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Rob Isbitts's well-researched quick takes that'll educate an RIA in 10 minutes on items from margin debt and corporate earnings to house-flipping
January 30, 2017 — 6:05 PM UTC by Guest Columnist Rob Isbitts
Brooke's Note: Rob Isbitts has the gift of taking some of the denser elements of investing and demystifying them. One of the all-time favorite articles on RIABiz is: The top 10 alternatives to alternative investments. It's nearly as relevant today as ever. So I demanded that he start this piece on that 'alts' topic because he is one of the few people I know who can talk about it from a healthy remove. He sees it for what it is and observes how actual advisors and investors use hedge funds and other alts -- often none too wisely. In this column, Isbitts offers some other contrarian views -- like why he's none-too-bullish in an investing atmosphere where optimism predominates.
This is the first investments trend roundup I've penned for RIABiz in a while -- since 2013 to be exact. It's good to be back! In these pieces I traditionally sync the number of trends the year in question, but this year Brooke asked me to pen an 18th entry, one sizing up the viability of alternatives in a market that's just cracked 20,000.
So we'll start with that. But first, my annual disclaimer investing is not about predicting, it is about assessing, and thinking beyond what the herd is saying and doing. See: The 5 biggest errors of intellectual omission by RIAs -- in fact, most advisors.
Bonus pick: Alternatives: Still burdened with unnecessary complexity and confusion, alternatives have made it to the mainstream, as they are on the lips of many major mutual fund companies and financial advisors. But despite a dizzying array of products and plenty of educational material, I still get the idea that the client's reaction to all of it is "what the heck is this thing again?" See: Chasing bad performance: Why investors can't get enough of those increasingly lame hedge funds.
This chart of an ETF that tracks an alts index devised by Morningstar Inc. and a product created by ProShares may help us understand why. The index mixes private equity, global infrastructure, hedge funds, break even inflation, long-short equity and merger arbitrage. I am not opining on the specific pros or cons of this ETF, and each of the sub-component investment styles may or may not have appeal to certain types of clients. I am just pointing out that for advisors, I continue to see a hurdle in helping clients make sense of alternatives to traditional stock/bond mixes. See: How the alternative investments category got bastardized and why that's a shame.
Each alternative asset class is an explanation in itself, and the continued risk I see to advisors is that the effort ends up in futility. As with the fund of funds concept in the hedge fund world, the liquid alternatives mix concept is like eating a portion of your breakfast, lunch and dinner for the day at the same time. Each part is potentially enjoyable and healthy on its own, but together it can seem more like a mishmash of food and leave you wanting a simpler approach. I think that in 2017 and beyond, the key issue in making alts work for advisors is to simplify their delivery and try not to do too much at once. I refer to this as a "meat and potatoes" approach to alts, but there I go again with the food analogies! See: Top 10 alternatives to alternative investments for RIAs: 2013 edition.
Now, back to our regularly scheduled program:
1. Margin debt: This is just one sign of speculation in the market. And as in 2015, it is nearly at an all-time high, along with the S&P 500 Stock Index. Back then, the market had global central banks to print more money. Today, not so much. This is one of many items on this list that are not a problem…until it is. Then it's a big problem and can contribute to a run on the stock market as people are forced to exit positions to pay back what they borrowed. See: Wall Street thriller 'Margin Call' is a cautionary tale -- even for RIAs.
2. High-yield (junk) bond market: 2016 was a strong year for these. The sector even held up quite well during the recent decline in higher-quality bond prices. But now yields are near multi-year lows. There was a time when investors would laugh if their advisor told them 5.45% was “high” yield. Not in today’s measly excuse for a retirement income source, the bond market. Reaching for yield is dangerous. I prefer dividend income to high yield income in 2017. See: Picking through the ETF pile for some relatively safe high yields
3. Market breadth: This was a nagging problem for the U.S. stock market until the presidential election, when all of a sudden anything other than health care stocks seemed to “catch a bid.” Now that most U.S. stocks have performed well for a spell, the big laggards are non-U.S. stocks, in part due to the strength of the U.S. Dollar. The other issue as 2017 approaches is whether the Trump rally has run its course, at least for a while. From my view, stocks and sectors are not moving quite as in sync as in past years. This is an opportunity for active investment managers. See: How Donald Trump jolted Sallie Krawcheck out of sexism denial, maybe, and the startlingly retro remedies she prescribes for young women.
