Dividend funds: caveat emptor!

Market Indicators Remain Positive

With the US S&P 500 stock index hitting new highs, we might ask ourselves if shares are finally starting to become expensive, and vulnerable to a near-term correction. Checking a number of my favourite market indicators, conditions look to remain favourable for stocks and shares. 

1. US advance-decline indicator hits new highs

The cumulative advance-decline indicator, that measures how many stocks have gone up versus those that have gone down each day and adds the up-down balance up over time, continues to make new highs. This points to good market breadth, i.e. that the market is being driven by a large number of stocks rising. If this were not to reflect a similar pattern to that for the benchmark stock indices, then I would be concerned. But no worries here...

US Advance-Decline Index Remains very Bullish

 2. US Value Line Geometric Index Also Very Strong

A second measure of market breadth is the Value Line index, which looks at the performance of the average stock in the US. Again, if this were not to be making new highs at the same time as the benchmark stock indices, I would be concerned. But once again, things look good...

US Value Line Index Also In A Bull Trend

3. European Industrial, Bank Stocks Still Performing Well

In an economic recovery scenario, both industrial and financial stocks should perform well, reflecting the benefit of a stronger underlying economy for profits in both these cyclical sectors. Looking below, we can see that European Industrial (SXNP) and Bank (SX7P) sectors are still in strong uptrends, and close to new highs. 

European Industrials, Banks Close to New Highs

But High Quality Dividend Stocks Now Expensive In the US

Interestingly, stable dividend stocks have in particular started to become expensive as investors have looked for yields outside of the traditional bonds and cash sources, given the very low rates of interest currently on offer from both asset classes. 

US Dividend Aristocrat Dividend Yield at record low

The chart above represents the US dividend aristocrat ETF, which only holds US large-cap companies that have raised their annual dividend consistently each year over the last 25+ years. Members include healthcare companies like Johnson & Johnson, and consumer staple companies like Coca-Cola.  All very high quality companies, but now increasingly expensive, only offering a 1.8% dividend yield now as opposed to nearly 2.5% at mid-year. Clearly investors are looking for a better yield than they can get on bonds or cash, but without taking big risks and thus preferring to invest in companies that offer relative stability. 

Focus more on Small-Cap stocks

October has been a pretty good month for Small-Cap stocks, with both UK and US small-cap indices continuing to outperform the large-cap benchmarks and rising in a strong, steady pattern. Both small-cap indices have gained nearly 5% over the last month, continuing to forge new all-time highs. 

UK, US Small-Cap Indices In Steady Uptrend

Favour Industrials, Small-caps; Beware Overvalued Dividends

I remain a big fan of ETFs exposed to small-cap stocks such as the iShares MSCI UK Small-Cap ETF (CUKS) and the iShares S&P Small-Cap 600 ETF (ISP6). You could get exposure to Small-Cap stocks in Europe overall via the db x-trackers MSCI Europe Small-Cap ETF (XXSC). With capital expenditure trends improving, European Industrials also remain a good area for investment at this moment: db x-trackers STOXX 600 Industrial Goods ETF (XSNR). 

But I would be wary of continuing to chase large-cap dividend stocks and indices higher at this point, as many of these stable growth stocks are now sitting at relatively expensive valuations, particularly in the US.  

If you want to buy exposure to European dividends, it would perhaps be better to look at a high-yielding sector ETF that is performing well, such as the STOXX Europe Telecoms ETF (offered by db x-trackers, Lyxor amongst others) rather than chasing what seems to me to be expensive dividend growth, at this point.  

Banks Breaking Higher In Spite of US Political Roadblocks

Given the drag to US economic activity from the ongoing US government shutdown, and the looming need to raise the US debt ceiling (before the US government runs out of money!), I am surprised to see that US investment banks and broker-dealers continue to do very well, with hardly a pullback in sight. 

US Broker-Dealers Bounce off 3m Moving Average

Boosted by Retail Investors Buying Stock Funds

This particular index comprises investment banks such as Goldman Sachs and Morgan Stanley, stock and commodity exchanges such as the CME, ICE and NYSE Euronext, and electronic trading platforms with as TD Ameritrade and E*Trade. They are all clearly benefiting from the current bull market in stocks, and the swtch by retail investors away from bond funds back towards equity funds, e.g. in the form of buying equity ETFs. 

