Equity Markets Bullish Trend Prevails – So Does Unusual Volatility Countertrend

Monday, August 20th, 2012

by Don Vialoux, EquityClock.com

Upcoming US Events for Today:

1. The Chicago Fed National Activity Index for July will be released at 8:30am.

Upcoming International Events for Today:

1. The Reserve Bank of Australia Board Minutes for August will be released at 9:30pm EST.

The Markets

Markets pushed marginally higher on Friday, helped by improving data pertaining to Consumer Sentiment. The University of Michigan’s Consumer Survey provided a reading of 73.6, beating estimates of 72.0 and improving over last month’s read of 72.3. This is important as we are entering the big season for retail sales into the end of the year with back-to-school spending already underway, followed by a series of holidays, including Thanksgiving and Christmas, which are often crucial for overall year-over-year profitability of companies. Strong consumer sentiment often translates into robust retail sales numbers into the remaining months of the year.

Looking at equity markets, the bullish trend that began in June continues to prevail, not only maintaining a positive bias, but also showing signs of improving. Risk sentiment continues to improve, as gauged by the performance of high beta benchmarks, such as the Russell 2000 Small Cap Index, relative to market benchmarks, such as the S&P 500. Cyclical Sectors, such as Energy and Industrials, are leading the market higher, while recent crowd favourites in Defensive sectors are lagging market performance, trading flat to negative as a result.

In another optimistic sign, breadth is also showing signs of improvement, reaffirming the strength in the overall market. The S&P 500 Equally Weighted Index is starting to outpace the Capitalization Weighted index and the Cumulative Advance-Decline line across the benchmarks are also improving.

A recent setup in the US Dollar Index suggests that equity markets may still have a little way to go before topping out. The currency, often an inversely correlated asset to equity market strength, continues to show a short-term head-and-shoulders top combined with a bear-flag formation. The target of each formation points to a low at 81, a target that would keep the intermediate positive trend intact, which has negative longer-term implications for equity markets, assuming the negative correlation to equities continues.

All of this data suggests that equities continue to maintain a Hold rating, following the Buy signals that were initiated over two months ago. With that being said, given how mature this rally has become and the levels of overhead resistance above, provided by previous significant highs and long-term trendlines, a correction of some magnitude appears inevitable. As such, a certain amount of skepticism of the recent positive price action is warranted, especially given the significantly low volumes and surging complacency, which is sitting at the highest levels of the year. Seasonal tendencies turn particularly weak into September and October, so we are well within a window in which a correction is probable.

Sentiment on Friday, as gauged by the put-call ratio, ended at 0.75, one of the lowest ratios of the year. Complacency is at an extreme, a fact that is also evidenced via the volatility index (VIX) which hit the lowest level since 2007. Volatility remains seasonally positive through to October, so the recent decline that is counter to the seasonal trend may not persist unimpeded.

S&P 500 Index

Chart Courtesy of StockCharts.com

TSE Composite

Chart Courtesy of StockCharts.com

Horizons Seasonal Rotation ETF (TSX:HAC)

• Closing Market Value: $12.37 (down 0.48%)
• Closing NAV/Unit: $12.39 (down 0.07%)

Performance*

* performance calculated on Closing NAV/Unit as provided by custodian

Click Here to learn more about the proprietary, seasonal rotation investment strategy developed by research analysts Don Vialoux, Brooke Thackray, and Jon Vialoux.

Tags: Activity Index, Advance Decline Line, Bank Of Australia, Board Minutes, Bullish Trend, Cap Index, Chicago Fed, Consumer Sentiment, Consumer Survey, Don Vialoux, Industrials, Market Benchmarks, Market Performance, Market Strength, Months Of The Year, Reserve Bank Of Australia, Russell 2000, Sales Numbers, Small Cap, Thackray, Us Dollar Index, Volatility, Weighted Index
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Outperformance By Low Volatility Equity ETFs

Saturday, August 11th, 2012

by Richard Shaw, QVM Group, LLC

Over long periods, low volatility stocks have produced both a higher total return and lower volatility (better risk adjusted return and higher absolute return) than broad indexes. This is referred to as the “low volatility anomaly”, because it is contrary to the long held view that more return only comes from taking more risk. There are various theories as to why the anomaly exists, but factual evidence shows that it does.

Over shorter periods, low volatility does not always outperform. No approach always outperforms. As a generality, low volatility tends to lag in rising markets (captures less of the upside move), but to lead in falling markets (captures less of the downside move). Over cycles, that has come out ahead.

