Styles Come & Go - What’s in Today?

7/24/2015

By Michael McKeown, CFA, CPA - Chief Investment Officer

Cheap stocks outperform expensive stocks.  It is a well-documented investment anomaly.  Investors are compensated for owning stocks by not only earning the return of the market, but an additional “value premium.”  It exists over the long-term, but does not work every quarter or every year.  Companies possessing value characteristics such as a low Price to Earnings Ratio are put into the value “style” (as opposed to the growth style).

Why own small companies classified as ‘value’ versus small growth companies?  Over the last 36 years in the United States, the small value index outperformed by nearly three times.  Large value stocks outperformed large growth stocks by 42% over this period.

Is this just a U.S. abnormality?  Looking at international markets, the answer is definitely ‘No.’ In fact, the exact same ranking order for size and style as in the U.S. was evident for as long as we have data, which is back to 1994.  Both went from Small Value, to Large Value, to Large Growth, to Small Growth.

Over the same time frame, companies in the emerging markets based on size (large, small) and style (value, growth) ranked in the same order as the international developed market peers.  It is clear the value premium exists in addition to a small cap premium (which we will leave for another time).

Yet, this does not hold for the last five years across regions.  In fact, the worst performing style (small growth) over the multi-decade periods we looked at performed the best in each region.

Note that growth outperformed value across both large cap and small caps in the U.S., Internationally, and Emerging Markets (EM).

One reason for the difference in style performance the last five years is sector dispersion.  With biotechnology and pharmaceutical companies reaping the benefit of years of research and development costs on building a pipeline of drugs, the healthcare sector shot through the roof.  The American consumer continues to shop and go out to eat, boosting share prices for the discretionary sector. Technology is on fire from all the fundraising in Silicon Valley (a sign of excess perhaps with an HBO show called “Silicon Valley”) and growth from Facebook, Google, Apple, et al.

Looking under the hood of the small cap style indices shows a big difference in weights in these three top performing sectors over the past five years.

In total, the U.S. small growth index has nearly 3 times as much sector exposure to healthcare, consumer discretionary, and technology as the U.S. small value index.  For today, the growth ‘style’ is in and value is out, with sector exposure being the main driver of the difference.

The “momentum premium” typically rules in the short-term, with assets outperforming on a relative basis persisting with outperformance anywhere from 2-12 months into the future.  We highly doubt that cheap stocks will underperform expensive stocks in the long-term, however, cyclical periods of growth outperformance occurred in the past and likely will again.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Demographics Driving the Bus

6/25/2015

By Michael McKeown, CFA, CPA - Director of Research

Demographics are quantifiable characteristics of a given population.  Such a simple explanation for something that explains so much about the trends in our world.  This affects real estate prices, corporate planning, state and local taxes, and much more.

In just 15 years, the demographics around the world will look very different.  Due to lower fertility rates, the dependency ratios of retirees to workers will be higher than ever.  In some countries such as Japan and parts of Europe, the majority of the population will be retired.  Only certain areas of the world will have populations considered young, such as Africa, the Middle East, and India.

Turning to the United States, over the next 15 years, the Conference Board projects that 22 states will lose its workforce population. The losses are concentrated in the Northeast and Midwest with the winners being the Southeast and West.

The working-age population trends are due to net changes in the 18 to 64 year-old age group, deaths, international immigration, and domestic migration.

What demographic note would be complete without a discussion of the “M-word” – Millennials?  Larger than both the Baby Boomers and Gen-X, Millennials are those born between 1980 and 1995, comprising 83 million people.  This group along with the evolving technology landscape in which the group grew up, is the reason why there will be less shopping malls in the future, changes in the workplace, and greater emphasis from all on social media platforms.  Corporations and small business that do not plan for the shift will be left in the dust.

 

Source: BarnRaisersLLC.com

One area getting less attention, because it is such a slow process, is the peak spending years that the millennials will enter over the next 15 years.  The largest generation in history will continue to see rising incomes and increase spending as they hit their mid-30s.

Source: BLS.gov, Consumer Expenditures Report 2014

The table above shows that spending ramps up slowly and then increases quickly from ages 35-44 as families form and more money goes to housing, education, and consumer products.  This matters for inflation and interest rates, as a respected quantitative analyst showed that even beyond money supply, the number one driver of growth and inflation is not Federal Reserve policy, it is demographics. This is pervasive across time and countries, showing robust statistical significance.  It is another reason investors should be wary of interest rate exposure given the low premium currently being earned compared to history for bonds.

