Small capitalization stocks (small caps or small companies) have outperformed both mid caps and large caps since the late 1990's when large caps got grossly over-heated. If we look at the ratios of the SP Small Caps Index (SML) to Large Caps (SPX), Mid Caps (MID) to SPX, and SML to MID, we can see the progression out of the bloated SPX of the late 1990's and 2000. (Click on the thumbnail images for a full-sized image.)
What we see in 2005 is that small caps are beginning to lose strength to the mid caps, although both are still outperforming the SPX large caps.
While this may seem arcane, it tells us something about market dynamics at a time when the FED is increasing short interest rates and when the US Treasury yield curve is flattening.
Once again my favorite portfolio economists at Hussman Funds have an analysis on this very issue from 2003.
William Hester wrote a brief and crystal clear account of the diagnostics of portfolio rotation amongst small and larger caps against the background of a flattening or inverting yield curve such as
we are now seeing. As Hester puts it: "... for a sign that conditions for small companies might be weakening, keep your eye on the bond market."
In 2003 the yield curve wasn't flattening, but it certainly is flattening in the past year as the FED raises the short end and the bond rate has fallen at the long end--the famous "conundrum" of Greenspan.
As corporate profit growth begins to slow, small caps feel it first and large caps later. This was certainly the case in the later 1990's and may be starting again.
Hester writes, "As profits slow, value stocks lose their edge. In this environment, mid-sized and large growth stocks have done best, rising 18.5 percent and 16.5 percent, respectively, with small value stocks gaining 15.8 percent ......"
We care for two reasons. One reason is that we may need to adjust or re-balance our own portfolios toward the larger caps and away from the smaller caps. This needn't be an all-or-none switch but a weeding or re-balancing.
The second reason is that the yield curve and the cap rotation may both be hinting of an economic slowdown in the future, and both do so predictively. See Hester's "The Yield Curve - A Multi-Talented Indicator" for further details. http://www.hussman.net/popup/yldcurv.htm
In 2002 I began to look around and think about what to do with my life and money. Partly by luck, partly by fear, and partly by ignorance i got through 1999-2003 mainly in short term bonds, cash and gold. I never made nor lost a penny or a bundle in tech which i never understood. I felt foolish for a long time and people who asked me what I owned agreed...lol. Because of Long Wave studies I thought gold was making bottom, but i had no idea how well it would pay off.
I decided I wanted to retire while I still had half a brain and a healthy body. And I didn't want to spend full time trying to properly analyze and keep up with 20-40 stocks to make a classical low volatility, moderate growth and income portfolio.
At that time I happened upon Paul Merriman's fine basic set of articles on "The Ultimate Buy-and-Hold Strategy". Of course, "buy and hold" was totally discredited and mocked in 2002 as many people who had bought and held simply went down the tubes without benefit of roto rooter and were never heard from again. Being a contrarian by nature I thought it might be worth a look at "buy and hold". lol
My first realization was that here was a guy, Merriman, who had been doing mutual funds for thirty to forty years, so he might have a few good ideas. Merriman didn't really like "buy and hold" as an only or preferred strategy, but he knew it could be done. This was just the kind of test I like.
What I got from his short series of articles (http://www.fundadvice.com/FEhtml/BHStrategies/0108/0108a.html) was the notion of index and value funds divided into small and large capitalization US stocks, plus international funds, and interest bearing (bonds, money market) funds. We knew then that value funds had plunged in 1999 while index funds roared up, so this was initially intuitive that one might want to do both. Also small stocks had bad innings in the late 1990's but had outperformed from 1999/2000 to 2002.
The basic premise and main advantage of such a portfolio is diversification amongst asset classes so that risk is reduced in any one type of market. This is a strategy for nest eggs which one wants to grow steadily and not blow away in a freakish market. Also it works for an older investor who can't afford to lose too much in any one market environmemt as she or he wouldn't have time to make it up. But Merriman's point is that it also will work over time for people who really don't want to actively manage a portfolio, or who don't have enough to hire an advisor for, but have lots of years before retirement. Read Merriman's papers and see how it works.
I didn't really inherently like the idea of index funds very much as you are buying the good, the bad, and the ugly all in one fund, when you really want only the good. The SP500 funds, even with all dividends reinvested as received, are still under their peaks of five years ago. The chart shows two funds with all dividends reinvested (total return) for the last five years: VFINX is Vanguard's SP500 index fund (with very low costs), and DODBX is Dodge & Cox's managed middle of the road balanced fund with stocks and bonds in a variable allocation.
