These Crises Could Drive a Deep Bear Market

Investors are wondering whether or not stocks will continue moving lower. Many are seriously considering the possibility. But others are highlighting that the stock market has frequently pulled back and this could be just another buying opportunity in a bull market.

That argument ignores several important developments. The bull market began in March 2009 and is now almost ten years old. It can’t continue forever, if history is a guide, and the news from around the world is increasingly bearish.

Europe Could Be a Problem

The bull market has been driven in part by easy monetary policy of central banks around the world.

An easy money policy is defined as a monetary policy that increases the money supply usually by lowering interest rates.

It occurs when a country’s central bank decides to allow new cash flows into the banking system. Since interest rates are lower, it is easier for banks and lenders to loan money, thus leading to increased economic growth.

The most immediate effect of easy money, if implemented when the economy is below capacity, may be increased economic growth. In addition, the value of securities rises in the short term.

If prolonged, the policy affects the business sentiment of firms and can reverse course over fears of rampant inflation. This is an effect of forward-looking expectations.

That could all be changing now. Reports indicate the European Central Bank needs to keep its monetary policy easy while tightening slowly as underlying inflation in the euro zone remains weak and global risks such as protectionism loom, ECB policymaker Olli Rehn said recently.

“Core inflation is still rather weak in the euro zone at around 1 percent, as it has been for the last couple of years, so an accommodative monetary policy is still needed in Europe,” Rehn said. This could reverse a long down trend in interest rates.

European Central Bank

Source: TradingEconomcis.com

Higher rates in Europe or an end to quantitative easing could have a bearish impact on stock prices.

Brexit Could Roil Markets

Brexit, according to the BBC, “is used as a shorthand way of saying the UK leaving the EU – merging the words Britain and exit to get Brexit, in the same way as a possible Greek exit from the euro was dubbed Grexit in the past.” 

Britain leaving the European Union after a referendum – a vote in which everyone (or nearly everyone) of voting age can take part – was held in June 2016 to decide whether the UK should leave or remain in the European Union.

Leave won by 51.9% to 48.1%. The referendum turnout was 71.8%, with more than 30 million people voting.

After months of negotiation, the UK and EU have agreed on a deal. It comes in two parts.

There is a 585 page withdrawal agreement. This is a legally-binding text that sets the terms of the UK’s divorce from the EU.

It covers how much money the UK owes the EU – an estimated £39bn – and what happens to UK citizens living elsewhere in the EU and EU citizens living in the UK. It also proposes a method of avoiding the return of a physical Northern Ireland border.

There is also a 26 page statement on future relations. This is not legally-binding and sketches out the kind of long-term relationship the UK and EU want to have in a range of areas, including trade, defense and security.

The UK cabinet agreed the withdrawal agreement text on 14 November, but there were two resignations, including Brexit Secretary Dominic Raab and there was an, as yet unsuccessful, attempt by Brexiteer MPs to force a confidence vote in Theresa May.

The next step is for MPs to vote on the deal, which will take place on 11 December after five days of debate. If they pass it, the European Parliament will get a vote before Brexit day next March.

There are concerns about Brexit and it is affecting stocks in the United Kingdom as the next chart shows.

FTSE weekly chart

After rallying on the referendum and then stalling, prices of the FTSE 100, a benchmark index, are now falling.

France Is Another Concern

Europeans and traders around the world are also watching France where thousands of demonstrators, according to NBC News, known as “Yellow Jackets” due to their fluorescent garb descended into the streets across France over the weekend to protest planned tax hikes on gas.

In Paris, the rallies turned violent recently with blazes set on the world-famous Champs-Élysées avenue while masked protesters waved the French flag. Police responded to skirmishes with water cannons and tear gas. More than 100 people were arrested.

Motorists have blocked highways across the country since Nov. 17, setting up barricades and deploying conveys of slow-moving trucks. Around 280,000 protested in the streets across the country that day, with 106,000 people attending rallies in Paris.

On Jan. 1, the tax on gasoline will go up by around 12 cents per gallon and on diesel by approximately 28 cents per gallon, according to Transport Minister Elisabeth Borne.

Gas taxes will go up by another 5 cents per gallon by 2020, with diesel jumping an additional 2 cents.

On Monday, gasoline cost around $6.26 per gallon in Paris, while diesel was around $6.28 a gallon.

Macron has so far refused to reconsider the hikes, which he says will help reduce France’s dependence on fossil fuels. By raising the cost of diesel, the French government hopes to convince more people to buy less-polluting vehicles.

But he did agree to a six month delay in its implementation.

While the protests were sparked by the looming increase in fuel prices, experts say they have become an outlet for people to express their discontent with the high cost of living in France and with Macron’s presidency more generally.

A poll published on Friday found that only 26 percent of French people have a favorable opinion of Macron.

Joseph Downing, an expert in French politics at the London School of Economics, agreed that the protests were about “much more” than taxes on gas.

“It’s this entire idea of the squeezed middle or the squeezed upper working-class person who feels an entitlement to an ever-increasing standard of living but is something that no politician can deliver,” he said. “This is where we’ve seen disenfranchisement with Sarkozy, with Hollande and now with Macron.”

This is also a potential factor for stocks as the chart of the CAC 40 benchmark index shows.

CAC Index weekly chart

The question is whether these factors can end the long bull market. Investors should consider that possibility and begin preparing defensive strategies.


Looking Beyond Gold

Gold prices have been rallying. They are now at their highest level since July. And, this could be the beginning of a significant rally in gold prices. That can be seen on the chart of SPDR Gold Trust (NYSE: GLD) shown below.

GLD monthly chart

This ETF makes gold easily accessible to individual investors. Right now, it could be worth considering as a buy.

It’s widely believed that gold prices have historically gone higher in times of crisis. That has often been true. Gold serves as a safe haven investment and could be particularly appealing right now as a number of geopolitical crises threaten, the Federal Reserve could be reversing policy, and the stock market could be declining.

It’s one of those times when it is impossible to completely list all of the global hotspots. Brexit could roil Europe as the European Union struggles with an Italian budget and France faces rioting. All of this is occurring as the European central Bank is expected to reverse its policies early next year.

