FXIS Market Insights

Here is the latest issue of Market Insights.  Thanks to those of you who completed our reader survey last week;  your feedback is much appreciated!  For those who didn’t have a chance to complete the survey yet, please do so when you have a spare moment.  The survey has only 10 questions and should take less than 10 minutes to complete.  It will remain open until the end of this month. Click here to Start The Survey

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In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• A Series Of Unfortunate Events For Europe
• Back-Testing ETFs To Improve Your Odds
• What To Make Of This Week’s Data
• Recommended Video
• Last Not Least 

Weekly Snapshot
• New orders for durable goods in March decreased 1.3% from February, to $176.7 billion (ESA)
• US new home sales in March (seasonally adjusted) were up 26.9% from February (ESA)
• Greece formally requests the activation of the €45bn aid package from the EU and the IMF (WSJ)
• Moody’s cut its rating on Greece one notch to A3 (Bloomberg)
• On Thursday, Greek 2-year yields jump over 11% amid ratings cut by Moody's (Business Week)
• Greek 10-year yields rose to a high of 9.13% on Thursday (Bloomberg)
• Portguese bond yields under pressure, with 10 year yields up to 4.77% (EuroIntelligence)
• US Producer Price Index for finished goods rose 0.7% in March, seasonally adjusted (BLS)
• US existing home sales surge 6.8% in March the highest level since December (AP)
• Spain's real estate market bound to deteriorate further, non-performning loans increase (EuroIntelligence)
• Canadian $ dollar at parity vs. US$ - consensus is that rates will go up by June 1 (CBC News)
• The Reserve Bank of India raised its key lending rate by 0.25% to 5.00% (Marketwatch)
• US index of leading economic indicators, up 1.4% in March (Conference Board)

Chart Of The Week
US markets ended the week higher; for the Dow it was the 8th weekly gain.  The broader market index S&P500 is now almost 80% above the current bear market low, the infamous 666.79 from March of last year.  Below is a nice summary of the volatile journey since the peak in October 2007. 

Source: http://www.dshort.com/

Weekly Barometers

A Series Of Unfortunate Events For Europe
Europe has been plagued by a series of unfortunate economic events in recent months and, as luck might have it, mother nature has now chimed in as well.  Last week’s volcano eruption in Iceland and the subsequent flight ban for large parts of Europe caused havoc among travelers and businesses.  It did not help the Euro either which was just about to regain a bit of strength the week before on renewed news that support for Greece from Eurozone member countries would be forthcoming.

When the flight ban was finally lifted on Wednesday, analysts were still debating the economic effects of the volcanic ash cloud and wondered whether the total cost of this calamity would be severe enough to derail the nascent recovery.  No rest for the wicket though and the focus of attention went right back to Greece where the yield on their 10-year government bonds rose above 8% on Wednesday and higher still, above 9% on Thursday.  For the first time, Greek 10-year yields were more than 500 basis points above German Bunds while Greek 2-year Bond yields jumped over 11% amid another ratings cut by Moody's.

Greece's formal request to activate the aid package from the European Union and IMF seems to have calmed investor nerves a bit.  On Friday, the European stock markets recovered, the Euro regained some losses and ended up almost 2 cents above the 12 month low of 1.3205.

To see how Greece got there, please consider the illustration below showing the yields on 10-year Greek Government Bonds as well as the movement of the Euro versus the US Dollar.  April appears to be a pivotal month thus far.  With the formal request by Greece to activate the bailout funds, markets may return to more normal levels now.  But if unfortunate events were to continue and/or the sovereign debt crisis were to proliferate to other Mediterranean Eurozone countries, the blue and red lines below would spread apart even further...

Back-Testing ETFs To Improve Your Odds
The naughties (00’s) are often referred to as the lost decade culminating in the financial tsunami of 2008/09.  Total returns (including all dividends) on the S&P 500 were about –9% (-22% in nominal terms) for the entire decade.  With those numbers, it has become difficult to find a rationale for the “Buy and Hold” strategy that has been indoctrinated to the average investor for decades.

But despite the poor performance of stock markets over the past decade, there is ample evidence suggesting that stock picking and other active investing strategies are bound to run into substantial headwind over a longer period of time.  As Tom Lydon of www.etftrends.com suggests in his post: How to Become a Better ETF Trader:

According to a recent TrimTabs study, ETF investors are so bad at picking the right time to buy or short-sell the equity markets that those doing exactly the opposite of what ETF players did in the past 10 years would have ended up making sevenfold profits, reports Oliver Ludwig for Index Universe. 

The likelihood that a similar scenario would apply to most other active trading strategies in general is high and the rationale for that is quite simple: With more frequent transactions, trading approaches the realm of a zero sum game and the probability of outwitting other investors is by definition 50/50 minus transaction costs.  Unless you are an above average investor (trader), you won’t beat the crowd.  Although this may seem an oversimplification in terms of stock trading, an active investment strategy should on average under-perform the market by the amount of transaction costs incurred. 

So we have established that “Buy and Hold” didn’t work in the past decade and that market timing is also a particularly challenging task.   How can one improve the odds and what is the right strategy?

Tom Lydon suggests a few simple rules:

• Implement a simple strategy. Studies have shown time and again that there’s a direct correlation between how complicated a strategy is and how often you’ll use it. Keep it simple, silly.
• Have a stop loss. “It’s easy to buy and hard to sell,” goes the adage. Make selling easier by knowing when you’ll do it. And then do it.
• A simple strategy we suggest is trend following by using the 200-day moving average to determine when you buy and sell. You’re buying when a trend is there, and only when the trend is there. This allows you to check your emotions at the door.

