Expect Double-Digit Losses In 2014; Here's My Forecast For Performance Of Sectors, Styles, And Countries
Monday, January 06, 2014 10:27

Tags: earnings | global investing | sector investing | stocks

If 2014 is a “normal” year, with earnings growing at 6% and P/E ratios at 15, the U.S. stock market will lose about 15%.


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The following is a brief summary of my annual market review and forecast, which you can peruse in more detail here. The commentary is divided into three sections:
The Future: Despite popular opinion to the contrary, 2014 is likely to disappoint rather than delight, but you can use a formula I provide to draw your own conclusions - just plug in your estimates for earnings growth and P/E. Also, momentum effects point toward continuing problems in material stocks and good relative performance from certain growth companies. Similarly, some sectors in foreign countries are projected to perform better than others.
The Present:  A 33% return on the U.S. stock market is among the best and places the past five years in the better category as well, in sharp contrast to the previous five years, which were among the worst. The U.S stock market has outperformed all other asset classes.

The Past: I provide tables and histograms of returns on U.S. stocks, bonds, T-bills and inflation, going back 88 years.

Favorite Posts Of 2013 About Behavioral Finance And Math From CFA Institute
Saturday, December 21, 2013 15:38

Tags: behavioral finance | CFA | investment management

Lauren Foster writes a blog for CFA Institute's private wealth practitioners. Perhaps because Foster’s blog is off the beaten path for most financial planners, A4Aers might want to look at it. I'll be tracking it regularly for you.

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Foster spent a lot of time this past year curating content about about two major themes,  behavioral finance and math.
In perusing Foster’s favorites of 2013, are some real gems, like a New York Times opinion-sectoin piece by Steven Strogatz explaining in simple diagrams the math concepts underlying economic catastrophe. And then there's a link to a video of The Wall Street Journal’s Jason Zweig interviewing Nobel Laureate Daniel Kahneman about behavioral finance talking about how he first started thinking about silly human decisions when he was evaluating officer candidates for the military.


What Could Make Me More Cautious About Stocks? Are Companies Sitting On Piles Of Cash And Not Investing? Answers To Advisor Questions From The November 2013 Economic And Market Update Webinar
Monday, November 25, 2013 15:47

At my November monthly economic and market webinar for Advisor4Advisors, attendees asked a number of questions that we did not have time to answer. Thanks for your thoughtful questions. See my answers below.


What type of indicators or data would you be focusing on to make you a bit MORE cautious about the US stock market? An earnings slide? Substantially higher 10-year US bond? Spike in inflation?
The main thing that could make me more cautious on stocks would be obvious deterioration in the key economic data – the monthly ISM purchasing managers surveys, the index(es) of leading economic indicators and the employment numbers, both weekly unemployment insurance claims and the monthly new jobs report. And, yes, if we started to see ominous signs pointing to higher inflation, it would be a big negative. Rising bond yields, no—as I point out in the charts. Rising bond yields have been entirely consistent with rising stock prices.

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Advisors4Advisors members ($60 annually) can view the replay of the sessoin and receieve CFP Board or IMCA continuing education credit. 

When will business investment pick-up?  Are businesses still sitting on piles of cash?

True, businesses are sitting on piles of cash and their ability to borrow cheaply has rarely been stronger. In the following chart, see how business investment in plant, equipment and inventories contributed a total of +1.0% to the third quarter’s +2.8% total GDP growth. Not bad considering that business investment constitutes only about 6% of the total GDP. The post-recession pattern of business investment actually looks pretty typical to me. Significantly weak post-recession business investment, I think, is something of a myth.


In my opinion, lower-range GDP growth is largely due to repressive fiscal policy in Washington DC, i.e. higher taxes, regulations, etc.  You seem to disagree, correct?
No disagreement from me. In the equation ∆ GDP = ∆ productivity + ∆ labor force, these are factors that work significantly against productivity gains, the key driver of GDP growth that I was discussing. So, for example, if a company has to hire one additional employee in order to cope with increased government regulation (filing forms, etc.), then that company’s output per employee suffers. Similarly, higher taxes take away from a company’s ability to purchase additional productivity-enhancing equipment, denying the company a means to improve output per employee.
On slide 25 (below), the pattern is very erratic. Does you expect it to smooth out as illustrated. Or will it continue to have more dramatic moves?
I assume the reference to page 25 refers to the long-term volatility in actual year/year GDP growth. No, I do not expect this pattern to change in the future. The U.S. will undoubtedly continue to experience a great deal of cyclicality in its economy for the foreseeable future. The flat squiggly line that I inserted as a “forecast” for GDP growth is simply an illustration of Prof. Gordon’s forecast for a trend rate of growth in the years ahead.


Won't proposed lowering of corporate taxes also add to higher profit margins in the future if Congress changes the tax on corporations?

