Posts tagged ‘volatility’
From Rocket Ship to Roller Coaster
The stock market has been like a rocket ship over the last three years 2019/2020/2021, advancing +90% as measured by the S&P 500 index, and +136% for the NASDAQ. After this meteoric multi-year rise, stock values started to come back to earth in 2022, and the rocket ship turned into a roller coaster during January. More specifically, the S&P 500 fell -5% for the month and the NASDAQ -9%. Yes, it’s true volatility has increased, and your blood pressure may have risen with all the ups and downs. However, the fact remains the economy remains strong, corporate profits are at record levels, unemployment is low, and interest rates remain at attractive levels despite nagging inflation (see chart below) and the removal of accommodative monetary policies by the Federal Reserve.
Math Matters
I did okay in school and was educated on many different topics, including the basic principle that math matters. This notion rings especially true when it comes to finance and investing. As I have discussed numerous times in the past, money goes where it is treated best, which is why interest rates, cash flows, and valuations play such a key role in ultimately determining long-term values across all asset classes. This concept of money seeking the best home applies equally to stocks, bonds, real estate, commodities, crypto-currencies, and any other asset class you can imagine because interest rates help determine the cost of holding and using money.
Normally, mathematics teaches us the lesson that more is better when discussing financial matters. And currently the stock market is compensating investors significantly more for investing in stocks relative to investing in bonds – I have reviewed this concept repeatedly on my Investing Caffeine blog (see Going Shopping: Chicken vs. Beef ). Currently, investors are getting paid about +5% to hold stocks based on the forward earnings yield (i.e., the inverse of the stock market’s Price-Earnings ratio of 20x) vs. the +2% yield on the 10-Year Treasury Note (1.78% more precisely on 1/31/22). What’s more, historically speaking, stock investors typically get rewarded with an earnings yield that doubles about every 10 years, whereas bond yields usually remain stagnantly flat, if bonds are held until maturity.
With that said, I am always quick to point out that diversification in a portfolio is important (i.e., most people should at least own some bonds), even if bonds are currently very expensive relative to other asset classes (see Sleeping on Expensive Financial Pillows). If bond yields climb significantly to the point where returns are more competitive with stocks, I will likely be buying significantly more bonds for me and my Sidoxia (www.sidoxia.com) clients.
Fed Jitters
The recent stock market volatility is reinforcing the idea that the Federal Reserve’s more aggressive stance regarding hiking interest rates is making many investors very anxious – just not me. I have lived through many tightening cycles in my lifetime and lived to tell the tale. It is true that all else equal, higher interest rates generally depress asset values, but it is also important to place the current interest rate environment in historical context. Although the Federal Funds interest rate target is expected to increase to 2.5% over the next few years (currently at 0%), this forecast is nothing new and there is no guarantee the Fed can successfully pull off this feat. Many people have short memories and forget the Fed hiked interest rates 10 times from the end of 2015 through 2018. In the face of this scary period, the stock market (S&P 500) still managed to approximately climb a respectable +22% (albeit with some volatility). Furthermore, if you give the Fed the benefit of the doubt of achieving this uncertain target, this 2.5% level is very appealing and still extremely low, historically speaking (see chart below).
When discussing interest rates and inflation, investors should also expand their views globally to the other 95% of the world’s population. Many investors are very myopic in their focus on U.S. interest rates. It is important to understand that rates are not just low here in the United States, but also low almost everywhere else as well. While international interest rates have bounced marginally higher in recent months, those countries’ long-term international rates, by and large, remain tremendously low too – in most cases even lower than rates in the U.S. (see chart below). Yes, the Fed has some control over short-term interest rates in the U.S., but considering other crucial forces that are depressing long-term global rates is worth pondering. Factors such as globalization and the pervading expansion of deflationary technology into our personal and work lives are contributing to disinflation. Valuable conclusions can be synthesized beyond digesting the pessimistic and nauseating analysis of Jerome Powell’s Congressional testimony, along with the needless wordsmithing of recent Fed minutes.
In order to earn above-average, financial returns in your portfolio over the long-run, experiencing unsettling volatility and corrections is the price of doing business. Flying on rocket ships might be fun, but sometimes the rocket can run out of gas, and you are forced to jump on a roller coaster. The ups-and-downs can be frustrating at times, but if you stay on for the full ride, you will almost always end with a smile on your face when it’s over.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (February 1, 2022). Subscribe on the right side of the page for the complete text.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in PFE and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
January a Ball After Year-End Fall
Investors were cheerfully dancing last month after the stock market posted its best January in 30 years and the best monthly performance since October 2015 (see chart below). More specifically, the S&P 500 index started the year by catapulting +7.9% higher (the best January since 1987), and the Dow Jones Industrial Average climbed 1,672 points to 25,000, or +7.2%. But over the last few months there has been plenty of heartburn and volatility. The December so-called Santa Claus rally did not occur until a large pre-Christmas pullback. From the September record high, stocks temporarily fell about -20% before the recent jolly +15% post-Christmas rebound.