To wrap up, one of my colleagues at Skoda Minotti, Scott Swain, attended a very interesting presentation by demographer Ken Gronbach.  Below are a sample of his notes:

  • Africa is where the opportunity is, 1 billion population now, will grow to 4 billion if they can raise average age of death through better nutrition, disease control, reducing violent deaths.
  • China is in trouble with a very small population ages 0-36 due to population controls starting 36 years ago and 90 million men of marrying age with no one to marry.
  • Russia is also in trouble with a 1.41 fertility rate, which is very low, makes Russia a net death country on an annual basis.
  • Generation Y is flooding the labor market, will have to open lots of small businesses in order to survive.  Labor will get cheap again, making US manufacturing more competitive.  Gen X was so small salaries rose for manufacturing jobs to attract bodies.
  • 25% of the people in Ohio, baby boomers, will retire and leave Ohio, and move south.  Florida real estate should do very well, Ohio will suffer from smaller tax receipts.

 

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

Sources: Google.com, Matt Busigin http://blogs.cfainstitute.org/insideinvesting/2013/11/18/a-non-monetary-explanation-for-inflation/

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The Bond Who Cried Wolf

6/11/2015

By Michael McKeown, CFA, CPA - Director of Research

In the largest two-month move since 2013, the interest rate on the 10-Year U.S. Treasury Bond tagged 2.50% this week.  It is the 6th largest move higher of this magnitude in the last 20 years at 30%, yet few seem to be panicking.

After recovering from the taper tantrum in 2013, the change in interest rates has fixed income benchmarks off the April peaks ranging 1-4%.

Over the last few years, investors came around to the idea that bond yields should stay low because of variety of reasons, from lower structural growth to the deflationary aspect of technology and robotics.

Because of this complacency around interest rates, investors poured money into asset classes that pay high yields, such as dividend stocks, Master Limited Partnerships, and Real Estate Investment Trusts.  The latter of which, REITs, have a negative correlation of -0.9 to the 30-year bond yield over the last two plus years.  Should rates continue to rise, REIT shares are likely to remain under pressure.

In the past, each spike of interest rates led investors to become concerned about portfolio exposure to interest rates rising, but this time, so far, is different.  Anecdotally, advisors and the investment community are rather blasé about interest rates today.  Flows out of fixed income and investor sentiment does not seem overtly negative at this point.  Did the 10-year bond yield cry wolf one too many times?

This seems to be the case as the Federal Reserve governors and Chairwoman have made clear over the past several months that an interest rate hike will be coming.  While inflation data is low today, partially due to higher energy prices, the back part of 2015 could see inflation data trend higher, and with it, interest rates, which could surprise yield-oriented investors in the ‘safe’ part of portfolios.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Did Everyone Fail Statistics Class?

Aurum Weekly Access - 5/29/2015

By Michael McKeown, CFA, CPA - Director of Research

If you graduate with a business degree from John Carroll University, there is a very high probability that you took a statistics class from Dr. Andrew Welki.  The exams were grueling but he was a fair teacher, and not afraid to give you a hard time just for fun or if he expected more.  During my time studying R-squared and statistical significance my sophomore year, I did not think I would use the foundation of those lessons on a daily basis like I do today.

So it makes me wonder, did all of these portfolio managers that use a static allocation strategy with only passive indices fail statistics class?  Because with the evidenced based data in front of me, Dr. Welki would surely give them an ‘F’ on the final exam.

Let’s explain.

For a study to have statistical validity and ‘prove’ something, it must have an absolute t-stat ratio greater than 2.  This means that the variable has a 95% chance of not being random, or having significance.  So a group of professors sought to beat out a higher hurdle rate using an absolute t-stat of 3 (the 99% significance level) and tested 316 financial factors that were ‘discovered’ since 1964.

The wild chart below shows that many factors have significance, but only a few have t-stats of 5, which means they have over a 99.9% chance of being significant and less than 0.1% chance of being random.  The two factors that are investable with a t-stat above 5 are circled in red: value (represented by HML) and momentum (represented by MOM).

