2 Popular Minimum Volatility ETF Strategies

Tuesday, August 21st, 2012

by Del Stafford, iShares

By now, you’ve probably heard about the benefits of a minimum volatility (or, “min vol”) strategy and the ETFs that seek to deliver it, but you might still be wondering how to use these funds in a portfolio. One common misconception is that min vol ETFs are a tool designed for volatile markets specifically, but this simply isn’t the case. In fact, the two minimum volatility ETF strategies we see our clients using most often are both strategic, long-term plays that have nothing to do with current market volatility. These two strategies are: 1) lowering overall portfolio risk or 2) increasing allocation to equities without increasing overall portfolio risk.

Lower overall portfolio risk
Investors who are trying lower their overall portfolio risk can simply replace their existing market capitalization based equity investment with the corresponding minimum volatility ETF. For example, let’s say a client’s portfolio consists of 60% equity and 40% fixed income. Let’s use the MSCI USA Index to represent “equity” and the Barclays US Aggregate Bond Index to represent “fixed income”. The client would replace the 60% allocation to the MSCI USA Index with a 60% allocation to the MSCI USA Minimum Volatility Index.

This strategy would result in a ~20% reduction in portfolio risk since inception of the analysis (June 2008) and an even greater reduction in risk in the nearer term (see below).

Increase allocation to equities without increasing overall portfolio risk
Like the example above, an investor looking to employ this strategy would start by replacing their existing market capitalization based equity investment with the corresponding minimum volatility ETF, but then they would also increase their allocation to the minimum volatility ETF while decreasing their allocation to fixed income. After replacing the MSCI USA Index with the MSCI USA Minimum Volatility Index, the investor would increase their allocation to the MSCI USA Minimum Volatility Index and decrease their allocation to the Barclays US Agg Bond Index until the total portfolio risk reaches the level they desire. For example, they may seek a level of portfolio risk that is just below the since inception risk of the Original Portfolio, which is 12.15%.

This strategy allows the investor to increase their allocation to equity by 17% while obtaining a consistently lower level of risk than the Original Portfolio (see below).

While there are certainly other ways to employ minimum volatility ETFs in a portfolio, our team has found that these two strategies are the most commonly used among our clients.

Source: Markov Processes International (MPI)

Del Stafford, CFA is the iShares Head of Product & Investment Consulting and a regular contributor to the iShares Blog. You can find more of his posts here.

The iShares Minimum Volatility Funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Copyright © iShares

Tags: Barclays, Bond Index, Case In Fact, Common Misconception, Current Market, Equity Investment, ETF, ETFs, Fixed Income, Inception, Investor, Investors, Ishares, Market Capitalization, Market Volatility, Msci, Portfolio Risk, Risk 2, Usa Index, Volatile Markets, Volatility Index
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Guest Post: Major Sell Signal Triggered

Wednesday, July 25th, 2012

by Lance Roberts, Street Talk Live

For some time now we have been warning about the danger to portfolios given the deteriorating fundamental, economic and technical backdrop in the markets.  Our warnings, for the most part, have been ignored as individuals continue to chase stocks in hopes that “this time will be different”, and somehow, stocks will continue to ramp higher even though all three support legs are weakening.  Currently, it is the imminent arrival of the next round of Quantitative Easing (QE) that keeps “hope” elevated but further Central Bank intervention is unlikely in the near term leaving the markets at risk of a further correction.

My job is to analyze the trend of the data, both economic, fundamental and technical, to build a frame work of possibilities and probabilities about what might happen soon.  Like any good poker player before making a “bet,” which requires putting my capital at risk of loss, I want to make sure that the odds are in my favor of winning.  If I am highly confident of success – I bet a lot.  If not – I do not.  The same philosophy goes into managing money.  Wall Street tells you to be invested all the time because that is how they make money.  However, the reality is that investing is very akin to playing poker – you are making bets today based on the possibilities of some future outcome.

