Small and Micro Caps led this market down but taking a quick glance it appears they are pausing. Too soon to know if they’ll hold here but its the first sign of stability and makes some degree of sense.
No positions in IWC
This morning’s early morning flushout is helping to push sentiment to negative extremes which is necessary for short term stabilization for the equity markets. Our very high cash levels will help us to keep our emotions in check but the fear of an out of control Ebola epidemic could likely end any short term rallies at this juncture.
To be quite blunt, the markets are broken right now. Our hedging oscillators reflect this dysfunction and are untradeable.
At present our largest position is the “TMF” which is a leveraged Treasury Bond ETF. The TMF will benefit from the rampant fear that presently exists be it due to economic weakness in the US, Europe or Ebola. Today’s wicked spike higher is a reflection of the panic existent for the time being and is doing a very credible job of hedging our remaining equity holdings.
We continue to sell equities on rallies only at this stage. A case could be made that this mornings plunge in stocks may mark at least a short term bottom that we can rally from. Its too late to sell into weakness but too early to buy as well.
Be careful out there.
Brad Pappas
Long TMF
Show me an investment manager with strong convictions and I’ll show you a manager with spotty returns. Flexibility is a key attribute if we’re seeking to avoid major downdrafts because markets are continually evolving. Even using highly effective quantitative systems we know that there is always the chance that markets will do something unexpected or never seen before.
Many of my quant friends are extremely rigid in their methods. Its their belief that human judgement is best avoided altogether even if you have 10,20 or 30 or more years of experience and have seen many bear markets come and go. But experience tells us that just when you think you’ve mastered the markets, be prepared to get whacked…..and hard. Hence my reluctance to rely solely on historical data when our current economic foundation has elements that have never existed before. What good is a system that worked in 2000 or 2007 when Quantitative Easing was an unknown term, when we’ve never had an economy so reliant on 0% interest rates?
As you can probably tell I do believe there is a place for experienced human judgement and when properly applied it can enhance the performance of purely mechanical systems.
A case in point is whats happening now in the stock and bond markets: Both the stock and bond markets are acting as if we’re entering a recession and that a new bear market is emerging. But the classic signs of impending recessions are not visible yet. Our long lead indicators are telling us that a recession is not likely within the next 9 months nor have we seen the peak in the business cycle. Treasury bond yields have not inverted…..yet. Regardless the stock and bond markets are sending a very strong message right now and that message is its likely we’re entering into a bear market.
I’ll let the talking heads and my quant associates debate whether raising interest rates from 0% to 1.5% is considered tightening or not. All I’m concerned about is how the markets are processing this news. Simply put: Markets are behaving just as we’d expect them to react during a period of Fed rate hikes where their motivation is to dampen economic growth which in turn devolves into a recession.
What we are looking at now
The economy is slowing.
Present data shows no recession in sight but we do have slowing. Slowing does not mean a recession is imminent but recent data suggests tops in Auto Sales, Home Prices, Consumer Confidence. RecessionAlert.com is flagging Corporate Profits Growth Index, Private Residential Fixed Investment, Housing Long Lead Growth Index approaching or near recession levels. RA’s probability of a recession starting in 12-18 months is 4.54%* The caveat with these recession odds is that no one is quite sure how the economy will react when the 0% interest rate policy ends.
Quantitative Easing or 0% interest rates are ending. The Federal Reserve will let the economy sink or swim without the aid of QE. This is especially important since market performance and the size of the Fed Balance Sheet have been tightly correlated since 2009.
* The with the major indices down 7% or more the drum beat for an extension of QE is starting. The Fed’s Williams says QE may be needed if economy falters. Translation: If the markets make another steep leg down look for another round of QE and time go all-in once again.
Small Cap stocks are lagging badly, the disparity between large and small caps is dangerously wide.
