Video Newsletters: Insights and Observations

Everything listed under: 2017

  • November 2017

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    Of Pigeons, Information & Interest Rates

    Have you ever noticed how pigeons walks? Their heads bob back and forth with each step they take. Although I consider myself a recreational bird watcher (as opposed to an actual birder), I never gave this behavior any thought until I read a fascinating book: Storm in a Teacup: The Physics of Everyday Life, by physicist Helen Czerski. The author explains that this movement is necessary because the bird cannot process the changing visual scene fast enough as it walks. Czerski writes: “The head stays in the same position throughout the step, so the pigeon has more time to analyze this scene before moving on to the next one.”

    I can sympathize with the pigeon, since I often feel like there is way too much information available to me every day from numerous sources, all clamoring for my attention. After all, we live in the information age. And yet we must attempt to sort it out; to make some kind of sense out of it all; to discern the signal from the noise.

    One of the five guiding principles of our investment philosophy at Coyle Financial Counsel is that investment decisions should be based on information, not emotions. And because we also seek to be evidence-based in our investment process, gathering and analyzing information is essential.

    This will be the second Commentary in a row to discuss interest rates, but this time I want to address a point made in the video, that the yield curve is flattening. A yield curve (also known as the term structure of interest rates) plots the yield-to-maturity of an issuer’s debt securities by date of maturity. We want to answer the question of whether there is useful information in the shape of that curve.

    Here is a plot of the term structure of U.S. Treasury debt for two different dates:

    The curve dated January 2, 2014 is much steeper than the curve we have now. We know from last quarter’s Market Observer Commentary that inflation expectations are a key determinant of the general level of interest rates and that the Federal Reserve influences what short term interest rates will be through the market activities of the Federal Open Market Committee. Inflation expectations at the end of 2013 were higher than they are today.

    Besides inflation, there is one other interesting historical feature of the shape of the yield curve which might give us information as to the future health of the economy. The measure we use for this is called the term spread, the yield difference between longer and shorter maturities. If we compare the current yield-to-maturity on the 10-Year maturity Treasury note (currently at 2.37%) to the 2-Year maturity (1.76%), the current term spread is 0.61%. This is the lowest reading we’ve seen in almost 10 years, since just before the Global Financial Crisis:

    If you look closely at this chart, notice what happens to the term spread just before the economy slips into an economic recession (the gray vertical bars): the spread turns negative. This is called an inverted yield curve and it has been an almost infallible leading indicator of economic recessions in the U.S.

    The intuition around using inverted yield curves as a recession indicator is as follows: an economy in significant decline tends to exhibit falling inflation, causing long term rates to fall along with falling inflation expectations. Short term rates, on the other hand, lag behind, anchored as they are by the Fed until it decides to start lowering them to stimulate the economy as it implements monetary policy.

    Another theory used to explain this is called the Expectations Theory. The intuition here is that longer rates can be thought of as a series of future short term rates strung together. If investors believe that the Fed will start lowering short term rates in the future, they will start buying more long term securities to lock in higher yields, which gradually has the effect of lowering long term rates (this is because bond prices and yield are mathematically inversely related).

    A declining (but still positive) term spread is certainly not cause for alarm. A quick glance at the graph shows many instances since 1976 where it declined but failed to invert. It is just one of many economic variables that we monitor as part of our investment process. While recessions are notoriously hard to predict, we don’t believe the U.S. is in any immediate danger of slipping into one.

    As we mentioned last quarter, we are not in the business of predicting the future course of interest rates. But, like the pigeon, we try our best to process the continuous flow of economic and market information available to us, without getting too overloaded. Even so, trying to discern the signal from all the noise is easier said than done.

  • August 2017

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    What’s (Not) Up With Interest Rates?

    Credit is the lifeblood of any healthy economy and the price of credit (or the cost of borrowing) is measured by the annual rate of interest charged. There are as many different rates of interest as there are types of credit available. For example, consider borrowing from a bank to purchase an automobile. If you’re fresh out of school and newly employed, the interest rate on your auto loan might be in the double-digits. But if you have a long, well-established credit history, you might be able to buy a new car with zero percent financing.

