Volatility is Not Risk (Carnevale)

Friday, April 13th, 2012

by Chuck Carnevale, FAST Graphs

This article was inspired by Roger Nusbaum’s post on his Random Roger blog – Sunday Morning Coffee on Sunday, April 8, 2012.  Roger is a highly respected financial blogger that I believe is genuinely interested in providing his readers meaningful and prudent investment advice and guidance.  Therefore, I have a great deal of respect for his work and intentions. On the other hand, Roger and I often disagree on certain investing principles, especially those that deal with asset allocation, proper diversification and the definition of risk.  However, I would hope that he respects my differing views as being offered with the same best of intentions, as I see his offerings.

The Greater Risk is People’s Reaction to Volatility

Roger’s blog dealt with his feelings about a recurring theme in Barron’s over the weekend referencing people’s complacency for risk. The first part of his writing dealt with the risks associated with the utilization of puts.  On this subject, Roger and I are in agreement.  However, the second part of his blog talked about what he obviously felt was the great risk of using dividend paying equities as an alternative investment choice.  The following excerpt introduces his views, which frankly, up to this point, I take little exception to:

“The other point from Barron’s (this was repeated in a couple of places) was a repeat of the idea that the Fed’s interest rate policy (and the other attempts to stimulate the economy) are forcing investors into other instruments to seek a “reasonable return.”

However, I do take exception to his next paragraph as I felt that it is overstating the risk associated with the utilization of dividend paying stocks for two primary reasons.  First of all, his assumption that a bear market will provide a tragic outcome because dismayed investors will panic is more assumption than fact. Second, his last sentence insinuates, at least in my opinion, that dividend paying stocks are not safe investments.

“I hate this line of thinking. It would be great to get a “reasonable” rate of return from cash and treasuries but for now that is not the case. That people put what should be their low risk dollars into higher risk instruments to get a return they used to get from cash has tragic outcome written all over it. If there is another bear market before interest rates normalize there will be an avalanche of dismayed investors panic selling their dividend stocks because they thought the stocks were “safe.”

But it was with the last couple of sentences of his blog post that I took the greatest exception.  More precisely, I found that his example of Phillip Morris International (PM) to be misleading.  However, not because of what Roger included, but rather because of what he left out. I will elaborate more right after the following excerpt where he closed out his blog post:

“All stocks have strong and weak holders and I promise you that the weak holders will sell into the face of something bad–this is normal market behavior and has nothing to do with the merits of a stock or a strategy. I believe a client holding Philip Morris Intl (PM) is favorably viewed by the dividend crowd yet it went down 32% from when it spun off in March 2008 into the March 2009 low–weak hands not bad stock.”

It is certainly possible, and perhaps even probable that Roger is correct in assuming that so-called “weak holders” may in truth do as he suggests and panic sell. However, I believe a lot of that “normal market behavior” can greatly be attributed to the preponderance of negatively biased information that is promogulated upon the general public, especially regarding equities and how risky they are.  In other words, if people were offered a more reasoned perspective, then perhaps much of the irrational and catastrophic panic selling that Roger alludes to could be avoided.

The following analysis utilizing the F.A.S.T. Graphs™ earnings and price correlated research tool on Philip Morris International illuminates the important parts that I feel Roger’s comment left out. Roger is correct regarding how far that Philip Morris International’s stock price dropped, as can be seen by reviewing the black monthly closing stock price line marked by the flags on the graph.  Phillip Morris International’s stock price did, in fact, fall by the 32% plus number that Roger presented, and as he also stated, can most likely be attributed to “weak hands.”  However, what his comment left out was the fact that the company’s operating earnings were stable and continued to grow.  More simply stated, the stock price fell even though the company’s operating results remained strong and solid.

Therefore, investors armed with that information could have seen that this low point in Philip Morris International’s stock price represented an incredible opportunity not a high risk. The smart money (strong hands) would have added to their positions in this high-quality company that was continuing to post good results and raised its dividend every year, rather than sell out.  However, even if no one added money and simply held on they would have been given a substantial increase in their dividend each year and had their stock price rise from the original $50 a share to the more than $80 a share that it currently trades at (see flags on graph). The risk was not in the volatility itself, true risk would have been irrationally reacting to the volatility.

My point is that price volatility in itself is not risk, in my opinion, true risk is how people react to volatility when it occurs. Moreover, I believe that the reason there are so many “weak hands” is because of the weak information that investors are inundated with.  Knowledge is power, and I believe that if people were provided with greater knowledge on how equities, especially dividend paying equities, truly work, then we would be cultivating a lot more strong hands.  At the end of the day, this could also reduce the level of volatility by reducing the level of panic that would result from a better informed public.

Risk, Diversification and Prudent Behavior

In an attempt to summarize my views on diversification and how they differ from Roger’s I offer the following.  The principles of proper diversification are both important and sound, and therefore should never be neglected when developing an asset allocation strategy.  Moreover, the principles of proper diversification are valid and necessary when dealing with uncertain markets, but especially during times when markets are functioning (plus or minus) in a normal manner. Therefore, I am comfortable with and embrace a strategy of diversifying across numerous asset classes as long as each asset class makes sound and prudent economic sense at the time. However, when, and if, an asset class sits at an extreme level, then I feel it is imprudent to utilize it for the sole sake of so-called diversification.

I believe bonds of all types are currently sitting at such an extreme.  Traditionally thought of as safe investments, I believe that over the next four or five years bond prices could show more downside volatility than equities did even during the great recession of 2008.  Under normal times, bonds would offer yields that were several percentage points higher than quality dividend paying stocks.  Consequently, bonds were attractive due to the higher level of income they offered and were relatively stable as long as interest rates remained within historical normal ranges. Today that is not true.

As a result, I currently eschew the asset class bonds in favor of high-quality blue-chip dividend paying stocks. To be clear, when bond yields move back to more normal levels I would once again be happy to embrace including them in a properly diversified asset allocation plan.  But at today’s low rates, I believe that the traditionally safe bond has become one of the riskier asset classes, especially if you consider the potential for high volatility with their prices as risk. My point is, my aversion to bonds is a temporary one that would change if and when interest rates normalize and stabilize.

Therefore, to mindlessly invest in an obviously dangerous asset class for the sole sake of diversification does not make sense to me. We believe that investors should always think their way through the process of allocating their assets when building their portfolios. On the other hand, I don’t believe that money should be forced into an asset class when it doesn’t make economic sense just because you hold the notion of diversification as sacred.

Diversification when properly applied is a great way to control risk.  But investing in an asset class that is upside down solely for the purpose of diversification when it can be obviously avoided makes no sense to me.  Technology stocks during the 1999 bubble were a case in point. All you had to do was run the numbers and you could have quickly determined that there was no economic value in technology stocks at that time.

In contrast, today when looking at quality blue-chip dividend paying stocks that are trading at historically low valuations thereby offering above-average and growing yields, makes a lot of sense to me. I would argue that because of historically low valuations, they have never been a safer investment choice than they are today. And, the only reason to consider a Dividend Aristocrat or a Dividend Champion, at least to my way of thinking, is because you intend to own it for a very, very long time. Therefore, you cannot avoid short to intermediate term volatility, nor should you try.  Instead you should accept it as an unavoidable fact of the market. Otherwise, a record of increasing the dividends every year for 25 straight years or more doesn’t really seem relevant, unless you were going to hold for many years.

Not All Price Drops are the Same

A final point I would like to introduce is the idea that not all price drops are the same.  Sometimes the drop in a company’s stock price is justified and the harbinger of real systemic issues. At other times, a drop in the price of a stock can represent an incredible opportunity to buy an excellent business that has unjustifiably gone on sale.  Making these distinctions regarding volatility is a critical differentiation that should be made.

Furthermore, it’s also valuable to be able to identify and determine whether an interruption of a company’s business is a temporary one or a more permanent phenomenon.  Because, there are times when the drop in price of a stock is a sell signal, and there are times when it represents an attractive buying opportunity. The following discussion is offered to illustrate examples of the many faces of stock price volatility to include the good, the bad and the ugly.  These are just a few select examples, and there are many others that I could have used.

