Friday, August 30, 2013
It has been cited so many times by so many people that you would think its underlying logic would be ingrained into the U.S. investors’ psyche but markets are irrational because people are irrational so no matter how many times someone has heard this piece of wisdom, there is a tendency to jump on investment bandwagons when the trend is long in the tooth and bail or stay out of underperforming investments right when they are ready to take off.
I am following one technician who thinks the stock market is close to topping but he is waiting for the last doubters to jump on the bull bandwagon before he puts out a sell signal.
Over the past few months I have been hearing a lot of pouting regarding managed futures. A lot of managers are having a hard time raising money because of poor recent performance and some are paring back their marketing efforts. The asset class suffered down years in 2011 and 2012 — the first back to back down years in the history of the Barclay CTA Index — and it is struggling midway through 2013 as well. The normal stories are being written, i.e. “Is Trend Following Dead,” and “What is wrong with Managed Futures.”
The correct answer may be, “I don’t know,” but anyone who understands the nature of the trend following beast also should understand that now is the ideal time to get in. Critics of the trend following approach like to point out that most investors don’t participate in the often strong returns of successful managers because of the tendency to get in after strong performance and get out after drawdowns.
First off I am not so sure the average investor is as dumb as some of these critics assume them to be. I have been examining money flows in CTA databases for more than a decade and noticed years ago that often money under management leaves following strong performance and returns following a drawdown.
Warren Buffett is not the only smart guy out there.
But the underlying logic of that criticism, and Buffett’s philosophy as well as the nature of trend following says that now is the time.
Why bring this up? Well another well-known investment guru, close to the stature of Buffett, has decided now is the time. Investment News reported earlier this week that massive bond investment firm Pimco, founded and managed by Bill Gross, has filed a preliminary prospectus with the Securities and Exchange Commission (SEC) for a managed futures mutual fund named the Pimco Trends Managed Futures Fund.
The story points out the poor recent performance of managed futures but does note there have been some successes. It also points out that Pimco has made a point to add to its alternative portfolio since 2008, nearly quadrupling assets in alternative mutual funds, from $28 billion to more than $100 billion.
Has the market changed? Yes, markets always is change as Bill Eckhardt once told me. But remember so does managed futures. The beauty of it as an asset class is that it is not monolithic. There are literally hundreds of thousands of models looking to profit from trends in futures markets and while they may all end up in the same place when you have major trends, they get there in different ways. That is proven by the substantial number of managers that loosely fit in the trend following mode who have performed well over the recent difficult environment. These are not long only mutual funds but largely systematic strategies built to detect trends of varying time frames, in a mixture of up to 70 or so markets, with multiple risk management overlays. Yes there are better and worse environments for trend following and managed futures but these are truly absolute return vehicles that cannot really be benchmarked.
A perusal of CTA performance shows definite weakness in the last 30 months, roughly 60% of managers have a negative compound annual return since January 2011. But there are 51 managers with a compound annual return of greater than 10% in that time (out of a universe of 493). I have profiled 16 of them in the last few years.
Gross took a hit to his reputation back in 2011 by being a couple years early on his call for rising interest rates. I don’t think he is too early here and I feel a little better when I advise folks in the industry to make its push now for more assets. I am in good company.
Posted by Bud Fox at 9:10 AM
Tuesday, August 27, 2013
The CHART OF THE DAY shows Treasury yields have gradually declined as the proportion of U.S. citizens over 65 years climbed. The age group will swell to 20 percent of the population by 2030 from 14 percent now, according to the U.S. Census Bureau. The chart tracks a similar trend in Japan, where 24 percent are over 65 years, the world’s highest ratio of seniors, up from 19 percent a decade ago.
“As Japan’s population aged, that suppressed bond yields,” said Larry McDonald, the chief equity, credit and policy strategist at Newedge USA LLC in New York. About 4,100 Americans are turning 65 every day, quadruple the number in 2003, he told Bloomberg Radio’s “The Hays Advantage” earlier this month. “Those people are more likely to own bonds,” he said. Baby boomers are considered people born from 1946 to 1964.
