A month ago ‘The Market’ appeared to be rosy with the SPY, the ETF tracking the S&P 500, up 8.16% YTD, as of 9/30/2014. Then a few weeks ago the markets crumbled forcing most of the indices to give up most, or all, of their gains for the year (SPY: +2.35% YTD thru 10/15). Then suddenly, without hesitation, the markets recovered (SPY gained 9.40% from 10/15 to 11/12); well many of them at least. That is how it reads in the papers anyways.
Upon closer inspection, it has only been a handful of domestic indices which have returned positive results this year. For example, as of November 12th, IWM, the ETF tracking the Russell 2000, a broader index of mid-cap sized companies, was up only 3.14% compared to SPY’s +11.97%. In fact, prior to the most recent recovery, IWM had a -4.34% YTD return thru 9/30. The majority of the markets outside the U.S. have also suffered. The political and economic troubles overseas this year (Russia/Crimea, Scotland/ England, Brazil, Mexico, etc.) have left many countries with negative returns. These losses have been exacerbated by the strengthening dollar. For example, the flagship of Europe, VGK, the ETF tracking FTSE Europe, is down -5.68%, and EFA, the ETF tracking the EAFE Index, is off -3.85%. Regarding the most recent recovery, the US ETF’s outperformed the international ETF’s, evidenced by SPY and IWM’s +9.40% and +10.60% recoveries versus VGK and EFA’s +4.43% and 4.79% recoveries, respectively.
The risk of investing overseas this year has fostered a flight to quality, compelling investors to chase the S&P 500 for investment returns. Being in such demand, few other investments have delivered the risk-adjusted returns of the S&P 500. One challenge created by the S&P’s out-performance is that it has made it difficult to use the S&P 500 index to compare results of a fully diversified portfolio, or the general performance of the world equity markets.
Granted, much of the boon enjoyed by the S&P 500 is a result of the Fed’s monetary policy over the past several years. A recent Fed announcement2 said they would conclude Tapering of funds this month, yet interest rates have continued to remain low (US 10yr Note: 2.46% on 11/10/143). The questions remain, how low can rates go? How much money can be printed into the system without causing major inflation? Time will tell.
The problem we see with the S&P 500 is that it can only go one direction, while all others are going another, for so long. They will need to realign themselves at some point. Two weeks ago was the start of the realignment. We saw the S&P 500 (SPY), and to some extent the NASDAQ market (QQQ), down more than other major benchmarks. From September 30 to October 15, SPY and QQQ were down (-5.38%) and (-6.50%) respectively, while IWM was only down only (-2.51%). However, investors will still seek a flight to quality in volatile markets. We see more volatility ahead in the near future, but my guess is the markets will hold their own for the remainder of the year. At this point, we can’t see the Federal Reserve taking much more action than they already have. Long-term rates are near 2% again (US 10yr Note: 2.46% on 11/10/143); just as I forecasted in 1984 when rates were at 16%.
Our research has uncovered a uniquely high correlation between volatility and security prices. When volatility rises, prices tend to fall; and vice-versa. Most of what we see happening this quarter is tied to market volatility; so we will address market risk in the next section. My guess is that volatility is on its way back in. This is great for High Frequency Traders who have been laying low for the past few years. These traders are like bears. They feast heavily then go in their caves to hibernate. When they come out of their caves they are mad with hunger. These traders are hungry.
Risk = Volatility
A popular tool used by investment managers and investment consultants is called the ‘Sharpe Ratio’. This measure takes the historical return, less the risk free rate (2 Year Treasury), and divides it by the security’s volatility (measured in standard deviation). In other words, it’s the historical return/historical risk. This risk-return ratio (Sharpe Ratio) can help you identify the best performing securities on a risk-adjusted basis. As you can imagine, the S&P 500 is the poster child for an ideal Sharpe Ratio.
S&P 500 Index ETF (SPY) ¹ October 15, 2014
Note the continuous rise in price while the volatility remains consistently low (i.e. high Sharpe Ratio). From this chart, an investor should be a major buyer in SPY after the selloff in the market two weeks ago. The SPY was below the 200 day moving average, which is a level from which it has bounced upward for the past five years; and that is what happened. Now, two weeks later, it’s right back to the top of its range. So our forecast is that it will trend slightly higher by year end, but other investments look better.