The reason for this framework is that I have been negative on the markets since early April.  The weight of evidence has clearly been negative.  While the mainstream media continues to look for glimmers of “hope” – hope is not an effective investment strategy.  However, when the flow of data changes and price action becomes more constructive – my outlook will also. (Read “Thoughts On Long Term Investing”)

For new readers, welcome to the site, here is a brief compendium of previous articles which have been guiding our readers through the current market correction process that began in early April:

• April 9th – The Correction Has Started
• May 21st – Sell Signal Confirmed – Initial Targets Set
• June 6th – Forecasting The Rebound And Bottom
• June 26th – June Rally Complete – Summer Sell Off Ahead?
• July 3rd – Coming This Fall The Best Time To Invest

Major Sell Signal Is In

This bit of history leads us to our latest, and most important, sell signal to date.  With the economy continuing to weaken, corporate earnings, showing severe signs of strain and the Eurocrisis emerging once again – the risk at the moment is clearly to the downside.  The continued deterioration, in both the fundamental and technical frameworks, has significantly increased the risk of further equity market declines. 

The decline in the markets on July 24th pushed the two main moving averages that we follow into negative territory initiating a major SELL signal for the markets.  These major sell signals should not be ignored.  The first chart plots our two moving averages relative to the S&P 500 over the last 12 years.  During this time frame there has only been 7 “sell” and 6 “buy” signals.  As with all investment strategies and disciplines there is always the possibility of getting a false signal.  The same is true for this particular indicator.  Since 1930, there have been a total of 51 major “sell” signals of which 9 gave a false reading translating into a 17.6% failure rate.  As I said, no indicator is perfect, but as an investment manager I am willing to make investment decisions based on an indicator that has an 82% success rate.

More importantly, as shown in the chart, this strategy helped us avoid the bulk of the last two recessionary market debacles.  The problem is that while it is easy to assume that the current correction could be shallow, like previous two summers as the Federal Reserve stepped in to prop up asset prices, there is always a chance that it could be a much bigger correction.  Following the signals previously would have limited downside risk while keeping you primarily invested in for the majority of bullish trends.

The next chart shows the similarities of the 2011 and 2012 markets.  In both cases rallies in June, post a May decline, led to sloppy sideways trading in July.  The major “Sell” signal occurred on August 5th of 2011 as the markets began a steep sell off.  While there is no guarantee that the market is about to plunge towards the 1200-1250 level this August – the striking similarities of market action certainly does suggest a more cautionary stance be taken.

Sell Into The Bounce

Technical signals must be put into “context” based on current market conditions. In order to strip out the “noise” in our analysis we use weekly instead of daily price data.  This smoothing of the daily data allows for better clarity of the trends in the market.   However, due to this smoothing process by the time a signal is given the markets are generally overbought, or oversold, on a daily basis and are generally close for a reflexive bounce.  That bounce should be sold into.

The problem for most investors is that when the market bounces in order to correct the short term oversold condition they assume that the “sell signal” was incorrect.  More than 80% of the time, as our data shows, the market will bounce and then decline to lower levels.  Therefore, the rules are simple:

• In negative trending markets – sell rallies.
• In positive trending markets – buy dips.

The technical and fundamental setup is currently a negatively trending market.  It is very likely that, in the current environment, we will retest the May lows, if not ultimately set new lows, in August.  Those lows will likely coincide with further weakness in the economy which should be the perfect setup for the Fed to launch a third round of Quantitative Easing.  Should that occur that will provide the best opportunity to take the cash we are holding in reserve and increase equity exposure at lower price levels.

The caveat to all of this is if the Fed acts early with QE 3 at the end of this month.  I don’t think this is likely but it is a possibility.  In that event the boost to asset prices will reverse the current signal and we will need to add equity exposure back into portfolios.  However, until then, with the major “sell” signal in place it is more important to remain cautious, and conserve investment capital, until a better risk/reward opportunity presents itself.

Tags: April April, Backdrop, Bet, Central Bank Intervention, Current Market, Data Changes, Frame Work, Glimmers, Hope Hope, Imminent Arrival, Investment Strategy, Lance Roberts, Mainstream Media, Managing Money, Playing Poker, Poker Player, Probabilities, Qe, Support Legs, Term Investing
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The Price Action is Not QE-Like

Wednesday, July 25th, 2012

Think back to those QE days when the market went up day after day after day for months on end without more than a single pullback of more than 1%.  Yes, the good old days.  Certainly, there was a lot of angst in the air not because prices were going higher but because to participate in the rally you had to hold your nose, jump in and pray that the end wasn’t tomorrow.

