Market Psychology Archives

The “Great Rotation” and Risk

The FundLogik Application continues to point towards a risk weighting. For most portfolios, that means a shift towards equities and away from fixed income.

Last week, we looked at one of the main currents of money flow which drives global financial markets. This week, we look at the factors which drive the money flows into one of the key asset classes available to investors: Equities.

How Wall Street views Equities

According to the collective judgement of investors on Wall Street, a dollar of earnings this year will cost $15 if you select the average Blue Chip stock from the S&P 500. And, for the optimists in the room, that $15 dollar figure for stocks falls to $12.30 if one looks forward to 2014 earnings rather than backwards to 2012 numbers. That same dollar of earnings will cost you $50 if your tastes run to 10 Year US Treasury Bonds. As bond interest is fixed, there is no need to calculate a rosy scenario.

To Wall Street strategists, this big price difference between equities and fixed income suggests an imminent “Great Rotation” from bonds to stocks as rational investors rebalance between relatively expensive bonds and cheaper equities.

Three Factors

Three FactorsAre they right? The answer is yes but probably not for the reason usually pushed to the front of the research report (stocks are cheap, bonds are expensive). There are three factors which drive stocks and stock markets: Earnings, Interest Rates and Risk.

Earnings: Supportive of Equities

If you limit your focus to quarterly earnings and consensus forecasts, you will see an exciting jump in expectations at the beginning of this year. The numbers that go into the overall S&P 500 estimate are important because most institutional money is benchmarked to the index or a close derivative thereof. If you are interested in some of the key biases which drive the consensus forecast process, ZeroHedge has an insightful article on the subject.

Earnings pop
Source: Bloomberg

Before one gets too excited, let’s step back and view a couple of years at once. The phenomenon highlighted with the small red arrows is known as “earnings roll.” Analysts, who are employed by brokerage firms in the business of selling stocks to clients, push their numbers up in the beginning of the year and then adjust them as quarterly reports come out.

Earnings roll
Source: Bloomberg

So, if you look at the red line on the second chart (which charts the running 12 month forward forecast), earnings are moving in a positive direction but not dramatically. This is supportive of the market but not enough to make the case for a “Great Rotation” on its own.

Interest Rates: Neutral for Equities

This is an easy call because all the Central Banks are working in concert to keep a lid on interest rates. These generational lows in US dollar interest rates have hardly spurred the borrowing and investment boom that some Keynesians had expected. But with debt levels reaching what some consider dangerous levels relative to GDP, few G-20 countries want to think about servicing their debts at high single digit interest rate levels. Rising rates are bad for stocks, falling rates are good. Interestingly, there are new studies suggesting that low and steady levels of interest rates do not correspond to above average stock market returns while high and steady do not necessarily mean poor performance. With no movement expected up or down, this part of the equation is neutral.

Risk: Positive for Equities

The Chicago Board of Options Exchange has an excellent index for measuring the level of risk in the short term (ie. a matter of a month or two) called the VIX. Although this is often cited as The Fear Index in the market, it is important to remember what it is actually used for on a day-to-day basis: pricing options. A high reading certainly does reveal high anxiety in the market and a low reading, relative calm but the measure is by design a short term one.

The risk we are trying to measure is the certainty of forecasts. To give a simple example, the range of expectations for a consumer products company like Proctor and Gamble are much narrower than they might be for United Continental. While the former may stumble in an emerging market or be subject to margin squeeze, the latter can see profits quickly turn to losses with an adverse move in jet fuel prices. Broadly speaking, the tighter range of expectations command higher Price/Earnings ratios (P/E) while the broader range means the company (or the market) is accorded a lower P/E.

Macro factors can also be measured in a similar fashion. When the range of possibilities are uncertain (think some of the hyperbolic commentary ahead of the “Fiscal Cliff”), investors respond with caution and P/E ratios tend to fall. When uncertainties drop away, investors are willing to bid up asset prices and P/E multiples expand.