S&P 500 Index ETF (SPY) ¹ November 12, 2014
Fooled by Statistics
Mark Twain said “There are lies, damn lies and statistics”. To me, the Sharpe Ratio is one of them. This ratio is based upon mean-variance, which simply put, is a long-term average of data. It’s the average return and average risk. It has no reflection on current geo-political risk, macro-economics (like the strengthening dollar), or corporate valuations (near highs dating back to 2007).
To solve these flaws, we use our own custom built models incorporating algorithms of recent Nobel Laureate winning scientists. Traditional models from the 50’s & 60’s, such as Modern Portfolio Theory, Sharpe Ratio, Standard Deviation, prove ineffective. As such, banks and insurance companies were mandated to use a newer method of measuring risk called Value-at-Risk (VaR). Unfortunately VaR is built on the same flawed methodology known as a normal distribution. Let me show you the difference.
In the chart below the green line in the upper chart is the daily price change of the S&P 500 ETF: SPY. In the lower chart, the black line represents the daily price change. The red line is the 3 month rolling VaR risk metric. We make it a rolling VaR to help it out a bit. This is the line that signals a ‘worst case loss’ scenario (1% of the time). This is saying that every 1 in a 100 days, the worst you should lose on average, is X%. The blue line is our risk metric; let’s call it ‘Expected Shortfall’.
SPY (iShares S&P 500 index ETF), Time Period Ending November 12, 2014¹
In the past two years, two of the best in history, the market lost more than forecasted 8 times using VaR (the daily loss (black line) is below the red line). On January 24, you can see the level of estimated loss versus the actual loss. Note, the blue line accurately predicted a larger loss. The blue line never violated its estimated loss during this two year period.
If ever there was a secret sauce in investing we believe it’s in understanding risk. Price changes are highly correlated to changes in volatility. When volatility increases, security prices tend to fall. Another nuance of price movement is in understanding how prices react in low, medium and high volatility situations. Securities tend to rise in low volatile markets. As an example:
SPY (ishares S&P 500 index ETF), 5 Year Time Period (6/22/2005 – 6/24/2010)¹
Note how the security price is rising during the low risk period (thick green line in lower chart) and when risk is decreasing (time period related to the thick blue line) using Expected Shortfall. You can also see risk increasing (time period related to the thick red line) between 2007 and mid 2008. Here is where we are today (11/12/14):
Only a few months ago the risk, as measured using our risk metrics, was at the lowest level in SPY’s trading history. The security was trading at record highs with an all time high Sharpe Ratio. By all accounts it should go straight up…… according to traditional risk models. The underlying fundamentals are still historically high:
SPY (iShares S&P 500 index ETF), Time Period Ending 10/31/2014)¹
A few months ago the historical fundamentals (Price-to-Book, Price-to-Earnings, Price-to-Cash Flow, etc) were at record highs (based on history back to 2007). The only saving grace was the forecasted earnings. Any hiccup in earnings will adversely affect the markets.
Starting from a moderate equity position this quarter, we have trimmed back our equity exposure in most accounts (ranging from 53% to 60%). Recently we took on some defensive positions such as Inflation-protected Bonds and US Dollar currency. We have also increased our position in Utilities as interest rates have continued to decline. We are not willing to bank on the long-bond due to the inherent risk of rising rates and with PIMCO flooding the market with bonds due to heavy liquidations in their bond funds.
As our asset allocation shifts, we find ourselves holding equities that have held up suprising well during the recent down turn. Meanwhile, many securities fell out of bed and not all of them have returned. Our positions in Health Care, Consumer Staples, and Biotech have held relatively strong. The best performers as of late have been Real Estate and the US Dollar (held in some accounts).
The market valuations remain high relative to the past ten years and the S&P 500 index has not reflected the underlying action of the U.S. or foreign markets. We believe these two will come closer together. Either the majority of indices will outperform, or the S&P 500 will underperform.
Either way, this recent spike in volatility reminds us of the market’s sensitivity to changing risk. We are continuously making small tweaks to the portfolios in an attempt to optimize our performance and reduce risk. We like these market conditions because this is where our models shine. We appreciate your vote of confidence in our money management and thank you for trusting us to prudently manage your investments.
Information provided is the opinion of Bryce James of Smart Portfolios and is not a solicitation or offer to purchase any investment. Information provided is believed to be from reliable sources. Charts and graphs are internally generated unless otherwise indicated. The data for internally generated reports is provided by Thomson Reuters.
¹ Sources: Smart Portfolios Internal Research with Reuters Data
2 Source: http://www.federalreserve.gov/newsevents/press/monetary/20141029a.htm
3 Source: http://www.federalreserve.gov/releases/h15/data.htm#fn1