During the QE days, the market never pulled back and it only went up.  Looking at the price structure — which is the path that prices take as they swing from low point to high point and back again — we note a series of higher lows.  See figure 1, a 60 minute bar chart of the S&P Depository Receipts (symbol: SPY).  The black dots are key pivot points, which are the best areas of support (buying) and resistance (selling).

Figure 1. SPY/ 60 minute

The area inside the gray bars is the time frame from December 9, 2011 to March 1, 2012.  During that time, the market blasted off because of the belief in Operation Twist and the European Long Term Refinancing Operations.  What we note is 12 consecutive, higher key pivot points over 3 months, which is an extraordinary amount of time without a pullback that breaks support.  This kind of price action was also seen during QE2 (12 consecutive, higher key pivot points over 3 months) and QE1 (8 consecutive, higher key pivot points over 3 months) .

Now contrast this with the current market environment.  See figure 2, a 60 minute bar chart of the SPY.

Figure 2. SPY/ 60 minute

Since the bottom in June, prices have traveled within a well defined trend channel, and it is only over the past 2 days that prices have fallen from this channel.  But more importantly, the pattern of higher lows, which is characteristic of unabated buying seen during Operation Twist and the QE’, is not being seen.  In fact, prices have struggled and appear to be rolling over.

Tags: Amount Of Time, Amp, Belief, Current Market, Depository Receipts, Dots, Gray Bars, High Point, Lows, March 1, Market Environment, Pivot Points, Price Structure, Pullback, Qe, Rally, Refinancing, Resistance, Time Frame, Trend Channel
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Emerging Markets Radar (July 16, 2012)

Saturday, July 14th, 2012

Emerging Markets Radar (July 16, 2012)

Strengths

• China’s second quarter GDP was up 7.6 percent, in line with the market expectation of 7.7 percent. Asia markets were up after the data release. Fixed asset investment growth accelerated on stronger infrastructure, increasing 20.4 percent year-over-year for the first half of the year versus the forecast of 20 percent. Consumption was stable, rising 13.7 percent in June, slightly down from 13.8 percent in May, but better than the estimated 13.4 percent. Clearly, China is growing at a slower speed, which makes it possible for the government to stimulate with easing monetary and fiscal policies.
• China’s June new loans were RMB 919.8 billion versus the estimate of 880 billion, but short-term lending is still high at about 50 percent. Household lending was 30 percent, which explains why housing sales went up 41 percent in June.
• Korea unexpectedly cut its benchmark interest rate by 25 basis points to 3 percent.
• For the China Region Fund we find that the current market is offering plenty of investment opportunities of growth at a reasonable price (GARP) in the China region. The Fund’s portfolio currently has an average dividend yield of 3.4 percent with average revenue growth at 25 percent.

Weaknesses

• China’s June industrial production was up 9.5 percent, lower than the estimate of 9.8 percent, but just slightly down from 9.6 percent in May. The growth of industrial production was still restrained by enterprises’ destocking and deleveraging, which has negative implication for the economic growth. As a leading indicator to China’s GDP growth, power output is in decline, flat in June, compared to 2.7 percent year-over-year growth in May.

Opportunities

Acceleration in Chinese Bank Lending Should Help Sustain Property Transaction Recovery

• After two interest rate cuts, China housing transactions have increased as home buyers can borrow at lower rate. In the meantime, the People’s Bank of China, the central bank, has encouraged banks to lend to first-time home buyers. The increased new loans in June are a positive sign that new loans are back on an upside trend.

Threats

• Although China’s June economic numbers are showing a steady economic growth, the trend can be on the downside, which makes the market believe the Chinese government will continue to spend to backstop growth weakness.

Tags: Asia Markets, Asset Investment, Bank Of China, Basis Points, Benchmark Interest Rate, China Region, Chinese Bank, Current Market, Dividend Yield, Emerging Markets, Fiscal Policies, Garp, GDP Growth, Housing Sales, Implication, Investment Growth, Investment Opportunities, Leading Indicator, Property Transaction, Quarter Gdp
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This Time is Different ….This is Not What You Think

Thursday, May 3rd, 2012

by Guy Lerner, The Technical Take

The very erudite Dr. John Hussman is as good as a market researcher as there is, and he defines a set of market conditions that when they come together generally leads to poor equity performance.  One of Hussman’s syndromes is the “overbought, over-bullish, overvalued, and rising yields syndrome.”

