All posts by Charlie Bilello

Lower Earnings, Higher Stock Prices: The Voting Machine

“The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers.”- Graham and Dodd, Security Analysis

Earnings drive stock prices, so says investing lore. As earnings rise, stock prices move higher. As earnings fall, stock prices move lower. If it were only that simple.

With the S&P 500 hitting new all-time highs, earnings should be exploding higher. To the contrary, for the 2nd consecutive quarter, they are moving lower. With 92% of companies reported, S&P 500 earnings have declined 13% in the first quarter of 2015. This follows a 14% decline in the prior quarter.

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What about the top line?  Surely this just an accounting issue.

But sales growth is also showing a decline, -1.8% over the prior year, the first year-over-year decline since 2009.

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What about sectors? Surely the decline in earnings is solely due to Energy which had a terrible quarter due to the collapse in Crude.

But six out of the ten major S&P 500 sectors showed year-over-year declines, including both consumer sectors which were supposed to have benefited most from the decline in gas prices.

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So how in the world are stocks hitting new all-time highs? As Graham and Dodd said, the stock market is a voting machine that responds to factual data only as they effect the decisions of buyers and sellers.

Buyers and sellers have become fixated on one fact and one fact alone: easy monetary policy. While earnings and economic data have been weak in 2015, the Federal Reserve has responded by becoming increasingly dovish.

Expectations for the long-awaited rate hike off 0% have been pushed all back to December, with Fed Fund futures now predicting there is only a 50% probability of that occurring. We are only a hair’s breadth away from expectations moving to 2016.

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And so it is not earnings that drive stocks prices but the multiple investors are willing to pay for those earnings. While earnings have declined, investors have been happy to pay a higher and higher multiple as long as interest rates remain at 0%.

When will that change? When investors choose to respond to other data beyond monetary policy or when the Fed chooses to finally raise interest rates after nearly seven years. Not as intellectually satisfying as “earnings drive stocks prices,” but that’s what actually moves markets in the short-run.

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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Bond Math and the Elephant in the Room

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What are you expecting from the bond portion of your portfolio over the next six years? 5%? 6%? 7%? These would all have been reasonable expectations in the past, but past is not prologue, especially when it comes to investing.

Whatever number you were thinking of, it is likely too high. Why?

  • The largest Bond ETF (BND) with over $27 billion in assets (Vanguard Total Bond Market ETF) has a yield of only 1.95%.
  • The second largest Bond ETF (AGG) with $24 billion in assets (iShares Core U.S. Aggregate Bond ETF) has a yield of only 1.85%.
  • The U.S. 10-year Treasury yield is currently 2.27%.

What does this have to with returns? As it turns out, everything.

In the bond market, the beginning yield has been the best predictor of forward returns bar none. The lower the starting yield, the lower the future return. The linear relationship is clear in observing the chart below.

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As you can see, we are in uncharted territory today, off the graph in terms of an extremely low starting yield. There is not yet a six-year precedent for future returns starting from such a low yield. But unless the math on bonds has changed, we should be expecting among the lowest returns in history in the coming years.

There are only three sources of returns for a bond: (1) return of principal, (2) interest, and (3) reinvested interest from coupon payments. Before maturity, the value of bond will move higher and lower based on the direction of interest rates, but in the end your total return is likely to closely mirror the beginning the yield.

This is true for government bonds. For riskier issues like high yield bonds and leveraged loans, investors will also have to factor in default risk and a potential haircut to their return of principal.

For over 30 years, interest rates have been falling, a tailwind for both stock and bond investors.

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But that prior tailwind comes with a price: lower future returns. Bonds have returned an average of 7.8% per year since 1976 (Barclays Aggregate Bond Index). If we’re being objective, they are unlikely to come anywhere near this return in the coming years.

We are already seeing the effect of low yields in looking at the largest bond ETF (BND) which has produced a total return of 6.17% over the past three years. That’s a 2.02% annualized return. During this period we saw bond prices fall as rates rose sharply in 2013 and bonds prices rally as rates fell sharply in 2014. In the end, though, the low starting yield was the overwhelming factor.