Bank of America an Ugly Price Drop

Our first example looks at Bank of America (BAC), and represents a quintessential example of an operating meltdown due to the now infamous financial crisis. Bank of America’s stock price fell from a high of over $55 to a low of $2.53, which followed an earnings collapse from $4.65 in calendar year 2006 to a loss by calendar year 2009 (see red highlight at bottom of graph).  Therefore, since both earnings and price collapsed, not only was the price drop justified, but the recovery may be years away, if ever.  This is why I consider this an ugly price drop.

General Electric – a Bad Price Drop and an Ugly Price Drop

In the case of General Electric (GE), there are actually multiple variations of different kinds of price drops.  First, we can see that in calendar year 2000 General Electric’s stock price had become massively overvalued.  Consequently, even though earnings continued to look good for several years, the falling prices in 2001 and 2002 were justified due to excessive valuation. Then, of course, we see a price drop where prices followed earnings down during the financial debacle in 2008 and 2009.  In this case, recovery should be sooner than what we saw with Bank of America, although it still looks like it’s still going to be many years away. 

Wells Fargo – a Bad Price Drop Getting Better

Wells Fargo & Co. (WFC) represents a financial that had a bad price drop that followed a similar drop in earnings.  However, earnings have subsequently recovered and stock price recovery has already been good to the extent that it may soon eclipse historical highs.

Cognizant Technology Solutions – A Good Price Drop

My last example looks at a company that had its stock price drop significantly during the great recession, while operating earnings continued to increase at a very strong rate.  Consequently, this represents an example of a good price drop that created an extraordinary bargain.  Therefore, price recovery has already dramatically exceeded historical highs (see price flags on graph).

The point with this exercise was simply to illustrate that a drop in a company’s stock price is not always a bad thing. Sometimes it is, as we saw with the Bank of America example, and sometimes it represents a great opportunity as illustrated by the Cognizant Technology Solutions’ example.  I believe that investors need to make these types of distinctions in order to truly be able to make sound and proper buy,sell or hold decisions. In other words, sometimes the price drop is justified and sometimes it’s not.

Summary and Conclusions

As I mentioned in the opening of this article, it was inspired by comments that were made by a financial blogger that I respect.  On the other hand, there was much about what he wrote that I disagreed with,and therefore, I felt compelled to offer my opposing views.  On the other hand, I cannot argue with his position regarding weak or strong hands.  It is true, that many investors, because they are ignorant of the facts, can and will panic during periods of market turbulence.  However, what I disagreed with most was the fatalistic attitude surrounding the notion that equities were bad because investors would panic.

I once read a quote attributed to Bob Veres, a respected columnist for the financial planning community that at its essence summarizes my view. I offer it as a pseudo-quote because I maybe interjecting a little paraphrasing:

“the definition of an excellent investment advisor is one who possesses the courage and integrity to insist that his clients do what they should do, rather than what they want to do.”

In my way of thinking, I believe it is our responsibility as professional financial advisors and bloggers to educate our clients and readers to factual and valid principles of sound investing practices.  To suggest that it’s a bad idea for investors to own equities only because you believe they will panic because their hands are weak, is not a valid recommendation, in my humble opinion.  Instead, I believe it’s incumbent upon us to offer the correct information and education that will prevent investors from behaving in irrational ways that could hurt their long-term investment results.

Furthermore, the bottom line is that I believe that equities, especially blue-chip dividend paying equities are being given a bad rap from this attitude by suggesting they are riskier than, in fact, they truly are.  The truth is that blue-chip companies such as Procter & Gamble (PG), Johnson & Johnson (JNJ) and many others too numerous to mention, have long legacies spanning decades of operating excellence and increasing dividends.  To classify them as risky investments based on simply the idea that pricing can be volatile, is in my way of thinking, an injustice.

If these blue-chip companies are purchased at reasonable valuations based on fundamentals, then the prudent investor can and should be capable of owning them over long periods of time. On the best ways to do this is to make the distinction between emotionally-driven price volatility versus permanent deterioration of the company’s long-term fundamentals.  As I stated before, both competent mountain climbers and Dividend Growth Investors recognize that the only way to get to the highest peak is to be willing to traverse the occasional valley along the way. We should not be telling investors that they are too dumb or weak-minded to own stocks, instead, we should be educating them on the true benefits and risks that come with owning them. Knowledge is power.

Disclosure:  Long CTSH, PG at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Tags: Alternative Investment, Asset Allocation, Assumption, Barron, Bear Market, Best Of Intentions, Blogger, Complacency, Dividend Paying Stocks, Excerpt, Interest Rate Policy, Investment Advice, Investment Choice, Morning Coffee, Proper Diversification, Prudent Investment, Roger Nusbaum, Sunday Morning, Tragic Outcome, Volatility
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Bill Gross: Investment Outlook (April 2012)

Tuesday, March 27th, 2012

The Great Escape:
Delivering in a Delevering World

by William H. Gross, PIMCO

April 2012

• When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
• In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
• We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.

About six months ago, I only half in jest told Mohamed that my tombstone would read, “Bill Gross, RIP, He didn’t own ‘Treasuries’.” Now, of course, the days are getting longer and as they say in golf, it is better to be above – as opposed to below – the grass. And it is better as well, to be delivering alpha as opposed to delevering in the bond market or global economy. The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.

The term delevering implies a period of prior leverage, and leverage there has been. Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, this combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth. Stocks for the Long Run was the almost universally accepted mantra, but it was really a period – for most of the last half century – of “Financial Assets for the Long Run” – and your house was included by the way in that category of financial assets even though it was just a pile of sticks and stones. If it always went up in price and you could borrow against it, it was a financial asset. Securitization ruled supreme, if not subprime.

As nominal and real interest rates came down, down, down and credit spreads were compressed through policy support and securitization, then asset prices magically ascended. PE ratios rose, bond prices for 30-year Treasuries doubled, real estate thrived, and anything that could be levered did well because the global economy and its financial markets were being levered and levered consistently.

And then suddenly in 2008, it stopped and reversed. Leverage appeared to reach its limits with subprimes, and then with banks and investment banks, and then with countries themselves. The game as we all have known it appears to be over, or at least substantially changed – moving for the moment from private to public balance sheets, but even there facing investor and political limits. Actually global financial markets are only selectively delevering. What delevering there is, is most visible with household balance sheets in the U.S. and Euroland peripheral sovereigns like Greece. The delevering is also relatively hidden in the recapitalization of banks and their lookalikes. Increasing capital, in addition to haircutting and defaults are a form of deleveraging that is long term healthy, if short term growth restrictive. On the whole, however, because of massive QEs and LTROS in the trillions of dollars, our credit based, leverage dependent financial system is actually leverage expanding, although only mildly and systemically less threatening than before, at least from the standpoint of a growth rate. The total amount of debt however is daunting and continued credit expansion will produce accelerating global inflation and slower growth in PIMCO’s most likely outcome.

How do we deliver in this New Normal world that levers much more slowly in total, and can delever sharply in selective sectors and countries? Look at it this way rather simplistically. During the Great Leveraging of the past 30 years, it was financial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more levered those flows, then the better they did. That is because, as I’ve just historically outlined, future cash flows are discounted by an interest rate and a risk spread, and as yields came down and spreads compressed, the greater return came from the longest and most levered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the ability of global economies to consistently replicate them. Financial assets relative to real assets outperform in such a world as wealth is brought forward and stolen from future years if real growth cannot replicate historical total returns.

To put it even more simply, financial assets with long interest rate and spread durations were winners: long maturity bonds, stocks, real estate with rental streams and cap rates that could be compressed. Commodities were on the relative losing end although inflation took them up as well. That’s not to say that an oil company with reserves in the ground didn’t do well, but the oil for immediate delivery that couldn’t benefit from an expansion of P/Es and a compression of risk spreads – well, not so well. And so commodities lagged financial asset returns. Our numbers show 1, 5 and 20-year histories of financial assets outperforming commodities by 15% for the most recent 12 months and 2% annually for the past 20 years.