These histograms, using Morningstar Principia data, shows the three key US low volatility ETFs (SPLV, USMV and LVOL) versus the Russell 1000 index ETF (IWB) for total return and for upside and downside market move capture within the past 12 months ending July 31, 2012.

click image to enlarge

Two of the low volatility funds outperformed the Russell 1000 YTD and the low volatility funds outperformed the Russell 1000 over 1 month, 3 months and 12 months.

click image to enlarge

In the past 12 months, the Russell 1000 (IWB)captured 99.10% of the upside movements of the S&P 500 (did a bit better), and captured 104.77% of the S&P 500 downside movements (did worse). The two low volatility ETFs with 12 months of history (LVOL and SPLV) captured 71.81% and 64.92% respectively of the upside, and captured 7.58% and 54.71% of the downside, according to Morningstar, [the 7.58% downside capture figure for SPLV seems like it may be an error, but we expect the capture was lower than the Russell 1000].

The trailing yields on each of the three funds with 12 months of history are:

• IWB: 1.84%
• SPLV: 2.68%
• LVOL: 1.91%

The assets in each fund are:

• IWB: $6,395.2 million
• SPLV: $2,326.7 million
• USMV: $342.0 million
• LVOL: $67.9 million

Here are some key valuation metrics for the four funds:

Standard and Poor’s Had This To Say and Illustrate About the Low Volatility Anomaly: (download their report)

“With so much uncertainty in riskier investments, many investors are seeking calmer waters for at least a portion of their portfolios.

The S&P 500 Low Volatility Index comprises the 100 least-volatile stocks in the S&P 500.
Volatility is measured as the standard deviation of price changes over the trailing 252 days. The 100 securities are then ranked and weighted according to their volatility, with higher weights assigned to less-volatile stocks. The index is rebalanced quarterly. Historical data shows that an index comprising low-volatility securities outperform more-volatile securities by providing better downside protection during volatile periods while offering favorable relative annualized returns.

Lower Risk Doesn’t Mean Having to Settle for Lower Returns
Getting better returns without taking higher risks may seem counterintuitive. However, the simple, yet powerful low-volatility investment approach has resulted in higher relative performance compared to the parent index over a long-term period.

In terms of annualized, risk-adjusted returns, the S&P 500 Low Volatility Index outperforms the S&P 500 over near-, medium- and long-term investment horizons.”

The real world problem illustrated by the chart above is that many (perhaps most) investors would have abandoned their low volatility stocks, or fired their low volatility oriented investment manager in the late 1990s due to underperformance, not seeing the outperformance ahead.

Standard and Poor’s Release An Updated Low Volatility Study in August 2012 (download report)

They said,

“Among the long-standing anomalies in modern investment theory, perhaps none are as puzzling and compelling as the low-volatility effect. It challenges the traditional equilibrium asset pricing theory that an asset’s expected return is directly proportional to its beta or systematic risk, or, in other words, higher-risk securities should be rewarded with higher expected returns while lower-risk assets receive lower expected returns.

Contrary to that theory, the empirical evidence of numerous academic studies has illustrated that low-volatility or low-risk investing outperforms the broad market as well as high-risk strategies over a long-term investment horizon with much less realized volatility. In the U.S. equity market, the S&P 500 Low Volatility Index returned 6.95% (10.75% standard deviation) and the MSCI USA Minimum Volatility Index returned 5.1% (12.32% standard deviation) on an annualized basis over the 10 years ended March 31, 2012, with 23% to 30% lower volatility than a market cap-weighted benchmark such as the S&P 500, which returned 4.12% (15.99% standard deviation).”

Russell Investments Says This About the Low Volatility Anomaly: (download their report)

“Intuitively, investors might expect stocks that are less risky than other stocks – stocks we refer to as defensive stocks – to deliver lower returns than the broad market over the long term. … Key findings from the academic research: no evidence of a risk premium for risky stocks.”

They provide this chart hat shows lower return for higher volatility (a higher return for lower volatility) for investments in US stocks from 1986 through 2006.

Copyright (c) QVM Perspectives

Tags: Absolute Return, Anomaly, Downside, ETFs, Factual Evidence, Generality, Group Llc, Histograms, Iwb, Long Periods, Lvol, Market Move, Morningstar Principia, Outperformance, Qvm, Richard Shaw, Risk Adjusted Return, Shorter Periods, Volatility, Ytd
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Don Vialoux: Increase in Volatility Between Now and October Seasonally Common

Friday, August 10th, 2012

by Don Vialoux, EquityClock.com

Upcoming US Events for Today:

1. Import/Export Prices for July will be released at 8:30am.
2. The Treasury Budget for July will be released at 2:00pm. The market expects -$71.0B versus -$129.4B previous.