Demand from retirees hasn’t been enough to offset a bond market rout this year. Treasuries have tumbled on speculation the Federal Reserve will taper an $85 billion monthly debt-buying program designed to stimulate the economy amid signs output and jobs are growing.Government securities have fallen 3.9 percent through Aug. 22, based on the Bloomberg U.S. Treasury Bond Index.
Japan’s 10-year bonds yielded 0.765 percent at the end of last week, the lowest of 27 developed markets Bloomberg tracks. The nation’s central bank has its own debt-buying program, worth about 7 trillion yen ($71 billion) of securities a month.
Investors are snapping up Japanese bonds even though the nation’s debt is equivalent to more than double its gross domestic product, McDonald said. The ratio is the highest in the world, data compiled by Bloomberg show. The U.S. debt is equivalent to 74 percent of GDP.
Posted by Bud Fox at 3:46 PM
Monday, August 19, 2013
As the bond market plunged in late June, Ray Dalio convened the clients of Bridgewater Associates LP, the world’s largest hedge-fund manager, to tell them that a fund designed to withstand a broad range of market scenarios was too vulnerable to changes in interest rates.
Posted by Bud Fox at 11:26 AM
It has been a busy two weeks. The Leen’s Lodge gathering added an intense interlude of high-powered conversation and analysis. The Yellen-Summers headlines now have two added mystery names per President Obama. The Fed (Federal Reserve) tapering talk adds the question “What is the policy?” to the question “Who will be making the policy?” Markets are going through gyrations in both bonds and stocks. And we see surprising reactions in foreign currencies, with the Japanese yen strengthening while changes in policy at the Bank of England have resulted in a market reaction opposite to what the BOE expected.
At Cumberland, there have been a number of strategy changes. Clients are aware of these changes by observing the activity in their accounts. We will summarize here the strategy changes and the reasons for them. Expect further commentaries on these matters as we keep you apprised of factors affecting the market and our timely responses to changing conditions.
We have raised cash in both US and international equity accounts. The bottom line is that the risk profile in stock markets is up. There are questions about the pace of economic recovery, some of the sectors such as energy or housing, and the impact of the Fed’s talk of tapering and what it is doing to risk premia and re-pricing in the market. The possibility of a Summers Fed chairmanship, coupled with Elizabeth Duke’s departing, Jerome Powell’s term ending next year, Sarah Bloom Raskin’s leaving for the Treasury, and Janet Yellen’s departing (If she is not appointed chair?) , leads market agents to conclude that an entirely different configuration of the Fed board may soon be at hand.
Add to that the retirements of some of the seasoned presidents (Cleveland Fed president Sandra Pianalto has announced), and the structure of the US central bank may reach a point where the remaining experienced and historically seasoned members of the FOMC (Federal Open Market Committee) are few. New observers and appointees may have seen the financial crisis from the outside; however, they will not have acquired firsthand the knowledge and experience gained only through making decisions under fire. Markets are aware that they face the biggest US central bank transition in many years.
Bond markets have backed up in yields. This is true in the Treasury, municipal and taxable bond markets. We have written about how yields have been distorted and yield spreads have widened enormously. Our example was a trading day in which the 30-year US Treasury obligation (federally taxable) traded at 3.62% yield. In the same 24-hour period, the tax-free New Jersey Turnpike traded at 4.73% yield, and the taxable New Jersey Turnpike traded at 5.15%. In our view, the tax-free turnpike bonds are screaming bargains in the present climate. In fact, Cumberland owns them in clients’ accounts.
Risk management issues loom larger than usual. What do you do when the stock market has reached your next year’s target? Our target was the S&P 500 at 1700 by the end of 2014. We are there. What do you do when the outlook for earnings is starting to deteriorate? We have ratcheted back our S&P 500 estimates for this year by a couple of dollars. We still think that earnings will come in around $110, give or take $2. The picture is trending toward more softness in earnings growth.