While I didn't totally dismiss the idea of index funds, I decided first to look for funds, like DODBX, which had actually made money during the 2000-2002 tech and bloated leaders crash. Not surprisingly there were not a lot of such funds, but they were there. Instead of trying to pick twenty to forty stocks I'd look for the best stock pickers for at least part of my portfolio. Any stock picker who made it through 2000-2002 and came out ahead must know something.
A good way to evaluate a stock picker's performance is to use the free service and data base at FastTrack: http://www.fasttrack.net/
They have an extensive database of total returns (as above) for mutual funds and for many dividend stocks and ETF's. They have software you can buy, but all I needed was well covered by their on line free service.
This was a learning and growing experience, and I did not wake up the second morning knowing exactly what to do. As a futures trader and former stock investor I had some technical analysis skills. Everything I knew said we were making a major low in 2002, but I needed some hand holding. It's one thing to trade futures where you are in and out whevever you want, but for mutual funds that doesn't work.
Three people convinced me that I was right and helped give me the courage to start the new plan: Don Hays, Joe Rosenberg (in an interview by Kate Welling), and Don Wolanchuk. Rosenberg is the chief investment strategist for Loewe's (and hence CNA Insurance), and the other two are seasoned technical market analysts. All three saw the market being grossly oversold. Personally I had never seen sentiment so gloomy, whether measured by market internals or by surveys or anecdotal data. As an example of the latter, internet investment chat sites were hilariously gloomy with all the usual suspects ranting and braying. And the closer we got to March 2003 the worse (and therefore better) it got.
I started buying in January 2003 all the way into the low. Since I was new to this type of investing I did not get more than 50% invested by the low, but as I learned and as we went up I added into the late summer low of 2003 and along the way in 2004.
Since I had been a Kondratieff Wave enthusiast for decades and knew that the wave was bottoming along with the four year cycle, I added to Merriman's mix by buying some specifically inflation-advantaged funds as well as the "generic" stock and bond funds. I bought several real estate funds (domestic and international), a gold fund and a polymetallics fund, Bill Gross's commodity fund, and several energy funds, but not in overwhelming percentages of total assets, since I really did (and do) want to stick to the basic idea of reasonable diversification. I also bought an inflation-adjusted US bond fund and a foreign bond fund
As I became more aware of individual long term fund returns and costs, I exchanged some of my original picks for better managements with lower costs. I decided not to limit myself to funds of one mutual fund management company, and to buy and sell mutuals through a "pick and choose" broker. For index funds, niche funds, and bond funds it's very hard to beat Vanguard on costs. Of 24 funds I own in various personal and family retirement accounts, cash accounts and trusts, seven are Vanguard Funds, two each are from Third Avenue and Dodge & Cox, three from Profunds and two are from Rydex. Rydex and Profunds are used for index funds in which I switch from long to short funds on a swing trade basis. Their costs are higher than the rest, but by using them as hedges on the short side and "augmenters" on the long side, I can boost my returns without disturbing the long term portfolio. On the short side I generally use the 200% leveraged funds to cover a larger part of the "good pickers funds".
My buddy, Perrin Gower, introduced me to John Hussman who runs a very good "hedged" fund, some of which I own: HSGFX. He picks stocks he thinks are undervalued and sells and buys OEX and SPX options against them on a variable basis depending upon the market and the valuation environment. This is the idea of being long the "good stuff" via managed funds and being short the "good, bad, and ugly" stuff via indexes. The chart again is a FastTrack total return chart of Hussman's fund in blue and Vanguard's SP500 index fund in red.
Hussman was "the man" from 2000 to early 2004, but hasn't done as well since then. On an annualized basis he is up about 16% per year compounded even so. Hussman is younger than I am so if I get tired of my hedging with Profunds and Rydex or become unable to continue, I'll let him take over since wifey isn't an investor. (He even has some gold stocks.) But I'm beating him handily since last year, and I'm having fun. :)
By using the Profunds and Rydex on the long side I am being true to the Merriman maxim of including index funds in a diversified mix, but by using them on the short side I am emulating Hussman as well.
