Why the Market is up

To the surprise of many, including me, the S&P 500 Index traded over 2,100 Wednesday and the Dow Jones Industrial Average changed hands above 18,000.

That comes after a stunning 15% rebound from a Feb. 11 low, leaving the major indexes less than 2% below their all-time highs of last May.

What caused this remarkable turnaround? I see five main reasons.

5. Oil prices have stabilized

As I wrote earlier this week, stock and crude oil futures prices have had an 86% correlation this year, meaning they moved together almost one for one. Traders and investors have viewed oil prices as a barometer for equities or a proxy for the health of the global economy.

As oil plunged last year, it took share prices with it, and fears of a global recession rose. Both stocks and oil bottomed Feb. 11. Investors now appear to view that low in West Texas Intermediate crude in the $25-$26 range as a cyclical bottom for the commodity — and it’s about where crude made its previous bottom in 2008.

4. The global economy isn’t tanking

Like last year, the U.S. economy had a weak first quarter, this time due largely to lower energy prices and a strong dollar. But also like 2015, it should bounce back later this year and post annual GDP growth of around 2.4%-2.5%. Nothing to write home about, but better than the rest of the developed world. Meanwhile, the consumer is holding up well, as auto and housing sales are on pace for strong, if not record, years.

Europe and Japan are treading water at best, but China has eased many investors’ concerns with its recent report of 6.7% annualized GDP growth in the first quarter. That was down from the fourth quarter and would be less than 2015’s 6.9%, China’s slowest growth in 25 years.

Of course, China’s growth comes with ballooning debt that’s not sustainable over the long run, depending on how much debt the Chinese government ultimately writes off or makes disappear. But for the immediate future, it removes one more fear from investors’ minds.

3. The dollar has fallen from its highs

The U.S. dollar index, which tracks the greenback against other major currencies, traded above 94 Wednesday, a 6% decline from its 10-year high above 100 last December. That’s helped oil, which is priced in dollars, stabilize, and has contributed to big rallies in gold, silver and other commodities.

More importantly, it may ease the pain of U.S.-based multinational companies, which have had to repatriate earnings into more expensive dollars. No doubt that was a big factor in four consecutive quarters of year-over-year earnings declines for the S&P 500 SPX, +0.08% including the first quarter.

But later in the year, weak comparisons for energy companies and a slightly weaker dollar should help earnings turn positive, perhaps surprisingly so. Investors, who typically look six to nine months ahead, could be factoring that in now as they bid up share prices.

2. Foreign central banks have kept the spigots open

Last month, the European Central Bank expanded its own extraordinary bond-buying plan (quantitative easing, or QE) to 80 billion euros ($90.4 billion) a month, while cutting benchmark interest rates to zero and deposit rates deeper in negative territory to combat stagnant growth. But ECB president Mario Draghi said he didn’t think the ECB needed to cut rates more, words he may have to eat as the euro trades near its six-month high.

The Bank of Japan, fighting two decades of deflation, has used the double-barrel shotgun of QE and negative interest rates to depress the yen and stimulate demand, with little effect so far. Hungary, Turkey, Norway, Taiwan and India have cut rates, while others, like Canada and Australia, have held steady. Sweden, Switzerland and Denmark already have negative interest rates.

1. Which brings us to the Fed …

One analysis found that the Federal Reserve’s monetary policy was responsible for 93% of stocks’ gains in the current bull market. And, indeed, stocks have stalled over the past year as Fed Chairwoman Janet Yellen and her cohorts pivoted toward raising rates gradually and modestly. The Federal Open Market Committee’s first quarter-point rate hike in mid-December spurred the selloff that took the S&P 500 down 12% to the low 1800s by Feb. 11.

Since then, Yellen’s dithering in the face of “uncertain” markets and overseas economies has prompted investors to lower their expectations of how much the Fed will raise rates in 2016. Traders now look for the FOMC to raise the federal funds rate just once this year, by 25 basis points.

