Recently, many investors and market pundits have been looking at the term structure of interest rates – also know as the “yield curve”-  as a source of concern for equity markets.   In the attached chart, courtesy of Ed Yardeni, one can see why: in many instances yield curve inversions have indeed been precursors to market sell offs.  Of course, there have also been instances where inverted yield curves did not result in market sell offs.  The key is the spread.  At a positive 100 bps spread between Fed Funds and the 10-year note, the yield curve remains upwardly sloped and would clearly be in the territory that historically has allowed for a continuation of bull markets.  A better question, perhaps, is why did the curve invert in the past?  In ’73 and ’80 the Fed was tightening to curtail sharply increasing inflation.  In ’99 and ’07 the Fed tightened to reduce “market excesses.”  In those instances, Fed moves did lead to credit crunches which were the primary reasons for the subsequent market sell offs.   However, if today’s yield curve moves were signaling a credit crunch, high yield spreads would be widening out sharply and they are not.  They have barely moved all year.

Any credit spread widening we may be experiencing is more a function of increased credit demand in a strong economy, which have written about recently.  In fact, per Federal Reserve data, commercial and industrial loans increased by nearly eight percent in the second quarter of this year and total credit expanded over three percent.  Does that sound like a credit squeeze?

Lastly, European and Japanese interest rates remain at extraordinarily low nominal levels and at negative real rates.  Among developed bond markets, the US is the only game in town.   For global investors, a strong US economy and our high interest rates are very compelling.  So the dollar strengthens, monies flow into longer term US government debt, and the yield curve flattens.

We believe when you look through the headline, thoughtful investors will see a flattening yield curve as a by-product of a strong domestic economy and a rate normalization process by the Fed; in isolation, it is not a factor that would cause us to change our otherwise bullish viewpoint on US equities.

We are at the point in the calendar when the “mid-year market overviews” start to appear, fast and furiously.  The theme this year has been how dominant FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) have been in S&P 500 returns year-to-date.  The following post is typical of what has been peppering our Twitter timeline recently.

And then there was this story last week from CNBC.

You read this, seemingly every day, and you wonder why anyone buys anything else but FAANG.  While it makes for a fun headline, and an interesting two-minute segment on CNBC, the reality of course is different.

Netflix (until yesterday) and Amazon have indeed had spectacular runs in 2018, up 106% and 55% year to date respectively as of July 13th, and while they are the second and eighth best performers in the S&P this year, 99 other stocks have outperformed Facebook, 104 have outperformed Apple, and 129 Google in the same time frame.  What’s our point?  You don’t need to own FAANG to outperform.

More importantly, in spite of the FAANG headlines, correlations between stocks are now at their lowest level in almost a decade, and investors need to properly evaluate the implication.  We are moving into a period, likely to continue for some time, where stock picking has been and will be the most important characteristic if one wants to outperform benchmark indices.  How do we know?  We have three portfolios that own no FAANG, and those portfolios have been miles better than their benchmarks (and the S&P 500).  A fourth, which owns a teeny bit of FAANG (just two of the five names) and which uses the S&P 500 benchmark as its index, is also beating the S&P 500 by a wide margin.

As of Friday, July 13th, the S&P 500 Index is up 5.86% for the year-to-date period.  But, 244 of the 500 stocks in the index have lower year-to-date returns than the index and more than 200 actually have negative returns.  This should tell you that portfolio construction matters.  Most everybody has a spice rack in the kitchen, how it is used is up to the chef.

While stock selection has been a hugely important factor aiding portfolio performance this year, it is not the only one.  Asset allocation has also mattered.  Growth continues to outperform value, small stocks have outperformed large, and stocks have outperformed bonds by a wide margin (which is not as obvious an outcome as you think. . .).  While the S&P 500 is up nicely this year, its small stock cousin, the Russell 2000, is almost 2x better.  Also, the U.S. has clearly been the place to invest in 2018.  The MSCI All-Country-World-Index is only up 1.92% and the MSCI Emerging Markets index is down 5.66%.  The Barclay’s Aggregate Global Bond Index is down 1.41%, and gold is down 4.11%.