I should mention that I am also trying to be a bit pro-active with bonds as well by occasional shifts from long term to short term or vice versa, but I've kept a core bond position of inflation-adjusted US Treasuries with Vanguard's VIPSX.
The only account where I still have some individual stocks is a taxable income account in which I have a some Canadian and US oil royalty trusts, some pipeline and infrastructure master limited partnerships, and Vanguard's REIT fund. These all pay pretty decent dividends which are either partly tax sheltered or are not taxed at the source and therefore only once. I also bought some GM preferreds and GM PET bonds paying 8-10% when bought. I have a few core gold stocks in there too. There is also a separate municipal money market and muni bond fund sub account.
I still trade SP futures and occasionally other futures, but I can take those or not as I please and travel whenever I want. I have cut down daytrading futures except if I see a "sure thing"...LOL. The rest are traded on a swing basis according to the principles in the Blue Series charts.
That's my voyage of discovery the past few years. Learning for fun and profit. Beating inflation and currency decay by a healthy margin in an inflationary age is the name of the game. It can be done.
the question unanswered there (or here in the last fed discussion/reply, though asked, and yes i DID notice ... lol) was how the low long term rates do not fit into the longwave view, herein and heretofore espoused, and the predictions for many, many moons of higher yields as the key ingredient in the inflationist gumbo.
Every long term trend has large contra-trend reactions. In gold we have been playing the "little winter" scenario for a year or more (after a run from 1999), and in bonds for "a while". Unfortunately copper, iron ore, coal, and petroleum won't dance that tune. Nor CPI, PPI, GDP price deflator, etc.
In brief, we have been in a contra-trend period this year with players trying out the old idea that the FED or someone or something will overshoot and cause the deflation bogeyman to return. Everyone has been rushing around rebalancing and re-allocating portfolios, causing waves in the bathtub. But nothing has changed fundamentally, and the rubber ducky is still afloat even in the bathtub.
The "almost too good to be true" sell signal for 31 May/June 1 wasn't good enough. The SP paused, but never fell. Now there is a new buy signal to add to those of May. Unless SP September futures print tomorrow under today's low of 1205.30, we'll have yet another reconfirmation of the buy. This projects to a high of at least 1235 by July 1. (Click on the thumbnail image for larger chart image.)
The 2C Sentimeter was 51 as of Friday's close, so there has been no real change in the past few weeks. This is part of the current technical analysis dilemma. The set up for a sell was so perfect as to be "too good", and indeed we haven't sold off. Being so late and so little off the timer line date of May 31/June 1 generally means the market isn't going anywhere or not far in the opposite direction.
Since 2003 not every sell setup has failed but a meaningful number have for SELLS but not for BUYS. So this inaction at present is consistent with a continuation of the bull market from 2002 or 2003. Also the mechanical trade entry method I call the Scottish system has not given a sell signal. IT can do so each day under certain conditions but so far those conditions have been negated or aborted, leaving the last buy signal of May 16 in force.
As a result I have removed my short hedges in cash stock and fund accounts and have just been scalping the stock index futures, awaiting a sell signal at some point.
A fair question has been put to me before about this approach:"Tom, if you don't do anything until you have a mechanical trade entry signal, why do you bother with the TA, sentiment and timing methods?"
The best answer I can give, apart from enjoying TA in itself, is that having a "weather forecast report" from that work I am psychologically ready to act when I do get a signal. The draw down is being psychologically ready for a move that doesn't happen, as may be the case here. If it weren't for the fact of leverage with futures and the occasional need for a next day confirmation with the Scottish, I would be tempted to use the Scottish method exclusively for trading. Having the TA weather report gives me the confidence to act upon the early warning or preliminary Scottish signal.
If we do not get a sell here and rather soon, it's pretty obvious that we are going to new highs on the year in SPX. The SP small cap and mid cap indexes already have done so.
""with due respect, i think the inflationists need to explain, convincingly, the action of the long bond. it is hard to accept greenspan's explanation of shortcovering by those who expected his widely pre-announced tightening campaign to produce the results history records. that may have had something to do with it, but the bond market is just TOO large to have had such a long and deep reaction. "
"also, the monetary aggregates are showing serious deterioration and suggest the beginning of an uncontrollable implosion. i hope this excellent site develops into a forum which fosters debate on these important matters and not just a trafalgar square soap box for one view. ""
Daniel, thanks for commenting at this site on several occasions. :) Blogs generally are part diary, part ego billboard, but you ask an interesting question about Greenspan's long bond "conundrum", and I'll give you my soap box opinion .