With the European Central Bank commitment to support the Euro at almost all costs, the passing of the “Fiscal Cliff” and the realization that the trajectory of US Government Debt issuance is likely to pursue a more sedate upward trajectory while the underlying economy continues to grow at a lower but sustained pace, some of the big worries in the market are being calmed.

If one wants a proxy (rather than anecdotal assurances), a reasonable measure of longer term anxiety is the spot gold price. With the arrivals of ETFs, gold is certainly cheaper to hold but the shiny metal still provides no income. Investors buy gold because they are willing to forego income to hedge against the risks they perceive in other asset classes. The FundLogik application and just a cursory look at the charts show that the upward trajectory of gold has cooled dramatically.


The FundLogik application has been flashing “Buy Riskier Assets” since November last year. Now we are starting to see that the market has been a good leading indicator as the conditions for better earnings and a less volatile environment shape up.

Keep holding onto the riskier end of your watch lists…and as they say on the airplane, “sit back, relax and enjoy the ride.”

A Good Apple or a Bad One

One of the most common questions we get is whether a particular asset is “good” or “bad”. Usually, the investor has been looking at an asset and wants to know if now is the time to buy or sell. We tend to view assets that are going up as “good” and those that are going down as “bad”. That is, unless we are buying things from a store. In that case, a deep discount sale is definitely to be regarded as “good”…but we digress.

It is hard to know how to answer the good/bad question because assets are neither good nor bad. They are merely the building blocks for an investment strategy. Also, one can rarely assess an asset in isolation. And finally, the price one pays for a particular asset goes a long way towards determining whether it represents good value to the buyer.

So the black and white question has quickly morphed into three separate considerations, two of them strategic and the final one tactical.

  1. Does the asset make sense as a candidate for a particular investor’s investment strategy?
  2. If yes, are there other assets that could do the job just as well or better?
  3. At current prices, is the investor over or underpaying for the asset?

Since we are already talking about good apples or bad ones, let’s look at the company which has filled my house with iProducts. Is Apple a good company? Most reasonable people would answer yes. This is a company which has changed and in several cases invented several categories of consumer electronics and made buckets of money in the process.

But let’s look at it through our three questions.

  1. Should you consider Apple Inc’s common equity as a potential investment for your long term investment strategy? What is your risk profile? What is your investment time horizon? Is this a company that has staying power like Microsoft, Intel and Google? Or is it a Dell, HP or perhaps a Yahoo? Will it continue to lead or could it lose its way. Will it reward you as a shareholder? And if so, how?
  2. Are there other companies (singular or in combination) that give you exposure to the same market segment or investment opportunity as Apple? Are they better? Worse? Up and coming? Or fading? Do you need to pick one company or is there a fund or ETF that gives you exposure to the thematic risk without exposing you to too much individual company risk?
  3. Is Apple a good value at these prices? Well, what are you looking for? Are you looking for bold M&A strategies, new must have products and explosive growth? Or are you looking at low relative P/E ratios and strong cashflows to support a healthy and growing dividend. Are there better opportunities?

As you can see, even for one simple equity the question of whether it is good or bad is not as simple as this modified 1 year chart.
Apple Inc 1 year chart
Source: Bloomberg

What should an investor do?

Approach investing from a broad perspective. If you start from too narrow a perspective, you run the risk of asking the wrong questions. The risk is that the person who answers that question may not take the time to work through all the strategic and tactical considerations before giving you the proverbial thumbs up or thumbs down. If you ask the wrong question, your chance of getting the wrong answer increases. And more importantly, you may not even understand why the answer is wrong.

How long will “January Effect” last?

Now that the politicians on both sides of the aisle have decided to take a bit more of the private economy in taxes and keep piling up debts for future generations, it is time for markets to return to normal seasonality and resume weighing up the prospects for different investment classes without constant reference to the hot political winds gusting out of Washington.

The question most investors should be contemplating is whether we will see a repeat of last year when the equity markets extended the “January Effect” through the entire first quarter of the year.

The FundLogik application indicates that now is the time allocate a larger portion of your assets towards the “risk” end of the spectrum. Whether that momentum peters our in February or steams on until the beginning of April remains to be seen.

