Wednesday, February 25, 2015

Howard Marks Video : Stick to your approach

Monday, February 23, 2015

This Won't End Well

With the S&P 500 now in positive territory for the year and the mainstream media back in normal cheerleading mode, it is worth noting that 1) "Most shorted" stocks have outperformed the broad market this year, 2) the last 3 weeks have seen the biggest short squeeze in almost 4 years, and 3) Hedge funds are now at a record high 57% net long. We suspect, given the looming Humphrey-Hawkins and March FOMC and the short-term 'gap' between the market and fun-durr-mentals, volatility will be on the rise again.

The "Most Shorted" stocks outperformed the broad market in 2015 so far...
Amid the biggest short squeeze since 2011...
Hedge funds have never been more net long the market...
Short positions shed light on the “other side” of fund portfolios
We combined $1.5 trillion of single-stock and ETF long holdings in 13-F filings of 854 hedge funds with our estimate of hedge fund short positions. We estimate hedge funds accounted for 85%, or $627 billion, of the $738 billion in single-stock, ETF and market index short interest positions filed with exchanges as of December 31, 2014.
Our analysis suggests that hedge funds operate 57% net long (net/long), a new record.
And the yawning chasm between markets and macro and micro is daunting to all but the most 'ignorant'...

Wednesday, February 11, 2015

To Hedge or Not to Hedge Currency in International Stock Portfolios: Morningstar

Currency-hedged exchange-traded funds have come into vogue of late in the United States. Investor interest was first piqued by the performance of the oldest and largest of them all:  WisdomTree Japan Hedged Equity  (DXJ). The fund owns a portfolio of dividend-paying Japanese stocks that generate more than 80% of their revenue outside of Japan. It gained nearly 42% in 2013, as a massive dose of monetary stimulus contributed to an 18% decline in the value of the Japanese yen, and steady improvement in the global economy gave Japan's stock market an additional boost. In contrast,  iShares MSCI Japan ETF (EWJ), which tracks a standard market-cap-weighted benchmark and does not hedge its yen exposure, increased by 26% in 2013. Clearly, it paid for U.S. investors in Japanese stocks to have a hedge against a declining yen over this span. But was this a flash in the pan, or do currency hedges have value over longer time frames? With the U.S. dollar marching steadily higher--thanks in part to (relatively) attractive interest rates--and double-digit moves in major currencies making headlines, now is a good time for investors to explore these questions.

Back to Basics: Return, Risk, and the Practicalities of Putting a Currency Hedge in Place
In simple terms, a domestic investor's local-currency-denominated return in a foreign security (or a portfolio of them) is equal to the foreign security's (or portfolio's) return plus the foreign currency return, plus the product of the foreign security return and the foreign currency return. The last part of this equation accounts for the interplay between the two, and as it is the product of these two figures, its contribution to the overall return will grow as either the foreign asset return or the foreign security return grows larger.

Domestic Currency Return = Foreign Security Return + Foreign Currency Return + (Foreign Security Return x Foreign Currency Return)

The effect of fluctuating exchange rates can either help or hurt returns. In the case of U.S. investors holding Japanese stocks, the yen's depreciation hurt the U.S. dollar return for unhedged investors in 2013, as evidenced in part by the iShares fund's relative underperformance versus the WisdomTree offering. In another extreme example, the 34% appreciation of the Brazilian real contributed to the 124% calendar-year return posted by  iShares MSCI Brazil Capped ETF (EWZ) in 2009. These examples highlight that currency effects can be extreme in magnitude.

It's also important to consider currencies' effect on the risk of a portfolio of foreign securities: The expression for the variance (the square root of which is the standard deviation) of a foreign security or portfolio's returns is as follows:

σ2$ = σ2LC + σ2S + 2σLCσSρLC,S,


σ2$ = the variance of the foreign asset returns in U.S. dollar terms;

σ2LC = the variance of the foreign asset in local-currency terms;

σLC = the standard deviation of the foreign asset in local-currency terms;

2S = the variance of the foreign currency;

σs = the standard deviation of the foreign currency;

ρLC,S = the correlation between the returns of the foreign asset in local-currency terms and movements in the foreign currency.

This expression demonstrates that the volatility of a foreign asset in domestic-currency terms is directly related to the volatility of the asset in local-currency terms (the first term in the expression) and the volatility of the foreign currency (the second term). It also shows that the higher the correlation between the foreign asset in local-currency terms and movements in the foreign currency, the greater the variance will be in local currency terms. (Again, take the square root and you'll get the standard deviation.) Hedging away currency exposure will reduce risk, as measured by standard deviation--as can be seen in Exhibit 3 below.