This outperformance by financial as opposed to real assets is a result of the long journey and ultimate destination of credit expansion that I’ve just outlined, resulting in negative real interest rates and narrow credit and equity risk premiums; a state of financial repression as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie staring Steve McQueen called The Great Escape where American prisoners of war were confined to a POW camp inside Germany in 1943. The living conditions were OK, much like today’s financial markets, but certainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and American officers to try to escape and get back to the old normal. They ingeniously dug escape tunnels and eventually escaped. It was a real life story in addition to its Hollywood flavor. Similarly though it is your duty to try to escape today’s repression. Your living conditions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover liabilities. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this financial repressive world.

What happens when we flip the scenario or perhaps reach the point at which interest rates cannot be dramatically lowered further or risk spreads significantly compressed? The momentum we would suggest begins to shift: not necessarily suddenly or swiftly as fatter tail bimodal distributions might warn, but gradually – yields moving mildly higher, spreads stabilizing or moving slightly wider. In such a mildly reflating world where inflation itself remains above 2% and in most cases moves higher, delivering double-digit or even 7-8% total returns from bonds, stocks and real estate becomes problematic and certainly much more difficult. Real growth as opposed to financial wizardry becomes predominant, yet that growth is stressed by excessive fiscal deficits and high debt/GDP levels. Commodities and real assets become ascendant, certainly in relative terms, as we by necessity delever or lever less. As well, financial assets cannot be elevated by zero based interest rate or other tried but now tired policy maneuvers that bring future wealth forward. Current prices in other words have squeezed all of the risk and interest rate premiums from future cash flows, and now financial markets are left with real growth, which itself experiences a slower new normal because of less financial leverage.

That is not to say that inflation cannot continue to elevate financial assets which can adjust to inflation over time – stocks being the prime example. They can, and there will be relative winners in this context, but the ability of an investor to earn returns well in excess of inflation or well in excess of nominal GDP is limited. Total return as a supercharged bond strategy is fading. Stocks with a 6.6% real Jeremy Siegel constant are fading. Levered hedge strategies based on spread and yield compression are fading. As we delever, it will be hard to deliver what you have been used to.

Still there is a place for all standard asset classes even though betas will be lower. Should you desert bonds simply because they may return 4% as opposed to 10%? I hope not. PIMCO’s potential alpha generation and the stability of bonds remain critical components of an investment portfolio.

In summary, what has the potential to deliver the most return with the least amount of risk and highest information ratios? Logically, (1) Real as opposed to financial assets – commodities, land, buildings, machines, and knowledge inherent in an educated labor force. (2) Financial assets with shorter spread and interest rate durations because they are more defensive. (3) Financial assets for entities with relatively strong balance sheets that are exposed to higher real growth, for which developing vs. developed nations should dominate. (4) Financial or real assets that benefit from favorable policy thrusts from both monetary and fiscal authorities. (5) Financial or real assets which are not burdened by excessive debt and subject to future haircuts.

In plain speak –

For bond markets: favor higher quality, shorter duration and inflation protected assets.

For stocks: favor developing vs. developed. Favor shorter durations here too, which means consistent dividend paying as opposed to growth stocks.

For commodities: favor inflation sensitive, supply constrained products.

And for all asset categories, be wary of levered hedge strategies that promise double-digit returns that are difficult in a delevering world.

With regard to all of these broad asset categories, an investor in financial markets should not go too far on this defensive, as opposed to offensively oriented scenario. Unless you want to earn an inflation adjusted return of minus 2-3% as offered by Treasury bills, then you must take risk in some form. You must try to maximize risk adjusted carry – what we call “safe spread.”

“Safe carry” is an essential element of capitalism – that is investors earning something more than a Treasury bill. If and when we cannot, then the system implodes – especially one with excessive leverage. Paul Volcker successfully redirected the U.S. economy from 1979-1981 during which investors earned less return than a Treasury bill, but that could only go on for several years and occurred in a much less levered financial system. Volcker had it easier than Bernanke/King/Draghi have it today. Is a systemic implosion still possible in 2012 as opposed to 2008? It is, but we will likely face much more monetary and credit inflation before the balloon pops. Until then, you should budget for “safe carry” to help pay your bills. The bunker portfolio lies further ahead.

Two additional considerations. In a highly levered world, gradual reversals are not necessarily the high probable outcome that a normal bell-shaped curve would suggest. Policy mistakes – too much money creation, too much fiscal belt-tightening, geopolitical conflicts and war, geopolitical disagreements and disintegration of monetary and fiscal unions – all of these and more lead to potential bimodal distributions – fat left and right tail outcomes that can inflate or deflate asset markets and real economic growth. If you are a rational investor you should consider hedging our most probable inflationary/low growth outcome – what we call a “C-“ scenario – by buying hedges for fatter tailed possibilities. It will cost you something – and hedging in a low return world is harder to buy than when the cotton is high and the living is easy. But you should do it in amounts that hedge against principal downsides and allow for principal upsides in bimodal outcomes, the latter perhaps being epitomized by equity markets 10-15% returns in the first 80 days of 2012.

And secondly, be mindful of investment management expenses. Whoops, I’m not supposed to say that, but I will. Be sure you’re getting value for your expense dollars. We of course – perhaps like many other firms would say, “We’re Number One.” Not always, not for me in the summer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are certainly a #1 seed – with aspirations as always to be your #1 Champion.

William H. Gross
Managing Director

“Safe Spread” also known as “Safe Carry” is defined as sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios. All investments contain risk and may lose value.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. An investor should consult their financial advisor prior to making an investment decision.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2012, PIMCO.

Tags: Bill Gross, Bond Market, Bretton Woods, Central Banking, Commodities, Commodity, Commodity Products, Debasement, Dividend Paying Stocks, Financial Assets, Financial Leverage, Future Returns, Global Economy, Gold Standard, Great Escape, Gross Investment, Inflation Protected Bonds, Investment Outlook, PIMCO, Three Decades, Treasury Bills, William H Gross
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Where to Look for Dividends? Try Outside the US (Koesterich)

Friday, March 16th, 2012

In a world in which fixed income yield is scarce, investors have increasingly been turning to dividend paying domestic stocks as an alternative source of income.

But with much of the dividend corner of the US equity market – including US utility stocks in particular — now crowded and expensive, investors might want to consider looking abroad for dividend income, as I write in my recent Market Update piece. Here are three reasons why.

More Reasonable Valuations: Outside of the United States, dividend paying stocks still appear cheap and are trading at a significant discount to the broader equity market. For example, the Dow Jones EPAC Select Dividend Index – primarily composed of companies domiciled in Europe and Asia – is currently trading at a bit below 12x trailing earnings. In comparison, the MSCI World Index of developed countries is trading at more than 14x earnings.

More Attractive Yields: Non-US dividend companies are offering more enticing yields than their US counterparts. Currently, the Dow Jones Industrial Average yields 2.5%, while the broader S&P 500 yields 2%. In comparison, international markets currently providing yields in the 3% to 5% range include Germany, the Netherlands, Norway, Australia, Hong Kong, Singapore, New Zealand and Brazil.

Outperformance in a Slow Growth Environment: As pointed out in a recent BlackRock Investment Institute paper on the pros and cons of investing in dividend stocks, high dividend paying stocks tend to outperform during periods of slow growth like the one we’re experiencing this year. As the chart below shows, while international dividend paying stocks have generally outperformed a broader global benchmark since 1999, the median outperformance of the international dividend index was more than 18% in years in which global growth was below average. In contrast, in years when global growth was above average, the international dividend index’s relative outperformance fell to around 3.5%.

In short, there’s a strong case for why investors in search of equity income should consider international dividend paying stocks, which are accessible through instruments like the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE).

Source: Bloomberg

Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.  For actual iShares Fund performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares (1-800-474-2737).

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.  There is no guarantee that dividends will be paid.

