Client Note {Conclusion}

Here is the conclusion to our recent client note:

You have said before that dividends are ETF’s secret weapon.   What do you mean by that?  

 Dividends are the silent workers in a portfolio.  They don’t directly add to value each day like price movement and when they show up in a portfolio they generally arrive with little fanfare.  But over time their contributions add up.  Let’s illustrate this with an example using an actual ETF, although I will not name the security I’m discussing so as to not be seen as recommending a specific name.  {Feel free to call if you want to know the ETF. Also as a disclosure many clients own this security with us.} There is a dividend paying ETF that first came to the markets in 2003. It started trading at $50 and went below $26 in 2009.  It has appreciated along with the markets since then and now trades around $71. It has paid its dividend every quarter since inception, although the dividend did decline after the 2008-2009 bear market. If you had bought that security on it’s initial offering it has paid you nearly $25 in dividends and the dividend has increased 50% since its initial payment.  If you bought in 2009 or even in the next few years, your current dividend is about 3.45% but the yield based on your original investment is currently north of 6%.  This ETF’s dividend should increase over the years as the economy grows.   Growth like this may be boring to some but our opinion is that boring works in the long run.  Dividends like this can also provide some support in market declines. 

We should also mention how ETFs provide some stability in unstable markets.  I wrote about this last fall but will repeat again here.  There are enormous advantages to ETFs, especially during volatile times.  ETFs are not immune from market declines.  If their underlying index declines then they will also lose value by something that mirrors the decline in the underlying index.  They are also not a panacea for volatility.  The events of the most recent flash crash last fall shows that ETFs can be violently whipsawed around.  However, we can invest during such periods knowing we are buying a diversified portfolio of assets, backed by the value of the securities in an underlying index while removing single stock risk from the portfolio.  The history of equities tells us they can be wracked by fraud, can trade to zero due to a catastrophic loss or be rendered obsolete by unforeseen technological change.  It is an extremely low probability event that a plain vanilla ETF, especially one with a long trading history and based on a well-established index, will suffer such a catastrophic event causing it to lose all value.  We say this is a low probability event because 30 years of investing tells us there are no guarantees.  However, the inherent value of the underlying assets and the unique creation and redemption process of ETFs make this unlikely.  Frankly probability suggests the only events that would cause the inherent value of a majority of ETFs to trade to zero would be ones where we think most of us would have more things on our minds then the value of our investment portfolios.  Because the underlying assets supporting ETFs have value, we can use our systematic approach to creating portfolios and strategies from this asset class.

 Finally a note on market volatility.

Investors hate volatility.  Rather I should say investors hate volatility that leads to portfolio declines.  I receive few questions about markets on days where they go up 2%.  So I will repeat what I have often said in the past.  We know of no mechanism or system short of being 100% in cash that can completely protect a portfolio from volatile markets.  If Warren Buffett has not developed a way to protect his portfolio from market declines then we surely are not about to.  {Buffet’s Berkshire Hathaway by the way was down 11% in 2015.}  While there are ways to hedge a portfolio, these can be expensive and will often produce losses as a function of the hedge that the average investor is not willing to tolerate.  The best hedge in our opinion for a portfolio is cash.  The best action in our analysis is to have a disciplined investment plan and to readjust that plan as market forces dictate.

*Long ETFs related to the S&P 500 in client and personal accounts, although positions can change at any time.

I will be attending the Inside ETFs conference next week and posting may be sporadic from there.  I will resume a regular schedule the week of February 1st.  Of course we'll break in if events warrant.

Client Note {Part II}

We're publishing today part II of a recent note we sent to clients.  We'll publish the conclusion tomorrow.

Could we have a stock market crash?  There’s been talk of that on the television lately.