If they’re right, it’s good news for stocks. Of all Wall Street’s rules of thumb, “don’t fight the Fed” is probably the most valid. And if stocks are rising because the Fed isn’t tightening, don’t fight the tape, either.

 

ETFs vs Mutual Funds

ETFs, Mutual  Index Funds, and Active Mutual Funds

One of the great debates in the investment world centers on whether mutual fund managers, in the aggregate, add any value for investors. Since Vanguard introduced the first index fund in the 1970s, skeptics and critics of the financial services industry have argued that professional money managers have failed to earn their keep. Taking all of them together, they simply don’t do any better than a random selection of securities in any given market or investment style.

Nonsense, argue investment companies. There are many managers who have demonstrated they can outperform a random selection of securities, even after subtracting their fees – you just need to know how to identify them. Furthermore, an active manager can provide benefits that a random basket of securities can’t: An active manager can hold more cash when things look ugly, or sidestep some bad news at a company by selling before the whole thing collapses. In contrast, indexers have to ride the bus off the cliff.

Who’s right? Well, if you have to ask, then it’s time to go back to the basics and look at how mutual funds  – including index funds – are designed and built. You must also examine some of the key metrics.

As with so many aspects of investing, context counts, and there is frequently a time and a place for both approaches.

What Is a Mutual Fund?

A mutual fund is simply an arrangement in which a group of investors pool their money together and hire a professional money manager to buy and sell securities on their behalf. The typical arrangement is for the money manager (or his company) to take an investment fee out of the assets of the fund each year – typically between 0.5% and 1.5%. It is referred to as an expense ratio, and comes directly out of your account as a proportion of your assets.

The investment company takes this money and uses it to take care of overhead, office expenses, and marketing, and to pay a custodian to handle transactions. The money also pays a salary to the fund manager and a team of analysts that helps the fund manager pick and choose stocks, bonds, and other securities to buy and sell. When you have a manager – or team of managers – that actively buys and sells selected securities in order to maximize return, minimize risk, or both, that approach is called active management.

But what if you didn’t need to pay a team of analysts to sit around all day and analyze securities? Could you pay a lower expense ratio? It turns out you can, via a special kind of mutual fund called an index fund.

What Is an Index Fund?

Index funds are still mutual funds, arrangements in which you pool your money with other investors. And you still have an investment company that handles your transactions. The difference is that the investment company isn’t paying a fund manager and a team of analysts to try to cherry-pick stocks and bonds. Instead, the fund cuts out the middlemen, saves the investors their salaries, and just buys everything in the particular index it aims to replicate. This index could track stocks, bonds, or REITs, for example.

What Is an Index?

An index is an un-managed collection of securities designed to reflect the properties, returns, and risk parameters of a specific segment of the market. An index is a theoretical construct: You can’t buy shares directly in an index, but you can buy shares of the companies that are included in the index.

For example, the most widely known index is probably the Standard & Poor’s 500 index of  large-cap stocks. This index is simply the largest 500 U.S. companies traded on the New York Stock Exchange, as measured by their market capitalization, or the total value of all their stock.

The index itself is weighted by market capitalization, meaning the index includes more shares of larger companies. Larger companies therefore have a bigger effect on index fund returns than smaller companies.

How does it work? It’s simple: An investment company starts an index fund and wants the fund to track the S&P 500. So they raise money, and then use the money to buy an equal percentage share of every company in the index. This share is going to be small – there are a lot of other people who already own each company, so they will typically buy something like 0.001% of each company in the index. The investors don’t own the index directly, but they own shares in this fund, which theoretically will track the performance of the index very closely, minus the amount of their costs.

Note that there’s no role for the analyst here – and all the fund manager does is ensure that the fund holds the securities in the index at all times. He doesn’t try to beat the index; he just makes sure the portfolio matches the index as closely as possible. This approach is called passive management.

Common Indexes

Investors, of course, aren’t limited to the S&P 500 index for their index investing. There are actually hundreds of indexes out there to choose from, and many investors use them in combination with one another.