What do you do when the outlook for the future earnings growth rate is also deteriorating? We base that assessment on the fact that the profit share of the GDP in the US is at the highest level it has seen in decades and the labor share is at the lowest level. That means productivity seems high and earnings that come from that profit share seem to be strong. Could the profit share go higher? Yes it could. Is that likely now? We think not. Furthermore, the ratio of the value of the entire S&P 500 index to the GDP has reached 100%. History (Ned Davis database) suggests that this is a dangerous level.
We think the profit share of the GDP is rolling over, peaking, and tipping into what might be a long-term decline from this very high level. And the labor share may be bottoming and is positioned now to start a gradual rise over time from this very low level. If this view is correct, then American companies begin to face headwinds that will slow the earnings growth rate. This is not just a day-to-day, week-to-week or month-to-month rate of change. This is strategic. What lies before us is a longer-term stretch in which the tremendous benefit to American business from central bank policy in the post-crisis period will come to an end.
Lastly, there is the issue of demographic headwinds. Rob Arnott, a guest at Leen’s Lodge this year, has offered thoughtful analysis on demographics. He notes, in his serious research, how strongly demographics have contributed, in the past, to accelerating growth rates, and he forecasts significant headwinds that demographic change may introduce into our strategic future.
Put that package together and there emerges a set of circumstances in which stocks, having risen terrifically, now look less appealing at the current price level. Certain sectors of the bond market, by contrast, look more appealing.
Consider that New Jersey Turnpike 4.73% tax-free yield. We sat in a meeting with one of our New Jersey clients and reviewed his portfolio. The client is a successful businessman. He was joined in the meeting by his financial professional. We dissected his New Jersey tax bracket. He is somewhere in the 51%-52% marginal tax bracket. He is a New Jersey resident paying federal income taxes and New Jersey taxes at the top rates. He bumps up against levels which limit his deductions and expenses when he completes his tax return. And we must add the Obamacare tax he pays. That is how his marginal tax rates reach 52%.
Sitting in that meeting, we took apart 4.73% as a yield that he can obtain by investing in a long-term debt instrument with a senior claim on the revenues of the New Jersey Turnpike. The compounding taxable equivalent yield for him is approximately 9.5%. He can get that yield year after year.
What that means is that, to scrape up a viable and comparable investment alternative, he would have to find an investment somewhere else deriving a taxable income of 9.5% and pay all of his taxes on that percentage. The residual would equal the return generated by the New Jersey Turnpike instrument. Where are you going to find such a low credit risk, high quality, and liquid investment in New Jersey to compound at a 9% or 9.5% rate pretax so that you can derive a match against the New Jersey Turnpike? I cannot see any, and neither can he. That is why we allocated in favor of his tax-free bond portfolio. Do the same math with some long-term holding and use the 20% capital gains rate. Add Obamacare tax and add NJ taxes. The case for the New Jersey Turnpike tax-free bond is still very compelling.
We have changed our internal asset-allocation mix at Cumberland Advisors. In the beginning of this cycle, we were as high as 80% stocks in balanced accounts. That allocation has been reduced to 60%. We have taken the bond piece up to 40%. Furthermore, we have extended duration in individually managed accounts. The entire hubbub over Detroit, San Bernardino, and other specific tax-free municipal bond credit issues has provided an entry opportunity in the tax-free municipal bond market that is unparalleled except for one other time. I would characterize that other time as the “Whitney moment,” when Meredith Whitney went on 60 Minutes and predicted the end of the municipal bond world. Let’s call this current time the Whitney-esque moment.
We are buyers of tax-free bonds. We have a cash reserve in our US equity and international ETF accounts. That cash reserve is higher than it has been in our accounts in quite some time. And we are going to hold that cash reserve on the sidelines for a time. We cannot say how long and we do not know when or how much will be redeployed.
We are now facing the transitional period for the central bank. We do not know who the next chairman is going to be or what the composition of the board will be. But we do know that the current wave of uncertainty will soon be cresting into decisions sure to have cascading consequences in churning markets. We have seen a lineup of commentary coming from FOMC members that suggests a form of tapering is coming.
