I believe that the U.S. financial markets may be nearing the end of the third stock market bubble in fifteen years. By some measures, equity valuations have reached the most extreme point in history. Market "internals" are starting to break down. Unless one has a 25 year time horizon, now is one of the worst times in history to enter into a traditionally allocated "buy and hold" equity and bond portfolio.
Using seasons as a metaphor, it is late fall in the U.S. equity market and economic cycle. There is a winter season coming. Between now and 2022, broad U.S. equity indexes are at risk of falling 50% to 60%. This may happen as soon as 2016-2017.
A Review of the last 20 years in the US Equity Market
(Figure 1) below shows the 20 year history of the U.S. S&P 500 index. Note two completed market cycles: market cycle one from the late 1994 low to the March 2003 low and market cycle two from the March 2003 low to the March 2009 low. Now note that we are nearly seven years into the third market cycle and that in 2015 the market was flat. Further inspection of last year’s flat or sideways market shows signs of a late stage topping action.
The high in 2000 took a little over a year to complete and coincided with the end of the "dot.com" era. The following 47% decline in U.S. equity indexes (83% in the NASDAQ index) marked the end of such notable and widely traded companies as WorldCom and Enron.
By early 2003, the Federal Reserve had lowered short term interest rates to 1%, sowing the seeds for the housing bubble and a global financial crisis. The U.S. equity markets made highs in July and October of 2007, before falling 55 percent into March of 2009. Notable financial companies such as Lehman Brothers and Merrill Lynch went bankrupt or were acquired; respectively.
The Federal Reserve rushed in to "save the day" and short term interest rates were taken to zero. When that was not enough to get the economy going, experiments and economic voodoo such as "quantitative easing" were implemented in 2011. Several additional rounds of easing followed and continued through October of 2014.
Over 30 central banks from around the world followed the lead of the U.S. Federal Reserve; lowering interest rates to below zero and implementing their own quantitative easing measures. This does not seem to be working, as over half of the world’s largest 93 equity markets were down by over 10% in 2015. This trend has accelerated in the first week of 2016. See (Figure 2) below for 2016 results in some of the larger markets.
Investor's Business Daily (IBD) ®
Valuations at Historic Highs
(Figure 3) below from hussmanfunds.com shows 6 different valuation methods that have an 83% to 93% correlation to subsequent 12 year returns. The methods are plotted as a percentage of their "average range". This "average range" is plotted at zero and the vertical axis on the left is the "percent" above average for the particular valuation measure.
Ranking the most extreme periods gives us the following years: 2000, 2015, 1929, 1927, 1907, and 1968. All of these periods were followed by 50% plus declines with the exception of 1968 and of course 2015. The 1968 high had a 30% plus decline and we have yet to establish if and how much the decline will be following 2015.
Given the current extreme valuation of U.S. equities, a 50% decline would be expected and a 60% decline would merely take valuations back to the "average range" line on the graph.
What does the "93% correlation to subsequent 12 year market returns" mean? (Figure 4) titled "Future Return Expectation" from hussmanfunds.com plots in blue the value measure as a percent of its long term average on the left axis (inverted) and then overlays this with the S&P 500 12 year subsequent return (right axis).
As an example, note that in 2000 (peak of the Dotcom bubble) the blue valuation line was suggesting an approximately minus 1 percent return per year for the next twelve years (right axis). You can prove this to yourself by going back to (Figure 1). Observe the level of the S&P 500 in 2000, which was at the 1,500 level.
Note that twelve years later in 2012, the index spent the entire year below the 1,500 level. If you had purchased an S&P 500 index fund in 2000, you would have sat through two 50% drawdowns and by the end of 2012 you still would not have been back to where you started.
(Figure 4) above is suggesting a zero percent 12 year return for purchases of an S&P 500 index fund today, which is why I started this paper with the statement that now is one of the worst times in history for a traditional “buy and hold” approach to the U.S. equity market.
Market Internals Breaking Down
Markets can remain "overvalued" for long periods of time. We know that an important factor in determining when an "overvalued" market will start a reversion to its mean, i.e. a decline in price, is the participant’s appetite for risk. This "risk off" attitude can manifest itself in a breakdown of market internals. It can be observed in divergences, such as higher stock index prices while the advance/decline line marches lower. Divergences in the price of various stock indexes can also be a great heads up of a pending overall decline in equities.
