S&P 500 Index 1685
By Steve Blumenthal
July 31, 2013
I met Rob Arnott several years ago at John Mauldin’s 60th birthday party and have been a big fan since. Yesterday I visited with Rob at the Four Seasons Hotel in Philadelphia. He was presenting his thoughts on the markets, forward expected returns, demographics and how he guides positioning in the PIMCO All Asset All Authority fund. It was an insightful few hours.
I liked how Rob sensitively addressed an advisor’s question related to investor behavior. Rob’s fund is down approximately 5% year-to-date when the S&P 500 Index is up close to 20%; though overall he has an enviable track record.
The advisor asked how he should explain this to his upset client. Rob answered, “everyone compares everything to the S&P: not wise and not appropriate” and added, “our business is the only business in the world where people enter the store and race to the checkout counter to buy after prices go up 20% and avoid the store all together when prices decline 20%.” They should be doing the exact opposite.
I believe that how funds and strategies are combined in the portfolio is critical to both return and, importantly, risk control. Many investors (maybe most) incorrectly compare whatever they have to the S&P 500. Why not compare to biotech? It’s up 48% year-to-date; or domestic 60/40? It’s up approximately 7.4% year-to-date. What about bond total returns in 2008 vs. the S&P? We’d all like to pick the best gainer each year.
Investing is about combining a diverse set of risks together within a portfolio. Narrow focused targeted bets are just that – bets. Rebalancing from what is overvalued to what is undervalued in a disciplined way is prudent and can enhance return. Few are rushing to Rob’s store.
I like buying great talent when it is on sale, not when it is marked up. We’ll be doing some correlation work to see how Rob’s global macro like fund fits with our favored strategies.
Fortunately, you are in a position to help a lot of people; though along the way you may be more psychologist than investment advisor. It is a challenging business to say the least.
How do we help save our clients from their worst instincts? I think it is in a well constructed investment game plan combined with great coaching from you to help your client stay on plan.
I featured an interview with Rob in a recent On My Radar. Click here if you missed that interview.
Following are the most recent Investor Sentiment charts, an update on the Cyclical Bull trend and a new version of the Research Affiliates 10-year forward expected return chart (updated by PIMCO) as presented by Rob at yesterday’s meeting:
Investment Sentiment charts 7-30-2013:
Sentiment Chart 1. NDR Crowd Sentiment Poll – Extreme Optimism (Bearish) -hedge core equity exposure.
Investor Sentiment has quickly moved back into the Extreme Optimism zone. I favor putting hedges in place at points of Extreme Optimism and removing hedges at points of Extreme Pessimism. Note the prior Extreme Optimism peaks at 71.6, 68.3, 70.70 and 73.
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the 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.
Sentiment Chart 2. NDR Daily Trading Sentiment Composite – Neutral
This daily sentiment chart also supports a mildly bullish trading view.
The cyclical bullish trend remains in place as reflected on the next two charts.
Both the 13/34-Week EMA and Big Mo Cyclical Trend Charts remain bullish.
- I’ll reflect the charts again next week (see last week’s charts here)
Research Affiliates (PIMCO’s) updated as of June 30, 2013 Forward Expected 10-year return for 60/40:
My two cents: Risk remains elevated. Risk protect core equity from time to time (I favor Investor Sentiment extremes as a risk on risk off tool), reduce equity exposure, reduce fixed income exposure and build out a third bucket of four to six non-correlating tactical strategies. Let me know if you would like us to show you how we can help you build the third bucket and provide you with a simple total portfolio presentation for you to show your client.
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.
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
I continue to favor a hedged approach towards long equity positions put in place from time to time tied to Investor Sentiment extremes. The cost of collared option protection (selling out of the money covered calls and buying out of the money puts) is relatively nominal compared to the potential downside market risks. I am looking for Extreme Pessimism Sentiment readings tied to logical technical support (1440-1460 first support area) as a point to remove the option hedge.
33/33/34 – My broader view is outlined in a piece called The Portfolio Construction Game Plan for 2013.
Modern Portfolio Theory is alive and well. The problem is that most portfolios do not include a broad enough set of important risk diversifiers and far too many individual investors chase into and out of the stock and bond market.