As it almost always is, the Middle East is a cause for concern. Saudi Arabia, Yemen and Iran are just three countries which could create negative and market moving headlines.

This is often a cause for gold to rally. But, there are other metals that could provide gains to investors.

Palladium Could Be a Buy

According to a recent story in MarketWatch.com:

“In the near-term, palladium’s superior supply-demand backdrop could see it surpass gold,” analysts at precious metals consulting firm Metals Focus wrote in a recent research note.

Palladium is “characterized by the strongest supply-demand backdrop across the major precious metals,” even as mine production stands at historically high levels, leading to an estimated 2018 global supply of 9.7 million ounces—the “second highest total this decade.”

Global automotive demand for palladium, meanwhile, despite weak recent sales of light vehicles in China and the U.S., may “achieve a new record high in 2018 of around 8.5 [million ounces],” the analysts said. The metal is widely used in the pollution-control catalytic converters on gasoline-powered vehicles.

This means the price of palladium is rising and could move above gold. That was how the relationship looks for a time earlier this century.

Gold chart

Source: MarketWatch.com

Platinum Is Also a Potential Buy

The market has also seen a rise in platinum group metals “loadings to meet tighter emissions standards,” Metals Focus analysts said.

Also, “over the past decade palladium automotive demand in Europe has grown noticeably, in part due to substitution gains at the expense of platinum in light duty vehicles, but also as diesel has lost market share to gasoline passenger vehicles.”

Platinum is palladium’s sister metal, is more commonly used in catalytic converters for diesel engines, but in 2015, Volkswagen VOW admitted to manipulating emissions tests on some diesel-power vehicles in the U.S. and elsewhere.

Looking further ahead, however, gold may re-establish its premium over palladium, the Metals Focus analysts said.

“There will be some headwinds” for palladium, “in particular, investors have also been heavy buyers,” and “a sizable overhang has been built up, of around 1.5 [million ounces], which leaves scope for profit-taking,” the analysts said. “In addition, as we move through 2019 and U.S. growth slows, this will weigh on investor risk appetite, which in turn will affect palladium.”

Traders in the futures markets have easy access to these metals.

Individuals could also consider the Aberdeen Standard Phys Palladium Shares ETF (NYSE: PALL), an exchange traded fund with more than $140 million in assets, or Aberdeen Standard Phys Platinum Shares ETF (NYSE: PPLT) which has more than $500 million in assets.

Assets under management is an important consideration for an ETF. That is because smaller funds could be closed because they are not profitable to their sponsors. There is no answer to the question of what the correct minimum amount of assets is. It varies by sponsors and comfort level of individual investors.

Silver Could Also Shine

If gold rallies, it is likely that silver will move higher as well. In this market, the individual investor has a number of investment options.

Given the relatively low price of an ounce of silver, it is possible to simply buy the metal in the form of bullion or coins. This can be expensive and it is important to research dealers to ensure that you are buying from a reputable source.

One advantage of this approach is that silver coins or bullion in the form of bars or ingots is relatively easy to sell. One disadvantage is that spread between the buy and sell prices can be large and it can be expensive to own silver in this way, especially in the short term.

The cheapest way to invest in silver could be with futures contracts but this investment carries significant risks and will not be the right choice for many investors.

There are also silver ETFs including the iShares Silver Trust (NYSE: SLV).

SLV monthly

But you can also invest in silver through mining companies. Shares of miners will generally track the general trend of silver prices, but miners also offer some degree of leverage.

An example might be the best way to explain the leverage miners offer.

Let’s assume it costs a miner about $10 an ounce to produce silver and they mine 1 million ounces a year. If silver is at $11 an ounce, the company should generate a profit of about $1 an ounce or $1 million

This is a simplified example so we will assume the company has no other costs and no additional revenue. The actual model would be much more complex.

If the price of silver increases by 10%, to $11.11 an ounce, assuming the costs of production stayed the same, the miner’s profits would increase to $1.11 an ounce or $1.11 million for the company, an increase of 11%.

The miner is leveraged and benefits immensely from higher silver prices.

Remember, there is no free lunch in the stock market. Leverage can help increase investment returns on the upside but can cause significant losses on the downside. A 10% decline in the price of silver could result in an 11% drop in earnings for this miner.

This leverage makes silver miners an excellent way to invest in silver. The same is true for gold. Buying miners when metal prices are low can lead to large gains when the price of the metal recovers.

Now is an ideal time to consider adding miners to your portfolio.




Alternative Data: The Next Big Thing

Alternative data has recently become the “next big thing” for investors who are searching for edges and the data is now going mainstream.

Nasdaq (Nasdaq: NDAQ) recently announced today it has acquired Quandl, Inc., a leading provider of alternative and core financial data.


Source: Quandl.com

Quandl provides alternative data and core financial data from over 350 sources to more than 30,000 active monthly users.

The company offers a global database of alternative, financial and public data, including information on capital markets, energy, shipping, healthcare, education, demography, economics and society. Examples of alternative data includes data on car sales or movements of corporate airplanes.

Bringing Alternative Data to the Mainstream

Nasdaq plans to combine Quandl with its existing Analytics Hub business within Global Information Services.

Founded in 2012, Quandl is used by eight of the top 10 hedge funds and 14 of the top 15 largest banks. Quandl delivers financial, economic and alternative data to over 400,000 analysts worldwide.

Quandl has also established strategic relationships with many leading data providers to provide institutional and Main Street investors with access to a growing library of data to inform research and trading / investing decisions.

In assessing the overall market opportunity for alternative data across the financial industry, in November 2017, Deloitte estimated that spending on alternative data may exceed $7 billion USD by 2020, with an annual growth rate of 21 percent.

Making Alternative Data More Accessible

Barron’s recently looked at this situation from the perspective of an individual investor.

The sheer volume of data available today, and the price of obtaining it, can be overwhelming for investors unfamiliar with the field. Gaining a quant-like investing edge by examining credit cards or location-tracking apps can mean writing a big check, with no guarantee of success.

Most credit card data starts at $10,000 a year, according to Quandl, a marketplace for alternative data.

Ashby Monk, a Stanford University academic who has studied how funds use data, says that the best way for most investors to use alternative data is as a risk-management tool rather than as an idea generator.