    Or, consider what sovereign governments have to pay investors to borrow in the capital markets. The United States can borrow for ten years right now at an annual rate of 2.19%. Brazil, on the other hand, must pay investors close to 10% per year to borrow for ten years.

    How are interest rates set? Interest rates are established like any price, by market forces, via the supply and demand for loanable funds (there is one important exception which we will discuss in a minute). Think about that bank making an auto loan. They have several things to consider when deciding to extend credit to someone: (1) the creditworthiness of the borrower, (2) how many years to pay the loan back, (3) the cost of funds that the bank has to pay to depositors, and (4) the rate at which the purchasing power of the currency declines over time (the inflation rate).

    Let’s focus on the last point, inflation. Savers and bond investors hope to earn income on their funds at a rate that exceeds the rate of inflation, otherwise they lose the purchasing power of the income stream. Therefore, one component of the interest rate setting process by the market must consider what the future rate of inflation is expected to be.

    The last slide in the Market Observer video showed that there has been a very close correlation between the US inflation rate (as measured by the CPI) and market interest rates (in this case, 3-month Treasury Bills). While other things come into play when thinking about how interest rates are set, such as credit quality and the term to maturity, inflation expectations are a key consideration. It is the reason that the US can borrow at just over 2% for ten years while Brazil must pay almost five times as much: inflation in the US is below 2% compared to almost 9% in Brazil.


    This is why any discussion of the future course of interest rates must take into account inflation expectations. The US Federal Reserve, through Monetary Policy, started targeting core inflation at 2% in 2012. Since that time, inflation has struggled to get anywhere close to 2%, with the most recent reading at 1.7% (July, 2017). This has been a conundrum for many economists, policy makers and market participants, particularly since unemployment is now at a low 4.3%. Even though the US economy is barely growing at a 2% real annual rate, some expect wage pressures to start pushing consumer prices higher. So far this has not happened.

    Persistent low inflation has created a lively debate within the Fed’s Federal Open Market Committee (FOMC). The FOMC decides where to set the one interest rate that is not market determined, the Federal Funds Rate (the overnight lending rate on bank excess reserves). The Fed has been trying to “normalize” the Fed Funds rate recently after almost a decade of keeping the rate near zero since the depth of the Great Financial Crisis of 2007-2009. Even though the effective Fed Funds rate has now been raised to over 1%, the market is pricing in only a 36% chance that the Fed will raise the Fed Funds rate for the third time this year in December. Meanwhile, the bellwether 10-year Treasury yield has dropped again to 2.19%.

    For some time now, there has been much talk about the prospect of rapidly rising interest rates, particularly since the Fed first raised the Fed Funds rate in December, 2015, from zero to 0.25%. But the Fed controls only one rate, the overnight bank lending rate. They do not set mortgage rates, or auto loan rates or other bank lending rates, much less the yields on longer term treasury, corporate or municipal bonds.

    While we are not in the business of predicting the future course of interest rates, our guess is that as long as inflation stays low and the economy limps along at an average 2% real GDP growth, long-term rates are more likely to stay low than to rise significantly from here.

  • May 2017

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    DIVERSIFIED OR CONCENTRATED?

    When it comes to stock investing, investors often ask if is it better to hold a well-diversified portfolio of hundreds of stocks or a concentrated portfolio of, say, 20 or 30 stocks? The answer may not be as clear-cut as you think. Let’s look at what academic research might have to teach us.

    The Case for Diversification

    The essence of diversification is captured by the old adage that we shouldn’t put all of our eggs into one basket. Investing in capital markets involves the risk of loss, so we should spread our investable wealth across many securities. In support of diversification, research provides some very sobering facts about investing in stocks.