Actually, as you know, a conundrum is a mystifiying event or question which is answered by or in a riddle. So what is Greenspan doing with this issue in this way? I owe part of my analysis, or at least the impetus to analyze, to two bearish analysts: John Hussman and George Slezak.
Hussman suggested that part of the pressure to buy bonds in quantity is coming from holders of pre-packaged mortgages who are suffering from "duration gap" as mortgages in nearly all prior packages have been and are being pre-paid. The mortgages were bought as long term investments in a stream of income, but as these long term mortgages are refinanced--with the old mortgages paid off--the mortgage holders, who planned their own funding needs based upon coupon yield AND length in time, are being left stranded. Note that this is not an "at the margin" effect on new mortgage packages but affects each and every mortgage held from the past which gets refinanced. It's an on-going cumulative effect. The holders are thus faced with the urgent need to replace the yield and duration as best they can as rates fall. Thus it is very nearly a buying panic as they buy long duration treasuries to bridge the duration and coupon gaps.
Now we come to Greenspan's riddle: Remarks by Chairman Alan Greenspan Central Bank panel discussion To the International Monetary Conference, Beijing, People’s Republic of China (via satellite) June 6, 2005
Here are a few excerpts:
"The pronounced decline in U.S. Treasury long-term interest rates over the past year despite a 200-basis-point increase in our federal funds rate is clearly without recent precedent. "
"A number of hypotheses have been offered as explanations of this remarkable worldwide environment of low long-term interest rates."
"One prominent hypothesis is that the markets are signaling economic weakness. This is certainly a credible notion. "
Then he talks about three other possible hypotheses. The second has to do with pension funding demands for future retirees, and he rejects this as not sufficiently robust. The third is bond buying by Central Banks. This he doesn't reject but finds the reality "modest" and "implausible" in the current environment.
Likewise number four:
"A final hypothesis takes as its starting point the breakup of the Soviet Union and the integration of China and India into the global trading market, developments that have permitted more of the world's lower-cost productive capacity to be tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of cost-reducing investments."
Thus of four hypotheses which have been bruited about, he finds only the first, economic weakness "plausible", but doesn't endorse it.
Later in the week: Testimony of Chairman Alan Greenspan The economic outlook Before the Joint Economic Committee, U.S. Congress June 9, 2005
After introductory remarks on the general economy he once again turns to the "conundrum":
"Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates on U.S. Treasury securities despite a 2-percentage-point increase in the federal funds rate. This is clearly without recent precedent. The yield on ten-year Treasury notes, currently at about 4 percent, is 80 basis points less than its level of a year ago. Moreover, even after the recent backup in credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period."
Note that he tempers the "plausible" but not endorsed hypothesis of ecnomic slowing by mentioning that "yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period." If economic weakness were the ghost in the attic scaring the treasury market, less than investment grade long duration bond yields would not be dropping this much.
After repeating the conundrum for the Congressmen, he launches into the riddle:
"That said, there can be little doubt that exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding and home turnover, and especially in the steep climb in home prices. Although a "bubble" in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels."
"The housing market in the United States is quite heterogeneous, and it does not have the capacity to move excesses easily from one area to another. Instead, we have a collection of only loosely connected local markets. Thus, while investors can arbitrage the price of a commodity such as aluminum between Portland, Maine, and Portland, Oregon, they cannot do that with home prices because they cannot move the houses. As a consequence, unlike the behavior of commodity prices, which varies little from place to place, the behavior of home prices varies widely across the nation."
"The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace. "
A riddle tells you part of the solution, but only a part, and usually in a deceptive manner. Here Greenspan is telling us that falling rates induce mortgage refinancing and rising prices in houses, as well as in bonds. but don't worry because the housing market, at least for owner-occupied homes, isn't homogeneous or fungible since owners can't move their inexpensive Portland Maine home to dearer Portland Maine to sell it.
What Greenspan is hiding in the riddle is that the FED has caused the "bond-carry" bull market in bonds by excessively low short rates, and now there is a rush to be the last man into the carry trade while there is still a spread and before the yield curve inverts. What else Greenspan is hiding is that the mortgage refinancing binge is precipitating a mortgage holders' duration gap buying panic as we saw above.