Source: FactSet via The Wall Street Journal
Although investors have been gleefully boogying on the short-run financial dance floor, there have been plenty of issues causing uncomfortable blisters. At the top of the list is China-U.S. trade. The world is eagerly watching the two largest global economic powerhouses as they continue to delicately dance through trade negotiations. Even though neither country has slipped or fallen since the 90-day trade truce, which began on December 1 in Buenos Aires, the stakes remain high. If an agreement is not reached by March 2, tariffs on imported Chinese goods would increase to 25% from 10% on $200 billion worth of Chinese goods, thereby raising prices for U.S. consumers and potentially leading to further retaliatory responses from Beijing.
When it comes to the subjects of intellectual property protection and forced technology transfers of American companies doing business in China, President Xi Jinping has been uncomfortably stepping on President Donald Trump’s toes. Nothing has been formally finalized, however Chinese officials have signaled they are willing to make some structural reforms relating to these thorny issues and have also expressed a willingness to narrow the trade deficit with our country by purchasing more of our exports. Besides procuring more American energy goods, the Chinese have also committed to buy 5,000,000 tons of our country’s soybeans to feed China’s hungry population of 1.4 billion people.
Reaching a trade settlement is important for both countries, especially in light of the slowing Chinese economy (see chart below) and the dissipating stimulus benefits of the 2018 U.S. tax cuts. Slowing growth in China has implications beyond our borders as witnessed by slowing growth in Europe as evidenced by protests we have seen in France and the contraction of German manufacturing (the first time in over four years). Failed Brexit talks of the U.K. potentially leaving the European Union could add fuel to the global slowdown fire if an agreement cannot be reached by the March 29th deadline in a couple months.
Source: Wind via The Wall Street Journal
While the temporary halt to the longest partial federal government shutdown in history (35 days) has brought some short-term relief to the 800,000 government workers/contractors who did not receive pay, the political standoff over border security may last longer than expected, which may further dampen U.S. economic activity and growth. Whether the hot-button issue of border wall funding is resolved by February 15th will determine if another shutdown is in the cards.
Despite China trade negotiations and the government shutdown deadlock placing a cloud over financial markets, brighter skies have begun to emerge in other areas. First and foremost has been the positive shift in positioning by the Federal Reserve as it relates to monetary policy. Not only has Jay Powell (Fed Chairman) communicated a clear signal of being “patient” on future interest rate target increases, but he has also taken the Fed off of “autopilot” as it relates to shrinking the Fed’s balance sheet – a process that can hinder economic growth. Combined, these shifts in strategy by the Fed have been enthusiastically received by investors, which has been a large contributor to the +15% rebound in stock prices since the December lows. Thanks to this change in stance, the inverted yield curve bogeyman that typically precedes post-World War II recessions has been held at bay as evidenced by the steepening yield curve (see chart below).
Source: Calafia Beach Pundit
Other areas of strength include the recent employment data, which showed 304,000 jobs added in January, the 100th consecutive month of increased employment. Fears of an imminent recession that penetrated psyches in the fourth quarter have abated significantly in January in part because of the notable strength seen in 4th quarter corporate profits, which so far have increased by +12% from last year, according to FactSet. The strength and rebound in overall commodity prices, including oil, seem to indicate any potential looming recession is likely further out in time than emotionally feared.
Source: Calafia Beach Pundit
As the chart above shows, over the last four years, spikes in fear (red line) have represented beneficial buying opportunities of stocks (blue line). The pace of gains in January is just as unsustainable as the pace of fourth-quarter losses were in stock prices. Uncertainties may remain on trade, shutdowns, geopolitics, and other issues but don’t throw away your investing dance shoes quite yet…the ball and music experienced last month could continue for a longer than expected period of time.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (February 1, 2018). Subscribe on the right side of the page for the complete text.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Will the Halloween Trick Turn into a Holiday Treat?
The interest rate boogeyman came out in October as fears of an overzealous Federal Reserve monetary policy paralyzed investors into thinking rising interest rates could murder the economy into recession. But other ghostly issues frightened the stock market last month as well, including mid-term elections, heightening trade war tensions, a weakening Chinese economy, a fragile European economy (especially Italy), rising oil prices, weakening emerging market economies, anti-Semitism, politically motivated bomb threats, and anxiety over a potential recession after an aged economic expansion embarks on its 10th consecutive year of gains.
This ghoulish short-term backdrop resulted in the Dow Jones Industrial Average suffering a -5.1% drop last month, and the technology-heavy NASDAQ index screamed even lower by -9.2%. The results for the full year 2018 look more constructive – the S&P 500 is up +1.4% and the NASDAQ has climbed +5.8%.