Investors decided in mid-December that their economic projections were too optimistic.  They went into risk-off mode and have sold every rally since then. But this change in market sentiment shouldn’t be confused with a crash. The financial press needs headlines to grab attention.  The return of market volatility since 2015 is a great way to get those eyeballs back watching CNBC or reading the papers.  I’ll define a market crash, as when an unexpected event catches too many investors on the wrong side of the market.   Something important to note is that you usually need a catalyst for that to occur.  That’s usually an unexpected event washing up over the transom that has everybody looking for an exit all at once. Typically these events also resonate well beyond Wall Street.  In 2008 it was the banks, in 2000-01 it was the events around the terrorist attacks and the bursting of the dot.com bubble. Market sentiment may have changed, but so far we’re seeing a pretty typical correction in stocks, not the sort of far reaching event that historically has led to a catastrophic event for stocks.  That’s not to say that stocks can’t decline further, but again a true financial crash is still by our work a low probability event absent that unexpected catalyst.  Even the flash-crashes we’ve seen in the past few years have had more to do with short term issues that have righted themselves almost right away.  

What are your current market assumptions?

We do not assume.  Our system uses a probabilistic assessment that weighs market evidence based on three factors, fundamentals {both market and individual sector}, valuation and money flow analysis.  Based on the weight of the current evidence, probability suggests that we are in a market consolidation.  A market consolidation is a period where stocks correct by both time and price.   Right now the market’s pattern appears similar to how equities traded in 2011-2012.  The red box in the included chart highlights that period.  By the time that corrective phase started, stocks had advanced nearly 100% from the 2009 lows.  Like today, slowing economic growth was one of the factors that marked that period. There were three peak-to-trough corrections in 2011-2012.  They are numbered on the chart and produced declines of 16%, 11% and nearly 10%.  At the lows of each correction back then you were looking at stock prices that were not that much different than a few years before.  You could also find the financial press full of stories about how the bull market back then was over.  Each time the market bent but didn’t break. Near the end of December 2012, stocks traded only about 3% higher than they had back in February of 2011-almost two years of going nowhere. Stocks advanced another 50% coming out of that corrective phase.  

The US markets have now marked time consolidating between roughly 1,820 and 2,120 on the S&P 500.  That’s about a 16% price band and not too far off the market’s historical 14% volatility.  The price declines in this phase are similar to what we’ve seen in other consolidating periods. The percentage bands look larger because of how much prices have advanced over the last few years.

That line of reasoning-that we are in a consolidation-will be right until it is wrong.  It will eventually be wrong because one of two things will occur.  The first is that markets will turn and ultimately break out to new highs.  We think stocks will ultimately experience a rally.  Right now markets are very oversold by our work.  However, we think it is a lower probability event in this current environment that stocks will power forward to significant new highs in the near term unless we see better economic news and better investment sentiment. The second way we can be wrong is that markets break convincingly lower.  In that case we would have to become more defensive in our portfolio structure.

So what are you doing? 

The first thing you have to do is recognize how things have changed and then adapt that change to portfolios and client mandates.  In aggregate we made fewer new purchases for clients last year because we found little back then we judged attractive enough to put larger amounts of money to work.  We have higher levels of cash right now in most client accounts as a result.  Cash is an asset that currently pays nothing.  However, it is a nice hedge to have when markets are declining.  We will use this period as we do all corrective phases as a period to reassess and reorganize where needed in client accounts.  We could also raise some more cash on rallies to higher prices.  As we have indicated before, there are also levels of market participation or events that might via our disciplines force us to raise more cash, especially if we believed the market was resolving this corrective phase to a lower level of trading.  We are always attracted to ETFs where the current market dislocation has brought the fund down to levels where the dividend is attractive.  Many ETFS that specialize in paying dividends are now trading at levels where the dividends are paying 3.5-4%.  That should provide a cushion in case of further market declines.

*Long ETFs related to the S&P 500 in client and personal accounts, although positions can change at any time.

Client Note {Part I}

Below is Part I of a note I sent to clients yesterday.  It is in a question and answer form, mirroring queries I've received from clients in the past few weeks.

What’s been going on with the stock market?

The character of the stock market changed at some point in 2015.  While certain large capitalization indices like the S&P 500 and the Nasdaq composite posted positive returns, almost everything else failed to keep pace. Currently more than half the names in the S&P 500 are down by more than 20%.  If you broaden this out to the S&P 1500, then the average stock in that index is down nearly 27%^ and it’s worse when looking at smaller cap issues.  Three things have been bothering investors, slowing growth in China and how that has affected other emerging markets, the decline in oil and slowing earnings growth here in the United States.  Stocks already traded at stretched valuations so this has made investors skittish about prices.