My own research would agree this assessment.  The markets tend not to do well when yields are rising and when investor sentiment is overly bullish.  These constructs have formed the basis of some of my most basic and robust trading models, and this combination of excessive investor bullishness and rising yields is at the core of my “Will Robinson” signal.  Will Robinson was the young boy on the 1960′s TV show, “Lost in Space”, and when he was in danger, his robot friend would exclaim, “Danger, Will Robinson, danger!”  So when I see this constellations of market findings, it is usually danger ahead for the equity markets.

So what does this have to do with the current market environment?  From this perspective very little as I currently don’t find these conditions in the current market environment.  Over the past couple of weeks, bullish sentiment (and market “over -boughtness”) has been unwinding slowly, and as my bond trading is positive (i.e., lower yields), I am not expecting yield pressures to be a factor.  Valuations, as measured by the Shiller 10 year P/E ratio or cyclical adjusted PE ratio, remains lofty, yet truth be told, valuations are a poor market timing tool anyways.

But while Hussman is “right” about the “overbought, over-bullish, overvalued, and rising yields syndrome” and market weakness, the opposite set of conditions is probably a market positive.  The current market environment shows more bulls than bears (but necessarily extreme) and falling yield pressures.  Historically, this combination of factors has been associated with some of the more memorable price runs in recent market history.  For example from March, 1995 to February, 1996 under similar conditions, the SP500 gained approximately 30%.  There was a repeat from May, 1997 to May, 1998 when the SP500 gained 34%.  This set of conditions were also seen at the 2003 market bottom, and the late 2006 through 2007 blow off market top.  Needless to say, it does take bulls to make a bull market, and by the way, it does help to have falling interest rates.  So maybe this is why investors are currently all lathered up.

But I would contend that you need to be careful for what you wish for as something has happened to the relationship between bonds and stocks over the past 2 years.  In 2010 and 2011, falling bond yields have not been beneficial to equities.  Rather, falling bond yields, as measured by bullish signals from our bond model, have been a sign of economic weakness, and have led to crushing (i.e., poor) returns in the equity markets.  When bond yields were falling and when investors were more bullish than bearish, the SP500 had two draw downs exceeding nearly 15%.  From the 1970′s to the late 1990′s it was rare (< 5% occurrence on 70 unique instances) for such market conditions to even have a draw down greater than 6%.

I suspect investors remember those good old days from the 1990′s when the Federal Reserve had the luxury to put the pedal to the metal and keep rates low despite extreme investor enthusiasm and market overvaluations.  They don’t have that luxury now, and the only reason for the Fed to continue act in such a fashion is economic weakness.  Our bond model is currently positive suggesting lower yields.  While investors want to hark back to the “good old days”, I don’t think that is the correct interpretation.  I believe this signal suggests economic weakness as it did in 2010 and 2011.  This time is different as lower bond yields won’t see a blast off in equity prices.

Copyright © The Technical Take

Tags: Bond Trading, Bullish Sentiment, Constellations, Constructs, Current Market, Danger Will Robinson, Dr John, Guy Lerner, Investor Sentiment, John Hussman, Lost In Space, Market Environment, Market Researcher, Market Timing, Market Weakness, Pe Ratio, Robot Friend, S Tv, Syndromes, Timing Tool, Valuations
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First Quarter Asset Class Performance (Bespoke)

Monday, April 2nd, 2012

Below is our key ETF matrix that highlights the performance of various asset classes during the first quarter.  As shown, the best performing ETF in the entire matrix was the Financials (XLF) with a first quarter gain of 21.5%.  India (INP) ranks second with a gain of 21.13%, followed by Germany (EWG) at 21.12% and the Nasdaq 100 (QQQ) at 20.99%.  The worst performing ETF in Q1 was natural gas (UNG) with a decline of 38.89%.  The 20+ Year Treasury ETF (TLT) and the Yen (FXY) did the second and third worst with respective declines of 7.46% and 7.15%.

Looking for more info on this market?  Each Friday, members of our Bespoke subscription services receive our Week in Review newsletter.  This report provides Bespoke’s current market thoughts through commentary and the unique graphs and charts that our clients have come to love.  If you’re looking to get a better grasp of the market, subscribe to one of our membership packages today and download our Week in Review newsletter.