Tags: Blackrock, Brazil, Chart Below Shows, Developed Countries, Dividend Income, Dividend Paying Stocks, Dividend Stocks, Domestic Stocks, Dow Jones, Fixed Income, Global Benchmark, Global Growth, Growth Environment, High Dividend Paying Stocks, Hong Kong Singapore, International Markets, Msci World Index, Netherlands Norway, Outperformance, Us Equity Market, Utility Stocks
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Andrew Lo: Navigating Volatile Markets (Video+Transcript)

Sunday, March 4th, 2012

MIT’s Andrew Lo, “Financial Thought Leader,” and the dean of Adaptive Market Hypothesis, discusses managing your portfolio’s risk in volatile times with Connie Mack.
Here is the full transcript of the interview, courtesy of Wealthtrack.com:

Consuelo Mack WealthTrack – February 24, 2012

CONSUELO MACK: This week on WealthTrack, keep your seatbelts fastened and prepare for turbulence! Financial Thought Leader, alternative investment manager and MIT Professor Andrew Lo says ongoing market volatility requires skillful maneuvers. He’ll tell us which ones to follow next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Investors are dealing with some really difficult choices. The Federal Reserve has kept short term interest rates near zero for three years and has told us it is committed to another three, until late 2014. That means savers are getting zilch- actually less than zilch when you subtract the affects of two percent inflation. So called negative yields don’t pay the mortgage, put food on the table or compound over time because there is nothing to reinvest. The result is that savers and retirees are being forced into riskier investments, that, to paraphrase Mark Twain, don’t guarantee either a return “on” or a return “of” your money.

As you know, many recent WealthTrack guests have been advocating investors return to the stock market and specifically to high quality, dividend paying stocks for capital appreciation and income. Companies are taking note. According to Standard and Poor’s, dividend increases reached $50.2 billion last year. That’s an 89% rise over the $26.5 billion in dividend increases announced in 2010. S&P predicts companies will set a new record for dividend payments this year. Among the reasons: dividend payout rates remain near historically low levels of around 30% of earnings- historically they average 52%, and companies still have robust cash reserves and cash flows. In addition, that much dreaded market volatility of the past four years seems to be abating. The CBOE Market Volatility Index, or VIX, a measure tracking price movements of the S&P 500, has fallen dramatically in recent months. But for how long?

This week’s WealthTrack guest is skeptical of the markets recent docility and believes investors need to be wary, vigilant and more proactive. He is Andrew Lo, a noted Financial Thought Leader, economist, Professor of Finance at the MIT Sloan School of Management, director of MIT’s Laboratory for Financial Engineering and a money manager. He is putting his research to work at AlphaSimplex Group, the investment firm he founded and now chairs, where he and his team run several alternative investment mutual funds under the Natixis ASG name. In his words, they are “designed to help investors achieve greater diversification than traditional stock and bond funds, while actively controlling risk and liquidity.”

I began the interview by asking Professor Lo why he believes market volatility has not disappeared.

ANDREW LO: Well, one of the things about volatility is that it’s triggered by real events. And I think probably the biggest issue hanging over markets today is political instability. It turns out that government has become the biggest source of systemic risk. And until we work out the implications of Dodd-Frank and what’s going on in Europe, I think we’re going to continue having that hanging over the heads of investors.

CONSUELO MACK: So give me a time frame for that, because I don’t have really any particular optimism that we’re going to solve the solutions of Dodd-Frank and government regulation in Europe anytime soon, so this is a multi-year process that you think we’re going to go through?

ANDREW LO: This is definitely a multi-year process. It’s probably going to take between two to five years before we see any real differences. For example, here in the U.S., we’re not going to see much movement on the political scene until after the 2012 elections. And even after that, it’s going to take some time for the new President, whether it’s the incumbent or the challenger, to be able to put in place his or her implementations of various different policies. At that point we’ll see a little bit more clarity, but even then it’s going to take years before the actual implementation of Dodd-Frank becomes clear enough for us to understand.

Even the Volcker Rule is something that is not going to be clear for another two or three years. And in Europe, my guess is that that’s going to be a very slow-burning fuse. Things might come to a head this year, but more than likely they’ll figure out a way to push it off for another year or so. And then we’ll see what happens with Greece, Spain, Portugal and other countries.

CONSUELO MACK: So therefore, get used to market volatility. It’s a way of life for now.

ANDREW LO: I think for now it’s the volatility of volatility that we have to be aware of.

CONSUELO MACK: So talk to me about, what is the volatility of volatility.

ANDREW LO: Well, the idea behind the volatility of volatility is that we’re really on a volatility rollercoaster ride. During periods of time when markets look calm, volatility will be low. The VIX will be at a reasonable range of, say, 15 to 20%. But within a matter of days, after any kind of political change, we may see that volatility going up to 25, 50, 60%. And at 60% volatility, investors are really going to have to be very careful about what’s going on with their portfolios.

CONSUELO MACK: So are there new rules of investing that we need to apply in this new market that we’re seeing?

ANDREW LO: Well, I think there are definitely some new rules. And I would probably focus on three of them. The first new rule is that markets are not stable. That they can change at a drop of a hat. So we have to be more active about managing our risks. So the case in point is volatility. In the past, if you had a 60/40 portfolio- 60% stocks, 40% bonds, you had an idea that you were going to be getting something on the order of overall, ten or 11% volatility for your overall portfolio.

CONSUELO MACK: And let me stop you there. So ten or 20% volatility’s within any given year. that the market would move or your portfolio would move up and down ten or 20%, that was kind of a range that you could depend upon.

ANDREW LO: Exactly. And what we’re seeing now is that even with a 60/40 stock/bond allocation, there are periods of time when your portfolio can have 30/40 percent volatility, which are swings that no investor has signed up for. So the first new rule is that we have to start getting more active about managing our risks and being aware of those risks.

The second new rule is that we all suffer from a disease that I call diversification deficit disorder. That means that we think we’re well diversified with some stock and bond funds, but in fact, we have to be much more proactive about getting diversification across stocks, bonds, currencies, commodities; across different asset classes, across different countries, and over time. So it’s actually harder work now to achieve the same level of diversification that we had before.

And that third new rule is that we have to be aware that while stocks may provide good returns in the long run, that in the long run, we may be dead and we have to make sure the short run doesn’t kill us first. That is that we have to manage our way around these market dislocations. And so it means that we have to pay more attention to our portfolio, we have to spend more time thinking about it. Basically we have to become more educated about our own finances.

CONSUELO MACK: One of the really interesting things, Andy, that you’ve written about and talked about, is the fact that there’s something called the efficient market hypothesis, which is that the markets are efficient. That we’ve been dealing with and have assumed it was going to be the case for the future. And then you’re now talking about something called the adaptive markets hypothesis. What’s the difference between the efficient market hypothesis and the adaptive markets hypothesis?

ANDREW LO: Sure. Well, let me first start by saying that the efficient markets hypothesis has been a very important part of modern finance theory. And it says that prices generally fully reflect al available information. It’s hard to beat the market. And I would say that that hypothesis is still very important, but it’s incomplete. It’s not wrong, but there’s a piece that’s missing. And the piece that’s missing is that, while most of the time, markets do work quite well, and they do reflect most information, and it is hard to beat the market, that every once in a while, markets can be punctuated by periods of dislocation and irrationality. And the important thing to note is that people react to these kinds of market conditions, they adapt.

And so the adaptive markets hypothesis starts with market efficiency as the baseline and asks the question, do investors maintain that baseline all the time? And from looking at the empirical evidence, or the financial crisis, the evidence is pretty clear that, no, they don’t. That when market conditions change abruptly, people react. And they react in fairly predictable ways. When there’s a fire, people will run out of the room. And when there are losses, people will unwind their portfolios and seek safer ground. So the adaptive markets hypothesis focuses on that dynamic. It tries to understand under what conditions are markets efficient, and what other conditions might make people panic and move into other asset classes, thereby changing the traditional risk-reward relationships.

