Bank Loan Comparables

Some investment pros like to quote Morningstar Ratings as an objective measure of an investment’s performance.  The rating has come under criticism periodically since it has not really been a good predictor of future returns (https://citywireusa.com/professional-buyer/news/not-a-mirage-morningstar-hits-back-at-ratings-criticism-in-wsj/a1063338).  But, it still persists as the go-to measure to confirm or deny an investment manager’s investment decision.  I came across a new problem recently with the Morningstar system that bears attention.

I am a fan of diversified exposures to manage portfolio risks.  One of the fixed income asset classes I favor is the bank loan sector.  That sector is not without credit risk, and perhaps liquidity risk, if not properly managed, but it has been a valid long term performer to smooth return profiles.

Looking at the top performers in the Morningstar Bank Loan Category revealed an interesting fact.  A top performer over the past five years in that category, the Eaton Vance Floating Rate Advantage I mutual fund (EIFAX), produced a 5-year total return of 4.32% besting the average Bank Loan total return of 2.97% and Intermediate Core Bond total return of 2.88% garnering it a Morningstar 5-star rating.

Upon more research, however, I found that the fund has a large leverage component to boost returns that the adviser discloses on its website and Fact Sheets; but this point is nowhere to be seen on the Morningstar site.  Leverage, of course, adds risk to a portfolio and could produce magnified gains and losses if on the right or wrong side of the bet.

Without a full review of all the Bank Loan funds in that category, it is hard to say how many other funds in that category utilize leverage.  Consequently, it is an unfair comparison to lump all bank loan funds, those with and without leverage, together within a ratings framework.  Once again, buyer beware and know what you are buying and why.       

Why Bonds? Part 2

As a “bond guy,” it is not unexpected that I am a fan of the positive attributes that bonds can bring to a portfolio. Things like regular cash flow, the ability to “dial-in” the amount of interest rate and credit risk, and negative correlations to equities all lead to a good portfolio component.  This thought process has worked out very well on a year-to-date basis (see previous blog post here for more info:  https://www.dattilioash.com/our-blog/2019/8/7/why-own-bond-funds). 

During my years managing interest rate risk at a major insurance company, we had sophisticated systems and analytics to measure and manage our fixed income portfolios and exposures along the yield curve.  The math was sound and proven to provide useful information that we could use to manage exposures.  The trouble, however, was that we were not very good at forecasting interest rates!  The best we could do was manage our exposures; trying to position for a rate spike or yield curve flattening or steepening to pick off some extra total return almost always ended in a losing proposition.  Consequently, we resigned ourselves to manage a “matched” book; making sure that our asset and liability durations were matched within a tolerance range to “immunize” our target return.    

I feel the same way today.  Running an “immunized” fixed income portfolio to its liability target is exactly analogous to managing a “long term strategic asset allocation” to a target risk profile.  Some of my peers in the industry took confident positions in “short bond ladders” and “short government agency paper” to position for rates to rise due to the consensus view for 2019.  They were all dead wrong (so far) and missed the excess returns provided by taking duration and credit risk from other fixed income sectors. 

Certainly, rates could go lower from here or stay the same for a protracted period of time; especially if the global trade tensions lead to a U.S. (and global) recession.  In that case, bonds could produce positive total return above current yield rates (10-year treasury yield of 1.64% as of today, for example).  Alternatively, rates could go higher if the U.S. Fed and global central banks are (ever) successful in promoting more robust growth and inflation above meager sub-2% levels.  Of course, rates are ALWAYS subject to ups and downs; we just don’t really know when they will emerge.

Please see my prior blog post from June 2019 to see more detail on interest rate forecast foibles: https://www.dattilioash.com/our-blog/2019/6/13/interest-rate-forecast-foible

Why Own Bond Funds?

I am a “bond guy.”  I worked in an insurance company managing investments for 25 years and spent most of my time worrying about bond duration mismatches, credit quality, defaults, and sector exposures.  We had equities, too, but they comprised a small allocation since they didn’t work very well to hedge liability cash flows.  We loved bonds for their cash flow characteristics and lower risk profile.

