Madison Weekly Market Wrap July 18, 2016

Market Snapshot

A Third Straight Strong Week

The large-cap stock benchmarks gained more than one percent for the third straight week and established a series of new highs last week as traders reacted to encouraging developments overseas and a positive start to earnings season. The smaller-cap benchmarks and the tech-heavy Nasdaq gained too and pushed into positive YTD territory but remained below the records established in 2015. The small-cap Russell 2000, which is typically more volatile, saw the biggest gain for the week.

Stocks marched higher from the start of last week's trading as a good start to the second-quarter earnings reporting season boosted sentiment. Aluminum giant Alcoa, which is typically the first major company to release quarterly earnings, surprised investors by reporting a smaller-than-expected decline in quarterly profits, helped by strength in the commercial aerospace and auto markets. More good early news on earnings came Thursday, when banking giant JP Morgan Chase beat expectations, thanks largely to cost reductions, although it also saw an overall decline from the same quarter a year ago. Still, data and analytics firm FactSet currently expects overall earnings for the S&P 500 to decline 5.5 percent year-over-year in the second quarter, which would mark the fifth quarterly drop in a row -- the longest such stretch since the financial crisis of 2008-2009.

Falling earnings have come even against the backdrop of continued U.S. economic growth, and much of last week's economic data was upbeat. Retail sales rose 0.6 percent in June, much above expectations. Industrial production for the month of June also beat expectations and rose 0.6 percent, thanks primarily to increases in the output of motor vehicles and utilities. Producer prices saw a substantial gain as well, although consumer prices rose more moderately. Rising wages have been partly responsible for compressed earnings margins. 

Prices of U.S. Treasuries fell and thus yields rose steadily throughout last week as equity markets march upwards and positive economic data releases spurred selling in the Treasury market. The Treasury's 30-year bond auction saw robust demand, however, which was surprising considering a weaker 10-year note offering earlier in the week. This news highlights the continued demand for long-term security, even in the face of a risk asset rally and generally positive economic data. 

Investment-grade corporate bonds generated strong demand, especially from non-U.S. investors, across all parts of the capital structure and ratings spectrum as the search (reach) for yield continued. The relatively light new issue calendar as the earnings reporting season got underway helped to create a favorable technical backdrop and led to a more active secondary market. High yield bonds advanced amid strong demand and limited new supply. Notably, high yield ETFs saw the largest daily inflows on record.

European equities rallied as the markets grappled with the lasting effects of the June 23rd Brexit vote that prompted stocks there to plummet. Pan-European benchmark Euro Stoxx 600 logged about a 3 percent gain, but its climb was diminished on Friday following the major terrorist attack in Nice, France. Travel-related stocks were among the biggest losers on Friday. For the week, European equities were within striking distance of where they stood before Brexit.

Prime Minister Shinzo Abe's LIberal Democratic Party and its allies won a two-thirds majority in Japan's upper house elections on Sunday. Abe now has a parliamentary supermajority, enough support to push through constitutional reform and his economic agenda. The Nikkei 225 went vertical and posted five consecutive daily gains, advancing 9.2 percent. Nevertheless, for the year-to-date, the Nikeei 225 is still down more than 13 percent, the large-cap TOPIX 100 is off more than 15 percent, and the TOPIX Small Index is roughly 13 percent lower. 

China's currency continued to hover near six-year lows last week after the People's Bank of China guided the yuan sharply lower in response to the currency turmoil sparked by the June 23rd Brexit vote. The yuan weakened 2.5 percent against its reference basket of currencies in June in its biggest-ever monthly move. A weaker yuan helps Chinese exporters but it hurts the competitiveness of firms outside China, increases downward pressure on other emerging markets currencies, and worsens deflationary pressures globally. Most traders have fixated on China's slowing economy, but a sudden yuan revaluation could have more severe consequences for many market participants. 

Chart of the Week

Performance data from the world's most successful hedge fund.

Performance data from the world's most successful hedge fund.

Book of the Week

Expected Returns: An Investor's Guide to Harvesting Market Rewards, by Antti Ilmanen, with a foreward by Cliff Asness, is a comprehensive reference guide that delivers an important toolkit for advisors who want to learn what sorts of investment performance to forecast and expect at different times and in different market conditions, a process that is crucial for making asset allocation decisions. Expected returns of major asset classes, investment strategies, and the effects of underlying risk factors such as growth, inflation, liquidity, and different risk perspectives, are also explained. Judging expected returns requires balancing historical returns with both theoretical considerations and current market conditions. Expected Returns provides extensive empirical evidence, surveys of risk-based and behavioral theories, and practical insights. 

Fact of the Week

College degree holders are now 36 percent of the workforce as opposed to workers with a high school diploma (or less) who are now just 34 percent. 