Tags: asset class, Asset Classes, Class Performance, Current Market, Decline, Declines, Ewg, First Quarter, Graphs And Charts, Grasp, India, Inp, Market Thoughts, Membership Packages, Nasdaq 100, Natural Gas, Qqq, Subscription Services, Tlt, Xlf, Yen
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Uncovering Equity Yield Traps

Wednesday, March 28th, 2012

by Stephen Petty, American Century Investments

As the low interest rate environment persists, numerous uncertainties continue to abide even as new marketplace concerns begin to emerge. This observation is especially applicable to certain investors that are desperate for current income (yield) opportunities. In their search for equity investments providing attractive returns, many will opt to screen for opportunities using current yield as the main filtering criterion. In situations such as this, those in hot pursuit of rich rates find themselves at risk of falling prey to nasty yield traps. Although yield traps exist in the fixed-income space, this piece focuses on yield traps involving equities.

Pursuing Equity Yield in Today’s Environment

An investment’s total return, at least potentially, has two sources: income and capital appreciation or depreciation. Income can be enjoyed from interest paid by fixed income investments, distributions, or equity dividends. Capital appreciation or depreciation consists of the net change in the market price of an asset. To calculate current yield, annual income is divided by the current price of the security. The stress on “current” in the term current yield is very important. Just because a bond pays a fixed coupon or a stock pays a stated dividend, it does not mean the actual rate of return (current yield) from these income sources will stay constant over time.

Current Yield = annual income (e.g., dividends, interest)
current market price of the security

The current market price is reflected in the denominator of the above current yield formula. As the security’s price rises, the current yield goes down. When the price falls, the current yield goes up. Yield is subject to fluctuation over time as market conditions change and price adjusts to reflect those changes.

Many investors are pursuing yield opportunities because of current financial considerations and global economic conditions. They are doing this in the aftermath of the 2008 Financial Crisis. After seeing equity and other risk-asset nest eggs suffer depreciation of 30% to 40% or more, many shunned the pursuit of capital appreciation and opted instead for income opportunities. Shell-shocked equity investors have been very gun-shy since 2008 and riskier assets have had trouble gaining traction given the on-again, off-again periods of stock market volatility.

For some, this can be viewed as pragmatic, especially in light of the fact that losses for the S&P® 500 Index were over 38% for 2008. Action of some sort needed to be taken to replace what was lost. In this case, many have chosen to pursue the income, as opposed to the capital appreciation, route to equity returns. This may seem like the path of least resistance. To pursue income, one must do a little digging, sniff around, and find the yield. To date, many risk-asset prices have not yet rebounded to pre-2008 levels. Due to that single fact, many investments, particularly those able to maintain dividend (or other income payment) levels, have seen their yields became relatively more attractive (apply the current yield formula above). It sounds simple. It also happens to be dangerously superficial.

The other route to consider is capital appreciation. This approach typically requires more up-front knowledge as well as substantial amounts of patience. Know-how and patience have not won the day. Each of the past four years have seen substantial net outflows from equity mutual funds and big net inflows for bond mutual funds. Resurgence in the capital appreciation approach has not happened, at least not yet. Instead, investors have flocked to bonds/bond funds, dividend payers, and other income products, en masse. As a result, many questions have arisen. Will the tide turn, with respect to which total return route is employed? If and when it does turn, what will bring it about? Will equity yield traps play a role?

The Basics of Equity Yield Traps

Yield traps are prospective investments that offer unsustainably high yields that lure investors in and can result in undesirable consequences, such as capital depreciation or lower-than-expected yields. The basic equity yield trap scenario starts with a security that, regardless of the reason, presents itself with an outsized income contribution to total return (e.g., a dividend-paying stock with an unusually high current yield). This high current yield will attract investors that are screening for income based on highest available current yields. This trap is now in play. The yield trap can spring if: 1) the security price rises significantly, 2) the firm is unable to continue providing the high yield, (e.g., cutting or suspending the dividend payment, or 3) a combination of the two.

In the case of a dividend-paying stock, when market conditions cause the stock price to rise but the dividend payment remains the same, the formula’s denominator increases in size, the numerator stays the same and the overall ratio (current yield) drops. When the stock price stays the same but the dividend is cut, then the denominator stays the same, the numerator decreases in size, and the overall ratio, again, drops. Note that if the dividend payment is suspended, the current yield becomes zero. Finally, if the stock price rises and the dividend payment falls, the current yield is doubly impacted; dropping once again.

