Archive for the ‘Investment Strategy’ Category

Stocks With Strong Potential Earnings Boost From Trump Tax Plan

Friday, December 9th, 2016
  • Companies that have low effective tax rates due to current “tax loop holes” may find their effective tax rate rise (and profits decline), even if nominal corporate tax rates decline, because “tax loop holes” may be closed to pay for the tax rate change
  • Companies that have effective tax rates near the nominal rates, would likely see their effective tax rate fall (and profits rise), if nominal corporate tax rates decline
  • Searching for companies that may benefit from a tax rate decline, and are otherwise potentially attractive is a useful exercise
  • We found 22 stocks among all listed with favorable yield and valuation attributes that may provide interesting Trump tax plan return potential
  • We found 100 stocks in the S&P 500 with effective tax rates from 30% to 35% that would like benefit significantly from a corporate tax reduction
  • 34 of those 100 S&P 500 stocks are in current up trends.

Our search for stocks with favorable yield and valuation was of all listed US stocks, for those with these characteristics:

  • 7-year cumulative effective tax rate greater than 30% and less than 36%
  • 12-mo trailing dividend yield greater than 2%
  • PEG ratio less than 2
  • 12-mo trailing shareholder yield (dividend yield + buyback yield) is no less than dividend yield (no share issuance).

There are companies with tax rates  much higher than the nominal rates.  Those cases are too complicated for this simple search, and that is why we limited the effective tax range to less than 36%.   The 30% minimum is to find those with a substantial potential benefit from a corporate tax rate reduction.

These are the 22 companies that came through the filter criteria:

DE Deere & Company
HMC Honda Motor Co Ltd (ADR)
ETH Ethan Allen Interiors Inc.
PII Polaris Industries Inc.
HOG Harley-Davidson Inc
AFL AFLAC Incorporated
LM Legg Mason Inc
PDCO Patterson Companies, Inc.
IPG Interpublic Group of Companies
TEO Telecom Argentina SA (ADR)
AMX America Movil SAB de CV (ADR)
HRB H & R Block Inc
GATX GATX Corporation
IX ORIX Corporation (ADR)
AEO American Eagle Outfitters
M Macy’s Inc
PAG Penske Automotive Group, Inc.
BBY Best Buy Co Inc
MINI Mobile Mini Inc
NSC Norfolk Southern Corp.
CPPL Columbia Pipeline Partners LP

These are the metrics for each company, along with the Standard and Poor’s Capital IQ ratings for 12-months forward (“stars”) and fair value:

(click image to enlarge)





This table presents the trend condition of those 22 stocks, using the QVM 4 Factor monthly trend indicator.

A rating of 100 is for the leading end of the major trend line moving up.  A rating of zero is for the leading end of the major trend moving down. A rating of 50 is for the leading end of the major trend line in transition between trend directions.  At the bottom of this article, there is an explanation of how the QVM 4 Factor indicator works.



The median tax rate among S&P 500 stocks that have positive 7-year cumulative tax rates is 30%, and the average is 24%.

Our search among S&P 500 stocks simply eliminated those with 7-year cumulative effective tax rates below 30% and greater than 35%.  We found 100 such stocks shown in this table:


Thirty-four of those 100 stocks are currently in up trends as measured by the QVM 4 Factor monthly trend indicator, as follows



Companies currently with effective tax rates below the 20% rate that is often mentioned in Washington for the next Congress, may find their effective tax rate rising and profits declining, if the “tax loopholes” they have relied upon are repealed to pay for a new lower corporate tax rate.  Companies with rather full effective tax rates (such as those in between 30% and 35%) in our filter, would likely find their effective tax rate dropping and profits increasing under a new lower corporate tax rate.

Currently low effective tax rate companies with high valuation multiples would possibly see the double effect of declining profits and declining valuation multiples.

Currently high effective tax rate companies with high valuation multiples may see support for their multiples as their profits increase as their taxes decline.

If a company with a current 35% tax rate (with a 65% after-tax income rate) goes to a 20% tax rate (with an 80% after-tax income rate), that would be a 23% increase in profits.  That profits increase could offset a similar decline in valuation multiple, that might be triggered by a general multiple contraction in the broad market.

All-in-all that suggests to us that overweighting stocks of companies that would most strongly benefit by a corporate tax rate reduction, and a underweighting stocks whos effective tax rates might increase as a result changes in the tax law is a reasonable idea.

Within these two lists, there should be good hunting ground for strong Trump tax plan beneficiaries, that may be suitable for you.

Post Script: How the QVM 4 Factor Trend Indicator:

A quick summary is in the graphics below.  A more expanded discussion is at this link.


Target Date Funds As Aid In Retirement Portfolio Design

Sunday, October 4th, 2015
  • Investors in or near retirement should be aware of portfolio design leading fund sponsors suggest as appropriate
  • Leading target date funds appear to generally have less severe worst drawdowns than a US 60/40 balanced fund
  • The funds have slightly higher yields than a US 60/40 balanced fund
  • Target date funds have underperformed a US 60/40 balanced fund in part due to a cash reserve component and non-US stocks
  • Non-US stocks drag on historical performance could become future boost to performance.