How does currency hedging work in practice? Most currency-hedged ETFs will use currency forward contracts to reduce their foreign-currency exposure. A currency forward contract is an agreement between two parties to buy or sell a prespecified amount of a currency at some point in the future (typically one month out in the case of currency-hedged ETFs) at an exchange rate agreed upon between the two parties. Because the value of the forward contract is fixed ahead of time, and the value of the fund will fluctuate during the course of a month as asset prices and cash flows into and out of the fund fluctuate, the forward may not be a perfect hedge. It's also important to note that these hedges come at a cost, though their price tag typically amounts to just a few basis points in the case of developed-markets currencies in stable interest-rate environments.

FX Effects
It is useful to look at historical data to frame the effects of currency hedging on investment performance (for U.S. investors in this case). There are two key elements to consider when assessing the effects of currencies on equity portfolios: their contribution to return (as covered above) and their contribution to risk.

Exhibit 1 shows "success ratios" for a trio of MSCI benchmarks over the 20-year period ended Jan. 31, 2015. These benchmarks are all tracked by one or more currency-hedged (and unhedged) ETFs. The success ratio represents the portion of the overlapping monthly rolling one-, three-, and five-year periods over these two decades during which the unhedged version of the index outperformed its fully hedged counterpart. For example, the MSCI EAFE Index outperformed its fully hedged counterpart in 59% of these overlapping rolling one-year periods over this 20-year span. In hindsight, in the case of the MSCI EAFE and MSCI Germany benchmarks, the winner could have been predicted by the flip of a (mostly) fair coin. The story is different when it comes to the MSCI Japan Index, where "getting the yen out" has clearly paid off more often than not.

Exhibit 2 contains the annualized average returns for each benchmark across each of the overlapping monthly rolling one-, three-, and five-year periods dating back 20 years from the end of January 2015. The differences in relative performance vary between the hedged and unhedged versions of these indexes depending on the length of the measurement period. The MSCI Japan Index is again a unique case, as evidenced by the yawning performance differential between its hedged and unhedged versions.

What about risk? Currency risk is a significant contributor to overall risk in the context of a foreign-equity portfolio. Exhibit 3 shows the trailing 20-year annualized standard deviations and Sharpe ratios for the same benchmarks featured in the first two exhibits. In the case of all three benchmarks, it is clear--as evidenced by the difference in  Sharpe ratios between the U.S. dollar and hedged versions of the indexes--that currency exposure is a meaningful source of risk, currency hedging can serve to mitigate this risk, and it may ultimately result in superior risk-adjusted performance.

To Hedge or Not to Hedge?
The best answer to the question of whether it makes sense to hedge the currency exposure of an international-stock portfolio is this: It depends. By hedging foreign-currency exposure, investors can mitigate a source of risk--but at the expense of a potential source of return. The trade-off between the two is important, and investors' decisions will depend on a variety of factors, including but not limited to their return requirements, risk tolerance, investment horizon, and the costs associated with hedging currency exposure.

High Market Valuations May Signal Low Future Returns: Morningstar / GMO

In the summer of 2000, I vividly recall accompanying John Rekenthaler to meet GMO co-founder Jeremy Grantham in a café in Chicago. Vanguard had just launched its U.S. Value Fund (VUVLX), for which GMO was the subadvisor, and I was the (somewhat) young analyst assigned to cover it. Grantham had agreed to meet to discuss GMO's approach and investment outlook.

I do not remember much about what Grantham said about GMO's approach to selecting individual stocks, but I know that he had a lot to say about market valuations. In particular, he had a firm belief--citing GMO's long-term asset-class forecasts--that U.S. growth stocks were incredibly overvalued. He also said that, as a value-oriented firm, GMO had suffered massive investor redemptions in previous years, thanks to investors' moving assets to more growth-oriented shops.

Of course, subsequent events proved Grantham and GMO correct. For three calendar years in a row, between 2000 and 2002, the Morningstar US Growth Index lost more than 25% of its value. Meanwhile, on a cumulative basis, the Morningstar US Value Index lost just a few percentage points. Fast forward a few years: Grantham and GMO's equity return forecasts proved accurate again in 2007, when they signaled that equity valuations were overheated prior to 2008's market meltdown.

Grantham and GMO are sounding alarms again. In its latest round of seven-year asset-class forecasts (registration required), GMO predicts that U.S. large- and small-cap stocks will deliver negative inflation-adjusted returns, while developed-markets international stocks will produce just slightly positive returns.

In most of the developed world, GMO considers valuations too high to generate solid returns during the next seven years. With respect to valuations, GMO's asset-class forecasts incorporate some amount of mean reversion, so as valuations fall over a market cycle, projected returns will decline as well. Note that GMO is not trying to make a short-term market call; rather, the firm highlights longer-term investment opportunities based, in large part, on valuation measures.