As an example, a narrowing of market breadth demonstrated by the Dow Jones Industrial Average, an index of only 30 large companies, making new highs while broader indexes such as the Russel 2000 lags behind.
This is a process our industry refers to as “the troops not following the generals”. This is what took place in 2015. (Figure # 5) below
Credit spreads are also particularly helpful in identifying periods of changing risk attitudes. (Figure 6) below shows high yield bonds (JNK), orange line, declining from May 18, 2015 to July 17, 2015. The S&P 500 stock index moved sideways and attempted to make a new high. This "divergence" preceded the sharp decline into August 24, 2015. Again during the highs made by the S&P 500 index on November 03, 2015 and December 01, 2015, the high yield bonds (JNK) declined during this same period setting the stage for the current market sell off.
In summary, high valuations coupled with deteriorating market internals suggest that we are in for a difficult year ahead as U.S. equities join the global equity sell off.
We continue to believe that PCM’s Multi – Directional Strategies represent an excellent place for one’s investment capital.
A brief review of 2014 financial markets and what it may mean for 2015:
With the exception of the US, India and China, the world's equity markets were down in 2014. Japan was down 7.4% and officially entered into a recession. The three largest European markets; the U.K., Germany, and France were down 13 plus percent and their economies are very close to following Japan into a recession.
The Goldman Sachs Commodity Index, led by Oil and Precious Metals fell 33%. This in turn led to significant losses in commodity export economies/stock markets such as Russia, down 49%, Brazil, down 18.2% and Australia, down 9%.
**Source of above Map and Performance Statistics: Investors' Business Daily
Interest rates around the globe fell sharply. As an example, the US 10 Year Government Bond Yield has fallen from 2.95% to under 1.80% a drop of 115 basis points or 39%. The 10 year German Bond rate is below .50% and Swedish Banks are now CHARGING 75 basis points (paying a rate of -.75%) on funds held in their accounts.
Since the great financial collapse of 2008 the world has been in an inflation - deflation tug of war. Falling world equity prices, falling commodity prices, and falling interest rates in the face of massive central bank intervention clearly suggest that deflation won the battle in 2014. So you may find yourself asking; what is so bad about deflation? It doesn't seem so bad when we save at the pump.
Deflation is a problem for several reasons. First, the decline that we have seen in oil prices is already leading to layoffs of very good paying jobs in the only real area of job growth that the U.S. has seen since the 2008-2009 financial collapse (Oil exploration, Fracking). In addition, many of these shale companies and even the big oil companies have already reported that there will be major cuts in capital expenditures. These cuts in spending for new projects, equipment and technology upgrades will have a further ripple effect that will cause layoffs in related fields such as engineering, law, accounting and for suppliers such as drilling equipment, pipes, and steel manufacturers. Many of the smaller shale businesses won't make it and there will be a setback to the huge strides that the U.S. has made towards oil independence.
A second problem is that lower oil means a stronger dollar. A stronger dollar can hurt the U.S. economy, as our products become too expensive and non-competitive on the global market, once again costing jobs and reducing incomes. In addition, as our dollar continues to strengthen and the economy worsens from job losses, consumers and businesses begin to delay expenditures in hopes that they can save by waiting. This can lead to a very vicious and destructive cycle for the growth of any economy.
Lastly, the selloff in oil has been so severe and happened over such a short period of time, it is likely that we don't yet know the ripple effect of that in the financial markets. Much like we were told that the housing crisis was "contained", financial markets can experience a domino effect when any asset class falls this much and this quickly. With margin debt at historical highs, the need to cover a margin call generated by the drop in oil and derivative financial products can quickly cause fear and panic in other asset classes. It is estimated that the energy sector represents as much as 15-20% of high yield bonds. This is one area that we could begin to see many defaults and also result in a ripple effect to other asset classes.
There are several headwinds as we go into 2015 including the Fed potentially raising rates, extreme high bullish sentiment, volatility increasing, high yield bonds indicating that risk aversion is increasing, recent pullback in the historically high margin debt levels, market levels significantly higher than the long term mean, and deflation as discussed. It will be a very interesting year to watch the markets, as quantitative easing has ended and markets appear to be returning to more normal levels of volatility.
