October 9, 2015
By Steve Blumenthal
“Facing up” to returns that will be less than the historical norm is the “single largest factor out there we have to deal with.”
– AQR’s Cliff Asness
Valuation work seems to be showing up everywhere. Being the data geek I am, each month I like to take a look at the most recent data (posted at month end based on prior 12-month earnings) and I see 2% to 3% annualized 10-year forward bond and stock market returns. That just doesn’t feel very good.
I’m writing from Hotel Zaza in downtown Dallas. What a place! Last night I presented at the Bloomberg ETF Masters Class. On the panel with me was a gentleman representing a large ETF issuer, a fellow ETF strategist and an expert in ETF trade execution. I always learn something new. It’s been well worth the trip.
Do you recall the Carl Icahn vs. Larry Fink (BlackRock) ETF liquidity debate? Essentially, Icahn blames BlackRock for bond market volatility and he sees a coming liquidity crisis due to ETFs. My question to my panelist friends was, “bank trading desk liquidity is gone. It has shifted to ETFs. Where do you fall in on the liquidity issue especially as it relates to less liquid bond markets (EM, bank loan and HY)? If there is a rush to the fire exit, what happens?
The answer lies in the diverse set of investment participants that surround our capital markets’ ecosystem and the size of a particular asset class relative to the total size of its market. For example, HY ETFs make up just 2% of the overall HY market. Not a liquidity issue and there are a number of highly liquid, highly correlating assets like small cap stocks that market makers and other market participants can use to source liquidity. Can markets dislocate? Sure, but none of us see ETFs as being the trigger. A far less liquid exotic type ETF can have issues. How big is the market? Who are the buyers? Focus on the liquid ETF instruments. I loved the bus cartoon above; however, Icahn is wrong.
Included in this week’s On My Radar:
- Valuations Through September Month End
- What’s Your 2016 Target Allocation Look Like?
- Trade Signals – No Go Says Big Mo, Zweig Model Bullish On Bonds (10-7-2015)
Valuations Through September Month End
Chart 1: Median PE (note overvalued and undervalued price targets – circled in blue)
- Also note a better median PE at 20.2. Still in the most expensive quintile of historical PEs but better.
Chart 2: Stock Market Cap as a % of Gross Domestic Income
- Still in bubble territory
Chart 3: Price to Sales
- Expensive
Chart 4: Price to Operating Earnings
Chart 5: Various – Market Remains Overvalued but off of highs
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What’s Your 2016 Target Allocation Look Like?
The market is expensively priced. We are in Quintile 5 (most expensive). Past periods of overvaluation have historically lead to 10-year annualized returns of approximately 3%. I’m setting my sights on Quintiles 1 and 2; even Quintile 3 is attractive. The big opportunities are Quintiles 1 and 2 with probable forward 10-year annualized returns in the 14% to 16% range.
I noted last week that David Swensen has the Yale Endowment positioned into Alternatives (absolute return, leveraged buyouts, venture capital, real estate and natural resources). The university said its fiscal 2016 asset allocation targets are as follows:
- Absolute Return: 21.5%
- Leveraged Buyouts: 16%
- Foreign Equity: 14.5%
- Venture Capital: 14%
- Real Estate: 13%
- Natural Resources: 8.5%
- Bonds and Cash: 8.5%
- Domestic Equity: 4%
Source: MarketWatch via 361Capital
As an interesting point of reference, here is a look at their June 2014 asset allocation targets:
Here is a comparison of Yale vs. other educational institutions:
I’m pretty sure Yale is not too happy with their Natural Resources allocation given the 2015 all-out rout in commodities. Additionally Absolute Return in general (categories such as managed futures, arbitrage, long/short equity, market neutral and tactical) has done ok; however, the category has underperformed buy-and-hold equity over the last five years. The point is to create a combination of diverse sets of risks and most risks found it tough to beat the QE, Fed induced, equity market, asset inflation party.
Yale states, “The heavy allocation to nontraditional asset classes stems from their return potential and diversifying power. Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management.”