We are not afraid of tapering. Tapering by itself is not an issue if it is coupled with an extension of the short-term interest-rate commitment. In other words, the Fed can cut the rate of additional purchases and use guidance to extend the period before and until the Fed Funds rate will be elevated from its present 0.0%-0.25% range. Some members of the FOMC are thinking that tapering means reducing the amount of stimulus but extending the time period in which it is applied. If the market grasps that concept, bonds will rally, and tax-free bonds even more so.
Think about it. If the inflation rate in the US is roughly 1% and there is a possible downward trend, then a 4.73% tax-free New Jersey bond is delivering a real return of 3.73% after taxes to a New Jersey resident. That is a phenomenally high return on an investment for someone living in New Jersey. The real return is still quite high if the inflation rate heads up to 2%. This is now a win-win for an individual investor. There are similar opportunities in jurisdictions throughout the US.
To sum this up, carefully selected bonds now offer an entry opportunity and long duration. It is critical to check the quality of credits, particularly in the municipal bond market.
Stocks require selectivity as to sector activity and many other characteristics. We have had terrific success in our US ETF portfolios this year. We do not want to give those strategically achieved profits back. So we now have a cash reserve until we get through this difficult period.
David R. Kotok,
Chairman and Chief Investment Officer, Cumberland Advisors
Chairman and Chief Investment Officer, Cumberland Advisors
Posted by Bud Fox at 11:20 AM
Leveraged loans are becoming more volatile as they attract unprecedented cash from investors seeking debt that offers protection from rising interest rates.
Posted by Bud Fox at 11:17 AM
The Federal Reserve’s plan to end quantitative easing, in part to prevent financial bubbles, is in fact driving investors into riskier corners of the debt markets.
While the safest bonds have sold off hardest since Ben Bernanke, Fed chairman, set a timetable for tapering its monetary stimulus, the best-performing fixed-income assets have been the lowest-rated junk bonds.
Junk bonds rated triple-C, the lowest tier possible, are the only corporate bonds to have generated positive returns since Mr Bernanke’s June 19 press conference, when he said the Fed would most likely start scaling down its Treasury and mortgage purchases this year and wind them up by the middle of next.Money has also poured into loans in the past three months, with the result that many borrowers no longer have to provide customary investor protections.
“Investors are so afraid of rising rates that they are trading off rates risk by taking on more credit risk,” said Ashish Shah, head of global credit at asset management group AllianceBernstein.
Riskier bonds tend to offer higher interest rates and so repay their purchase price more quickly – a measure called “duration” – something that has become critically important in a rising interest rate environment. Longer duration bonds fall more sharply when market interest rates rise.
Investment grade bonds have lost 1.3 per cent and double-B rated junk bonds have shed 0.8 per cent since June 19, compared to a positive return of 0.9 per cent for the triple-C class.
The extra yield, or spread, that triple-C investors are demanding over risk-free Treasuries has narrowed by 20 basis points over the same period, compared to 5 basis points for investment grade corporate bonds.
Bankers have been emboldened by the demand for high-yielding investments to seek more advantageous terms for borrowers.
Matt Duch, a portfolio manager at Calvert Investments, said there had been an increase in borrowers seeking to add high leverage and “payment-in-kind toggle” deals, which give borrowers the option to pay lenders with more debt rather than cash.
“The strong demand for low-rated high yield could be fostering a generation of paper with subpar structures,” he said. “That could definitely be a problem in the future should defaults pick up or financing suddenly become less available.”
Some of the most aggressive deal structures are being proposed in the loan market, which is used for financing leveraged buyouts. There have now been 61 consecutive weeks of inflows into mutual funds and exchange-traded funds specialising in loans, according to Lipper, adding up to $39.1bn of new money chasing investment opportunities. Some $11.6bn has been added since June 19.
Because loans offer a floating rate of interest, they are seen by investors as insulated from the risks of rising rates as the Fed tapers QE.
The US software group BMC, which was acquired by a private equity consortium led by Bain Capital and Golden Gate Capital, this month sold $5.86bn of debt with only light covenant protections for investors and with an unusual provision giving more freedom to sell assets before repaying lenders.