This article is suitable for investors who are in retirement or nearly so, and who are or will rely heavily on their portfolio to support lifestyle.

It is not suitable for those with many years to retirement, or those with a lot more money in their portfolio than they will need to support their lifestyle.


We have been writing about the short-term recently (here and here and here), because we are in a Correction, that may become a severe Correction, and possibly a Bear.

For our clients who fit the profile of being in or near retirement and heavily dependent of their portfolio to support lifestyle in retirement, we have tactically increased cash in the build-up to and within this Correction, as breadth and other technical have deteriorated.

However, we don’t want to lose sight of long-term strategic investment.  This article is about asset allocation for investors that fit that retirement, pre-retirement, portfolio dependence profile.


We think it is a good idea to begin thinking about allocation by:

  1. reviewing the history of simple risk levels (see our homepage) from very conservative to very aggressive to get a sense of where you would have been comfortable
  2. reviewing what respected teams of professionals at leading fund families believe is appropriate based on years to retirement (they assume generic investor without differentiated circumstances).

This article is about the second of those two important review — basically looking at what are called “target date” funds.

Generally, portfolios should have a long-term strategic core, and may have an additional tactical component.  We think some combination of risk level portfolio selection and/or target date portfolio selection can make a suitable portfolio for many investors.

You may or may not want to follow target date allocations, but you would be well advised to be aware of the portfolio models as you develop your own.

In effect, we would suggest using risk level models and target date models as a starting point from which you may decide to build and deviate according to your needs and preferences, but with the assumption that the target date  models are based on informed attempts at long-term balance of return and risk appropriate for each stage of financial life.

For example, an investor might deviate one way or the other from more aggressive to less aggressive based on the size of their portfolio relative to what they need to support their lifestyle, and the size of non-portfolio related income sources; or merely their emotional comfort level with portfolio volatility.

There no precise allocation that is certain to be best, which is revealed by the variation in models among leading target date fund sponsors.  Their allocations are different, but similar in most respects.


For this article, we identified the 7 fund families with high Morningstar analyst ratings for future performance (those ranked Gold and Silver, excluding those ranked Bronze, Neutral or Not Rated).

Those 7 families are:

  • Fidelity
  • Vanguard
  • T. Rowe Price
  • American Funds
  • Black Rock
  • JP Morgan
  • MFS

Fidelity, Vanguard and T. Rowe Price have about 75% of the assets in all target date funds from all sponsoring families combined.


We then used Morningstar’s consolidated summary of their detailed holdings to present and compare the target date funds from each family.  The holdings were summarized into:

  • Net Cash
  • Net US Stocks
  • Net Non-US Stocks
  • Net Bonds
  • Other

While we have gathered that data for retirement target dates out 30 years.  This article is just about target date funds for those now in retirement or within 5 years of retirement.


We simulated the hypothetical past performance of those target date funds using these Vanguard funds:

  • VMMXX (money market)
  • VTSAX (total US stocks)
  • VGSTX (total non-US stocks)
  • VBLTX (aggregate US bonds)

Admittedly, this is a gross proxy summary of the holdings of the subject target date funds  The funds may hold individual stocks or bonds, may hold international bonds, may use some derivatives, and may have some short cash or short equities. Nonetheless, we think these Vanguard funds are good enough to serve as a proxy for the average target date funds, and as a baseline model for you to examine target date funds and to plan your own allocation.


As a benchmark for each allocation, we chose the Vanguard Balanced fund which is 60% US stocks/40% US bonds index fund. Figure 1 shows the best and worst periods over the last 10 years for that fund, as well as its current trailing yield.



So, let’s keep the 2.10% yield in mind as we look at the models, and also the 19.7% 3-month worst drawdown, the 27.6% worst annual drawdown, and 7.3% worst 3-year drawdown.


Figure 2 shows the allocation from each of the fund families for those currently in retirement.  It also averages their allocations for all 7 and for the top three (Fidelity, Vanguard, T. Rowe Price).

(click image to enlarge)


You will note substantial ranges for allocations from fund family to fund family.  For example, MFS using about 19% US stocks while Fidelity uses about 38%; and MFS uses about 64% bonds and Fidelity uses about 36%.

The average bond allocation for the 7 families is about 54%, but the top three by assets average about 42%; and their average cash allocation is about 9% versus the top 3 average of 5%.

Figure 3 shows how a portfolio using Vanguard index funds would have performed over the past 10 years with monthly rebalancing if it was based on the average of the top 3 families.

We recalculated the allocations to exclude “Other” which is undefined, but which is relatively minor in size in each fund.

We also note that the Vanguard index funds have a small cash component, so that the effective cash allocation is higher than the model.