Bonds, however, have not gotten a lot of “love” in this post-Crisis environment.  Inflation, which most market commentators said was sure to follow the aggressive global central bank easings (but has yet to materialize), would certainly crush the value of all those long duration bond portfolios, as they say.

But, on days like we have seen most of this year, owning bonds have performed exactly as we would hope; as a hedge against equity volatility.  Year-to-date through July 2019, core bonds have exhibited a negative correlation of -0.41 to the S&P 500; a much higher negative correlation than over longer time horizons (10-year correlation to the market is almost 0.0; granted this is an unusual time horizon).

To all my peers buying short term bond ETFs and mutual funds to protect value and running away from credit quality, you have missed a key value of core bonds; as a diversifier of market risk.  There is certainly a place for all the different varieties of bonds funds, and I like most of them, but not to the exclusion of good old “core” bonds with some moderate duration and investment grade credit quality. They are called “core” for a reason, after all!

Yikes! The aggregate core bond ETF from Schwab (SCHZ) is up 7.86% year-to-date while the investment grade corporate ETF from iShares (LQD) is up 14.02%, pretty close to the S&P 500 returns of 16.2%.

Best to own a well-thought-out diversified mix of different bond types to capture the unique characteristics that each of them offer.

"Beats Me!"

A former chief investment officer at my prior firm (you know who you are!) was one of my favorite market commentators.  At client meetings, he would talk for a good 30 minutes about the economic and capital market issues of the day.  Usually there would be a good mix of positive and negative characteristics to end up with a balanced presentation of the current situation.  At the end of each presentation, and he always did this, he would close by saying, “so, what is the market going to do?  Beats Me!”

I am quite comfortable saying the same thing today!  Plenty of good news and plenty of bad news.  It certainly seems like a great time to buy dividend paying equities since the S&P is currently paying about 2% (and high dividend equities are over 3.5%) which is much higher than the 10-year Treasury at under 2% (1.76% as of August 5).   See my blog post dated Feb 27, 2019 for more detail on this topic ( https://www.dattilioash.com/our-blog/2019/2/27/dividends-and-treasury-yields).  Plus, qualified dividends are a tax-advantaged investment compared to bond interest.  But, there is a huge overhang of market stress due to the escalating trade war.  And, weakness in other global economies. Etc., etc.

As I am wont to say, plenty of reasons to be cautious, but no reason (yet!) to run for the hills.  New money should go into the market slowly, since that is ALWAYS the low risk approach to get market exposure.  Investors with a long term strategic approach properly diversified and positioned in the risk profile appropriate for their situation should stay the course.

Do You Need a Retirement Plan?

Most investment advisers offer some form of investment planning for retirement.  Sometimes it can start and stop with a few rules of thumb; fund an “emergency fund”, max out your 401k, identify an age- and situation-appropriate risk profile, live within your means and check back when you are 65 to see how you did.  Alternatively, you can do some fancy income, expense, goals and investment modeling with some of the great investment modeling software available to advisers to come up with a probability of success.  Depending upon your age and financial situation, it can be very useful or overkill.  Let’s take a look at the differences.

If you are under 40 or 50 years old, you have a long time to go before you retire; probably 25 or more years – when a lot can happen.  Though you can certainly model out all of your “known” financial and non-financial considerations to get some insight into your financial future, I can guarantee you that you will be wrong and miss some important unknowns that will throw a kink into your plans.  Usually, it makes best sense simply to do some high level planning and stick to a simple approach.

On the other hand, if you are 50 or older you will likely have a much better handle on how the next 10 or so years will evolve and can take meaningful steps to help ensure a high probability of success to fund your retirement goals and expenses.  It makes very good sense to map out a budget of income and expenses with short-, medium- and long-term goals and overlap that with your investment portfolio and projected savings to see how it could perform until your “end of plan” (when you die!).  Your goals will include things like European vacations, a Florida condo, a new car every five years and whatever else you can think of.  Your expenses and goals need to have an inflation adjustment, too, with things like health care expenses getting a higher inflation adjustment.

