IEV and IVE: Two ETF Winners

excerpts from this week's report.

"As the chart on the next page shows (see report), two positions held by the Model Growth Portfolio have produced above market returns over the past twelve months: Europe 350 and Large Cap Value. The Europe 350 is benefiting from a confluence of developments (dollar weakness, growth in Asia, modest resurgence in European..."

Investment Strategy Implications

"It is likely that the outperformance of the two sectors will continue for the foreseeable future and may even accelerate, particularly for Large Cap Value, as private equity..."

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Uncertainty – The One Constant in a Global Environment

What does it say when a gaggle of economists can’t get a monthly domestic number correct like the April retail sales? When you combine this morning’s April retail sales number with the just concluded 1Q07 earnings season, the issue that leaps out is unpredictability. This unpredictability factor is key to valuation models as the Fed Model shows on today’s blog.

Investment Strategy Implications

The Fed Model (see updated model on May 23rd blog entry) illustrates the risk adjustment process that reflects uncertainty. As noted earlier this week, an 80 to 100 basis point upward adjustment to the capitalization rate of the 10-year US Treasury (which equals the downward adjustment to the P/E ratio) has been the average risk premium throughout most of this bull market. A reduction of that premium implies an increase in risk taking.

As much as bullish investors would wish otherwise, today’s world is a highly uncertain one. So, when forecasts go awry with such regularity, a substantial reduction in the risk premium seems most unwarranted.


Have a good weekend.

Reading, Researching, and ‘riting – The 3Rs of the Independent Investor.

Capital isn’t the only thing that is very affordable and abundant these days. Information is as well.

Information availability has leveled the playing field for all investors. The investment implications are significant. Take, for example, the work that I do.

While I do benefit directly from my first hand experiences as a moderator of my events, from my access to investment opinions from various sources, and the occasional interaction with fellow investment professionals at selected functions, the vast majority of my research time is spent in quiet solitude at my desktop reading, researching, and ‘riting – the 3R’s of the independent investor.

The power of the Internet has made independent research possible. As has the financial innovation of ETFs, which has enabled me to perform investment strategy analysis on a sector and style basis, something not possible previously. The construction of the all-ETF Model Growth Portfolio is the investment strategy expression of my work.

So, if information is very affordable and abundant, what's left for an investor to gain a performance advantage? There appears to be four specific ways an investor can achieve a superior rate of return: non-public information, advanced trading systems, leverage, and insight

The first two are out of reach for most investors. One is illegal. The other is the domain of specialized trading firms. That leaves the last two –leverage and insight – as the sole areas where investors can hope to gain a performance advantage.

Leverage is the path that many investment professionals are either engaged in or headed toward – whether intentional or inadvertent. As I have noted numerous times before, liquidity is being aided and abetted by leverage (see May 1 blog entry for most recent comment in this regard). However, with leverage comes added risk. One example of added risk was noted in last Friday’s blog "Quotable Quotes" entry (BlackRock’s founder and CEO, Larry Fink – “…probably the greatest issue that’s confronting the world’s investors is we are trading liquidity for illiquidity.") And leverage is a major function of that trade.

As for insight, it is the only pure and unique element of investing. Everyone tries but few succeed at being insightful. However, it is important to note that insight is not the domain of the smart, nor the well connected. In fact, it could be argued that the further away one is from the mainstream thought process, the better the chances of operating in an environment that insight can flourish*.

Investment Strategy Implications

As the equity markets continue to set new highs and threaten to overheat, some professional investors might take solace in the fact that the individual investor, the so called little guy, has yet to join the party in earnest. Last week’s large jump in individual investor bearishness is one example. However, when information is both very affordable and abundant, I wonder just how uninformed that little guy actually is.

Investors live in an age of empowerment. The playing field has been leveled, at least in the legal areas. And insight is the greatest tool of the independent investor.


*Warren Buffet being the most prominent example, at least from a geographical perspective.

Keeping It Simple

The Fed Model referenced in the most recent Sectors and Styles weekly report described the closing of the valuation gap to the point where, based on one’s assumptions of risk, the market is either 24% undervalued or less than 6% undervalued (see updated model on May 23rd blog entry).

If an investor assumes that a 80 to 100 basis point premium is warranted (which has been the case for the past several years) and that $92 is the appropriate 2007 operating earnings number for the S&P 500, then the best case return potential for stocks is little more than that which one can receive owning a US Treasury.

Investment Strategy Implications

The analytical process may involve a very complex set of data, but the valuation process is quite simple. It’s the getting the inputs as well as investor perceptions and expectations correct that’s the hard part.

Technical Tuesdays: What’s With the VIX?

Under the radar and out of the discussion of late, but as noted in a prior comment, the VIX has settled into a trading range approximately 30% higher than previous bottoming levels (see 3 year chart to the left). What is the significance of its elevated trading range? One possible answer lies in the increased fragmentation of market size and styles.