In the process he has identified several scapegoats--definitely not including himself or other Central Bankers: hedge funds and second home buyer/flippers. He implies that none of this is the fault of banks, for whom he works, but rather of hot money. Since Greenspan is already into lame duck and swan song mode with retirement looming at year's end, he is pre-writing his excuses why something went wrong after he leaves. He is also explaining why he must continue to raise short term rates with the dual risks of choking off economic activity or causing a mortgage and housing disaster.
Finally, his conundrum and riddle also reinforce his reputation as a victorious inflation fighter. Every time he speaks he downplays inflation, as if it were common knowledge that inflation is history, not the present. The reality is quite different , as everyone knows. By waiting too long and by being excessively cautious he now admits (in riddle form) that he underestimated how powerful the new demand inflation was and is, and how he stimulated it further through the bond-carry and mortage duration gap bond panic.
The conundrum and riddle are classic retirement "cover your ass" farewells. The riddle master caused the conumdrum. Inflation rules.
Naturally I could be wrong. But the weight of evidence from sentiment to chart analysis tells me we have moved off the top for this recent up move which started in mid April. Two factors will help to confirm it for me. One is for SP500 to break under 1190 and stay there. The other would be for on-balance volume (OBV) of the SP500 futures to break under the 65 day moving average (65 days~= one quarter of the year). OBV has stayed above this moving average, except for a day or two, ever since March 2003. June is the month that SP500 futures switch from the June to the September contract so we'll also watch closely to see if the open interest (number of contracts held by overnight and longer traders) drops indicating that some players jumped ship.
The open interest of legal commercial or financial institutions who are hedging portfolios showed a major increase last week in net shorts in the combined, size-adjusted futures and futures options contracts. We don't know what they are seeing, but it might be somthing like their version of my chart: something which makes them thinks stocks are in for a tumble. They are the "insiders"-- quite legally too-- and they are in a much better position than we are to know what's going on. (Click on the image for a full-sized popup of the chart.)
We're in an era of nearly totally freely floating prices, not only for stocks and bonds, but for all interest rates, foreign currencies (plus one's own), commodities, and real estate. This has been true for thirty years now, but what is new about it is that any small or large individual investor with a stock or mutual fund trading account at a brokerage can buy or sell any asset class. Most of this has occurred within the past five years.
Even if you want to keep all of your money in money market funds, do you want it in US dollars or in a basket of non-US currencies? I covered some alternative near cash income funds several weeks ago. All of the funds I mentioned are US-based and can be bought through any US brokerage with a mutual fund trading setup.
There are, of course both mutual funds and exchange-traded funds (ETFs) for real estate (domestic and foreign), gold or precious metals funds, commodity funds, and both long and short stock and bond funds. Rydex Funds will soon have both a long and short dollar fund.
For asset allocation either inside or outside a self-directed retirement account, it isn't sufficient merely to buy a stock index fund, a bond fund, and a money market fund. That worked in the 1990's, but this isn't the 1990's. Both stocks and bonds are far closer to their thirty year highs than lows. That isn't to say they can't go higher, but they are far riskier now than when they were much lower in the early 1990's or early 1980's.
I firmly believe that most people should do their own research before investing. With the miracle of modern internet search engines one can get information on nearly anything in the investment universe.
I've found a great website to help me (and maybe you) evaluate stocks versus bonds versus gold versus commodities versus foregn currencies. It will not tell you specifically what to buy, but you can see what is strong and what is weak. Obviously you want to be in something which was weak but is now getting stronger. Perhaps I should say you want to favor those things which are getting stronger. You'd never want to have all your asets in one asset class, and your price risk overall is less when you are diversified among three or more classes.
The website is maintained by StockCharts.com and is put together by James G Craig. I know nothing about Craig. The beauty of his site is that it consists of a huge number of comparative charts. Look at his index before you jump in. He has daily, weekly and monthly charts on different pages. It is very easy to use the index to focus in on the comparison you want to learn about.
GOLD & SILVER, and their Relationships to Stocks, Bonds, Commodities, and the Dollar
I plan to spend a lot more time on asset allocation from the point of view of a private individual investor. Check the Portfolio Ideas section from time to time.
To be perfectly clear, and in case you haven't seen my statement elsewhere, I am a private investor only and do not manage or wish to manage other people's money. I don't work for anyone except myself, and I receive no fees or benefits from anyone or any company in the investment business.