Unlike a more generic approach, a modeled approach with realistic cash flow assumptions allows for a statistical measure of the “probability of success”, i.e. the chance that you will reach your end of plan with the means to fund it over your retirement period!  After considering your income from all sources, e.g., part-time work, pensions, annuities, social security, required minimum distributions from tax-deferred accounts, etc., and your expenses and goals, it is useful to overlay scenario testing of different risk-based investment portfolios over your planning horizon.

For example, you could find that an aggressive portfolio could have a higher probability of success (maybe 80%), but the large drawdown in any one year (perhaps -30% or more) is too big a risk to take in any one year.   In that case, you may opt for a lower risk portfolio (with maybe a 70% probability of success), but with only a -15% drawdown.  Modelling software helps to fine-tune the risk profile of a target investment portfolio to your retirement needs and desires.

Quid Est Veritas?

Translated: “What is Truth?”  The financial (and other) media has many ways to tilt its reporting of news.  Whether it is due to the selection, frequency, or framing of stories, the media has a choke hold on how consensus views get formulated by the consuming public.  The CFA institute (of which I am a member) published an article titled, “How to Read Financial News Redux:  Understanding Consensus” by Robert J. Martorana, CFA (https://blogs.cfainstitute.org/investor/2019/07/22/how-to-read-financial-news-redux-understand-the-consensus/) that highlights some of the issues to consider when reading financial news.

The author highlights the main ways he reads the news and makes informed decisions to get his version of “truth”.  First, he reads a variety of general news sources, such as the New York Times, Wall Street Journal, and Google News.  He then gets to the investment news from sites such as Dash of Insight, Fundamentalis, and Factset Insight, as well as pure investment research such as from the JP Morgan 2019 Long-Term Capital Market Assumptions.

The author looks at how each source covers the story, such as if it was a lead story with deep analysis or if it was buried somewhere with only a cursory overview.  Also, if the story keeps recurring with updates, that news source obviously has some bias (legitimate or otherwise) to keep reporting on it; which could be different from a different news provider.   Also, there is obviously a political bias in news reporting today; it is critical to “spot it quickly, read multiple viewpoints, and come to our own conclusions”.

As an investment professional, I am intrigued by how investment-related stories are covered by the mainstream media. Oftentimes, I hear or read a story that is blatantly wrong or mis-reported. The errors are obvious to me as an “investment professional”. Consequently, I wonder how many other stories I hear or read about that I am NOT an expert in that are mis-representing the facts. As a Chartered Financial Analyst (CFA), we need to do our due diligence as we prepare and implement investment plans and management. We need to ensure that our sources of information are fair, unbiased, and “truthful” so that we can faithfully serve our clients.

After-tax Benchmarks? Not!

Maybe it’s hard to believe, but there are no readily-available published investment benchmark indices calculated and presented on an “after-tax” basis. However, this should not be surprising given the personal and complex nature of taxes. For example, everyone has their own personal “effective” tax rate and also their own variable timing of cost basis and the receipt of taxable income; not to mention the realization of capital gains and losses; short- and long-term!!

I found an interesting article by Morgan Housel (https://www.betterment.com/resources/after-tax-performance-explained/) that got into some of the details on the impact of taxes on a taxable equity portfolio. He did the math and found that from 1993-2017 the S&P 500 returned 7.7%; add in dividends (that are taxable) and the pre-tax return jumps to 9.7%. Add in an adjustment for inflation and you get a “real” return of 7.4%. Now, finally, factor in some assumptions for taxes on the dividends and you see a drag of 0.6% per year making the total return 6.8% annual return over the horizon. This is a bit intuitive since the S&P 500 currently yields about 2% per year; a 15% Fed tax on qualified dividends plus an assumed 5% state tax (totaling 20%) puts the tax cost at about 0.4% per year (not including compounding, etc.). But, of course, not everyone is paying 15% Fed tax or 5% state tax, hence the benchmarking problem! And, most investors also have some non-qualified dividends and bond interest that are taxed as ordinary income, making the problem even more complex.