Other fundamentals-based, long-term-oriented valuation measures are flashing warning signs as well. In particular, Nobel Prize-winning Yale Professor Robert Shiller's favored measure, the cyclically adjusted price/earnings ratio (known as CAPE, or the Shiller P/E), also suggests that U.S. equity investors should temper their expectations for future returns. CAPE--which is a measure of equity prices divided by the past 10 years' earnings, adjusted for inflation--currently suggests that valuations are more than 60% above their historical norm.

Like Grantham, Shiller boasts an enviable record of forecasting asset-class returns. In his 2000 book Irrational Exuberance, Shiller--in contrast to many market commentators at the time--said that the equity market was in bubble territory and would therefore subsequently deliver disappointing returns. Like Grantham, he was right, though it is worth noting that both began raising concerns about market valuations several years earlier. Shiller updated the book in 2005 to argue that there was a bubble in the housing market--a view that also was vindicated when house prices subsequently crashed.

Research has shown that CAPE does an impressive job of forecasting future returns across a variety of equity markets. Based on research using more than a century of earnings and equity return data, Shiller and co-author John Y. Campbell found that CAPE was a strong predictor of U.S. stock returns over subsequent 20-year periods. And a study by Norbert Keimling of Germany's StarCapital has found that the relationship between CAPE and subsequent returns exists in 14 other markets as well. In short, when CAPE is very high, in general relatively low long-term equity returns will follow. (Click here to see current CAPE levels for countries around the world.)

Daniel Needham, Morningstar Investment Management's president and chief investment officer, agrees that "the U.S. market is very overpriced and is at a level that is associated with very low prospective returns." Moreover, Needham says that in this high-valuation, low-interest-rate environment, even small changes in earnings forecasts or interest rates can lead to greater volatility. In short, Needham expects "lower prospective returns and higher prospective volatility."

So, what is an investor to do with this information? Interestingly, despite the much higher-than-normal level of CAPE, Shiller recently told CNBC that he has not yet pulled back on his equity exposure. Despite the fact that "my own indicator (CAPE) is looking kind of scary," Shiller said that his expected longer-term returns from real estate or fixed income are even worse. So, in Shiller's view, equities might be the least bad of some weak alternatives.

Shiller has also pointed out that there may be some pockets of value in global markets. In terms of their asset-class forecasts, GMO's strategists agree. For example, at the end of 2014, GMO projected nearly 4.0% annualized real returns on emerging-markets stocks and a nearly 3.0% real return on emerging-markets debt. Both areas compare favorably with the projected annualized returns of negative 1.8% for U.S. large-cap stocks and negative 2.9% for U.S. small caps. Those seeking emerging-markets exposure would do well to look at Morningstar analyst favorites such as  American Funds New World  (NEWFX) or  Vanguard Emerging Markets Stock Index (VEMAX), while those who want bond exposure in developing markets will want to take a look at the likes of  Fidelity New Markets Income  (FNMIX) and  PIMCO Emerging Markets Bond (PAEMX).

Morningstar's equity research can also help investors uncover attractive opportunities. Although, in the aggregate, Morningstar analysts consider the market somewhat overvalued, there are individual stocks that are attractively priced. Morningstar analysts currently assign 5-star ratings to a couple dozen stocks, including  BHP Billiton  (BHP) Priceline  (PCLN) Apache  (APA), and  Cabot Oil & Gas (COG). Premium Members can define their own criteria to focus on stocks with the characteristics that they most desire.

Of course, when it comes to forecasting market returns, there are no guarantees that any methodology--even those that have often worked in the past--will be absolutely spot-on. But extremely high equity valuations and exceptionally low interest rates tilt the odds against investors. In addition to seeking out pockets of value, perhaps the best things investors can do are avoid counting on unrealistically high returns, save enough to compensate for potentially weak returns, and keep costs to a minimum. Those are not very exciting tips, but they may represent the most useful advice in what is likely to be a low-return environment.

GS Explanation on Oil Prices; Good Chart

Oil prices have gotten crushed for the last six months. The extent to which that was caused by an excess of supply or by a slowdown in demand has big implications for where prices will head next. People wishing for a big rebound may not want to read farther.
Goldman Sachs released an intriguing analysis on Wednesday that shows what many already suspected: The big culprit in the oil crash has been an abundance of oil flooding the market. A massive supply shock in the second half of last year accounted for most of the decline. In December and January, slowing demand contributed to the continued sell-off. Goldman was able to quantify these effects. 