Other commonly used indexes include the following:

• The Russell 2000 tracks U.S. small-cap stocks.
• The Wilshire 5000 attempts to track the entire universe of stocks publicly traded on the NYSE.
• MSCI EAFE tracks the largest companies in the European markets.
• MSCI Emerging Market tracks the stock markets in various emerging economies, such as in Southeast Asia, Africa, South America, and Central America.
• Barclays Capital Aggregate Bond Index tracks the universe of publicly traded bonds, including treasuries, corporates, and high-yield bonds.
• NASDAQ 100 is an index of the largest 100 companies whose shares are traded on the NASDAQ. This index is also a large-cap index, like the S&P 500, but is much more technology heavy.
• Nikkei 225 is an index that tracks the largest Japanese companies.
• MSCI U.S. REIT Index tracks the performance of the largest publicly traded real estate investment trusts in the U.S.

There are indexes that track nearly every country in the world, most regions, and most asset classes. The U.S. market represents a little less than half of the entire market value of stocks traded all over the world. Many investors like to have substantial exposure to U.S. stocks, but also have a counterweight of exposure to European stocks, Asian stocks, emerging markets, REITs, and bonds. Some or all of this can be achieved through owning index funds.

Does Index Investing Work?

Over the years, indexing has proven to be an effective strategy for a lot of retail investors. Here’s the theoretical underpinning behind the logic of indexing as a strategy:

Advantages

1. Markets Are Efficient. The indexer basically believes that the market as a whole is very good at quickly pricing all the available information about a stock or a market into the market price (i.e. efficient market hypothesis). It is therefore almost impossible for a given money manager to outguess the market consistently over a long period of time.
2. It Is Very Difficult to Identify Winning Fund Managers in Advance. Go back through time and look at the returns of the top fund managers every year. In the vast majority of cases, a fund manager will be flying high for a year or two, riding a market trend. But after the markets have run their course, another investment style becomes popular, and last year’s heroes are this year’s goats. The indexer believes it doesn’t pay to try to guess who will be this year’s best performing manager.
3. Mutual Fund Managers Cannot Reliably Add Value Beyond Their Costs. The advocate of passive management reasons that in the aggregate, mutual fund managers and other institutional investors cannot reliably beat the market. Why? Because, collectively, they are the market. They are therefore all but doomed to under-perform a well-constructed index by approximately the amount of their costs.
4. Index Funds Have Lower Turnover. It costs money to churn – or excessively trade – securities in your portfolio. Mutual funds have to pay brokers and traders, and must also absorb the hidden costs of bid-ask spreads every time they trade. The bid-ask spread is the difference between what a stock exchange market maker pays for the stock and what they sell it for. Brokerage firms identify the overlap between what investors are willing to pay for a security and what investors are willing to sell a security for, and make part of their money by pocketing the difference. The more trading a fund does, the higher these costs. But index funds never have to trade, except when new securities are added to the index, or to buy or sell just enough to cover fund flows coming in and out as investors buy or sell. (Closed-end fund, or ETF, managers do not have this worry.)
5. Index Funds Are Tax-Efficient. Index funds are normally tax-efficient, thanks to their low turnover. This is important because every time a mutual fund sells a holding at a profit, it must pass that profit on to its shareholders, who pay capital gains taxes on that profit. This isn’t relevant for funds held in retirement accounts, like an IRA or a 401k, but it’s a major consideration for mutual funds held outside of retirement accounts. For this reason, index funds are popular choices for use in taxable (non-retirement) accounts.

Performance

Because of these built-in structural advantages, one would expect index funds to routinely outperform the median performance of actively managed funds that invest in the same category. Index funds can’t beat the index, but because they approximate the returns of the index while minimizing expenses, the lower expenses should give index funds a noticeable advantage. We would not expect to find a low-cost index fund in the bottom half of the universe of mutual funds with a similar investment style for a long time.