In the 6 ETF FundLogik Portfolio, Non-US large cap equities (represented by EFA) and the Emerging Market Equities (represented by EEM) are ahead of SPY, TLT and DBC with QQQ bringing up the rear. However, if the January Effect does stretch further into the first quarter, it would be logical to expect QQQ to move up smartly in the rankings.

In the sample bond portfolio, Convertibles and Emerging Market debt funds are leading the pack. This suggests an appetite for more risk and a reach for yield.

In the sample equity portfolio, European Equities ranks at the top while Emerging Markets replaces Developed Markets, largely mirroring the FundLogik Portfolio ranking.

In the Blended ETF Portfolio, China (FXI) and International Real Estate (RWX) come out at the top of the list. China was volatile for most of last year but picked up steam after the leadership transition was completed. Real Estate is both a yield play and a capital gains play.

Political Risks will resurface

There are still a few more “political crises” to come, all of them just as manufactured as the one that was “narrowly averted” in the wee hours of the New Year. Whatever one’s political leanings, most can agree that the resolutions are of the “kick the can down the road” variety. Despite the promises to do better next time, the bottom line is that the new political line up in Washington looks the same as the old line up. There is little reason to expect a different outcome next time.

So, what does this mean for investors?

“January effect” should be fairly well pronounced this year. A combination of tax loss harvesting from a volatile 2012, the rehashing of the Euro crisis, leadership change in China and the political drama in the US means that institutions entered 2013 with a bias towards safe assets. Don’t be surprised to see money flowing back into QQQ and SPY favorites as fund managers rebalance for first quarter optimism.

Last year, the “risk off” trade was US Treasuries, the US dollar and, at times, precious metals. But these asset classes have rallied hard in recent years. It is hard to see how there is much upside left in these assets, particularly US Treasuries. The conditions which support the high prices will persist: a still massive US current account deficit, FED purchases of Treasuries and the fact that many other major currencies, particularly the Euro, don’t look very promising relative to the US dollar. Since none of those conditions appear ripe for change in the near term, one can expect continued fund flows towards two of the largest asset classes. There will continue to be “worry pieces” in the financial media about China, Japan or Middle East sovereign wealth funds looking to “dump” their Treasuries. The outcome will be no different; these large holders can shift at the margin but cannot dump. US dollars flowing out through the Current Account will flow back into US Treasuries and other similarly overpriced assets for the foreseeable future.

That does not mean there will be no volatility. Given the fact that both the household and government sectors are still massively in debt, even small shock events will continue to be magnified by the excessive leverage that remains in the system.

The real question is that of rebalancing. Will institutions remain happy to add to their piles of low yielding US Treasuries and cash as well as their non-yielding hoards of Gold? Or will we see more shifting towards riskier assets? At the margin, it is not the foreign sovereign wealth fund that drives the asset allocation but the large US institutions. If a consensus forms that equities and real estate assets are a better value than US Treasuries (ie. not just lip service but actual shifts in asset allocations), then we could see a rise in interest rates combined with a strong surge of liquidity into the stock and property markets. The stock markets will react positively while the US real estate market would probably just accelerate the digestion of the inventory hangover of the last 5 years.

At this point it is hard to say which way the balance will swing. Low growth in the G-8 economies could give comfort to asset allocators that the lofty values at the long end of the Treasury market will be supported by the FED’s commitment to “twisting” the yield curve. A change to the delicate balance however could send investors scrambling. The bloated FED balance sheet plus Bernanke’s commitment to keep interest rates low for as long as possible may not be enough to stem the rush for the exits.

For now, the FundLogik application is pointing towards a healthy “January Effect”. Position yourself accordingly.

Deja Vu all over again

Yogi Berra, the famous wordsmith who also happened to manage the Yankees, is reputed to have said: “It’s like déjà vu all over again.”

That happened to me this morning with my HTC Smartphone because an app had not been properly updated.

Having arrived at work earlier than expected due to surprisingly light traffic, I decided to have a sit down breakfast near the office. While eating, I decided to check out the markets using the very handy Bloomberg app.