Upcoming International Events for Today:

1. German CPI for July will be released at 2:00am EST. The market expects a year-over-year increase of 1.7%, consistent with the previous report.
2. Canadian Net Change in Employment for July will be released at 8:30am EST. The market expects an increase of 8,000 versus an increase of 7,300 previous. The unemployment rate is expected to remain unchanged at 7.2%.

Recap of Yesterday’s Economic Events:

The Markets
Equity markets ended flat on Thursday despite better than expected reports in the US pertaining to employment and international trade. Volume was once again deadly, amounting to the lowest four-day volume in 5 years. In an article posted by Zerohedge.com, the website notes that “the last 4 days have been the lowest volume for a non-Xmas holiday week since 2007 in futures and NYSE volumes are just remarkably bad compared to even normal cyclical seasonal dips.” Looking at the 4-day simple moving average of the S&P 500 ETF (SPY) volume, the last time the average was this low outside of a Christmas holiday week was October 2007, the last market high prior to the significant decline in the months and years to follow in 2008/2009. Volume confirms conviction, of which very little exists. Conviction to equities remains low as debate grows over the sustainability of the present rally that appears based solely on hope of further monetary stimulus from one of the major central banks around the world.

The divergence between price and volume can also be picked up on the NYSE Cumulative Advance-Decline Volume line, which is derived from the volume of advancing stocks less the volume of declining stocks. The NYSE recently managed to break firmly above the high of early July, yet the NYSE Cumulative Advance-Decline Volume Line has yet to accomplish the same. The pattern of this breadth indicator and price typically match each other, showing similar highs and lows, therefore this divergence just adds to the concern that conviction to equities is lacking, often a precursor to market declines should buyers fail to accumulate.

Sentiment on Thursday, according to the put-call ratio, ended bullish at 0.86. The apparent declining wedge pattern that can be derived from the ratio over the past three months is reaching a peak, which could imply a significant jump higher should the tendencies of this pattern be fulfilled. A significant move higher in the put-call ratio would likely be accompanied by an increase in volatility, a pattern that is seasonally common between now and October.

S&P 500 Index

Chart Courtesy of StockCharts.com

TSE Composite

Chart Courtesy of StockCharts.com

Horizons Seasonal Rotation ETF (TSX:HAC)

• Closing Market Value: $12.37 (down 0.24%)
• Closing NAV/Unit: $12.39 (up 0.18%)

Performance*

* performance calculated on Closing NAV/Unit as provided by custodian

Click Here to learn more about the proprietary, seasonal rotation investment strategy developed by research analysts Don Vialoux, Brooke Thackray, and Jon Vialoux.

Copyright © Don Vialoux, EquityClock.com

Tags: Canadian, Canadian Market, Central Banks, Christmas Holiday, Conviction, CPI, Dips, Divergence, Don Vialoux, Economic Events, ETF, ETFs, Export Prices, Import Export, International Trade, Moving Average, Nyse, Stimulus, Trade Volume, Treasury Budget, Unemployment Rate, Volatility, Xmas Holiday
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Bond Model Positive = Risk Off

Tuesday, August 7th, 2012

by Guy Lerner, The Technical Take

Our bond model turned positive one week ago, and since the bottom in March, 2009, this has generally meant “risk off” for the markets.

Figure 1 is a weekly chart of the SP500.  In the lower panel is an analogue representation of our bond model.  Currently with the value “up”, the bond model is positive and we should expect higher bond prices and lower yields.  Looking at the SP500, I have put buy and sell signals on the price bars that corresponds to those times when the bond model is positive.  As you can see, the bond model was positive during the market tops of 2010 and 2011.  In each instance, rising bond prices was forecasting economic weakness that ultimately led to QE2 and Operation Twist.

Figure 1. SP500 v. Bond Model/ weekly

Since March, 2009 with the bond model positive (i.e., falling yields), the SP500 has gained 14.99% on a cumulative basis, and as you can see, the majority of the gains occurred in the initial thrust from the lows.  Since 2010, buying equities when the bond model is positive has produced a little gains for your efforts.  But there has been a lot volatility.  Clearly, this has been the “risk off” period.  In contrast, since March, 2009 with the bond model negative (i.e., rising yields), the SP500 has gained 39.04% cumulatively.  All 9 trades have been winners.

In summary, our bond model is positive.  Over the past 2 years, this has coincided with economic weakness and an equity market top in 2010 and 2011.