Should the dreadful October result be surprising? Historically speaking, seasonality in the stock market has been quite scary during the month of October, especially if you consider the spooky stock Market Crash of 1929 (-19.7%) , the 1987 Crash (-21.5%), and the bloody collapse during the October 2008 Financial Crisis (-16.8%). There is good news, however. Seasonally, the holiday months of November and December typically tend to treat investors more cheerfully during the so-called “Santa Claus Rally” period. Since 1950 through 2017, the average return for stocks during November has been +1.4% (45 up years and 23 down years). For December, the results are even better at +1.5% (51 up years and 17 down years).
| November (1950-2017) | December (1950-2017) | |||
| Up Years | Down Years | Up Years | Down Years | |
| 2017 2.40% | 2015 -0.02% | 2017 1.08% | 2015 -1.87% | |
| 2016 3.29% | 2011 -0.32% | 2016 1.76% | 2014 -0.33% | |
| 2014 2.45% | 2010 -0.44% | 2013 2.31% | 2007 -0.76% | |
| 2013 2.68% | 2008 -7.48% | 2012 0.70% | 2005 -0.10% | |
| 2012 0.28% | 2007 -4.18% | 2011 0.86% | 2002 -6.03% | |
| 2009 5.74% | 2000 -8.01% | 2010 5.99% | 1996 -2.15% | |
| 2006 1.66% | 1994 -3.93% | 2009 1.48% | 1986 -2.83% | |
| 2005 3.52% | 1993 -1.29% | 2008 1.65% | 1983 -0.87% | |
| 2004 3.86% | 1991 -4.39% | 2006 1.26% | 1981 -3.01% | |
| 2003 0.71% | 1988 -1.89% | 2004 3.25% | 1980 -3.39% | |
| 2002 5.71% | 1987 -8.51% | 2003 5.08% | 1975 -1.15% | |
| 2001 7.52% | 1984 -1.51% | 2001 0.76% | 1974 -1.78% | |
| 1999 1.92% | 1976 -0.78% | 2000 0.41% | 1969 -1.87% | |
| 1998 5.91% | 1974 -5.32% | 1999 5.78% | 1968 -4.16% | |
| 1997 4.46% | 1973 -11.39% | 1998 5.64% | 1966 -0.15% | |
| 1996 7.34% | 1971 -0.25% | 1997 1.57% | 1961 -0.32% | |
| 1995 4.10% | 1969 -3.41% | 1995 1.74% | 1957 -3.31% | |
| 1992 3.03% | 1965 -0.88% | 1994 1.26% | ||
| 1990 6.00% | 1964 -0.52% | 1993 0.98% | ||
| 1989 1.65% | 1963 -1.05% | 1992 1.01% | ||
| 1986 2.15% | 1956 -3.10% | 1991 11.19% | ||
| 1985 6.51% | 1951 -0.95% | 1990 2.48% | ||
| 1983 1.74% | 1950 -0.26% | 1989 2.14% | ||
| 1982 3.60% | 1988 1.48% | |||
| 1981 3.27% | 1987 7.28% | |||
| 1980 10.24% | 1985 4.51% | |||
| 1979 4.26% | 1984 2.24% | |||
| 1978 0.61% | 1982 1.50% | |||
| 1977 2.86% | 1979 1.68% | |||
| 1975 2.47% | 1978 1.16% | |||
| 1972 4.56% | 1977 0.28% | |||
| 1970 4.74% | 1976 5.25% | |||
| 1968 4.80% | 1973 1.79% | |||
| 1967 0.75% | 1972 1.18% | |||
| 1966 0.31% | 1971 8.62% | |||
| 1962 10.16% | 1970 5.68% | |||
| 1961 3.77% | 1967 2.63% | |||
| 1960 2.97% | 1965 0.90% | |||
| 1959 1.52% | 1964 0.39% | |||
| 1958 1.78% | 1963 2.44% | |||
| 1957 3.17% | 1962 1.35% | |||
| 1955 7.64% | 1960 5.08% | |||
| 1954 7.71% | 1959 2.03% | |||
| 1953 0.41% | 1958 4.78% | |||
| 1952 4.31% | 1956 1.50% | |||
| 1955 0.29% | ||||
| 1954 5.85% | ||||
| 1953 0.12% | ||||
| 1952 3.47% | ||||
| 1951 3.62% | ||||
| 1950 3.81% | ||||
While the last 31 days may have been distressing, at Sidoxia we understand that terrifying short-term volatility is a necessary requirement for long-term investors, if you desire the sweet appreciation of long-term gains. Fortunately at Sidoxia our long-term investors have benefited quite handsomely over the last 10 years from our half-glass-full perspective. The name Sidoxia actually is derived from the Greek word for “optimism” (aisiodoxia).
Performance has been fruitful in recent years, but the almost decade-long bull market has not been all smooth sailing (see Series of Unfortunate Events), as you can see from the undulating 10-year chart below (2008-2018). Do you remember the Flash Crash, Debt Ceiling, Greek Crisis, Arab Spring, Crimea, Ebola, Sequestration, and Taper Tantrum, among many other events? Similar to the volatility experienced in recent weeks, all these aforementioned events caused scary downdrafts as well.
The S&P 500 hit a low of 666 in March 2009, but even with the significant fall last month, the stock market has more than quadrupled in value to 2,711 today.
The compounding benefits of long-term investing are quite evident over the last decade when you consider the record profits of the stock market. Compounding benefits apply to individual stocks as well, and Sidoxia and its clients have experienced this first hand through ownership in positions in stocks like Amazon.com Inc. (+2,692% in 10 years), Apple Inc. (+1,324%), and Google (parent Alphabet) (+507%), and many other less-familiar growth companies have allowed our client portfolios and hedge fund to outperform their benchmarks over longer periods of time. Although we are proud of our long-term performance, we have definitely had periods of under performance, and there will come a time in which a more defensive stance will be required. However, panicking is very rarely the best course of action when you are talking about your long-term investment strategy. Staying the course is paramount.
