All posts by Charlie Bilello

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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The Illusion of Stability

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U.S. equities continue to trade like a risk-free money market. Over the past seven months, the range (from high to low) in the Dow Jones Industrial Average has been among the smallest in history.

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This behavior has been comforting to most investors as they tend to equate low volatility with low risk. Additionally, every time there is minor spike in volatility, it soon collapses. We saw this in extreme fashion this month after Greece agreed to yet another bailout. The news was followed by the largest 5-day decline in the history of the VIX Index.

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Behind this illusion of stability, though, are a number of signs pointing to increasing fragility…

1) S&P 500 earnings are likely to decline (year-over-year) for the third consecutive quarter.

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2) S&P 500 sales are likely to decline (year-over-year) for the second consecutive quarter.

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3) Credit risk is rising with U.S. Investment Grade spreads approaching multi-year wides.

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4) High Yield credit is also weakening, with spreads widening and negative total returns over the past year.

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5) Breadth within the equity market is deteriorating. While the S&P 500 is near all-time highs, only 42% of stocks in the NYSE are above their 200-day moving average.

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6) The yield curve is starting to flatten again, with long duration bonds outperforming shorter duration issues (for why this matters, see our research on Treasury Bonds).

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7) Breakeven inflation rates are falling again as commodities collapse and expectations for global growth are declining.

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8) Industrials, a key cyclical sector that typically correlates with the broad market, is showing extreme relative weakness.

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9) Emerging Market currencies are moving lower again, with many currencies like the Brazilian Real at multi-year lows. This is major issue for Emerging Market companies that issued a record-high $276 billion of dollar-denominated bonds in 2014.

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10) The first rate hike in 9 years is getting closer. Fed Funds Futures are currently predicting a December hike, only five months away. This is the closest market expectations have been to a rate hike since 2009.

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“But No One Cares”

Collectively, these factors point to an equity market that is increasingly fragile and in the past one that was about to become much more volatile. The response from market participants today: “no one cares.” Volatility is low, stocks are still acting like a 6-month CD, and monetary policy is easy.

All true, but investing is about the future, not the past. No one knows when the Minsky moment of this cycle will occur, but a necessary precursor is low volatility and the illusion of stability. Add fragility to the equation and you have a powder keg just waiting to explode.

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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 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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Stocks Fall On…

Stocks are down today and you want to know why. We all do; the need to explain things is an innate characteristic of humans. A random walk down Wall Street doesn’t suffice. We want something more tangible, something in the news, something non-random.

There will be no shortage of explanations for today’s decline, ranging from a potential Greek default to China’s stock market collapse to a “technical glitch” that halted trading on the New York Stock Exchange.

For passive consumers of news, any of these rationales will serve their purpose (explaining the why) and are more or less harmless.

For investors, though, they can be quite harmful indeed. Why?

Because we are emotional beings and our impulsive response to bad news is to panic and sell after the fact. This would be bad enough on its own, but we also respond to good news and higher prices by panic buying (fear of missing out).

The S&P 500 is only down 4% from its recent all-time high (though it feels much worse because the S&P has been behaving like a risk-free CD). That pales in comparison to what we saw from 2000-02 (51% decline) and 2007-09 (57% decline). It also doesn’t yet measure up to the 18 previous corrections greater than 5% since the March 2009 low.

All of these corrections had fear-inducing explanations associated with them that seemed like the end of the world at the time. All were soon followed by new stock market highs.

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That may or may not be the case this time around. It could be another run-of-the-mill correction or it could be the start of something bigger. We’ll only know in hindsight. Regardless of what happens next, reactionary buying and selling is not likely to be a successful investment strategy. If you can’t handle a 4% decline in stocks, you own too much equities. Lower the beta in your portfolio to your risk tolerance, to the point where you can sleep at night.

This is not to say that being more tactical, especially at this point in the cycle, is unwarranted. As I wrote on the six year anniversary of the bull market in March of this year, the next six years is not likely to mirror the last. This should favor more active strategies, particularly ones that focus on risk management.

It’s just that the execution of such a strategy should be systematic and unemotional. In plain English: you need a process to stand a chance. If you sell today, when do you buy back in and what is the catalyst for doing so? If you can’t answer that question with a repeatable process, stick to your investment plan. If you still feel the need to be more tactical, outsource it.

The news should play no role in how you manage your money because the news tells you what has happened, whereas investing is about anticipating what will happen. The time to think about and position for rising risk in markets is ex ante, not ex post. By the time the October 2002’s and March 2009’s come around, it’s too late.

Now back to your regularly scheduled program

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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 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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