FIGURE 3 – Backtest Performance:
(retired now: average of top 3 families)



  • Yield is somewhat higher (2.28% versus 2.10%).
  • Worst 3 months were somewhat better (-18.4% versus – 19.7%)
  • Worst 1 year was somewhat better (-26.2% versus -27.6%)
  • Worst 3 year drawdown was better (-5.7% versus -7.3%)
  • Underperformed benchmark over 10, 5, 3 and 1 year and 3 months (10 years underperformed by annualized 1.05%).

Reasons For Underperformance:

Inclusion of non-US equities may be the biggest contributor to underperformance versus the balanced fund with 100% US securities.

Another part of the underperformance is maintenance of a cash reserve position that is over and above any cash position within the benchmark balanced fund.  Part is also  due to a higher bond allocation.

Those factors probably account most of the performance difference.  We did not try to determine the exact contributions of each attribute to performance differences.

The historical underperformance due to non-US stocks could possibly turn out to be a long-term reason for future outperformance.

FIGURE 4 – Backtest Performance:
(retired now: average of top 7 families)


  • Yield is somewhat higher (2.19% versus 2.10%).
  • Worst 3 months were significantly better (-12.6% versus – 19.7%)
  • Worst 1 year was somewhat better (-17.7% versus -27.6%)
  • Worst 3 year drawdown was a lot better (-2.3% versus -7.3%)
  • Underperformed benchmark over 10, 5, 3 and 1 year & outperformed over the last 3 months (10 years underperformed by annualized 1.32%).
  • Incurred less drawdown in exchange for lower cumulative return.


FIGURE 5 – Allocation:
(expected retirement within 5 years)

(click image to enlarge)


Again, we see substantial variation between fund families, and also between the averages for the top 3 by assets and for all 7 of the Gold or Silver rated target date families.

The average bond allocation for the 7 families is about 44%, but for the top 3 it is only about 34%.  For the 7 families the average non-US stocks are about 15%, but for the top 3 families it is about 21%.

FIGURE 6 – Backtest Performance:
(up to 5 years to retirement: average of top 3 families)


  • Yield is higher (2.30% versus 2.10%).
  • Worst 3 months were somewhat worse (-21.1% versus – 19.7%)
  • Worst 1 year was somewhat worse (-30.1% versus -27.6%)
  • Worst 3 year drawdown was the same (-7.3% versus -7.3%)
  • Underperformed benchmark over 10, 5, 3 and 1 year and 3 months (10 years underperformed by annualized 0.95%).

FIGURE 7 – BacktestPerformance:
(up to 5 years to retirement: average of top 7 families)


  • Yield is somewhat higher (2.19% versus 2.10%).
  • Worst 3 months were better (-16.2% versus – 19.7%)
  • Worst 1 year was better (-22.9% versus -27.6%)
  • Worst 3 year drawdown was better (-4.4% versus -7.3%)
  • Underperformed benchmark over 10, 5, 3 and 1 year & slightly outperformed over the last 3 months (10 years underperformed by annualized 1.19%).


Figure 8 presents the current yield and rolling returns of the five individual proxy funds used in this review.


(click image to enlarge)



(click image to enlarge)



Stock Market Top — Are We There Yet?

Tuesday, August 11th, 2015
  • The US stock market appears to be in transition toward a significant top
  • Several key market top indicators are flashing caution (but they are still mixed)
  • Greater selectivity toward higher quality and larger-capitalization is in order
  • Above average cash levels may be appropriate

The stock market is in a tender condition.  Caution and selectivity, and possibly reduced allocation to equities with above average cash, is a reasonable approach for investors, particularly those who have accumulated most of the assets they are going to accumulate in their lifetime.

Investors far from retirement, or with substantial excess assets beyond their retirement needs, can be more aggressive and weather more severe market downturns waiting for price recovery.

Investors who are relying, or may soon rely on their portfolio to support lifestyle, and who do not have excess assets, have reasons to err on the side of caution; because portfolio value declines during fixed Dollar withdrawals shorten the “life expectancy” of the portfolio.  It is important for those investors that their portfolio live at least as long as they do – to avoid the “risk of ruin”.

Market timing is not a good idea for almost everybody.  It more often than not results in long-term underperformance, as a result of getting out late and re-entering late – thus leaving performance on the table.  Most peaks and troughs are too close together in price for most people to extract value by timing.  However, in the case of infrequent major marker reversals, exiting and re-entering, even if a bit late, can result in outperformance (the DotCom crash and the 2008 crash being recent examples).

We certainly face a market decline of some sort sooner than later, but the question is whether it will be garden variety (stick to your allocation) or major (get out of the way).  So what are the typical signs of a developing major market top?   A major top tends to develop when SEVERAL of the 12 factors listed below manifest themselves and CONFIRM each other in trends within broad market indexes.  The Treasury yield curve indicators are perhaps the most powerful and most important of the indicators.