So are we in a bear market?

I think the verdict is out on a bear market although; there’s been a lot of talk about that by the financial press.  Part of the reason this is less clear-cut is that the US economy keeps puttering along.  We will probably see GDP growth of 1-2 % this year.  Growth might be better if oil prices quit declining.  We’re also at 5% unemployment {although there’s debate on the real number of people without jobs}, inflation remains low and consumers have shown the willingness to open their wallets when they perceive value.  We set a record for car sales these past two years, while housing has also been robust.  Certainly there have been parts of the world and market sectors that have been in a bear market-energy certainly comes to mind.  Energy ETFs are down almost 50% from their highs so that means there are a lot of individual companies in those underlying groups that have declined much more than that.  The S&P 500 is down about 11% from high’s set last May.  That’s painful but around historic averages when measuring market corrections.  However, the tenor of the market has changed and that’s something we have to watch closely and factor into our portfolio analysis.  

What do you mean by tenor of the market changing?

Investors bought each market dip until last summer.  You can see that in the weekly chart I’ve provided with this letter.  Market corrections tended to be short, shallow and met by buyers who perceived value.  That’s changed. It’s not necessarily important why that change came about, but it is important to realize this change in investor mentality.  First, a point we discussed several times in the fall, there’s a significant level of price resistance now around 2,100 on the S&P 500. {See Chart included below and the area highlighted in yellow.} This pattern now goes back about a year and represents investors who bought at higher prices and now hold losses. Theory states that those “trapped longs” are likely to become sellers as we near their old purchase prices.  That’s a wall of resistance that we haven’t seen for years and will likely need some better economic results and better investor sentiment to be overcome.  Also investor mentality has changed.  Market declines are not being bought or at least they haven’t been at higher levels. We are also seeing lower market highs and lower lows, the opposite of what occurs in a bullish phase.  That pattern needs to change and stocks probably need to build some type of base before they can start to advance again.

Long ETFs related to the S&P 500 in client and personal accounts, although positions can change at any time.

Chart is from Tradingview.com.  Annotations are mine.

^Zero Hedge:  The Average Stock is Already Down 20%

A Hard Year To Make Money

How hard was it to make money in 2015?  Very hard according to Jeff Gundlach of DoubleLine Capital.  He through up a chart that I noticed on Business Insider yesterday that showed that taking all of major US investment classifications, last year was one of the five worst years ever for the best   returns amongst that group of investments.  Here's the chart:

According to Gundlach, the best asset class last year, the S&P 500 with a 1.38% return, outdid everything else.   It's best return ranked third best of the five worst years since we've been recording these things going back probably to the 1920s.  When you hear about all the hedge fund closures last year and Warren Buffett being down 11% in 2015, then you get some idea of how hard it was to make money last year.  With stocks down about 6% so far in 2015, January's been nothing to write home about either.

Back hopefully with something a bit more in depth about the markets later in the week.

*Long ETFs related to the S&P 500 in client and personal accounts although positions can change at any time.

Link:  Business Insider:  Gundlach Presentation.  

Thoughts {01.12.16}

I'm working on something a bit longer that will cover what I think is happening in the markets and I hope to have out later in the week so this post is going to be brief.  Markets are poised to turn around at least on the open today.  We are oversold now and the markets are close to certain levels of support that the probability of a reflex bounce here is higher than anytime in this month.  We still have an options expiration at the end of this week to contend with so volatility likely is only taking a breather.

How bad has it been?  Well the S&P 500 is down around 9% since the beginning of December.  Most of that has been tacked on though since the last few days of 2015.  The S&P 500 lost nearly 2% in the last two trading sessions of 2015.  It is down about 6% this year {not including the likely bounce we'll see at the open today.  

The S&P 500 is down slightly over 10% from highs set last May as of yesterday.  We are again trading back at levels first seen in June 2014.  Depending on how you want to define it the market has traded in a 12-18% since the summer of 2014.

Hopefully back with something longer in the next couple of days.

*Long ETFs related to the S&P 500 in client and personal accounts.  Although positions can change at any time.

Thoughts: {01.11.16}

Rest In Peace David Bowie.