An interesting pattern has emerged over the past year in which the performance of style segments within market caps are widening. For example, for several years small cap growth and small cap value have tracked very closely to one another (see chart to the left). However, beginning last spring, the performance patterns have changed with small cap growth outperforming small cap value. The same is true in the mid cap area – only the reverse is true: mid cap value has begun to outperform mid cap growth.

Investment Strategy Implications

I have argued in recent television appearances that we have likely entered a market period where size and style selection will matter more than it has in the recent past. The performance data bears that out. And with it is an elevated level of the VIX implying that the homogenization of market returns has ended and in its place is greater performance diversity, higher uncertainty, and, therefore, greater risk. Correlations are still high but I would suspect that they are about to change as well.

Valuation: All in the Eye of the Beholder

excerpts from this week's report

Astute investors know that equity valuation is 2 parts science, 1 part art. The methodology used to derive the science part of the valuation equation is fairly well known – cash flows (or earnings, if you prefer), a projected growth rate, and a discount rate. The fabled discounted cash flow (DCF) model.

However, valuation isn’t all science. Numerous behavioral finance studies have made this quite clear and irrefutable. Loss aversion is as much a part of the valuation process as risk aversion is. And the regret factor plays a very large role in the investment decision-making process.

As equities move into new high territory, the fundamental anchor is valuation. It is the justifier for M&A, as well as the analytical support for equity positions taken and held. As long as there is a projected higher valuation level forecasted (based upon the mix of the three DCF inputs), investors are able to find reasons to remain long. Which brings us to a very reliable and effective valuation tool for the overall market – the Fed Model.

As shown on the following page (see report), the updated Fed Model shows a valuation gap still remains despite the current double-digit rally. The only question is just how wide is that gap?

As the model makes clear, if one uses the current 10-year Treasury as the discount factor, then stocks have a very long way to go to the upside. However, throughout this bull market, a risk premium has always been a part of the valuation equation, which has ranged from 80 to 100 basis points. (see table in report)

Using that discount benchmark, the valuation gap is right around the rate of return an investor can get in a US Treasury. (see table in report)

The risk adjustment I have used to reflect the numerous uncertainties investors face (from exogenous events to geo political risks to financial contagion) is made via the 10-year interest rate level. By adjusting upward the discount factor* to the level it has maintained for the past several years (80 to 100 basis points), the valuation gap has closed significantly. The only question now is has the relationship between risk and reward changed?

Investment Strategy Implications

If earnings growth remains on track and rates remain well behaved, then valuation support for the equity markets will remain intact. The only issue is the aforementioned risk/reward dynamic. If that has changed, then the valuation gap is sufficiently large enough to push equities meaningfully higher.

The concern expressed here, however, is that so much has work to work so well and little can go wrong. In other words, there is little margin for error.

Valuation, like beauty, is all in the eye of the beholder. Or as Lord Keynes once said:

“It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”


In my opinion, it won’t take much to change perceptions.

*In the Fed Model case, the 10-year Treasury is used as a capitalizaton rate. Nevertheless, the effect is the same as a discount rate used in a DCF model.

Note: All research reports require a subscription. For information about our subscription service, please click on the Blue Marble Research services link to your left.

Quotable Quotes

"Bull markets are characterized by disbelief. Our sentiment work still shows extreme bullishness. In this respect, this market is in no way similar to that of the mid-cycle pause of 1995. At that time investors were immensely bearish. Keep in mind that Alan Greenspan's "Irrational Exuberance" speech was in 1996, and that he was not commenting on the yet-to-come Tech bubble."
Rich Bernstein


"The right response to current balmy economic conditions is not complacency, but to treat them as an opportunity for action. This is an ideal time to implement long-term reforms that will allow individual economies to grow faster and adapt better to change. This is, above all, the ideal opportunity to make the policy changes that will allow countries to exploit the opportunities provided by globalisation."
“Risks and rewards of the world economy’s golden era”
Martin Wolf
(see related chart to the left)


FT: "We’re seeing LBOs become more and more leveraged. We’re seeing covenants weaken. As a buyer of loans does that worry you?"
MR FINK: "Absolutely. I think we are going to look back two or three, four years, the same way we were looking at the subprime market where we saw standards and covenants deteriorated. We’re seeing the same thing in the credit markets. I believe if I was the chairman of the Federal Reserve I’d be paying more attention to that, because to me this is going to be tomorrow’s problems. The biggest reason for this, we’ve had just vast liquidity. The global capital markets have flourished so well, and there’s so much money sloshing throughout the world, people are looking for ways to invest. And so the risk we have throughout the world now is that not only are we trading credit, higher grade credits to lower grade credits with poor covenants; probably the greatest issue that’s confronting the world’s investors is we are trading liquidity for illiquidity."
FT interview with Blackrock’s Larry Fink

"Get your facts first, then you can distort them as you please"
Mark Twain

Have a good weekend.