Source: Harvey, Liu, Zhu

Talking about factors and t-stats sounds esoteric, so let’s examine historical returns to see how it worked.

Sources: AQR, Kenneth French Data Library (excess returns over cash on y-axis)

The value factor worked quite well for stock selection in the U.S. over the last 64 years.  The cheapest 20% of stocks outperformed the most expensive 20% of stocks by 9% annualized.  Why does the value factor exist?  Behavioral biases that are inherent within investors are likely the root cause.  Investors extrapolate recent growth rates of high flying ‘glamour’ stocks, causing them to become overpriced and allowing for lower priced value stocks to earn a premium return.

Sources: AQR, Kenneth French Data Library (excess returns over cash on y-axis)

The momentum factor for U.S. stock selection showed a difference of 10% between the top quintile and bottom quintile over the past 64 years.  A stock outperforming its peers over the past 2-11 months tends to continue to outperform in the short term.  Anchoring bias to past views likely causes an under-reaction to news on stocks, allowing for the momentum factor to persist.

The great attribute about adding these factors to portfolios is that value and momentum, with each one’s very different fundamental reasons for existence, actually exhibit a negative correlation to one another when implemented across asset classes.  Thus, including these factors in portfolios results in great diversification benefits with an overall lower risk profile and higher expected returns.

Even the kings of passive investing acknowledge the existence and persistence of factors. Vanguard, the second largest asset manager in the world, just penned a white paper on its findings even though the firm does not implement this research within its indexed products due to the active risk and cyclical variation in performance.

Asset flows today are going to passive ETFs and indices across stocks, bonds, and other asset categories.  According to Morningstar’s April 2015 Fund Flows Report, over the past 1-year period, $490 billion went into passive funds across asset classes while $30 billion was sold from active funds.  What passive funds do have going for them is that they are the cheapest in terms of expense ratio.  However, the main factor that these passive indices look to exploit is company size, which does not show a tendency for excess returns (outperformance), although it at times has a correlation with momentum.

Perhaps all of these investors and money managers did not fail statistics class, many just might need a refresher since passive indices outperformed nearly all strategies the last few years.  The evidence is clear that inclusion of factors makes a lot of common and statistical sense, providing a compliment to passive or other active allocation strategies.
 

1. Campbell Harvey, Yan Liu, Heging Zhu., "...and the Cross-Section of Expected Returns." SSRN, April 20, 2015.

2. Scott Pappas, Joel Dickson. "Factor-based Investing." Vanguard, April 2015.

3. Alina Lamey. "U.S. Asset Flows Update." Morningstar Direct, April 2015 Report, published May 18, 2015.

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Back in the Saddle

Aurum Weekly Access - 5/15/2015

By Michael McKeown, CFA, CPA - Director of Research

After a brief hiatus, I am just about caught up and ready to throw down a few charts I think investors will find interesting.

The last several quarters have seen three different asset classes move together.  The currency, commodity, and interest rate markets seemed to go down together since the summer of 2014 and bottomed over the last two months.  The chart below shows the Euro versus the U.S. Dollar, German Bund yields, and oil prices.

The magnitude was different for each, as German yields fell over 90%, the Euro dropped 20%, and oil prices fell 50%, yet the direction down and back up were closely related.  Many traders held these cross market positions, however, taking the three together, it was not necessarily diversified.

A lot of worry led many investors to miss out in the 100%+ rise in the Chinese equity markets over the last year.  Typically moves of this magnitude in such a short time frame are difficult to sustain, although the aggregate price to earnings ratio is at a benign 8.7X, so fundamentally the value is not rich relative to history.

Despite the average 30-year mortgage rate rising to 4.11% from the start of the year (below chart, teal), the mortgage applications index broke out to a two year high (top graph, orange).  In addition, new home sales hit a 5-year cycle high while existing home sales nearly topped the highs from 2013.  I recently attended a speech at the CFA Society of Cleveland and the economist mentioned something I have heard over and over.  He claimed the millennials will only be city dwellers and eschew the suburbs.  My anecdotal observations from the ‘older millennials’ is that home purchases are just delayed compared to prior generations, not put off all together.