Charts courtesy of Jason Geopfert of Sentimentrader.com
Jason Goepfert of SentimentTrader.com has published a very telling chart that shows how rare and the potential result when the small stock Russell 2000 closes at a 200 day low while the large stock S&P 500 closes within 30 days of a 200-day high. Normally, these two indices tend to move hand in hand and the disparity is both rare and troublesome. It makes some sense that the best way (relatively speaking) to solve this disparity is to bring all sectors of the stock market down hard and then begin a new cycle. We think this is a real possibility here and now.
Europe is heading to a recession and the European Central Bank in moving at glacial speed. Whoops, sorry…..slower than Glacial Speed.
What was once a tight correlation has delinked as the S&P 500 has rallied hard based on the Fed’s QE intervention. Whereas the European Central Banks has been………quiet.
Stock market volatility is increasing – this is frequently a harbinger of market direction change.
What concerns me about the rise is volatility as you can see from the chart below is the time duration for the bear markets to evolve, years. While 2011 does fall into this category we need to add that the Fed started a new round of easing right after the decline in 2011. I don’t think we’ll have that luxury this time around.
Investor Sentiment has been stubborn and excessively complacent for far too long.
The lack of investor worry and concern is very troubling and unsustainable. Sentiment can swing swiftly and sharply as the herd can migrate in extremes of exuberance to panic. Markets are manic / depressive and with the Fed taking away QE this can be like Carrie Mathison not taking her Lithium.
Long dated Treasury Bonds are rallying hard and threaten to invert the yield curve.
Indicative of a slowing economy and the end of QE is the strength in Treasury Bonds. There is no reason for Treasury prices to rally in a normal healthy economic expansion as demand for loans and use of capital would add pressure on bond prices. But short term rates have been rising in the US in anticipation of the Fed raising rates next year. The rise is bond prices is likely due to the weakness in Europe and a reaction to a sharp decline in yields in Europe. Weakened US and Euro economies and the Taper (the end of QE) are bullish for Treasury bonds. Does this foretell a new recession? I don’t know and its too early to tell, but it is ominous.
Long TMF
One of my all time favorite movies is Gosford Park which is a complex murder mystery set in a grand manor house in Britain in between the first and second world wars. The movie was scripted by Julian Fellows and directed by Robert Altman and laid the foundation for Downtun Abbey
There is a scene between a passively scathing Constance, the Countess of Trentham (played by Maggie Smith) a failing silent film star Ivor Novello (played by Jeremy Northam):
Constance: “Tell me….how much longer are you going to go on making films?”
Ivor: “I suppose that rather depends on how much longer the public want to me in them.”
Constance:”It must be hard to know when its time to throw in the towel….What a pity about the last one of yours…what was it called? “The Dodger”?
Ivor:”The Lodger”
Constance: “It must be so disappointing when something just “flops” like that”?
Ouch….
Alas, now that the small caps have “flopped” in 2014 we have likely reached the tipping point where we must bid adieu to micro, small and mid cap stocks otherwise remaining will likely be akin to Ivor’s box office busts. And the rationale is quite clear:
We have reached the point in the economic cycle where both the current market rally and economic expansion are quite mature…perhaps as late as the 7th inning. Investors are no longer looking to the Federal Reserve to maintain its massive liquidity supply as the Fed has openly stated that they will be targeting the Fed Funds rate to 1.5% by late 2015, hence our eyes are looking to the endgame of the expansion and rally.
Micro, small and mid-cap stocks are frequently among the first market sectors to decline in anticipation of a recession or bear market. Even though the bear market/recession may be years away, just the knowledge of its inevitability will cause investors to migrate to Large Cap stocks and likely remain there until the final signs of a recession are visible. Hence I don’t anticipate our returning to small stocks until after the next recession.
Employment levels are the key for the Fed and based on current projections by the first half of 2015 we can expect the Fed to begin a slow and gradual series of rate hikes. But as always, markets anticipate the future well ahead of the actual event and the weakness in the micro, small and even mid cap markets is reminiscent of the last “late cycle” of 2006-2008. In 2006, despite the recession being two years away small stocks began a noticeable lag compared to large caps.
