Lots of cash and animal spirits: What could possibly go wrong?

If you’ve ever been to a particularly raucous New Year’s party, you know that there’s a logical progression from the first awkward arrivals and introductions until you’re sleeping in a car full of raccoons and empty Cheetos bags.  And, at the time, each step makes wonderful sense.

Right now, the markets are at a spot where spirits are high and cash is flowing like liquor at your broker’s annual Christmas party. Let’s take a look at the animal spirits first.

University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, January 1, 2017.

 University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT, January 1, 2017.

As you can see, consumer sentiment has been rising since the dark days of 2009; it now stands at 98.2 — the chart is lagged by a month. Sentiment is now higher than it was in January 2015 (98.1), and the highest since February 2004.

Soptimism-graphmall business confidence is also up post-recession, but it jumped markedly after the election, presumably on the hopes of lower taxes and regulation by the new administration.

And that confidence — plus the 12% gain by the Standard & Poor’s 500 stock index this year — has sparked optimism among investors. The American Association of Individual Investors sentiment survey now stands at 45.6% bullish, vs. its 38.5% historical average. Similarly, just 25.7%  of those surveyed said they were bearish, vs. a historical average of 30.5%. Bullish sentiment is at a five-week high, and its third-highest level of 2016.

At the same time, there’s plenty of money on the sidelines, and some of it appears to be returning to stock funds. In the last week of 2016, investors poured an estimated $118 million into U.S. stock funds. But that’s a piker compared to the previous week, when an estimated $18.6 billion flooded — more than the previous 24 months combined, according to the Investment Company Institute, the funds’ trade group.

As of the end of November, there was $2.7 trillion in money market mutual funds, earning approximately zilch. A roaring stock market provides a great deal of temptation for at least some of that money.  Stock funds had about 3.2% of their assets in cash, which is not particularly high, and that figure’s usefulness has been eclipsed somewhat recently.

Another potential source of cash: Companies in the S&P 500 have a record $1.5 trillion in cash cooling its heels on their balance sheets. They can use this for buying back stocks, paying dividends, or — and this is crazy talk — reinvesting in plants, equipment and their own employees.

The bad news is that the stock market is already expensive. The S&P 500 sells at about 24 times earnings, as opposed to a historical norm of about 17 times earnings. S&P predicts that earnings will rise through 2017, bringing down the PE ratio to about 18. Bear in mind that forecasts are notoriously unreliable, particularly when they’re about the future.

Bear in mind, too, that the Federal Reserve is likely to continue to raise interest rates, and at a faster pace if the economy grows faster than expected.

Right now, it looks like animal spirits and plenty of cash will keep the market party going, and that can be good, clean fun. Enjoy the ride. Just remember that market rallies always last longer than a sober person would think. But remember that many things must go right for the rally to continue. It’s probably a good time to readjust your portfolio back to your original goals. No one ever went broke taking a bit of profits.





They don’t ring a bell

According to hoary Wall Street lore, they don’t ring a bell when a bull market ends or a bear market begins. (Those would actually be the same thing). But Federal Reserve Chair Janet Yellen did all but that today when she spoke at the Kansas City Fed’s economic conference in Jackson Hole, Wyoming.

“I believe the case for an increase in the federal funds rate has strengthened in recent months,” Yellen said, which is just about as close to skywriting “RATES ARE GOING UP!” as a Fed chair can get. Wall Street, which has anticipating higher rates since 2009, reacted predictably, selling off stocks and bonds at the same time. The Dow Jones industrial average fell 53.01 points, to 18,395.40, and the bellwether 10-year Treasury note yield rose to 1.635%. Bond prices fall when interest rates rise, and vice-versa.

Naturally, the case for raising interest rates soon is debatable. In terms of timing, the Fed is traditionally reluctant to raise rates in the months before a presidential election. If that reasoning still holds, the next opportunity to increase the key fed funds rate would be in December.

And on a relative basis, interest rates are pretty high already. The fed funds rate is 0.25% to 0.50%. The European Central Bank’s rate is zero, as is the Bank of Japan’s. The Swedish central bank’s rate is -0.25%, and the Swiss government rate is -0.75%.

The Fed doesn’t control long-term interest rates, but the picture there is just as grim. Germany’s 10-year yield is -0.07%. France’s decade note yields 0.17%, albeit with a certain je ne sais quois. Italy’s 10-year rate — Italy’s! — is 1.17%.

What is starting to make the Fed uneasy, however, is rising wages. The Fed has been able to flood the world with easy money for nearly a decade without fear of a wage-price spiral because wages have been flat for more than a decade. You just can’t have a wage-price spiral without higher wages.