Money Still Flowing Into Equity ETFs

European Financials Lead the Stock Market

In Europe, the same trends can be seen, with both the European Banks and Insurance sectors at or breaking new highs:

European Banks break a new year high

European Insurers also hitting a new high

You might argue that financial markets are perhaps being a little too sanguine over the risk of a US government debt default; the accepted consensus seems to be that a US default would wreak complete havoc on the US and global economies (not to mention global financial markets), and thus will be avoided by a combination of the US Treasury and Federal Reserve at all costs. 

Nevertheless, the fact remains that volatility remains historically low in spite of the political deadlock, and investors are still stuck looking for somewhere to invest their savings where they can garner a half-decent return, which is still leading them back to stocks and shares. 

Implied Volatility Still Close to Multi-Year Lows

Personal caution

I personally would rather be a seller into this rally than a buyer, as I believe that any eventual debt ceiling deal in the US could result in the stock market cooling off, as it is often better to "buy on the rumour, but sell on the news". 

That said, the US and European Banks and Insurance sectors still contain many companies that look attractively valued when looking at P/E, dividend yield or price/book valuation metrics, at a time when the US stock market overall could be argued to be already fully valued (as was argued recently by the famed investor Julian Robertson in a recent CNBC TV interview: Julian Robertson interview).

So what to do? I am still heavily invested in the UK, European, US and Japanese stock markets for now, but I must admit, I am looking to sell down positions sooner rather than later. After all, we are still not even halfway through the month of October, which has proven a pretty volatile month for stock markets in the past (see previous post for details)...

So invest in banks and insurers if you are confident of a successful resolution to the US debt ceiling issue, and if you believe that upcoming quarterly earnings releases from giant US banks such as JP Morgan and Wells Fargo will not disappoint expectations. 

Good luck,

Edmund

How Much Longer can Small-Caps Outperform?

I have been pleasantly surprised this year to see small-cap stocks outperforming their large-cap cousins in the UK, US, and Eurozone pretty much all year long. As a simple example, while the UK FTSE-100 benchmark index sits close to its 3-month lows, in contrast the FTSE Small-Cap index is only 2% off its all-time high!

Small-Caps around All-Time Highs!

If we look at three small-cap indices, the FTSE UK Small-Cap, the MSCI Europe Small-Cap and the S&P 600 Small-Cap, we can see in each case that small-caps are still very close to their all-time highs. 

UK Small-Caps 2% of all-time highs

MSCI Europe Small-Caps also within spitting distance of highs

Last but not least, US Small-Caps Breaking Higher

Note the last chart, where US small-caps are breaking out to a new all-time high despite the obvious question marks in the US about political gridlock in Washington. 

Economic Momentum Helping Domestic Stocks

One key indicator that is positive for domestic economic momentum in the US is the recently-released national ISM manufacturing survey: the reading for September clearly outperformed expectations with a solid rise to levels not seen since early 2011. 

US manufacturing showing strong positive momentum

This is equally true of the UK economy, where manufacturing is also seeing an accelerating rate of expansion:

UK manufacturing also returning to early 2011 levels of growth

So, this is all very well, but it could well be argued that this good macro news is already reflected in the current price of small-caps: more importantly, where next?

Seasonal Performance Suggests Continued Caution

Interestingly, looking at the case of Small-Caps, it would seem that the worst month of the year for performance historically has been September (which was actually decent for small-caps this year): 

September has been the worst month for small-caps

But I wouldn't assume from the chart above that the worst is past, now that we are into the month of October. After all, you need also to consider the following chart:

Small-Caps: Worst months have been August-October

So despite the strong upwards momentum of small-cap indices and the favourable macro following winds, I would not conclude that all will be plain sailing necessarily this month for small-caps. 

So what to do? Stay long small-caps, but watch carefully!