Treasury Yield Curve

  • 2-Yr Treasury Yield / 10-Yr Treasury Yield Ratio
  • 3-Mo Treasury Yield / 10-Yr Treasury Yield Ratio


  • Reported Earnings Direction
  • Forward Earnings Estimates Direction
Market Breadth
  • Cumulative Net New Highs (new highs less new lows)
  • Cumulative Net Advances (advanced less declines)
  • Cumulative Net Advancing Volume (advancing volume less declining volume)
  • % Issues Above 200-Day Average
  • % Issues With Bullish Chart Patterns
Simple Chart Conditions
  • Index Price Position vs 200-Day Average
  • 200-Day Average Recent Direction
Federal Reserve Multi-Factor Indexes
  • Z-Scores vs Total Stock Market

These factors do not call exact tops, but as more of them blink caution, and as their state becomes more severe or prolonged, the major top becomes closer or more likely.

Of course, big macro surprises and “fat tail” events can preempt all of that and disrupt a market in a major way.  There are no quantitative methods to anticipate those events.  Valuation in and of itself probably can’t be shown to predict tops —  valuation can go much higher and much longer than ever anticipated.

These 12 factors, however, provide a pretty good warning or confirmation of a major trend reversal. Here what those indicators are saying now – not calling a top, but more substantial reasons for caution.

(Click Images To Enlarge)











Let’s look at the sectors of the S&P 500, breadth indicators similar to those we used for the S&P 500 overall.

Materials and Energy are in the worst shape. Financials, Staples, Utilities and Healthcare are in the best shape.

Here are the 2105 calendar year earnings growth rate estimates for each sector and the S&P 500 index:



And, here are the estimates for 2016:



The expected reversal from negative to positive growth, particularly for energy and materials, is the major notation between 2015 and 2016

Just a quick note about possible rising interest rates

These charts show the reaction of the S&P 500 to the last three Fed Fund increase cycle.  The reaction is not consistent, and shows stocks marching to more than one drummer, not just the Fed rates.  Overall, the stock market went its own way, and tolerated rising Fed Funds rate fairly well over time (up to the point that if forced the yield curve to flatten as we saw at the beginning of this report.



For intermediate-term interest rates as expressed in the 10-year bond, stocks showed  positive correlation to interest rates (meaning stock prices rose as interest rates rose) up to a 10-year yield of about 5%.  Above 5%, stocks began to have a negative correlations (higher interest rates tended to force stocks down).  We are in the good part of that chart now.



In terms of 5-year US stock market return expectations, this chart from JP Morgan Asset Management (vertical red line and current forward P/E added by us) indicates that we should expect a lower pattern of return over the next five years than we have experienced over the last 5 or so years.  We had lower P/E ratios in years past, and this shows that the higher the current forward P/E, the lower the 5 year returns that are realized.



JP Morgan points out that the data is from 1990 to the present, and that the R-squared number indicates the portion of 5-year future returns that were explained by the forward P/E (43%) – so there are other factors that explain 57% of the future returns.


Overall, it is hard to make a strong Bullish or strong Bearish case at the moment.  However, in the net I believe a cautious approach is appropriate and prudent at this time;  with above average cash allocation, and an emphasis on large-cap, established, high quality stocks with strong business models and enduring prospects; and/or domestic large-cap fund core positions with selected domestic sector or industrial satellite positions.

There is no question that such caution could have opportunity costs, but for those at or near retirement the relative risk and return balance suggests less than a full equity allocation.

As is always the case, individual suitability varies.  It is important to manage to your objectives, limits and circumstances, not to a hypothetical investor. Think about how these market status data relate to you and your specific portfolio.


Figures 1 and 6 are from the Federal Reserve Bank of St Louis
Figures 3, 4, 8 and 9 are from FactSet Earnings Insight
Figures 10,11 and 12 are from JP Morgan Asset Management
Figures 2 and 5 are generated with

While many US large-cap stocks are effectively relevant to this letter, three specifically relevant as S&P 500 funds are: SPY, IVV and VFINX.
Similarly, various US large-cap sector funds are effectively relevant to this letter, but these are specifically relevant as S&P 500 sector ETFs: XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY, XTL

Breadth Indicators Suggest Weakening Bull

Thursday, July 30th, 2015
  • The broad market is demonstrably technically weaker than the S&P 500
  • Breadth indicators suggest the Bull market is weakening
  • 7 breadth indicators provide the clues
These charts compare breadth indicators for the NYSE composite (over 4800 securities, stocks, ETFs, CEFs and some bonds, but overwhelmingly individual stocks) with the S&P 500 large-cap stocks  These are all technical factors.  Two other big ones I will write about later are the yield curve and reported and forecasted earnings (and revenue) growth. Those are fundamental factors. 

The purpose of breadth indicators is to reveal whether more or fewer of the constituents of an index are participating in a move (whether an up or down move).   