Quote of the Week

"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

-Benjamin Graham (The Intelligent Investor)

Securities and advisory services are offered through Madison Avenue Securities, LLC, a member of FINRA and SIPC, a registered investment advisor.

This report provides general information only and is based upon current public information we consider reliable. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment or any options, futures or derivatives related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Diversification does not guaranty against loss in declining markets.

Madison Weekly Market Wrap July 5, 2016

Market Snapshot

Back in the Black

U.S. stocks rose solidly last week after a rally took hold Tuesday and reversed another Brexit-related decline on Monday. The gains brought the large-cap S&P 500 (+3.2 percent for the week) nearly back to its level before the UK's surprising vote to leave the European Union was revealed in the pre-dawn hours on the previous Friday. These gains also left the S&P and most of the other major benchmarks with gains for the month of June and for the second quarter as a whole. The tech-heavy Nasdaq was again the notable exception, recording losses for both periods. 

UK and European stocks markets also gained ground late last week after Bank of England Governor Mark Carney suggested there would likely be further monetary policy easing there in the next few months. His comments added to pressure on the British pound, which fell to a three-decade low following the UK's vote to leave the EU and pushed the yield on the 10-year UK in the pound and that the bank would "take whatever action is needed to support growth". Both the FTSE 100 and the pan-European Stoxx Europe 600 ended last week higher, if not as strong as markets here. 

S&P stripped the UK of its AAA credit rating last Monday after warning that a vote to exit the EU threatens the country's constitutional and economic integrity. Fitch followed, cutting UK ratings one note to AA. S&P also lowered the EU's long-term credit rating to AA from AA+, noting that the UK's departure will require complicated budget negotiations, which would create significant uncertainty. The IMF called Brexit the biggest current risk to the global economy as financial tremors from the UK decision threaten further to destabilize the world. The statement signaled a downgrade in the IMF's July forecast for global growth, which is currently 3.2 percent this year and 3.5 percent for 2017.

Brexit concerns were still at the forefront as last week began, pushing the major indexes to their lowest levels since early March. Funds designed to exploit market volatility appeared to drive much of the selling, but traders clearly continued to worry about the implications of the Brexit vote on global trade and business investment.

Growing confidence that those implications would only pay out over the longer term, if at all, seemed to help drive the rebound that began on Tuesday, as may have speculation that Britain would at least delay formal exit procedures (which would take two years in any event). Traders were encouraged by a number of merger announcements and takeover bids, suggesting that companies were conducting business as usual in the wake of the vote. As global markets headed higher (including the U.S., Japan, China, and emerging markets), short covering -- or the need of some investors to hedge against bets that stocks will go down -- appeared to accentuate the upturn.

Some positive U.S. economic data also boosted sentiment later in the week. The economy's first-quarter growth estimate was revised upward due to better readings on net exports and business investment. Consumer confidence jumped in the month, reaching its highest level since October of 2015.

The benchmark 10-year U.S. Treasury note briefly reached a record low in yield market last week, but that asset class later retraced its losses with both better-quality and more-volatile issues grinding higher as buyers returned to the market. Investment-grade corporate bonds also followed equities higher as a relief rally took hold. Issuance increased and investors displayed a robust appetite for new deals as month-end buying helped sustain the positive momentum.

Municipal bonds performed pretty well last week despite a pause in the wake of the post-Brexit rally in risk assets. Last Thursday President Obama signed legislation that will set up an oversight board to help Puerto Rico restructure its debt. The U.S. commonwealth has about $70 billion in overall debt and has been a significant issuer in the municipal bond market because of its ability to issue bonds that are tax-free in all 50 states. Puerto Rico has defaulted on several debt obligations over the past year, including $2 billion that was due July 1, badly weakening the value of Puerto Rican paper, necessitating the need for legislative action.

Chart of the Week

Book of the Week

The 4th of July conjures up memories for most of us, and baseball was and remains a big part of the American sporting life. In their new book, The Only Rule Is It Has to Work: Our Wild Experiment Building a New Kind of Baseball Team, Ben Lindbergh and Sam Miller describe the ultimate in fantasy baseball. They got to pick the roster, set the lineup, and decide on strategies -- with real professional players, in a real ballpark, in a real playoff race. Lindbergh and Miller got to help run an independent (very) minor-league team in California, the Sonoma Stompers, using the best analytics and the most advanced statistics. We tag along as the authors apply their number-crunching insights to all aspects of assembling and running a team. It's a wild ride, by turns provocative and absurd, as Lindbergh and Miller tell a story that will speak to numbers geeks and traditional baseball fans alike. And they prove that you don't need a bat or a glove to make a genuine contribution to the game.

Fact of the Week

The United Kingdom accounts for about 13 percent of the EU's population and roughly 15 percent of its economic output. To put this into perspective, Brexit would be akin to the Northeast region of the United States, including the financial hub of New York, choosing to secede from the union because of a belief that the region pays more in taxes than it receives in returned benefits.