What do we do without an after-tax benchmark? There are few things, but one approach is to look at each distinct holding in a portfolio and evaluate its relative attractiveness on an after-tax basis. For example, compare tax-free municipal bond rates to taxable corporate bond rates on an after-tax basis. Today, the median A-rated tax-free municipal bond has a yield of 1.97% and the median A-rated corporate bond has a higher yield of 2.82%. Simple math shows that for any effective tax rates lower than 30%, it is more economic to buy the corporate bond (i.e., 0.70 * 2.82% = 1.97%) and vice versa. This analysis, however, ignores risk measures, portfolio correlations, and ignores the possibility of trading and perhaps generating gains or losses.

June PMI at 51.7; weakened once again...

The ISM PMI came in weaker again for June 2019 at 51.7, following a weak May measure of 52.1. Still over 50, indicating a growing manufacturing sector, but more weakness in this number will portend slower economic growth in the U.S. When this statistic was released on July 1, there was not much media hoopla and the markets absorbed it pretty well. Since then, the S&P 500 hit an all-time high again on July 3, 2019!

Plenty of reasons to be cautious here, but no reason to fear any kind of prolonged drawdown (yet, as things can change on a dime given the propensity for Fed-speak and Trump/China trade talk to impact market dynamics). Fears of a global growth slowdown seem well-founded, but slower growth is not something to fear as much as a negative growth! Moreover, this could just be a pause that refreshes!

...always having to say you're sorry!

The common catchphrase from the 1970 movie Love Story goes, “Love means never having to say you’re sorry.” This can be modified and applied to diversification in an investment portfolio to read, “Diversification means always having to say you’re sorry!” This certainly applies to the performance metrics we have seen from diverse asset classes so far in 2019.

A baseline moderately aggressive strategy with a 70% equity and 30% fixed income allocation produced a 14.16% cumulative return for the year-to-date period ended June 30, 2019 (see the chart). The component asset classes were spread amongst the usual suspects including large cap, mid cap, and international equities; plus a few special purpose alpha generators. The “core” asset classes turned in their benchmark returns, whereas the alpha generators did there job by adding (and subtracting) excess return. Who were the winners and losers over this 6-month horizon?

On the equity side, the S&P 500 represented by the iShares Core S&P 500 ETF (IVV) turned in a great performance with 18.33% total return for the period. However, others did better! Positions in the factor space, momentum and minimum volatility (MTUM and USMV) produced benchmark-beating returns of 19.28% and 18.91%, respectively. Likewise, mid-cap and small cap equities won out as well with 19.87% and 18.49% returns ouflanking the S&P 500. On the flip side, however, REITs marginally underperformed, but international developed equities and emerging market equities underperformed the S&P 500 by wide margins for the first half of 2019.

On the bond side, the Bloomberg Barclays U.S. Aggregate Bond Index (through the iShares AGG ETF) turned in a stellar return (for bonds!) of 5.84%. Other alpha generators in the fixed income space, however, all beat the “agg” handily including investment grade corporate bonds, emerging market bonds, high yield bonds, and bank loans with YTD returns of 11.92%, 11.29%, 9.91%, and 6.62%, respectively. Only short term bonds lagged the agg with a measly 2.15% return. So much for placing a bet on the consensus views that rates were going to “go up” and that credit spreads were ready to spike!

So, despite some good calls, being diversified cost this strategy some upside… over the long haul we hope to have more ups than downs.

Timing is Everything

A former Chief Investment Officer at my prior firm used to say “timing is everything!”  At the surface, a very simple phrase but in reality, a very important truth in investing (as in life!)

