Taking A Simplistic High-Level Look at S&P 500 Earnings

Dec 10, 2012 in Earnings | S&P 500

The S&P 500 is expected to earn about $110-$112 in earnings in CY 2013.   With the S&P 500 cash index closing at 1,418 yesterday, the P/E is 12.7x.

In January, you can be sure to hear a lot about earnings and speculation on what will happen to that ~$111 figure.   It is probably too high given that is the norm.  That is,  estimates usually start high and then move down somewhat throughout the year.   That has not been bearish in the past -- that is the normal 'expected' result (there are many, many examples of the market doing well as earnings dropped). What is significant is if it falls sharply -- or rises even modestly-- those are not normal.

Recessions cause S&P earnings to drop sharply so that is of course the ultimate in concerns.   What is always interesting is for an earnings report from XYZ company to come out and then various commentators will try to extrapolate a forthcoming big disaster for the economy based on that result.   Those people have been consistently run over in this bull market.  

With that all in mind, here are some high level numbers to help keep it in perspective -- just the S&P 500 companies alone are projected right now to do about $1.04 trillion in net income (with a 't').   So that means that each $1 in S&P index earnings per share is about $9.3 billion in actual after-tax income dollars.   Next time you hear about some company that is going to drive the economy off a cliff, think about that statistic.   Is it so bad as to take -$93 billion off S&P aggregate earnings --- if it is, then that will cost the S&P -$10 of its ~$111.

Taken a step further, a recession might cause EPS to drop back well below $100. But to get from $112.00 down to say $90.00 (a -$22 per share) --- that works out to be about ~$202 billion less in net income.

That is quite a drop.   Wal-mart is projected to do about $18 billion in 2013 so we need the equivalent of 11 Wal-Marts to all simultaneously become profitless.  

We will have another profit downturn someday because we will have another recession someday -- but that is about all you can say as there is nothing right now that would indicate this is happening.  Indeed, financial sector earnings have actually increased over the last 90 days -- led by Bank of America, a company expected to do $11 billion of earnings in 2013 -- which is still down by about 50% vs expectations ~5 years ago.   Yes, tech earnings have weakened and energy has had a very poor earnings year -- so of course we will continue to pay attention to those developing situations.

Then again, you don't need any of that to happen just to have a market correction.   Be diligent and manage risk of course --- but keep this all in mind next time you hear how Caterpillar is taking its profit estimate down by $300 million for 2013 --- which is not even the equivalent of a nickel of the ~$111.00 S&P index earnings per share.   For S&P earnings to drop real materially,  you need a major sector to pretty much implode (like Tech in 2001 and Financials in 2008) ---  and then for a real doozie of a drawdown, you need the problem child sector to also drag others down with them into the abyss.   That is what causes the largest market drawdowns. 

 

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Allocation ETF Overweight Example

Dec 01, 2012 in Ratio | Strategy

Quick mini-analysis of an ETF we are long in our Allocations Board models (EPP).

 

 

Here is a summary of the rationale:

We went long EPP on an Allocations Board portfolio during a small pullback in late August.  (members can see allocation board for details).  Why EPP and why then?

First, EPP is a regional ETF covering developed markets in the Pacific ex-Japan region.   This means companies based in Australia, Hong Kong & to a lesser extent Singapore and New Zealand.   Note that none of these are considered emerging markets --- though all are clearly closely tied to the growth of Eastern Asia, which in turn are all emerging Markets  (ex-Japan).

EPP began by performing well on a relative strength basis during the summer of 2012 vs various lists we keep on constant monitor.

EPP is very volatile -- so we wanted to expose the model to strong relative strength -- but also be sure to plan ahead in case things went adversely against us.    This can be a tricky situation because you absolutely must give yourself a chance to participate in the uptrend by giving it some room in the short-run ---- but we wanted also to have a plan in place to avoid large portfolio drawdowns.    Below is a snapshot using the Ratio MA module to manage the individual position.   Also included are some pullbacks which are normal for a volatile security like this.    These would be buying opportunities within a perceived uptrend.   This is not meant to be how anyone else should choose to manage a position.   This is just a snapshot of how we were thinking about it.    

