US stock market and the huge ETF inflows. – What does it mean?

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How strong is the relationship between the consistent new highs being set by the US stock market and the huge ETF inflows?

As we know from previous commentary in the Radar Newsletter there is an ETF ‘force’ that is causing stocks to be elevated to levels that that are artificially, abnormally and dangerously higher than the market would normally take them. This significantly heightens downside risk.

To answer the question posed requires some heavy number crunching to match a stocks performance with its current price levels. Current price levels are to a large degree supported by sentiment, EPS and sales growth especially in the very ‘rich’ area of technology i.e. the FANG stocks. How much of their elevated price levels are to do with the fundamentals and how much is caused by the ETF ‘forces’ is hard to determine but what we do know is that the huge inflows into the passive ETF market are having an effect. So the ‘how much’ is hard to determine but the fact is that it is happening and if you hold an ETF you are exposed.

It is interesting that the US market, which is 30% of world markets and has the majority of ETF’s, is far and above exceeding the performance of every stock market in the world. The current up trend has been unusually ‘steady’. Is the US economy that good? I wonder, or is it accelerated by the ‘ETF effect’?

Without knowing the exact answer we are aware of its factual nature and thus as investors we need to understand what it means to us and what will be the effect should the market take a turn for the worse. At some stage it will so where does that leave us and how can we protect ourselves. As an ETF holder we can’t unless we sell and that leaves us neutral on the market. It’s an all or nothing approach.

If we observe retail behaviour in the last market decline of significance it was one of an overriding fear effect and in that case all reason was swept aside in the name of perceived survival. We can thus expect capital repatriation to occur and the ‘magnifier’ effect of the upside is likely to occur on the downside too. It could get messy.

The important point here is not to panic nor take this as a sell signal but to be aware of the potential effect while still riding the waves of strength. We can either be in the ETF market (passive) or in specific stocks (active). The effect will be on both but the specific stock approach can be managed far more effectively. So what has been perceived as a great low cost way of accessing a rising stock market judging by the enormous growth of ETF’s has its own shortcomings and ignores the peril of a market down swing.

What do we know about ETF’s?

Firstly they can never give you outperformance and stock market averages can also drop. When they do, passive investors will ride their indexes or baskets down just as they rode them up. An actively managed fund, by contrast, puts thought and attention into 1) protecting against downside and 2) choosing stocks that have the best chance of going up, regardless of where they are in an index.

My tip: Ride the waves higher but watch your stock specific stops and you’ll be safe.

The purpose of this article is to offer you proactive awareness rather than be reactively discussing the problem once the market horse has bolted. ETF’s are low cost for a reason.

 

Just how big is the American economy?

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Renaming US States Based on Similar GDP’s

The U.S. economy is so big that all of the individual states are comparable to entire countries.

Not surprisingly – big states like California, New York, and Texas are very similar in size to other formidable economies like France, South Korea, and Canada.

Perhaps even more interesting, however, is that even small states are similar to the size of countries.

Wisconsin is about the size of Malaysia, and Louisiana is comparable to the Philippines. Even Vermont, a state with a population of 626,000 people and the smallest state economy, is approximately the size of Bahrain.

It’s pretty incredible to think about the United States this way – and it helps put the economic power of the full country in real context.

And what a trade pickle it’s in that Trump so rightly points out

Don’t forget there are problems with passive investing.

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Passive investing has been in the news lately because more and more investment funds are being placed in passive investments.

Assets managed by passive funds rose 18 percent last year, according to Morningstar. Assets managed by active funds increased just 4 percent in the same period.

Institutional investors such as large pension funds are also placing more of their money under management in passive strategies. Seventy-nine percent of institutions used active strategies in 2012, reports Greenwich Associates. But three years later, the figure had dropped to 67 percent.

These inflows and changes in investment trends are gradually making passive investing more dominant than it used to be. Moody’s estimates that passively managed investments may make up more than 50 percent of all investments by 2024.

What Is Passive Investing?

Before we go on, let’s be clear on what both passive investing and active investing mean. The terms do not refer to an investment style. They refer to a method.

In passive investing, funds are invested in an index or a basket of stocks such as an exchange-traded funds (ETFs). Investors may purchase a fund that tracks the performance of the S&P 500, for example. No single investment manager is reviewing and choosing stocks in the fund based on his or her assessment of their performance and potential. They are buying every stock in the S&P 500 to replicate its performance, or buying one of the funds that do.

The “passive” refers to the fact that the fund is not actively managing what’s in their funds. They are simply replicating a larger group of stocks. This is true whether the basket of stocks are all stocks in the banking sector or all stocks in the gold sector. As long as they are replicating an already-existing group of stocks, they are passive investments.

The counterpart to passive investing is active investing. In an actively managed fund, a fund manager pours over financial information and makes a judgement about which stocks to buy. Generally, they do not use passive investment funds, but purchase a specific group of stocks and bonds they decide upon.

What It Isn’t

Investors may hear a term like “aggressive investing” used and believe it is a synonym for active investing. It isn’t. Characterizing investments as aggressive is a style. Aggressive investing means the investor wants the highest return possible and may, for example, choose to invest in high risk start-ups in the hope the stock of such companies will give very high returns at some point. Aggressive refers to the risk versus reward trade-off and its role in outperforming the general market.

Similarly, “conservative investing” is not some sort of synonym for “passive investing.” A more conservative investor wants a very low risk versus reward profile. They don’t like risk! But they would like some reward in stock price appreciation or dividend yield. A conservative investor may, for example, choose bonds or stocks with high dividends. They are hoping for a maximum return with very low risk potential.