“It’s a smart way to begin to dip your toe in the world of alternative data and not get caught up in the arms race,” Monk says. “Think of this as a risk tool to help you better understand your portfolio and the assets you’re investing in, rather than trying to spot some trade that you want to make.”

Michael Recce, chief data scientist at Neuberger Berman, uses only about five major sets of data and buys them on a delayed basis, a tactic that allows him to pay as much as 90% less for the information.

He’s willing to have “old” data because it’s meant to complement, not replace, the fundamental-investment process. “If you care about long-term capital gains, you don’t care if it’s one month old,” he says. Recce uses job-posting, online-shopping, and credit-card data.

For do-it-yourself investors, e-brokers have begun expanding their alternative data offerings, too. TD Ameritrade allows people to access the social-sentiment app LikeFolio in their trading accounts.

Sentieo, another start-up data provider, offers tools that combine alternative and traditional data on its platform, which costs $500 to $1,000 a month.

Brokers See An Opportunity

Sell-side firms—bankers, brokers, and research shops that analyze and market investments—are also stepping in to guide investors through the minefield.

The buy side—asset managers—tends to be “massively ahead” when it comes to new investment trends, but this time “we’re starting from a similar point as our buy-side partners,” says Dan Furstenberg, global head of equity hedge fund distribution and head of data strategy at Jefferies.

For fund managers worried that they have already missed the data boat, he says their concern is misplaced.

Only about a quarter of managers Jefferies surveyed last year were high-volume users who look at more than 50 data sets. “For traditional portfolio managers, it’s incredibly early,” he says. “We’re in the first inning.”

Veteran asset managers may not be keen on using the data, but it’s likely to become a must-have for the next generation. “It’s really hard to transform the very discretionary process of a 50-year-old portfolio manager,” says Leigh Drogen, the CEO of Estimize.


Source: Estimize.com

“They know that they just have to hang around another 10 years and collect money. They don’t want to go learn [programming language] Python. The 30-year-old at that fund knows they’re not going to have a job in 10 years if they don’t learn it.”

Recce thinks fund managers—even the well-seasoned ones—can learn to program. He’s planning to teach a class on computer science at Neuberger Berman.

The people most at risk from the shifting trends could be traditional sell-side analysts, argues Daniel Goldberg, the founder of consulting firm Alternative Data Analytics.

“You’re going to get more money going to analytical tools than to sell-side research,” he says. “Data will be the new consensus estimate. Instead of the sell-side providing estimates, the data will do that every day.”

As a starting point, individual investors could turn to Estimize or considering searching through the Federal Reserve data base for free. Fred Economic Data is available here. For example, here investors can find data on Italy’s unemployment rate.

unemployment rate

Source: Federal Reserve

On Fred, investors will actually find 2,613 data series on Italy. That data can be combined with data from the United States and could include a limited history of stock market data. Using this capability investors could search for data that leads market turns.

Fred data can also be exported to Excel for more detailed analysis. This is a rich source of untapped data in many cases. The site actually contains more than 528,000 data series and new data is being added quite often.

This task won’t be easy, but the use of alternative data has not been easy for large investment managers to master. However, the rise of alternative data demonstrates, and largely confirms what many investors already believe, that the widely available data such as earnings isn’t enough.

Maybe earnings data was never enough to earn big profits but it seems that it is more difficult today. It could pay for individual investors to wade into the study of alternative data with Fred.



What Individual Investors Can Learn From GE’s Pension Plan

General Electric (NYSE: GE) has been in the news quite a bit recently. Analysts have been cutting price targets, some citing operational concerns while others cite pension obligations and the lack of a clear plan for a turnaround.

The stock has certainly been in an extended down trend.

GE weekly chart

The company’s operational shortcomings are likely to be the subject of business school case studies for several years. They are interesting. But the company’s retirement plan could be among the most important lessons for individual investors.

GE’s Plan Is Underfunded

GE (has about 430,000 retirees and active workers covered by defined benefit pension plans according to a recent report in Barron’s.

It’s important to note that defined benefit plans are increasingly unusual. These type of plans promise retirees fixed payments every month for life. This is different than an individual plan or a company’s more common fixed contribution plan where companies make regular payments to a 401(k).

Despite these differences, the problem GE faces are illustrative of the problems individuals can face in their own plans. This will be true no matter type of plan an individual is funding and relying on for retirement.

According to the Barron’s article:

“In all, GE’s workers have been promised about $100 billion in payments, but the company has only $71 billion in assets set aside to meet those obligations.

There’s no consensus among investors and analysts about the GE pension plan. Some analysts fret about the funding gap. Others argue that pension gaps are only theoretical—because a pension number isn’t like a bond with a face amount and a fixed maturity.

Those who downplay concerns also argue the funding situation is spelled out clearly for anyone willing to read the notes to the financial statements.

So is it, or isn’t it, something to worry about?”

For Your Individual Plan, Underfunding Is Something to Worry About

GE’s plan, as noted covers 430,000 retirees. The law of large numbers indicates that the plan is likely to pay out $100 billion but the amount could be more or less. That’s why some analysts aren’t worried about the plan. If the company ends up owing less, funding the plan now would waste resources.

But it is especially important to note that “pensions don’t usually become an issue for investors until the stock market declines, shrinking the value of the assets set aside to pay workers.”

This is an example of how analysts can, at times, make overly optimistic assumptions. Notice that they usually don’t worry about pensions until the market declines. The chart below shows that markets do decline significantly at times.

quarterly bar chart

This is a chart of the S&P 500. When a plan covers hundreds of thousands of individuals, there is time to recover from losses. That’s simply because some will retire and some will continue to work during the market down turn.

With an individual plan, if the individual intended to retire in 2000 or 2008 as the down turns shown above were beginning, it would have been difficult to retire. The individual could have extended their working career due to a bear market.

One way to address this problem is to overfund the retirement account. But, for an individual that isn’t usually possible. The individual investor has competing claims against their limited resources and must fund current expenses while saving for retirement. That makes adequate funding a challenge and overfunding is unlikely.

Help Could Be On the Way

GE could be bailed out by higher interest rates.