60/40 is not diversified in a low yield, low dividend, relatively high PE valuation world, yet those asset categories are important within the construct of a broadly diversified investment portfolio and the risks can be inexpensively hedged from time to time.
To me, a balanced portfolio today is comprised of 33% Equity (hedged from time to time), 33% Fixed Income (tactically managed) and 34% Tactical-Trading-Alternatives. Of course, you may allocate differently based on your risk level, age, needs, time horizon, etc.
The forward projected 60/40 expected return of just 4.37% is the lowest expected return in the last 14 decades. Source: Expected Returns – Research Affiliates. Here is a link to the Expected Return charts on our website.
The good news is that there remain ways to drive returns. I believe portfolios can be constructed in such a way as to drive return whether one is correct or incorrect in his forward view. I favor a broader allocation of 33/33/34 that includes an allocation to tactical and other liquid alternative investments. Endowments have managed towards broader diversification for years and I believe the approach better captures the core principals of Modern Portfolio Theory (MPT).
MPT is “a mathematical formulation of the concept of diversification in investing with the aim of seeking a diversification of investment assets that has collectively lower risk than any individual asset”. 60/40 falls exceedingly short of meeting this definition.
Given the global macro risks that exist today, as well as the relatively high valuations, low dividend yields and low interest rates, some form of proactive risk management makes sense to me. One day soon (maybe within the next five years), PEs will be much lower, dividend yields will be much higher and interest rates will be much higher.
Opportunity will present itself in a period of crisis and while others are panicking out, you’ll be in a position to capitalize. Until then, I favor a broader portfolio construction approach (33/33/34) that includes a disciplined hedging strategy to protect the long-term focused equity portion of your portfolio(s).
Trade Signals was created with the intention of providing a disciplined process to hedge the long-term equity portion of a well diversified portfolio. You will be right from time to time and look like a genius in those moments and, frankly, you will also be wrong from time to time and look less than spectacular. I am far less concerned about getting a short-term directional call correct. I am more concerned about making money. For me, it is about inexpensive risk management in a high risk world. The cost of protection is nominal if executed correctly.
Investor sentiment indicators have helped me over the years and I hope that the statistical math behind investor sentiment extremes (human behavior) can help enhance the risk management of the equity portion of your portfolio(s) as well.
Overview: A disciplined equity hedge – risk management approach
Several times each year investor emotion reaches levels of Excessive Optimism and several times each year emotions reach levels of Extreme Pessimism. A strategy idea I favor is a disciplined risk management equity (hedge) approach as it relates to the long-term equity portion of a portfolio. Initiate hedges when investor sentiment reaches Excessive Optimism and remove hedges at periods of Extreme Pessimism.
A collared option strategy which involves writing covered out of the money calls and at the same time buying out of the money puts is something to consider. It is a relatively inexpensive hedge approach and allows your client to stay on plan with their long-term equity exposure. The game plan is to implement the hedge just a few times each year tied to sentiment extremes. Today is one such extreme. Then remove hedges tied to Extreme Pessimism. Go to www.cboe.com and search for “collared option strategy” to learn more. I favor selling 5% out of the money calls and buying 5% out of the money puts with maturities several months out. It is important to manage to your risk tolerances/investment objectives but at most budget spending a small percentage of your equity exposure each year.
Given the overbought extremely optimistic nature of the market today, I believe spending a small amount of money to protect that long exposure is prudent.
Please note that this is absolutely not a recommendation to buy or sell any security. For discussion purposes only.
A note on active hedging
Within the long-term secular bear environment I believe we are in, I favor hedging the long-term equity portfolio exposure tied to periods of Extreme Optimism and removing those hedges tied to periods of Extreme Pessimism. As you can see in the above charts, there are just a few times each year that the market moves into “Extreme”. I like put options and covered calls against long equity exposure. Never sell “naked” put or call options. Another idea is to budget a percentage of your long equity exposure to actively put on and take off exposure to a leveraged inverse index based ETF.
I believe that we are in a period of time which favors actively hedging long equity exposure. I like putting hedges on when investors are extremely optimistic and removing hedges when investors are extremely pessimistic. The focus on the long equity portion of your portfolio is to enhance return, reduce risk and preserve capital. Go to www.cboe.com to learn more about options. All investments involve risk.
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