Robo-Advisors Are Desperately Clinging To A Dangerous Dogma

I’ve recently argued that the success of passive investing potentially sows the seeds of its own demise. Patrick O’Shaughnessy also made a similar point recently and probably a bit more eloquently. But, to dig deeper into the push towards passive, there’s one big problem I have with virtually every one of the major robo-advisors that very few folks seem to be talking about. That is they all seem to advocate a heavily overweight position in equities, and for the most part this is skewed towards U.S. equities.

For example, below is the allocation WealthFront would put me in. It’s 91% in stocks, 49% U.S. stocks and 42% foreign, and 9% muni bonds. (This is their taxable allocation but the retirement allocation is very, very similar.)

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I assume this massive equity overweight is simply based on the, “stocks for the long run,” dogma that everyone has bought into in recent years. The trouble with this is that it fails to take into account the simple fact that, in recent years and across a wide variety of time frames, bonds have outperformed stocks and with far less volatility, or what some might call, “risk.” As The Economist points out, “there was a point in 2011 when equities had lagged Treasury bonds over the previous 30 years.” 30 years!

Intrigued, I decided to run some of the numbers myself. The chart below tracks the difference in performance between Vanguard’s S&P 500 index fund versus their long-term treasury fund. It dates back to the start of 1999; that’s as far as will let me go. Notice that since then, bonds have nearly doubled up on the performance of stocks and this includes some of the greatest years in stock market history! This time frame is especially compelling to me because stocks are currently valued, according to the Buffett yardstick and a few other valuable measures, just as highly today as they were back in 1999-2000.

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We can also just look at the past 10 years. Stocks have had an incredible run recently; surely they’ve outperformed bonds over the past decade. Nope. Bonds win again and, if you owned them instead of stocks, you felt much better about your investments during the financial crisis and were thus much more likely to stick with your investment strategy through that difficult period.

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So it’s fascinating for me to see so many hang on so fiercely to the idea that buying and holding U.S. stocks over any and all time frames is the way to go, despite their much greater volatility and lagging performance in recent years. And to see this dogma take form across every robo-advisor I’ve found just validates how deeply ingrained this dogma has now become.

In fact, WealthFront is so in love with the idea they wouldn’t put any of my money at all into long-term treasuries. Why not? Because they’re clinging to a dogma that perhaps worked at one point a long time ago, when stocks were more consistently fairly valued. But this dogma hasn’t worked for quite a long time now. Maybe this is why Ray Dalio’s firm, which has adopted just the opposite dogma – overweight bonds versus stocks because they offer better risk-adjusted returns over the long-term, has become the largest hedge fund firm by assets in the world.

Now I’m not saying you should forget stocks and put all your money in bonds. But there is a wonderful case to be made for diversifying across a variety of asset classes. WealthFront makes it appear as if they’re doing so. They’re not. In fact, they would just put all my money in the stock market and say, “good luck!” True diversification is something very, very different and also something far more valuable. Sadly, it may take another painful bear market in equities before the robos learn this important lesson.

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Economy, Investing, Markets, Posts

Why Comparing Dividend Yields To Interest Rates Is A Dumb Idea

I’m hearing a lot of folks these days draw attention to the fact that the dividend yield on the S&P 500 (2.17%) is now greater than the yield on the 10-year treasury note (1.7%). In doing so, they are obviously making the case that stocks are undervalued relative to bonds.

There are a few problems with this line of thought. First, just because the dividend yield is currently higher than the 10-year treasury yield doesn’t mean stocks will necessarily outperform risk-free treasury notes going forward. If you hold that treasury note to maturity you know exactly what you’re going to get over that time. The same can’t be said for owning stocks which carry far more risk.

To get an idea of what to expect from stocks, you need to study valuations. Personally, I like to use the Buffett Indicator (market cap-to-GDP) because it’s about 90% negatively correlated to 10-year future returns. History shows that the higher starting valuations are the lower your future returns will be and vice versa. This has been true regardless of where interest rates have been or where they are going.

Right now valuations, based upon this measure, suggest the total return from owning stocks is likely to be less than the risk-free return on 10-year treasury notes. So why, you might ask, should you take far more risk in owning stocks when you are likely to do better in risk-free treasuries? Good question.

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Some might say that high valuations today are justified by low interest rates. And this is really the case folks are making when they compare the dividend yield in owning stocks to the interest rate on the 10-year treasury note. Well, there are a few guys plenty smarter than I am that have demonstrated why this is such a, ‘dumb idea.’ I would mainly direct you to Cliff Asness’ now classic treatise on the subject, “Fight the Fed Model.”