Various cyclical and secular factors can act as catalysts for changes in the price of a security or changes in the interest income or dividend payment of a security. Changes in these catalysts can trigger existing yield traps and contribute to new potential yield traps entering into play. Not very long ago, it was the bursting of a huge housing bubble that helped set the stage for a new round of yield traps to come about. A wide range of investors, including soon-to-be retirees, lost a great deal of their invested capital and accumulated retirement income. As these investors have sought to recover and recoup from their losses, many have faced temptation from attractive yield opportunities that actually represent yield traps.

Are Equity Yield Traps a Concern in the Current Financial Landscape?

The low interest rate environment in the U.S. has persisted since coming out of economic recession in 2009. By the Federal Reserve’s reckoning, we can expect low interest rates to continue into 2014. Against this backdrop we can identify quite a few uncertainties that are weighing heavily on equity investors’ minds. These uncertainties, individually or collectively, have the ability to become game-changers in terms of their impacts on financial markets. Having described what yield traps are, how likely they are to come into play and what can cause this to happen is discussed next.

A sampling of economic and financial market uncertainties is listed below:

• Slow growth – annual real GDP is expanding at 3% or less;
• The specter of inflation continues to lurk in the background;
• The pain from the 2008 Financial Crisis is still remembered;
• International headlines continue to show they can move markets;
• The election year signals potential regulatory and legislative consequences;
• The rise of global securities and whether they will have staying power.

How each of these plays out will determine, to a large extent, how sectors, markets, and individual equity securities will be impacted from a yield perspective. Although the first quarter of 2012 has shown that some traditional equity income sectors (e.g., real estate, utilities) have underperformed the broader market, yield play opportunities and yield trap concerns really never go away. The speed with which any one or more of the uncertainties above can impact income prospects deserves respect. It’s possible for reversals of fortune to take place relatively quickly in traditional income sectors, as well as others. Other yield sectors, newer on the scene, (e.g., global securities) are yet another source of yield opportunities and yield trap concerns.

Slow growth continues to wear on the economy. Labor markets have been slow to pick up in some regions, resulting in changes in consumer spending habits, lower sales tax collections, and cuts in state budgets. All this contributes to anxiety and serves to make investment prospects with higher yields more enticing. The looming threat of inflation has the potential to roil fixed income and income-generating equity markets in a big way. Higher inflation in the next few years could make many investments currently on the books look very unattractive.

The persistence of memory regarding the Financial Crisis of 2008 continues to keep many investors on the sidelines with respect to pursuing capital appreciation opportunities. This contributes to the investment spotlight shining brightly on income prospects. International headlines have shown that they can jumpstart volatility in the equity markets at any time. Another round of these headlines has the potential to wreck our current bull market.

This year is a presidential election year. Whether or not the incumbent administration is returned to office will go far in determining the legislative agenda in 2013 and beyond. Financial regulation and health care markets, specifically, could find themselves impacted to a large degree by election results. Lastly, whether or not global securities have the ability to deliver sustainable and attractive yields in this environment remains to be seen. Transparency and geo-political issues associated with these products make it difficult to evaluate true levels of risk.

How Equity Investors Can Navigate this Environment

A fine-tuned picture regarding equity income investing is difficult to bring into focus. Given the uncertainties existing in our current low interest rate environment, the challenges are formidable but not necessarily insurmountable. Individual investors, financial advisors, and retirement plan sponsors can all benefit from securing investment know-how from asset managers pursuing long-term, low volatility investment goals by employing repeatable processes that avoid chasing yield.

The long-term perspective typically includes features that emphasize selection of securities that tend toward stability, avoiding large price swings. The long-term perspective fares well when applied to income investing because it focuses on the staying power of firms to continue generating income and increase these payouts, prudently, over time. Finally, asset managers that employ repeatable investment processes benefit from the mechanism that allows them to gauge success in a consistent manner. The right asset manager can bring to bear resources that allow the consideration of many important investment factors. This is counter to the myopic approach of maintaining a chief focus on screening for high yields.

Displaying patience, securing the know-how, and adopting the long-term perspective are helpful considerations in understanding and avoiding pitfalls such as yield traps in this financial landscape.