Often the case on the upside is that few and fewer stocks (the largest ones generally) are “pulling the wagon” while  more and more of the other constituents move into their own correction or bear market – that bear markets are actually a rolling event that culminates in the largest stocks eventually capitulating and joining in.

Direction divergences between the price of an index and the breadth measures is either a prediction of, or confirmation of, a change in trend direction; and divergences between the breadth of the broadest market (NYSE) and smaller indexes (SP500) can indicate potential problems for the smaller index.


The first side-by-side is a 10-year daily comparison (NYSE on the left and SP500 on the right). 

(click image to enlarge)


The top panel in gold measures the percentage of constituents with Bullish Point & Figure charts (a classic chart type with clear objective standards for Bullish and Bearish).  This measure shows little difference in pattern and levels between NYSE an SP500 (NYSE currently at 49% and SP500 and 51%), with both weakening from a strong 70+% at the beginning of 2014.  The 50% line is the “warning” line.  70+% is overbought and less than 30% is oversold.

The next panel in red (not a breadth measure, but one indicating the degree of deviation from the 200-day trend  the “strength” of the mean reversion force) plots a horizontal line at “1” for 2 Standard deviations above the 200-day; and another at “0” for 2 standard deviations below the 200-day trend.  A horizontal line value of “0.5” is at the 200-day trend line. 

Under a normal probability curve (ignores “fat tail” risks) 95% of prices are expected to be within +/- 2 Standard deviations (only 2.5% chance of price being above or below the +1 and 0 lines).  The fact is that stocks can and do sometimes move outside those boundaries for extended periods, but the odds favor reversion toward the 200-day mean trend line outside of those bounds.  Both NYSE and SP500 are in OK territory, but note that the NYSE has been breaking below the 0.5 (trend line) multiple times and much more than the SP500 during 2015.  That is a sign of comparative weakness in the broader market.

The main panel (price in black and 200-day trend line in gold) shows the general shape of the price and the position of the price above or below the 200-day trend line.  You can see (as discussed with the standard deviations) that the NYSE has dropped below its trend line a lot more than the SP500 and is below now, whereas the SP500 is not.  That shows broader market weakness.  You can also see that the NYSE has been rather flat since mid-2014, whereas the SP500 has only been flat in 2015.  That show broader market leading weakness with the SP500 following on a delayed basis.

The bottom panel shows the record high percent shows new highs divided by the total of new highs and new lows normalized to a 100 point scale [ {New Highs / (New Highs + New Lows)} x 100 ].  The pink histogram is the daily value and the blue line is its 10-day average.  The horizontal lines are the 70%, 50% and 30% levels.  NYSE had significantly more below 50% levels in 2013 and 2014.  In 2015, NYSE dropped to about 50% a few times and the average is down to 25%, whereas the SP500 did not drop to 50% until recently and is now at 54%.  The broader market is weaker.

All this data is merely to validate the simple statement that you may have heard on Bloomberg or CNBC that a smaller and smaller number of large companies are holding up the SP500.  Not yet a big problem, but clearly a maturing Bull market.


Here are the same indicators on a 1-year daily basis.  It gives a better view of the current situation (but in light of the long-term picture in FIGURE 1).

(click image to enlarge)


The two main observations are that the NYSE 50-day average is declining steeply and is near the 200-day average; and the price is below the 50-day; whereas the SP500 50-day average is declining mildly and the price is above the average.  The broader market is weaker. The other observation is the 97% record high percent on the most recent day for the SP500 (a very powerful upsurge); and a “pretty good” upsurge at the NYSE (58%) suggesting that new buying interest came back to both indexes.


These 10-year charts show different indicators of breadth.  The top panel shows the percentage of constituents above their 200-day trend line.  The main panel shows the index price and its 200-day average.  The lower panel in red shows the cumulative Net New Highs (highs less lows).  The panel in blue shows cumulative Net Advances (advances less declines). The bottom panel shows cumulative Net Advancing Volume (advancing volume less declining volume).

(click image to enlarge)


The NYSE percent above the 200-day average is weaker than the SP500 (40% to 56%).  Levels below 30% seem to correspond to trend reversals (and an extreme low level defined the 2009 bottom).

The index moving below the 200-day average was not a good indicator with too many false signals (“whipsaws”); but when the 200-day itself turned down, it was a pretty good signal of a problem market.,

When the Net New Highs, and Net Advances, and Net Advancing Volume  (collectively the “Nets”) all exhibited a trend reversal, so did the NYSE and SP500 indexes.

FIGURE 4:       

These next charts are the same as immediately above, but are daily for 1 year.

(click image to enlarge)


The data to note is that since June, all three of the “Nets” turned down for the NYSE; but for the SP500 only Net Advancing Volume declined.  Net Advances for SP500 have been flat all year and Net New Highs are rising at a decreasing rate toward flat.  The broad market is weaker than the S&P 500.