Copyright © The Technical Take

Tags: Analogue, Bond Market, Bond Prices, Cumulative Basis, Economic Weakness, Figure 1, Guy Lerner, Initial Thrust, Lows, Market Tops, Qe2, risk, S&P500, Signals, Trades, Volatility
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Mythbusting: How Elections Affect Markets

Friday, August 3rd, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

Elections do matter for the markets, but not necessarily for the reasons that investors tend to believe. Ahead of the US presidential election in November, I’m going to attempt to debunk some of the common myths surrounding markets and elections:

Myth #1: Party affiliation matters when it comes to market returns.

There is little to no evidence to support the fact that the winning candidate’s party makes a difference to markets. Over the past century, which party occupies the White House has had no discernible or consistent impact on US equity markets. Since 1900, when a Democrat has been in the White House, the average return for the Dow Jones Industrial Average has been around 8.5%; for Republicans the average is around 6% (neither average includes dividends). When you adjust those averages for the market’s volatility, the numbers are statistically the same. In other words, the party affiliation of the president has had no consistent influence on stock market performance, though many investors still believe this.

Myth #2: Divided government is good for the financial markets.

Following the halcyon days of the 1990s, many investors have come to believe this myth. While divided government was certainly good for markets in the 1990s, that seems to have been an anomaly. The 1990s were unusual and were a function of many factors, including a secular drop in interest rates, a productivity surge, and the taming of inflation. Unfortunately, conditions are very different today.

Looking at the last century of data, there is no evidence that divided government produces better returns. In fact, in the past equities appear to have actually done better when one party has controlled both Congress and the White House, though the numbers backing this better performance aren’t statistically significant and should be taken with more than a grain of salt.

What Does Matter: Policy

None of the above implies that the outcome of this election is irrelevant for financial markets. While politicians cannot fix much of what ails the global economy, sensible economic policy would help mitigate the damage. There is also quite a bit that politicians can do to make matters worse. In short, as I write in my new Market Perspectives piece, the election will matter a great deal.

There are a number of issues, both long and short-term, which can only be solved in Washington. The absence of progress will likely worsen the economic malaise and in the case of the fiscal cliff push, the United States back into recession. On the other hand, real progress on taxes and entitlements could remove at least some of the headwinds holding back growth.

Both the fiscal cliff and the entitlements issue are extremely important to the capital markets. Evidence that we’re not doing everything we can to resolve them is likely to push stocks lower and volatility higher. To state the obvious, should we allow this to occur it would be a game changer for US financial markets.

If we wake up on the morning of November 7 with continued divided government and no consensus on reform and then no consensus is reached before the fiscal cliff hits in January, investors may want to consider opting for these five portfolio moves:

1.) Less equity exposure

2.) A higher allocation to defensive sectors like consumer staples and healthcare, accessible through the iShares S&P Global Consumer Staples Sector Index Fund (NYSEARCA: KXI) and the iShares S&P Global Healthcare Sector Index Fund (NYSEARCA: IXJ).

3.) Less credit exposure in the fixed income section of their portfolios

4.) A smaller allocation to commodities

5.) A higher weight to dollar-denominated assets

Source: Bloomberg

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

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. Narrowly focused investments typically exhibit higher volatility.

Copyright © iShares

Tags: 1990s, Anomaly, Chief Investment Strategist, Common Myths, Democrat, Dividends, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Financial Markets, Grain Of Salt, Halcyon Days, inflation, Ishares, Koesterich, Myth 2, Party Affiliation, Russ, Stock Market Performance, Us Presidential Election, Volatility
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Equity Implications for a Modest-Return World

Monday, July 30th, 2012

by Andrew Pyne, PIMCO

• Equity valuations appear reasonable, but volatility is likely to remain elevated amid slowing global economic growth and macroeconomic risks.
• As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value.
• Investors should consider increasing exposure to emerging markets, deploying downside-risk and volatility-mitigation, emphasizing dividends and focusing on active share.

PIMCO’s secular outlook calls for slowing global economic growth, a world that is still multi-speed, and unresolved macroeconomic risks that are likely to result in continued heightened volatility. While our view on the economy is a cautious one, overall equity valuations appear reasonable, and corporate fundamentals, as measured by earnings, margins and balance sheets, are relatively attractive. The outlook for equities, then, can be expressed as a tug of war between these macro headwinds and micro fundamentals.

What does this mean for equities, which are still the dominant risk in investor portfolios? Overall, we believe that continued policy confusion and economic fundamentals that are trending in a negative direction will create headwinds. As the developed world continues to delever, we expect global equities to experience a modest-return environment.