4. Nasdaq Composite vs. NYSE Composite: This may be the most bullish aspect of the current stock market environment, after being one of the biggest threats a year ago. As a reminder, U.S. stocks are either Nasdaq or NYSE listed. After a significant out-performance of the Nasdaq versus NYSE stocks, this year has been about even. That’s healthier than a market ginned up on tech and biotech stocks, which dominate the Nasdaq. Still as of Dec. 16, the five-year return of the Nasdaq was about 113% versus 53% for the NYSE. The Nasdaq’s relative return to NYSE broke down in the year 2000 and it was an ominous sign, so while the market appears healthier on this parameter alone, I don’t suggest getting too comfortable. See: Why EF Hutton's rebooters took the arse-backward tack of selling public shares and buying a brand before developing a product
5. U.S. corporate earnings: And this is why you should not get too comfortable. The earnings yield of the S&P 500 (which is S&P earnings / S&P value) last declined to its current sub-4% level in 2008. Before that, it happened in 2000. It’s also been falling for half a decade. Fed QE distracted the market from this in the past, but I think that game is over. And this is a clear warning sign for U.S. stocks over the intermediate term.
6. Global economic growth: The International Monetary Fund report as of Oct. 14 was titled “The World Economy: Moving Sideways.” World GDP growth was expected to finish 2016 at 3.1% with an uptick to 3.4% in 2017. That sounds like a good thing to the incoming U.S. Administration, except that it includes parts of the developing world where growth is still double that or more. The United States. may have its sights on sustained 3% to 4% growth, but I have a hard time seeing how we get there without significant inflation…which incidentally could go a long way toward paying down the $20 trillion debt.
7. The Post-ZIRP era: The Fed's zero-interest-rate policy officially ended in late 2015 and took another step up toward higher rates when they again raised rates recently. Last year, I wrote about the first rate hike as follows: “The market's initial reaction has been quiet, but it's the holiday season, so...” What followed was the worst start to a year for the U.S. stock market. Ever. Let’s see what this January brings. See: Are negative yields for US bonds on the horizon?.
8. Wall Street bullishness: Now, this is a tough one this year since most of Wall Street appears to be transitioning to working for the government…but seriously, expect “buy side” investment firms like brokerage houses to be universally bullish, except for shorter periods of time, just to keep the audience honest. I feel the opposite way – the further out I look, the riskier the stock market looks.
9. Silicon Valley private-equity valuations: Valuations are quite high after years without a serious economic or market decline to act as a reality check. Currently, there are cross-currents here, as the $300 billion CalPERS pension fund recently reduced its private equity allocation, but investors look forward to the possibility of U.S. companies repatriating cash that has been stuck overseas. Some of that cash could be used to buy private companies. Or, it could all just be blind hope. See: CalPERS's hatchet man, Ted Eliopoulos, goes on a manager firing spree, shaving hundreds of millions in management fees -- but is it enough?
10. High-frequency trading firms: I believe more than in the past that these firms are part of a larger motivation for investors to embrace active management. I don’t mean day-trading, but rather to come to grips with the idea that increased market volatility, sector rotation, etc. actually can be used to your advantage, at least in part of your portfolio. See: What RIAs need to know about systemic risks in the wake of the flash crash.
11. Capital-expenditures bubble: Last year, I wrote about overbuilding in China. In 2017, the world will be watching as the U.S. attempts to embark on a Capex spree, with massive borrowing to fund infrastructure and other major efforts to increase employment here. My take: helps stocks temporarily, wrecks bond market eventually. See: Why the U.S. should follow China in issuing 50-year bonds.