The summation of these observations is that the broad market is tired; the S&P large-cap market is still rising, but with less participation among its constituents.  Overall, this is the sign of an aging bull market, and suggests that extra alertness, or extra cash, or both are appropriate.  It may also suggest that a bit more in select fundamentally and technically solid individual stocks at the expense of index allocations could be appropriate.

If we are lucky, this analysis is wrong and the party continues unabated.

Retirement Balanced Portfolio: Asset Super Class Performance From 1928

Monday, June 29th, 2015

Allocation all boils down to Owning, Loaning and Reserving.  Everything else is a variation on implementation of these three super classes.

Retirement portfolios need some Owning (for capital and income growth), some Loaning (for steady income and portfolio volatility dampening), and some Reserving (for dependable cash availability for withdrawals, and less reason to panic when the market is panicking).

The term “asset class” gets tossed around a lot and sometimes asset types that are merely subcategories of true asset classes are mislabeled as “asset classes”.  While the use of the term is certainly arguable, the three most basic asset classes are: (1) cash reserves, (2) loans made to others, and (3) ownership of something like stocks, real estate or commodities.  We think of them as “super classes”, because just about everything else falls under one of these as a subcategory (even derivatives).


Three specific examples of Loan, Own and Reserve are the 10-Year Treasury Bonds (Loan), the S&P 500 (Own) and 90-day Treasury Bills (Reserve).

They, like the super classes to which they belong, are substantially minimally or even negatively correlated over reasonable periods of time.

While stocks and bonds have periods of high correlation, such as in panics, where there may be a rush to cash for safety and liquidity; for the most part they react differently to different circumstances, making them good pairs, along with cash reserves in a portfolio where risk (volatility) control is an important goal.

For most asset categories really long-term data is hard to find, but for 10-year US bonds, US large-caps stocks (S&P 500 and precursors), and 90-day T-Bills; we have data back to 1928 as proxies for the Loan, Own and Reserve super classes.

Let’s see how those super classes behaved in total return, price return and income return in an annually rebalanced tax-deferred or non-taxable account from 1928 through 2014.

The portfolio we use here is 60% US large-cap stocks, 31% 10-year Treasury Bonds, and 9% of 90-day T-Bills. US large-cap stocks are the S&P500 and its precursors.

That is a specific modification of a generalized 60/40 portfolio to make room for a three bucket (9%) operating reserve for retirement accounts.  The reserve is important to create fairly high certainty of capital available for withdrawal for up to 3 years, which is helpful to avoid panic in a steep down stock or bond market.

There are very few periods where a balanced portfolio is down for more than 3 years, so the 9% 3-bucket reserve can help a retiree glide over a bear market without selling assets at fire sale prices to fund living expenses.  Selling assets at depressed prices in retirement is a good way to outlive your assets — and that is not a good thing.

In practice, the 60% in stocks would likely include different market-cap sizes, and some international in most cases; and the 31% in bonds would likely include different durations and perhaps qualities, and maybe some international; and the 9% in reserves (90-day T-Bills as proxy here) would probably consist of 3% in a money market fund (duration about 90 days),  3% in an ultra-short bond fund (duration about 1 year) and a short-term bond fund (duration about 2.5 to 3 years).

Figure 1 is a chart showing the annual total return of the 60/31/9 portfolio from 1928 (87 years), along with the three-year moving average of total return:

Figure 1: Total Return – 60 stock / 31 bonds / 9 reserve

60-31-9 total return

There were some substantial dips on an annual basis, but the 3-year average was almost always positive, and where negative was mostly only mildly so.  Except for the Great Depression where the 60/31/9 declined over 14%, the worst decline was less than 4.5%

There were only 7 years of the 3-year average that were negative, and only two periods had back-to-back negative years: 1931-1932 and 1941-1942.  Two of the 7 down years had declines of less than 0.5%.

Specifically for individual years, there were 19 out of 87 years with a negative return (21.84%) of the time.

The periods of back-to-back negative periods were:

  • 4 years from 1929-1932
  • 2 years from 1940-1941
  • 2 years from 1973-194
  • 2 years from 2001-2002

The traditional 60/40 fund uses the S&P 500 index and the Aggregate Bond index.  That fund had total return less than negative 22% in 2008 (ref: Vanguard Balanced Fund VBIAX), whereas this 60/31/9 portfolio illustration uses Treasury debt for both the 31 and the 9.  Since 2008 was a year of panic, Treasury debt outperformed Aggregate Bonds.  This example portfolio declined 15.56% in 2008.

Both VBIAX and this example portfolio declined more than 22% and 15% from their intra-year 2007 peak to their 2008 intra-year bottom, but this memo is only about calendar year performance.

Figure 2 is a chart showing the price return separate from the income return for the 61/31/9 allocation.

Figure 2: Price Return and Income Return – 60 stock / 31 bonds / 9 reserve

61-31-9 price and income return separately

As you might expect the income return is far less volatile and more reliable than the price return.  That is important to retirees who are drawing on their portfolios.