Challenges and solutions

The clear implication is that this creates a challenge for investors. Most investors historically have relied on equities to help achieve their target portfolio returns. In this environment, though, beta is unlikely to deliver the returns required. We believe that investors should consider the following:

• Increase exposure to faster-growing economies. Many portfolios should be more global with higher allocations to emerging markets.
• Incorporate downside-risk and volatility-mitigation to address the higher probabilities of negative macro events.
• Emphasize dividends, which will likely be a more important component of equity total returns.
• Take greater active risk and focus on active share. In a modest-return world, if beta doesn’t get the job done, then alpha may be a significant percentage of an investor’s equity returns.

Multi-speed world

The key risk to the global economy is Europe, which given significant structural challenges and policy uncertainty is facing prolonged subdued growth and the risk of recession. Why then do we suggest equity portfolios be more global? The answer lies partly in the way equities have traditionally been categorized. Companies are often classified by their country of domicile, but we think they are better defined by their end-markets. Despite significant risks at home, many European multinationals have meaningful exposure to emerging markets. If we find businesses with stable cash flows, high dividend yields, strong end-market growth – and with valuations that discount home-market risks – these can be attractive investment opportunities.

In addition, we believe most investors, particularly those with a home-market bias, would benefit from increased direct exposure to emerging markets. While emerging markets are certainly not immune to the struggles of the developed world, emerging markets and developed markets face very different economic scenarios. We expect emerging markets to continue to gain share of global GDP, but most investors are still underweight the asset class. We expect emerging markets to account for more than 50% of global GDP in purchasing power parity terms over the next three to five years. They already are about a third of global equity market caps. Yet emerging market equities represent only about 7% of the average investor’s portfolio.

Managing macro risks

Our second suggestion is to prioritize downside- and volatility-mitigation in equity portfolios. Correlations among stocks have increased meaningfully over the past few years; they’ve tended to spike around negative macro events and decrease as uncertainty subsides (see Figure 1). This suggests that the “risk-on/risk-off” sentiment that drives stock prices is often governed by macro news flows, not company fundamentals.

There are two takeaways for investors. The first is that macro does impact stock prices, and so while equity investing has traditionally been thought of as a bottom-up endeavor, we believe managers need to consider both bottom-up and top-down views as part of their research process.

The second takeaway is that because there are unresolved macro risks, investors must recognize that, given the way returns compound over time, protecting on the downside could be a critical contributor to long-term returns. Part of the solution may be increasing allocations to active mandates from passive. Although investors could lose more with an active approach, by definition traditional indexes will capture 100% of down-market performance.

We believe protecting on the downside requires a very active approach. Strategies including low-volatility and dividend-focused investing, tail-risk hedging, and flexibility to short stocks or raise cash, may result in improved risk mitigation compared with a passive strategy.

Dividend income

Dividend income, a significant portion of historical equity returns, is likely to be even more important in an environment of slower growth. Of course, if we were expecting broad multiple expansion and strong global growth – as we saw in the ‘80s and ‘90s – then the message simply would be “buy equities and enjoy the ride.” As Figure 2 shows, however, dividends often have been a substantial portion of total equity performance during periods of modest returns. While many investors’ assumptions and expectations for equities were formed by the 20-year bull market of the ‘80s and ‘90s, the ‘40s, ‘60s and ‘70s may be more instructive for the period ahead.

We also believe the opportunity for dividend-paying stocks is more of a global story than a U.S. one. Given demand from U.S. investors for income, traditional dividend-paying sectors in the U.S. – telecom, utilities, Real Estate Investment Trusts (REITs), and Master Limited Partnerships (MLPs) – are generally quite expensive, whereas select non-U.S. equities, including emerging markets, remain attractive sources of yield.

Essential alpha

Two points outlined above – the notion that macroeconomic news flow influences stock prices and the expectation for modest returns – each reinforce the importance of alpha in helping investors achieve their goals. As macro events drive markets, the probability of fundamental mispricing increases, providing opportunity for active managers to add value. The key is to be highly selective, identifying the long-term winners even as the markets are indiscriminate in the short term.

For many investors, the importance of alpha should prompt a reconsideration of the mix of passive and active equity allocations. At the very least, we believe investors should ensure that their active managers are truly active, with high active share a prerequisite for inclusion in their portfolio (please see Equity Investing: From Style Box to Global Unconstrained, May 2012).

Revisiting equity portfolios

In an environment of fatter tails, there is always the possibility of a right-tail event. Enactment of comprehensive and bipartisan policies to address structural problems in developed markets, for example, would be welcome news and would likely lead to broad multiple expansion and higher returns in the equity markets. However, absent such developments, economic fundamentals suggest more modest returns.