We continue to believe the period recently passed, where passive investment vehicles outperformed their active peers, will prove to be the anomaly.  We have written in the past about the problems with ETFs  https://cppinvest.com/problems-etfs-part-ii-junk-trunk/.  The return performance laid out above also frames the issue with passive investing.

We started out this piece saying one doesn’t need to own FAANG to outperform.  The table below is two media stocks.  One (NFLX) is a media darling that everyone talks about and the other (WWE) is an old-world media company that no one talks about.  The latter quietly executes relentlessly well.  We own the latter.  You don’t need to own FAANG to outperform.  As the bull market matures, stock picking and asset allocation become all-the-more important.

 

If you hadn’t noticed, markets have been skittish lately. Much of the angst relates to rising rate fears and rate sensitive sectors have gotten crushed this year. Here is a sample:

Commentators will tell you raising rates is a subject the Fed has approached cautiously out of concern that any decision to shrink the balance sheet would be seen as a tightening of monetary policy with the predictable impact on asset prices (see table above). We would argue the opposite – that unwinding may not be tantamount to tightening, and there is room for equity markets to continue to run as rates rise.

Why? The answer lies in the arcane and not easily understood world of excess reserves. Excess reserves resulted when the Fed bought up trillions of dollars in securities after 2008 in a bid to keep long-term interest rates low and the economy well-lubricated during the post crisis stress, a strategy you know as quantitative easing.

Excess reserves of the banks at the Fed are presently over $2 trillion and exist only to smooth out the need for reserves in the financial system – crisis management by the Fed in effect.  As you can see below, excess reserves were close to zero before the Lehman crisis. But they are still sloshing around the system and Lehman is now a distant memory.

You may have also heard that the yield curve is “flattening” with the usual concerns voiced that a flattening yield curve is a precursor to recession. Near term rates have indeed risen (somewhat dramatically) and the long end hasn’t moved much. But we think the answer is less ominous than recession and relates more to the simple differences between investor bases at the short and long end of the curve.

For example, from the time of the Fed’s 25 basis-point rate hike on Dec 16, 2105 until the eve of U.S. elections on November 8, 2016, the yield on the 10-year US Treasury note actually declined, to 1.8% from 2.3%. This occurred even as markets digested sizeable sales of Treasuries by many emerging markets throughout 2016. In the US, the unwinding of the Fed’s balance sheet did not result in tightening at the long end.

All the Fed is doing is releasing $2 trillion of excess reserves, which is vastly different from tightening. It’s most certainly not a reduction in banking system deposits, (i.e., reserves balances on the liability side of the Fed balance sheet). What do we mean? The Fed is indeed reducing its balance sheet but the banking system is expanding credit creation at the same time (fairly rapidly as you can see below). Commercial loan growth is up 14% but deposit growth is only up 1%. This, to us, is a clear sign that the economy is expanding and that is what is causing the rise in near term rates. We haven’t seen that in so long, we forgot what normal commercial growth looks like. It’s bullish.

More importantly, and a reason why the long end of the curve hasn’t reacted like the short end, is that one of the oft-overlooked effects of the reduction in excess reserves is also a reduction of money in circulation, which is deflationary. That’s why the yield curve looks as it does, not because the economy is slowing with a recession around the corner, but because inflation expectations are benign.

Here is how we would summarize:

  1. Credit expansion is occurring and with it, the US economy;
  2. Inflation is not a factor;
  3. The dollar is likely to remain strong and rates are going up;
  4. US Small-Caps should outperform with that backdrop.

A leaner central bank balance sheet, because it doesn’t result in tightening, could justify much higher policy rates than currently anticipated. Let the Fed raise rates. Loan activity would support the move. In normal times, and we are getting back to normal times, a lean balance sheet allows a central bank to focus on the core of its mandate, which is smoothing out the bumps. As central banks contemplate the timing of their balance sheet unwind (e.g., not rolling over maturing securities and outright sales thereafter), it may be useful to remember what reducing excess reserves really means.