Quote of the Week

"Infostorms may be generating a new type of politics: the post-factual democracy. Facts are replaced by opportune narratives and the definition of a good story is one that has gone viral."

-Vincent F. Hendricks

Securities and advisory services are offered through Madison Avenue Securities, LLC, a member of FINRA and SIPC, a registered investment advisor.

This report provides general information only and is based upon current public information we consider reliable. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment or any options, futures or derivatives related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Diversification does not guaranty against loss in declining markets.

Madison Market Monitor Second Quarter July 1, 2016

Market Snapshot

Full Snapshot.PNG

Brexit Bombshell

One week ago the United Kingdom voted to leave the European Union. The impact of this "Brexit" (for "British Exit") decision has been far and wide (if not nearly as much as the media might suggest), with global markets hit and U.K. Prime Minister David Cameron announcing his resignation.

The vote was wildly split across the U.K., suggesting that Scotland may well seek independence and Northern Ireland may seek reunification with the Republic of Ireland because they decisively desired to stay in the E.U. Significantly, the older and the less educated the voter, the more likely s/he was to vote "Leave."

Other countries may seek to leave the E.U. as well, now that the seal is broken, perhaps starting with the Netherlands. European banks will be asked to weather a big storm and may not be up to the challenge. However, the vote must still be ratified by Parliament and it will take at least two years to implement the leaving fully. There is even talk of another Brexit vote because so many voters have expressed "buyers' remorse," but that doesn't seem likely.

 "The people of the United Kingdom have spoken, and we respect their decision. The special relationship between the United States and the United Kingdom is enduring," said President Barack Obama in a statement. "The United Kingdom and the European Union will remain indispensable partners of the United States even as they begin negotiating their ongoing relationship to ensure continued stability, security, and prosperity for Europe, Great Britain and Northern Ireland, and the world." The U.S. Federal Reserve and the Treasury Department also sought to soothe nerves.

 Markets for risk assets around the world responded badly to the news as Brexit reactions rippled across the globe. Stocks in particular felt the brunt of the fallout, alongside the British pound. The British pound fell to 30-year lows against the dollar. Banks got hit especially hard. The major safe havens were U.S. Treasuries, gold and the Japanese yen. But by the middle of this week (and quarter-end) most global markets had recovered nicely.

 Economic professionals overwhelmingly held the view that the U.K. leaving the European Union was a very bad idea. And until voting results started coming in, the consensus of public opinion experts - at least if one uses prediction markets or polling data as a proxy - was that voters would in the end decide to stay in the E.U. The financial markets followed suit and, accordingly, were on the wrong side of the trade and were initially hit hard when the result was announced.

 The impact of the Brexit vote will likely be very substantial for Great Britain and for Europe. Indeed, the E.U. referendum is tearing the U.K. in half. Radical parties are making inroads at every level of government around the continent of Europe as well. However, I don't expect long-term negative consequences in U.S. markets to any significant degree. A stronger dollar will likely lower GDP a bit and perhaps push interest rates a bit higher, but there is no reason to expect a recession at this point. Brexit also gives the Fed more reason not to move on interest rates. But if we do ultimately suffer a correction, remind yourself that this is why diversification matters and that volatility is the price you pay for higher equity market returns as compared with other investment options.

 That said, the political volatility expressed and evidenced by the Brexit vote already seems at work here. The GOP Presidential ticket will likely be led by a deeply disliked man with no political experience and a highly volatile track record. Prominent members of his own party are refusing to support him. Meanwhile, the Democrats will likely be led by a woman almost as disliked as her opponent, who is widely regarded as a poor campaigner, and who has a political past for which to answer. The level of anger and vitriol at work seem much higher even than we've seen in the recent past, polarized and fractious as the political climate has been.

 David Brady, the Bowen H. and Janice Arthur McCoy Professor of Political Science at the Stanford Graduate School of Business and the Davies Family Senior Fellow at the Hoover Institution, was interviewed recently by Goldman Sachs about the political instability the world seems to be experiencing. In the developed world, he points to globalization and technological change as the factors driving the biggest upheaval for traditional political parties since the late 19th Century. That first great wave of globalization eventually moved farm workers and household servants into the American blue collar working class, but only after substantial political upheaval surrounding the fear of mass immigration, income inequality, the loss of low-skilled jobs and the alleged culpability of the banking class.

 Sound familiar?

 According to Brady, the key difference today is that this second great wave of globalization is more powerful because the world economy is much larger and broader, now including more of Europe and most of Asia. Roughly three-quarters of the world is now involved in the global capital-based economy. Technological change is also much faster. And whereas agrarian jobs were largely replaced with industrial jobs during the last transformation, many jobs lost today are disappearing altogether, which has impinged on people's sense of identity.

