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A Vote For Small Cap Stocks?

Written by Weston Wellington, VP Dimensional.

In the days immediately following the recent US presidential election, US small company stocks experienced higher returns than US large company stocks. This example helps illustrate how the dimensions of expected returns can appear quickly, unpredictably, and with large magnitude.

Average returns for US small company stocks historically have been higher than the average returns for US large company stocks. But those returns include long periods of both strong and weak relative performance.

Investors may attempt to enhance returns by increasing their exposure to small company stocks at what appear to be the most opportune times. Yet this effort to time the size premium can be frustrating because the most rewarding results often occur in an unpredictable manner.

A recent paper1 by Wei Dai, PhD, explores the challenges of attempting to time the size, value, and profitability premiums.2 Here we will keep the discussion to a simpler example.

As of October 31, 2016, small company stocks had outpaced large company stocks for the year-to-date by 0.34 percentage points.

To the surprise of many market observers, the broad stock market rose following the US presidential election on November 8, with small company stocks outperforming the market as a whole. In the eight trading days following the US presidential election, the small cap premium, as measured by the return difference between the Russell 2000 and Russell 1000, was 7.8 percentage points. This helped small company stocks pull ahead of large company stocks year-to-date, as of November 30, by approximately 8 percentage points and for a full one-year period by approximately 4 percentage points.

This recent example highlights the importance of staying disciplined. The premiums associated with the size, value, and profitability dimensions of expected returns may show up quickly and with large magnitude. There is no guarantee that the size premium will be positive over any period, but investors put the odds of achieving augmented returns in their favor by maintaining constant exposure to the dimensions of higher expected returns.

 

1. Wei Dai, "Premium Timing with Valuation Ratios" (white paper, Dimensional Fund Advisors, September 2016).
2. Size premium: the return difference between small capitalization stocks and large capitalization stocks. Value premium: the return difference between stocks with low relative prices (value) and stocks with high relative prices (growth). Profitability premium: The return difference between stocks of companies with high profitability over those with low profitability.

Higher Rates: The Tempest in the Teapot

Written by Gerald E Gasber, CFP®, CIMA®, QPFC & Bob Veres.

Anybody who was surprised that the Federal Reserve Board decided to raise its benchmark interest rate this week probably wasn't paying attention. The U.S. economy is humming along, the stock market is booming and the unemployment rate has fallen faster than anybody expected. The incoming administration has promised lower taxes and a stimulative $550 billion infrastructure investment. The question on the minds of most observers is: what were they waiting for?

The rate rise is extremely conservative: up 0.25%, to a range from 0.50% to 0.75%—which, as you can see from the accompanying chart, is just a blip compared to where the Fed had its rates ten years ago.

The bigger news is the announced intention to raise rates three times next year, and move rates to a "normal" 3% by the end of 2019—which is faster than some anticipated, although still somewhat conservative. Whether any of that will happen is unknown; after all, in December 2015, the Fed was telegraphing two and possibly three rate adjustments in 2016, before backing off to one now.

The rise in rates may be good news for those who believe that the Fed has intruded on normal market forces and suppressed interest rates much longer than could be considered prudent. It may even be better news for those who are bullish about the U.S. economy. The Fed may have been the last remaining skeptic that the U.S. was out of the danger zone of falling back into recession; indeed, its announcement acknowledged sustained growth in economic activity and low unemployment as positive signs for the future. However, investors in bonds might be less pleased, as higher yields mean that existing bonds, particularly longer term bonds lose value. The recent rise in bond yields at least hints that the long bull market in fixed-rate securities—that is, declining yields on bonds—may finally be over.

For stocks, the impact is more nuanced. Bonds and other interest-bearing securities compete with stocks in the sense that they offer stable—if historically lower—returns on your investment. As interest rates rise, the see-saw between whether you prefer stability or future growth tips a bit, and some stock investors move some of their investments into bonds, reducing demand for stocks and potentially lowering near term future returns. None of that, alas, can be predicted in advance, and the fact that the Fed has finally admitted that the economy is capable of surviving higher rates should be good news for people who are investing in the companies that make up the economy.

The bottom line here is that, for all the headlines you might read, there is no reason to change your investment plan as a result of a 0.25% change in a rate that the Fed charges banks when they borrow funds overnight. There is always too much uncertainty about the future to make accurate predictions, and today, with the incoming administration, the tax proposals, the fiscal stimulation, and the real and proposed shifts in interest rates, the uncertainty level may be higher than usual.