Our posting has been sporadic lately as new business initiatives have kept us away from the keyboard.   Distractions we will happily endure, so no complaints.  But, in our four months away, we’ve found that

. . .absolutely nothing has changed in the markets.

Everywhere we look investors and commentators seem to be living in fear of the low levels seen in the VIX, the most widely watched measure of market volatility.  Yes, volatility has been at historical lows for quite some time, but it can also stay low longer.  Just because volatility is low is not a reason for it to increase.  While we can predict with 100% certainty that the VIX will spike upward at some point, instead of worrying about whether the low level in vol portends great danger, maybe we should consider why it’s been so low lately.

Historically, geopolitics has been a big mover of markets.  Currency crises and devaluations, war, blockades, political upheaval, Brexit, all have negatively impacted markets.  So much so it seems like we are conditioned to fear the geopolitical bogeyman.  Literally as I was typing, this showed up on my Twitter TimeLine:

Two Tankers, a Nuclear Button, and You

But what about the opposite?  What of geopolitics being a source of persistent calm in markets?  The Reagan “Peace Dividend” which carried through to two subsequent administrations is an obvious example.  Like Reagan was, President Trump is widely derided as a madman.  Unstable and insane are some of the adjectives frequently used to describe him.  Just last week, the Freak of the Week was Trump’s mocking of Kim Jong Un’s comment regarding the nuclear button on Kim’s desk.

But what actually happened?  Almost immediately after, South Korea seized two ships suspected of selling oil to North Korea, and North Korea sent a delegation to South Korea to discuss a détente of sorts.  It would be foolish to overlook the fact that Trump’s comments and aggressive stance vis-à-vis North Korea could have emboldened South Korea to stop the oil smuggling.  Indeed, just three months prior, the Chicago Tribune wrote an article openly speculating about Russian smugglers sending oil to North Korea.

In the last few months we’ve also seen this: the Saudis sharing intelligence with Israel, a historically unprecedented move; the Saudis moving aggressively against Hezbollah, Yemen and other bad actors in the Middle East; and widespread protests erupting in Iran, which were far different in scale and scope from what was seen in 2009.  No matter your politics, as much as some will either never admit or hate to admit, it is possible that President Trump’s foreign policy stance could prove to be quite consequential.  The market is telling us it is a real possibility.

When one considers positive surprises that drive markets, we would bet that few have ever considered this: Trump could have as lasting and positive an impact on easing geopolitical tensions as Kennedy, Nixon or Reagan.  The president’s domestic policies have already had an impact on markets.  If you doubted “Animal Spirits” you missed a great leg up in markets.  If political tensions continue to abate, you will see another.

Over a year has passed since the election of Donald Trump. It’s been a fascinating period in political circles and, according to CNBC, in investing markets. But has the market really been that interesting? Profitable, no doubt, but from a price action standpoint, there’s not been much to report – the market just chugs along, seemingly going up almost every day. In fact, since the election through Nov 30, 2017, the S&P 500 has risen 155 of 266 trading days and has not had a losing month since before the election. Over that time the market’s greatest one day gain has been 1.4% and its greatest one day decline has been 1.8%. Even more remarkably, we’ve also not had any sort of a meaningful correction whatsoever. The largest peak to trough drawdown has been 2.8% which occurred from the beginning of March to mid-April.

Source: Bloomberg

Given all that, market volatility, as measured by spot VIX, was at its highest just prior to the election and has hovered around 10 with notably few spikes since then.

Boring, but we’ll take it.