To boil it down to the simplest argument, Cliff shows that low interest rates imply low future inflation and concomitant low earnings growth. High valuations in equities, on the other hand, imply high future growth. Thus, the idea that low interest rates, which imply low growth, somehow justify high valuations, which are completely dependent upon on high-growth, is faulty, at best.

But probably the best real world example of the inanity of this argument is the experience of Japan over the past couple of decades or so. The interest rate on the Japanese 10-year bond in 1990 was 7%. At the same time, the Nikkei stock market index stood at 39,000 and carried a CAPE ratio of 90. Today, that yield has fallen from 7% to below zero. At the same time, the Nikkei has fallen 60% to 16,000 and a CAPE ratio of 25.

Over the past 25 years, then, both interest rates and stock market valuations have fallen together. According to the Fed Model, this should never happen. Intuitively, though, it makes perfect sense. Japanese inflation and economic growth have fallen dramatically over that time so both of these asset classes have reflected this development in their valuations.

If the Fed Model were a viable way to forecast equities, Japanese stock market valuations should have soared in reaction to such an massive drop in interest rates. In fact, according to the Fed Model, Japanese equity valuations should have no upper limit today. At the very least, they should be trending higher as interest rates have trended lower yet just the opposite has happened. Sadly, even massive buying of equities by the Bank of Japan, which now owns more than half of the country’s outstanding equity ETFs, hasn’t been enough to make this theory a reality.

So even though it’s been demonstrated to be false in both the academic realm an in the financial markets, that clearly hasn’t stopped investors from continuing to embrace it and making costly errors in the process. But before you go buying stocks believing that falling interest rates will support prices you might want to ask yourself this very basic question: “Are plunging interest rates and, perhaps more importantly, a plunging yield curve bullish signs for economic and business fundamentals?” Because those are what really matter to stock market valuations, not some theory that both defies common sense and also has no historical validation anywhere in the real world.


2 Questions To Ask Yourself If You’re Worried About Your Investments Right Now

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” -Benjamin Graham, The Intelligent Investor

Are you concerned about the markets right now? Do you worry about how your investments might fair in a prolonged decline? If so, I encourage you to think them in terms of that quote above.

According to Ben Graham, Warren Buffett’s teacher at Columbia Business School, an investment must meet two simple criteria:

  • First, does it offer safety of principal? In other words, ‘is my initial investment protected somehow such that I’m likely to get it back even if my analysis is faulty?’
  • Second, will it provide an adequate return? In other words, ‘am I being adequately compensated for the risk I’m taking here?’

If you can honestly answer both of these questions with a confident ‘yes’ then you should have no worries.

If you answer either of these with a ‘no’ then you should probably have some sort of stop loss (like the primary trend) in place to make sure you don’t let a speculative position hurt you too badly if it goes against you.

Finally, if you don’t know where to begin in answering these questions then you’re clearly operating outside your own “circle of competence.”

In this case, you probably want to educate yourself a bit more so that you understand how to answer these questions and then focus your efforts going forward on investments that are within your own ability to analyze.

And why not start right where Buffett did with, “The Intelligent Investor“?


Is It Time To Buy Stocks? Not If You’re A Long-Term Investor

The stock market is off to its worst start in history this year. Not only that, the losses over the past few weeks have come amid one of the most rapid declines over the past few decades. This has some coming to the conclusion this has to be buying opportunity.

I’ve seen plenty of headlines and articles lately featuring advisors suggesting investors ‘stay the course’ or even ‘buy into the depressed prices.’ But is this really good advice for the average investor?

There are a couple of questions to be answered here. First, how ‘depressed’ are prices? Are stocks actually cheap? I think most investors would be shocked to find out that, not only are stocks not yet cheap, they are, in fact, still very expensive.

Using Warren Buffett’s measure of total market cap-to-GDP, stocks are still well above their long-term average valuation even after the declines we have seen recently. In fact, the only time they were more expensive than today, even after the recent selloff, was during the height of the dotcom bubble in 1999-2000.

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Furthermore, “well above fair value,” carries a couple of unpleasant implications. First, it means returns going forward are going to be well below average. “The price you pay determines your rate of return.” Pay a high price and you are guaranteed a low rate of return.