Oddly — and somehow justifiably — those at the lowest end of the wage spectrum have been seeing the biggest wage increases, thanks in large part to state-mandated minimum-wage increases. But that’s not the only reason. Many companies, such as Walmart and McDonald’s, have come to the realization that they rely heavily on those who face the public. Those people are almost invariably on the lower end of the wage spectrum.

Perhaps Lily will get a raise.
Perhaps Lily will get a raise.

Service companies are also discovering, to no one’s surprise than theirs, that people who don’t make much don’t feel a lot of loyalty to their employers. Low-wage employees will often gladly jump ship to another company that pays better wages. In the recession, companies could simply say, “Be glad you have a job.” But many of the new job gains have gone to low-income employees — so much so, in fact, that there’s a relative shortage of people willing to take low-wage jobs.

“Wage acceleration has been concentrated in low-pay sectors, such as restaurants and retailing,” says Bank of America Merrill Lynch. “In our view, the increase in low-pay wages is due to state-level minimum wage increases and a shortage of younger, less-educated workers. We see sharp increases only in low wage sectors: broader wages should rise more gradually as joblessness falls.”

The Fed raises interest rates to slow the economy and reduce the threat of inflation. But bear in mind that interest-rate increases take a long time — 18 months or so — to fully take effect on the economy. Furthermore, a more or less normal fed funds rate, which is neither accommodative nor restrictive — is somewhere between 3% and 4%. It will take many more quarter-percent rate hikes to get back to normal.

The big danger is that the economy isn’t exactly boiling over. Current estimates for third-quarter gross domestic product are a 1% increase or less.

If you’re looking for a rate shock, you probably won’t see one any time soon. You may start to see better rates on bank CDs: The top ones now yield about 1%, according to Bankrate.com. But you should start to be wary of interest-rate sensitive stocks, such as utilities and preferred stocks. And if you’re thinking of loading up on bonds, you might want to wait a bit.





How the naive are faring

You could line up all the advisers from here to Albuquerque, and you still wouldn’t reach a conclusion as to the best diversified portfolio for your retirement savings.

Because of that, many investors simply use the 1/n portfolio — which is to say, they divide their money equally among all the options in their 401(k) plan. Among those who study these things, this is called the Naive Portfolio.

What would a Naive Portfolio look like? Most 401(k) plans are not exactly paragons of fund-picking: They often choose the largest funds. After all, those funds typically have decent long-term records and low expense ratios, and no one is going to get sued using those criteria.

Let’s compose a naive portfolio of the 10 largest mutual funds. It would look like this, ranked by size:

Tot. ret. Tot. ret.
Fund Ticker Category 2015 5 years
Vanguard Total Stock VTSMX Large blend 2.37% 13.98%
Vanguard 500 Index VFINX Large blend 2.89% 14.23%
Vanguard Total Intl Stock Idx VGTSX For. large blend -2.35% 3.30%
Vanguard Total Bond VBMFX Interm. bond 0.68% 2.86%
Growth Fund of Amer A AGTHX Large growth 6.98% 13.78%
Europacific Growth A AEPGX For. large growth 1.57% 5.49%
Vanguard Prime MM VMMXX Money market 0.03% 0.03%
Fidelity Cash Reserves FDRXX Money market 0.01% 0.01%
JPMorgan Prime MM VPMXX Money market 0.01% 0.01%
Fidelity Contrafund FCNTX Large growth 7.93% 13.87%
Average 2.01% 6.76%

Source: Morningstar.

So how did our naive investors do? At least this year, they have done pretty darn well. The average expense ratio in this portfolio is 0.35%, which, honestly, you can’t beat with a stick.

Furthermore, a 2% return is just a shade lower than what you would have gotten with a single investment in the Vanguard Total Stock Index fund. And you would have gotten that return with far less risk than a pure stock index fund, given that 30% was in money market funds and 10% in bonds.


Just how successful a naive investment would be over the long term is a more difficult calculation, which I’ll tackle in future posts. But the takeaway is that naive diversification is probably better than no diversification at all.




Seeking Alpha

According to — well, just about everyone — it’s nearly impossible to beat the Standard and Poor’s 500 stock index for any prolonged period of time on sheer cunning alone. Those who do may owe more to chance than to skill. And for that reason, your best investment bet is a low-cost index fund, such as the ones in the Amish Portfolio.

From the wonderful The Brokers With Hands On Their Faces Blog (http://brokershandsontheirfacesblog.tumblr.com)

If there is any hope for active management, it’s in small markets where 1,000 analysts aren’t looking at each stock — such as small and micro-cap companies. The problem with small companies is that they have an unfortunate tendency to become much smaller companies, at which point they become former companies. And many small-company stock funds have to sell small companies when they become too large. Imagine if you had done that with Apple.

Nevertheless, if you’re hoping to get a boost from active management, small-cap funds are probably the place to look. And small-company value funds, which look for unappreciated and cheap companies, might be the best part of of the small-cap universe to look. One of the many questions about looking for a small-cap fund: Is the fund performing well because it’s taking outrageous risks?

