More Risk, Less Reward: The Changing Market Environment

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One of the casualties of zero-interest rate policy has been the important balance in investing between risk and reward. After three rounds of quantitative easing and seven years of 0% interest rates, investors have been told in no uncertain terms: the streets are paved with reward; forget about risk.

With U.S. equities hovering near all-time highs, having more than tripled since March 2009, this is the primary message we are hearing from investment advisors today. There is no risk in the new investing paradigm so don’t bother worrying about it. The S&P 500, we are told, is the new 6-month CD.

And while on the surface it seems that this is true and nothing has changed, when we look underneath it is clear that something very different is going on.

More Risk, Less Reward

Over the past year, within many areas of the investable landscape, taking more risk has actually led to less reward.

In the credit markets, High Yield bonds and Senior Loans are flat since the beginning of 2014 while long-term U.S. Treasuries are up over 25%.

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Last week, High Yield credit spreads hit their widest levels in over two years.

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Distressed bonds are also reflecting a changing risk appetite, declining over 45% since last June.

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Within the equity market, High Beta stocks (SPHB) have declined 3% over the past year while Low Volatility (SPLV) names have advanced close to 14%. The ratio of High Beta to Low Volatility is at its lowest level since 2013.

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Within the currency market, Emerging Markets are trading at multi-year lows as investors are increasingly seeking out the safety of the U.S. dollar.

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When Risk Matters Again

Whether investors realize it or not, risk is starting to matter again. The Dow may be flat over the past eight months but that doesn’t mean holding a higher percentage of stocks than your risk tolerance warranted was a good decision. Just because an investment is not down does not mean it is without risk.

At Pension Partners, evaluating the balance between risk and reward is at the heart of our investment process. Currently, risk is outweighing reward with leadership in Utilities (click here for our research on Utilities) and long-duration Treasuries (click here for our research on Treasuries) suggesting an increase in volatility may be coming. As such, we have been defensively positioned since early July and will remain so as long as the risk/reward dynamic remains unfavorable.

Many U.S. equity investors believe we are sailing in calm waters here and nothing but smooth sailing lies ahead. With the Volatility Index (VIX) at 13 and years since we’ve seen a decline last more than a week, this feeling is understandable. But make no mistake about it, there’s a storm brewing just beyond the mountains. We don’t know if that storm is going to lead to another small decline as we have seen a number of times over the past few years or something larger. If nothing else, though, this storm will serve as a healthy reminder that sailing in equities is not without risk.

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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 Revenue Recession

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What do General Motors, JPMorgan Chase, Microsoft, IBM, Proctor & Gamble, Citigroup, Johnson & Johnson, Coca-Cola, Oracle, and Caterpillar all have in common?

1) They are among a long list of S&P 500 companies with negative year-over-year revenue growth.

2) They are not in the Energy sector.

With 80% of companies already reported, S&P 500 sales are on pace to decline (year-over-year) by 3.1%, the second consecutive quarter of negative growth.

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The last two times we saw declines in revenue growth were back in 2008 and 2001, during U.S. recessions. Today the U.S. economy is still expanding, but corporate sales are not. Much of this decline has been blamed on the stronger Dollar which has made U.S. multinationals less competitive.

Indeed, the Dollar’s historic advance over the past year has been problematic for companies with overseas business, and I have described it as the Black Swan in plain sight.

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But it is not just the stronger Dollar that is to blame. Nominal GDP growth in the U.S., at 3.3%, is the slowest on record for an expansion. In fact, we have seen many recessions with higher nominal growth than this. It should hardly come as a surprise, then, to see corporate profits slowing as well.

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“It’s Just Energy”

With the U.S. stock market still higher over the past year, many have dismissed the decline in company sales. “It’s just energy” has been the most common refrain as energy companies have been hit hard by the sharp decline in Crude prices. In looking at the actual data, though, we find that it is hardly “just energy” that is showing top line weakness.

Of the companies that have reported thus far, 48% have shown negative year-over-year revenue growth. Of these, 142 companies are outside of the Energy sector. Below is a small sampling of that group.