Please take a look at the chart below (1995 to 2014) which identifies which months tend to be the best and worst for small stocks ($RUT) compared to large stocks ($SPX). You’ll obviously notice that October is the worst month while November and December are the best.
Now lets examine two “late cycle” periods: 1998 to 2000. You’ll notice that 8 months in the calendar year the small cap Russell 2000 lagged the S&P 500. And, in the months of March and October there were zero cases where the Russell 2000 excelled.
Our second example is 2007 to 2008: A similar pattern emerges where the Russell 2000 outperforms the S&P 500 only three months of the year.
Now lets take a look at the last 5 years from 2010 to 2014: The relative performance is 180 degrees in reverse, its been a wonderful ride but with the onset of rate hikes the continuation is likely doomed.
By this point I’m sure that you’re ready to ask: “What will work in the late cycle environment”?
As always, we are agnostic to markets whether they be micro, small or large or even if we should be invested in stocks at all. 2006 and 2007 are not so long ago that we can recall what worked and use those methods again. We have already integrated these systems into accounts over $250,000 and will continue to periodically sell off small and micro cap holdings. We still have time on our side since none of our long lead indicators are giving advance notice of an incoming recession. While I said earlier that we could be in the 7th inning, we could also go into extra innings which would push a recession past 2017. Regardless based on the data it appears likely that the small cap run is over. Long live the large cap run!
What works?
The graphs shown below are hypothetical backtests and not real time examples. Real time results will vary and the returns shown in this example cannot be extrapolated to real time investing in the future. As always, past performance is no assurance of future performance nor may it even be profitable going forward. But as Mark Twain said: “History doesn’t repeat itself but it does rhyme.”
Our version of the Joel Greenblatt’s “Magic Formula” for starters. Its exclusively large cap-centric and easily adaptable for socially responsible investors and Vegan investors. We’ve eliminated owning financial stocks in the system which gives a boost to performance.
Secondly, our own proprietary large cap system. This system is 93% large caps and 7% mid caps and has a socially responsible and a Vegan screen installed.
And now for something in real-time: Back in 2007 we had quite a good year. Our strategy then was Large Cap Technology stocks. The names you’re all familiar with: Google, Apple, Research In Motion (R.I.P), Nokia, etc. As growth across the world begins to falter with impending rate hikes investors flock to reliable growth and Big Tech appears to be working its magic again in 2014. In this case the cycle is not just rhyming but it may be repeating.
In 2007 we did not have the luxury or safety of owning a basket of Big Tech in a single Exchange Traded Fund (ETF). But we do now and it makes a great deal of sense in this case of owning the ETF rather than the individual stocks.
Case in point for growth oriented investors: Direxion Technology Bull 3x.
If you look at the chart below you’ll see that the TECL has been leaving the small cap ETF “IWM” and the S&P 500 in the dust for the past 12 months. Our best guess is that this trend will continue and we plan to make it a core holding.
Long TECL
Labor day Sunday background music: Allman Bros. with Eric Clapton Live March 20, 2009 “Dreams” At 70 EC has declared he’s tired of the hassles of the road and no more extensive touring. The Allman’s have lost both primary lead guitarists as well. So at least we have great live recordings.
Otherwise there is a poignant article in Forbes today: “How Mohnish Pabrai Crushed the market by 1100% since 2000. Apparently Pabrai’s long-only equity fund delivered 517% to investors versus 43% for the S&P 500. Further validation that Index only investing is not just one of the laziest ways to invest but one of the poorest. BTW Pabrai’s fund is closed to new investors – smart so as to not dilute returns for the earlier investors.