Created on Friday, 16 January 2015 14:37
Written by: Michael J. Chapman, CFP®, Chief Investment Officer
Melissa Wieder, CFP®, Director Institutional Services
In in effort to offer transparent and independent source of information we wanted to keep track of the debt to GDP of various countries. The chart below is from the IMF. We will let you draw your own conclusions.
Volatility plays a key role in our quantitative analysis for our indexes at PCM. We believe that the end of Quantitative Easing in the U.S. may lead to the more historical market volatility levels seen in and before 2011. The following is an analysis of the historical relationship between performance and volatility for the PCM Global Tactical Index. We chose to do the analysis on this index because it is in many of our portfolios and the quantitative analysis used for this model is similar to all of our models in that volatility is a key indicator.
- The following chart shows the relationship between the historical index performance of the PCM Global Tactical Index (blue line and left axis) vs two volatility measures (orange and gray bars and right axis).
- The orange bar captures volatility as calculated by our quantitative analysis that is used to determine which ETF’s we buy and sell in a given trading period.
- The gray bar is the percentage of days that the Dow Jones Industrial Average had either a 1% or 2% move.
**Notice that 2014 is the only year the index has been negative, which is also the same year that both our volatility measure and the number of volatile days in the markets was very low in comparison. In 2008, when the Global Tactical Index was up 37%, the number of days that the DJIA had either a 1% or 2% move was over 50% of the trading days with about half of those days being a 2% plus move. In 2014, only about 13% of days have had a 1% or 2% move and almost all of these moves were in the 1% category. So far in 2015, the DJIA is seeing these moves close to 50% of the time. Again, the analysis was completed on this particular model because it is in many of your portfolios and the analysis is similar to all of our models in that volatility is a key indicator.
Created on Friday, 16 January 2015 11:37
By: Melissa Wieder, CFP®, Director, Institutional Services
Provident Capital Management Inc. Absolute IndexesSM Disclosure:
PCM Absolute Indexes represent model and hypothetical performance prior to April 2011 and actual model performance going forward to current date.
One cannot invest directly in this index. One can only invest in accounts that attempt to track the holdings and results of the index. There is no guarantee that any client will achieve performance similar to, or better than, an index mentioned herein.
Provident Capital Management, Inc. owns and actively manages quantitative indexes that have an absolute, total-return approach. The indexes are rebalance bi-weekly, monthly or quarterly depending on the index. Periodic adjustments to structure or strategy may be made from time to time at the discretion of Provident Capital's Investment Committee.
Third-party investment professionals, including, but not limited to registered investment advisors and broker/dealers, may make available separate managed accounts (SMAs) that attempt to track our indexes. Provident Capital Management, Inc. makes available SMA’s that attempt to track our indexes. PCM maintains full discretion in implementing SMA’s for clients. Difference in holdings and percentage of holdings between actual accounts and the index may occur. PCM's Absolute Index selection uses an approach selecting the ETFs based upon a multi-factor quantitative approach.
There are three primary types of actively managed indexes developed and managed by PCM:
- Macro: Broad based equities, fixed income, currencies and commodities.
- Tactical: Equities and fixed income specific to countries, sectors and certain commodity ETFs.
- Asset Class Specific: Such as Absolute Metals Index, or Absolute Currency Index.
PCM’s index performance reflects the reinvestment of dividends from January 1, 2003 through December 31 2010 and no reinvestment of dividends January 1, 2011 through present. Performance does not include management custodial or trading fees. Investment products that may be based on Provident Capital Management’s Absolute IndexesSM are not necessarily sponsored by Provident Capital Management, Inc. and Provident Capital Management or any affiliate, advisor or representative does not make any representation regarding the advisability of investing in them. Indexes have an inception date of January 1, 2003 unless otherwise noted in this document. The closing price on the last trading day of the period is the buy and sell price. Inclusion of a mutual fund or exchange traded fund in an index does not in any way reflect an opinion of Provident Capital Management regarding the investment merits of such a fund. None of the funds included in the index have given any real or implied endorsement or support to Provident Capital Management or to any index owned or operated by Provident Capital Management.
January 2011 Provident Capital Management started reporting index results monthly to Morningstar. January, 2 2012 Provident Capital Management switched from monthly reporting to daily reporting. Daily reporting was through an electric submission process and is the calculated index value based upon the closing price of the underlying index holdings.
