocks and Bonds seems to add little additional benefit other than a lower correlation profile to the S&P 500.

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Note: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more consistent defensive alternative to stocks during periods of market stress with lower volatility and drawdowns than Gold. In our research on Treasuries (click here) and Lumber/Gold (click here), we illustrate tactical strategies that use bonds as the default position when equity volatility is expected to rise.

Gold, What is it Good For?

In the past forty years, Bonds have been the better alternative than Gold for investors seeking to minimize drawdowns and lower volatility in their portfolios. Bonds also throw off an income stream while Gold yields nothing. Does that mean Gold is good for absolutely nothing, having no place in a portfolio?

No. The future is not the past and anything could happen in the next five years.

Should we see high inflation and rising interest rates as we saw during the 1970’s, Gold would likely prove beneficial in a portfolio. If the U.S. Dollar were to experience a sharp decline, one would also expect Gold to perform well.

Handicapping these scenarios is not an easy task and I certainly wouldn’t recommend trying. The real questions for Gold investors are about staying power, discipline, and asset allocation.

1) Staying Power: How long are you willing to wait for Gold to prove its worth? Gold is down over the past five years which already seems like an eternity. Would you be willing to sit in Gold for twenty-seven years with flat returns as we saw from the peak in 1980 through 2007? Not likely.

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2) Discipline: Gold is prone to sharp spikes higher and dramatic moves lower. Do you have the discipline to resist buying Gold after a spike and selling Gold after a crash? This is true for any asset class but given the higher volatility of Gold it is a particularly important question.

3) Asset Allocation: Assuming you have staying power and discipline, what is the appropriate sizing for Gold in a portfolio?

There is no easy answer to this question and really comes down to 1) whether you view Gold as a better diversifier and equity hedge than Bonds and 2) what your expected returns are for Gold versus Stocks and Bonds.

As outlined above, Gold hasn’t been a better hedge or diversifier (on average) than Bonds in past forty years. On the second question, there is a strong case that can be made that equity and fixed income returns will be below average in the coming years considering today’s high valuations and low bond yields. This should increase the odds of Gold holding its own as compared to the early 1980’s when equity valuations were low and bond yields were high. That said, even if Gold performs well in the next five years, it’s likely to be a volatile ride. Which is why for most investors staying power, discipline, and sizing may actually be more critical than returns.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New York

 

 

 

 

 

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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