 

 

 

The exact parameter settings should not be the focus here.  Investing is not a pure science, in our view.   It is much more like a game of poker,  partly mathematical and partly behavioral/psychological.   Good poker players don't take wild risks with no plan in place if things go adversely.   They start out with a plan for each part of the hand and then make adjustments and often have to make some tough decisions as more information is revealed that is adverse to their position.   Sometimes they make a mistake and fold the best hand (like a trading whipsaw) --- but over time, good long-term decision-making is what makes a good investor (and a good poker player).  PLAN YOUR HAND.

Note that the ETF in discussion here (EPP) was not chosen in the first place because of this ratio MA analysis -- that is just a second more detailed view of how we planned to manage the position.   EPP was instead originally chosen because we like what the ETF represents on a fundamental basis (companies based in Australia, Hong Kong & Singapore) AND it also was showing strong signs of a new uptrend beginning (this is what good relative strength analysis does -- it locates particular strength in the market that over time suggests continuation rather than reversal).
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Yield To Maturity vs Holding Period Return

Nov 27, 2012 in Bonds

For more volatile bonds (those with at least intermediate duration),  yield to maturity is not a valid forecast of what you will get during time periods spanning far less the average maturity.   What does that mean?

We constantly read about how low yields are -- and we agree, fixed-income yields are low.    But this has been said for many years now and many people seem to draw conclusions and try to forecast based on misinformation.

For more volatile bonds, the return you get will relate to the duration of the bonds and the change in interest rates.   You are not required to hold bonds until maturity.   Individual bonds are often held to maturity because it is difficult to sell them at a reasonable bid.   Trading INDIVIDUAL bonds is very difficult, if not impossible for smaller accounts  ---- and still very difficult for large accounts.   However, ETFs have changed this dynamic.   You can now (somewhat amazingly) do bond strategies with no transaction restrictions.   No purchase fees, no redemption fees.    You can even trade things like Junk Bonds at TD Ameritrade for no commission.   And JNK very often has just a one penny spread.  This is not your grandfathers bond market.

But let's take a very basic case -- not even a long-duration example.   Below is the stated Yield-to-Maturity of Barclays Aggregate Index on specific dates.   The 2nd bar (in green) shows the actual 12-month realized return of AGG, a bond ETF that tracks that index.    As you can see, there is a fair bit of difference between the 1-year return and the stated YTM at the starting date.    Importantly, these differences increase dramatically if you go out to ETFs with longer durations.    Note that Barclays Aggregate index has a stated effective duration of just 4.5 years.   This is much more dramatic the longer you go out in maturity/duration.

 

 

 

To stay balanced, just keep in mind what has happened to the YTM for Barclays Aggregate Index.   Should it rise materially, you should expect the total return for an ETF like AGG to come in well below the index YTM.   The point is --- YTM is not a good 'forecast' of near-term total return UNLESS maturity/duration is short.   

 

 

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Utilities XLU and China GXC

Nov 11, 2012

 

Utility stocks are having very tough month so far.   The Utility index is often a big part of dividend funds and this segment is having a very tough go lately with dividend tax rates likely to increase.  XLU is now negative YTD 2012:

 

 

 

Here are all monthly returns for the past 10 years sorted from low to high for a logical look at XLU vs its own volatility over time.  This month is not over but if it closed here would be the 8th worst since 2002:

 

 

 

Perhaps this is decent example of how markets continually rotate.   Once hated, China ETFs have have now outperformed U.S. Utilities by well over 10% since June 30:

 

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Reaction on Day After Election 2008

Nov 07, 2012

You can set the ETF screener back to historical dates --- here is a look at what happened the day after the 2008 election:

Sectors:

 

 

Using the Fidelity No-Commission List As A Sample

 

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Global Investing and Home Country Bias

Nov 01, 2012 in Country Funds

If you follow the daily news cycle at all, you are probably getting a lot of news exposure to things that are pretty meaningless in the context of a global asset allocation.    Think about it for a minute -- a typical 'growth' allocation portfolio might be 75% risk assets and 25% income-oriented ('spread product' or gov't bonds).   Of that 75% risky, some percentage is U.S. equities -- and some percentage of that might be risk assets OTHER than US-based common stocks.  Already, we are taking a percentage of a percentage.