 

Source: Bloomberg

As they often do, many market prognosticators are forecasting pending doom. Yet, these forecasts are more shrill than usual as the distractions (very often caused by the President himself) from Washington are seemingly indications that the current environment cannot continue and a major revaluation of equities is imminent. A representative sampling of headlines follows:

“Why the Trump Bump Has Set Us Up for a Market Crash” – Fortune Magazine, Mar 7, 2017

“The Stock Market Has Been Magical. It Can’t Last.” – NY Times, Aug 19, 2017

“I Cannot for the Life of Me Understand Why the Market Keeps Going Up” – Mike Bloomberg, Sept 20, 2017

“Waiting for the ‘Trump Slump’ in the Stock Market” – The New Yorker, Oct 18, 2017

Yet the market continues to rise. But why? In our opinion, the answer is relatively simple: pure, unrepentant economic growth and profits. Yet it’s not just the U.S. enjoying an improved economic growth trajectory – it is a global phenomenon. Unlike a couple of years ago when several economic regions were struggling, Europe, Asia, and the Emerging Markets are all now experiencing enhanced growth rates with low levels of inflation. Even notable non-growers such as Japan are experiencing faster rates of economic activity.

Can we put the secular stagnation arguments to bed, now?

 

Source: World Bank, Bloomberg

A resurgence of constructive fiscal policy initiatives both in the US and abroad are now offsetting some of the “structural headwinds” that previously impacted the global economy. Regulatory reform )in the US) has been in full swing for nearly a year now impacting a wide range of industries and sectors. (Details of various regulatory initiatives can be found here.) Year to date through September 30th, deregulatory actions have outpaced new regulations by a ratio of 22 to 1, with an estimated economic benefit of nearly $10 billion. And it appears as if this trend is just beginning.

More recently, and most importantly, the Trump administration passed a tax reform package which will have sweeping effects on rationalizing and simplifying the US tax code, creating a more competitive landscape for US corporations. And yet again, this is not exclusively a domestic phenomenon. Globally, policy makers will need to respond to this change in US tax policy in order to remain competitive and you are now starting to see evidence of precisely that.

You can have “green shoots” in tax rates too!

 

So, we would suggest the doom-and-gloom crowd may again be wrong. The combined effects of tax and regulatory reform, which have clearly benefited the economy and markets for over a year, can continue to have a positive effect on commercial activity and ultimately risk assets.

At Crow Point Partners, we evaluate several key economic and investment variables to determine the attractiveness of the economic environment and whether we believe that investors will be compensated for taking risk.   Overall, right now, we believe that the economic and investing environment will remain attractive in 2018 and we have maintained aggressive risk postures in the portfolios which we manage.

Crow Point Global Macro
2018 1Q Key Economic and Investment Drivers

Risks are always present and the current environment is not void of them, in spite of the generally favorable backdrop. Any variable that diminishes the positive feedback loop of constructive policy, improved economic activity, increasing profits and ultimately rising stock prices is something to be taken seriously, particularly at today’s lofty valuations. In as much as an improved fiscal environment has created this virtuous cycle, politics and policy makers do represent the biggest visible risk to investment markets. Could we be one big geopolitical event away from a meaningful correction? Always. But, the current administration has been making it clear it is a friend of markets and the US economy. Until global economic growth and the animal spirits that are clearly in evidence show any signs of reversing, we remain long risk assets and expect markets to grind higher.

Our friend and partner Charles Trafton of FlowPoint Capital recently pointed out to us some very interesting data: right now growth rates for 2017 EPS are higher for value stocks than growth stocks. He also notes, ironically, that there is no manual for this.

He’s right. There is no manual for much of what we’ve seen lately, and that is precisely the point.   The makeup of the market has changed dramatically in the last ten years, with significant new earnings drivers and business models appearing. The distinction between value and growth might indeed be blurring (perhaps permanently) and investors need to adjust and rethink portfolio construction. As always, it’s never a mistake to focus on earnings quality first, regardless of its source.

For example, a frequent lament today is that the market’s valuation, excluding tech and financials, is stretched. To which we would say: then own more tech. Any review of the market’s earnings stream today shows the importance of tech and why that is now a good thing, indeed almost necessary. As you can see from the table below provided by FlowPoint, tech makes up 22% of the S&P’s market cap but contributes 32% of its operating margin.