 What happens in the markets in the nearer-term will not likely turn out to be a very big deal over the longer-term. There is absolutely no reason to change a well-crafted financial plan or to change one's asset allocation based upon the Brexit news. But the politics? That bears watching.

Forecasting Follies

Before this past season started, English Premier League football club Leicester City were 5,000-to-one longshots to win the title. In fact, they were the odds-on favorite to finish at the bottom of the table and therefore dropped to a lower division. The team was largely made up of low cost acquisitions of has beensnever weres and maybe will bes. Their primary aspiration had been merely to avoid relegation.

Leicester's ownership was ridiculed for hiring the 64-year-old Claudio Ranieri as manager last July. Despite having managed some of Europe's top clubs, he had never won a championship and he had been out of work since the previous year when he was fired by the Greek national team after an improbable loss to the Faroe Islands. His only job in the Premier League had ended 11 years earlier.

But deft management, team spirit, a tremendous work ethic, surprising player development, nearly every transaction working out, nearly every player having his best year ever and a remarkable lack of injury combined to create what is likely the greatest longshot victory in the history of sport. The alleged "experts" - who picked the usual suspects to win it all - failed utterly.

History has provided a long list of similar forecasting failures. Analyst Clifford Stoll argued that "no online database will replace your daily newspaper." Bob Metcalfe, an electrical engineer widely credited with the invention of Ethernet technology, predicted that the internet would "in 1996 catastrophically collapse." Federal Communications Commission commissioner T.A.M. Craven stated in 1961 that "There is practically no chance communications space satellites will be used to provide better telephone, telegraph, television or radio service inside the United States."

Marconi predicted that the "wireless era" would make war ridiculous and impossible. Decca Records rejected the Beatles because they didn't like the group's sound and thought guitar music was on the way out. Every other studio in Hollywood but one turned down "Raiders of the Lost Ark" before Paramount agreed to make it and it became one of the highest-grossing films of all time.

Thomas Bell, president of the Linnean Society of London, summing up the year 1858 (which included the announcement of Charles Darwin's theory of evolution by natural selection), stated: "The year which has passed has not, indeed, been marked by any of those striking discoveries which at once revolutionize, so to speak, the department of science on which they bear."

In April 1900, the great physicist Lord Kelvin proclaimed that our understanding of the cosmos was complete except for two "clouds" - minor details still to be worked out. Those clouds had to do with radiation emissions and with the speed of light, and they pointed the way to two major revolutions in physics still to come: quantum mechanics and the theory of relativity.

At the World Economic Forum in 2004, Bill Gates predicted that, "Two years from now, [email] spam will be solved." And nearly every political pundit gave Donald Trump no chance to win the Republican presidential nomination.

Most of the alleged experts making market predictions are highly educated, vastly experienced, and examine the vagaries of the markets pretty much all day, every day, Yet they too are wrong a lot - pretty much all the time in fact. Why are we so bad at forecasting?

The great Russian novelist Leo Tolstoy gets to the heart of the matter when he asks, in the opening paragraphs of Book Nine of

War and Peace: "When an apple has ripened and falls, why does it fall? Because of its attraction to the earth, because its stalk withers, because it is dried by the sun, because it grows heavier, because the wind shakes it, or because the boy standing below wants to eat it?" With almost no additional effort, today's scientists could expand this list extensively.

As Daniel Kahneman and Amos Tversky so powerfully pointed out, we have evolved to make quick and intuitive decisions for the here and now ahead of careful and considered decisions for the longer term. We intuitively emphasize (per anthropologist John Tooby) "the element in the nexus that we [can] manipulate to bring about a favored outcome." Thus, "the reality of causal nexus is cognitively ignored in favor of the cartoon of single causes." In short, whenever we try to figure out complex future outcomes we enter dangerous territory with disaster lurking everywhere.

Even when we recognize the fallacy of thinking in terms of single, linear causes (Fed policy, market valuations, etc.), the markets are still too complex and too adaptive to be readily predicted. There are simply too many variables to predict market behavior with any degree of detail, consistency or competence. Unless you're Seth Klarman or somebody like him (none of whom is accepting capital from the likes of us), your crystal ball almost certainly does not work any better than anyone else's.

All that said, the idea that we can live our investing lives forecast-free is as erroneous as the market predictions that are so easy to mock. As Cullen Roche repeatedly emphasizes, "any decision about the future involves an implicit forecast about future outcomes." As Philip Tetlock wrote in his wonderful book, Superforecasting: The Art and Science of Prediction: "We are all forecasters. When we think about changing jobs, getting married, buying a home, making an investment, launching a product, or retiring, we decide based on how we expect the future to unfold."