CONSUELO MACK: So right now, are we in a situation where the markets are not acting as we had assumed they would, and they actually have for, let’s say, the last four years; and in fact, so that the adaptations that individual investors are making, that number one, we’re making possibly wrong decisions. And then are there right decisions? What kind of adaptive behavior should we be adopting?

ANDREW LO: Well, I think there’s definitely some change afoot. And the best way to look at it is by taking the great expanse of market history, say from the 1930s to the most recent period, and just looking at our experience with, say, U.S. equities. From the 1940s to the early 2000s, that six-decade period is a period that I call the Great Modulation. And the reason I call it the Great Modulation is because during that period of time, we had a relatively stable financial regulatory system. In fact, today’s regulatory structure for mutual funds was actually built in the wake of the Great Depression, the 1930s and the 1940s. And those regulations haven’t changed a whole lot since then. Over that six-decade period, we had a relative period of calm and very, very healthy growth. So that no matter what ten or 20-year period you pick in that six-decade-long period, you would have done probably equally as well in terms of investing money in equities. I think that that’s changed. Over the last five or ten years, we have had some very significant shifts.

CONSUELO MACK: So that’s where the stocks for the long run thesis, you know, looking back, it worked.

ANDREW LO: Absolutely.

CONSUELO MACK: So your traditional approach of buying large cap or U.S. stocks, and reinvesting your dividends on a yearly basis, that in fact that was a pretty good strategy to adopt. Now what kind of a market are we in, and what’s changed and what should our investment strategy be?

ANDREW LO: Well, so there are a couple of things that have changed, and I think those changes inform how we want to think about changing our investment approach. One thing that’s changed is population. In 1900, the estimate of the world population was about one-and-a-half billion people. The most recent estimates for our current population of the world is about seven billion people. That is a big difference. And if you think about those seven billion people, most of them are going to need to have some type of financing and saving activities throughout their lives. And so that makes markets much more complex, and much more interdependent.

The second thing that’s changed is financial technology. We now have the ability to invest in a variety of assets, but at the same time we also have the ability at the click of a mouse to wipe out half of our retirement savings. That’s a very dangerous set of technologies to give to ordinary investors who may not really understand all of these kinds of risks.

CONSUELO MACK: Even professional investors make big mistakes.

ANDREW LO: It’s complicated, no doubt. And so I think one clear implication is that we actually need to spend more time thinking about our finances, in the same way that we have to spend more time thinking about our health. In the 1950s we didn’t know about cholesterol, we didn’t know about carbs, we didn’t know about a lot of things that we know now. And so now, to be an intelligent consumer, you really have to spend time learning these new concepts.

CONSUELO MACK: So, Andy, from an individual investor’s point of view, how can we more actively manage our portfolio, realistically- what should we be doing?

ANDREW LO: Yes. Well, first of all it’s hard. It requires work. And what investors should not be doing is becoming day traders. That’s not going to be successful. One thing they can do, though, is to spend more time learning about the investments that they do make. In other words, asking questions like, “what kind of risk profile does this particular investment have over the last ten years, five years, three years,” as opposed to asking “what kind of risk profile it has right now.” Because what looks relatively calm and conservative today may have looked very differently in 2008 or 2009, and may look different yet again next year. So start asking questions about how stable the risk is for each of these funds, that’s the first thing.

The second thing to ask about is liquidity. We haven’t really talked much about liquidity for mutual funds, because by definition, they seem to be liquid. You should be able to get in and out of them every day. But as we saw from the last four years, there are certainly mutual funds that are much less liquid than others and could create all sorts of difficulties for redemptions, if and when they all occur at the same time.

Third, there are a variety of financial instruments available to investors today, including ETFs, and other kinds of fancy securities. Before getting too fancy, investors need to spend time trying to really understand the various different kinds of circumstances under which those products will help or hurt their portfolios. So in other words, each investor now has to become a bit of a financial manager. They are managing their portfolios, and ultimately they’re going to be responsible for those decisions.

CONSUELO MACK: Which is a terrible thought. A very scary thought.

ANDREW LO: It’s scary.

CONSUELO MACK: You have a concept, an approach that I think is really fascinating. We’ve done a lot of work on WealthTrack on asset allocation, and if you go to any financial advisor, they’re going to talk to you about asset allocation, and your risk tolerance, et cetera. But you’re saying that we shouldn’t just manage our asset allocation anymore, that we really need to manage our risk allocation. Can you tell me what it means to manage your risk allocation, and what the difference is?

ANDREW LO: Sure. Well, the first point to start with is that investors generally respond to changes in risk. Most investors are happy to take risk. They’re perfectly willing to take risk. They even, I think, understand what risk means. What they aren’t willing to do is to be uncertain about their risks. If you’re going to take a particular kind of risk- ten percent swings in your portfolio over the course of the year- you want to know that that’s by and large what you’re going to see: ten percent swings in your portfolio over the course of a year. If you see 30% swings, that’s not good news. And so the idea behind risk allocation is to reduce the surprises in risk. If you think you’ve signed up for ten percent swings, then you need to be given ten percent swings. And there’s a way to manage your portfolio to make sure that that’s more likely than less. And the way to do that is to start with a particular risk budget.

Say that ten percent figure that we talked about. And say that if ten percent swings are what I’m comfortable with, let’s divide that up into three percent of that for equities, another three percent for fixed income, another two percent for commodities, and so on. And it’s a little bit more complicated because the risks don’t necessarily add up to 100% because of correlations among these various different investments. But with some help from literature online, or from financial advisors, it’s actually pretty easy to work that out so that you put your money in categories where you know you’re going to get a certain amount of risk. And this way, after the fact, the surprises will be far fewer and far less extreme.

CONSUELO MACK: So if I look at all the asset classes that are available to me as an investor to invest in, are there certain risk profiles that I should be adding to a portfolio that might not be in the traditional portfolio? Are there certain assets that are actually going to steady and provide ballast to my portfolio that I really don’t know about?

ANDREW LO: Well, I think there are other assets and certainly other approaches to investing in different asset classes. Stocks and bonds are the most traditional asset classes that most people have in their portfolios, and we’ve seen over the last few years that the volatility of volatility of those asset classes is quite high. It’s very hard to predict where that volatility’s going to go. But if we now increase the universe of assets to additional alternatives- commodities, currencies, interest rates, and investing long as well as short- if you mix all of those into these new multi-alternative asset classes, I think that there’s a better way to make that kind of diversification and to be able to manage the type of risks across these different asset classes.

CONSUELO MACK: So let’s talk about what you’re doing at the Natixis ASG Funds that you’re replacing the traditional asset allocation approach with what you call a new narrative. And that is, it’s how many dollars that you invest in different asset classes, instead of that, it’s how much risk you allocate to different asset classes. So just give us an example of what you’re doing, for instance, with your flagship from the Natixis ASG Global Alternatives Fund, which you’ve established an eight percent volatility. That’s your goal. So how do you achieve that?

ANDREW LO: Well, it’s actually pretty easy. What we do is to use futures contracts, which are very liquid, and we invest in futures across a variety of asset classes; stocks, bonds, currencies and commodities. And we are trying to capture the broad exposures of the entire hedge fund industry. But what we do that’s different from what hedge funds do is that we manage our volatility on a daily basis; where we balance our futures exposures to these various different asset classes so that we’re achieving a relatively steady level of volatility of around eight percent. And so when the underlying instruments that we invest in become much more volatile, as they did during the fourth quarter of 2008 after Lehman went under, we will reduce our exposures to those contracts, and thereby achieve a relatively steady rate of volatility. When that volatility of the underlying instruments comes down to a normal level, we’ll put back that market exposure.

So it’s a lot like cruise control in your car. Your car knows when it’s going uphill, it’ll put on the gas; your car knows when it’s going downhill it’ll put on the brakes. All the while achieving a relatively steady speed of 60 miles an hour. And if eight percent volatility’s what you’re trying to achieve, by using this kind of cruise control mechanism and by doing it on a daily basis, you can actually manage your risks more effectively than if you just rebalanced once a month or once a quarter.