So what do we find? Let’s look at the returns of the Vanguard 500, the original and one of the most commonly held index funds, which tracks the S&P 500. We’ll use the investor share class, which is the non-institutional variety and the fund that most investors can actually invest in.

1. Stock Funds
As of January 23, 2012, the Vanguard 500 fund is firmly in the top half of all large-cap blended style (balanced between growth and value style) that Morningstar tracks. This is true whether you look at the 10-year, 5-year, or 1-year track records, where the fund posts percentile rankings of 41, 33, 28, and 19 respectively. (With percentile rankings, low numbers are good and high numbers are bad. A “1” means the fund is in the top 1%, while a “99” means the fund is in the bottom 1%. Anything less than “50” means the fund did better than the median.)

Does the strategy transfer to bonds? Let’s see:

2. Bond Funds
As of January 23, 2012, the Vanguard Total Bond Market Index, which now tracks the Barclays Capital Aggregate Bond Index, posted 10-year, 5-year, 3-year and 1-year trailing return percentiles of 44, 36, 83, and 15, respectively. For the most part, the fund has been successful in outperforming the median bond fund, though not as consistently as the S&P 500 tracking counterpart. In both cases, though, the managers have been pretty successful tracking their indexes, trailing them over the last 10 years by amounts roughly equal to their costs.

That’s about what you’d expect, since indexes, as theoretical constructs, have no costs. Only actual mutual funds have costs, and indexers simply seek to minimize those costs.

The Warren Buffett Counterargument

Warren Buffett, the chairman of Berkshire Hathaway and among the most successful value  investors, rejects the logic of efficient markets. It’s easy to see why: He made his fortune – and the fortunes of an awful lot of other people – by buying stocks at a discount to their intrinsic value. Very simply put, he looks for stocks that markets are pricing unfairly low, precisely because the efficient market theory doesn’t hold in every case, by a long shot. In his view, he’s been successful many times in finding stocks selling for 30%, 40%, or even 60% off of their true worth. “I’d be a bum on the street with a tin cup if markets were efficient!” he once told investors.

The downside to this approach to investing, of course, is that it takes a great deal of time and frequently leads to very narrow portfolios, which can mean more volatility. Not every investor can take the time to emulate the Buffett approach, even if they had his prodigious knowledge of accounting and business experience – which brings you back to picking a mutual fund and deciding if you want to pay a manager a percentage to pick securities for you, or if you want to keep the fee and invest it, rather than paying it to the manager.

For most people who don’t have the time and expertise to dig deeply into analysis and research, even Buffet recommends the indexing approach.

Final Word

Naturally, investment companies are ferociously defending their turf. They make a good deal of money from people who hire active managers. And some managers have been able to add value for investors over and above their costs in expense ratios and fees. In fact, active management proponents argue that it doesn’t make sense to compare index funds to the average fund because it’s possible to identify stronger managers up front. You can, for example, restrict your analysis to active fund managers that have a tenure of at least 5 or 10 years and lower expense ratios.

And the debate goes on. To determine which approach you prefer, start by assessing your needs and what you’re investing for. For example, will capital gains be an issue – will you be investing in or outside a retirement account? And are you prepared to research mutual fund managers to identify which might procure gains over and above their relative index?

Review the advantages to index investing above and see if they make sense to you. If you still can’t figure it out, invest in both and let experience be your guide.

JP Morgan Chase: You or Them?

JP Morgan Chase – Putting Clients Second

New York Times: 12/20/2015

JPMorgan Chase has agreed to pay $307 million to settle accusations that it improperly steered clients to the company’s in-house mutual funds and hedge funds.

From 2008 to 2015, brokers and financial advisers in several divisions of JPMorgan gave preference to investment products created by the bank’s asset management division when deciding where to put client money, regulators said on Friday.

In some cases, regulators said, the clients were put into products with higher fees, which earned JPMorgan more money, even when the same JPMorgan product was available for a lower fee.

“The undisclosed conflicts were pervasive,” the head of enforcement at the Securities and Exchange Commission, Andrew J. Ceresney, said in a conference call.