“Higher interest rates also help shrink pension liabilities, reducing the present value of open-ended obligations. Discount rates track bond yields and the 30-year bond yield is up about 0.5 percentage point this year.

GE disclosed in its 2017 annual report that a 0.25 percentage-point increase in rates would shrink the pension obligation by $2.2 billion. That’s just how the math works.”

The math could work the same way for individuals. New investments into fixed income will carry higher yields and generate more income.  This could be especially helpful to a large fund but it is also at least somewhat helpful to an individual investor.

After a decade of below average interest rates, higher rates could have a significant impact on expected retirement income.

The experts noted that GE has several options. “Adding cash to the plan is one option. GE could also move a portion of its pension off the books entirely.

Steve Catone, a senior consulting actuary at Korn Ferry , told Barron’s that, “companies have been immunizing themselves from old pension obligations by purchasing annuities with insurance companies.” He added, “you can retire a pension plan for good for about 15% of the benefit obligation.”

Of course, you have to transfer the pension assets along with the liability. That could get expensive, and GE may want to hang onto its available liquidity.

But the company may be able to leverage higher rates and recent contributions to lower its obligation permanently. With the right mix of choices, GE could take the pension issue off the table for years to come.”

This could describe an approach for an individual to consider. When a company moves the pension obligations off its books entirely, it is generally selling the plan to an annuity provider.

An annuity is a contract between you and an insurance company in which you make a lump sum payment or series of payments and in return obtain regular disbursements beginning either immediately or at some point in the future.

The goal of annuities is to provide a steady stream of income during retirement. That goal is the same for company pension plans or individual retirement accounts. The steady stream of income could be combined with Social Security and other investments to meet the needs of some individuals.

Annuities are not right for everyone and even if they are the right choice for an individual, there are many products on the market that may not be suitable. Some annuities carry high costs, and some have other features that make them undesirable for many investors.

But annuities should be considered by many investors just like they are considered by large companies. Further consideration may lead to rejecting the product, but at least that will be an informed decision.


Value in a Bear Market

We may very well be in the early days of a bear market. No one knows for sure until the Dow Jones Industrial Average declines at least 20% from its high. That’s the official definition of a bear market.

But by the time the Dow falls that much, a number of individual stocks will have fallen significantly more than that. This means that individual investors could be facing large losses well before the experts on CNBC announce that we are officially in a bear market.

That leads to the question of what can be done about a bear market and the answer from the perspective of an individual investor could sound remarkably similar to what an investor could do about a bull market. They could consider applying a value methodology.

Value Cuts Both Ways

Many individual investors spend a great deal of time looking for value. They buy stocks that are undervalued. That is a strategy that has been proven to work in the long run for many investors. But at any given time there will only be some stocks that are undervalued. The rest will be either fairly valued or overvalued.

It is the overvalued stocks that could be of interest in a bear market. After all, in the long run value works according to a number of studies. Undervalued stocks tend to beat the market, on average, as a group.

Those studies, especially the ones that are published in academic journals, usually include an evaluation of overvalued stocks as well. The studies often show that undervalued stocks underperform the broad stock market, on average, as a group.

For example, the studies may look at a valuation tool like the price to earnings (P/E) ratio. Low P/E ratios indicate a stock is potentially attractive. High P/E ratios highlight, for many individual investors, the stocks that could be avoided.

In the studies, the authors often assume the low P/E stocks are bought and the high P/E stocks are shorted. When an investor buys a stock, they profit when the price of the stock goes up. When they sell a stock short, they profit from a decline in the value of the stock.

We will not go into the mechanics of shorting a stock. It is a high risk strategy that may not be suitable for many individual investors. But investors can also benefit from a price decline with a put option.

A put option gives the buyer the right but not the obligation to sell 100 shares of a stock at a predetermined price for a specified amount of time. The mechanics of owning put options can be confusing but interested investors should consider researching options.

One advantage of a put option compared to selling a stock short is that the risk is limited and well defined when buying a put. An option buyer can never lose more than the purchase price of an option which is often just a few hundred dollars or less, and can even be less than $100.

Finding Value Like a Quant

A quantitative approach to investing relies on computers to identify characteristics of successful stocks. Based on historical performance of that factor, the investor buys all stocks that meet the defined criteria.

Quants often use a computer output to drive all decisions. They may not supplement that output with any other analysis. This has provided success and outsized returns to some investment managers.

But, for many years it required expensive data sets and customized programming skills to find stocks with a quant strategy. Now, those tools are available to individual investors and some tools to implement quant strategies are even available for free.

A Free Quant Screening Tool

One way to find stocks meeting a variety of predefined requirement is with the free stock screening tool available at FinViz.com. At this site, you could screen for a variety of fundamental factors like free cash flow, high levels of institutional ownership and bullish institutional transactions.

There were 7,547 stocks in the database on a recent day. We want to search for just a few that could be good investments. We will focus solely on fundamentals criteria. There is no guarantee these stocks will be safe but we use quant criteria in an attempt to limit risk.

To ensure the stock is tradable at a reasonable cost, even in a market crash, we will limit the search using market cap selecting just the largest stocks which is defined in FinViz as stocks with a market cap of at least $10 billion. All selections are made with pull down menus as shown below.

We will also require the stock to be optionable. Then we will search for potentially overvalued stocks by looking for high income (a dividend yield of at least 5%) and for risk we required a high payout ratio of over 100%. That indicates the dividend might be cut.

This left us with 15 stocks. That could be a wonderful starting point for research for many investors. But we will add one more filter to reduce the number of stocks. The number of stocks to research can be a significant limiting factor for individual investors since research takes time.

We added a requirement for low analyst expectations. In this case, we looked for stocks where analysts expect earnings per share (EPS) growth to be less than 5% a year, on average.

This screen is shown below.

screening tool

Source: FinViz.com

Three Potentially Overvalued Stocks

The criteria we used left us with just three stocks to consider.

Three Potentially Overvalued Stocks

Source: FinViz.com

These are simply stocks that passed a quantitative screen. Additional research could be useful. But these could be stocks that offer potential gains in a bear market because they are overvalued by some measures.

It is possible for value investors to consider flipping their preferred criteria to benefit in a market decline. The same principles that are used to find stocks to buy, in many studies, have been effective at finding stocks that are vulnerable to declines.

