Beware of Bias in Benchmarks

Benchmarks are important tools to measure and evaluate performance, but beware of their shortcomings.  Over the years they have changed from "averages" to what many might call "promotional" tools.  Given the recent out-performance of the S&P500 compared to other "world" indexes, one should look carefully into the reasons for the out-performance. It is not just because the US is doing "better".

The S&P500 is a "market value weighted index".  Only 50 (10%) companies (the largest by market cap) comprise 50% of the index.  Apple is enormously dominant with twice the weighting as the next two largest (Microsoft and Exxon) combined. So when Apple does well, the S&P500 is highly affected.

Read more.

Forbes Article on the S&P500 as a Benchmark

When benchmarking, I suggest that comparing performance to indexes is somewhat useful, I find that risk as measured by volatility of the portfolio compared to gains is also an important factor when determining the "real" performance.  In that regard I find the Sharpe Ratio to be extremely valuable when evaluating portfolios.

Still, as the article mentions, indexes have become profitable businesses to the publishers and demand for the "product" is enhanced when the indexes have a bias toward gains.

Hurricanes, Blizzards and Seasonality

http://finance.yahoo.com/news/disconnect-us-stock-market-just-141141243.html

In January I wrote, “Be Diversified, Be Patient and Be Prepared”. There is no doubt that Central Banks all over the world are artificially holding down interest rates through various schemes that most have called Quantitative Easing. Quite simply, economics demands that price is affected by Supply and Demand.  Quantitative Easing is simply the process where Central Banks buy bonds, increasing demand, decreasing supply in the open market, raising the price of the bonds, therefore reducing the interest rate.  This scheme is “experimental” in that it has never been done before 2009 and nobody knows the long term effects. 

One result of the lower interest rates is that it makes borrowing cheaper. And when more money is borrowed, Classical Economics claims that economic activity increases. So far, it has not really turned out as expected.  QE has had a very perverse effect on equity markets.

First, if interest rates are lower, stocks that pay dividends are more attractive and their price rises. Second, since the price of a growth stock is the discounted present value of all future earnings, with lower rates, the present value goes up significantly. Finally, corporations have a capital structure that uses equity and debt. When debt is cheap, they tend to undertake a form of “Financial Engineering” by borrowing money to buy their stock, reducing the supply and therefore raising the price of the shares. Corporate CEO’s love this Financial Engineering since it creates a sense of rising corporate earnings per share—not because of rising earnings, but simply because of a reduction in shares.

So lower interest rates tend to make stock prices go up. But what happens to stock prices when interest rates rise back to “normal” levels?  Simple answer…. stock prices decline. For this reason, I have urged investors to adopt a cautious attitude and avoid getting caught in the trap of feeling that they are missing out on rising stock prices.  If stock prices rise because of a temporary government program, then logic tells us that stock prices will fall when that temporary government program ends.  Timing the rise and fall is a fool’s errand.

Back to the title of the article.  As Hurricane Season approaches, it pays to be prepared for the possibility of a Hurricane.  We may worry less about Hurricanes in December, but as June approaches, it pays to be cautious. As December approaches, it pays to be prepared for snow storms. I get my snow blower ready. I hope I don’t need to use it, but I get prepared.

As “seasons” approach, we get prepared. We really don’t know if our location will suffer a direct hit from a Hurricane or a Blizzard, but as the season approaches, smart people get ready.

We are now 7 years from the beginnings of the last big decline that started in 2008. Business cycles typically run over 7-10 years. So logic tells us we are approaching a normal season for some form of stock market correction. Sort of like November in Massachusetts and May in Miami.  Bad weather is coming, we just don’t know how bad or exactly when. We are also near the beginning of the “rising interest rate” season. Some of the Wall Street pundits would have you believe that “this time is different” and rising interest rates are not a concern. Don’t believe them.

An important factor to remember, is the sectors that have benefitted the most from low interest rates will likely be the hardest hit. Sectors that have already had corrections are likely to suffer less. Energy stocks are probably not overpriced and may not see much of a correction going forward. Auto Industry stocks are likely to be hit very hard. Sectors that have risen much faster than the average, like Health Care, may suffer disproportionately as “normal” returns.

Of course, it is possible that “normal” will never return. There are those that will try to make you believe this. In 1929, the most prominent and well respected Economist, Irving Fisher famously predicted three days before the crash, "Stock prices have reached what looks like a permanently high plateau."  So be careful about following market momentum based on an assumption that “this time is different”.

On the other hand, it does not pay to completely cash out and “miss the storm”.  Although this will be tempting to some, it seldom results in superior returns since the strategy requires perfect timing for the selling and buying. What history teaches us is to prepare for the possibility, but not the certaintly.

Stay diversified and maintain a balanced portfolio.  Don’t think your winners will keep winning forever and likewise do not assume your losers will never rise again.  Keep your fixed income allocation in very short maturities—even if the interest is almost nothing on some parts.  Be a bit more cautious than you would have been in 2010.

Obviously from the graph early in the article, some mutual fund managers have already become more cautious. A lot of money flowed out of the market—with prices maintained most probably by Financial Engineering.

Then there is the fact that Corporate Earnings are not growing much. The 1% rise year over year we have seen justifies only a 1% rise in stock market prices. That alone could be the catalyst for a 10% correction. Then add in the fact that revenues for companies in the S&P500 declined by 4.6%--not a good outlook for future earnings.

In addition, the price of the S&P500 is way “out of whack” with the value of our economy. This is often the best source of determining market conditions. See Graph. It is one reason why Fed Chairman Yellen just this week expressed concern that the “market” was too high. The blue line is the S&P500--the red lower one is the GDP for the economy. When the market gets significantly ahead of the economy--watch out. Timing the ultimate correction however is very difficult.

As I have said, over many years I have acquired many skills through experience and education, but one of those skills is not fortune telling.  We do not know when interest rates will begin rising. We do not know how fast they will rise or by how much.  We do not know how many shares will be removed from the market through stock buybacks, mergers and acquisitions, and other Financial Engineering that tends to cause prices to rise. But we do know that from an investing standpoint, it is a bit like May in Miami or November in Boston. Maybe what is coming will be mild. Maybe bad will miss us. On the other hand, maybe not.

The most difficult fact for many investors to fathom is that nobody rings a bell at a market top. Corrections are not announced in advance so that you can exit to avoid them. Severe corrections are usually the result of series of 1% declines over time. After a 5% fall there is usually a "buy the dip" media hype. Then after a 10% decline, a "10% is normal" report from the media, followed sometimes by a continued downward spiral punctuated with some daily gains. All of a sudden at about a 15-20% decline, you can begin to see some panic selling, driving the market down further.  It ends when bargain hunters begin buying. Typically, those that try to avoid the corrections by selling early are so affected by market sentiment at the bottom, that they avoid the gains that follow by staying on the sidelines--many times suffering a loss because of their actions.

Stay diversified and maintain a balanced portfolio.  Don’t think your winners will keep winning forever and likewise do not assume your losers will never rise again.  Keep your fixed income allocation temporarily in very short maturities—even if the interest is almost nothing on some parts.  Be a bit more cautious than you would have been in 2010.  Keep a bit more cash on hand for future needs so you will not need to sell any holdings if and when the market is down.

Here is the positive thing for you to think about. Corrections are the time that investors get the opportunity to buy good quality assets at cheap prices.  Corrections are almost always temporary. 

Summer will follow Winter in Boston, and December-March in Miami is predictably good weather after the Hurricane season ends in September-October.