It's a grand conundrum for the world of finance - we desperately need to make forecasts in order to serve our clients but we are remarkably poor at doing so. The key then, as Roche has argued, is that we should shun low probability forecasts. By contrast, Superforecasting points to (and laughs at) the general inaccuracy of financial pundits at CNBC, whose forecasts are low probability ones of the highest order. As Jon Stewart famously joked, "If I'd only followed CNBC's advice, I'd have a million dollars today - provided I'd started with a hundred million dollars."

The central lessons of Superforecasting can be distilled into a handful of directives. Base predictions on data and logic, and try to eliminate personal bias. Working in teams helps. Keep track of records so that you know how accurate (or inaccurate) you (and others) are. Think in terms of probabilities and recognize that everything is uncertain. Unpack a question into its component parts, distinguishing between what is known and unknown, and scrutinizing your assumptions. Recognize that the further out the prediction is designed to go and the more specific it is, the less accurate it can be.

In other words, we need rigorous empiricism, probabilistic thinking, a recognition that absolute answers are extremely rare, regular reassessment, accountability and an avoidance of too much precision. Or, more fundamentally, we need more humility and more diversity among those contributing to decisions. We need to be concerned more with process and improving our processes than in outcomes, important though they are. "What you think is much less important than how you think," says Tetlock. Superforecasters regard their views "as hypotheses to be tested, not treasures to be guarded." As Tetlock told Jason Zweig of The Wall Street Journal, most people "are too quick to make up their minds and too slow to change them."

Most importantly, perhaps, Tetlock encourages us to hunt and to keep hunting for evidence and reasons that might contradict our views and to change our minds as often and as readily as the evidence suggests. One "superforecaster" went so far as to write a software program that sorted his sources of news and opinion by ideology, topic and geographic origin, then told him what to read next in order to get the most diverse points of view.

The best forecasters are all curious, humble, self-critical, give weight to multiple perspectives and feel free to change their minds often. In other words, they are not (using Isaiah Berlin's iconic description, harkening back to Archilochus), "hedgehogs" who explain the world in terms of one big unified theory, but rather "foxes" who, Tetlock explains, "are skeptical of grand schemes" and "diffident about their own forecasting prowess."

But as Tim Richards has argued, we are both by design and by culture inclined to be anything but humble in our approach to investing. We invest with a certainty that we've picked winners and sell in the certainty that we can reinvest our capital to make more money elsewhere. We are usually wrong, often spectacularly wrong. These tendencies come from hardwired biases and also from emotional responses to our circumstances. But they also arise out of cultural requirements to show ourselves to be confident and decisive. Even though we should, we rarely reward those who show caution and humility in the face of uncertainty.

One forecast we should invoke, at least until the evidence demonstrates otherwise, is that the markets will generally trend upward. According to University of Oregon economist Tim Duy, "As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy."

Because of the many problems we have with forecasting generally, our portfolios should also be diversified. A diverse portfolio - one that reaches across market sectors - greatly increases the odds that at least some of a portfolio's investments will be in the market's stronger sectors at any given time - regardless of what's hot and what's not and irrespective of the economic climate.

At the same time, a diverse portfolio will never be fully invested in the year's losers. For example, according to Morningstar Direct, about 25% of U.S. listed stocks lost at least 75% of their value in 2008 but only four of over 6,600 open-ended mutual funds lost more than 75% of their value that year. Thus a diversified approach provides much smoother returns over time (even if not as smooth as desired!). On the other hand, a well-diversified portfolio will always include some poor performers, and that's hard for us to abide.

Next, make sure your time horizon is long enough. If you don't have at least a five-year time frame before using the money, stocks are almost surely a bad idea. That's because the chances of negative returns over shorter time periods are too high. But over the longer term, our investment prospects are reasonably bright.

Finally, recognize that there are limits to how precise even good forecasting techniques can be. No forecast should be seen as more than the roughest of outlines. Your mileage can and will vary. Keep your attention focused squarely on specific needs, goals and what you can actually expect to control about your portfolio and its results.

Forecasting is a necessary element of financial planning and investment management. Yet we tend to be really bad at it. Thus handle your forecasts and your forecasting process with extreme care.

The .400 Hitter and the Investment Superstar

More than 20 years ago, when I was still directly involved in the institutional sales and trading world, I was talking to a money manager client about a big global bond deal, managed by my then firm, that was about to hit the market. The manager didn't like the deal very much, but he was going to buy it anyway and in noteworthy size. His view was that since the deal would be a significant component to the index by which he was benchmarked, he wasn't prepared to risk being wrong on its value.

It was a classic trade by a closet indexer - a manager who claimed to be seeking active alpha but who was, instead, afraid to move too far from his benchmark. The last thing that manager wanted was to stand out, because the career risk to him of becoming a negative outlier was far greater than was the potential benefit of being right.