This fact could be especially interesting now as the market appears vulnerable to a decline.




This Is Why Smart Investors Study History

After the recent selloff in tech stocks, some investors are wondering if it is time to buy the FAANGs. The FAANG stocks are Facebook, Amazon, Apple, Netflix and Alphabet, parent company of Google. They led the market on the way up and have all delivered sharp declines to share holders.

But declines are often viewed as buying opportunities. That is the basis of the investment strategy known as buying the dips which means to enter a stock after it pulls back from its highs. The FAANGs have certainly dipped with losses of 20% or more. Apple is shown below with its 26% decline.

AAPL stock chart

History Favors the Bears

Traders often quote, or at least paraphrase, the European philosopher George Santayana who said, “those who cannot remember the past are condemned to repeat it.” In the stock market, there is a great deal to be learned from a study of the past.

In fact, the FAANG story could be leaving older investors with the feeling that they have seen this story before. In the late 1960s, instead of the FAANGs, investors talked about the Nifty Fifty.

The term Nifty Fifty was an informal designation for fifty popular large-cap stocks on the New York Stock Exchange in the 1960s and 1970s that were widely regarded as solid buy and hold growth stocks, or “Blue-chip” stocks.

These fifty stocks are credited by historians with propelling the bull market of the early 1970s, while their subsequent crash and underperformance through the early 1980s are an example of what may occur following a period during which many investors, influenced by a positive market sentiment, ignore fundamental stock valuation metrics.

Various sources assign different stocks to the group but many agree on many of the names. Lists were published by leading brokers of the day including Morgan Guaranty and Kidder Peabody. One list of the Nifty Fifty stocks is shown below.

NYSE Nifty Fifty

Source: Wikipedia

These stocks delivered great gains for a time but they fell quickly. In The Nifty-Fifty Re-Revisited, a paper by economists Jeff Fesenmaier and Gary Smith, the depth of the decline is easy to see. The authors noted,

“in the memorable words of a Forbes columnist, the Nifty Fifty were taken out and shot one by one. From their 1972–1973 highs to their 1974 lows, Xerox fell 71%, Avon 86%, and Polaroid 91%.”

As a group, the stocks performed relatively well in the long run. The table below shows the performance of different lists updated through 2001. The ratios show the performance relative to the S&P 500 with values above 1 indicating outperformance and valued below 1 showing underperformance.

wealth ratios

Source: The Nifty-Fifty Re-Revisited

He performance is close, “in comparison to the S&P 500’s 12.01% annualized return over this period, a portfolio of these 50 stocks would have had annualized returns of 11.64% (a frozen portfolio that is initially equally weighted) or 11.85% (rebalanced monthly to be equally weighted).”

But the gains are largely due to the performance of just a few stocks.

Returning to the paper,

“Only ten stocks on the Kidder Peabody list beat the S&P 500, but one did so spectacularly. Wal-Mart’s 26.96% annualized return over this 29-year period was the third highest in the entire CRSP data base.

The only stocks to do better were 28.94% for Southwest Airlines and 29.65% for Boothe Computer, now Robert Half International.

Perhaps, buying a high P/E stock is like buying a lottery ticket: the expected return is not good, but there is a chance of a huge payoff. Here, 80 percent of the Kidder Peabody stocks underperformed the market, but one (yes, one with a P/E above 50) hit the jackpot.”

Looking Ahead

It’s possible the FAANGs will be similar to the Nifty Fifty. That would mean the stocks carry additional down side risks and they should be avoided by bargain hunters. That is the opinion of two analysts recently featured in MarketWatch:

“Canaccord’s Martin Roberge and Guillaume Arseneau noted that [p]ortfolio managers haven’t seen any big hurt when it comes to that group of growthy stocks because year-to-date, some of those tech-focused names are still outperforming the market, they note.

Beaten-down Apple is still up nearly 3% year-to-date, against a 0.3% rise for the S&P.

“We expect the real pain will come when a clear rotation occurs. This rotation should get under way when it becomes clear that earnings growth for FAANGs and other technology names in 2019 do not live up to expectations,” said the Canaccord analysts.

And that second wave of selling should start in January when fourth-quarter results start rolling out, they say.”

The analysts could, of course, be wrong. But it could be best for conservative investors to wait for a few weeks before nibbling on the FAANGs. And then, perhaps Amazon and Netflix should be left for the just the most aggressive investors.

The reason for that is the high P/E ratios of those two stocks. The next table shows the P/E ratios of the FAANG stocks.

FAANG stocks

Source: TheIrrelevantInvestor.com

Although Amazon is growing, it is richly priced. The stock market expert Jeremy Siegel has important thoughts to remember on high P/E ratios. Siegel is a Professor of Finance at the Wharton School of the University of Pennsylvania and has studied market history covering hundreds of years.

Siegel noted of the Nifty Fifty, “It was so easy to forget that probably no sizable company could possibly be worth over 50 times normal earnings.” That would apply to Amazon and Netflix for now.

Apple, it could be argued, is reasonably valued and the same could be true for Facebook which dropped more than 40% from its high. But, remember that in the case of the Nifty Fifty, some of the stocks fell more than 90%. A few did deliver strong returns later but few beat the market.

And, that is important for investors to consider at this point. The FAANGs might have a bubble and delivered great gains for a time. But there will probably be new market leaders in the next bull market and it could be best to focus on finding the next FAANGs.




This Could Be the Best Way to Use Stock Charts

Stock charts show the price action. They simply record the history of trading and tell us nothing about the fundamentals or the financial performance of the company. Proponents of chart analysis sometimes argue the chart does incorporate the fundamental data.

They argue that the current market price reflects all of the information about the company. This is consistent with the Efficient Market Hypothesis (EMH), an academic theory that seeks to explain how stocks are priced in the market.

The theory does make some sense. When investors make a decision to buy or sell, they are acting on the information they have gathered. The current price reflects the collective decisions of millions of traders. Even a decision not to trade affects the price of a stock since that decreases the demand for the stock.

The chart presents the history of all of those individual decisions. In this way it is the running total of the collective decisions of the millions of traders. This is shown at a high level on the chart below.