The use of “covenant-lite” loans has re-accelerated since Mr Bernanke’s remarks, accounting for 58 per cent of all loan issuance so far this month. That puts August on course to be the second highest month ever, after January 2013, according to S&P Capital IQ.
Posted by Bud Fox at 11:16 AM
In 1975, shortly after joining the board of the Washington Post Company, Warren Buffett wrote a letter to the chairman and chief executive, Katherine Graham. He had some advice as to how the company should invest its pension accounts.
All 19 pages were recently published by Fortune, and are well worth reading. In the brief excerpt below, Buffett, then just 44 years old, makes a succinct case against traditional stock picking and fund management. We’ve highlighted some passages, and you can annotate the text by hovering over any paragraph and clicking the quote bubble off to the right.
If above-average performance is to be their yardstick, the vast majority of investment managers must fail. Will a few succeed due either to chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance just as would be the case if l,000 “coin managers” engaged in a coin-flipping contest. There would be some “winners” over a 5 or 10-flip measurement cycle. (After five flips, you would expect to have 31 with uniformly “successful” records—who, with their oracular abilities confirmed in the crucible of the marketplace, would author pedantic essays on subjects such as pensions.)+
In addition to the ones benefitting from short-term luck, I believe it possible that a few will succeed—in a modest way—because of skill. I do not believe they can be identified solely by a study of their past record. They may be operating with a coin that they know favors heads, and be calling heads each time, but their bare statistical record will not be distinguishable from the larger group who have been calling flips indiscriminately and have been lucky—so far.1
It may be possible, if you know a good deal about investments as well as human personality, to talk with a manager who has a decent record and find that he is using methods which really give an advantage over other investors, and which appear to be likely to provide continued superiority in the future. This requires a very wise and informed client—and even then is not free from pitfalls.+
For openers, there is one huge, obvious pitfall. I am virtually certain that above-average performance cannot be maintained with large sums of managed money. It is nice to think that $20 billion managed under one roof will produce financial resources which can hire some of the world’s most effective investment talent. After all, doesn’t the big money at Las Vegas attract the most effective entertainers to its stages? Surely $50 million annually of fees on $20 billion of managed assets will allow an array of industry specialists covering minute-by-minute developments affecting companies within their purview; top-flight economists to study the movement of the tides; and nimble, decisive portfolio managers to translate this wealth of information into appropriate market action.1
It just doesn’t work that way.+
Down the street there is another $20 billion getting the same input. Each such organization has its own group of bridge experts cooperating on identical hands and they all have read the same book and consulted the same computers. Furthermore, you just don’t move $20 billion or any significant fraction around easily or inexpensively—particularly not when all eyes tend to be focused on the same current investment problems and opportunities. An increase in funds managed dramatically reduces the number of investment opportunities, since only companies of very large size can be of any real use in filling portfolios. More money means fewer choices—and the restriction of those choices to exactly the same bill of fare offered to others with ravenous financial appetites.+
In short, the rational expectation of assuring above average pension fund management is very close to nil.+
The entire memo can be read at Fortune. The 1962 image of Buffett is from an interview with an Omaha, Nebraska, television station, KMTV.
Posted by Bud Fox at 7:07 AM
Sunday, August 18, 2013
It’s a classic moment in sports history. With less than 20 seconds left in Game 6 of the 1998 N.B.A. finals and the Chicago Bulls down by one, Michael Jordan goes one-on-one with Bryon Russell of the Utah Jazz. He pushes off (clearly!), Russell stumbles and the ball hits nothing but net. Game over. Bulls win.
Now let’s imagine that something different happened. Jordan misses the shot in Game 6, and Game 7 comes down to the same spot: fewer than 20 seconds left with the Bulls down by one. If you’re Phil Jackson, the head coach, do you set up the last play for Jordan, or does the ball go to someone else? Remember, Jordan missed the night before.
Of course the right strategy is to put the ball in Jordan’s hands. Just because he missed the shot before doesn’t mean it was the wrong strategy to have Jordan shooting the ball in the final seconds. The odds are incredibly high that he will make the shot even though he missed it the night before.