As this is an actively managed index Provident Capital Management may add or remove ETF candidates for any reason including but not limited to volume, liquidity and ETF issuer related events.
Absolute Indexes typically include one or more ETFs that are inverse to the long positions. The inverse ETFs must meet the same criteria as the long ETFs to be included in the active index. Should the ETF(s) not meet the inclusion criteria then the percent allocated to the non-investable ETF will rotate into cash or a cash equivalent ETF. As the index selects a number of ETFs based upon the quantitative criteria for the index, and if the respective Index includes an inverse ETF, it is possible that the index may be simultaneously in a long position and an inverse position in the same asset class or even similar ETF.
One cannot invest directly in an index. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. One of the limitations of hypothetical model performance results is that they are prepared with the benefit of hindsight. There are numerous other factors related to the markets in general or to the implementation of any specific trading or investment strategy which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.
Not all ETFs that are current candidates for the Absolute Index were available during the timeframe reported. Provident Capital’s Investment Committee makes every attempt to stay current with the availability of ETFs or other investments that may meet the standards of liquidity and transparency to be included as a candidate in any of the indexes. Results shown are for the index, not actual performance in any Provident Capital accounts. Returns shown are not indicative of actual performance for any client account. Although data shown is gathered from sources believed to be reliable, Provident Capital Management, Inc. cannot guarantee completeness and/or accuracy.
Inclusion of a mutual fund or an exchange traded fund in a Provident Capital index does not in any way reflect an opinion of Provident Capital Management, its Directors, Officers or employees regarding the investment merits of such a fund, nor should it be interpreted as an offer to buy or sell such fund’s securities. None of the mutual funds or exchange traded funds included in an index has given any real or implied endorsement or support to Provident Capital or to this index. Used as supplemental sales literature, the index or portfolio reports must be preceded or accompanied by the current disclosure. The underlying holdings of the portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Investment in securities involve investment risks including possible loss of principal and fluctuation in value.
The information contained in this report is from the most recent information available to Provident Capital Management as of the release date, and may or may not be an accurate reflection of the current composition of the securities included in the portfolio. There is no assurance that the weightings, composition and ratios will remain the same.
Benchmark Returns and Non-Provident Capital Management Indexes
Benchmark returns may or may not be adjusted to reflect ongoing expenses such as sales charges. An investment's portfolio may differ significantly from the securities in the benchmark.
S&P Diversified Trends Indicator TR (SPDTT) Follows a quantitative methodology that tracks a diversified portfolio of 24 commodity and financial futures contracts. Can go either long or short, the (SPDTT) is designed to capture the economic benefit derived from both rising or declining trends within a cross-section of futures markets. SPDR Gold Shares (GLD) The SPDR® Gold Trust is designed for the Shares to reflect the performance of the price of gold bullion, less the Trust's expenses. SPDR Gold Shares are designed to track the price of a tenth of an ounce of gold. iShares S&P GSCI Commodity-Indexed ETF (GSG) The iShares S&P GSCI Commodity-Indexed Trust (the 'Trust') seeks to track the results of a fully collateralized investment in futures contracts on an index composed of a diversified group of commodities futures. PowerShares DB US Dollar Bullish ETF (UUP) PowerShares DB US Dollar Index Bullish tracks the performance of the U.S. dollar against a basket of developed-markets currencies. Tracks the value of the U.S. dollar relative to a basket of the six major world currencies - the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss. Barclays Global Aggregate TR A measure of global investment grade debt from twenty-four different local currency markets. This multi-currency benchmark includes fixed-rate treasury, government-related, corporate and securitized bonds from both developed and emerging markets issuers. IShares MSCI EAFE (EFA) The iShares MSCI EAFE ETF seeks to track the investment results of an index composed of large- and mid-capitalization developed market equities, excluding the U.S. and Canada. WisdomTree Global Equity Income Index (DEW) The WisdomTree Global Equity Income Index ETF* is a fundamentally weighted index that measures the performance of high dividend-yielding companies selected from the WisdomTree Global Dividend Index, which measures the performance of dividend-paying companies in the U.S., developed and emerging markets. Standard and Poor (S&P 500) An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. iShares MSCI Emerging Markets Index (EEM) The iShares MSCI. Emerging Markets ETF seeks to track the investment results of an index composed of large- and mid-capitalization emerging market equities.iShares Core US Aggregate Bond (AGG)The Index Is composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.iShares JPM USD Emerging Markets Bond (EMB)Tracks total returns for U.S. dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, Eurobonds. S&P Target Risk Conservative PR (SPTGCU) The S&P Target Risk Conservative Index emphasizes exposure to fixed income in order to produce a consistent income stream and avoid excessive volatility of returns.