QQQ weekly chart

The Chart Shows Urgency of Buyers or Sellers

We know there are more buyers than sellers when prices are rising. Technically, that is not a true statement. It is more of a way to think about the market action.

Technically, each buy order must be offset by a sell order. In other words when someone enters an order to buy 75 shares of a stock, there must be an order from some other investor to sell 75 shares of that stock.

This will be true sometimes but often, market makers jump in to fill open orders.

What is a ‘Market Maker’

A market maker is a market participant or member firm of an exchange that also buys and sells securities at prices it displays in an exchange’s trading system for its own account which are called principal trades and for customer accounts which are called agency trades.

Using these systems, a market maker can enter and adjust quotes to buy or sell, enter, and execute orders, and clear those orders. Market makers exist under rules created by stock exchanges approved by a securities regulator.

In the U.S., the Securities and Exchange Commission is the main regulator of the exchanges. Market maker rights and responsibilities vary by exchange, and the market within an exchange such as equities or options.

At times, high frequency trading (HFT) firms will make the market. HFT is a program trading platform that uses powerful computers to transact a large number of orders at fractions of a second. It uses complex algorithms to analyze multiple markets and execute orders based on market conditions.

Typically, the traders with the fastest execution speeds are more profitable than traders with slower execution speeds.

Whether it’s a market maker or an HFT firm, there are firms that facilitate trading and they take the other side of orders to make trading possible. Their goal is a small profit on the trade for providing liquidity rather than taking a position designed to benefit from a price move.

Because some volume will be associated with these activities, the urgency of buyers or sellers will determine the direction of the trend. When sellers want out of positions more urgently than buyers want in to positions, they will push prices down. And, the opposite factors push prices up.

The Value of Charts

As shown in the chart above, the emotions of traders are shown in the price history. The next chart is of the SPDR S&P 500 ETF (NYSE: SPY). It’s a monthly chart and shows the long term trend.

SPY monthly chart

One problem with this chart is that it uses an arithmetic scale. That means the distance between prices is equally spaced. That is the distance from $10 to $20 is equal and the distance between $10 and $110 is ten times greater than that distance from $10 to $20.

This type of scaling minimizes the appearance of decline on long term charts. To avoid that problem, a logarithmic scale should be used when viewing charts of monthly data. This is shown in the next chart.

SPY monthly chart

Now, the distance between percentage changes is equalized so the distance from $10 to $20, a 100% change, is the same as the distance between $20 and $40 or $50 and $100. With this view, the bear market of 2008 looks as devastating as it was.

While the scaling can be difficult to understand, it is important to consider. The log scale shows that price declines since the bear market ended in March 2009 have been shallow. The panicky selling of the past few months is still visible and should not be ignored.

When looking at a chart, it is important to remember that when buyers are acting with urgency, prices rise. When sellers are acting with greater urgency, prices fall. And, when the sellers and buyers are about equally motivated prices move sideways.

That’s where we seem to be now from a long term perspective. The chart above shows how selling gave way to buying pressure in 2009. Since then, there have been few down moves. The decline in 2011 is instructive to consider.

At that time, it appeared stocks were falling. But, then prices reached a new high. The new high was bullish. That could be the signal to watch for now. Until prices reach new highs, the chart shows buyers are not acting with a sense of urgency.

If prices drop much more, falling perhaps 15% to 20% below their all time highs, a selling panic could develop. Investors often sell when they lose 20% and that threshold is within reach on the charts. That could send price much lower and down moves do tend to be quick, and steep,

When looking at charts, it could be best to take a long term perspective and to use a log scale to put the price action into perspective. Unfortunately, right now, that view is not what many investors want to see. It is time for caution in the markets.



This Year Is Different: It’s Worse Than Many Investors Realize

Many investors believe diversification can help them reduce risks. This phrase, “reduce risks,” does have many possible meanings. But, for many investors reducing risk means minimizing losses. That’s why they trade off higher returns for reduced volatility.

Morningstar, a research firm known for their detailed analysis of mutual funds, explains,

“”Don’t put all your eggs in one basket” is a common expression that most people have heard in their lifetime. It means don’t risk losing everything by putting all your hard work or money into any one place.

To practice this in the context of investing means diversification—the strategy of holding more than one type of investment, such as stocks, bonds, or cash, in a portfolio to reduce the risk.

In addition, an investor can diversify among their stock holdings by buying a combination of large, small, or international stocks, and among their bond holdings by buying short-term and long-term bonds, government bonds, or high-and low-quality bonds.

A diversification strategy reduces risk because stocks, bonds, and cash generally do not react identically in changing economic or market conditions.

Diversification does not eliminate the risk of experiencing investment losses; however, by investing in a mix of these investments, investors may be able to insulate their portfolios from major downswings in any one investment.

Over the long run, it is common for a more risky investment (such as stocks) to outperform a less risky diversified portfolio of stocks, bonds, and cash. However, one of the main advantages of diversification is reducing risk, not necessarily increasing return.

The benefits of diversification become more apparent over a shorter time period, such as the 2007–2009 banking and credit crisis. Investors who had portfolios composed only of stocks suffered large losses, while those who had bonds or cash in their portfolios experienced less severe fluctuations in value.”

For example, over the long run, studies have shown that small cap stocks are among the best performing asset classes. But that asset also has the highest degree of risk. To reduce the risk, most investors add assets besides small cap stocks to their portfolio.

The chart below highlights the data that requires the trade offs.

data that requires the trade offs

Source: Morningstar

Clearly, a 100% investment in small caps would maximize wealth. But the early years shown in that chart demonstrate the risks. A 100% allocation to small cap stocks also would have maximized the largest loss. To reduce the risk of ruin, many investors diversify.

But This Year Is Different

Diversification has worked in the past because there is no reason to expect all, or almost all assets to move in the same direction at the same time. That means lower returns and low risks. But, this year has been unusual.

An article in The Wall Street Journal recently highlighted how unusual this year is.

“Data show global stocks and bonds could both finish the year in the red for the first time in at least a quarter-century, according to BlackRock,” an investment management firm with more than $6 trillion in assets under management.

But, that’s just two asset classes.