Sources:

http://www.businessinsider.com/fed-fomc-statement-interest-rates-december-2016-2016-12

http://www.marketwatch.com/story/fed-to-hike-interest-rates-next-week-while-ignoring-the-elephant-in-the-room-2016-12-09

http://www.reuters.com/article/us-usa-fed-idUSKBN1430G4

http://www.usatoday.com/story/money/personalfinance/2016/12/15/fed-rate-hike-7-questions-and-answers/95470676/?hootPostID=32175354f7440337d62a767b3db92c68

 

The Employed and the Drop-Outs

Written by Bob Veres & Gerald E Gasber, CFP®, CIMA®, QPFC.

Headlines told us that the U.S. economy added 178,000 jobs in November, dropping the unemployment rate to 4.6%—the lowest level since August 2007, and surely an improvement over the 10% rates of the Great Recession. Those numbers represent great news, and indicate that the country is in strong shape as President-elect Trump takes office.

However, a degree of caution is in order as we look closer at the numbers. For one thing, average hourly earnings for all American workers declined by three cents, to $25.89, after large gains in October. Overall, average hourly earnings are up 2.5% this year, which is lower than you might expect if there was tight competition for workers.

Beyond that, part of the drop in unemployment was the result of new jobs, but a larger part was the fact that 226,000 people dropped out of the labor force in November, following a similar decline of 195,000 in October. The total labor force was 157.03 million in the U.S. in January 2015, and has risen somewhat sluggishly to 159.49 million in November 2016—despite 4.8 million new worker-age Americans coming into the economy. The bottom line: people are dropping out faster than they're being hired—for some reason.

This is not intended to be discouraging news. The U.S. economy is clearly in much better shape today than it was five or eight years ago, and most people can find work if they want to. Among those who will be looking hard at the numbers behind the numbers are Fed chairperson Janet Yellen and her team of economists, who will want to know when—or if—the unemployment rate has dropped so low that there is real competition for labor, driving significant increases in wages, driving inflation up high enough that it will be necessary to raise interest rates. That will be a topic of debate at the next Fed meeting December 13-14.

Sources:

http://www.newsmax.com/Finance/StreetTalk/nonfarm-payrolls-jobs-unemployment-media/2016/12/02/id/761870/

https://www.washingtonpost.com/news/wonk/wp/2016/12/02/u-s-economy-added-178000-jobs-in-november-unemployment-rate-drops-to-4-6-percent/?utm_term=.519490446fee

Prediction Season

Written by Dimensional Fund Advisors, LP & Gerald E Gasber, CFP®, CIMA®, QPFC.

The close of each calendar year brings with it the holidays as well as a chance to look forward to the year ahead.
In the coming weeks, investors are likely to be bombarded with predictions about what the future, and specifically the next year, may hold for their portfolios. These outlooks are typically accompanied by recommended investment strategies and actions that are aimed at trying to avoid the next crisis or missing out on the next "great" opportunity. When faced with recommendations of this sort, it would be wise to remember that investors are better served by sticking with a long-term plan rather than changing course in reaction to predictions and short-term calls.

PREDICTIONS AND PORTFOLIOS

One doesn't typically see a forecast that says: "Capital markets are expected to continue to function normally," or "It's unclear how unknown future events will impact prices." Predictions about future price movements come in all shapes and sizes, but most of them tempt the investor into playing a game of outguessing the market. Examples of predictions like this might include: "We don't like energy stocks in 2017," or "We expect the interest rate environment to remain challenging in the coming year." Bold predictions may pique interest, but their usefulness in application to an investment plan is less clear. Steve Forbes, the publisher of Forbes Magazine, once remarked, "You make more money selling advice than following it. It's one of the things we count on in the magazine business—along with the short memory of our readers." Definitive recommendations attempting to identify value not currently reflected in market prices may provide investors with a sense of confidence about the future, but how accurate do these predictions have to be in order to be useful?

Consider a simple example where an investor hears a prediction that equities are currently priced "too high," and now is a better time to hold cash. If we say that the prediction has a 50% chance of being accurate (equities underperform cash over some period of time), does that mean the investor has a 50% chance of being better off? What is crucial to remember is that any market-timing decision is actually two decisions. If the investor decides to change their allocation, selling equities in this case, they have decided to get out of the market, but they also must determine when to get back in. If we assign a 50% probability of the investor getting each decision right, that would give them a one-in-four chance of being better off overall. We can increase the chances of the investor being right to 70% for each decision, and the odds of them being better off are still shy of 50%. Still no better than a coin flip. You can apply this same logic to decisions within asset classes, such as whether to currently be invested in stocks only in your home market vs. those abroad. The lesson here is that the only guarantee for investors making market-timing decisions is that they will incur additional transactions costs due to frequent buying and selling.

The track record of professional money managers attempting to profit from mispricing also suggests that making frequent investment changes based on market calls may be more harmful than helpful. Exhibit 1, which shows S&P's SPIVA Scorecard from midyear 2016, highlights how managers have fared against a comparative S&P benchmark. The results illustrate that the majority of managers have underperformed over both short and longer horizons.