Markets look like the want to rebound at least at the open today.  Of course we started higher on Friday only to see a massive bout of selling hit the markets late in the day.  Nobody it seems wanted to go home long equities over the weekend.  Markets are very oversold right now so any sort of rally could hold for at least a few days.  Markets are a slave to oil and until that gets a bid then there is a real likelihood that stocks continue to struggle.  

Even when we rally it's going to be hard I think for stocks to break out to new highs.  All that resistance I've highlighted in the past {see Friday's post} is likely going to be a significant barrier to prices higher than last May's close.

I've been asked about ranges for the market this year.  I'm not done putting a pencil to all the numbers yet for this year but on a preliminary basis I'm thinking S&P 500 earnings of 122-127 with a 124 mid-point.  I think our Cone of Probability** will likely be 1,700-2,200 on the S&P 500-not much different than last year.   Again that is a work in progress and I'll go into this in more detail when I've finished the work.

I'm also thinking about some other changes in terms of market analysis but not prepared to do anything with these as yet.  

Back tomorrow.

*Long ETFs related to the S&P 500 in client and personal accounts. Although positions can change at any time without notice.

**The Cone of Probability {COP} is our current assessment of the trading range within which we think stocks have the potential to trade during the described time period.  It is a probabilistic assessment based on a many factors.  Some of these inputs are: Earnings estimates, also are those estimates rising or falling, dividend yield, earnings yield and the current yield on the US 10 year treasury.  This is not an exhaustive list of all of the variables that are used in creating the cone.  The Cone of Probability is used solely for analytical purposes.  It will fluctuate with market conditions and changes to the data inputs.  Index prices can and have traded outside of the range of the cone.  The data supplied when we discuss the cone is for informational use only.  There should be no expectation that this price range will be accurate and there are no guarantees that this information is correct.

Resistance

We talked a lot late in the summer and last fall when the market first took a tumble about all of this overhanging resistance.  By that we mean all of the investors that have bought stocks or indices higher and are now trapped longs.  That resistance barrier {shown in yellow in the chart above} is now even greater as the updated chart that I'm showing you of the S&P 500 only goes back to April of last year.  If I could have extended this out you would see this resistance band extends back to the fall of 2014.  Probability suggests that's going to be a tough barrier for stocks to crack in the short-term.  

Markets are very oversold now so probability suggests some sort of bounce at some point.

Charts are from FINVIZ.com.

*Long ETFs related to the S&P 500 in client and personal accounts although positions can change at any time.

Thoughts {01.07.16]

Before I put out anything more comprehensive I want to see what happens today with stocks and how they react to the open.  Here's a few thoughts before stocks start to trade.

*According to CNBC the average stock is down 20% from its high already.  That's bear market territory folks.

*However, market got creamed last January as well and roared back until topping out last May.  Will have to see if history repeats itself.

*Based on where it's likely to open, the S&P 500 is trading back now at levels we first saw around Memorial Day 2014.

*A lot of trapped longs now in almost everything at higher prices that creates significant resistance overhead.  Buyers of these long securities will likely be sellers as they get closer to break-even.  That's a significant overhang right now.

*Financial community is as bearish as I've seen it in years.  Public hasn't quite woken up to the whole thing yet.  Going to be harder for the Federal Reserve to continue raising interest rates this year if this keeps up.

Back either later today or tomorrow.

Chart Talk {01.05.16}

Chart of the S&P 500 ETF {SPY}.  Chart courtesy of FINVIZ.com.  New year but same old trading range for the S&P 500.  We use this as a proxy for the market but you should know that many stocks in this index did much worse than it did in 2015.  In any event when we look at the overall market we continue to see a investors struggling with the push/pull of good underlying economic activity but also grappling with valuations at the higher end of the historic range that makes stocks attractive.  You also have to couple this with an environment now where interest rates are increasing, albeit at a very modest rate and from levels that are historically very low.

It is interesting to us that on days like yesterday market commentators increasingly talk about a correction.  Yet we've now gone 14 months with the market stuck in this same trading range and after yesterday's shellacking stocks trade at the same levels we saw in the last week of August, 2014.  That looks to us like we've been correcting now for a long time.  Instead of a correction of price, we've been seeing a correction of time.....And only time will tell us how this will be resolved.  Maybe we're seeing a market that will power higher this year with a rebound in oil and a better environment for US companies overseas or maybe we're in a market that is rolling over or maybe a market that's just going to trade sideways for a very long period of time.  That would likely be the pain trade, the trade that frustrates both the bulls and the bears.  We'll just let our indicators be our guide.