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The Voting Machine

As I wrote a few months back, it is not earnings and sales that drive stock prices in the short run but the multiple investors are willing to pay for those earnings and sales.

As earnings and sales declined, investors initially seemed happy to pay a higher and higher multiple, but that enthusiasm appears to be fading here. The Dow has gone nowhere over the past eight months, creating an illusion of stability with increasing signs of fragility.

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The revenue recession also comes at an interesting time, when the Federal Reserve is closer (according to the Futures markets) to a rate hike than it has been at any point during the expansion that began in June 2009. Will the Fed really hike rates in September with negative earnings and sales growth or will they once again push back their “dot plot” plans? A better question after nearly seven years of 0% is whether market participants will still view a push back as bullish (see: when lower for longer is not enough). We’ll soon find out.

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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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Anomalies, Cycles, and Inevitable Periods of Underperformance

You’re new to investing and want to pursue a small cap value strategy. You’ve read that value stocks and small caps tend to outperform over time and you, of course, would like to outperform.

Looking at back at history, following such a strategy seems like an easy ride. An investment of $10,000 in 1979 would have grown to $829,578 in the Russell 2000 Value Index versus only $299,945 for the Russell 2000 Growth Index (annualized return: 12.9% vs. 9.8%).

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In reality, though, sticking with small cap value was anything but easy. There were many periods in which value underperformed growth. In fact, in looking at rolling 3-year returns, value underperformed growth 33% of the time. That means value was deemed to be “not working” or “broken” in one third of all rolling 3-year periods.

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This is where we are today. Value has underperformed growth by over 25% in the past three years. How many investors, given this backdrop, would choose value over growth? Not many.

And this is far from the worst period in history for value. At the end of February 2000, value had underperformed growth by 85% in the prior three years. Those selling value strategies at the time were literally laughed out of the room. We all know what happened next.

The moral of this story: all anomalies have cycles and periods of underperformance. It seems counterintuitive, but this is why they work in the first place. If there was a strategy that worked every month of every year, everyone would follow it and it would stop working.

In our 2014 paper on Beta Rotation, we illustrated a rotational strategy that outperformed the broad equity market in 80% of rolling three year periods. Notable outperformance, but this still meant the strategy was underperforming 20% of the time. And when you’re in one of those periods, it can feel like an eternity.

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How should investors think about periods of relative underperformance?

If they maintain a diversified portfolio of asset classes and factors (as they should), they need to accept the fact that by definition, something in their portfolio will always be underperforming. I agree, this is not easy to accept, but it is a mathematical truism. The prudent investor will welcome such underperformance as an opportunity to rebalance and add to the factor or asset class that may now be undervalued.

Most will do the opposite, emotionally chasing asset classes or factors only after they have shown strong performance and selling whatever “isn’t working” in the short run. Unfortunately, chasing after the hottest fads is not a particularly successful investment strategy.

The best example of this today is in biotech stocks. Many new investors are just learning about the biotech boom in which we recently saw shares quintuple over the past five years. They see the chart below and instantly fall in love, projecting past returns into the future.

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“Charlie, what do you think of biotech stocks?”

That is the most popular question I have been asked in recent weeks and tells you all you need to know about human psychology (certainly no questions on value stocks). Everyone loves a winner. I get that, which is why momentum exists and is one of the most powerful forces in markets.

But momentum, too, has cycles and few investors are willing to accept the drawdowns, volatility, and periods of underperformance that come along with such a strategy. Fewer still have a consistent process by which they try to take advantage of the momentum factor. Chasing performance years after a run is not the same as short-term momentum. There will many Johnny-come-lately biotech investors that learn this the hard way.

In the end, it all comes back to psychology. Can you accept the fact that something will always be underperforming in a diversified portfolio and use that to your advantage instead of giving in to your emotions? Can you ignore the noise of the short-term and understand that the path to successful investing is not paved by winning yesterday’s war and engaging in “what ifs,”  but by realizing the future is not the past. If you can, you’ll be investing often in things that “aren’t working,” but end up way ahead of those investors who believe that everything in their portfolio should be up at all times.

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 YorkCharlie 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 two award-winning research papers in 2014 on Intermarket Analysis 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, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

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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