We will be back to the semi-regularly scheduled missives next week.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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3 Ways to Win the Loser’s Game

Aurum Weekly Access - 4/3/2015

By Michael McKeown, CFA, CPA - Director of Research

The first book I read on investing was written by Charles Ellis, Winning the Loser’s Game.  It is a best seller described by Peter Drucker as “by far the best book on investment policy and management” and Money magazine dubbed Charlie “Wall Street’s Wisest Man.”  He was on the Bloomberg podcast last week and it was simply a delight to hear his stories and wisdom.

In a nod to the tenants of the book and what I learned, below are the ideas I keep in mind on a daily basis to minimize mistakes and avoid the loser’s game.

1. Avoid Picking Stocks – There are armies of analysts at hedge funds and institutional investment managers who live on coffee and Red Bull, seeking to eke out 1-2% of excess returns against the market, year in and year out.  Charlie Ellis poses the question, from which Olympic sport would you like to compete against the best athletes in the world – downhill skiing, swimming, the balance beam, or weight lifting?

The correct answer is none, because these individuals train their entire lives to compete and getting near the slopes, pool, or gym with them will be a losing proposition.

Picking stocks is doing the same thing, although it is a much easier game to get into – with a few clicks of the mouse.  Now, selecting stocks may be understandable if one has a good feel for an industry or sector and allocates a small portion to self-management (as long as there is a definable & repeatable edge), but self-selecting the majority of stocks can introduce a large variance in portfolio outcomes.

Secondly, if one is picking stocks, is the benchmark appropriate?  Is there a bias to small caps or certain factors (value, momentum, etc.)?  If so, going beyond the S&P 500 will be appropriate to see if value is added or there is just systematic exposure to a certain factor.  For example, buying dividend paying stocks might be great over time, but there are several indices that actually measure this and may be outperforming at a lower cost than a basket of names.

2. Keep Fees Low – It is an amazing time to be an individual investor and advisor.  While the competition in markets is fierce, the products, technology, and tools for constructing portfolios to meet the planning needs of individuals has never been better and more accessible.

3. Stay with It – Every strategy, investment style, and asset class has its day in the sun and it might will have a rough patch.  Sticking with the strategy, style, or asset class is the first step, rebalancing and increasing the allocation after a period of underperformance is the second step.  Selling a strategy, style, or asset class is appropriate for some reasons, however, poor recent performance is usually not a singularly good one.  In fact, it is often a good reason for buying back up to the previous established target weight for the portfolio. Likewise, turning this rule around will help avoid chasing strategies, styles, and asset classes that recently outperformed and may be due for underperformance. Thus one is sticking to the first rule of investing – buy low, sell high.

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Fed to Markets - “It’s not you, it’s me”

Aurum Weekly Access - 3/20/2015

By Michael McKeown, CFA, CPA - Director of Research

While ever so subtly, the Fed told markets it is done with the handholding.  Its own policy of transparency has been too easy for market participants to follow, thus lowering the ‘surprise’ factor to policy changes.  Several Fed governors hinted at this over the past few months, preferring “the old way” where there was some semblance of privacy for the committee.  The era of transparency is not over, but it is transitioning.

In a major alteration from previous statements, the Fed dropped the hints of when it will raise rates, other than to say it was unlikely at the next meeting.  Each of the twelve governors still provided a forward path of where they believe interest rates will be in the future, placing the Fed Funds rate at 0.625% as the median projection for the end of 2015, above the current policy range of 0.0% - 0.25%.
 
The Federal Reserve lowered expectations for growth and inflation along with a faster decline in the unemployment rate.  The general consensus from the media and traders was that the Fed succumbed to the market by lowering expectations for the future path of interest rates and economy.  Nonetheless, on the interest rate side the Fed governors’ fed funds rate projections came closer to what the economy could realistically handle given low demand and supply of credit.


The Fed’s mandate is full employment and steady inflation.  Employment is improving steadily and may go lower than the Fed’s projections, as it has the past several years.  The Kansas City Fed’s Labor Market Conditions measure is the most recent addition to the Fed’s labor analysis toolbox.  In both 1994 and 2004, when momentum crossed above zero (in the sky blue line), the interest rate hiking cycle commenced.
 
 

Inflation is currently running below the 2% target as it has for the last six years, despite 0% interest rates and all of the quantitative easing programs.  Perhaps it goes to show that inflation is much more than a monetary phenomenon (that is, the fiscal side matters too).  This is the variable holding back the Fed from completing its mandate and changing interest rate policy.
 