Technical Thursdays: Separation Anxiety

"In this week's edition of Technical Thursdays, we take a look at three charts - the VIX, Size and Styles, and selected global markets.

"VIX: It may have gone largely unnoticed but the VIX has settled into a higher trading range ... The implication is twofold – either bullishness is..."

"Size and Styles: The one-year performance gap between mega and large cap (which includes large cap value – IVE) continues to widen. If risk has returned..."

"Selected Global Markets: There are two interesting aspects to the global markets –one is the sustained strength in the Europe 350 (IEV) and the other is the sustained weakness in Japan (EWJ)..."

Note: To view today's report, a very modest subscription is required (less than 3 tanks of gas). To learn more about the benefits of subscribing, please click the Blue Marble Research services link to the left.

The Bull in the China Shop

“New accounts at brokers are being opened at a rate of more than 200,000 a day, touching a high of more than 310,000 on April 24th. The total so far this year is more than 8 million, which is around ten times as many as in the whole of 2005, when the market began to emerge from a four-year slump.”

from “It’s like a casino set up by the Communist Party”
FT.com’s blog Alphaville*

“If the bubble were to pop, it could have a bigger impact on social stability than any previous downturn in the stockmarket’s 16-year history. There are now more than 91 million accounts held by individuals at brokers or in mutual funds. Estimates for the number of investors vary widely. At the height of the last market boom, in 2001, there were 60 million accounts but perhaps fewer than 10 million investors. There are certainly many millions more now."

from “The people's republic in the grip of popular capitalism”
The Economist**

Investment Strategy Implications

If words don’t move you, perhaps the two charts above might. The first one is the Shanghai market over the past two years. The second is the NASDAQ over a comparable two year period at the height of the tech bubble. Guess which one has risen at a faster rate? (Hint: It ain’t the NASDAQ.)


*http://ftalphaville.ft.com/blog/2007/04/30/4202/its-like-a-casino-set-up-by-the-communist-party/

**http://www.economist.com/world/asia/displaystory.cfm?story_id=9084756

The Bubble Machine of Liquidity and Leverage

As someone who has conducted numerous hedge fund/alternative investment seminars over the past four years, I found yesterday’s front page article in the Wall Street Journal on leverage (“As Funds Leverage Up,
Fears of Reckoning Rise”) to be of great interest and a must read for all investors. Understanding the role leverage is playing on asset values and the actors involved is vital to a clear understanding of the real drivers of higher market values.

The issue of leverage was also succinctly addressed in my March 5, 2007 weekly report by the father of the Modern Portfolio Theory, Harry Markowitz:

“The unlevered investor cannot go any further than point (0,0), at which his return is maximized. If an unlevered investor tries to compete with a levered investor for returns, he can only access higher yielding, risky securities. As a consequence, the presence of leverage for some investors drives down the risk premium for ALL securities, including the riskiest securities with worse risk-reward profiles.”

As for liquidity, astute investors know that the global money supply growth shows no signs of abating. What is less appreciated is the role hedge funds are playing in the manufacturing of money. Here, Rich Bernstein’s comments on April 25, 2007 are most insightful:

“As we first wrote more than a year ago, the Fed and other central banks will effectively have to disintermediate hedge funds to curb inflation pressures. The unbridled credit creation outside the traditional banking system (i.e., from hedge funds, CDOs, CDSs, and the like) remains the key factor within the financial markets today. Monetarists, of whom we assume most central bankers are, would argue that the route to inflation is through credit creation. Inflation expectations, as measured by TIPs spreads, have been rising for five months. A manager at one of the world's largest hedge funds recently commented to us, "We aren't a hedge fund anymore, we're a bank." That is exactly our point. Interest rates may necessarily have to rise enough to disintermediate these new "banks" in order to slow credit creation.”

Investment Strategy Implications

Investors who insist that this bull market is all about earnings or some Goldilocks economic scenario are sorely mistaken. Granted, bull markets are a reflection of the real economy and earnings growth and profitability are a key component. As is low interest rates. But the lifeblood of this or any other bull market is liquidity. And when combined with leverage and the “genius” of financial engineering, capital is virtually unlimited.

As Milton Friedman would note, however, the problem develops when too much capital chases too few goods. In the real economy, capital is more than adequate. And certain economies (emerging markets) are threatening to overheat. In the financial economy, the sustained reduction in equity via M&A and buybacks is tilting the demand/supply equation strongly in the direction of over inflationing financial assets.

A valuable Greek expression sums it up, “All things in moderation.” However, moderation is the last attribute one equates with excess amounts of capital.