Moving into 2016, Yale has upped their allocation to bonds and cash, further reduced domestic equity to just 4% and slightly increased foreign equity, natural resources and absolute return strategies.
Easy for Yale to do. Try explaining this to your client who compares everything you do to the market. As Jason Hsu put it, “People make bad decisions all the time… everywhere.” Yale has a very long-term investment time horizon. Why do they not just buy equities and hang on? Show the above allocation mix to your client when they compare the diversified goals-based investment portfolio you created for them to the market (typically the DJIA and S&P 500). It would be so nice to pick the best asset class all the time. That doesn’t happen.
The Fed is boxed into a corner. The U.S. economy is ok yet the global economy is near or in recession. Inflation is tame. Party on? That’s the buy-and-hold bet. Yale’s not biting. This is where I believe valuation metrics tied to probable 10-year forward returns can help us all with portfolio positioning. Clients are expecting 8% or more from equities. We are in a statistically probable 10-year forward return (expensively priced) period that is forecasting just 2% to 3% annualized for equities. Opportunity will present. Stay patient.
Next is something that you can do while you wait for a better buying opportunity.
Hedging Your Equity Exposure
I continue to favor 30% Equities (hedged), 30% Fixed Income and 40% Alternative (defined as anything other than traditional buy-and-hold). Find complimentary (low-correlating) ETFs, funds and strategies to build your alternative bucket just as you’d diversify your equity and fixed income allocations.
One of the great advantages advisors and individuals have over large endowments and pensions is the ability to source liquidity quickly. One of the great disadvantages is that many individuals are unable to gain access to exceptional hedge fund managers or private equity funds. Though you can get close enough.
I’m just finishing a white paper on The Total Portfolio Solution. I hope to get it published and up on our website soon. The paper looks at combining low-correlating strategies, position sizing and what I call bucket sizing (when to tactically overweight or underweight equity, fixed income and alternative exposures).
Let’s look at one particular area – hedging your equity exposure today.
Assume that your portfolio is 30% allocated to equities. Further assume that mix is made up of 14% large cap, 5% mid cap, 3% small cap, 3% emerging and 5% international developed equities.
The ETF revolution has created many liquid tools for you and me to use. Once such tool is option contracts on various ETFs like SPY (the SPDR S&P 500 Index).
During periods when the market is expensively prices, consider using put options to hedge out much of your downside risk. Here is one idea:
I favor buying 2% out-of-the-money puts (typically two months to expiration) and at the same time selling 7% out of the money puts. A put option gives you the right to sell a stock or ETF at a defined price. It costs money to buy that right (think of it like downside protection insurance).
If your stock is priced at $100 today, in this example, you could buy a put option that gives you the right to sell your stock at $98. When the market declines in price, your put option goes up in price. In this example, if your stock declines to $90, you make the difference between $98 and $90. Your stock lost $10 but your hedge gained $8. You don’t have to sell your stock and you protected much of your downside.
Of course, there is a cost to buy the put protection so if you keep on doing this type of hedge and your stock continues to go higher the costs will eat into your long-term gains. So the big question is, just how expensive is it to hedge? The next big question is, when to do it?
I’m in the camp that believes there are some environments that favor hedging and others where there is no need to hedge. When the hamburgers are cheap, no need to hedge. Most of the downside has taken place, risk is less and forward returns much greater. When expensive, like today, hedge.
Statistically, most stock market corrections are in the 5% to 7% range. Given this, I favor buying 2% out-of-the-money puts (a cost) and selling 7% out-of-the-money puts (a credit). Doing this you limit the maximum amount of protection you put in place to 5% but by selling the deeper out-of-the-money puts, you limit the overall cost to hedge your stock exposure. I believe that such an approach may be implemented with close to a zero net cost for the downside protection.
But 5% max protection might not be good enough, you say. I get that, but think in terms of how you might roll that protection down as your stock exposure continues to decline. The goal, of course, is to continue to protect on the way down. You have to manage your exposure and continue to roll your put protection out approximately two months forward (making that adjustment about once every month).