The chart below shows the expected rate of return from current valuations compared to the yield on the 10-year treasury note. Right now investors are taking much greater risk for less return than can be gained from the “risk-free” rate. This makes it hard to justify stocks as an, “investment,” currently.

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Second, paying well above average valuations means you expose yourself to above average risks. If stocks fell back to their long-term average valuation based on this measure, it would mean about a 40% decline from current levels. For valuations to actually become ‘depressed,’ it would take an even greater decline. And the history of valuations and drawdowns validates this risk.

So simply based upon valuations it’s not a great time to buy stocks. However, Warren Buffett has also famously advised investors to, ‘be greedy when others are fearful.’ Have investors become unduly fearful which would mean it’s time to get greedy?

In the short-term, one could argue we are seeing a certain amount of fear in the markets. CNN’s fear and greed model recently got pretty low. DSI, another sentiment indicator, also shows investors have become pretty bearish recently.

DSIChart via Nautilus

It’s very important to note, however, that these are very short-term indicators. For this reason, they are probably only appropriate for short-term traders. On a long-term time horizon, we are only just now coming off of one of the extended periods of bullish euphoria in history for the stock market. Is a bit of short-term fear enough to form a long-term bottom?Screen Shot 2016-01-21 at 9.28.20 AMChart via Yardeni

One way to look at longer-term investor sentiment is to observe the total amount of leveraged speculation in the markets relative to the overall economy (as measured by margin debt-to-GDP). When leveraged speculation is very high, investors can reliably be considered greedy and vice versa.

Currently, the amount of leveraged speculation relative to the economy is about as high as it was just prior to the dotcom bust and the financial crisis. In other words, very rarely have investors ever been more greedy than they are today, which should remind you of the other half of Buffett’s advice: ‘be fearful when others are greedy.’

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All in all, it’s difficult to make the case it’s time to buy stocks today for anyone other than a very short-term trader. They remain very highly valued and investors have not become fearful yet on a long-term time frame by any stretch of the imagination.

These are two of the reasons I have been recommending investors consider reducing risk in their portfolios over the past year or so. If you’re a long-term investor, it’s still not a great time to buy. Considering the poor returns and elevated risks stocks pose currently, you may want to do just the opposite in order to match your risk tolerance and time frame to this reality.


5 Different Technical Tools For Traders In One Chart

Last fall I wrote a post titled, “This Is Now The Worst Possible Environment For Stock Market Investors.” My point then was that stocks were very expensive, sentiment was exuberant and the trend had shifted to the downside. In other words, all three of the major components of my investing strategy were bearish.

None of this his has changed (though stocks may bounce after the persistent selling we have seen recently). But, in that post, I shared a version of the chart above which became fairly popular so I thought I’d explain what’s going on it and the individual components noted in it.

First, the horizontal blue lines show a Fibonacci target for the S&P 500 at 2138 (2015’s high was 2134.72 on May 18). This target is calculated simply by projecting a 61.8% (the Fibonacci Ratio) extension of the bull market gains from 2009 to 2013, the point at which we finally broke above the old 2007 high. (Apple reached a similar target about a year ago which was a decent sell signal, as well.)

The vertical blue lines simply measure the time between major peaks. The span from the March 2000 peak to the October 2007 peak was seven years and seven months. Seven years and seven months from October 2007 was May 2015, the exact month the S&P 500 peaked last year.

I’ve also highlighted the momentum divergences on the chart. While prices made higher highs in March of 2000 and October of 2007, RSI was making lower highs, suggesting momentum was waning. The MACD crosses at the bottom of the chart were also decent sell signals on those occasions. Both occurred again last year in very similar fashion to those prior occurrences.

The “9” and “13” on the chart are DeMark Sequential signals. The 9 signifies a completed sell setup and the 13 is the completed sell signal. These are essentially the inverse of the buy signals I highlighted in March of 2009. (I also used these as part of my sell signal in Apple.)

Finally, I have included a 10-month moving average on the chart, roughly equivalent to the 200-day moving average. This may be the easiest signal for individual investors to monitor. It’s also Paul Tudor Jones single most important indicator. When prices close above this average, stocks are in an uptrend. Below and stocks are in a downtrend.

Do these things work on their own merit or do they work because so many traders watch and use them? That’s the age-old question posed regarding technical analysis. However, it’s fairly plain to see that simply paying attention to the overall trend can make a massive difference in your investing success by keeping you on the right side of the market. If it’s good enough for Paul Tudor Jones, it’s good enough for me.