The brown line is the price return and the green line is the income return.  The dashed black line is the 4% return level that relates to the 4% rule of thumb for retirement withdrawals.

While total return had 19 negative years of 87, price return had 29  (33.33% of the time).  It was the income return that saved the portfolio from the 10 extra negative years.

The specific back-to-back negative price return periods were:

  • 4 years from 1929-1932
  • 3 years from 1939-1941
  • 3 years from 1946-1948
  • 2 years from 1973-1974
  • 2 years from 1977-1978
  • 3 years from 2000-2002

With regard to the 9% 3-bucket reserve, individual bonds are probably not a practical alternative for most retirees for a variety of reasons. Here are three low-cost Vanguard funds that could probably fulfill the objectives and uses of the 9% reserve.

9 pct reserve bucket



Should You Currency Hedge Stock and Bond Funds?

Monday, April 27th, 2015
  • Foreign bonds are almost always better to currency hedge so they can serve fulfill their volatility moderation role
  • Foreign stocks are generally best hedged in retirement, and may be better unhedged during long-term periodic accumulation
  • Currency exposure is best pursued directly in FX or currency futures contracts

On balance, Dollar-based investors owning foreign assets hedged back to the Dollar is generally a good idea.

In the case of bonds, we think currency hedging is virtually always a good idea.

In the case of stocks, we think it is typically a good idea, unless you believe you have the time and skill to switch back and forth profitably between hedged and non-hedge stocks — and that you have the discipline and emotional strength and consistency to deal with the whipsaws that come with that approach.  Alternatively, you may find actively managed funds that effectively adjust their portfolio back and forth between hedged and unhedged.

For those in the accumulation stage with long-time horizons and doing Dollar-Cost-Averaging; the extra volatility of unhedged foreign equities could be an advantage.  Volatility is helpful with regular periodic investing, and harmful with regular, periodic withdrawal.  Therefore, retirees are better served by the volatility reduction that Dollar hedging is supposed to provide.

The array of hedge funds has proliferated and a review of unhedged fund substitution with hedged funds  for suitability is advisable

Hedging Equities:

Currency hedging equities is a two-edged sword. When the dollar is rising, hedged funds outperform unhedged funds. When the dollar is falling, hedged funds underperform unhedged funds.

There have been prolonged periods where one approach or the other has been superior, but in the very long-term the currency effect may be a wash.

These two charts based on MSCI indexes (one for EuroZone stocks and one for Japanese stocks) show the cumulative and monthly return differences from 1999 through March 2015:


You can see from these charts that the monthly returns (thin gray lines) vary wildly. The cumulative return differences (blue and orange lines) can have periods of several years of differential performance of hedged versus local currency returns.  Even though there are substantial periods of differential performance, the volatility is so significant, that whipsaws are a real impediment for many investors who wish to ride the currency trends by switching between hedging and not hedging.

Vanguard said in  “To Hedge or Not To Hedge: Evaluating currency exposure in global equity portfolios” published in September 2014:

“A reasonable forward-looking assumption is for an unhedged and a hedged investment to produce similar gross  returns over long time horizons.”

But that is over the long-term.  Over shorter periods of a year or two or three, for example, the choice to hedge or not hedge is quite material.

Hedging reduces one source of volatility (currency exchange rates at the portfolio level), but leaves unmodified the volatility of foreign stock expressed in the local currency; and the effect of currency exchange rates on the internal financial operations of the stocks in the portfolio.

Global Company Question:

For global giants currency effect is hard to pin down.  Major US companies may be massively exposed to foreign exchange; and foreign domiciled companies may do large portions of their operations in the US or in Dollars.

Global multi-national companies may be doing a substantial amount of currency hedging internally.

For a concentrated portfolio of global multi-national companies, the question of currency hedging at the portfolio level many be a more debatable one.

Dollar, Euro and Yen – The Three Major Currencies

The three major world currencies in terms of foreign exchange trading are the Dollar, the Euro and the Yen. These charts show the performance of the Euro and the Yen versus the Dollar over 16 years and 3 months.

FX1999 FX 3mo

From 2002 through 2004, with the Yen (red) rising versus the Dollar, if you chose to invest in Japan, you would have done better with an unhedged Japanese equities fund such as EWJ, instead of a hedged fund such as HEWJ available today. Then for 2005 through the middle of 2007, the Yen was falling and you would have done better with a hedged Japan stocks fund. From last 2012 through just recently as the Yen was falling, you would have done better with a hedged Japan fund such as recently available HEWJ.

Similarly, from 2002 through 2004 with the Euro rising versus the Dollar, if you chose to invest in the Euro Zone countries, you would have done better owning an unhedged fund such as the Germany ETF (EWG). However, from the 2008 crash through today, the Euro has been on a volatile up and down ride versus the Dollar, and you needed to switch back and forth several times to be on the right side of the currency trends. Over the past year, a hedged Germany fund, such as HEWG would have been the superior performer.