Source: FlowPoint Capital and Bloomberg

Today’s tech sector isn’t your father’s Oldsmobile, as we point out here. Tech earnings in 1999-2000, when the sector was 34% of the S&P’s market cap, were of a markedly lower quality. Dirty would be a charitable characterization. The old days of tech had companies doing things like trading network capacity between each other and recording it as revenue, and hiding the impact of stock options on earnings.

Today? Tech provides 38% of the S&P’s total Return on Assets, almost twice the contribution from the next most efficient sector, healthcare, which speaks to the quality of tech earnings now. Look at it selectively and the importance of tech’s earnings quality, and the efficiency of tech business models, becomes obvious. Apple’s return on assets is 14.29% currently, it levers those assets 2.5 times, for a return on equity of 35.0%. Apple’s weighted average cost of capital (WACC) is 11.0%. AAPL’s ROE is three-times its WACC. Now that is whack. We’re not saying AAPL is a buy here (we sold ours last month), only that its business model efficiencies produce a lot of operating leverage, as do most tech franchises.

What about tech companies that masquerade as financials, like MKTX? Right now, its ROA is 28.4% (only 3 cos in S&P 500 have a higher ROA–Altria, ebay and MasterCard) and it is levered only 1.1 times for a return on equity of 31.3% vs. its 10.3% WACC. Put another way, that’s $370,000 in after tax net income/employee.  These “tech” companies, especially non-tech tech like MKTX are all extremely efficient. A reason that NVDA is trading where it is, is this (among other good reasons).

It’s precisely because of what is occurring with respect to other sector’s earnings trends that tech becomes such an important pillar, and why investors need to rethink portfolio construction. Look at the chart provided by FlowPoint below. Six sectors of the S&P currently are contributing nothing to the S&P’s return on assets. By nothing we mean zero.

Source: FlowPoint Capital and Bloomberg

What’s most worrisome to us with respect to earnings are trends like the Amazoning of the consumer space. While Amazon hasn’t eaten the whole world yet, it is a massive deflationary force in a big space that right now contributes positively to the market’s return on assets and earnings growth. Amazon’s impact on retail recently has garnered headlines, and rightly so, but the real impact of the Amazon trend has yet to be truly felt. To us, this is a great risk today, that sectors become zero-sum games. If so, portfolio concentrations to the winners have to increase.

Is it any wonder then why tech stocks have become such core holdings for many? While tech is very much a crowded trade today, which creates its own risks, it is also a trade that appears to be selectively justified. The remaining question is will the other important market sectors make increasing contributions or not, and if not, are they worth owning at all?

The recent CCAR findings appear to indicate that banks will no longer be the drag or the concern they once were, so financials (at least the right ones) could start to help tech shore up the market’s earnings profile. What about energy? Historically it was a big driver of earnings but the current Administration is more likely than not to unleash a production boom (more on that in another blog post) that will act as yet another broad deflationary force. We have pointed out elsewhere what a train wreck consumer has been. Is that ever righted? Materials will always be a sector that responds to macro influences selectively, and should be played accordingly.

So, actively tilting portfolios toward higher quality earnings streams – sustainable, durable business models – will become more important if these earnings trends continue, as they seemingly are. Almost half of the names in the S&P posted negative returns for the past six months. The market is beginning to make distinctions between business models, as we have pointed out before, and so, then, should investors also address the real issue: not just the absolute level of earnings and valuation, but also the quality of the drivers, and who is driving. The evidence would suggest that greater concentrations around higher quality earnings streams is the better approach. We might be at the point where sector diversification is not the risk management tool it once was.

 

We write a lot about return dispersion with respect to stocks – the phenomenon whereby stocks either all move together, or begin to act distinctly. Dispersion comes and goes; when it disappears, like it did eight years ago, passive investing makes a great deal of sense. The return of dispersion in 2017 has been a boon to active managers, who are benefiting from it and other similar factors allowing for positive spreads vs. the market. No surprise then that through Q1 2017 more than half of all active mutual fund managers have beaten their 2017 benchmark.