During periods of heightened volatility, like we experienced in October, the importance of owning a broadly diversified portfolio across asset classes (including stocks, bonds, real estate, commodities, emerging markets, growth, value, etc.) is worth noting. Of course an asset allocation should be followed according to a risk tolerance appropriate for your unique circumstances. As financial markets and interest rates gyrate, investors should get in the practice of rebalancing portfolios. For example, at Sidoxia, we are consistently harvesting our gains and opportunistically redeploying those proceeds into unloved areas in which we see better long-term appreciation opportunities. This whole investment process is designed for reducing risk and maximizing returns.
As in some famously scary stock market periods in the past, October turned out to be another frightening month for investors. The good news is that we have seen this scary movie many times in the past, and we have lived to tell the tale. The economy remains strong, corporate profits are at record levels and still rising, consumer and business confidence levels are near all-time highs, and interest rates remain historically low despite the Fed’s gradual interest rate hiking policy. While Halloween has definitely worried many investors, history tells us that previous tricks may turn into holiday treats!
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (November 1, 2018). Subscribe on the right side of the page for the complete text.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in AAPL, AMZN, GOOGL, and certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Time Arbitrage: Investing vs. Speculation
The clock is ticking, and for many investors that makes the allure of short-term speculation more appealing than long-term investing. Of course the definition of “long-term” is open for interpretation. For some traders, long-term can mean a week, a day, or an hour. Fortunately, for those that understand the benefits of time arbitrage, the existence of short-term speculators creates volatility, and with volatility comes opportunity for long-term investors.
What is time arbitrage? The concept is not new and has been addressed by the likes of Louis Lowenstein, Ralph Wanger, Bill Miller, and Christopher Mayer. Essentially, time arbitrage is exploiting the benefits of moving against the herd and buying assets that are temporarily out of favor because of short-term fears, despite healthy long-term fundamentals. The reverse holds true as well. Short-term euphoria never lasts forever, and experienced investors understand that continually following the herd will eventually lead you to the slaughterhouse. Thinking independently, and going against the grain is ultimately what leads to long-term profits.
Successfully executing time arbitrage is easier said than done, but if you have a systematic, disciplined process in place that assists you in identifying panic and euphoria points, then you are well on your way to a lucrative investment career.
Winning via Long-Term Investing
Legg Mason has a relevant graphical representation of time arbitrage:
Source: Legg Mason Funds Management
The first key point to realize from the chart is that in the short-run, it is very difficult to distinguish between gambling/speculating and true investing. In the short-run (left side of graph), speculators can make nearly as much profits as long-term investors. As famed long-term investor Benjamin Graham astutely states:
“In the short-run, the market is a voting machine. In the long-run, it’s a weighing machine.”
Or in other words, speculative strategies can periodically outperform in the short run (above the horizontal mean return line), while thoughtful long-term investing can underperform. Like a gambler/speculator dumping money into a slot machine in Las Vegas, the gambler may win in the short-run, but over the long-run, the “house” always wins.
Financial Institutions are notorious for throwing up strategies on the wall like strands of spaghetti. If some short-term outperforming products randomly stick, then financial institutions often market the bejesus out of the funds to unsuspecting investors, until the strategies eventually fall off the wall.
Beware o’ Short-Termism
I believe Jack Gray of Grantham, Mayo, Van Otterloo got it right when he said, “Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” What’s led to the excessive short-termism in the financial markets (see Short-Termism article)? For starters, technology and information are spreading faster than ever with the proliferation of the internet, creating a sense of urgency (often a false sense) to react or trade on that information. With 3 billion people online and 5 billion people operating mobile phones globally, no wonder investors are getting overwhelmed with a massive amount of short-term data.
Next, trading costs have also declined dramatically in recent decades to the point where brokerage firms are offering free trades on various products. Lower trading costs mean less friction, which often leads to excessive and pointless, profit-reducing trading in reaction to meaningless news (i.e., “noise”). Lastly, the genesis of ETFs (exchange traded funds) has induced a speculative fervor, among those investors dreaming to participate in the latest hot trend. Usually, by the time an ETF has been created, any exploitable trend has already been exploited. In other words, the low-hanging profit fruits have already been picked, making long-term excess returns tougher to achieve.
There is rarely a scarcity of short-term fears. Currently, concerns vary between Federal Reserve monetary policy, political legislation, Middle East terrorism, foreign exchange rates, inflation, and other fear-induced issues du jour. Markets may be overbought in the short-run, and/or an unforeseen issue may derail the current bull market advance. However, for investors who can put on their long-term thinking caps and understand the concept of time arbitrage, opportunistically buying oversold ideas and selling over-hyped ones should lead to significant profits.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Sweating Your Way to Investment Success
There are many ways to make money in the financial markets, but if this was such an easy endeavor, then everybody would be trading while drinking umbrella drinks on their private islands. I mean with all the bright blinking lights, talking baby day traders, and software bells and whistles, how difficult could it actually be?