CONSUELO MACK: Basically you’re managing volatility on a daily basis. Individual investors really can’t do that. If I went to a traditional asset allocator, they would tell me, well, you know, what you need to do, Consuelo, is put more TIPS in your portfolio or more treasuries in your portfolio, or more managed futures in your portfolio. Is there any way to manage the volatility that we’re talking about, without actually managing it on a daily basis?

ANDREW LO: Well, I think it’s a matter of degree. So obviously managing it on a daily basis is one extreme. Not looking at your portfolio for a year is another year. Trying to be more sensitive to correlations is one way of managing it. So for example, you mentioned managed futures and TIPS. Those are two asset classes that are not part of the traditional investment portfolio which could actually help in terms of dampening some of those fluctuations and reducing the volatility of volatility. So by being more aware of different investment alternatives, by asking questions about how stable the risks are, by looking at the potential correlations of those risks, it is possible to put together a more robust portfolio than just simply picking stocks and bonds.

CONSUELO MACK: Are there any specific segments or products that are out there that we should have ourselves and our financial advisors look at?

ANDREW LO: The ones that I think might be most useful for an investor are these multi-alternative categories, managed futures, because they provide opportunities that are not easily accessible from the traditional stock/bond perspective. And many of these products are properly risk-controlled, so that they won’t provide the kind of unpleasant surprises that you might find in some traditional mutual fund products and ETFs. So I think that having a broad exposure to a variety of asset classes across different countries, across different securities, is really the best way to go and to spend more time thinking about these opportunities; to work with a financial advisor to get the best advice possible. But in the end, to answer the question, how much risk am I willing to take? What kind of portfolio swings can I withstand? And then to maintain as much of an investment in those types of securities with that level of risk that you can.

CONSUELO MACK: How important is it to pay attention to macro trends, number one? And to react to them, number two, in our portfolios? Do we need to time macro trends, not time the market, but possibly what’s going on in the macro level?

ANDREW LO: Well, I think it’s incredibly important to pay attention to macro trends. How we react to them is also critical, and there I think that most investors need help. I don’t think it’s possible for individual investors to understand, necessarily, how to interpret a European default. We need help from financial advisors, from various institutions, to understand how our reactions may or may not be beneficial to our portfolios. But I do think that it’s important for us to try to react in a sensible way as opposed to simply assuming things will work out in the end. Depending on what one’s horizon is, maybe that is true, but if your horizon is less than 50 years, I’m not sure that things will work out for you, with any degree of confidence. We need to think a little bit about how to change our behavior in the proper way to react to these market conditions.

CONSUELO MACK: And final question is for a long-term diversified portfolio, what is the One Investment or one strategy we should all adapt?

ANDREW LO: Well, I think that right now, the one idea that we should all adopt is to think very carefully about risk, is to manage risk actively. And that means thinking about diversification, thinking about broader asset classes like multi-alternatives or managed futures. Thinking about how our portfolio may change over time and over market conditions, and to do that soon. Not after the disaster hits, when we’re all going to be panicking. But rather do it now, while we’re relatively calm, and when we have some idea of what kind of consequences we can or cannot tolerate.

CONSUELO MACK: We will leave it there, Andrew Lo. Always wonderful to have you on WealthTrack.

ANDREW LO: Thank you, it was a pleasure.

CONSUELO MACK: Thought-provoking, you are an original thinker from AlphaSimplex Group and from MIT, thanks so much for being here.

ANDREW LO: A pleasure, thank you for having me.

CONSUELO MACK: At the conclusion of every WealthTrack, we try to leave you with one suggestion to help you build and protect your wealth over the long term. This week’s Action Point picks up on a major theme of Andrew Lo’s investment approach, which is to manage portfolio risk. So this week’s Action Point is: consider the risk allocation in your portfolio.

Investors have traditionally thought in terms of asset allocation, assuming relatively predictable returns and behavior in stocks and bonds over time. As Lo points out, for a number of reasons, the markets have changed. They have become much more complex, uncertain and volatile, so managing risk has become much more important. Building a portfolio around risk expectations for different asset classes can help you manage and control the risk according to your personal preferences.

Next weekend, as many public television stations start their spring fund raising drives, we will revisit our conversation with Sheryl Garrett and Mark Cortazzo, two top rated financial advisors who are catering to small investors. If you want to see WealthTrack interviews ahead of the pack, subscribers can do so 48 hours in advance. Go to our website, wealthtrack.com to sign up. And that concludes this edition of WealthTrack. Thank you for watching and make the week ahead a profitable and a productive one.

Tags: Alternative Investment, Blip Tv, Capital Appreciation, Cash Reserves, Cboe Market Volatility Index, Connie Mack, Consuelo Mack, Consuelo Mack Wealthtrack, Dividend Increases, Dividend Paying Stocks, Dividend Payments, Dividend Payout, Food On The Table, Full Transcript, Investment Manager, Maneuvers, Market Hypothesis, Market Volatility, Market Volatility Index, Professor Andrew, Seatbelts, Standard And Poor, Term Interest, Thought Leader, Video Transcript, Volatile Markets, Volatile Times, Wealthtrack, X Shockwave Flash, Zilch
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Miserly bonds yield to generous dividends

Sunday, February 5th, 2012

This Week: CLAYMORE S&P/TSX CDN DVD ETF Ticker: CDZ / TSX

Miserly bond yields won’t pay for a nice dinner these days. For that, you need the generosity of dividend-paying equities. Add the promise of capital gains and you may even opt for the nicer bottle of wine.

Bond investors are suffering from the lowest yields in a generation. Quality, five-year corporate bonds are yielding about 2.4%. That’s about half the average for the past decade. Compare that to equity dividend yields, which, at about 2.7% for the S&P TSX 60 Index, are the best in a decade, barring a period of extreme valuations in late 2008. In other words, equity dividends are higher by a third of a percentage points than quality bond yields, and that’s before the dividend tax credit and before any capital gains. (See Chart of Yields below)

What brought us to this upside-down wonderland? Last year’s poor showing by Canadian equities, combined with the Euro-zone crisis saw panicked investors flock to the safety of quality bonds. They were the best performing assets last year. Quality corporate bonds with maturities of about five to seven years returned about 9% in 2011.

Bonds prices are now hitting their ceiling and cannot go much higher. However, nor will they fall soon with the U.S. Federal Reserve committed to near-zero rates into 2014 and our own Bank of Canada likely to follow suit. More reason then for investors to look elsewhere for income.

The other factor pushing up dividend yields are record corporate profits that are as high now as they were just prior to the 2008 recession. Companies have been spending those profits buying back their shares and on dividends – both good for equity investors.

Eventually, the upside-down will right itself, as investors shun bonds in favor of dividend-paying stocks. That will push bond yields up and dividend yields down. To benefit from this, we have been re-allocating our Canadian equity exposure to ETFs of higher dividend-yielding quality companies.

Two we considered were iShares DJ Canada Select Dividend ETF (XDV/TSX) and the Claymore S&P/TSX Dividend ETF (CDZ/TSX). Both have consistently outperformed for years.

XDV, with a current yield of about 3.9%, holds the 30 biggest companies by market cap that also pay a dividend. As a result, 55% of the ETF is in banks and insurers.

The yield on CDZ is lower at 3.2% and its price-to-earnings ratio is higher at about 15.3 times but it is much more diversified. It holds 60 companies, all of whom have consistently raised dividends over the last five years and have at least $300 mln in market cap, though the average is $8 billion.

Energy and industrial firms are the biggest sectors with nearly half the ETF weight, followed by financials (though not the big banks or insurers) and then consumer discretionary firms like Tim Hortons, Shaw and Cogeco.

Of the two, we opted for CDZ mainly because of its diversification. XDV’s overweight in financials, especially in a period of increasingly heavier regulation of banks and insurers, makes us nervous.

Its diversification has also helped CDZ far outperform XDV as well as XIU/TSX, the biggest S&P/TSX 60 ETF. Over the last five years, CDZ has returned 23%, compared to XDV’s 9.4% and XIU’s 8.0%. XDV’s financial overweight helps link its return closely to the S&P/TSX 60, which has a 32% financials weighting.