Dispersion is the mother’s milk of active management, and skilled active managers can significantly enhance returns during such periods, highlighting a shortfall of passive investing and so-called “smart-beta” ETF’s. Our partners at FlowPoint Capital create research models that highlight dispersion opportunities at the market, sector and stock level. One of their methodologies we track closely is FlowPoint’s Trend1 model, a trend-following system that categorizes stocks into four groups: A, B, C and D. The graph below shows the performance of Russell 2500 stocks in these categories since 1990. These data highlight (1) amplitude and duration of the four categories’ share price performance over time, and (2) the power of a systematic approach to portfolio construction.

The Problems With ETF'S, Part II- Junk in the Trunk

Source: FlowPoint Capital

But for a brief “worst-to-first” run such as in 2008, stocks in the C and D categories are serial capital destroyers. Bull markets, bear markets, risk-on, risk-off, no matter – C’s and D’s are to be avoided. Well, guess how many stocks in the S&P 500 are in the C and D categories today? Eighty-six, or almost 25%. To be fair, many C-rated stocks have positive returns YTD, but the number of D’s with positive YTD returns can be counted on one hand. This in a year when the market is up 10%. So why own them? Well, you do. In your ETF. If you are holding your ETF and its C’s and D’s because you’re waiting for 2008 again, we should talk.

Today, D’s include a heavy representation of Consumer stocks and to a lesser extent, Energy. The carnage in the Consumer space has been well documented, with more than 35% of that sector negative for the past year, and Consumer is a 21% weight in the S&P 500. Nearly 100% of the Energy holdings in the S&P 500 are down YTD, though 100% of FlowPoint’s A-ranked energy stocks are positive for the year. More than 20% of FlowPoint’s category D stocks are down at least 30% YTD, more than a 40% return dispersion from the market’s. You can do the math many different ways, but what your return could have been by eliminating known risks like C’s and D’s is material.

That’s the opportunity cost with passive vehicles. You have to take the D’s with the A’s – like buying a car with a motion activated lift gate but having to also pay for the sun roof you don’t want. This risk is presumably what “smart-beta” ETF’s reduce. But smart-beta is a misnomer. Tilting portfolios toward lower-beta stocks, or high dividend payers, is one way to reduce portfolio volatility or enhance yield, but that simplistic approach doesn’t go far enough.

Take a hard look at your ETF’s. Then, build, buy or rent ranking systems that work and give your ETF an x-ray. See what’s inside. Your portfolio will thank you for it.

Crow Point would like to thank its intern, T.J. Pavone, for his help in compiling this post. It was TJ who did most of the research and analysis here. He has redeemed, somewhat, the millennial generation with his hard work. May he be an example to others.

 

This week, Paul Ryan held a press conference to highlight tax reform initiatives. It didn’t get nearly the attention it deserved. But then, tax policy in general rarely gets the attention it deserves (more on that later). You know what also never gets enough attention? Public policy.

After years of hostility to the notion, the United States appears to be now embracing a move toward more energy independence. The byproducts of that (no pun intended) are just beginning to be felt, which will have far-reaching and positive economic implications for the U.S. beyond energy.

A great article recently appeared in the UK Evening Standard about fracking and the risk not pursuing fracking aggressively presents to the UK. The article, by Anthony Hilton, touches upon an issue that we never talk about enough – the positive mushrooming impact on jobs from energy exploration. It is worth quoting Mr. Hilton at length:

Once you have built a major chemical complex, your main (in many ways, your only) worry is the cost of the raw material you need to feed into it. This can account for half or more of total production costs, and is similarly crucial for other energy ­intensive industries such as refining, iron and steel, glass, cement and paper.

Until a few years ago Europe and America paid more or less the same amount for their petrochemical feedstock — the US had a slight advantage but not so great after transport and other costs had been factored in. (Middle East plants, sited right by the oilfields, did have such a price advantage but lacked scale.)