Unfortunately, financial markets have a way of driving grown men (and women) to tears, usually when confidence is at or near a peak. The best investors leave their emotions at the door and follow a systematic disciplined process. Investing can be a meat grinder, but the good news is one does not need to have a 90% success rate to make it lucrative. Take it from Peter Lynch, who averaged a +29% return per year while managing the Magellan Fund at Fidelity Investments from 1977-1990. “If you’re terrific in this business you’re right six times out of 10,” says Lynch.
Sweating Way to Success
If investing is so tough, then what is the recipe for investment success? As the saying goes, money management requires 10% inspiration and 90% perspiration. Or as strategist and long-time investor Don Hays notes, “You are only right on your stock purchases and sales when you are sweating.” Buying what’s working and selling what’s not, doesn’t require a lot of thinking or sweating (see Riding the Wave), just basic pattern recognition. Universally loved stocks may enjoy the inertia of upward momentum, but when the music stops for the Wall Street darlings, investors rarely can hit the escape button fast enough. Cutting corners and taking short-cuts may work in the short-run, but usually ends badly.
Real profits are made through unique insights that have not been fully discovered by market participants, or in other words, distancing oneself from the herd. Typically this means investing in reasonably priced companies with significant growth prospects, or cheap out-of-favor investments. Like dieting, this is easy to understand, but difficult to execute. Pulling the trigger on unanimously hated investments or purchasing seemingly expensive growth stocks requires a lot of blood, sweat, and tears. Eating doughnuts won’t generate the conviction necessary to justify the valuation and excess expected return for analyzed securities.
Times Have Changed
Investing in stocks is difficult enough with equity fund flows hemorrhaging out of investor accounts like the asset class is going out of style. Stocks’ popularity haven’t been helped by the heightened volatility, as evidenced by the multi-year trend in the schizophrenic volatility index (VIX) – escalated by the international geopolitics and presidential elections. Globalization, which has been accelerated by technology, has only increased correlations between domestic market and international markets. In decades past, concerns over economic activity in Iceland, Dubai, and Greece may not even make the back pages of The Wall Street Journal. Today, news travels at the speed of a “Tweet” and eventually results in a sprawling front page headline.
The equity investing game may be more difficult today, but investing for retirement has never been more important. Stuffing money under the mattress in Treasuries, money market accounts, CDs, or other conservative investments may feel good in the short run, but will likely not cover inflation associated with rising fuel, food, healthcare, and leisure costs. Regardless of your investment strategy, if your goal is to earn excess returns, you may want to check the moistness of your armpits – successful long-term investing requires a lot of sweat.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in ETFC, VXX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Thank You Volatility
“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” -Warren Buffett
We’ve had some choppy markets and that’s fine by me. Great investors love uncertainty because volatility equates to opportunity. Selling or shorting into volatile euphoria and buying into panic is a time-tested, wealth creating strategy. On the other hand, when everything is consistently moving in one direction, either upwards or downwards, investing can be an easy and straight forward momentum game. Buy something and watch it go up…short something and watch it go down.
In tough, choppy, trendless markets, identifying trends by active traders becomes more challenging. During tricky markets like we’re in now is when the wheat gets separated from the chaff. Day traders and speculators act on a zig one day and are forced to zag the next. Because of the volatile, whippy market dynamics, this type of active trading by individuals rapidly destroys portfolios, not only because of the transaction costs and taxes, but also due to impact costs and spread losses (i.e., bid-ask).
Often, the greater losses come from the behavioral aspects of active trading. Performance chasing and/or the pursuit of overzealous loss mitigation frequently are driven by the destructively entrenched emotions of fear and greed. In the past, I can’t tell you how many times I have rushed into a highflying stock, only to see it pull back down -15-20%, in short order. On the flip side, how often have stocks bounced significantly, after I’ve made a panicked sale? Too many, unfortunately. Most investors don’t take to heart the fact that whenever you initiate a trade, you need to be right twice to optimize your profits. In other words, the security you initially sell needs to go lower (i.e., you should have kept the original investment), AND the security you subsequently buy needs to go higher (i.e., you shouldn’t have purchased the new investment in the first place).
Even in the cases in which the balance of the buy/sale trades becomes a wash, the trading costs and taxes will eat the active trader alive. Unfortunately, the other outcome of losing on both sides of the trade (the purchase goes lower and sale goes higher) is all too common. For example, the purchase you falls by -3%, and the investment you sold climbs +10%. Doing nothing would have been the best outcome!
All this investment tail-chasing inevitably results in a lot of portfolio bloodletting. There is plenty of academic research that shows practically all day traders lose money. Terrance Odean from Cal-Berkeley used 14 years of day trader data to conclude that more than 98% of day traders lose money. Even for those traders able to make a profit in the short run, usually the success doesn’t last very long:
- 40% of day traders quit within a month
- 87% of traders quit within 3 years
- 93% of traders quit within 5 years
Other sources besides Odean show the percentage of day trading losers as greater than 95%, and if you don’t trust the academic data, then simply ask your accountant what percentage of his/her active trading clients make a profit, after considering all taxes and trading costs.