The settlement is a black mark for JPMorgan’s asset management division, a business that the company has been aggressively expanding and that has been seen as particularly promising in the new regulatory environment. The bank admitted wrongdoing in the settlement.

“We have always strived for full transparency in client communications, and in the last two years have further enhanced our disclosures in support of that goal,” said Darin Oduyoye, a spokesman for JPMorgan’s asset management division.

“The disclosure weaknesses cited in the settlements were not intentional and we regret them,” he said. “We remain confident in our investment process and are proud of the way we manage money.”

JPMorgan will pay $267 million to the S.E.C. and an additional $40 million to the Commodity Futures Trading Commission.

The S.E.C. said that JPMorgan made $127 million in ill-gotten gains from its preference for in-house funds. The money from the settlement will not go to JPMorgan’s clients, though Mr. Ceresney said “there was significant harm to clients here.”

Several JPMorgan brokers told The New York Times in 2012 and 2013 that they were encouraged by their superiors to put their clients into proprietary funds even when lower-cost or better-performing funds were available.

One broker, Johnny Burris, said this month that after he complained about the practices he faced retaliation from JPMorgan employees. JPMorgan denied that its employees retaliated against Mr. Burris.

Jordan A. Thomas, a lawyer at Labaton Sucharow representing whistle-blowers, said on Friday that one of his clients — a former JPMorgan employee — had assisted the S.E.C. in developing the case announced Friday.

The agency said that starting in 2007, JPMorgan developed basic investment portfolios, in a program known as the Chase Strategic Portfolio, that automatically invested a significant portion of any money in proprietary JPMorgan mutual funds.

The company developed a similar program for wealthier clients in JPMorgan’s private bank, known as the JPMorgan Investment Portfolio, which funneled money into the bank’s own hedge funds. JPMorgan also gave a preference to outside hedge fund managers who were willing to pay placement fees — or retrocessions — to JPMorgan.

“If a manager declined to pay retrocessions, an alternative manager with a similar investment strategy that would pay retrocessions was typically sought,” the S.E.C. order released on Friday said.

Banks are generally allowed to show a preference for their own investment products as long as they disclose that to clients.

JPMorgan will not have to stop giving preferential treatment to its own funds as part of the settlement, but it will have to send new disclosures to all clients.

Junk Bond Update

Week ended Dec. 18, 2015

Not So Junky?

Wednesday  the Federal Reserve finally made its much expected rate increase and markets rose.

Junk bond funds which were under lots of pressure recently also rallied

Many investors fear a junk bond bubble. And now may be the time for a burst. Generally, it’s too soon to say the worst is over for investors, or even that the junk bond crisis is over.

Bubbles are not so common in a closely watched, highly liquid market like the $1.3 trillion United States junk bond market.

Two important attributes of a potential junk bond bubble: (1) high leverage (heavy borrowing to finance the purchase of assets) and (2) concentrated investments are not widespread.

In fact, most junk bond funds, including the two largest high-yield ETFs, have no leverage and are highly diversified, with hundreds of securities across all industries.

Further, many believe that the characteristics of ETFs made them far safer than owning individual junk bonds. The vast majority of ETFs are unlevered, passive vehicles.

Unlike mutual funds, which may need to sell underlying fund positions to meet shareholder redemptions, ETF shares trade like stocks. Last Friday, Blackrock’s flagship junk bond ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), experienced a surge in trading — $4.3 billion, four times the record daily volume before that week. (On an average day the fund trades about $700 million worth of shares.) On Monday trading hit $3 billion.

Some investors saw in last week’s junk bond turmoil not the makings of another crisis, but a buying opportunity.

That doesn’t mean, of course, that investors in junk bonds and other assets that benefited from years of record-low interest rates won’t lose money. Bond prices drop when interest rates rise, as they have in anticipation of this week’s Fed move, which can hardly be called a surprise.

Investors have to understand that junk bonds are a risk investment, but in many ways the recent pressure on prices may be a healthy correction.