12. Oil prices and energy companies: It took about 18 months for the price of West Texas Intermediate (U.S. produced oil) to drop from over $100 a barrel to under $30 a barrel. Four months later, it was back above $50, a level at which it has shown some stability as of late. Some of the weaker companies in the sector cut their dividends, and word on the street is that the U.S. is going to aggressively drill, refine and distribute oil and natural gas in the years ahead. But won’t that surplus production knock the price down, which will make energy another low-margin business? As a service economy, we already have plenty of those. I am far from an energy industry expert, but as a portfolio manager, I see this sector for what it is: a place to go to “rent” return potential, rather than own it. In other words, a buy-and-hold approach to this or any other commodity-driven segment of the stock market introduces risk beyond that which many investors are willing to deal with. Tread carefully, with your oil/gas-powered vehicle, and with this sector.
13. House flipping: This is defined as a home bought and sold within a 12-month period, according to RealtyTrac. 53,892 homes were flipped during the third quarter of 2016, down from a six-year high in the previous quarter. But now rates are moving up, and I fully expect that in next year’s edition of this annual list, I will be writing about how this item has changed for the worst. Pair it with No. 1 above (margin debt) and the expected fiscal stimulus from Team Trump, and you get a story that will probably end badly for jacked-up consumers. We just don’t know when.
14. ETF creation/issuance: According to ETF.com, these index-based funds that trade on the stock exchange are now over $2.5-trillion in value. Yet many investors do not even know what they are. More importantly, they have revolutionized the way many financial planners and investment managers access markets. But there is a not-so-obvious risk inherent in that. With so much money jammed into the largest ETFs, it focuses the “herd mentality” and this impacts all investors, whether they like it or not. ETFs are increasingly used as surrogates for buying a portfolio of otherwise less-liquid assets like junk bonds, corporate bonds and small cap stocks. The stock market looks more like a public version of the “swaps” derivatives market to me all the time. This does not change the attractiveness of the market in my view. You still have objectives to reach and the stock market can be a means to that end. But the ETF mechanism is something investors and financial advisors need to be aware of, so they can better understand how they have changed the way markets move, especially over short-term time periods. See: Vanguard and BlackRock slash prices at Christmastime but only Vanguard feels the need to defend its actions
15. “Flation”: Last year, I talked about declining wage growth, commodity prices and technology advancements adding up to a potential deflationary condition. As noted below (No. 17), the focus now should be on inflation. And when I look at the chart of inflation since the wild times of the late 1970s, I see slow, percolating price pressure which may bust out (and up) over the next few years. Accompanied by strong economic growth, it can be a decent tradeoff for investors. But if the economy does not grow along with inflation, it becomes “Stagflation.” I will have more on that in a future article. See: Too much debt causes deflation, not inflation.
16. Technical analysis: Thirty years ago when I entered the investment business, chart analysis of stocks and markets was akin to Voodoo. My late father and about 23 other people seemed to be the only ones doing it. Today, there is no doubt in my mind that any investor who does not include technical analysis in their investment process to some degree is driving with one eye closed. Charts have too much of a role in defining intermediate-term tops and bottoms to ignore them. See: With inflation on a tear, 401(k) plans look vulnerable and BrightScope publishes a cheat sheet
17. Populism: You can discuss politics elsewhere on many real and fake news sites across the web. My focus is on the one economic outcome that follows Brexit, the election of Donald Trump, and other “Populist” movements across the globe. See: How RIAs took one approach to Brexit and asset managers another -- and why only the latter group has egg on its face. For the United States, Trump’s policies may or may not improve growth, employment and wages. But what seems to be likely regardless of the outcome is that inflation will make its return to the American scene. The same can be said for stock and bond market volatility, which I think will be one of the biggest stories of 2017. Investors seem to have assumed a lot of positive outcomes well before they have occurred. I am happy to ride that wave, but I hope that like me you realize that the tide may eventually rise, and you will want to know how to return to the beach for safety.
Rob Isbitts is the lead manager of the Dunham Alternative Dividend mutual fund and the founder of Sungarden Investment Research (www.sungardeninvestment.com), an investment management firm. Over the past three decades, Rob has managed daily liquid portfolios through diverse market conditions. He created several investment strategies, including the Sungarden Hedged Dividend portfolio, an alternative approach to the pursuit of income, preservation and long-term growth. Rob has managed mutual funds and authored two books. He can be followed on Twitter@robisbitts.
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