While I may not necessarily fully rejoice in the pain and carnage of day traders, I am always thankful for these choppy markets. Without volatility, anybody can make money in upward trending markets (e.g., day traders did better in the mo-mo 1990s), but in those markets long-term opportunities become sparse. Without the transitory headlines of tightening Federal Reserve policy, negative interest rates, a strong dollar, and political dysfunction, I would not have a professional investing job. And for that blessing, I want to sincerely say, “Thank you volatility.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Out of the Woods?
In the middle of the 24/7 news cycle, many investors get distracted by the headline du jour, much like a baby gets distracted by a shiny new object. While investor moods have been swinging violently back and forth, October’s performance has bounced back like a flying tennis ball. So far, the reversal in the S&P 500 performance has more than erased the -9% correction occurring in August and September. Could we finally be out of the woods, or will geopolitics and economic factors scare investors through Halloween and year-end?
Given recent catapulting stock prices, investor amnesia has erased the shear horror experienced over the last few months – this is nothing new for emotional stock market participants. As I wrote in Controlling the Lizard Brain, human brains have evolved the almond-shaped tissue in our brains (amygdala) that controlled our ancestors’ urge to flee ferocious lions. Today the urge is to flee scary geopolitical and economic headlines.
I expanded on the idea here:
“When the brain in functioning properly, the prefrontal cortex (the front part of the brain in charge of reasoning) is actively communicating with the amygdala. Sadly, for many people, and investors, the emotional response from the amygdala dominates the rational reasoning portion of the prefrontal cortex. The best investors and traders have developed the ability of separating emotions from rational decision making, by keeping the amygdala in check.”
Evidence of lizard brains fear for flight happened just two months ago when the so-called “Fear Gauge” (VIX – Volatility Index) hit a stratospherically frightening level of 53 (see chart below), reached only once over the last few decades (2008-09 Financial Crisis).
Just as quickly as slowing China growth and a potential Fed interest rate hike caused investors to crawl underneath their desks during August (down –11% in four days), while biting their fingernails, investors have now sprung outside to the warm sunshine. The end result has been an impressive, mirror-like +11% increase in stock prices (S&P 500) over the last 18 trading days.
Has anything really changed over the last few weeks? Probably not. Economists, strategists, analysts, and other faux-soothsayers get paid millions of dollars in a fruitless attempt to explain day-to-day (or hour-by-hour) volatility in the stock markets. One Nobel Prize winner, Paul Samuelson, understood the random nature of stock prices when he observed, “The stock market has forecast nine of the last five recessions.” The pundits are no better at consistently forecasting stock prices.
As I have reiterated many times before, the vast majority of the pundits do not manage money professionally – the only people you should be paying attention to are successful long-term investors. Even listening to veteran professional investors can be dangerous because there is often such a wide dispersion of opinions based on varying time horizons, strategies, and risk tolerances.
Skepticism remains rampant regarding the sustainability of the bull market as demonstrated by the -$100 billion+ pulled out of domestic equity funds during 2015 (Source: ICI). The Volatility Index (VIX) shows us the low-hanging fruit of pessimism has been picked with the metric down -73% from August. With legislative debt ceiling and sequestration debates ahead in the coming weeks, we could hit some more choppy waters. Short-term volatility may resurrect itself, but the economy keeps chugging along, interest rates remain near all-time lows, and stock valuations, broadly speaking, remain reasonable. Investors may not be out of the woods yet, but one thing remains certain…an ever-changing stream of fearful headlines are likely to continue flooding in, which means we must all keep our lizard brains in check.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
The Art of Catching Falling Knives
“In the middle of every difficulty lies an opportunity.” ~Albert Einstein
It was a painful week for bullish investors in the stock market as evidenced by the -1,018 point drop in the Dow Jones Industrial Average, equivalent to approximately a -6% decline. The S&P 500 index did not fare any better, and the loss for the tech-heavy NASDAQ index was down closer to -7% for the week.
The media is attributing much of the short-term weakness to a triple Chinese whammy of factors: 1) Currency devaluation of the Yuan; 2) Weaker Chinese manufacturing data registering in at the lowest level in over six years; and 3) A collapsing Chinese stock market.
As the second largest economy on the planet, developments in China should not be ignored, however these dynamics should be put in the proper context. With respect to China’s currency devaluation, Scott Grannis at Calafia Beach Pundit puts the foreign exchange developments in proper perspective. If you consider the devaluation of the Yuan by -4%, this change only reverses a small fraction of the Chinese currency appreciation that has taken place over the last decade (see chart below). Grannis rightfully points out the -25% collapse in the value of the euro relative to the U.S. dollar is much more significant than the minor move in the Yuan. Moreover, although the move by the People’s Bank of China (PBOC) makes America’s exports to China less cost competitive, this move by Chinese bankers is designed to address exactly what investors are majorly concern about – slowing growth in Asia.
Although the weak Chinese manufacturing data is disconcerting, this data is nothing new – the same manufacturing data has been very choppy over the last four years. On the last China issue relating to its stock market, investors should be reminded that despite the massive decline in the Shanghai Composite, the index is still up by more than +50% versus a year ago (see chart below)
Fear the Falling Knife?