About 20 years before that, back in 1974, Paul Samuelson issued his famous Challenge to Judgment. In it, Samuelson challenged money managers to show whether they could consistently beat the market averages. Absent such evidence, Samuelson argued that portfolio managers should "go out of business - take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives."

In his view, investors were better off investing in a highly diversified, passively managed portfolio that mimicked an index than using judgment to pick stocks. Indeed, the idea behind indexing is to effect broad diversification within asset classes and broad diversification across asset classes so as to achieve market-like returns.

Unable or unwilling generally to meet Samuelson's challenge, "active" managers like my client have increasingly acted like indexers and, not coincidentally, have steadily ceded market share to passive or quasi-passive investment vehicles. In 1975, John Bogle launched the First Index Investment Trust (later renamed Vanguard 500), the first stock index fund for individual investors, which is now one of the largest mutual funds in the world, and with it launched a seminal market trend toward passive investment generally and indexing in particular. Although the idea took root slowly, passively managed funds now control roughly 40% of all domestic equity fund assets, according to Morningstar.

Moreover, most "actively managed" funds are actually highly diversified and thus cannot be expected to outperform. Even so-called "smart beta" portfolios are designed only to try to outperform marginally. That's because the more stocks a portfolio holds, the more closely it resembles an index. The average number of stocks held in actively managed funds is up roughly 100% since 1980, according to data from the Center for Research in Security Prices. (See Pollet & Wilson, "How Does Size Affect Mutual Fund Behavior?" Journal of Finance, Dec. 2008). Large numbers of positions coupled with average turnover in excess of 100% (per William Harding of Morningstar) effectively undermine the idea that such funds could be anything but a closet index.

As Patrick O'Shaughnessy of O'Shaughnessy Asset Management has recently and convincingly argued, managers today are much more interested in seeking assets than seeking alpha. A quality concentrated portfolio offers the opportunity for substantial outperformance. But such portfolios can significantly underperform for long periods and, even worse, a lesser quality portfolio might fall apart entirely. In either situation, the career risk to a manager is extreme. That explains the move to closet indexing pretty well, I think.

Since even before Samuelson's famous challenge, the Sequoia Fund has seemed to be exactly what a quality mutual fund should be. It is one of the last old-style funds with "conviction" - concentrated positions in stocks the fund managers believe in strongly. Since its inception in 1969, Sequoia has remarkably outperformed the S&P 500 by nearly 3% per year and has returned an average of over 13% annually to its investors. But recently the $4.7 billion fund was wrestling with heavy withdrawals as clients asked to pull more than $500 million in the first quarter of this year and more of late, largely due to a huge stake - roughly 30% of its holdings - in Valeant Pharmaceuticals International. The drug company's shares are down roughly 65% this year amid questions about its business and accounting practices.

Arguably, Sequoia is the only fund clearly to have met the Samuelson challenge. But as I write this, concentration and conviction aren't working so well for Sequoia as investors are aggressively questioning the judgment of Sequoia's managers and are taking their money elsewhere.

Accordingly, it seems beyond clear that the money management business today is dominated by indexers and closet indexers. Even the strongest advocates of active management must concede that, as a matter of simple arithmetic, the universe of active managers will underperform the universe of passive managers. Costs matter and passive management is a much cheaper endeavor. As Morningstar keeps demonstrating, in every single time period and data point tested, low-cost funds beat high-cost funds. Factor in the added tax efficiency of passive investing (much longer holding periods and far fewer transactions in general) and it is clear that active management bears a difficult burden in the contest to earn the trust and business of investors.

Perhaps even more tellingly, the performance of active managers and alleged active managers - in the aggregate - is astonishingly poor. A recent Bank of America Merrill Lynch analysis of mutual fund performance found that less than one in five large-cap mutual funds outperformed the S&P 500 in the first quarter in 2016, which represented "the lowest quarterly hit rate in our data history spanning 1998 to today."

"The average fund lagged by 1.9 [percentage points], marking a record spread of underperformance," explained equity and quantitative strategist Savita Subramanian and colleagues at Merrill. "And growth funds, for which our data extends further back, saw a 6% hit rate, the worst since at least 1991, with the average fund lagging by the widest margin we have recorded in our quarterly data: -3.5 [percentage points]."

As Bloomberg's Oliver Renick trenchantly pointed out, "It was a stock picker's market in the first quarter. Too bad about the stock picks." Active managers have gotten what they say they want so far this year: much lower correlations and much more breadth. However, the 50 stocks in which mutual fund managers are the least invested gained 5.3% in the first quarter compared with a 3.1% decline in a gauge tracking the most popular ones.