Then you think about how much coverage CNBC and other media outlets give to domestic company earnings reports -- and then compare that to something like the coverage of the entire "Asia-Pac" regional ETF investment opportunity.  Do you really need any coverage at all on Zynga and GroupOn? 

Let's put it another way -- how much have you heard about the Pacific Ex-Japan segment (Australia, Hong Kong & Singapore all combined) returning +20% this year?  Just the Hong Kong market alone has a weight in the Global index well above that of Apple or any other single stock.    Apple is of course a very important company and you should certainly pay attention to it -- but then you should also think about global investing opportunities at least as much (more) than you think about any specific individual U.S. company.  If you don't, you will be missing a lot of opportunities that may provide leadership for extended periods of time.

Let's look at the last ten years as an example.   While the U.S. market was leading the worlds equity markets for much of 2011-2012, keep it in context of what happened prior to that:

Home country bias is to be expected to a degree -- people invest in what they know.  Moreover,  prior to the ETF movement it was somewhat difficult to find low-fee vehicles that access international markets.   But that has all changed.   It's now ultra low-cost (no purchase fees, low expense ratios and in some cases zero commission).

The rankings chart below demonstrates a shift in relative strength that have been picked up and reflected in our Allocations Board portfolios back when it was occurring -- in August.   If you were just following news on a set of specific U.S. companies, you probably weren't paying attention to things like this.

 

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Risk Parity Basics

Oct 15, 2012 in Volatility

Risk-parity is a weighting methodology.  Given a set of securities in a portfolio, risk-parity overweights lower-than-average volatility securities and underweights higher-than-average volatility securities. 

Q.  How does it work? 

One of the most commonly accepted ways is to start with equal-weight positions and then make adjustments based on the relative volatilities. 

Because volatility always embeds a specific time-period assumption, you must specify the time-period (or lookback) you want to use.  There is no universal definition on what time-period is correct. 

If you choose a shorter lookback period, then your portfolio will adjust more quickly to major changes in volatility.   If you choose a longer lookback, then you will have less trading and less whipsaw losses when corrections end quickly and recover.  

(for what its worth, we have observed that some index providers use 12-months for the lookback time period and then chooose to rebalance quarterly.  But keep in mind that given two different analysts using different assumptions, you will get two different results for the same list of securities within a risk-parity portfolio.   As noted, there is no single 'answer').

Q.  What is the purpose of all of this? 

To us, one of the more interesting problems facing investors are questions having to do with how we weight securities that are in totally different asset classes.  Some securities mature at par (bonds) and some are perpetual (stocks) --- some represent  paper securities with high yields (preferred stocks) and some can be physical securities that have zero yield (Gold).  So long as something is actively traded on an exchange with accurate TOTAL RETURN pricing, risk-parity principles can offer an idea on a weighting methodology that uses the same metric across all of these disparate secruities.

Q.  Does risk-parity give an optimal weight?

No.  There is no way to calculate an optimal weight for the forward period so risk-parity looks at recent experience and applies that to the future period.  

Problem --  if short or intermediate bonds are used, the risk-parity methodology will always very heavily weight bonds (especially lower duration bonds).   This is because bonds that have fixed maturity dates will (nearly) always be far less volatile than securities that are perpetual (like stocks).   Clearly, low-duration bonds don't have much return potential either so if you were to follow risk-parity, you would end up heavily overweighting bonds relative to something like a 60-40 mix.    