This is what he meant:  you might have the fundamentals right with exactly the best possible analysis, but if you miss the timing you miss the above market returns.  Or, in other words, fundamentals tell you “what” to buy and technicals (market timing) tell you “when” to buy.  Of course, no one can predict the market, so the “when” is almost impossible to achieve.

The chart below is a good example of this.  Coming out of 2016, the Dow Jones Moderate Index (global) had a great run in 2017 (note the nicely upward sloping line with not much volatility).  Since then, 2018 into 2019 has been much choppier.  In fact, the steep dips and steep climbs since the end of August 2018 has resulted in a meek 1.2% return (through June 14, 2019).

Consequently, 2019 YTD performance is mostly irrelevant without a look-back to 2018 Q4.   We have been in a trading range since January 2018 with the great 2019 YTD performance simply a broad re-trace from the 2018 Q4 lows.  As always, plenty of discourse on where we go from here.

My Best Ideas (today!)

When people find out that I am in the investment business, it is not unusual for the conversation to turn to investments.  A lot of times I will get asked, “what is a good investment right now?”  Certainly, a tough question to answer without knowing the persons financial situation.  Depending on who you are and the resources you have, the answer could very well be a bank CD (not really, but it could be!)

However, I always felt I needed an answer (with caveats).  During the post-Credit Crisis environment, the answer I almost always gave was high dividend stock ETFs.  During that time that class of investment provided a low cost, diversified portfolio of income-generators with advantaged tax treatment for qualified dividends.  They also provided the potential for capital appreciation (upside) that was not likely from bonds.  And, most importantly, they provided a once-in-a-lifetime income rate better than bonds.  What was not to like?

I updated my analysis recently and found that this answer still works pretty well (see my blog post from February 27, 2019).  But, as we all know, things change and answers like these are subject to change.

Such is the case with another one of my favorite ideas:  the Corporate Income and Opportunity (PTY) closed end fund from PIMCO.  I wrote a blog post back on March 19, 2019 titled “A Non-Bond Bond Fund.”  PTY was trading at $17.21 per share back in March and it has rallied strongly since then to almost $19/per share recently.  Here is a case where the “value” equation takes precedence and something I said only two months ago is now “old news” and should be ignored.  Unlike stocks that can have unlimited upside, this particular closed end fund is trading way over its NAV and normal trading range at a 29.1% premium!  Maybe it will work out, but I am not buying!

Interest Rate Forecast Foible

Nothing new here; just more evidence that forecasting interest rates is very hard. Info from the Wall Street Journal… Not one economist surveyed predicted that 10-year interest rates would be as low as they are now!

Whither Rates Up or Down?

Forecasting the path of interest rates is very hard; impossible, really.  That doesn’t stop talking heads from trying to do it.  Starting in the post-Credit Crisis environment of 2008/2009, most thoughts pointed to rampaging inflation and sky-rocketing interest rates in the aftermath of aggressive Fed easing and increases in the money supply.  Certainly, that has not been the case.

Interest rates and inflation continues to be muted and well under control.  The 10-year treasury is currently yielding 2.13% today and from 2009 to today has been within a range of 3.98% (April 2010) and 1.38% (July 2016); a small range with hardly a trend.   Fed Funds, on the other hand, has moved up in a telegraphed and orderly manner from about 0% from 2009 to 2016 and then up in steps to about 2.37% today.

Barron’s had a few articles on interest rates in the June 10, 2019 issue.  One article titled, “Say Goodbye to Those 2% Rates on Savings”, made a point that Wall Street thinks interest rates are going lower.  So, if you have that view, some strategies that could benefit could include to try to lock in rates, place some bets on financials (that might be more profitable in a steep yield curve environment), or buy real estate investment trusts that could broadly benefit from a general decrease in rates.

Another article titled, “The Rate Swing of a Generation” by rate guru James Grant, made the point that bonds have traded in two great long-lived markets: the bear market of 1946-1981 and the bull market from 1981-2016 (which may be extended if we get another round of rate cuts).  He is not forecasting anything; instead, he is positing that rates could rise from here.  He thinks we have an unreasonable “love” for bonds that could turn on us.  One point he makes is that “real” rates, rates after adjusting for inflation, are historically low and should not persist. 