These findings are consistent with the regular SPIVA scorecards provided by S&P, which measure the performance of actively managed funds against their relevant S&P index benchmarks. During 2015, 66.11% of large-cap managers, 56.81% of mid-cap managers, and 72.2% of small-cap managers underperformed their respective benchmarks. Over the most recent five years, 84.15% of large-cap managers, 76.69% of mid-cap managers and 90.13% of small-cap managers lagged their respective benchmarks. Similarly, over a 10-year investment horizon, 82.14% of large-cap managers, 87.61% of mid-cap managers, and 88.42% of small-cap managers failed to outperform on a relative basis.

S&P's SPIVA Persistence Scorecard is even more depressing. Out of 678 domestic equity funds that were in the top quartile as of September 2013, only 4.28% managed to stay in the top quartile by the end of September 2015. Furthermore, only 1.19% of the large-cap funds, 6.32% of the mid-cap funds, and 5.41% of the small-cap funds remained in the top quartile.

Indeed, an inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status. No large-cap or mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period while only 7.48% of large-cap funds, 3.06% of mid-cap funds and 7.43% of small-cap funds maintained top-half performance over five consecutive 12-month periods. In part, that's because investors so often chase returns, swelling the assets under management of the recently "hot" firms and making future outperformance much more difficult (because size is the enemy of performance - being nimble helps a lot).

A key insight of Michael Mauboussin's excellent book The Success Equation is what he calls "the paradox of skill," simply defined as follows: "As skill improves, performance becomes more consistent, and therefore luck becomes more important." In 1941, Ted Williams had a batting average of .406, making him the last player in Major League Baseball to hit over .400 for a full season. Yet at least one batter hit .400 or better in nine of the 30 seasons between 1901 and 1930. How can this be, when overall skill has improved since then, in light of much broader access to talented players as well as superior coaching and conditioning?

As legendary scientist Stephen J. Gould has explained, as skill increases and moves toward human limits (the "right wall" of human achievement), the disparity between the average and the great narrows. As a consequence, although the mean batting average in the majors has remained roughly .260 since the 1940s, there are now fewer players at the extremes. In other words, "variation in batting averages must decrease as improving play eliminates the rough edges that great players could exploit, and as average performance moves towards the limits of human possibility and compresses great players into an ever decreasing space between average play and the immovable right wall."

In the same way, money managers can lose sight of the fact that while they may be improving their products or skills, others are too, thus reducing the opportunity for excess returns. The great Peter Bernstein made the right connection between baseball and money management: "Competition is too tough for somebody to hit .400. I watch baseball figures like a hawk, and it seems that's how the world has become. The market is full of smart, eager, highly motivated, highly informed people. It's hard to be a winner by enough to matter, or to stay a winner by enough to matter. There's also the whole benchmark problem, namely that there's tremendous pressure on managers to keep their tracking error down. There's no incentive to make the big bets that are necessary to hit .400. You can't beat the market by a lot unless you make big bets." See also: Peter L. Bernstein, "Where, Oh Where Are the .400 Hitters of Yesteryear?," Financial Analysts Journal, March/April 1999. Simply put, no money manager can expect to outperform by doing what everybody else is doing.

The hurdles that money managers must overcome to meet Samuelson's challenge and beat the market are high indeed. The vast majority of managers who try to do so will fail, even though many of them are extremely talented and dedicated. Many casual investors have no need or reason to beat the market, no matter what active manager marketing may suggest. Owners of an S&P 500 index fund generally own shares in 500 excellent companies. There is nothing inherently wrong with that. Nor is there anything wrong with utilizing market "factors" to try to improve investment performance. But investors in "smart beta" or similar strategies shouldn't expect outsized performance.

Investors who want or need substantial outperformance must look for and at managers with smaller accounts who use concentrated portfolios of quality assets that are held a long time to have a plausible chance of success. But these investors ought to understand that many such attempts fail and that the desired success is getting harder to achieve with each and every passing day.

Securities and advisory services are offered through Madison Avenue Securities, LLC, a member of FINRA and SIPC, a registered investment advisor.

This report provides general information only and is based upon current public information we consider reliable. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment or any options, futures or derivatives related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Diversification does not guaranty against loss in declining markets.

Madison Weekly Market Wrap June 27, 2016

Market Snapshot

Brexit Brings Pain

In what some are calling the single-most momentous day in British politics since WWII, on Friday the United Kingdom voted to leave the European Union. The impact of this result has been far and wide, with global markets hit and U.K. Prime Minister David Cameron announcing his resignation. The vote was widely split across the U.K., suggesting that Scotland may well seek independence and Northern Ireland may seek reunification with the Republic of Ireland. Other countries may seek to leave the EU as well, perhaps starting with the Netherlands. European banks will be asked to weather a big storm and may not be up to the challenge. However, the vote must still be ratified by Parliament and may take years to implement fully.