Deutsche Bank tracks 70 different asset classes and 90% of them are posting negative total returns in dollar terms for the year through mid-November. The previous high was in 1920, when 84% of 37 asset classes were negative. Last year, just 1% of asset classes delivered negative returns.

under pressure

Source: The Wall Street Journal

That makes this year highly unusual. More asset classes are showing losses right now than they did in 1929, the year that included the stock market crash that began the Great Depression. The peak of this data series during the Great Depression was 77% in 1931.

In the most recent bear market, the devastating decline in prices investors experienced in 2008, just 68% of asset classes declined.

What This Could Mean, For Now

Traders are fond of saying that in a crash, all correlations go to 1. Correlation is a mathematical definition of the relationship between two variables. It ranges from -1 to 1 with -1 showing a perfect inverse correlation (when one asset rises the other falls) and 1 shows a perfect correlation.

By saying correlations go to 1 in a crash, traders were noting the difficulty of making money during a stock market crash. That probably comes from their experience of seeing losses in their accounts on days when the market crash.

But, in years past, there were safe havens during crashes. In October 1987, when the Dow Jones Industrial Average fell more than 20% in one day in the largest one day decline in history, bonds went up. That’s not happening this year.

In fact, since the early 1980s, bonds have often moved up when stocks fell. That was largely because we were in a secular bull market for bonds. A secular, or long term, bull market in bonds means that interest rates are generally falling. And, rates fell from the 1980s, until now.

If we are in a rising interest rate environment, we can expect more losses in bonds. That makes the next bear market in stocks potentially different than other bear markets in recent years.

This time is different in that regard and it is different because of the globalization of markets. Hedge funds and other large investors buy and sell stocks all over the world, and many individual investors have the same capability in their accounts at popular discount brokers.

More investors trade foreign exchange now and commodities. These are typically markets where large investors follow trends and down trends will potentially be fueled by these investors in the next bear markets.

This market is different because it moves faster than ever thanks to high frequency trading and it is highly leveraged, in part because of low interest rates that allowed aggressive large investors to borrow at low costs.

These changes could explain why 90% of asset classes show losses this late in the year. This is also evidence that investors must have risk management strategies beyond diversification, potentially including plans for stop losses and other tools.





Retail Isn’t Dead, and Here’s a Trade for the Sector

It’s an old story by now. Retail is dead, and, at least to some degree it is because shoppers are tired of malls. No one seems to be quite sure what killed the regional mall. Maybe it was the long walk from the parking lot, or the long walk between stores. It could have been the lack of sales staff.

The basic cause, however, didn’t really matter to one of the most popular stories in the financial and general media over the past year. But the story might be a little overdone. In fact, retail might not be dead. In fact, it looked very much alive on the day after Thanksgiving.

According to The New York Times, “Retailers and analysts said Black Friday 2018 got off to a strong start — and all indications were that it finished strong, too.

“Adobe Analytics, reported that as of 8 p.m. Eastern, consumers had already spent about $4.1 billion on Black Friday — a 23 percent increase from the same period last year.”

Though the cold weather in the eastern United States may have kept some shoppers home, Mastercard SpendingPulse said that generally “online sales appear to be filling in any weather related soft spots in brick and mortar sales.” The clothing, electronics and interior furnishing sectors were seeing especially good traction, the analysis said.

The upbeat prognosis was supported, at least in part, by photos and videos posted Friday morning on Twitter, which showed long lines and bunches of bundled shoppers gathered at places including a Kohl’s in Mansfield, Mass., and the Mall of America in Bloomington, Minn.

“Stores are busy, there’s good traffic, the queues are manageable and well-staffed, and inventory levels appear to be good for the time of day too,” said Frank Layo, managing director of Kurt Salmon, which is part of Accenture Strategy. “Retailers helped themselves by starting promotions much earlier this year to spread out the holiday shopping traffic and mitigate chaos. Their efforts appear to be paying off.”

Trading the Trend

There are a number of reasons retail could prosper.

“The economy has been on good footing for the last few years” and federal income “tax breaks have flowed through to retail sales,” says D.J. Busch, a managing director at Green Street Advisors, a commercial research and advisory firm, recently told Barron’s.

Still, Busch warns that the quality and prospects of regional malls vary considerably. So, investors should do due diligence on properties these REITs own. Green Street’s concerns include the continuing onslaught from online retailers and “uncertainty about how the department store landscape is going to shake out,” he says.

Department stores, which are typically anchor tenants, historically have been growth drivers for malls, but their ranks have been thinned by bankruptcy filings, most recently by Sears Holdings, and retrenchment by Macy’s, J.C. Penney, and others. “

There is too much unproductive retail space in the U.S.,” Busch says. While the nation has 1,000 malls, he estimates that there’s enough demand to solidly support only 300.

This means that investors should be selective and Real Estate Investment Trusts (REITs) could be a way to obtain to access the sector without picking individual winners and losers.

REITs are popular income investments because tax rules require the structure to pay out at least 90% of their taxable income to shareholders.

Many regional mall REITs sport dividend yields in the mid-single digits or higher, as the accompanying table shows, and have solid economic prospects. For example, Simon Property Group (SPG) raised its earnings guidance for its current fiscal year, which ends next month.

Busch says that retail REITs “in general are going through a massive change,” partly to attract younger customers who want different facilities at malls than do older ones. That includes restaurants, movie theaters, and even bowling alleys.

He describes an industry that’s becoming increasingly bifurcated between top-notch properties that have capital to invest in growth and lower-quality ones that don’t. “Lower-quality properties are not getting better,” he says.

“High-quality properties are at least stable, if not improving.” Operators with deeper pockets are in a much stronger position. “The capital required to own and operate regional malls has gone up,” says Busch. It’s important to invest in REITs on the right side of that trend.

Finding Value in the Sector

REIT-owned regional malls’ same-store net operating income for properties open for at least one year rose 2.1%, on average, in the third quarter, their best showing in 18 months, according to the Nareit, a trade group that represents REITs of all stripes.

Calvin Schnure, senior vice president, research and economic analysis at Nareit, says that malls in which REITs invest are better positioned than those held by others. “There are more potential shoppers with more money to spend in the neighborhoods around a REIT-owned mall,” he maintains.