Download a PDF of this post.

This information is not intended to serve as investment advice; it is for educational purposes only.

Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.

The opinions expressed are those of Steven Petty, Ph.D. and are no guarantee of the future performance of any American Century Investments portfolio.

Copyright © American Century Investments

Tags: American Century, American Century Investments, Attractive Returns, Capital Appreciation, Criterion, Current Market, Current Yield, Denominator, Depreciation, Dividends, Equity Investments, Financial Considerations, Fixed Income Investments, Fluctuation, Global Economic Conditions, Hot Pursuit, Income Sources, Interest Rate Environment, Mining, New Marketplace, Rate Of Return
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Investor Sentiment Remains Elevated

Monday, March 26th, 2012

Central bankers have done their part flooding the world with liquidity, and investors have caught on as well by taking asset prices higher. Central bankers have their backs, but there is no reason to think that some new virtuous cycle has been created.  By lifting global markets, central bankers have averted a recession and cushioned any future fall in asset prices.  So what if the SP500 drops 10%?  That would take the SP500 down to its 200 day moving average.  What a buying opportunity that would be for the always bullish crowd.  So while it may not be a virtuous cycle, we can say, “mission accomplished”.  I don’t think the “all clear” is ever warranted and just when investors get comfortable with one thing, the market has a way of changing its tune.  Predicting when this will happen is difficult, but it is more likely to happen in the current market environment when bullish extremes in investor sentiment persist.  If you are a buyer now, you may not make any money, but that is the risk you take when buying high with the expectation to sell higher.  So while central bankers can claim mission accomplished, for the average investor it is going to boil down to market timing.

The “Dumb Money” indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator shows extreme bullishness.  As stated last week: “If we look at the “dumb money” indicator in figure 1, we know that as long as the indicator stays above the upper band (see green arrow on chart), prices should continue to go higher – albeit in a grinding fashion at this stage of the rally.  This is the syndrome I call “it takes bulls to make a bull market”.  If the indicator closes below the upper band, then the best time to sell is usually one week after this occurrence.  In this instance, the market is rolling over and those late to the party are buying that dip.  The data shows that this is the optimal time to sell.  But these are optimal scenarios, and I should caution that optimal and stock market are rarely spoken of in the same sentence.  The market is just too unpredictable.  Who saw the May, 2010 “flash crash” or the 20% drop over 3 weeks in 2011 coming?  If you hang around too long, you could be one of those casualties.  Alas, there are no right answers or guarantees.  These are just signposts that help us better understand the price action. ”

Figure 1. “Dumb Money”/ weekly

Figure 2 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “Insider selling levels continued at elevated levels, however, volume began to diminish as some companies began closing trading windows ahead of the quiet period straddling the end of one quarter and the beginning of another.”

Figure 2. InsiderScore “Entire Market” value/ weekly

Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 68.16%. This is the second week in a row that the indicator has turned down week over week. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops. It should be noted that the market topped out in 2011 with this indicator between 70% and 71%.

Figure 3. Rydex Total Bull v. Total Bear/ weekly

Copyright © The Technical Take

Tags: American Association Of Individual Investors, Asset Prices, Best Time, Current Market, Dumb Money, Extremes, Figure 1, Global Markets, Green Arrow, Investor Sentiment, liquidity, Market 1, Market Environment, Market Timing, Marketvane, Moving Average, Put Call Ratio, Recession, S&P500, Virtuous Cycle
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Current Market Volatility? Too Quiet

Friday, February 10th, 2012

When you’re watching horror movies, the time to worry is when things become eerily quiet. Last Friday, the market’s own measure of fear, the Chicago Board Options Exchange Volatility Index (VIX), hit its lowest level since last July. This is the financial equivalent of eerily quiet.

The VIX tracks the implied volatility on S&P 500 options. When investors are nervous, they’re more likely to purchase put protection, driving up the cost of options and implied volatility in the process. When markets are calm, or investors are too complacent depending on your point of view, the VIX tends to sink back into the teens.

At its current levels around 17 and 18, the VIX is modestly below its long-term average of 20 and is well below its 2011 peak of nearly 50. It’s also below the mid 30s it hit in October, when I argued that the VIX was too high and would likely moderate towards the high 20s or low 30s.