Given the fresh carnage in the U.S. and foreign markets, is now the time for investors to attempt to catch a falling knife? Catching knives for a living can be a dangerous profession, and many investors – professionals and amateurs alike – have lost financial fingers and blood by attempting to prematurely purchase plummeting securities. Rather than trying to time the market, which is nearly impossible to do consistently, it’s more important to have a disciplined, unemotional investing framework in place.
Hall of Fame investor Peter Lynch sarcastically highlighted the difficulty in timing the market, “I can’t recall ever once having seen the name of a market timer on Forbes‘ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”
Readers of my blog, Investing Caffeine understand I am a bottom-up investor when it comes to individual security selection with the help of our proprietary S.H.G.R. model, but those individual investment decisions are made within Sidoxia’s broader, four-pronged macro framework (see also Don’t be a Fool, Follow the Stool). As a reminder, driving our global views are the following four factors: a) Profits; b) Interest rates; c) Sentiment; and Valuations. Currently, two of the four indicators are flashing green (Interest rates and Sentiment), and the other two are neutral (Profits and Valuations).
- Profits (Neutral): Profits are at record highs, but a strong dollar, weak energy sector, and sluggish growth internationally have slowed the trajectory of earnings.
- Valuation (Neutral): At an overall P/E of about 18x’s profits for the S&P 500, current valuations are near historical averages. For CAPE investors who have missed the tripling in stock prices, you can reference prior discussions (see CAPE Smells Like BS). I could make the case that stocks are very attractive with a 6% earnings yield (inverse P/E ratio) compared to a 2% 10—Year Treasury bond, but I’ll take off my rose-colored glasses.
- Interest Rates (Positive): Rates are at unambiguously low levels, which, all else equal, is a clear-cut positive for all cash generating asset classes, including stocks. With an unmistakably “dovish” Federal Reserve in place, whether the 0.25% interest rate hike comes next month, or next year will have little bearing on the current shape of the yield curve. Chairman Yellen has made it clear the trajectory of rate increases will be very gradual, so it will take a major shift in economic trends to move this factor into Neutral or Negative territory.
- Sentiment (Positive): Following the investment herd can be very dangerous for your financial health. We saw that in spades during the late-1990s in the technology industry and also during the mid-2000s in the housing sector. As Warren Buffett says, it is best to “buy fear and sell greed” – last week we saw a lot of fear.
In addition to the immense outflows out of stock funds (see also Great Rotation) , panic was clearly evident in the market last week as shown by the Volatility Index (VIX), a.k.a., the “Fear Gauge.” In general, volatility over the last five years has been on a declining trend, however every 6-12 months, some macro concern inevitably rears its ugly head and volatility spikes higher. With the VIX exploding higher by an amazing +118% last week to a level of 28.03, it is proof positive how quickly sentiment can change in the stock market.
Not much in the investing world works exactly like science, but buying stocks during previous fear spikes, when the VIX level exceeds 20, has been a very lucrative strategy. As you can see from the chart below, there have been numerous occasions over the last five years when the over-20 level has been breached, which has coincided with temporary stock declines in the range of -8% to -22%. However, had you held onto stocks, without adding to them, you would have earned an +84% return (excluding dividends) in the S&P 500 index. Absent the 2011 period, when investors were simultaneously digesting a debt downgrade, deep European recession, and domestic political fireworks surrounding a debt ceiling, these periods of elevated volatility have been relatively short-lived.
Whether this will be the absolute best time to buy stocks is tough to say. Stocks are falling like knives, and in many instances prices have been sliced by more than -10%, -20%, or -30%. It’s time to compile your shopping list, because valuations in many areas are becoming more compelling and eventually gravity will run its full course. That’s when your strategy needs to shift from avoiding the falling knives to finding the bouncing tennis balls…excuse me while I grab my tennis racket.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including emerging market/Chinese ETFs, but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Who Gives a #*&$@%^?!
The stock market is just a big rigged casino, fueled by a reckless money printing Fed that is artificially inflating a global asset bubble, right? That seems to be the mentality of many investors as evidenced by the lack of meaningful domestic stock fund buying/inflows (see also Digesting Stock Gains). Underlying investor skepticism is a foundation of mistrust and detachment caused by the unprecedented 2008-09 financial crisis, when regulators fell asleep at the switch.
Making matters worse, the proliferation of the Internet, smart phones, and social media, has forced investors to digest a never-ending avalanche of breaking news headlines and fear mongering. Here is a partial list of the items currently frightening investors:
- Interest Rates: Will the Federal Reserve raise interest rates in June or September?
- Volatility: The Dow is up 200 points one day and then down 200 the next day. Keep me away.
- Greece: One day Greece is going to exit the eurozone and the next day it’s going to reach a deal with the IMF (International Monetary Fund) and European leaders.
- Terrorism / Middle East: ISIS is like a cancer taking over the Middle East, and it’s only a matter of time before they invade our home soil. And if ISIS doesn’t get us, then the Iranian boogeyman will attack us with their inevitable nuclear weapons.