So, no one knows and there are plenty of differing views.  Undiversified bets in either camp could cost you; best to stay diversified.

More Trouble with Tactical: GMOM Update

I have reported a few times in this space about the difficulty tactical managers have had in the recent market environment. This update today continues to show a trend of underperformance.

In February, the Cambria Global Momentum ETF (ticker: GMOM), a notable player in the tactical space, called a risk-off environment. As of June 4, 2019 the ETF is comprised of almost 100% bonds (of different varieties and flavors) and no equities except for some REIT exposure. Year-to-date through June 4, 2019, the ETF has produced a total return of 2.71%, compared to the S&P 500 of 12.74% and the Bloomberg Barclays U.S. Bond index of 4.91%. Most interestingly, yesterday June 4 when the S&P 500 was up 2.2%, this fund was up only 0.4%. Unremarkable performance by any measure.

This market environment has been characterized by geo-political turmoil, trade battles, Fed-speak, and economic stats that present a mixed bag of conclusions. More can be said on this topic, but let it be known that trying to outguess this market is ripe with risk. For long-term investors who have correctly evaluated their tolerance for risk, it is best to stay the course.

May PMI at 52.1

Weakening trends continue in the important ISM Purchasing Managers Index (PMI) manufacturing stat. April PMI was 52.8 that declined to 52.1 in May. This aspect of the U.S. economy is still growing, but at a slower pace than any time since October 2016. Under 50 indicates a contraction in manufacturing.

So, though there are many negative signs in the economy, offset by some positive signs, there is little indication for a prolonged drawdown. For long term strategic accounts, I see good reason to be cautious, but no reason to be tactical and reduce exposures in risky assets at this time. Active accounts with a tactical bias may be inclined to take risk off as a bet.

Here We Go Again

The yield curve inversion has reared its ugly head again with the typical market jitters, but this time it is accompanied by a few “friends” that could prompt concern.  As of today, the 3-month/10-year spread has a solidly negative relationship at 2.36% to 2.25%, respectively.  This alone is not too notable, despite what some of the “talking heads” may lead you to think.  I am skeptical of the research on this point since I think there are too many behavioral biases, externalities and other variables to effectively model causation.  But, when it is accompanied by other stats pointing in the same direction I take notice.

What is worrisome about it this time?  For the first time since 2016 Q4, the April ISM Purchasing Managers Index (PMI) has grown at its slowest level.  I am a fan of the PMI and the May PMI is due on Monday, June 3.  A continuation of this trend could be troublesome.  It could very well be a short term blip, but it is continuing a softening trend we have seen since March.  China, Mexico and Brexit pop up as the chief culprits influencing the stats; we are hopeful that market forces will help correct any imbalances, but it could take a while to adjust.

Another stat to take note of is the Conference Board Leading Economic Indicators (LEI).  It continued to show increases for February, March and April, but could be setting up for a surprise in May.  This stat covers many different aspects of the economy, including the impact of stock prices that could push the index down.

Market momentum has eased in May after a strong rally through April.  A few technical barriers have been crossed, but we are still (just barely) over the 200-day moving average.  A continuation of this trend is worrisome.

Thankfully, all is not lost!  For one, the yield curve inversion is occurring with a general decline in rates.  U.S. Treasury bonds are a safe haven investment around the globe, so when there are geopolitical hiccups, it is logical that U.S. Treasuries get bid up in a “flight to quality.”  It certainly doesn’t hurt demand for U.S. treasuries that “negative” yielding sovereign debt still persists in large numbers around the Eurozone and elsewhere.  Also, corporate and high yield bond spreads have weakened a bit in May but continue to get a bid, so stable bond markets give comfort that we are not entering a crisis stage.