    One study looked at the stocks that composed the Russell 3000 Index from 1980 to 2014. The index includes about 98% of all listed stocks in the U.S. The author found that two-thirds of all the stocks that were included in the index over those years actually underperformed the index itself. In fact, 40% of the stocks produced negative absolute returns over their life-span.¹

    Another study was even more ambitious, looking at the performance of all listed stocks from July of 1926 to December of 2015, a total of almost 26,000 stocks. The author summarized his findings by writing that “the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks.” In fact, he found that only 86 stocks account for over half of the roughly 32 Trillion dollars in stock market wealth creation. Worse yet, he found that 58% of those 26,000 stocks returned less than one-month Treasury Bills over their life-span (The median life-span of a stock was seven years).²

    We are often surprised to hear that stock returns are driven by just a handful of stocks. For example, in 2015, the S&P 500 Index returned just 1.38%. The top 10 performing stocks that year included the four so-called “FANG” tech companies, Facebook, Amazon, Netflix and Google (now known as Alphabet). According to another research piece published early in 2016, removing the impact of these 10 stocks would have reduced the index returns by 3.7% that year. The author then looked at the S&P 500 Index annual returns over a longer period, from 1995-2014, and found that the 2015 results are actually quite normal. The average performance impact of the top 10 performing stocks over that 20-year period was 4.1%.³

    In summary, the implication of what we have discussed so far is that we should diversify to spread the risk of owning losing stocks while increasing our chance of owning the relatively few stocks that will survive and grow in value.

    The Case for Concentration

    The most obvious reason in favor of concentration is that every successful business in the world, big or small, was started by somebody who had a vision and, in many cases, were willing to risk everything. This is wealth creation as the fruit of the entrepreneurial spirit. It is the opposite of diversification and the risk of failure is high.

    We call this idiosyncratic risk and finance theory says that a sufficiently diversified portfolio can eliminate almost all of the idiosyncratic risk among the different stocks in the portfolio. The risk that we are left with cannot be diversified away, and this is called market or systematic risk. The reward for bearing market risk is the equity risk premium over Treasury Bills that historically accrues to long-term stock investors. In addition to the equity risk premium, investors have historically earned additional long-term premiums for bearing the risk of owning small cap stocks, low volatility stocks or value stocks, for example. This is called factor-based investing.

    In 2015, Fidelity Investments issued a research piece titled “Does the Number of Stocks in a Portfolio Influence Performance?” They analyzed the returns of U.S. large-cap equity mutual funds over the 20-year period from 1994-2014 and concluded that there was no evidence of a meaningful relationship between the number of stocks in an actively managed portfolio and its performance. They added that portfolios with either higher or lower number of holdings have beaten their benchmarks with the same success rate.⁴

    Recently, research was presented at a conference sponsored by AQR Capital Management which compared these two approaches to equity investing. The first was called Quantitative, characterized by well diversified, rules-based, systematic, factor-based investment approach, designed to capture various market and factor risk premia. The second was called Fundamental, which relied on individual stock managers using a “Best Ideas”, thematic approach to managing concentrated portfolios, designed to capture more idiosyncratic sources of return, such as mispriced stocks.

    They compared the investment performance of the top 25% of U.S. large-cap core managers, both Quantitative and Fundamental, from December of 2000 to December of 2015. They concluded that both groups had identical excess returns after fees of 1.7% per year and that combining the two approaches could actually improve the risk-adjusted returns versus using just one of the approaches alone.⁵

    Conclusion

    We conclude, therefore, that there are advantages to using both a diversified and a concentrated approach to investing in equities. At Coyle Financial Counsel, we utilize a “Core and Satellite” investment process to capitalize on this idea. We use a well-diversified, quantitative, factor-based approach for our core portfolios while using certain concentrated “Satellite” stock managers who seek to outperform using a fundamental, “Best Ideas” approach. We believe that this combination will help our clients achieve their long term financial objectives.