 

 

Fed to Raise Rates While Black Swans Swim

Fed to raise interest rates in the fall. What?

1. Global growth is slowing to the weakest pace since the financial crash.

2. Greece has adds a new “Monkey Wrench” almost every day.

3. China financial turbulence and Eurozone chaos: weak growth, persistent unemployment, lots of debt weigh heavily and spell volatility and unpredictability.

4. Falling commodity prices are cutting into emerging market economies: Mexico, Nigeria, Brazil, etc.

5. Low oil prices are hurting advanced economies like Canada.

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Consent of the People – Alexander Hamilton, Federalist Papers

Alexander Hamilton, the first Secretary of the Treasury wrote the following in the Federalist Papers (no. 22, Dec. 14, 1787).

The fabric of American empire ought to rest on the solid basis of THE CONSENT OF THE PEOPLE. The streams of national power ought to flow from that pure, original fountain of all legitimate authority.

Not bad!!

Return of subprime?

Maybe so, maybe not.

Low-down payment borrowers are returning to the housing market. Economic growth and lower fees are resulting in increased demand among first-time buyers, and banks are increasingly offering mortgages with down payments of 10% or less.

This could drive housing prices higher (more demand), and maybe even bring back the dreaded “bubble.”

Lenders say the return of the disaster…”subprime” scenario is not in the cards since they have stricter credit policies than before.

We’ll see.

No Money Here…Just Wonder

Captain’s Log – November 4, 2012, Sunday AM

Training for the Newport (Pell) Bridge run, next Sunday morning. You see, we get up about 5 AM in preparation for the 6:30 start of the race.

The preliminaries go like this. We park in Newport and take shuttles across the bridge to the starting line in Jamestown. So, it’s going to be cold and windy for sure (could be really cold and really windy). Anyway, we want to wear warm clothes right up until we start (but of course need to shed them at the start). But there’s no place to leave and retrieve later on. So all leftover clothes are donated to the Salvation Army. I plan to buy some from the Salvation Army this week and then just leave them. Oh well.

The race is only four miles. But it starts with a long steep uphill run followed by a long steep downhill run. I usually like to run hills, but this one is too long. For the record I think running downhill is even worse than uphill.

I’ve been road racing since the 70s, and I’m a back-of-the-pack guy. I’d rather be passing people close to the finish then the other way around. The last 25% of the course I usually pick up the pace (if I’ve planned correctly) and start knocking off runners who have miscalculated or are simply slower (there aren’t many of these).

However, I’m in the 65 to 69 year-old category (I’m 67). I wonder how many others will be in my class (not that I expect to win or anything like that). And I’ve always feared coming in last, although this is totally unfounded.

I approach road racing as mostly cooperation rather than competition. The emotions and efforts of the other runners inspire me to do better. They, in effect pull me along. Sometimes a runner will pass me and I’ll pick it up and stay with him/her for a while.

Competition can come into play also. I see runners up front who appear vulnerable and I target them. If I’m right, I’ll zip (zip is relative) by them and then look for others. I like to do this near the end and on a uphill if possible. Of course, at the same time there are other runners flying by me.

My training times are alarmingly slow these days. I checked this out on a quarter mile track the other day, and when I picked up the pace to my former speed, I almost passed out.

I don’t race much anymore, but I run regularly. I have to, running is my passion. I’m simply drawn to it, and I must be outside no matter the season. Treadmills are dreadmills and that’s that.

Both knees have moderate to severe arthritis. So this is a bit of a flaw in the process. Injections of natural fluid have helped enormously. My orthopod guy was ecstatic, and he thinks I’m a “poster boy” for this low-probability treatment.

Bottom line: I don’t know how much longer I can do this. I’m careful and seek out trails and avoid shocking pavement as much as possible. I’m blessed to live a paradise called Newport, RI where Cliff Walk, the beaches and Sachuest Point are my salvation.

These days the natural highs are higher than ever. And that’s where I want to be.

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