The Culprit Is in Blue

Goldman’s model is simple on its face, looking at just two variables over time: the price of oil and the value of U.S. stocks (as measured by the S&P 500). The idea is that the stock market is a pretty good indicator of economic demand. So when stocks move in tandem with oil prices, demand is in the driver’s seat. When the price of oil moves in the opposite direction of stocks, the shock is coming from supply.
It’s a bit more complicated than that—for the statistically inclined, Goldman uses a “vector autoregression with sign restrictions”—but you get the idea. In the following chart, they split apart the effects of demand shocks (left) from supply shocks (right).

Demand & Supply

The chart on the left shows what you might expect: strong demand leading up to a precipitous decline during the recession beginning in late 2008. The supply chart on the right shows a shock of undersupply in late 2007, leading to years of relatively steady supply expectations. Oversupply shocks picked up, beginning in 2012, as U.S. shale-oil production exceeded expectations, culminating in a piercing shock of oversupply last year that sent markets reeling. 

The big take-away: “[T]he decline in oil has been driven by an oversupplied global oil market,” wrote Goldman economist Sven Jari Stehn. As a result, “the new equilibrium price of oil will likely be much lower than over the past decade.” 

Monday, February 09, 2015

Arnott: ‘Peasants With Pitchforks’ Seen If Profits Get Any Fatter

Rob Arnott, chief executive and co-founder of Research Affiliates LLC, recently picked up the phone to share some thoughts on the current state of the stock market. 

Arnott is a pioneer of investing strategies that could be considered “unconventional” if they weren’t slowly but surely becoming more conventional. Among them is the idea of “fundamental indexing,” or weighting stock portfolios by economic metrics like sales, dividends and cash flows rather than the market value of the companies. (The term “smart beta” came later.) 
As such, fundamental indexes tend to lean toward value stocks instead of growth stocks. How are they doing? Well, the FTSE RAFI U.S. 1000 Total Return Index returned 140 percent in the 10 years through 2014 compared with 114 percent for the Russell 1000 Index, even though growth far outperformed value in the same decade. 
Anyway, when talking to a person like this, sometimes it’s best for a reporter to just shut the heck up, save the bad jokes for the next happy hour, and let the smarter person do all the talking. So here goes. 
Q: Does it seem like the market will move back to a value orientation? 

Bubble ‘Echoes’ 

A: “I think the market’s stretched both in terms of valuation levels and the spread between growth and value. It doesn’t feel like the tech bubble to me, it feels a little bit more like ’98 or early ’99 in terms of the magnitude by which things are stretched. But you do have some relatively extreme examples, companies that are trading at large multiples to revenue, let alone multiples of earnings or cash flow. And that hearkens back to the ’98-’99 experience. So I think we’re seeing echoes of the bubble in today’s global market behavior. 
‘‘There is a flight to safety and the snapback from that, when it comes, will reward the value investor handily. You also see a huge spread between the comfort markets, the United States at a Shiller P/E ratio of 27 times earnings, and the fear markets, emerging markets, where a fundamental index in emerging markets is currently at a Shiller P/E ratio of 10 and a half. My goodness, 60 percent discount to the S&P 500. That’s startling. Why would it trade at such a vast discount? Because people are afraid. Fear breeds bargains. You cannot have a bargain in the absence of fear.” 
(Note: Created by economist Robert Shiller, Shiller P/E ratios measure the price of an index divided by average inflation-adjusted earnings from the previous 10 years. Traditionally, P/E ratios measured either just the prior year’s earnings or forecasts for the next year’s profits.) 
Q: What do you think about the Shiller P/E? Do you give it a little less weight considering the really bad earnings years during the recession? Does that skew it, or is that exactly what it’s meant to do? 

Peasants, Pitchforks 

A: “That’s exactly what it’s meant to do. It includes good times and bad times. Back in 2010 it included good years and two recessions, the ’02-’03 recession and the ’08-’09 recession. Now it includes two boom times and one deep recession, so I’m not troubled by including ’08-’09 at all. 
‘‘Right now we have earnings coming off of record highs as a percentage of GDP and yet you have Wall Street saying ‘don’t worry, it’s going to soar to new highs.’ Pardon me, but when did the peasants with the pitchforks come out and start rioting? Society at large has to enjoy some of the largesse, or else the pitchforks come out. So earnings as a share of GDP can’t really advance materially from current levels, or at least it’s not healthy if they do. 
‘‘So we’re looking at a likely mean reversion on earnings. What happens if there is mean reversion? Is the market ready for that? A strong dollar also points to mean reversion, when you get a strong dollar you usually get weak earnings, and the reciprocal for emerging markets and for Europe.”

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.