Of these 3 basic trading tips, the third one is the most concrete example of a relatively simple and verifiable trading strategy. Brokerage firms often provide free access to research and trading analytics.  But these days, there are also free online resources available that let you back-test whether the proposed strategy would have worked for any given ETF. Let’s take this 3rd rule for a test drive then...

As a example, please consider www.etfreplay.com (no affiliation with the author) which has a tool allowing you to back-test a strategy using moving averages:  http://www.etfreplay.com/backtest_ma.aspx

Enter the ticker symbol SPY (the ETF for the US benchmark S&P500), use the suggested 200-day moving average and select “Trade On: Day of Cross”.  Choose your time frame, in this case the past decade, and hit the button to run the Back-test.  Here are the graphical results:

The proposed strategy seemed to have worked quite well with a more than 3:1 ratio favoring the 200 day moving average over the buy and hold period (Note: Returns are calculated from date of first backtest buy).  

Winning vs Losing Trades

Avg Win vs Avg Loss

Return %

There are  a few caveats however, again pointing towards a difficulty with regard to timing and money management.  For starters, the first trade did not occur until January 2002 which means staying on the sidelines for 2 years, had we implemented the strategy in January 2000.   That would have required a lot of patience!  Perhaps more difficult even for seasoned traders is the necessity to stick to a strategy during times when patience and conviction are severely tested.  The first 6 trades of this strategy were all losing money, albeit small percentage losses.  But the fact that the majority of the trades (77%) were losing trades can shatter the guts of the most confident traders.  Sticking to a strategy when the first few trades aren’t working isn’t everyone’s cup of tea.

Avg Days in Trade

Max Consecutive Trades

Max Equity Drawdown %

Perhaps the easiest way to appreciate a simulation like this is to see the actual trading results.  These are detailed in the table below.

In closing, I’d like to note that as with any trading strategy, simulated results from a back-view mirror perspective are always to be taken with a grain of salt.  While the proposed strategy appears to have worked for the benchmark S&P 500 it may or may not work for other indices or other ETFs.  Please also note that this is just one example of an easy to implement trading strategy - there are many others.  In terms of an overall financial plan, a tailored asset allocation may be much more important and prove more successful over time than a serious of specific investments or individual trades, no matter what timing or trading strategy may be adopted.  Usual disclaimers and general investment risk disclosures apply here as well. 

Having said that, there are more and more trading tools available now that allow individual investors to test and verify if a given investment strategy could work, something which was available to only professional traders until recently.  Overall, the easier and often free access to professional trading tools and investment analytics should make for better informed and more educated investors.  But don’t take my word for it, test it yourself. 

What To Make Of This Week’s Data
Consumer spending is up again, realtors had a great month in March with new home sales up 27%, leading economic indicators up 1.4% and US Treasury Secretary Tim Geithner tells us, the economy is getting stronger.  All that is mirrored in the ongoing rise in equities.  And yet, there is this nagging question as to whether these bumper results that drove stock prices up nearly 80% from last year will continue. 

Let’s start with an article from this week’s Financial Times: Foreclosure backlog brings relief for homeowners
A few points to note here:

• As many as 6m people continue to live in their homes even though they are seriously delinquent or in some stage of foreclosure, according to Moody's Economy.com.
• Lender Processing Services, which tracks the mortgages on 40m homes, estimates that 1.4m borrowers have not made a single payment in the past year.

In plain English: Several million Americans have been living for free in their home.  Banks cannot clear the backlog in foreclosures fast enough; but even if they could, too many evictions would drive the property prices down further.  And rather than admitting a full loss and writing off the loans completely, a managed delay in processing these foreclosures and keeping the homes “occupied” actually helps the lenders.  But of course, that situation is not sustainable.  Give it 6-12 months and the backlog will slowly shrink, which means several million consumers will no longer have extra cash to buy anything other than the bare necessities.  Watch for a decline in retail sales when the free-loaders have to pay for housing again.

What about home sales?  Home sales definitely benefitted from the $8,000 tax credit for new home buyers as well as the $6,500 for qualified move-up/repeat home buyers.  Vincent Fernando, CFA and Kamelia Angelova of BusinessInsider.com call it “A Government Engineered New Housing Frenzy” (see chart below).

Those government subsidies will end this month and it is questionable whether the increase in home sales and an overall improvement of the US housing market will continue later this year. 

We also believe that the stock market may have run a fair bit ahead of itself.  The Price/Earnings ratio of the S&P 500 currently has a multiple of 22.04, on a cyclically adjusted basis.  That value is about one third above its long-term historic average of 16.36.  Further, through a combination of near zero interest rates and a general sense of “the worst is over”, risk appetite has returned to the markets.  The volatility index, a.k.a. the fear index, has been back at pre-crisis levels for a few weeks now.  Too much complacency?

We also question whether the US consumer can continue to bear the heavy weight of shouldering the majority of the US economy.  The personal savings rate, which recently improved in historic terms, has begun heading south again in the past few months.  The combination of continued high unemployment and a consumer that may soon be cash-strapped again, if personal savings were to approach zero, does not bode well for a sustainable recovery.  Unless a substantial improvement in jobs is on the horizon, the so far “jobless” recovery will stand on rather shaky ground and current valuations will come under pressure.

 

Recommended Video
Debatable but certainly entertaining is Paddy Hirsch's video illustration of how the infamous ABACUS/Goldman Sachs deal was put together.  As Paddy put it: “It's a bit like a bookie and gambler teaming up to fix a horse race.” Enjoy!

Last Not Least
In case you’re not upset enough yet here’s a good one.  Amid all the talk of more regulation, tougher rules and yet another federal agency to oversee the financial institutions, here are some examples of how certain federal regulators worked.  Turns out, not everyone at the SEC was asleep at the wheel when the financial markets collapsed; some of them were very busy with other activities...

Good luck and good investing!

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