Yes, they might. I say “might” because it would depend on whether lower tax rates actually result in lower corporate taxes paid. Congress might couple lower tax rates with the elimination of the many deductions (“loopholes”) that companies can currently claim.
According to the Bureau of Labor Statistics, the percentage of Americans over age 16 who have a job or are actively seeking one fell to a new 35-year low in October at 62.8%.  With the labor participation rate as low as it's been historically, and with the real unemployment rate in the low double-digits when factoring in those working part-time who want full-time work and those who have simply dropped out of the workforce, is this a worrisome picture—even moreso as Obamacare works its way through the system and has led to lots of shifts in payrolls already such as retailers, leisure and hospitality, etc?  
The decline in the labor force participation rate that you describe is a function of both the slow cyclical recovery from recession and secular changes in Americans’ propensity to get a job and go to work. The participation rate peaked at 67.3% in 2000 and started rolling over well before the last recession. The October figure is 62.8% as you point out. The historical context is important and I think the secular drivers of a declining participation rate are a part the story here and there’s really nothing much we can do to change them. If bad policy is contributing to lack of hiring, that is worrisome. However, I have great faith in our system to correct course which it very well might do with respect to Obamacare specifically.
Doesn’t the BNP Paribas study about active managers suffer from survivorship bias?
I referred to the FundQuest BNP Paribas Group study dated June 2010 in making the point that an appropriate application of Modern Portfolio Theory might include actively-managed funds in addition to indexed funds and ETFs. Whether or not the study suffers from survivor bias, I do not know. However, even if it does, and based on my own observations, my point is that in some asset categories there do exist actively-managed funds that have consistently beaten their index benchmark and, therefore, might deserve consideration in an asset allocation strategy. In some categories these outperformers might be small in number, indeed, or even non-existent. Whereas generally I believe that index products are probably the optimal solution, I do not believe that indexing, everywhere and always, is the superior strategy. Particularly in less-efficient parts of the global markets, or when it comes to alternative strategies, active management in some cases might prove to be superior to the index.






Tax Loss Harvesting And Bonds
Friday, November 22, 2013 02:02

Tags: asset management | bonds | interest rates | investment management | Tax-efficient investing

There's a lot written about tax loss harvesting (TLH) including some articles written by me. I will try to avoid repeating what we all know. After all, although some argue that TLH is not worth pursuing, most advisors agree that accelerating tax benefits is a good idea. 

While true that rebalancing software allows for more frequent, opportunistic TLH, the tech savvy advisors will be joined by the "spreadsheet brigade" in grabbing tax losses at the end of the year. This year, TLH is more important than ever because of the new surtax on investment income. Also, the process can be conveniently used to reposition clients' portfolios. 

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Advisors and clients are both concerned about bond investments. When interest rates rise, bond values will decline. As this rate increase nears (and we get closer every day), shorter term bonds will fall less than long term bonds. And, maturing bonds may be reinvested in higher yielding bonds. 
So, for advisors that want to shorten bond durations (or move to more aggressive bonds), year-end is ideal. Since many of our clients' bond positions have unrealized losses, selling to recognize these losses will provide the opportunity to reposition holdings. 
Please don't ignore this opportunity! In one simple step, you can lower your clients' tax bills, avoid the Medicare surtax and strategically reposition models. Such a deal!
Forget Smart Betas: Step Up to Smarter Betas
Friday, November 08, 2013 19:44

Tags: alpha | indexing | smart beta

Smart betas might succeed in beating the market, but so might smarter betas also, plus smarter betas complete active managers.

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Kudos to Rob Arnott for coining the phrase “Smart Beta.” Everyone wants to be smart. Indexes that use fundamental weightings, rather than capitalization weightings, are deemed to be smart by Mr. Arnott because they are predicted to perform better. For the first time ever, we have indexes that are designed to outperform. All other indexes are designed to match the performance of an entire market or a market segment.
Fundamental (smart beta) weights typically tilt toward value and smaller companies relative to their cap-weighted counterpart, and this tilt has a track record of performing better, so it may indeed be smart. Fundamental indexes are usually created for broad markets, like the U.S. or Europe and have attracted several hundred billion dollars in last few years.
Even Smarter Betas
Because smart beta indexes cover entire markets, they are not intended to be used in conjunction with active managers. If smart beta indexes were used in conjunction with active managers they would dilute active manager decisions by adding stocks active managers don’t want to hold. Furthermore, they would tilt the entire portfolio toward smaller company value, potentially undermining portfolio structure, especially growth allocations.
 Complementing active managers requires an even smarter beta, an index that works best in core-satellite portfolio structures. This smarter beta works better than smart beta, which in turn works better than standard cap-weighted indexes like the S&P500:
Smarter Beta is smarter than Smart Beta is smarter than the S&P500
The smarter beta index is created by identifying the stocks that lie in between value and growth – the stuff in the middle – and by allocating to them using fundamental weights rather than capitalization. The stocks in the middle are organized into economic sectors like technology and utilities, and assets are allocated to these groups at market weights. This avoids any sector bets. Then within sector groups, each stock receives an equal allocation, which is fundamental weighting.
The result is better diversification and higher returns, which is a promise you should question. Better diversification is achieved by adding stocks that active managers usually don’t hold because they don’t fit value or growth mandates. Higher returns result if you replace an existing core with the smarter beta core because smarter beta core does not dilute active managers. This higher return expectation is based on the belief that the active managers actually add value, which seems right since they wouldn’t be hired if that wasn’t the belief.     
Sometimes a good idea has its limitations. Smart betas don’t belong alongside active managers. Smarter betas are required instead. Or put another way, if your investments are entirely passive, smart betas hold the prospect of doing better than a capitalization-weighted market proxy. But if you use active management, smarter beta is what you need.     

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