This is no longer the case thanks to the fundamental changes across the Atlantic. The Marcellus field, which spreads over several states and is just one of many in the US, produces 15 billion cubic feet of gas a day which is almost twice the UK’s entire consumption. But the result is that US prices have disconnected from the rest of the world and the subsequent feedstock prices have given American chemical plants so vast a price advantage that, on paper at least, there’s no way Europe can compete. It is staring down the barrel of bankruptcy, not now, but in a few short years, unless it can find some way to get its raw­ material costs down to American levels.

Thus far, the effect has been muted — and the European industry has had a little time — because the US petrochemical industry was originally not built for indigenous US gas and oil supplies but instead located near ports and configured to process supplies of oil from the Middle East.

But this is changing fast. There has been virtually no big petrochemical investment in Europe in the past decade whereas in the US since 2010 some $85 billion of petrochemicals projects have been completed or are under construction. Spending on chemical capacity to 2022 will exceed $124 billion, according to the American Chemistry Council, creating 485,000 jobs during construction and more than 500,000 permanent jobs, adding between $80 billion and $120 billion in economic output. After years where chemical capacity has run neck and neck with Europe, the American industry is about to dwarf it.

Plainly stated, fracking and horizontal drilling have produced for the US a great economic advantage over Europe and elsewhere. It would be irresponsible to stop. Thankfully, the War on Drilling appears to have ended last November. Let’s hope state governments stay out of the way. . .

I have heard too often in my lifetime that presidential elections aren’t that meaningful because Washington gridlock prevents the U.S. from lurching too far in any direction, which is supposed to be a good thing. I hope the article quoted above can help debunk that idiotic notion. We can think of few things more complementary to economic growth than sound public policy from the Executive branch. Tax policy might be the only thing that matters more.

We will have more on the impact of tax cuts in future posts, but If you are looking for events to cause a sharp pullback in markets, a delay in tax reform, or weaker than expected tax reform, or tax reform being tabled altogether gets our vote as Public Enemy No. 1 for markets.

 

 

In the past few weeks, we have teased a few thoughts on the issues we see in ETF’s.  This week, we’re going to start a series called “The Problems in Your ETF.”  Today’s post centers again on the levered ETF’s.

Many (negative) market commentators point to Central Bank purchases of stocks as a looming issue – i.e., Central Banks have no business buying stocks, their purchases have helped push stocks to artificially high levels, and when those purchases inevitably reverse, stocks will get crushed, etc, etc.  Given their status as a buyer of last resort, their tendency so far to be long term holders, we’re not sure why Central Banks are bad shareholders.  But that’s beside the point, which is: why does no one talk about the skew introduced into the markets by the levered ETF’s?

Once again, our friends at FlowPoint Capital have supplied us with the necessary research. FlowPoint looked at 788 ETFs in the US that have greater than $1.0 million in average daily trading volume.  The total average daily value traded in this group is $65.6 billion, or 28% of all US equity trading.  The total market cap of these ETFs is $2.9 trillion, or only 9.4% of the entire US equity market capitalization.  You starting to see the disconnect?

The average ETF in this universe trades four percent of its market cap per day, and the average holding period is 162 days.  The $235 billion SPY, for example, trades eight percent of its market cap every day, which amounts to a 15-day average holding period.  In contrast, its buy-and-hold Vanguard cousin, the $80.0 billion VTI, has a 340-day average holding period.

The problem really is with the geared or levered ETF’s.  While some non-levered ETF’s have holding periods of 700 days, $93.0 billion in ETF market cap averages a holding period less than ten days, and most of that is in levered ETF’s which are designed specifically to encourage daily trading.  Does this concentration in levered ETF’s presage a potentially looming problem for equity markets?   Here it is graphically:

Source: FlowPoint Capital and Bloomberg

Look at the geared Direxion gold miners, the DUST (3x short) and NUGT (3x long).  The DUST has $273 million in market cap but trades $189 million per day.  The NUGT has $1.5 billion in market cap but trades $300 million per day.  Its swaps are based on the Vaneck gold miners’ ETF (GDX).  But, not too long ago, stories in the press appeared noting the issues GDX was having meeting subscriptions and redemptions. And that was just because the GDX was growing rapidly.  What happens when volatility spikes and everyone runs for the door?  What about the swaps the NUGT has on the GDX?  You know why no one knows?  Because neither the NUGT or the DUST existed in 2008.  They were created in 2010 and have only known stable markets.