Many investor portfolios may not be positioned for a lower-return world, particularly those that were structured during a higher-return equity environment. We believe investors would be well served to take a fresh look at their equity allocations. If beta will not suffice, then investors should work to ensure their portfolios have the characteristics needed to succeed.

Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. 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. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. 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.

The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. 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 for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The S&P 90 (prior to 1957) was a value-weighted index based on 90 stocks. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been 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 material may be reproduced in any form, or referred to in any other publication, without express written permission.

©2012, PIMCO.

Tags: Active Share, Balance Sheets, Downside Risk, Economic Fundamentals, Emerging Markets, Global Economic Growth, Global Equities, Headwinds, Impo, Mitigation, Negative Direction, PIMCO, Policy Confusion, Portfolio Returns, Pyne, Target, Tug Of War, Valuations, Value Investors, Volatility
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Only the Lonely Can Play

Wednesday, July 11th, 2012

by William Smead, Smead Capital Management

Successful investing is the defeat of human nature. Human beings prefer to buy shares of a common stock which have gone up in price recently. They prefer to participate in styles and sectors which have done better in the most recent five to seven years. Lastly, human beings prefer to make money sooner, rather than later. Fortunately for us, THE MOTELS wrote and performed a song back in the early 1980’s (Only the Lonely), which explains what we believe is needed to be a successful common stock owner and what we need to do in the marketplace as we look out into the second half of 2012. Excuse me while I expose the fact that I was somewhat addicted to music videos in my early twenties.

We walked the loneliest mile
We smiled without any style
We kiss altogether wrong
No intention

The price you pay to participate in the ownership of a business is usually critical to the compounded returns you will receive. Risk, in our view, is determined by the dollar outlay, not the volatility of either the stock price or stock market movements. Numerous studies have been done by such stalwarts as Francis Nicholson, Fama-French, Bauman-Conover and David Dreman on how much valuation matters to forward stock price performance. Regardless of the valuation metric used (PE ratio, Book Value, etc.), the studies all show that the cheapest stocks as a group outperform all other groups over short periods (one year) and longer periods (seven years).

To pay these depressed prices you must “walk the loneliest mile”. The warts that these out-of-favor shares carry mean that you “smile without any style”. Avoiding popular securities and cozying up with cheap stocks means that “we kiss altogether wrong”. It means that for a significant period of time that you have “no intention” of your securities reaching any meaningful popularity. It’s like she told us in the video, “Only the lonely can play.”

We lied about each other’s dreams
We lived without each other thinkin’
What anyone would do
Without me and you

Investment styles and sectors which have done extremely well must be avoided, in our opinion. A “well known fact” is a body of economic information which is known to everyone in the marketplace and has been acted upon by nearly anyone who could get access to capital. The problem with the “well known fact” is that we become convinced of it at exactly the wrong time. Think of it like this; everyone was very excited about the possibility of a radio in every home or car in 1929, confident about Japan as a great manufacturer in 1989 and that the internet was going to change our lives in 1999.

The problem is that stock prices “lied about each other’s dreams.” If you bought RCA in 1929 or the Nikkei Index in 1989 or Cisco in 1999, you know what a lie the “well known fact” was. Losses over the following years were stunning. Warren Buffett says it best when he says, “What the wise man does in the beginning, the fool does at the end.” Human beings like to gather together and be part of a crowd. We go to concerts and sports stadiums to cheer our favorite team or sing with our favorite performers. We don’t like to live “without each other”. We wonder as human beings how we could possibly do well investing without doing “what anyone would do.”

We believe there is an extremely damaging “well known fact” today, which will destroy capital over the next three to five years. Over the last two years, we have observed that institutional and individual investors “know” that China is not susceptible to business cycles and “know” that the emerging middle classes arising in BRIC and commodity-producing countries will cause demand for commodities like the world has never seen.

This fact might be true, but “what anyone would do” with this fact will have to be done “without me and you”. Former Intel CEO, Andy Grove, was asked what the best advice was that he ever got in business. He quoted his professor from the City College of New York who said, “When everybody knows that something is so, it means nobody knows nothin’!”

So hold on here we go
Hold on to nothin’ we know
I feel so lonely way up here

The weird thing about successful investing and defeating human nature is the intense urge to “hold on to nothin’ we know”. By avoiding China, the BRIC trade, commodities, energy stocks, basic materials companies, heavy industrial shares and anyone or anything that has “suckled on the bounteous teat” of China, we “feel so lonely way up here”. We believe it was the central reason for our outperformance over the last twelve months in the US stock market.