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Elephant in the Room

As much as we would like to, we can’t change bond math. What we can do is start talking about this elephant in the room and what, if anything, to do about it. Low single-digit bond fund returns are not something most investors, both retail and professional, are preparing for.

But what can an investor do? Some options include:

(1) Saving more, spending less, retiring later.

(2) Taking more risk with an increased weighting to higher yielding bonds in the U.S. or emerging markets.

(3) Taking more risk with a higher weighting to equities.

The second and third options require changing ones risk tolerance which is neither easy nor advisable for most investors, particularly those nearing retirement. They also assume that returns will be sufficiently higher in those asset classes to compensate you for the additional risk, which may not be the case given the low yields in junk debt and high valuations in U.S. equities.

Which leaves us with the most unpalatable but also the most realistic option: expecting lower returns in the years to come and adjusting your lifestyle accordingly. Which is why it is the elephant in the room; who wants to talk about that?

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 Cardinal Sin: Missing Out

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The greatest fear in the investment management industry is not what one might expect. It is not losing money but the fear of not making enough money when the market is moving relentlessly higher. This “fear of missing out” strikes terror into the heart of portfolio managers as clients will simply not tolerate it; it is the cardinal sin of the business.

The thinking was explained to me as follows. Lose money when the markets are going down and everyone else is suffering and you’ll be just fine. But fail to capture maximum upside during a raging bull market and you’ll soon be out of a job.

Since 1928, the S&P 500 has generated an annualized total return of 9.3%.

What if I told you that it was possible to exceed this return but in order to do so you had to be willing to accept only 63% of the upside when markets are moving higher? If you’re being honest, you’ll say that capturing only 63% of the market’s gain in up periods is unacceptable. There’s no way you would sit on your hands through those periods without the fear of missing out getting the better of you.

In our recent research paper on Lumber and Gold, this is precisely the upside capture ratio we illustrated in a strategy that outperformed the S&P 500 by roughly 4% per year over multiple market and economic cycles. How in the world was that possible if you only captured 63% of the upside?

Good question. As it turns out, the strategy did so by focusing on something way more important than participating on the upside: protecting on the downside. By limiting the downside capture ratio to only 31% over time, the strategy was able to not only outperform the broad market but do so with lower volatility and lower drawdowns. These secondary attributes (lower volatility and drawdowns) can be more important than returns, as they increase the likelihood than an investor will actually stick with a strategy.

Going back to 1928, if you had consistent upside capture of 63% while limiting downside capture to 31% in U.S. equities, you would have generated an annualized return of 12.9%. Contrast this performance with a more aggressive strategy that outperforms the market during up periods (110% upside capture) but exceeds the market’s losses in down periods (130% downside capture). The difference is telling. The aggressive strategy underperforms the S&P 500 by 3.6% per year (with higher risk) while the defensive strategy outperforms by 3.6% per year (with lower risk).

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But back to my initial assertion, that few managers would pursue such a defensive strategy in the first place due to the fear of missing out on upside. This is particularly true today, over six years into a bull market and four years without a sizable correction. Would you buy into a strategy that underperformed the S&P 500 by 14% over the past 3 years as this one has? Would your clients let you?

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Similar to the mid to late 1990’s the last few years have featured runaway gains in U.S. equities. Any strategy that was built to minimize downside over this time has dramatically underperformed as there has simply been no downside to capture.

While some would view this as flaw in these strategies it is the only way they can work over time. In order to minimize downside you have to be willing to give up upside in return, and by extension this means underperforming during runaway phases in bull markets. There is no other way if your primary goal is to protect capital.

The tide always turns and while out of favor today, preserving capital and managing risk will be back in vogue once more, but only after the declines occur. In the meantime, what will keep most investment managers awake at night is the greater instinctual fear – the fear of missing out – on another 1999-2000 blow off move and not being long enough.

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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