Q.  Is risk-parity better understood as a concept or as a formula?

While risk-parity sounds quite pleasing, our opinion is that like just about everything in investing, understanding the concept behind it is more important than solving a formula.   This goes back to the very basics of investing: given similar return expectations you should choose to more heavily weight the lower-volatility security.   This does NOT mean that high-volatility securities are not investable -- it just means that you must have higher return expectations for the high-volatile assets.   If your return expectations are indeed higher, then it will make sense to overweight the higher-volatile asset.

Risk-parity will tend to do very well in any period with significant bear markets for an obvious reason, its focus on bonds.   Risk-parity will generally (but not always) underperform in up markets for the same reason.  

In our view, the point of backtests -- including risk-parity backtesting -- should not be to determine a formulaic 'answer' --- the point is to let backtesting help you digest large amounts of data and be part of the research process that helps you come to a conclusion about what is the right portfolio - in that situation - for that client - at that time.  

There are many ways to use volatility to help think about your portfolio exposures and  it takes judgment at the end of the day.   Given that risk-parity does nothing to adjust for differing return expectations across securities, it should be viewed as simply another tool, not an entire strategy in itself.   

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Example:

To understand the risk-parity calculation, it is important to realize how a risk-parity portfolio differs from an equal-weight version of a portfolio with the same holdings.  

This example will use ETFs from 2 different asset classes:  Gold (GLD) and Real Estate Investment Trusts (REITs).  Think of it as a way you might want to research how to weight your 'alternatives' allocation.  For round numbers, assume alternatives make up 10% of your total portfolio and you want to research how risk-parity handled the past 7 years.

Below would be the weight of GLD using 3-month risk-parity for the period:

 

 

Note that in 2006, the risk-parity methodology had Gold as an underweight vs real estate.  At the time, real estate was in the tail-end of a major bull market.   As 2007 began, the weightings equalized (signalling equal volatility) and then REITs went into a major bear market and Gold came to be about 75% of the mix for about a year.  Since the end of 2010, the weightings have been on average near equal. Note also that over that same time, the returns of REITs and Gold have been about the same.

The risk-parity module is embedded within the core-satellite application.  Here is a screenshot:

 

 

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Comparing Some Benchmark Allocations Through Q3 2012

Oct 01, 2012 in Hedge Funds

 

Snapshot of some basic allocation returns for the Year To Date period ending Sep 30, 2012.   

 

Hedge funds are having a truly dismal year.   It is actually shocking to see the spread this wide.   For what its worth, the S&P 500 is +16.4% through Sep 30, 2012 --- it is not shown relative to these others because we do not consider the S&P 500 a relevant benchmark for an overall allocation.    It would be appropriate if we were to isolate the performance of just the stock holdings of a given allocation.

 

 

Note how the first 3 allocations shown below are all clustered near +11% for 2012.

 

 

And we include the below chart to show the paths taken for both the Yale and Ivy Portfolios:

 

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ETF Country Funds

Sep 28, 2012 in Country Funds
 
Good analysis is the synthesis of a lot of different research you do.   Below is one way to look at the global market in terms of its trend.   By this account, the trend remains up and the fact that the world markets had problems in the middle part of the year (significant drawdowns) is entirely consistent with many other bullish years.   September proved rewarding for the bullish camp.  On to October.   #RiskReward #Sharperatio
 
 
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Avoiding Trouble

Sep 24, 2012

U.S. Industrials have continued to be poor relative performers.   The weak performance has been accompanied by weak earnings guidance from firms like FedEx (FDX) and Caterpillar (CAT).     Allocation board portfolios have tilts to segments like financials and small caps -- and have avoided industrial ETFs altogether.

While we favor the use of relative strength lists for what to look to buy/overweight,  simplified relative strength ratio charts can sometimes be useful to your overall process by helping to see what to possibly avoid/underweight:

 

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