We mention the time we were together
So long ago, well I don’t remember
All I know is that it makes me feel good now

It’s like I told you
Only the lonely can play

Valuation matters and avoiding what is popular is critical, but none of it matters if you don’t practice long duration. In the stock market environment of the last five years, human beings have struggled to stay put in good quality common stocks which fit our eight proprietary criteria. Imagine how nearly impossible it is for the average investor to hold an index ETF or shares of their local company for any longer than six months. This is why, “We mention the time we were together.” Market timing produces trading costs and it is the enemy of the portfolio results of the human beings. Studies show that humans pour money into the stock market when it is popular and withdraw money when it is on sale. The combination of cutting off winning securities and incurring meaningful annual cost of as much as 1.5% to come in and out of the stock market is why most active managers under-perform the index they are benchmarked against. For us, our time frame is “so long ago, well I don’t remember”.

The reason to participate in the ownership of common stocks is to create wealth. When you invest in a portfolio of good quality securities, which aren’t part of the market’s most popular sectors and hold them for a long time, you are allowed to sing, “All I know is that it makes me feel good now.” Everyone wants to look back in five to seven years and be happy about what they accomplished with their portfolio when it comes to creating wealth. “But like I told you, only the lonely can play!”

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. All of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date stated in this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

Copyright © Smead Capital Management

Tags: Bauman, Capital Management, Cheap Stocks, Common Stock, Conover, David Dreman, Depressed Prices, Drea, Fama French, Francis Nicholson, Human Nature, Outlay, Pe Ratio, Short Periods, Smead, Stalwarts, Stock Price Performance, Valuation Matters, Volatility, Warts
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Global PMI: The Trend is Your Friend

Tuesday, July 10th, 2012

by Frank Holmes, CEO, CIO, U.S. Global Investors

Manufacturing around the world weakened in June, according to the JP Morgan Global Manufacturing Purchasing Managers’ Index (PMI). Its reading of 48.9 was the lowest in three years and the first dip below 50 since September 2011. The current reading is also below the three-month moving average for the second month in a row. As you can see on the chart, PMI crossed below the three-month in May.

While Europe, China and the U.S. were primarily responsible for the slowed activity, we believe the trend is your friend. In April, global PMI crossed above the three-month moving average, and historically, when a “cross-above” has happened, it’s signaled higher prices for many commodities. Take a look at the chart below which shows the following:

Ninety percent of the time, copper rose 10 percent over the following three months. Eighty-five percent of the time, West Texas Intermediate oil has also increased. Its median three-month change has been an increase of 11 percent.

Materials and energy were also positively affected, with modest results: When the PMI crosses above the three-month average, 70 percent of the time, the S&P 500 Materials Index rose, with a median return of about 3 percent. The S&P 500 Energy Index had a median three-month return of about 5 percent, with an 80 percent chance of the three-month change being positive.

Using history as a guide, this suggests that by the end of July, we could see strength in these commodities and energy and materials stocks. Although volatility and uncertainty rule the markets these days, we believe that the world’s central bankers are taking note of slowed activity and will act if deemed necessary.

The trend is your friend only if your portfolio is “resourceful” enough to benefit. Read the Financial Planning article, which showed how U.S. Global Investors’ Global Resources Fund strengthened a diversified portfolio over the past 10 years. Read the article.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. Because the Global Resources Fund concentrates its investments in a specific industry, the fund may be subject to greater risks and fluctuations than a portfolio representing a broader range of industries.

Diversification does not protect an investor from market risks and does not assure a profit.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

The Purchasing Manager’s Index is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The S&P 500 Energy Index is a capitalization-weighted index that tracks the companies in the energy sector as a subset of the S&P 500. The S&P 500 Materials Index is a capitalization-weighted index that tracks the companies in the material sector as a subset of the S&P 500.

Tags: Amp, Commodities, Copper, Diversified Portfolio, Energy Index, Financial Planning, Frank Holmes, Global Resources, Jp Morgan, Moving Average, Nbsp, Pmi, Purchasing Managers Index, Resources Fund, S Central, Three Months, U S Global Investors, Uncertainty, Volatility, West Texas Intermediate
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Why Investors Persist Hanging on to Long Treasuries at Such Low Yields

Monday, July 2nd, 2012

Some readers have asked if other fixed income asset classes could be just as effective as long term treasuries for an equities portfolio in hedging an equities book (discussed here). Here the comparison is made to municipal bonds, investment grade corporate bonds, and HY corporate bonds. Long term treasuries are still superior in reducing the portfolio volatility – at least based on the last couple of years. That’s because muni and corporate spreads tend to be inversely correlated to equities, reducing the hedge effectiveness of these instruments.