Let us not forget that, in the long-term, mid- and small-cap  stocks in the UK and US have tended to outperform the FTSE-100 and S&P 500 benchmark large-cap indices by quite a distance, albeit at the cost occasionally of higher investment risk at times of recession/crisis. 

One market indicator I like to keep a close eye on in the US at times like this is the cumulative breadth (advance-decline) indicator for US stocks (from Barrons) - so far, this looks fine, with the cumulative breadth line still advancing wekk-on-week. If this were to start to fall, then I would get worried about a potential correction...

US market breadth still up, giving comfort to small-caps

So remember that October can still be a terrible month for small-caps; stay invested in small-caps (as I am), but then watch the small-cap indices very carefully for any signs of impending market correction... 

My favourite UK small-caps for the moment: British Polythene (BPI), T. Clarke (CTO), Communisis (CMS), Inland Homes (INL), James Latham (LTHM) and Workspace Group (WKP). In France, I like Manitou (MTU) and Trigano (TRI). But as always when investing in single stocks, do your own research!

Hang in there,
Edmund

Should we invest in Stocks in October, Despite Seasonal Risks?

Stay in Stocks in October?

There are a number of reasons for avoiding risky assets like stocks in the month of October, ranging from seasonal to geopolitical to fundamental:

1. Seasonal: Historically, September and October have traditionally been the most volatile months of the year for stock markets worldwide, the months when most sharp stock market falls have been recorded (think Sept-Oct. 2001, Sept-Oct. 2008). Yes, stock markets have generally made small advances over the month of September, and have done well over the year to date. But isn't that precisely the reason for locking in profits now, at the beginning of October?
2. Political: The partial US government shutdown over the lack of agreement between the Democrats and Republicans over a the US budget could cause further volatility in the US economy and thus in financial markets. Thus far, markets seem to have taken these events in their stride (VIX volatility index close to a year low at under 15), but can we expect this relative calm to persist if no agreement is reached soon?
3. Fundamental: Let's not forget that the US Federal Reserve, having positively surprised the markets by not beginning the infamous "taper" (i.e. not reinvesting the proceeds of maturing bonds back into the US bond market) in September, could nevertheless begin this tapering process very soon. This was even hinted at by St. Louis Fed President James Bullard, who intimated that the taper might even begin in October (i.e. this month!). So the relief rally we have seen in bonds may not last much longer...

But some reasons to stay the course with stocks (for now)

A key reason to remain invested in stocks at the beginning of October is the basic fact that established uptrends in the major US, European and Japanese stock markets remain intact. Each stock market sits above its own 3-month and 6-month moving averages, and has not broken the general pattern of higher highs and higher lows. 

EuroSTOXX index in clear uptrend

Secondly, while it is true that September and October have contained some painful periods of stock market falls, we should not ignore the fact that, on average, the UK stock market has generated an average 2.1% total return (price change + dividends) over the two-month period over the 23 years from 1990 to 2012. 

UK stock market has gained 15 times out of 23 Sept+Oct periods

Indeed, over the past four years we have seen positive 2-month returns on each occasion... So from this simple statistic, I would say that the jury is out on whether these months should be completely avoided or not. 

Be pragmatic, use a stop-loss!

My pragmatic approach to investing in stocks at this time of year is relatively simple: I favour using liquid index-based ETFs rather than individual stocks, as then I can easily manage the level of risk in my portfolio by selling or reducing only a few investments. I also put in place a relatively tight stop-loss, so that I reduce my stock market investments before losses become painful. 

But, for this month of October, my ETF-based investment strategy is 100% invested in stocks, via UK Small-Caps (ETF code: CUKS), Euro Low Volatility stocks (IMV), US Small-Caps (ISP6), Emerging Markets Low Volatility stocks (EMMV) and FX_hedged Japanese stocks (IJPH). But in each case, I will be closely monitoring weekly moves, and selling them if they exceed the stop-loss levels I have set in place as of today. 

Year-to-date performance of my re-christened STAS

On a final note, I just wanted to point out that my asset allocation trending system STAS (Signal-driven Tactical Allocation System) has now gained 15.1% net of costs over the year to the end of September, including a monthly gain of 1.3% for September alone despite being 40% invested in cash. So far, still so good...