I bring this up because it perfectly captures the investing adage that never seems to die: diversification is “broken.” It seems as if this story pops up every year, but it’s not really about anything new. Both Joshua M. Brown at The Reformed Broker and Barry Ritholtz at The Big Picture have written blog posts about it recently. Mr. Brown quoted an adviser who said:
“Why bother diversifying at all? It’s just a drag on performance. What’s the point of owning any bonds or international stocks?”
So here’s the 2013 version of the diversification story.
Let’s say at the beginning of 2013 you finally decided you were going to stop pretending to be a trader and instead be a long-term investor. You were going to do what most of the academic research recommends and build a diversified portfolio of low-cost investments. Then you planned to hold on to it for a long time.
As part of your new plan, you put something like 30 percent of your portfolio in international mutual funds. Now seven months into the year, you’re disappointed because international has done poorly relative to your Standard & Poor's 500-stock index fund. In fact, year to date, your S.& P. 500 index fund is clearly the only place you should have put all your money. Its gains have been twice those of almost any other major asset class.
Obviously, it was a mistake to diversify, right? Wait. Before you answer, let me share one of my favorite stories about diversification.
In 1998, the S.& P. 500 ended the year up 28.6 percent. But nothing else was really performing. Small-capitalization stocks were down 2.2 percent, and small-cap value stocks were in the tank. The temptation to go all in on large-cap technology stocks proved to be too much for most of us. After all, nothing else was working.
Now fast forward to 2001. The tech bubble had burst. The S.& P. 500 was down a bunch in 2000 and ended 2001 down 11.9 percent. Based on those numbers, it’s fair to assume the stock market was terrible, right? Well, it depends on which market you were talking about.
Remember those small-cap stocks that everyone was complaining about in 1998 and ’99? Sit down for this. In 2001, while the S.& P. 500 was getting crushed, small-cap stocks returned 17.6 percent. And small-cap value stocks, down 10 percent in 1998, ended 2001 up 40.6 percent.
I suspect your first thought to this example is, “Why not just buy things right before they go up and sell before they go down?” Let me save you a lot of money and many headaches. It’s all but impossible for investors to catch all the up while avoiding all the down. But it can be equally difficult for us mere mortals to stick with diversification because it looks as if we should be able to time the market, and, well, diversification isn’t sexy or exciting.
First, diversification works over time, and no, seven months doesn’t count. When we talk about diversification working, we’re talking in terms of years, even decades. Not just days, weeks or even months. In other words, we’re talking in investing terms, not trading terms. We don’t like things that take a long time to work. We want to know what’s working now.
Second, diversification is not exciting. It’s the investing equivalent of hitting singles and doubles your whole life, and who grows up wanting to do that? We want to hit home runs. Players who try to hit home runs every time (like timing the market) are going down swinging in a blaze of glory or knocking it out of the park. Either way, it’s cool, sexy and exciting — all the things diversification is not.
Finally, diversification can look like a mistake at any given moment. A well-designed and diversified portfolio will always have something that’s not doing well, a few things that are average, and, hopefully, one or two things that are exciting. The problem, of course, is that the investments change places about the time you’ve had enough and you decide it’s time to boot out the underperformers. It’s human nature to run from things that cause us pain and get more of the things that bring us pleasure. It’s why we look for ways to “fix” our portfolios.
It may seem counterintuitive, but if you have something in your portfolio that you’re complaining about, it’s a good sign you’ve built a diversified portfolio. And if that’s the case, you’re probably complaining right now about international mutual funds and wondering why you aren’t invested 100 percent in the S.& P. 500. But as Mr. Brown so wisely notes, “Five months still to go, anything can happen …”
Next year, there will be a different story about why diversification is “broken,” but all it takes is looking at the year before that, then 5, 10, 15 and 20 years before that to see why you want to hit singles and doubles for the rest of your investing life. Personally, I’d rather save my energy for other things besides trying to second-guess which market will take off next. I’ve got better things to do. Don’t you
Posted by Bud Fox at 6:57 AM