Exhibit 1. Percentage of US Equity Funds That Underperformed a Benchmark

Source: SPIVA US Scorecard, "Percentage of US Equity Funds Outperformed by Benchmarks." Data as of June 30, 2016.
Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor's Index Services Group.

Rather than relying on forecasts that attempt to outguess market prices, investors can instead rely on the power of the market as an effective information processing machine to help structure their investment portfolios. Financial markets involve the interaction of millions of willing buyers and sellers. The prices they set provide positive expected returns every day. While realized returns may end up being different than expected returns, any such difference is unknown and unpredictable in advance.

Over a long-term horizon, the case for trusting in markets and for discipline in being able to stay invested is clear. Exhibit 2 shows the growth of a US dollar invested in the equity markets from 1970 through 2015 and highlights a sample of several bearish headlines over the same period. Had one reacted negatively to these headlines, they would have potentially missed out on substantial growth over the coming decades.

Exhibit 2. Markets Have Rewarded Discipline
Growth of a dollar—MSCI World Index (net dividends), 1970–2015

In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. MSCI data © MSCI 2016, all rights reserved.

CONCLUSION

As the end of the year approaches, it is natural to reflect on what has gone well this year and what one may want to improve upon next year. Within the context of an investment plan, it is important to remember that investors are likely better served by trusting the plan they have put in place and focusing on what they can control, such as diversifying broadly, minimizing taxes, and reducing costs and turnover. Those who make changes to a long-term investment strategy based on short-term noise and predictions may be disappointed by the outcome. In the end, the only certain prediction about markets is that the future will remain full of uncertainty. History has shown us, however, that through this uncertainty, markets have rewarded long-term investors who are able to stay the course.

 

Source: Dimensional Fund Advisors LP.
Diversification does not eliminate the risk of market loss. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Pound Poor, Pound Foolish

Written by Bob Veres & Gerald E Gasber, CFP®, CIMA®, QPFC.

You may have read that the British pound has had a very rough couple of weeks on world markets, losing more than 4% of its value against the dollar in one week, and continuing the slide through the next, finally reaching a 31-year low against the dollar. Part of the problem was a mysterious "flash crash" that sent the pound down more than six percent last Friday morning before it briefly stabilized—and then promptly started the next week by testing those crash lows all over again. Market analysts blamed the initial decline on trading algorithms—that is, computers programmed to buy or sell in milliseconds based on news or shifts in the marketplace. Apparently, the twitchy programs triggered other algorithms to create a cascade of sell orders that had to be interrupted by human intervention. But now the human traders appear to be in agreement with the original panicked consensus.

The obvious cause for this decline in one of the world's most historically stable currencies is uncertainty. U.K. Prime Minister Theresa May has signaled that her country will pursue a so-called "hard Brexit," meaning a full uncoupling of British and mainland European trade agreements sooner and more definitively than the markets apparently expected. Brexit Secretary David Davis probably didn't help matters when he said that Britain would renounce any contribution to the European Union budget, agree to jurisdiction of trade disputes in the European Court of Justice, or (a big issue for British voters) the free movement of labor across national borders.

Of course, French President Francois Hollande, responding to his counterpart's rhetoric, promised that the European response would be equally harsh, and German Chancellor Angela Merkel added that negotiations would not be easy on her side of the table.

Right now, the British currency seems to be a way for all of us to visibly watch how market participants view the future of Britain's economy, based on what they're hearing about the way negotiators plan to handle the disengagement.

This is a classic case of foolishly trading on headlines rather than fundamentals, since the actual negotiations will last two years, and won't even start until late Spring of next year. Whatever the outcome of those negotiations, you can bet there will be a lot more news about movements in the British pound between now and two and a half years hence—up and down.

Meanwhile, with the pound this cheap, British-based exporters are expected to prosper, since whatever they sell abroad will now enjoy a price advantage. And this might be a great time for American tourists, if they can endure the Autumn weather, to visit London, Stonehenge and Scotland—at bargain prices.

Sources:

http://gizmodo.com/rogue-algorithm-blamed-for-historic-crash-of-the-britis-1787523587?utm_campaign=socialflow_gizmodo_twitter&utm_source=gizmodo_twitter&utm_medium=socialflow

https://www.ft.com/content/28787548-8c82-11e6-8cb7-e7ada1d123b1?ftcamp=published_links%2Frss%2Fpersonal-finance%2Ffeed%2F%2Fproduct

http://www.bloomberg.com/news/articles/2016-10-07/rude-awakening-in-the-u-k-over-brexit-costs-send-pound-tumbling