Monthly Archives: March 2015

First Fed Hike & Stock Market

Interest RateGuest post by Contributing Editor, David R. Kotok, Cumberland Advisors.

There has been a lot of discussion about the Federal Reserve (Fed) and when it will move its interest rate to something higher than the present 0 to 0.25%. The Fed has been at the zero bound for years. My friend Jeff Saut at Raymond James noted that there are people who have been in this business over eight years and have never experienced a Fed rate hiking cycle. We have to look back more than a decade to recall what sequential hikes were like.

The questions are, when they will do it, by how much, in what sequence, for how long, to what level, and with what effect on the markets?

Bond market pundits think the Fed may raise rates quickly, as they did in other hiking cycles. Others, like our team at Cumberland Advisors, think they will take gradual steps in view of the fact that the US dollar is the strongest currency in the world. It is getting stronger, and worldwide interest rates are low and going lower. Approximately $4 trillion in total sovereign debt worldwide is now trading at negative interest rates. Additionally, the Fed does not see an inflation threat. It does see gradual recovery in the US and healing labor data.  Today’s employment report will add to the list of monthly improvements.  But the labor markets still have a long way to go to get to normal.  The Fed remembers the 1937 experience when they hiked interest rates too soon and dumped a recovering economy back into recession.

All that said, there is one question that remains. What happens to the stock market when the Fed raises interest rates?

Talley Léger is the co-author of our new book, the second (and revised) edition of From Bear to Bull with ETFs. He has published a study entitled “Don’t be too spooked by Fed rate hikes,” dated January 31, 2015. Talley has given us permission to share this Macro Vision Research piece with our readers. The link to his commentary is here.

We do not know what will happen in this particular cycle, since we are now in uncharted waters. We are coming out of the zero-interest-rate regime. We do know that the market has spent a lot of time and energy fretting about the prospect and the timing of rising rates. Our internal view at Cumberland Advisors is that the first rate hike will not trigger a market selloff. Further, we do not expect the bond market to sell off and interest rates to go shooting up when the Fed raises the interest rate from zero by an eighth or a quarter percent. And we expect the first rate hike to take place in the very latter part of this year or in early 2016.  In a few hours we shall see the newest labor data for the US.  We expect that it will validate this gradualist approach in our Fed forecast.

 

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with FOLIOfn or The Portfolioist.

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Investing: What the heck is a Larry Portfolio?

PortfolioGuest post by Contributing Editor, Matthew Amster-Burton, Mint.com.

Recently, I wrote a three-part series on how to start investing.

Today, I want to look at an advanced topic. Generally, I avoid advanced topics in investing, for two reasons:

  1. Most people don’t even have a grasp of beginner-level investing yet.
  2. The vast majority of “advanced” investing techniques can’t beat a simple, diversified portfolio over time.

Today, I want to look at a possible exception. It’s called the Larry Portfolio, developed by a guy named (you guessed it) Larry Swedroe and presented in his short and readable new book, Reducing the Risk of Black Swans, cowritten with Kevin Grogan.

Like momentum investing, which I explored last week, the Larry Portfolio is a way to attempt to capture more return from your portfolio without taking more risk—the holy grail of investing. Spoiler alert: it’s a promising idea that may or may not be appropriate—or possible—to implement in your own investments.

This is fairly technical stuff, although I’ll leave the math out of it. If you’re interested in investing as a hobby, read on. If you just want a simple portfolio that will beat your stock-picking friends, that’s fine. Go back to my original series.

One kind of risk

Smart investors like to take smart risks.

Investing in just one company is a dumb risk. That company might go bankrupt in any number of unexpected ways. Investing in lots of companies (aka diversification) is a smart risk: you’re no longer exposed to the risk of one company flaming out.

You’re still exposed to the risk of the market as a whole, and that’s the risk that investors can expect to get paid for over time.

Investors call this total-market risk beta. Beta measures the volatility of the stock market as a whole. Generally speaking, to get more return, you have to take more risk: Treasury bonds have low beta and low expected returns; stocks have high beta and higher expected returns. A total stock market portfolio has a beta of 1. (Let’s talk about low-beta stocks another time, please!)