But while the VIX should certainly be lower now than it was six months ago, I believe its current levels seem too low. While market conditions have certainly improved since the fall, it looks like investors may have become a bit too at ease. With the risks to Europe lingering and most of the world still stuck in a lackluster recovery, a bit more caution — or fear — may be warranted.

Historically, economic activity, credit conditions and market momentum are three key drivers of implied volatility. All three have improved in recent months. Leading indicators have risen, market momentum has improved and credit spreads – measured by the spread between the 10-year note and an index of high yield bonds – have contracted by around 1%. Thanks to the improved general market environment, the VIX should certainly be lower than my October forecasts. However, in my opinion, a fair current value for the VIX would be around the low to mid 20s, higher than today’s levels. And unless we see a further acceleration in the economy and more spread tightening, I would expect volatility to post a modest rise in the coming months.

So assuming that volatility is set to rise, how should investors adjust their portfolios? First, remember that it’s the change in, not the level of, volatility that tends to impact asset prices. In an environment of rising volatility, investors would want to modestly lower their weight to market segments that are very sensitive to changes in volatility and raise their weight to less sensitive or lower beta instruments.

Practically, this could mean a modest reallocation out of high-yield fixed income towards investment-grade bonds, an asset class that currently appears to be a better relative value (potential iShares solution: LQD). While the spread between high yield and Treasuries has contracted by roughly 200 basis points since September, the spread between Baa bonds and Treasuries has been stuck at approximately 325 bps. Investors may also want to consider modestly increasing their weight to mega-cap equities. This segment of the market still trades at a significant discount to the broader market and is less sensitive than other segments to changes in volatility (potential iShares solutions: OEF, IOO, IDV, HDV).

Source: Bloomberg

Disclosure: Author is long LQD

Bonds and bond funds will decrease in value as interest rates rise

Tags: Acceleration, Caution, Chicago Board Options, Chicago Board Options Exchange, Current Market, Current Value, Economic Activity, Financial Equivalent, High Yield Bonds, Horror Movies, Implied Volatility, Last Friday, Leading Indicators, Market Environment, Market Momentum, Market Volatility, Mid 20s, Mid 30s, Options Volatility, Volatility Index
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Is This the End of the Road for the Rally?

Monday, January 23rd, 2012

The article below is a guest contribution by Guy Lerner, writer of the Technical Take blog.

The “dumb money” indicator has become extremely bullish (bear signal), and this is what one would expect with rising prices. The higher prices go the more bulls that are recruited. But is it the end of the road for the rally? Not necessarily so. In 1995, 2003, 2009, and Q4 2010/Q1 2011 we saw the phenomenon that I have dubbed “it takes bulls to make a bull market”. It is a market characterized by rising prices and excessive bullishness. In the case of 1995, 2003, 2009, the excessive bullishness and multi-month rally seem to be warranted as the markets were bouncing back from steep losses or a prolong period of consolidation (1995). The Q4 2010/ Q1 2011 version of this phenomenon was a QE2 induced feeding frenzy. With investors taking their cues from the Federal Reserve and European Central Bank, the current market environment resembles Q4 2010/ Q1 2011. For now, we need to respect this dynamic as we could be witnessing another melt up. The bulls have the ball in their court and are on the cusp of turning this recent price move into a multi-month barn burner.

The “Dumb Money” indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator shows extreme bullishness.

Figure 1. “Dumb Money”/ weekly

Figure 2 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “Insider trading volume was seasonally thin last week, the result of most insiders being locked-up and prohibited from trading until after their companies’ Q4’11 earnings announcements, as well as the market holiday.”

Figure 2. InsiderScore “Entire Market” value/ weekly

Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 65.09%. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops.

Figure 3. Rydex Total Bull v. Total Bear/ weekly

Let me also remind readers that we are offering a one-month free trial to our Daily Sentiment Report, which focuses on daily market sentiment and the Rydex asset data. This is excellent data based upon real assets and not opinions.

Source: Guy Lerner, Technical Take, January 22, 2012.

Tags: American Association Of Individual Investors, Cues, Current Market, Cusp, Dumb Money, Earnings Announcements, Federal Reserve, Feeding Frenzy, Figure 1, Figure 3, Guy Lerner, Insider Trading, Market 1, Market Environment, Marketvane, Price Move, Put Call Ratio, Q4, S&P500, Steep Losses
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