*Long ETFs related to the S&P 500 in client and personal accounts although positions can change at any time without notice to our readers.

Back Thursday.

Numbers & Statistics

Statistics on market, sector and stock performance for 2015 have been rolling in over the past few days {hint:  Not Good}.  I'm going to share a few of these with you as I see them and as I think they are relevant.

From the Wall Street Journal's Blog.  {WSJ: 2015 in the Markets} "For the S&P 500, 2015 will go down in history as one of the smallest annual moves in the benchmark’s history. But that doesn’t mean it was a dull year for global markets. From London to New York, from Riyadh to Shanghai, here are some of the numbers that mattered most in 2015.The S&P 500 was up for the year as recently as Dec. 30, but finished down 0.7% thanks to a decline on the last trading day of 2015. The year-end figure snapped a three year winning streak. Six of the ten sectors ended in the red, while 281 of the individual stocks in the index declined.  Meanwhile, the Dow Jones Industrial Average finished down 398 points, or 2.2%."

*Long ETFs related to the S&P 500 in client and personal accounts.  A few accounts have legacy positions in ETFs related to the Dow Jones Industrial Average.  Positions can change at any time.

• 
  

A Thought Before The Open

World markets are getting squashed today.   I know right now that's not looking good for US stocks. I'd note we opened sharply lower last year the first trading session in 2015 as well.  Last January was choppy for stocks but led to a decent rally for the next month.  

I think what we're seeing is more of  the same choppy action we saw for most of 2015.

Back tomorrow.

Solas! The Introduction

Solas!

Hello and Welcome! At least once a year I will  republish the introduction to this blog and my general disclaimer:

As stated way back when, this is an experiment and Solas! so far seems to me to be the best opportunity to focus on what I want to write in a time efficient and hopefully interesting manner. However, please keep in mind that so far this is a hit or miss experiment. I don't yet know if this is going to work, how it's going to look or even if I am going to be satisfied with the end product. As a work in progress, especially at its inception, this may be a hit or miss endeavor. I don't know how and may never have time to do many of the things that make this look pretty or more professional. Nor am I going to take time away from my business to become an expert blogger. I do over time hope to make this better. I welcome your comments and suggestions.

What this is:

A learning experience. A way for me on occasion to make a point.

A way for me on occasion to discuss markets and investing.

A place for me on occasion to discuss the vagaries of life and perhaps editorialize.

A place to discuss the investment process.

What this is not:

A forum to tout any form of individual investments. (Particularly individual stocks or ETFs). We do not make recommendations on this blog! If we do discuss individual sectors or securities it will be solely in the context of a learning experience. You should understand that any individual sector or security that may be discussed here has the possibility of loss of principal.

A place for me to give individual investment advice. (Call me or others for this).

A theatre for me to tell you how wonderful I am.

An environment for me to make stock valuation claims i.e. "XYZ is worth 50 dollars!" If & when we do discuss valuations, that will be an opinion and nothing there should be construed as a guarantee of return or a guarantee that a stock will ever trade to an actual price.

And anything else that I might think of going forward.

One other thing. Where I discuss any individual security I will disclose whether I or clients currently own that stock or ETF. That disclosure is only valid for the day of the post as investments can change at any time. Any person who reads this blog and is not a client of Lumen Capital Management, LLC should either do their own research, give us a call or talk to their own investment advisor before making any investment based on anything written within the confines of this blog.

Oh and a final disclaimer!!! I write principally for the clients and friends of my firm, Lumen Capital Management, LLC. It is a way for them to get a quick read on my thoughts about the markets and any other subject I might cover. I do so after understanding to the best of my ability their unique risk/reward criteria. As such any casual or outside reader of this blog should understand that I am not writing for them! Therefore I or my firm takes no responsibility for any actions overt or otherwise a casual reader of this blog might take based on our discussions here. Casual or outside readers should do their own homework, discuss our articles with their own investment advisors or better yet hire us.

In short if you're not a client and you read this you're on your own.