The TQQQ, your favorite 3x levered technology play, owns $1.8 billion in tech stocks, including $100.0 million in AAPL.  It was also only formed in 2010.  When all the fish start swimming in the other direction, what will that leverage unwind do to stocks?  Our point is that the number of shares owned today by short term shareholders is ominous.  Levered Bull funds outweigh levered Bear funds in number and in assets. So, while it’s nice to have the Bear funds to supply liquidity in Bear markets, they will get swamped by their cousins. And it isn’t just the levered vehicles.  Some of the widely owned country and sector ETF’s have shockingly high turnover rates, which will only get worse in a prolonged selloff.

Remember when the Flash Crash in ETF’s was an issue?  That was two days in August 2015.  What happens when it turns into something real, when people are actually paying attention?  It’s easy to pick on the levered ETF’s.  The real concern ought to be with the un-levered, widely held ETF’s.  Many names in the ETF universe, mostly created after 2010 and untested in bear markets, attract tourists and not investors.  That’s a problem. Portfolio insurance, a brand-new product and untested in Bear markets, exacerbated the 1987 crash. Long-Term Capital, everyone’s favorite pariah, was a brand-new concept when it almost caused markets to melt down in the late 90’s. Risk parity funds are brand new. And so are many ETF’s.

Should we be worried about CAPE, the popular Shiller Cyclically Adjusted Price Earnings ratio? Experts tell us it is trading at exceedingly high levels and, the experts also say, those high levels portend poor stock returns, according to CAPE.   We’ve thought about that and have come to the following conclusion:

So what?

First, CAPE is a notoriously bad prognosticator. Second, CAPE has been high for the past 20 years, and has moved steadily higher since 2010. Anyone complaining about stock market returns this decade? Finally, what about the “E” part of CAPE? What do earnings imply about current levels?

For those unaware, CAPE is a price earnings ratio based on average inflation-adjusted earnings from the previous 10 years, sometimes called the Shiller PE Ratio, or PE 10.  As you can see from the chart below, CAPE valuations are at historically high CAPE levels relative to the average.

Source: http://www.multpl.com/shiller-pe/

 

But are CAPE valuations truly stretched?  This is a ten-year average calculation.  In the last ten years, adjusted SPY earnings included two years (2008-2009) that could easily be considered trough earnings based on recent history ($17.31 and $51.71 per share, respectively versus $95.00 for the 2010-2016 average).  When the 2008-2009 earnings fall out of CAPE starting next year, and IF those earnings are replaced by anything remotely close to recent history, is today’s ​CAPE multiple truly rich?

When we project CAPE by replacing trough earnings, we consistently see about a 15% decline in the multiple which puts CAPE on an adjusted basis today between 24-25, below the 27.12 average seen between 1996 and 2016.  Even if you kick out the goofy 1999-2001 period, CAPE’s average historical multiple drops only to 24 for the twenty-year period, again in line with our adjusted CAPE today.


Source: www.multpl.com/shiller-pe/

What about earnings?  How reasonable is our assumption that 2018-2019 earnings will stay within recent historical averages?  Google and Facebook account for about 8% of the S&P’s earnings today.  Facebook wasn’t even part of the S&P prior to 2012.  Ten years ago, Apple was a company in the index, not THE company.  Would you rather own 2017’s earnings quality or 2007’s?

We’ve said it before and it’s worth repeating: from 2001 through 2005, the S&P 500’s p/e multiple DECLINED from 29.55 to 16.33, and the index traded up 41% mostly because the “e” in the p/e ratio materialized.  Over the next two years, it seems entirely plausible that earnings driving CAPE ratios can hold. You could identify a handful of reasons for the market to trade down from here (China, North Korea, interest rates), but it is hard to argue that an over-valued CAPE is one of them.