Pabrai talks about his base method, should we call it a “system”, because it most certainly is. His primary method is based on the strategies of Warren Buffet in his letters to shareholders. And, he confesses that investing is not an “originality contest” by which he freely appropriates the ideas of others. The structure of his fund is based on the Buffet partnerships of the 1950’s and he lifts investment ideas from such notables as Seth Klarman of Baupost and Joel Greenblatt of Gotham and author of “The little book that beats the market”.
But the most important lesson from this article is Pabrai keeping his nerve and sticking to his strategy when times were frightening in 2008 and his fund was down 60%. Personally speaking, I don’t believe its wise to hold on to equities when a recession is on the horizon but I have enormous respect for Pabrai to continue to hold and add to his positions despite the decline.
The point I’m trying to make is that there are significant commonalities between Pabrai’s fund and OP:
1. Style points are not given to originality. While we have created and developed original equity ranking and trading systems we love to use ranking systems invented years or decades earlier whereby we can develop, modify or improve. Older systems developed by Greenblatt, Piotroski and others have the advantage of being real time tested for 20 years or more. We have modified and actively use Greenblatt’s “Magic Formula” as a 5 stock system in client accounts. The Magic Formula represents one of the finest large cap value systems* we’ve ever come across and to not use it for our clients benefit would be a shame.
*Note: If you read the Magic Formula book or visit the website where you can see a list of qualifying stocks you need to understand that what you’re looking at is merely a display of the Magic Formula ranking system. A ranking system alone is not enough to effectively manage a portfolio, a Trading system must be developed and integrated with the ranking system for effective management.
Professor Joseph Piotroski formerly of University of Chicago and now Stanford developed an excellent small cap ranking system as well, which anyone can easily Google and download. The “Piotroski F-Score” is an excellent tool but at present it is “on the bench” since we have our original small cap systems which outperform the Piotroski’s.
2. Once a plan is in place STICK TO IT: Investment pro’s hate to say this but all the time tested investment strategies are still at the whim of the investor who makes emotionally based decisions. Odds are very high that if an investor quits a strategy its likely during a period of duress and the client is in panic mode. Know anyone who sold in 2008? How long did they take to buy back in? Its never a matter of days or even months, its always a matter of years at the cost of huge lost opportunity had they just done nothing.
A fact that really surprises potential investors when we show them the details is that how little long term returns are affected by avoiding major market declines like 2008. While its likely we’ll never see anything like ’08 again, the effects of a well hedged portfolio versus un-hedged are small. However we feel that a client knowing a hedge can be effected is more likely to ride through a bad patch and not panic.
3. No shock to see that Pabrai’s fund may only own 10 holdings at a time. Our own testing has shown that 10 can be an optimal number of holdings in a given system. However, we’d prefer to have our clients diversified amongst multiple systems rather than a single system. But if the method is sound there no reason that 10 cannot work.
Summary: There is no such thing as a single best method to invest. We would never be so foolish to say that our methods are the best as I’m sure better systems or methods exist. I only say that the systems we use are the most effective I’ve tested and aware of. What the common adage that comes with age: “The more I learn the more I realized what I don’t know.”
There are many methods that work well but there there are also a few common traits investors must have. From my experience patience and persistence are at the top of the list.
Be careful out there
Brad Pappas
BTW the 200
We’ve been long term fans of Dwaine Van Vuuren at Recessionalert.com for his unbiased and accurate analysis of economic cycles. In his most recent update regarding the “Yellen Dashboard”, which is a list of labor statistics that Fed Chair Janet Yellen pays close attention to. We may be closer than we thought to the Fed transitioning from an easy money policy to tightening.
We already know that the Fed will stop Quantitative Easing (an extremely aggressive form of accommodative monetary policy) in October. Based on Dwaine’s analysis the first quarter of 2015 may be the time when the Fed will have the economic backdrop it wants to begin raising short term interest rates. This change in policy could set the stage for a Fed created Bear Market for equities in 2016 or 2017.
Recessions and the bear markets for stocks are born from peak economic cycles.