 

Even though interest rates declined of late, we see many smart managers running portfolios at below average durations, meaning they are minimizing interest rate risk compared to previous history. This seems to makes sense, though it is with the consensus that expects higher interest rates, a consensus that has been incorrect for the last 15 months.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Euro-Trip

Aurum Weekly Access - 3/13/2015

By Michael McKeown, CFA, CPA - Director of Research

The European economy may be turning the corner, with demand for credit up and retail sales jumping at the fastest three-month rate in the last 15 years at 8.65%.

Investors noticed the improvement, and just in the last 2.5 months, poured $9.2 billion into WisdomTree’s Europe Hedged ETF, which shorts the Euro to take out the currency risk.  This nearly triples the amount of assets in the fund from $5.6 billion on 12/31/14 to $14.8 billion as of yesterday.

Germany’s DAX index is up 20% with France not far behind up 17% in 2015, however, the Euro actually fell 12% against the U.S. dollar, partially driven by the flows to currency-hedged ETFs.  Others recognize the extremely low interest rates in Europe and Germany, whose 10-year debt saw its yield plunge below 0.20% this week.  This compares to the U.S. Treasury 10-year at 2.10%, where investors are picking up almost 2% in yield.

Over the long-term, this negative relationship between the Euro currency and stock performance is quite prevalent (it is -0.5 over the last 35 year).  The yellow area chart shows the ratio of the S&P 500 to Europe is above the levels of 1985 and 2002, driven by the quickly falling blue line, which depicts the Euro and a model of how its predecessor would have traded prior to its existence in 1999.

The European Index trades at 8.5X its Price to Cash Earnings ratio (P/CE), or in the 93rd percentile of history since 1980.  In other words, this ratio has only been more expensive 7% of the time.  In addition, according to Morgan Stanley, the median stock’s P/CE ratio is 12.9, higher than in 2000 or in 2007.

Expectations for the economy are turning and investors are embracing European stocks.  Just a few years ago, when prices were much lower, investors shunned most equities in the region fearing the worst with the debt problems of Greece and peripheral nations. These fears seem to have subsided for now.   Forward return expectations should be tempered given where prices stand today.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Plan To Live Longer Than You Think

Aurum Weekly Access - 2/27/2015

By Michael McKeown, CFA, CPA - Director of Research

In the 1800s, old age was considered making it to 40.  At the beginning of the 20th century, life expectancy was 47 years old.  A baby born today will live to 79 years old on average, and perhaps much longer, as biotechnology and medical research funds pour into anti-aging treatments.

There are researchers all over the country seeking the holy grail.  The Buck Institute in San Francisco has quintutupled the life span of laboratory worms. Google even is in the mix with its California Life along with Craig Venter, the first person to sequence the human genome.  These groups are not just seeking to extend life spans, but improve the ‘health span’ of individuals.    “Drugs that lengthen health span are becoming to medical researchers what vaccines and antibiotics were to preivous generations in the lab: their grail.  If health span research is successful, pharmaceuticals as remarkable as those earlier generation drugs may result.”

There is a lack of retirement readiness endemic in the United States today.  Most people are not prepared to fund retirement given current life expectancies, let alone if these increase.  Economist Barry Bosworth looked at data from the Brookings Institute that showed how life expectancy changes based on wealth.  In fact, it can be much longer than average for those with above average income and assets.  The charts below lay this out in detail.

 
What the above charts show is the average 55-year old in the top income decile will live another 35 years to age 90 for both men and women.  This compares to the median income decile projection of 85 and the bottom decile at 80-81 (for men and women, respectively).

We consistently see clients underestimating how far in the distance their own mortality actually is.  The scenario analysis our firm goes through projects life expectancy out to ages 90 to 100, as even a couple with both spouses at the age of 65 have a one in five chance of at least one living to age 95.   All of this has consequences for savings, spending, estate planning, and more.

What can people do to stay on track for retirement and ensure they do not have to drastically scale back lifestyle or be concerned about running out of money in retirement?  In two words: Save More.   Applying a consistent process to saving makes this habitual.  The table below lays out a checkpoint based on income, age, and baseline assumptions on income replacement during retirement. 
 