3 Problems with Passive Investing

Despite its popularity, there are several issues with passive investing.

  1. Passive Investments Can Drop as Well as Rise

Many observers think the climbing popular of passive investments is occurring because the markets have done quite well since the Great Recession. Major indexes like the S&P 500 and the Dow Jones Industrial Average has risen robustly on average since the end of 2009.

Stock market averages can also drop, however. When they do, passive investors will ride their indexes or baskets down just as they rode them up. An actively managed fund, by contrast, puts thought and attention into 1) protecting against downside and 2) choosing stocks that have the best chance of going up, regardless of where they are in an index.

  1. Passive Investors Can’t Beat the Market

Many investors go into the stock market hoping to beat the market averages. If the S&P 500 returns 12 percent in a year, for example, they hope to make 14 percent. If their passive investment is, say, healthcare stocks, and a basket of healthcare stocks makes 20 percent, they hope to make 23 percent. Over time, those gains become significant.

Passive investments can’t beat the market. They are the market.

  1. Good Investing Is Complicated

Passively managed funds require no expertise about the markets they cover. In fact, they can literally be done by a robot.

But active management by people who really know an industry can result in much higher returns. If you are investing in oil stocks, for example, the expertise in comparing royalty and working interests in oil investing can lead to a much more sophisticated understanding of a company’s financial picture. The more sophisticated the picture, the more active management can forecast which stocks will do well and which won’t. The same with a sector like biotechnology. An aggressive investor focused on the merits of a therapy can predict much more accurately whether the stock is likely to do well.

Despite the popularity of passive investing, it is not always the best strategy. Passive investors may get a rude awakening if the market ever drops. They also can’t expect market-beating returns. Finally, the more expertise that goes into picking a stock, the better.

Source: Kayla Matthews. Freelance blogger and technology writer

To succeed in trading, use the wisdom of others, but still be your self.

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“I have heard many men talk intelligently, even brilliantly, about something – only to see them proven powerless when it comes to acting on what they believe.  Investors must act in time.”  — Bernard Baruch

There is a fine line between embracing your methodology, trading it, trusting it, understanding all its nuances, strengths and weaknesses versus never truly trusting your methodology. Suspecting that your methodology is flawed and therefore constantly tinkering with it and needing to reinvent it will not lead to success.

This is when looking in the mirror and asking some personally pointed questions is required. Do you have some deep-seated need to constantly tinker? Are you a pessimistic soul at heart who believes your methodology is fundamentally flawed? Is it possible that you seek some unattainable perfection and therefore pursue new indicators and inputs just because you believe one more will make it possible to achieve that perfection?

After more than 25 years of trading, I’ve managed to simplify and trust my methodology enough to achieve an equilibrium that’s consistent and profitable. There are two corollaries. One, if it isn’t broken, I don’t try to fix it. Two, perfection doesn’t exist nor is it attainable. Small losses are part of one’s stock market tuition.

The human tendency is to keep tinkering because it gives investors a false sense of accomplishment. Most people refuse to embrace the fact that investing is, for example, the opposite of golf. Course designers build bunkers and hazards to make golf interesting. A flat course would be tame, monotonous and boring.

In contrast, investing at the very highest levels is in fact boring.  Your methodology should have removed all the sand traps and water hazards.  Your objective over the years should be to tame the behavioral bunkers and to embrace your “boring” methodology.

Don’t confuse a good methodology with a profitable methodology. I can share with you a detailed description of my methodology which is both good and profitable for me because I built it and I use it judiciously each day. I trust it to provide me sound judgments which will produce consistent profits as long as I follow it. It is not dissimilar to an athlete who knows which daily exercise routines will increase his or her muscles. I know that judiciously exercising my methodology each day will increase my trust and intimate understanding about all aspects and nuances of it. Both this trust and understanding facilitate my implementation of my methodology.

This is why you can’t simply hand another investor your “good” methodology. They must take the time to experience it as I have done. Over time, they will come to trust it and make it their own so that eventually they, too, will produce consistent profitable judgements. There are no short cuts.

Trade well; trade with discipline!
– Gatis Roze, MBA, CMT

Are you wary of the US market or overtly bullish?

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Most investors are wary but the US markets still climb and climb. That in itself is a very bullish sign. Consider these price studies by the Fat Pitch blog:

First, the current uninterrupted rally is rare and extended from a historical perspective, but these periods can last much longer.

Second, when the current uptrend ends, it is not likely to lead directly into a more significant downturn. Momentum like this weakens before it reverses.

Thirdly seasonality. Specifically, with two days left in February, the SPX has risen almost 6% YTD. In the 27 prior instances since 1945 that SPX has been up in both January and February, it has closed up for the full year all 27 times. The average full year gain was 24%; in only 2 cases was full year gain less 10%

All momentum readings on the major US indices are historically high. Momentum indicators provide a valuable insight into price performance.

Momentum is an interesting barometer but is often misread. Let’s look at the MACD, a momentum indicator, on the S&P500 (see below). Yes it’s strong, very strong. Momentum may slow or even diverge but as discussed above the index can still go much higher yet and the probabilities of this are very high.

Price analysis and sentiment readings can provide a very helpful insight especially when you ‘think’ a trend may be extended. Chances are they will extend a lot further. When riding trends it is always vital to maximise their potential and in turn your portfolio returns.