So you might imagine that the best possible portfolio would look something like this:

  • Low-risk bonds (Government bonds from stable governments, high-quality corporate bonds, CDs)
  • A total world stock market fund

Mix them in whatever proportion suits your risk tolerance. One popular formula is 60/40: 60% stocks, 40% bonds.

Many kinds of risk

Then, in the early 1990s, two professors at the University of Chicago, Kenneth French and Eugene Fama, took another look at the data. They found that beta couldn’t explain all of a portfolio’s returns.

Two other factors seemed to be important, too. A portfolio taking these factors into account could, some of the time, beat a total-market portfolio without being riskier. These factors are:

Size. Small company stocks tend to have higher returns than large company stocks.

Value. “Value” stocks, essentially stocks with low prices, tend to have higher returns than growth stocks. How do you decide which stocks are value stocks? Use a measure like price-to-earnings ratio.

Value stocks are essentially stocks in mediocre, boring companies. This seems like an odd way to make money, but it’s a highly persistent effect. (Value is believed to be a stronger effect than size.)

You can now easily buy mutual funds concentrating on small or value stocks, and many investors choose to “tilt” their portfolios toward these factors, hoping for bigger returns without bigger volatility.

It’s a reasonable hope, because beta, size, and value have low historical correlation. When you have multiple stocks in your portfolio that are exposed to different risks, we call that diversification. The same can be said for having multiple factors in your portfolio.

The Larry Portfolio

Now, what if the stock portion of the portfolio was made up of entirely small value stocks?

That would give plenty of exposure to beta (because small value stocks are still stocks, and correlate with the wider stock market), and also maximum exposure to the small and value premiums. It’s also reasonably well-diversified, because there are thousands of stocks that fit the profile.

This sounds like a risky stock portfolio, and it is: high risk, high expected return.

Larry Swedroe’s insight was: what if we mix a little of this very risky (but intelligently risky) stock portfolio with a lot of very safe bonds? Say, 30% small value stocks and 70% bonds?

The result is the Larry Portfolio, a portfolio with similar expected return to to 60/40 portfolio I described, but lower risk, because the portfolio is mostly bonds—the kind of bonds that did just fine during the Great Depression and the recent financial crisis.

Swedroe warns in the book that there are no guarantees in investing. “[A]ll crystal balls are cloudy—there are no guarantees,” he writes. The research behind the Larry Portfolio may be sound, but “we cannot guarantee that it will produce the same returns as a more market-like portfolio with a higher equity allocation.”

Is it for you?

I took a look at my portfolio. It looks almost exactly like the portfolio Swedroe describes in the first part of the book, a diversified 60/40 portfolio with plenty of exposure to beta but no exposure to the size or value premiums.

So I asked him the obvious question: should I have a Larry Portfolio?

“There is no one right portfolio,” Swedroe told me via email. “The biggest risk of the LP strategy is the risk called Tracking Error Regret.”

Tracking Error Regret is a nasty thing. Here’s what it means.

Inevitably, the Larry Portfolio will sometimes underperform a 60/40 portfolio. If the stock market is soaring, it might underperform it for years at a time. A Larry Portfolio holder might look around and say, “Dang, everyone is making a ton of money but me. This portfolio sucks.”

Then you jump off the Larry train and back into a 60/40 portfolio—probably right before a market crash that decimates your stock portfolio. (That’s the Black Swan in the book title.) “Oh no—Larry was right!” you conclude, and buy back in, but it’s too late: now you’re selling cheap stocks to buy expensive bonds.

There really isn’t any cure for Tracking Error Regret. You can write an investment policy statement (IPS) to remind yourself that you’re a long-term investor and shouldn’t be watching the market too closely, because it’ll only raise your blood pressure.

The worst way to address the problem is to assume that you’re too smart or tough to experience it.

Can we build it? Maybe we can

Finally, there’s one other reason the Larry Portfolio might not be for you: it requires using mutual funds that might not be available in your retirement plan.

If most of your money is in a 401(k) plan, and that plan doesn’t have a US small value fund and an international small value fund, you can’t really build a Larry Portfolio. You might be able to build a watered-down version, but it won’t have the same risk-return characteristics as the real thing.