 

Source: JPMorgan Guide to Retirement

The table provides a decent starting point for benchmarking whether someone is on the right path toward retirement or needs to make adjustments.  The earlier the better for modifications to savings and planning, as even Albert Einstein noted that “compound interest is the eighth wonder of the world.”


If you would like to see more interesting information on savings, longevity, or retirement data, please contact us.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

[1] “What Happens When We All Live to 100?” by George Easterbrook, The Atlantic http://www.theatlantic.com/features/archive/2014/09/what-happens-when-we-all-live-to-100/379338/

[2] JPMorgan Guide to Retirement 2015, page 6. Social Security Administration.

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Tea Leaf Reading with the Fed

Aurum Weekly Access - 2/19/2015

By Michael McKeown, CFA, CPA - Director of Research

According to the ever powerful Wikipedia, tasseography (aka tea-leaf reading) traces back to medieval European fortune tellers who developed readings from splatters of wax, lead, and other molten substances.   Over the years, economists, analysts, and the media often feel like tea leaf readers when decoding the language used in memos and speeches from Federal Reserve members, searching for hints of the next policy move.  Yet this Fed has been quite transparent about its plans, though not everyone believes them this time.

Last week, John Williams of the San Francisco Federal Reserve Bank was interviewed by the Financial Times.  It is a great interview I recommend to all readers. This quote stuck out to me:

“Say the Fed were to raise interest rates later this year, a few times and over the next year or so, interest rates would be above zero, and say the economy slows relative to our expectations and progress on our inflation mandate slows. Well obviously we can slow down the process of raising interest rates. We can even pause for a while, not raise interest rates further. We have a lot of degrees of freedom to adjust our policy dependent on how circumstances develop. It is really important to remember though that monetary policy does work with a lag. Typically our models, our analysis, tells us it takes us a year or two to have a full effect on the economy and inflation.

So let me randomly pick a date out of my head. Say middle of 2015 you started just removing accommodation, well the effects of that on inflation really wouldn’t be felt until mostly until the middle of 2016 or maybe 2017 given the lags in monetary policy.”

Source: CME Group FedWatch, as of 2/19/15

Many large investment firms whose research we still follow have been notoriously wrong at predicting interest rates the last several years.  Why bother read it you may ask?  Well, to get a feel for what the majority of folks may be thinking.  Writing an opinion is easy, it's best to look at where traders placed bets in the Fed funds futures market (chart above).  Investors believe there is an 82% chance that the Fed hikes rates by the end of the year, with the slight majority believing at the last meeting rates will be at 0.75% (from a 0 to 0.25% range today).

In anticipation of the move, the change in interest rates followed similar patterns to previous hiking cycles.  While short-term interest rates increased (the 1-5 year maturity area), longer term maturities (of the 10 and 30-year variety) actually decreased in yield.

 

Source: NBER.org/cycles.html

The expansion of the business cycle reached its 68th month as the previous recession ended in June 2009, making it the fifth largest all-time since 1857.  The chart above demonstrates that cycles are living longer than previous expansions, as each of the previous three made it over 6 years.  We would attribute this to the growth and availability of credit.  While many cite the lack of credit expansion in this cycle as holding it back, banks are in the midst of loosening standards while demand for credit is increasing at the margin.  Still, we should keep this chart handy as the signaling of interest rate hikes marks a key line of demarcation from accommodative monetary policy to tightening policy.

Many of the bond fund managers we use within portfolios forecasted the Federal Reserve’s intention of interest rate hikes in 2015, including Doubleline’s Jeff Gundlach and Guggenheim’s Scott Minerd.  In his note last week, Minerd keyed on St. Louis Fed President James Bullard’s outspokenness on policy over the past few years, including lately.  He wrote, “Whenever ‘lift off’ actually occurs, we’ve been long anticipating this day would come…. The good news is there is still time [for investors] to prepare for when the Fed finally runs out of patience.”

Interest rates seem to be reacting to this rhetoric, and so far closely following  an analog to the “Taper Tantrum” in 2013 (when then Fed Chairman Ben Bernanke uttered the word ‘taper’ in regards to the quantitative easing program).

No central bank has been able to get off the 0% floor, that is, raise rates once the policy rate has been at the lower bound like it has been in the U.S. for the past six years.  Investors will be reading the tea leaves from the Fed closely, as removing accommodation will likely bring volatility to capital markets.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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