Another approach is to buy 20% out-of-the-money put protection. This is a relatively inexpensive way to protect against the big declines that typically come during recessions. If your stock is at $100 today, consider the $80 put options that mature about three to four months from now. If your stock goes up to $110, roll your put protection to $88 (or 20% below the current prices).
Personally, I favor a combination of writing covered calls along with the 2/7 out-of-the-money put hedging process and when our CMG NDR Large Cap Momentum Index is in a sell, buying deeper out-of-the-money puts or some other form of hedging as risk is then generally higher.
Talk to an options specialist. Your broker-dealer may have one in house or your custodian (Fidelity, TD, Schwab, and Pershing) likely has an options team. Further, learn more about hedging through the CBOE.
Finally, innovation is alive and well. While trading options is easy to do, it requires additional paperwork and may be difficult to implement across a large number of client accounts. Then there is the “try explaining this” to your client challenges. There are mutual funds that buy stocks or index exposure and do some form of active hedging packaged within the funds structure. There are funds that use moving average crossovers to put risk on and take it off. The idea is to mix a number of equity risks in your equity bucket that are hedged and/or add stocks and low fee ETFs that you can hedge yourself.
The main point is that you can build your equity portfolio exposure in a smart way. Call us if you need a few ideas.
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Trade Signals –
- Cyclical Equity Market Trend: Sell Signal
- CMG NDR Large Cap Momentum Index: Sell Signal on June 30, 2015 at S&P 500 Index 2063
- 13/34-Week EMA on the S&P 500 Index: Sell Signal
- NDR Big Mo: Sell Signal on October 2, 2015 at S&P 500 1951
- Volume Demand is greater than Volume Supply: Sell Signal for Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Extreme Pessimism (short-term Bullish for stocks)
- Daily Trading Sentiment Composite: Extreme Pessimism (short-term Bullish for stocks)
- Don’t Fight the Tape or the Fed: Indicator Reading = -1 (Negative for Equities)
- U.S. Recession Watch – My Favorite U.S. Recession Forecasting Chart: Signaling No Recession
- The Zweig Bond Model: Buy Signal
Click here for the link to the charts.
Personal note
I’m rushing to finish up today and look forward to heading home. Dallas was productive. A special call out to Joe Alexander and ex-Navy fighter pilot Jeff Kennedy. They joined me for a dinner hosted by Ethan Kahn from Wolverine. John Mauldin, with full-on Texan hospitality, ordered for the table. I had my sights set on a steak but he advised that was not the best pick. The brisket and ribs didn’t disappoint.
Susan’s son Tyler is coming home to visit this weekend. There has been a quietness in the house since he left for college in August. To say he is missed is an understatement. Brianna is heading to Penn State for homecoming weekend then looping back through Philly on her way to work. There is a soccer tournament and some golf in the lineup as well and a big family dinner Monday evening. Our collective six kids plus cousin Tommy means a lot of food to be prepared. I can just hear the boys now… what’s for dinner? When are we eating? I so love the dinners when we are all together.
Trust Company of America is hosting its annual “Focus on the Future” advisor client event later this month. Las Vegas and Scottsdale follow. I’ll be speaking at the Alternative Asset Summit October 28 – 30 at the Wynn Las Vegas and I’ll be presenting on portfolio construction and best execution at IMN’s Global Indexing & ETFs Conference in Scottsdale December 6-8. Let me know if you will be in the area. I would love to get together.
Have a great weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO. Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.
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A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
Trade Signals History: Trade Signals started after a colleague asked me if I could share my thoughts (Trade Signals) with him. A number of years ago, I found that putting pen to paper has really helped me in my investment management process and I hope that this research is of value to you in your investment process.
Provided are several links to learn more about the use of options:
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions. We do not offer options strategies at CMG.
Several other links:
http://www.theoptionsguide.com/the-collar-strategy.aspx
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