I haven’t decided yet whether the Larry Portfolio is for me. If you’ve read this far, however, you’ll probably enjoy Swedroe’s book. And if you already use a Larry Portfolio or are considering one, please let me know in the comments.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Mint.com is not affiliated with Folio Investing or The Portfolioist.

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The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA and SIPC.

Goodhart’s Law

Goodhart's LawGuest post by Leo Chen, Guest Contributor to Cumberland Advisors.

Goodhart’s Law

“When a measure becomes a target, it ceases to be a good measure.”

-Charles Goodhart

When it was first introduced in 1975, Goodhart’s Law focused mainly on social and economic measures. Since then, many financial market indicators have lost their forecasting power and succumbed to Goodhart’s Law. Nevertheless, Goodhart’s Law in no way depreciates the value and importance of market indicators; it simply means that investors are unlikely to be able to consistently generate abnormal returns over time using popular measures that are publicly available to the entire market. A clear example is what has happened to the CBOE Volatility Index, or VIX.

The Volatility Index

The Volatility Index (VIX) was a groundbreaking product when the Chicago Board Options Exchange (CBOE) released it in 1993. Also referred to as the fear index, VIX measures the expected underlying volatility in the S&P 500 over the next 30-day period on a real-time basis. Using various measures of VIX such as the two-week mean, the 30-day rolling standard deviation, etc., VIX traders and portfolio managers developed strategies that were initially profitable. However, over time it has become extremely difficult to profitably forecast the market by simply observing the movement in VIX.

While the history of the VIX demonstrates how a market gauge lost its predictive power once it caught investors’ attention, the CBOE Low Volatility Index, LOVOL, provides an even better illustration of how an indicator can lose its forward-looking power very quickly. CBOE began calculating the Low Volatility Index on March 21, 2006, and started disseminating LOVOL data on November 30, 2012. The forecasting ability of LOVOL immediately plunged to almost zero within a month. In fact, Goodhart’s Law has captured nearly all of the CBOE volatility indexes as prisoners. These fallen angels are no longer useful tools for forecasting purposes.

Another prominent index, developed in the late 1960s, that uses extremes in its value to signal that a market may soon change direction is the Arms Index (TRIN). As predicted by Goodhart’s Law, while technical indicators such as TRIN were able to successfully predict market returns in the past, their loss of forecasting power was only a matter of time when every technician used these ratios for trading purposes. Even the Federal Reserve was no exception. The pre-FOMC announcement drift was found to explain the equity premium puzzle in 2011. But this 24-hour window disappeared soon after the research was published.

Investors Beware

On one hand, Goodhart’s Law teaches us that a smart investor should not rely on any single factor known by the general public to be “powerful”; on the other hand, it does not negate the significance of any indicator.

The following figure is a ratio brought up by Chairman and Chief Investment Officer David Kotok of Cumberland Advisors. The CBOE SKEW Index measures S&P 500 tail risk, while the VXTH Index hedges “black swan” events such as Black Monday in 1987. Lagging and scaling both indexes by the lagged VIX, we are able to track the daily SPX with a correlation that can top 90%, comparable to the correlation between the S&P 500 and GDP. Nonetheless, a high correlation is not necessarily equivalent to strong forecasting power. While one could use this chart for long-term investing strategy, the accuracy of using these daily ratios to predict the daily market movement is approximately 51%, not economically significant enough for forecasting purpose.

3-5-2015

Figure 1. Correlations between SPX and Volatility Indexes

Conclusion

The list of captives of Goodhart’s Law is clearly longer than just the indicators mentioned above. High-quality research should be able to produce positive abnormal returns as long as there is information that can be exploited; however, superior research alone is no longer synonymous with outperformance – time is also of the essence. Because of technological innovation in financial markets, the time frame in which Goodhart’s law operates today is much shorter than it was in earlier decades. Just as Moore’s Law predicts that chip performance will double every 18 months, investing methodologies must continually evolve in order to remain profitable, due to Goodhart’s Law.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with Folio Investing or The Portfolioist.

Related Links:

logo-folioinvesting

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA and SIPC.