Each of the above Benchmark indexes is included merely to show general trends in the market during the periods indicated. Inclusion of these Benchmark indexes is provided only for reference purposes and is not intended to imply that any Provident Capital Management index was comparable to any Benchmark index in either composition or element of risk. There is no guarantee that any client will achieve performance similar to, or better than, a Benchmark index mentioned herein.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Any projections, market outlooks or estimates in this presentation are forward-looking statements and are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Provident may change the exposures and index compositions reflected herein at any time and in any manner in response to market conditions or other factors without prior notice to investors.
None of PCM indexes referred to herein reflect the deduction of the fees and expenses to be borne by a client, whose separately managed account may trade and invest in different financial instruments than those in a particular index. Concentration, volatility and other risk characteristics of a client’s account also may differ from the indexes shown herein.
It’s been five years since investors lost billions in the Bernie Madoff Ponzi scheme. Despite historical increases in industry regulation and oversight, we continue to read and hear of new scams and lost fortunes, proving no government agency can foolproof your investments against fraud. Fortunately, there is one important thing all investors can do to minimize potential exposure and protect themselves: Separate who’s managing your money from the custodian holding your money.
Having been in the financial industry for over 30 years, I am certain that adding an experienced and competent financial advisor to your team is well worth the incremental cost by allowing you to avoid the many pitfalls inherent in investing. Having said that, I am equally certain your advisor should have limited authority over your assets. These authorized activities should be restricted to:
The buying and selling of securities on your behalf and transferring your funds, but only into an account with the same title and ownership. These permissions and restrictions can be accommodated by signing a limited power of attorney. Ensure the investment account your advisor manages is not held at the advisor’s company. Said a different way, the company you write your checks to and that custodies your assets should not be the same company that is managing your money.
The custodian will provide a monthly or quarterly statement showing all of the activity in your account. A good money manager will provide you with performance statements, usually on a quarterly basis, which gives you two different statements from two different sources to compare. You now have a system of checks and balances to ensure your funds are exactly where you believe them to be, in the amount you believe there to be.
Let the Investor Beware.
In the case of Madoff and so many like him, the manager was furnishing fabricated statements and it was not until it was too late that the investors discovered their money was long gone. This would not have been possible if their funds had been deposited at a separate custodian, whereas Madoff was simply given the power to invest those funds. He could not have used the funds to pay off other investors in his Ponzi scheme if a separate custodian had been used. Additionally, the custodian’s monthly statements would have reflected his true dismal performance.
Most registered investment advisors (RIAs) do not hold or custody client funds. Instead, they have a contract that allows them to buy and sell securities on their clients’ behalf and to move funds from one account to another, as long as they are titled in the same name. Keep these things in mind:
Some RIAs will act as the money manager for your accounts, but again, your accounts are held at a different custodian.
My firm, Provident Capital Management, Inc. (PCM) uses discount brokerage firms such as TD Ameritrade and Charles Schwab to hold client assets. Each month you receive a statement from the discount broker and each quarter a performance statement from PCM. It is in your best interest to compare the ending balances on these two statements. If the balances don’t match, then you know further research is needed. An additional benefit of this type of arrangement is the custodians mentioned above offer 24/7 viewing of your accounts online, which means you could monitor your funds daily. As a registered investment advisor, we operate this way to add an additional check and balance to protect you as the consumer.
Greed, fear, fraud and deceit have been around throughout our history. Human nature has not varied much over the ages. Despite modern advances in finance, monetary policies and investment options, we still continue to see asset bubbles and watch investors chase too-good-to-be-true investment returns, only to lose a great deal of money. However, risk of losing money extends beyond the gains or losses in stocks or bonds. The first step to take in protecting yourself from fraud is to separate who’s holding and reporting your money from who is managing it.