- Inflation: The economy is slowing improving and as we approach full employment in the U.S., wage pressure is about to kick inflation into high gear. After falling significantly, oil prices are inching higher, which is also moving inflation in the wrong direction.
- Strong Dollar: Now that Europe is copying the U.S. by implementing quantitative easing, domestic exports are getting squeezed and revenue growth is slowing.
- Bubble? Stocks have had a monster run over the last six years, so we must be due for a crash…correct?
Seemingly, on a daily basis, some economist, strategist, analyst, or talking head pundit on TV articulately explains how the financial markets can fall off the face of the earth. Unfortunately, there is a problem with this type of analysis, if your evaluation is solely based upon listening to media outlets. Bottom line is you can always find a reason to sell your investments if you listen to the so-called experts. I made this precise point a few years ago when I highlighted the near tripling in stock prices despite the barrage of bad news (see also A Series of Unfortunate Events).
While I am certainly not asking anyone to blindly assume more risk, especially after such a large run-up in stock prices, I find it just as important to point out the following:
“Taking too much risk is as risky as not taking enough risk.”
In other words, driving 35 mph on the freeway may be more life threatening than driving 75 mph. In the world of investing, driving too slowly by putting all your savings in cash or low-yielding securities, as many Americans do, may feel safe. However this default strategy, which may feel comfortable for many, may actually make attaining your financial goals impossible.
At Sidoxia, we create customized Investment Policy Statements (IPS) for all our clients in an effort to optimize risk levels in a Goldilocks fashion…not too hot, and not too cold. Retirement is supposed to be relaxing and stress free. Do yourself a favor and create a disciplined and systematic investment plan. Being apathetic due to an infinite stream of worrisome sounding headlines may work in the short-run, but in the long-run it’s best to turn off the noise…unless of course you don’t give a &$#*@%^ and want to work as a greeter at Wal-Mart in your mid-80s.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and WMT, but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on ICContact page.
March Madness – Dividend Grandness & Volatility Blandness
March Madness has arrived once again. This NCAA basketball event, which has been around since 1939, begins with a selection committee choosing the top 68 teams in the country. These teams are matched up against each other through a single-elimination tournament until a national champion is throned. The stock market does not have a selection committee that picks teams from conferences like the SEC, Big East, Pac-12, and ACC, but rather millions of investors select the best investments from asset classes like stocks, bonds, real estate, commodities, venture capital, and private equity.
In the investment world, there are no win-loss records, but rather there are risk-return profiles. Investors generally migrate towards the asset classes where they find the optimal trade-off between risk and return. Speculators, day-traders, and momentum traders may define risk differently, but regardless, over the long-run, capital goes where it is treated best. And over the last six years, the U.S. stock market hasn’t been a bad place to be (the S&P 500 has about tripled).
Why such outperformance in stocks? Besides a dynamic earnings recovery from the 2008-2009 financial crisis, another major factor has been the near-0% interest rate environment. When investors are earning near nothing in their bank and savings accounts, it is perfectly rational for savers to look for riskier options, if they are compensated for that risk. In addition to loose central bank and quantitative easing policies fueling demand for stocks, rising dividends have increased the attractiveness of the stock market. In fact, as you can see from the chart below, dividends have about doubled from 2008-2009 and about tripled from the year 2000.
Source: Buy Upside
Stock prices have moved higher in concert with rising dividends, which, as you can see from the chart below, has kept the dividend yield flat at around 2% over the last few years. Treasury bond yields, on the other hand, have been on steady declining trend for the last 35 years. So, while coupons on newly issued bonds have been declining for virtually the last three and a half decades, stock dividends have been on a steadily upward moving rampage, excluding recessions (up +13% in the most recent reported period).
Source: Avondale Asset Management
Declining interest rates have made stocks look attractive relative to investment grade corporate bonds too as evidenced by the chart below. As you can see, over the last half-century, corporate bond yields have predominantly offered higher income yields than the earnings yield on stocks – that is not the case today.
Source: Calafia Beach Pundit
What does all this stock dividend, earnings yield stuff mean? In the grand scheme of things, income starving Baby Boomers and retirees are slowly realizing that stocks in general stack up favorably in an environment in which interest payments are going down and dividend payments are going up. One of the areas highlighting the underlying demand for stocks is the Volatility Index (VIX) – a.k.a., the “Fear Gauge.” Despite Greece, Russia, ISIS, the Fed, and the Dollar dominating the headlines, the hunger for yield and growth in a declining interest rate environment is cushioning the blow during these heightened periods of volatility (see also A Series of Unfortunate Events).
Since the end of 2011, the monthly close of the VIX has stayed above its historical average of approximately 20 only two times (see chart below). In other words, over that timeframe, the VIX has remained below average about 95% of the time. When the VIX has spiked above 20, generally it has only been for brief periods, until cooler heads prevail and bargain hunters come in to buy depressed stock bargains.
Source: Barchart
I’m not naïve enough to believe the bull market in stocks will last forever, but as long as interest rates don’t spike up and/or corporate earnings crater, underlying demand for yield should provide a floor for stocks during heightened periods of volatility. We may be in the midst of March Madness but volatility blandness is showing us that investors are paying attention to dividend grandness.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and SPY, but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
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