Beat the Benchmark

Long term strategic investing is usually baselined against naïve mixes of the S&P 500, as a proxy for a broad mix of large cap U.S. stocks, and the Bloomberg Barclays U.S. Aggregate Bond Index (AGG), as a proxy for broad core bonds including U.S. government and investment grade corporate bonds.  These broad naïve categories, however, miss many areas of the capital markets and optimized asset weighting that could provide extra diversification and additional return per unit of risk.

So far during 2019, some of the passive exchange-traded funds (ETFs) that are designed to track a broader selection and optimized mix of assets have added incremental return to naïve mixes of the S&P 500 and AGG.

Two equity ETFs that have done well are the iShares Edge MSCI Min Vol USA (USMV) and the iShares Edge MSCI USA Momentum Factor (MTUM).  Both of these ETFs are structured to capture some of the “factor” anomalies that research has shown to outperform the naïve S&P over time.  YTD through May 24, USMV and MTUM have returned 14.93% and 14.06%, respectively, whereas the S&P 500 (SPY) has returned 13.64%.

Real estate investment trusts (REITs) are a good asset class to help diversify equity exposures and also hedge against inflation.  An ETF that tracks that asset class is the Schwab US REIT ETF (SCHH).  Real Estate Investment Trusts tend to be a more risky subset of the equity space and has returned 17.26% so far in 2019, beating the 13.64% of the S&P 500.

Another innovative ETF that helps diversify exposure is the AI Powered Equity ETF (AIEQ).   This ETF uses artificial intelligence in the portfolio management process with a target to outperform the S&P 500 with a similar amount of risk.  Year-to-date through May 24 this ETF has returned 17.74%, easily outpacing the 13.64% of SPY.

Likewise, selected carveouts of the fixed income space have easily beat the Bloomberg Barclay Aggregate U.S. Bond index (AGG).  While the AGG has returned 3.76% YTD, other fixed income sub classes have added incremental return and diversified exposures.  For example, preferred stocks (represented by iShares Preferred & Income Securities ETF, PFF) has returned 9.03%.  Additionally, the high yield bond, investment grade corporate bond, emerging market bonds, and bank loans (tracked by HYG, LQD, EMB, and BKLN) have all outperformed AGG with 7.49%, 7.42%, 7.10%, and 6.44% respectively, against the AGG of 3.76%.

In this environment, a broader diversification approach and optimized weighting will help portfolios to outperform the naïve S&P 500 and the AGG. 

That's Life!

“You're riding high in April
Shot down in May
But I know I'm gonna change that tune
When I'm back on top, back on top in June”

- Frank Sinatra

Not sure if Frank Sinatra was thinking about the stock market when he sang those words back in 1966, but they certainly seem apropos!  Through April 2019, the S&P 500 was up 18.3% year-to-date; in May alone, the index has given back 4.6% so far though May 13!

On last Friday, the U.S. increased trade tariffs from 10% to 25% on $200 billion of Chinese goods.  China then retaliated announcing an increase of tariffs on $60 billion of goods.  Prior to this, the markets had accepted that trade negotiations were proceeding smoothly.  Words like “constructive” and “candid” were tossed around like candy to children to appease anxious markets.

As of now, economists are producing all kinds of statistics to measure the economic and earnings impact this may have on the U.S. or global markets; they are all over the place!  Not surprisingly, all the forecasts are negative, thus the negative market reaction.

However, these forecasts presume that the tariffs persist, increase, and never get resolved.  No one knows, of course.  But, I have faith in the market system and believe that whatever happens will end with a positive outcome for all parties; as in all good negotiations.  What we are seeing here is a knee jerk reaction to the unknown.  It is reasonable to be cautious, but the market could just as easily knee jerk in the other direction once this gets resolved - since it will; hopefully producing winners on both sides! 

It takes a lot to produce a large market drawdown; this alone is not it – yet.  We will continue to watch.

The “New” New Normal?