Fortunately, there’s a stat for that, and it’s called alpha, which measures a fund’s return in relation to the risk it takes. A fund with an alpha greater than 1 gives off more return than one would expect, given the risk.

Risk, in this case, is determined by beta, which measures how a fund relates to an index, such as the Standard and Poor’s 600 small-cap index. A fund with a beta of 1 runs in lockstep to its index. One with a beta below 1 will rise or fall less than its index; one with a beta above 1 will rise and fall more. Basically, you want a fund with an alpha above 1 and a beta below 1.

Finally, you want a fund that’s not too large. Most funds won’t buy more than 5% of a company’s outstanding stock. Small-cap stocks, by definition, have about $1 billion or less in shares outstanding. Suppose a fund liked a stock whose outstanding stock was worth $500 million. The fund could buy a maximum $25 million of the stock. If the fund had $2 billion in assets, the position would be just 1.25% of the fund’s assets — a relatively small stake.

So: If you’re looking for a small-cap value fund that actually adds value, look for one with an alpha greater than 1, a beta less than 1, and assets less than $1 billion or so. And if these managers are truly cunning, consider selling them if the rest of the world catches on. Sooner or later, their success will translate into higher assets, and that, in turn, will make it harder for them to succeed.

Some caveats: The S&P 600 small-cap index has risen an average 15.42% the past three years, and small-company value funds typically lag in a red-hot small-cap market. This has been the case recently: The average small-cap value fund has gained 13.17% during the same period. It’s usually best to buy small value after a market meltdown, so there’s clearly no hurry. And several of these funds are microcap funds, which invest in companies small enough to fit into a mouse’s teacup. With all that in mind, here’s the list.

Fund Ticker Total return 2015 Total return (annualized) 3 years Alpha Beta
James Micro Cap JMCRX 7.3% 21.3% 7.00 0.96
Ancora MicroCap C ANCCX -3.4% 15.8% 3.44 0.92
Emerald Small Cap Value Institutional LSRYX 3.8% 15.0% 2.91 0.92
Great-West Invesco Small Cap Value Init MXSVX -0.6% 14.8% 2.44 0.97
Perritt Ultra MicroCap PREOX -1.1% 14.7% 5.42 0.55
Ancora Special Opportunity C ANSCX -1.0% 13.9% 1.90 0.86
Nationwide Bailard Cognitive Value M NWHFX 2.2% 13.6% 2.20 0.92
Queens Road Small Cap Value QRSVX 2.8% 13.1% 4.06 0.70
DGHM V2000 SmallCap Value Instl DGIVX 1.2% 12.4% 1.57 0.89
Small Cap Value SCAPX -13.6% 7.9% 7.99 0.93
Pinnacle Value PVFIX -1.2% 7.5% 2.62 0.37
Cozad Small Cap Value I COZIX -6.6% 0.0% 1.44 0.96



The long and short of it

The world would be a better place if certain mythical creatures existed. It would be nice to spot a unicorn amid the deer grazing on your hostas. Heck, I’d settle for a jackalope.

A rare sighting of a jackalope.
A rare sighting of a jackalope.

Among other quasi-mythical creatures are the stock fund managers who can make money in bull and bear markets. In theory, this is possible. After all, you can make money by buying stocks, which is called “going long.” You can also make money on stocks that fall by selling shares and repurchasing them at a lower price — a process called “going short.”

Lately, the fund industry has been pumping out funds that are both long and short. Not surprisingly, they’re called long/short funds. The strategy, borrowed from the hedge fund world, gives some protection in a bad market, while also giving you much of the return from a bull market.

As a group, the long-short funds have performed decently since the stock market’s most recent peak on May 20, 2015. The median long/short fund — half higher, half lower — is down 4.52% through Wednesday, vs. a 7.85% loss for the Standard and Poor’s 500 stock index with dividends reinvested.

Unfortunately, the farther back into the record you look, the worse things get. The past 12 months, for example, the median long/short fund has fallen 2.5%, vs. a 0.64% loss for the S&P 500. Go back five years, and long/short funds are up 5.71% a year, vs. 14.72% for the S&P 500.

What happened? Part of it may well be the fact that while some people are good at shorting, and some are good at going long, relatively few managers are good at both sides of the game. And a long/short strategy gives you the opportunity to be wrong as well as right in both directions.

Another big factor: Expenses. The median expense ratio for long/short funds is 1.77%, which, in technical terms, is called “horrible.” It’s hard enough to beat the S&P 500 without sporting it 1.77 percentage points a year.