With Dollar Cost Averaging Unhedged Equities May Be Better:

Of note for investors with long-term horizons, particularly those doing regular periodic dollar-cost average investing; there would have been little benefit of seeking hedges. As you can see over periods of 10 and 15 years, currency effect can amount to virtually nothing. And, those doing dollar cost average with an unhedged fund would have benefited by the volatility and peaks and troughs along the way.

Hedging Was a Winner Over The Past 12 Months:

The top 1 year chart below shows  the performance of the unhedged Germany ETF (EWG), the hedged Germany ETF (HEWG) and the Euro exchange rate versus the Dollar (FXE).  The bottom 1 year chart below shows the unhedged Japan ETF (EWJ) and the hedged Japan ETF (HEWJ) and the Yen exchange rate versus the Dollar (FXY).

They both show the substantial outperformance of the hedged approach during that time period.


Hedging of Marginal Value Last Few Months:

Over the last 3 months, however,  both the Euro and the Yen seem to have stabilized against the Dollar. Over 3 months hedging showed no advantage, and in fact a slight disadvantage to owning the hedged equity funds.

HEDGE 3 mo

If the current generally flat exchange rate performance of the Euro and the Yen is to continue, or is harbinger of a weakening of the Dollar, then the unhedged forms of the Germany and Japan equities (EWG and EWJ) would be the superior choice for those moving between hedged and unhedged.

With QE increasing abroad and the Fed moving away from QE, an argument can be made that further Dollar strength is ahead, and that hedged equity funds are a better choice for total return. The consensus is that the Dollar has more strengthening ahead. How far and how long the Dollar will rise is, of course, uncertain.

Which Way To Go?

If you are young and Dollar-Cost Averaging, consider using unhedged equity funds.

If you are retired and withdrawing assets (without excess assets), consider using hedged equity funds.

If you are good enough with calling trend reversals (as opposed to volatility noise) and can live with a certain percentage of decisions being wrong due to whipsaw markets, then moving between hedged and unhedged investments may be suitable for you.

If you are a Dollar based investor and will not chastise yourself for sticking with Dollar investments when unhedged assets outperform, then stay with hedged funds.

If you don’t have a view, and aren’t one of the above, it may make sense to split the baby – 50% of international stocks hedged and 50% unhedged.

Foreign Bonds Are A Different Matter:

With foreign bonds hedging is a more clear-cut decision, unless you actually want to trade currency, but then you might be better off doing that directly in the FX or futures markets.  U.S. investors are likely to want bonds in their portfolio to reduce overall volatility, and/or also to match certain Dollar denominated capital expense or periodic withdrawals intentions.  Hedging helps realize those goals.

Currency risk significantly increases bond portfolio volatility — that’s a bad thing for most investors who buy bond funds.

This 10-year chart of the PIMCO foreign bond fund hedged (red) and unhedged (black) shows the volatility dampening effect of hedging.


Vanguard makes the point that international bond funds should be hedged all the time.  They said this in an interview on their website “Total International Bond Index Fund: Why and How We Hedge” (June 17, 2013):

“Foreign currency exposure by far dominates the volatility profile of international bonds. It accounts for about two-thirds of volatility. So currency hedging will minimize that currency volatility or currency risk.

This short-term chart showing the Vanguard international bond fund (BNDX) in gold versus the PIMCO hedged international bond fund (PFODX) and the PIMCO unhedged international bond fund (PFBDX) illustrates the point that currency creates the vast majority of volatility in a bond fund at a more granular level.  By including the Vanguard fund, it helps to show that the hedging effect is not something peculiar to PIMCO.


Vanguard goes on the say this about foreign bond hedging,

investors can isolate the interest rate and the credit risk and can maximize the diversification benefit that international bonds bring to their portfolio… [the portfolio] uses one-month forward currency exchange transactions, as the index is rebalanced the last business day of the month. 

There is a cost associated with currency hedging … Liquidity is crucial to keeping costs low…. Eighty percent of Vanguard’s Total International Bond Index Fund will consist of euros, Japanese yen, and British pound exposure. …those are three of the most liquid currencies in the world. … those currencies will be hedged back to the dollar, which is the most liquid currency in the world. So the cost of hedging… will be minimal.”


  • Bonds are best used when denominated in or hedged back to investor’s home currency — hedge all of the time
  • International bonds are a poor way to speculate on currency swings
  • Speculating in currency exchange rates is best accomplished directly with FX instruments, not piggy-back on bond or stock instruments
  • For stocks currency makes a significant difference over the short-term and intermediate-term, but over the long-term it pretty much a wash
  • For young investors in the accumulation stage of life, unhedged foreign equities may be preferable, but for investors in the withdrawal stage of life (without excess assets) hedged foreign equities are preferable.
  • You have to be effective at trend and trend reversal analysis to move back and forth between hedged and unhedged equities with satisfactory results.