I was pleased to read that the markets were up because a conference of Euro big wigs had made some promises and decisions. I didn’t realize there was a big wig meeting but these things are pretty common nowadays. I was pleased to hear that the brilliant conclusions had led the market to recover significantly over the past few days with allusions to the peak in the Spring, low US Treasury yields and…hold on…it was time to check the date…oops, right in the middle of 2011.

I finished breakfast, made a few phone calls (which my children regard as a wonderfully archaic use for such a device) and by the time I went back to check the date, my HTC had figured out that this app was woefully out of date and called in the upgrade function.

The main point is that we, as active participants in the global financial economy, are not making much progress, are we? The fact that I could get more than halfway through an article before I realize it is from last year is not a good sign.

The fact that the Bloomberg newsroom is writing articles about the European Debt Crisis which are nearly indistinguishable from year to year means one of two things. Either Bloomberg is using a software program to write the articles or much of the official response to the Crisis has been in vain (I suspect both!).

This time, however, we are unlikely to be rescued by more stimuli. With a US Presidential Election, a Chinese leadership shuffle and gridlock in Europe, much of the officialdom tasked with rescuing the world is otherwise engaged. Also, if you read John Hussman’s recent update, he has some excellent charts which show that the impact of such intervention is fading.

Since doom and gloom are in fashion this season,as they often are in the “dog days of summer”, it might help to look at some of the things that are going right in the global economy.

In the US, housing has hit a bottom of sorts. Time will tell if this is just a temporary ledge on the six year down slope but for the first time in a long time, housing is not a dragging anchor on the US GDP calculations.

China is trying to cajole its citizens to spend a bit more and develop a domestic, consumer driven economy. Having lived in and travelled to China on many occasions, I have no doubt about the average middle class Chinese person’s ability and desire to consume. The real issues are structural and are in the process of being addressed. But, just as Mitt Romney doesn’t want to talk about sensitive red-meat conservative issues, China’s fifth generation of leaders are not going to bang the drum for Yuan convertibility until they are fully ensconced in their new offices.

And finally in Europe, despite the 24 hour newscycle soundtrack of gloom and doom, we have companies like VW taking global pole position for cars sold from Toyota and GM while Airbus breaks ground on an Alabama factory to produce single aisle planes for the domestic market.

With Governments and Households over extended in most of the developed markets around the world, expect more volatility in the markets as even small shock events have outsized impacts. But, while we may not see broad, index wide growth in the various economies, competitive spirits have not faded at the sector and individual company level.

It may be “déjà vu all over again” for now but it would be risky to get too complacent that all the bad news we are getting fed on a daily basis will come to pass. The “Fiscal Cliff” is scary indeed but so was Y2K. Just talking about it and worrying about it caused solutions to be put in place before the global economy ground to a halt on January 1st 2000. The same thing will happen at the end of this year at the last minute because no one is going to take the blame for driving the US into another recession.

Buying Long Term Treasuries

“Don’t Fight the Fed” is one of the basic chestnuts of market wisdom that is impressed upon any newbie coming into the business.

Why don’t you fight the Federal Reserve? There are many good reasons but at the end of the day, the FED’s day job is to create and destroy US dollars at will in the pursuit of the dual mandate of maintaining price stability and promoting economic growth. Unless one moonlights as a counterfeiter, there is nothing big enough in one’s “bag of tricks” that one could conceivably bring to that fight.

When our simple 6 ETF Portfolio told us to swap out of QQQ (NASDAQ 100) for TLT (20 plus year Treasuries) a week and a half ago, my first reaction was to think that I was smarter than the system once again. Surely there is almost no chance that Treasuries could still go up further…

Ah, but then I scanned the news to find out that Operation Twist would most likely get a new lease on life (so I made the switch a few days late). The Wall Street Journal editorial sums up the main issue perfectly. Investors don’t want to fight the FED. So to play along, they need to divert investment funds towards long term Treasuries.

That’s what the Fund King System picked up the other week…that the investment tides were being pulled once again towards the long end of the US Treasury market. What have I learned?

“Dont’ Fight the Fed”

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