A few long-short funds deserve honorable mention. Caldwell & Orkin Market Opportunity (COAGX) has gained 4.2% during the recent unpleasantness, and is up 11.1% for the full year. (It’s up just 5.36% a year the past five years, though). Burnham Financial Long/Short (BURFX) is up 3.61% for the mini-correction and 14.9% for the year. It’s up an average 14.91% a year the past five years.

Guggenheim Opportunity Alpha A is the only long/short fund to have beaten the S&P 500 for the past five years, scoring an average 15.54% gain. It has lagged the index in the recent correction and the past 12 months.

The other thing to consider about long-short funds is this: Adding a 10% position in a long/short fund to your stock portfolio will have about the same effect as a mosquito on a moose. And betting entirely on a long-short strategy seems like a longshot. You’d probably have more fun hunting jackalopes.

The funds you probably own

For all the ink that’s been spilled about small, undiscovered mutual funds, most people simply own the ones that are in their 401(k) savings plan. And, by and large, those are very big, long-ago discovered funds.

This is not a bad thing, necessarily. Some funds, like Fidelity Contrafund or the American Funds Growth Fund of America, have gotten big because they have had good returns over time. Others, such as Fidelity Magellan, are big because they once had had good performance, but shareholders haven’t become entirely disillusioned.

So how well is your big fund doing? On average, reasonably well in this kidney stone of a market. The table below gives you the answer. Skip below the table for a few observations.

Name Ticker Morningstar Category Total return (YTD)
Vanguard Total Stock Mkt Idx Inv VTSMX  Large Blend 2.5%
Vanguard 500 Index Inv VFINX  Large Blend 2.4%
Vanguard Institutional Index I VINIX  Large Blend 2.5%
American Funds Growth Fund of Amer A AGTHX  Large Growth 6.4%
Fidelity® Contrafund® FCNTX  Large Growth 7.7%
Fidelity Spartan® 500 Index Inv FUSEX  Large Blend 2.4%
American Funds Washington Mutual A AWSHX  Large Value 0.1%
American Funds Invmt Co of Amer A AIVSX  Large Blend 1.9%
American Funds Fundamental Invs A ANCFX  Large Blend 3.3%
Vanguard Mid Cap Index I VMCIX  Mid-Cap Blend 3.9%
Dodge & Cox Stock DODGX  Large Value 0.7%
Vanguard Small Cap Index Inv NAESX  Small Blend 2.1%
Vanguard Growth Index Inv VIGRX  Large Growth 5.2%
Vanguard Windsor™ II Inv VWNFX  Large Value 1.1%
American Funds AMCAP A AMCPX  Large Growth 4.5%
T. Rowe Price Growth Stock PRGFX  Large Growth 11.6%
Vanguard PRIMECAP Inv VPMCX  Large Growth 1.5%
Vanguard Extended Market Idx Inv VEXMX  Mid-Cap Blend 2.9%
Fidelity® Low-Priced Stock FLPSX  Mid-Cap Value 4.1%
Fidelity® Growth Company FDGRX  Large Growth 8.2%
Vanguard Instl Ttl Stk Mkt Idx InstlPls VITPX  Large Blend 2.6%
Vanguard Value Index Inv VIVAX  Large Value 0.2%
American Funds American Mutual A AMRMX  Large Value -0.2%
MFS® Value A MEIAX  Large Value 2.1%
Fidelity Spartan® Total Market Idx Inv FSTMX  Large Blend 2.6%

Source: Morningstar.

So far this year, the Standard and Poor’s 500 stock index has gained 2.5%, including reinvested dividends. The 25 largest funds have gained 3.3%.

A few observations:

Growth funds have beaten value — not just this year, incidentally, but the past five. The standout in this particular table is T. Rowe Price Growth stock, a $47 billion giant that has beaten the S&P 500 for a decade and ranks in the 15th percentile or above in its category during the entire period. Its largest holdings: Amazon, Priceline and Visa, accounting for about 10% of the fund’s assets. The one drawback to the fund: Current manager Joe Fath has been at the helm for about a year and a half. (He’s been with T. Rowe since 2002.)

Value funds have been laggards. You shouldn’t be surprised by this: It’s the sixth year of a bull market and few stocks are cheap, relative to earnings. Few of the big value funds have significant cash on the sidelines: They’re paid to be fully invested, so one has to presume that managers are holding their noses and buying the cheapest stocks they can find in an expensive market.

The one exception is Fidelity Low-Priced stock, which has a cash stash of about 9%. The fund is arguably the most eclectic and diverse of the group, with 52% of its assets in U.S. stocks and 39% abroad.

By and large, you don’t have much choice when it comes to the funds in your work-sponsored retirement plan. And in most cases, you’ll get big funds with a good track record — not the best way to choose funds, but again, you don’t have much choice. But remember this: Unless you’re on the verge or retirement, it’s probably better to get the right amount of your savings in a mediocre stock fund than it is to have too much in cash or bonds.