One thing to note: iShares bought Claymore a few weeks ago. It has not said it will change Claymore products and given the success and distinctive approaches of CDZ and XDV, I doubt these two ETFs will be affected and even if they are, it likely won’t harm unitholders.

The Claymore takeover may also be to the benefit of Canada’s other ETF managers, including BMO, Horizons, RBC and Vanguard as they carve out their own space from a growing ETF market place.

The biggest winners will be investors, more of whom are investing through ETFs, either directly or through investment managers. In fact, Morningstar said recently that U.S. firms managing ETF portfolios saw assets grow my 43% last year as investors opted for top-down, asset-allocation strategies that minimized stock-specific risk.

Dividend Yields rarely exceed Bond Yields

Charts courtesy of Bloomberg L.P. Click on Chart for Larger Image

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Tags: Bank Of Canada, Bond Investors, Bond Yields, Bottle Of Wine, Canadian Equities, Canadian Equity, Corporate Bonds, Corporate Profits, Dividend Paying Stocks, Dividend Tax Credit, Dividend Yields, Equity Exposure, Equity Investors, Euro Zone, Generation Quality, Investors Flock, Nice Dinner, Quality Bond, TSX 60, Zero Rates
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The Continuing Case for Mega Caps (Koesterich)

Friday, January 20th, 2012

Last year, mega-cap companies were cheaper and more profitable than their smaller counterparts. That’s why I continuously advocated for mega-cap, quality stocks as a defensive play amid last year’s market volatility, economic shocks and political paralysis. Ultimately, investing in mega caps in 2011 was a good call.

Now, after last year’s flight to safety, many investors are asking if mega-cap stocks are still a bargain. As I write in my recent Market Update piece, the answer is a resounding yes.

Despite outperforming in 2011, mega caps are still trading at a historically high discount to other segments of the market. Let’s take US mega caps, for example. At the end of 2011, the S&P 100 Index traded at 12x trailing earnings, while the broader Russell 3000 Index traded at 14x.

This represents a discount of approximately 15% for mega caps and compares favorably with a long-term average discount for the stocks of around 9%. The chart below nicely shows how the relative valuation of US mega caps has generally been declining over the last decade.

Source: Bloomberg, 12/31/2011.

The situation looks even more favorable for global mega caps. They currently trade at 11x earnings. In comparison, the MSCI World Index currently trades at 13x earnings.

Large stocks in most defensive sectors also still appear to be a bargain. The one exception: US utilities. Of the four classic defensive sectors – utilities, consumer staples, healthcare and telecommunications – only utility stocks are trading above their long-term average valuations.

Given the prospect for more volatility and politically-driven risk this year, I expect large, dividend paying stocks to continue to outperform. In short, there is a compelling argument for sticking with the mega-cap trade in 2012 (potential iShares solutions: OEF, IOO, DVY, IDV and HDV).

Source: Bloomberg

Disclosure: Author is long IOO and DVY.

Past performance does not guarantee future results.

Tags: Cap Companies, Cap Stocks, Caps, Consumer Staples, Counterparts, Dividend Paying Stocks, Economic Shocks, Last Decade, Market Volatility, Mega Cap, Msci World Index, Political Paralysis, Quality Stocks, Relative Valuation, Russell 3000 Index, S Market, Sectors, Segments, Utility Stocks, Valuations
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The Bond Specialist