Again, the x-axis is the percent of the portfolio invested in the S&P500, with the rest of the portfolio being in one of the fixed income asset classes. The y-axis is the combined portfolio daily volatility over the past two years.

That is the reason investors are willing to take asymmetric risk and dismal current yield to hold long term treasuries. Whether this relationship holds going forward remains unclear. A scenario in which both treasuries and equities sell off some time in the future is not unrealistic.

SoberLook.com

Tags: Amp, Asset Classes, Axis, Bonds Investment, Corporate Bonds, Current Yield, Fixed Income, Investors, Municipal Bonds, P500, Portfolio, Reason, Relationship, risk, Treasuries, Volatility
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A Lesson in Minimum Volatility Gleaned at the Horse Races (Morillo)

Thursday, June 7th, 2012

by Daniel Morillo, iShares

At the Belmont Stakes horse race coming up June 9, I’ll Have Another will attempt to become the 12^thhorse to win the Triple Crown. Now, I’m not a huge fan of horse racing, but the economist in me is always intrigued by what sporting events can teach us about investor behavior. In particular, I’m interested not in which horse wins the race but in how those who follow the races place their bets. Let me explain why – and how it applies to minimum volatility portfolios.

In an earlier blog post, I argued that equity minimum volatility portfolios are potentially a good replacement for a traditional equity investment in a cap-weighted market portfolio. Key to this claim is the fact that a wide range of empirical studies show that minimum volatility portfolios have performed equally well, if not better, than the market but have done so with lower risk.

Still, no matter the strength of the historical observation, I am continually asked whether minimum volatility portfolios can continue to perform as they have in the past. One way of answering the question is to focus on what are the sources of the performance of minimum volatility portfolios and make an assessment of their likely persistence

Today I want to discuss “behavioral” sources for the low-risk anomaly. “Behavioral” is a catch-all term that encompasses a wide range of theories of how people’s behavior appears to deviate from the theoretically ideal behavior when dealing with uncertainty.

My favorite example is what has been known since the 1950s as the “favorite/long-shot bias”[1]. This is the finding that people who bet on horse races bet on the long-shot horses more than would be justified by the actual odds of winning (and conversely bet less than they should on the favorite horses). The story generally goes like this: Horse-racing bettors have difficulty evaluating small differences in outcome probabilities, for example the difference between a 1-in-50 odds horse and a 1-in-100 odds horse. That’s a 2% probability of winning versus a 1% probability of winning. This results in a large proportion of bettors placing too high of a bet on the longer odds because the potential winnings appear larger in that case[2].

If I replace horses with stocks, you can see where this leads: Stocks with high beta (or high risk) may be “overbought” (leading to future underperformance) and vice-versa for low-beta (or low risk) stocks. While the various theories around this behavior can get complicated (as theory always does), there is a common theme: Investors have difficulty evaluating small differences in probabilities, particularly when large outcomes are possible. This results in an apparent preference for risky assets of various kinds, thus leading to their underperformance[3].

Why is this explanation interesting? It tells us that the “hurdle” for thinking that the low-risk effect may persist in the future could be similar to other factors that equity investors have already come to rely on, like momentum investing, which are tied to behavioral explanations.

There is an additional reason that the low-risk effect may persist. This is the fact that the widespread use of active-management benchmarks may induce money managers to prefer high-beta stocks even in the absence of any behavioral biases. More on this on my next post.

Daniel Morillo, PhD is the iShares Head of Investment Research and a regular contributor to the iShares Blog. You can find more of his posts here.

Past performance does not guarantee future results.

[1] Griffith, R. M. 1949. “Odds Adjustments by American Horse-Race Bettors.” American J. Psychology 62 (August): 290–94

[2] See, for example, “Explaining the Favorite-Long Shot Bias: Is it Risk-Love or Misperceptions?” Journal of Political Economy 2010, vol 118, no 4.

[3] See, for example, Barberis N. and Huang M. “Stocks as Lotteries: The implications of Probability Weighting for Security Prices”. American Economic Review 2008, 98:5 2066-2100.

Tags: 1950s, Anomaly, Answering The Question, Belmont Stakes, Belmont Stakes Horse Race, Bias, Economist, Empirical Studies, Equity Investment, Horse Races, Horse Racing, Investor Behavior, Ishares, Market Portfolio, Persistence, Portfolios, Probabilities, Sporting Events, Triple Crown, Volatility
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