    John G. Finley, CFA

    May 18, 2017

    Footnotes:

    1. “The Agony & The Ecstasy: The Risks and Rewards of a Concentrated Stock Position”, by Michael Cembalest, J.P. Morgan Asset Management (“Eye On The Market”, J.P. Morgan, 2014)
    2. “Do Stocks Outperform Treasury Bills?”, by Hendrik Bessembinder, Dept. of Finance, W.P. Carey School of Business, Arizona State University, Draft: February, 2017, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447 (Accessed 5/8/2017)
    3. “SNAFU: Situation Normal, All-FANGed Up”, Cliff Asness, AQR Capital Management (1/11/16), https://www.aqr.com/cliffs-perspective/snafu-situation-normal-all-fanged-up (Accessed 3/13/17)
    4. “Does the Number of Stocks in a Portfolio Influence Performance?” by Michael Hickey, CFA, et al, Fidelity Investments (Leadership Series / Investment Insight, FMR LLC, 2015)
    5. Author’s notes from attending AQR University Event, Chicago, Illinois, May 9, 2017, Sponsored by AQR Capital Management
  • February 2017

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    Passive versus Active Investing

    The recent unseasonably warm weather and complete absence of snow this year in the Chicago area has been a very pleasant surprise. Flowers are pushing up through the soil and many migrating bird species have arrived a bit earlier than normal.

    What’s not so surprising is the ongoing debate in investment circles about the relative merits of active versus passive investing. Passive investing refers to the use of mutual funds or exchange traded funds that replicate well-known market indexes such as the S&P 500 or the Russell 3000. Active equity managers attempt to beat the market by offering superior stock picking.

    Investing in passive, index-based strategies has grown enormously in popularity in recent years. Last year alone, Morningstar estimates that $262 billion moved from active to passive U.S. equity funds (1). This is understandable: Index-based funds tend to have lower fees than active funds (1) and the average active manager does not outperform its index benchmark after fund fees and expenses (2).

    While the trend from active to passive seems to be showing no signs of slowing down, although, in theory at least, there is a limit to how far it can go. The reason is that indexes use only one characteristic to rank the constituent stocks: price times the number of shares of a company’s stock. Market value, of course, depends on price. And how are prices determined? Buying and selling of those shares on stock exchanges done by active managers.

    The price of a share of stock is a critical piece of information for skilled active managers, especially value investors. Value investors, such as Warren Buffett, seek to buy stocks that are undervalued and cheap relative to other stocks. They analyze the fundamentals of a company to arrive at an estimate of what the intrinsic value of a stock is, then compare that to the current price. If there is a sufficient discount (or margin of safety), the value manager purchases the stock in the hopes that eventually other investors will agree with that valuation and bid the price up to its fair value (or higher).

    Academic research has consistently shown that value investing outperforms growth over long periods of time, though it may underperform growth for shorter time periods. One problem with passive investing is directly related to its sole reliance on price valuation because popular growth stocks will always have a greater weight in the index than unpopular value stocks. Popular growth stocks also tend to have more price volatility.

    This became abundantly clear during the dotcom bubble of the late 1990’s when technology stocks (growth stocks) were everyone’s darling, eventually driving the tech sector to a weight of over 29% of the S&P 500 Index. That bubble ended in a three year bear market, where value investing (buying cheap stocks) outperformed growth (owning popular stocks) seven years in a row.

    While some may worry that our “Early Spring in February” may not end well for the flowers when the freezing weather returns, we need not fear that active managers will be driven to extinction by passive indexing any time soon. Skilled and experienced equity managers who can find quality companies with good fundamentals, purchased below their intrinsic value with a “margin of safety”, should always have a prominent place in every investor’s portfolio. The goal is to grow wealth over the long haul by diversified exposure to the global capital markets, capturing a share of what the market has to offer as cheaply as possible, with less volatility, and avoiding the never-ending parade of popular investment fads.

    (1) Morningstar Direct Asset Flows Commentary Feb. 14, 2017
    (2) https://us.spindices.com/documents/spiva/spiva-us-mid-year-2016.pdf