Friday, January 13th, 2012

A guest contribution by Anna W. via The Big Picture

The following comes from an asset manager, formerly of New York, since relocated to Colorado. Because of his employer’s rules on publishing, this is anonymous. We shall call him  The Bond Specialist. I know him and his colleagues for many years, and can attest to his 35 year career on Wall Street.

~~~

2011 was a confusing year from start to finish on Wall Street and the arrival of 2012 is not offering much relief. Today the popular message is that the economy is getting better in the U.S. and problems abroad can be overcome. Recession has been avoided and “escape velocity” will be achieved in the second half. Our economy can “decouple” from Europe and some of the big developing nations that have seen their economies slow such as China, India and Russia, now that they have run into trouble. Most economists and stock market strategists seem to have cut and pasted their 2011 forecast into their 2012 forecast. (How is that for the pot calling the kettle black?) But the concerns that clouded the outlook a year ago only seem to have gotten deeper. The positive messaging is focused on the following;

-The politicians will kick the can down the road and therefore avoid the kind of austerity that could derail the recovery. The Fed will engage in more quantitative easing (a euphemism for money-printing) if the economy or the stock market falters.

-Interest rates and inflation have nowhere to go but up so the least attractive place to put your money is in the bond market. That is, unless you keep the maturities short and stick with “spread product” like corporate bonds and bonds issued by foreign governments.

-The S&P 500 will be up 10% by year end. I have been in the business for 35 years and for the last 20, the prediction for the market has always been “up 10% or more”. The rationale changes but the upside prediction does not. This year the place to be is “dividend paying stocks” that pay so much more than Treasury notes and have a great track record of increasing dividends. Also, the 3rd and 4th years of the Presidential Cycle are usually positive for stocks. Last year the emphasis was on domestic small cap, international and emerging market stocks because of their superior growth potential.

-The dollar will be weak because our fiscal and monetary situation is worse than those other countries that we have decoupled from since they are in so much trouble. Gold will be higher because some Central Banks are substituting gold for dollars as a reserve asset and lots of women will be getting married in India.

-Commodity prices will be higher in general. Oil and fertilizer are in short supply and all the rural Chinese are planning to motor on down to Kentucky Fried Chicken for some protein sooner or later.

-The housing market and home prices are finding a bottom.

Based on the popular forecast for 2012, you can buy practically anything but long term bonds and probably do just fine as long as you are diversified.

That is not the way it worked in 2011 and it seems to me to be even less likely in 2012. The S&P 500 was exactly unchanged in price for the year, providing only a 2% dividend return. It was like a video game where many aliens were destroyed and many points were scored, but it was game over on December 30th and we will have to put another quarter in on January 3rd. Small capitalization stocks (Russell 2000) were down 5% and the Dow Jones Industrial Average, the home of dividend paying stocks, was up 6%. European and Emerging Market indexes generally delivered double digit losses. They all had big swings during 2011, but the big story was how many times that the stock indexes were up or down more than 1% (100 Dow points) or more in a day. It seemed like all of them.

Gold and silver roared earlier in the year, but gold is down 18% from a high of $1900 just since September and silver peaked in May at $50. It is now $28. Gold was up 11% in 2011 and silver was down 10%. The dollar index was flat. Oil was up 9% but natural gas was down 37% to a multi-year low. Copper was down 22%. Corn was flat and wheat was down 18%. For the most part, confusion reigned.

But there was no confusion in the bond market. In 2011, the most abhorred investment vehicles; long term Treasury bonds and long term Municipal bonds were the two best performing major asset classes. After a swoon in January, long term bonds just marched up in price (down in yield) practically without interruption for the remainder of the year. As is always the case when interest rates are declining, the longest maturity and highest quality bonds perform the best. The 2039 Treasury Strip (0% coupon bond) returned 62% in 2011 and the average leveraged Closed End Municipal Bond fund returned 21%. Closed End Build America Bond funds, which contain taxable municipals where the Federal government pays 35% of the interest, did even better with an average return of 28% in 2011. The important question to ask is: in what ways will 2012 be different and how will it be similar?

As previously mentioned, the majority of pundits think that, even though they missed the boat in 2011, it is only a matter of timing and it will sail in 2012. That sentiment is understandable, but the expectation that the economy is going to return to a trend of expanding organic growth and a return to the secular credit expansion lacks credibility (no pun intended). To paraphrase Bob Farrell, in the early stages of a new secular paradigm the market is adapting to a new set of rules while most market participants are still playing by the old rules. But the old paradigm of credit expansion must resume if stocks and commodities are to appreciate, housing prices are to stabilize, the government is to avoid raising taxes and slashing spending and interest rates are to rise. As disappointing as it is, a far less rosy outcome is more likely.

Tags: 35 Years, Asset Manager, Attractive Place, Austerity, Big Picture, Bond Market, Corporate Bonds, Developing Nations, Dividend Paying Stocks, Economists, Escape Velocity, Euphemism, inflation, Market Strategists, Maturities, Money Printing, Rationale, Recession, Stock Market, Year End
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Don Coxe: Investment Recommendations (November 2011)

Thursday, November 24th, 2011

In his latest Basic Points, “It’s the Economy Banks, Stupid!,” dated November 18, 2011, Donald Coxe, Coxe Advisors LLP, makes the following recommendations, in the context of the full body of the issue. Here they are, Don Coxe’s investment strategy recommendations, in summary, paraphrased:

2. Investors in European bonds  should scale back their exposure to euro-denominated bonds, and companies should try to raise money and/or borrow in euros. The euro is on its way down to much lower levels.

3. Trim positions in non-Canadian bank stocks to minimiums. ‘B5′ bank stocks seem to be cheap, when they may indeed be greatly overvalued. Dexia’s troubles are not exclusive – Remember the ‘cockroach’ principle.

4. Build positions in high-quality “bullet-proof” dividend-paying stocks. We don’t mean utilities, which represent some of the more obvious high yielding stocks – though owning these as part of a overall equity portfolio strategy is appropriate. By bullet-proof, we mean the high quality dividend-paying equities of financially strong, well-managed companies focused on delivering total return to shareholders by providing dividend growth in the context of sustainably rising profits.

5. Recession risk is not the important ball to keep an eye on, when considering endogenous risk to major equity indices; banking/bank risks are. The next recession is more likely to be mild compared to that of 2008, on account of interest rates remaining near zero percent.

6. Most central banks have lost pride in their own currency. As a group, they are competing with each other, in the ‘race to the bottom,’ the goal being to see whose is the most competitive. Outside of the global Depression, this course of events is without precedent, and inflation risks are escalating.

7. Replace overvalued government bonds with high-quality corporate bonds, in bond portfolios. Ignore the Capital Asset Pricing Model.

8. If the eurozone takes tough and dramatic policy changes to end the terminal struggling and/or sinking of bank stocks, there may be a buying opportunity for non-financial equities ‘surprisingly’ soon. Keep some cash available, be prepared, and be on the lookout for a opening in the market, in the midst of a flurry of sea changes in Europe. Soaring bank stocks too would be a sign.

9. The chance of an attack on Iran’s nuclear facility is unlikely, however, global, critical, pressure on Israel may make those in its government to move forward on its own accord, in spite of those countries who have never had a true relationship with Israel. Most of the great oil companies’ shares are cheap anyway, so you get the insurance against a raid for free. Keep good exposure to to oil stocks, but don’t speculate on an airstrike.

10. We continue to recommend that its better to invest in oil producing companies as compared to investing in shale gas companies. It remains to be seen what the political outcome/risk – though still remote – over this development will be.

11. Our favourites continue to be the Canadian oil sands stocks, since they have achieved our two most important criteria: they are long duration reserves, and they’re location is low risk, politically speaking. Political (activist) enemies of the U.S. will go to great lengths to constrain their output, and have a President who seems to be more concerned about pleasing them, rather than the oil industry – whom is his main ‘whipping boy,’ as he idealistically promotes ‘Green Energy.’

Canada needs to realize that the folks in Washington D.C.’s inner circle do not feel the same way about its friendship with the U.S., and to take on new initiatives regarding pipelines and other export strategies. Until then, institutional investors who have holdings in oils sands stocks can expect to continue to be unfairly roughed up in discussions with their green clients.

Source: Donald Coxe, Basic Points, November 18, 2011

Tags: agricultural, Agricultural Commodity, Bank stocks, Bullet Proof, Central Banks, Cockroach, Commodity Stocks, Dividend Growth, Dividend Paying Stocks, Don Coxe, Donald Coxe, Equity Portfolios, Global Depression, High Yielding Stocks, Inflation Risks, Investment Recommendations, Investment Strategy, Oil Sands, Portfolio Strategy, Precious Metal, Quality Bullet, Race To The Bottom, Recession, Shale
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Special Report: The Merits of Dividend Investing (TD Waterhouse)

Thursday, November 10th, 2011

Today, TD Waterhouse (Portfolio and Investment Research) has released its report titled, “The Merits of Dividend Investing,” in which TD analysts, Ryan Lewenza ( U.S. Equities ) and Martha Hill (Canadian Equities) dig into the merits of investing in dividend paying stocks by examining the positive return and risk attributes associated with dividend payers, as well as providing a list of some of their preferred U.S. and Canadian dividend paying equities.

Report Prepared by:

Ryan Lewenza, CFA, CMT
V.P., U.S. Equity Strategist

Martha Hill, CFA
V.P., Canadian Equity Strategist

Highlights:

- In this report we dig into the merits of investing in dividend paying stocks by examining the positive return and risk attributes associated with dividend payers, as well as providing a list of some of our preferred U.S. and Canadian dividend paying equities.

- Given our expectations for lower rates of return over the next few years, dividend paying equities could outperform with dividends likely to play a more important role in future total returns. As anecdotal evidence of this, we note that dividend payers within the S&P 500 Index (S&P 500) have outperformed non dividend payers by 5.50%, year-to-date. Looking at Canada (S&P/TSX Composite Index), the returns from dividend payers are even greater, outperforming non-dividend paying stocks by roughly 12%.

- Looking longer term, if a U.S. investor invested $100,000 in the S&P 500 in 1988 they would have roughly $527,974 today. That equates to a compound annual growth rate (CAGR) of 7.50%. However, if you include dividends over this period, an investor would have over $900,000, which equates to roughly a 10% CAGR. Similarly, Canadian investors who invested $100,000 in 1988 would have over $700,000 including dividends (8.9% CAGR) versus $397,000 (6.20% CAGR) if only looking at price return.

- When investing we also need to consider risk. On this front dividend paying stocks are generally lower risk stocks relative to non-dividend payers. We have found that the highest yielding stocks within the S&P 500 (4% and above) have the lowest betas (0.84 on average), which means they move less than the overall market. Conversely, stocks that do not pay a dividend or have a low dividend yield of less than 1% have higher betas than the market, at 1.23 and 1.31, respectively.

- Overall, our analysis shows that dividend paying stocks can enhance total returns for investors, with potentially lower risk.

The report is available here, or viewable/downloadable below.

[pdf http://advisoranalyst.com/documents/The%20Merits%20of%20Dividend%20Investing%20-%20November%2010,%202011.pdf 500 650]

Tags: Anecdotal Evidence, Attributes, Cagr, Canadian, Canadian Equities, Canadian Equity, Canadian Investors, Canadian Market, Cfa, Cmt, Composite Index, Compound Annual Growth Rate, Dividend Payers, Dividend Paying Stocks, Dividend Stocks, Dividends, Investment Research, Martha Hill, Merits, Strategist, Td Waterhouse, Tsx
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US Dividend Stocks: Paid to wait? (Sykes)

Thursday, September 22nd, 2011

This online video features David Sykes, Vice President and Director, TD Asset Management in conversation with MaryAnn Matthews.

The equity markets have sold off sharply after the Federal Reserve offered a gloomy assessment of the US economy and sparked fears of a double dip recession. On this backdrop, David discusses how dividend paying stocks could offer investors the opportunity to “get paid to wait” through this period of market turmoil.

During the interview, Sykes addresses the following topics/concerns:

• What is Operation Twist and why are we seeing a global sell-off?
• What can we expect from US corporate earnings going forward?
• Are US Banks attractive at current levels and which name do you like?
• Will the trend of companies raising dividend remain intact?
• Any other stock that you like?

Click here or image below to view:

Tags: Addresses, Asset Management, Backdrop, Banks, Corporate Earnings, David Sykes, Dividend Paying Stocks, Dividend Stocks, Double Dip Recession, Economy, Fears, Federal Reserve, Gloomy Assessment, Image View, Investors, Market Turmoil, Maryann, Stock, Stocks Online, Vice President
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