According to Nareit, the average household income within five miles of a REIT-owned mall is $66,148, compared with $60,877 for other malls.

And, Schnure adds, after anchor-store departures, REIT-owned malls “line up new tenants a lot faster than a mall that doesn’t have the population density and the higher incomes in the areas around it.”

Among retail REITs, Simon Property (NYSE: SPG) has returned more than 10% since the start of the year. Simon is the largest mall REIT by market capitalization and number of malls owned among the five shown in the table below.

shopping for REITS

Source: Barron’s

SPG has done well but remains well below its all time highs.

SPG chart

Investors should not extrapolate the trend from strong sales on one day. But they should consider that the death of retail is a story made for headlines. The truth is that there will likely be a shakeout in retail. There will be survivors, but they can be hard to find.

Instead of buying the stores, investors could consider the REITs that offer space to the stores. Even as some retailers meet their demise, the property owners like SPG still own assets that could be leased to new entrants to the market.

Plus, REITs offer income that could be beneficial in any market downturn.





Buffett’s Putting His Money Into This Sector

Warren Buffett isn’t always right. But he is right quite often. That’s why it can be profitable for individual investors to watch what Buffett is doing with his own money. It’s also important to remember his actions are more important than his words.

That’s why we watch Buffett’s actions and they are disclosed through his company. Like other large investors Buffett’s publicly traded holdings are subject to disclosure. Large investors are required to tell us what stocks they are buying and selling every three months.

Through these publicly available filings, some of the world’s most successful investors, a list which includes Warren Buffett, share the results of their research.

We don’t know the specifics of their investment decision process, but we do see the results of the process in these disclosures and that provides us with an opportunity to benefit from the research those steep fees pay for.

Among the filings large investors must make is SEC Form 13F, more formally called the Information Required of Institutional Investment Managers Form. 13Fs must be filed once a quarter by any investment manager with at least $100 million in assets under management.

By law, 13Fs must be filed with the SEC within 45 days of the end of a quarter. For example, forms must be filed by February 15 for the quarter which ends December 31 each year. So we don’t know what Buffett is doing in real time, in all cases. But, he must usually disclose large buys and sells almost immediately.

Trends In Holding Highlight A Favored Sector

Through Berkshire Hathaway, we can see that Buffett appears to be focusing his portfolio on large U.S. banks. Filings tell us what stocks the company owns, and Buffett does have additional managers involved in the portfolio.

However, from his public comments, it appears that he is still behind major investments and is most likely approving the large moves that reflect the portfolio strategy.

In the most recent 13f, Berkshire disclosed that the company bought more than $13 billion of bank stocks in the third quarter which ended on September 30. The largest disclosed buys included a $6 billion purchase of Bank of America (NYSE: BAC) and $4 billion in JPMorgan Chase (NYSE: JPM).

Berkshire has been an investor in JPM for some time, but the addition of BAC was new. After adding BAC, Berkshire now owns significant positions in seven of the country’s top ten banks.

Buffett's financial exposure

Source: Barron’s

Some readers may be wondering which of the ten largest banks Berkshire doesn’t own. They are:

  • Citigroup (NYSE: C)
  • Morgan Stanley (NYSE: MS)
  • Capital One Financial (NYSE: COF).

These three have heavy exposure to consumer loans, especially in the form of credit cards. Buffett may be signaling he believes this is a weak sector. But, that is speculation based on the fact that he avoided these three stocks.

Analysts Agree With Buffett

Barron’s recently reviewed the financial sector and found analysts to be as bullish as Buffett appears to be.

“Buffett’s investments offer validation for what we see as the value in the group,” says Mike Mayo, a banking analyst with Wells Fargo. “Banks are less cyclical than they have been in decades and have more resilient earnings streams because of improved financial discipline and risk control.”

He sees earnings growth of 50% or more for JPMorgan and Bank of America over the next four years.

The report noted that Buffett “may see what Mayo and other bulls do: a group that has lagged behind the market despite strong earnings growth and the most generous capital returns of any major industry.

Earnings at large banks are expected to rise about 40% this year. With income rising and stock prices generally lower, bank valuations have contracted.

Large banks now have an average forward price/earnings ratio of just 10.2, against a forward P/E of 12.6 at the start of the year, based on 22 institutions covered by Barclays analyst Jason Goldberg.

“Investors can get good earnings growth and good capital returns at a discounted valuation relative to the overall market,” Goldberg says. “Just because we’re late in the cycle doesn’t mean we’re at the end of it.” He sees 9% growth in bank earnings per share in 2019.

John McDonald of Bernstein estimates that mid- and large-cap banks will return about 100% of their earnings to holders in dividends and buybacks in the year ending in June 2019, up from 60% in 2015.”

Trading Alongside Buffett

Besides owning large stakes in the seven big banks, Buffett also has a large position in American Express (NYSE: AXP) and some smaller bank positions. Altogether, Berkshire owns about $85 billion worth of financial stocks, more than 40% of Berkshire’s total equity holdings of $200 billion.

Investors could gain exposure through an exchange traded fund such as Financial Select SPDR ETF (NYSE: XLF).

XLF daily chart

The ETF sold off sharply in the recent market decline.

Or, investors could consider Buffett’s most recent addition to the portfolio, BAC.

Morgan Stanley analyst Betsy Graseck agrees with Buffett on BAC. She sees 16% growth in 2019 earnings per share and an 18% gain in 2020, driven equally by operating profits and stock buybacks. In a client note after the third-quarter report, she urged investors to “dig in.”

Like XLF, BAC has sold off in the recent market decline. The long term chart shown below indicates the stock could be near the lower end of a trading range, or at a significant top.

BAC chart

The weekly chart of BAC demonstrates the risks of the sector. There is significant downside and not everyone has the ability to sit through large declines like Buffett does. But, the financial sector is obviously one Buffett is interested in.

Investors could, of course, also invest directly in Berkshire Hathaway but that is an expensive investment. Given the risks, it could be best to put stocks like BAC on a watch list and consider buying when the market shows signs of rebounding.

Like Buffett, it is important to plan for the downturn and be positioned to benefit. He doesn’t sell everything in a bear market and individuals might not be best served by panicking. It could be best to think like Buffett and add to long term positions.