Are we in or entering a “New” New Normal? It is still a developing story, but the persistent short rotations into and out of high and low volatility periods, more stable economic growth with less severe peaks and troughs, trending lower unemployment with surprisingly low income growth, and growing corporate earnings all point to a new paradigm that capital markets are embracing. The latest indicators show a continuation of these trends.

The first business day of every month is a big day for capital markets because that is when the ISM PMI (Institute for Supply Management Purchasing Managers Index) report is released. This May 1 report for April continued a trend that started 10 years ago; for the 120th straight month the ISM PMI index indicated a GROWING economy! The index reading showed a value of 52.8 for April (readings over 50 indicate a growing manufacturing sector).

This is one of the most important economic indicators that I follow. Combining this with other indicators like leading economic indicators (LEI), industrial production, job and income growth, yield curve, technicals, asset correlations, etc. can give a good measure of how we are doing and if things are getting unhinged.

Year-to-date through May 3, market strength seems well-deserved. As I reported back on December 31, 2018, “On balance, there are warning signs, but no reason yet to run for the hills. The recent stock sell-off [during Q4 2018] has priced equities attractively and corporate bond spreads are reacting favorably with spreads lower than recent historic (indicating less concern about default risk).”

History tends to repeat itself, so let’s not get ahead of ourselves. But, for now, let’s enjoy the ride!

The Benefits of AI Portfolio Management

The first exchange-traded fund (ETF) to be managed by artificial intelligence, AI Powered Equity ETF (AIEQ) was launched with a bit of fanfare back in October 2017. After all, it used the ground-breaking (and Jeopardy-beating) logic of IBM’s Watson Artificial Intelligence to manage the stock selection and portfolio management function. Asset growth started slow, then jumped to over $100 million in 2018 and it currently resides close to the $150 million range.

The benefit to the investor of this ETF is its active strategy that is insulated from behavioral biases and scours all financial and unstructured (news articles) information as the portfolio management approach. Its investment goal is to outperform the broad equity market (investing in all market capitalization sectors) at a similar level of risk. In theory, it should provide a good low-correlated complement to an index-based approach to portfolio management.

Performance since inception has been mixed. It has rotated from lagging, then matching, then beating (by a lot!), then lagging again (by a lot!), while now recently beating the S&P 500. From inception through April 5, 2019, AIEQ is up +15.4% compared to SPY being up +16.4%. On a YTD basis through April 5, 2019, AIEQ is way ahead at +21.46% compared to S&P 500 at +16.02%; ranked in the highest 2 percentile in its Morningstar Large Blend Category.

It is too early to evaluate how well AIEQ has performed as a portfolio complement, but it has certainly provided a strong case for it to remain as a portfolio position. Unlike tactical asset managers, the drawdown in 2018 Q4 did not scare away AIEQ from its portfolio positioning. Some constant large exposures in Alphabet (GOOGL), Amazon (AMZN), Costco (COST), NETAPP Inc. (NTAP), and SS&C Technologies (SSNC)(overall, 10.7% of its portfolio) have contributed to its 2019 recovery (and last years drawdown!)  AIEQ maintains a current cash weighting of 3.7%.

What can we learn from how AIEQ weathered the 2018 Q4 drawdown leading into 2019 Q1? First, if you have a strong fundamental basis, there is no reason to run away from your core positioning since they will recover. Certainly, one of its largest holding in Amazon and its -25% drawdown in Q4 could have scared away many active investors; and perhaps causing it to miss its strong 22.3% YTD recovery. Second, there will be periods where you will underperform the market, but over a long horizon you only need to be right 51% of the time to provide an advantage. Third, relatively large and diverse positions can create alpha if you have a firm conviction; for example, AIEQ is currently overweighted to Alphabet (GOOGL) at 3.8% compared to its S&P 500 weighting of 3.0%, thus benefiting from Alphabet's +15.9% YTD index-matching performance.  Additionally, broadening the universe to include all market cap sectors provides better diversification exposures.  AIEQ includes three mid-cap holdings in its current top 5, being SSNC, NTAP, and Aaron's (AAN).