Risk assets around the world suffered one of their worst days of the decade, as Brexit reactions rippled across the globe. Stocks in particular felt the brunt of the fallout, alongside the British pound. The British pound fell to 30-year lows while the Japanese Nikkei fell nearly 8 percent before recovering into the close. The Stoxx Europe 600, a pan-European benchmark, and London's FTSE 100 both tumbled more than 8 percent in early Friday morning trading, though they began to recover as the trading day came to an end. Germany's DAX fell the most since the 2008 global financial crises.

Banks got hit especially hard with the U.K. Barclay's down over 20 percent at one point while American banks including Goldman Sachs, JPMorgan Chase, and Citigroup also saw significant losses. The major safe havens for world traders were U.S. Treasuries, gold, and the Japanese yen.

Here at home, Wall Street followed global markets lower, erasing significant gains made earlier in the week (see the Market Snapshot above). The tech-heavy Nasdaq performed moderately worse than the other benchmarks, losing over 4 percent. The declines brought the S&P 500 (-3.59 percent), the Dow (-3.39 percent), and the small-cap Russell 2000 (-3.81 percent) near or into negative territory for the year-to-date, alongside the Nasdaq.

The Brexit vote dominated market sentiment throughout last week (and not just Friday). U.S. stocks reached their highs for the week on Thursday, when many wrongly concluded that the U.K. would vote to remain in the EU. Futures plunged in overnight trading, however, after it became clear that the vote had gone the other way. The major indexes plummeted at the open, recovered a bit, but then fell back to new lows in afternoon trading.

Last week's U.S. economic data were mixed. Existing home sales rose 1.8 percent in May, while new home sales fell 6.0 percent. The smaller sample size used in the new home sales data often results in volatility in the reading. Durable goods orders fell 2.2 percent, with core capital goods orders falling 0.7 percent. The data pointed to a lack of business investment and concerns over productivity, but the numbers also reflected a recovery in export orders.

The yield of the benchmark 10-year U.S. Treasury note rose marginally through last week, only to plummet to its lowest levels in nearly four years as bonds rallied after the release of the results of the vote. The favorable macro backdrop created a firmer tone in the investment-grade corporate bond market, but it sold off sharply following the Brexit news. The high yield market was also volatile.

As I have noted, the impact of the Brexit vote will likely be very substantial for Great Britain and for Europe. Rating agency Standard & Poor's has already confirmed that the U.K. is likely to lose its highest-level AAA credit rating. The EU referendum is tearing the U.K. in half. London, Scotland, and Northern Ireland voted strongly to stay in the EU while the north of England, the Midlands, and Wales wanted out. The young and the educated wanted to stay while the old and the uneducated wanted to leave. Meanwhile, radical parties are making inroads at every level of government around the continent of Europe. 

However, I don't expect long-term negative consequences in U.S. markets to any significant degree and, as the above chart suggests, the markets appear to have overreacted given the magnitude of what happened today relative to other major events. If the U.K. experiences something like the predicted 3.5 percent decline in GDP then it will be bad for the U.K, but it will mean little globally. Remember, the U.K. represents just 4 percent of global GDP. Even in a worst case scenario it is not large enough to derail the global economy on its own. 

A stronger dollar will likely lower U.S. GDP somewhat and push interest rates a bit higher, but there is no reason to expect a recession at this point. Brexit gives the Fed more reason not to move on interest rates. But if we do suffer a correction, remind yourself that this is why diversification matters and that volatility is the price you pay for higher returns. There is no reason to alter a good financial plan or change one's asset allocation on this news.

Chart of the Week

Good Reads

The following recent articles are well worth your time.

Simple Financial Advice for New Grads (Morgan Housel)
Do You Pass the Financial Stress Test? (Bloomberg)
The Importance of Asset Allocation vs. Security Selection: A Primer (GestaltU)
When Winners Fail (Basis Pointing)
Simplexity (Michael Batnick)
The Market's Buyback Yield is not a Timing Tool (Patrick O'Shaughnessy)

Book of the Week

Daniel Kahneman, winner of the Nobel Prize in Economic Sciences for his work in psychology challenging the rational model of judgment and decision-making, wrote this insightful memoir about his life and work, Thinking Fast and Slow. In it, he tells his story, summarizes his life's work. He also reveals when we cannot trust our intuitions and how we should use the benefits of slow, deliberative thinking. His work (and this book) challenged and ultimately transformed the way I think about thinking.

Fact of the Week

A new report from Berenberg research projects that life expectancy will keep increasing and fertility will keep decreasing on a global scale. The number of countries with high life expectancies (over 75 years old) and low birth rates has been steadily increasing since the mid-20th century, and it will keep rising. Berenberg projects that over 75 percent of countries will reach this by 2050. Taken together, long lives and low birth rates mean the percentage share of older people in these countries -- and in the world -- will increase as well. The number of countries with a higher percentage of citizens older than 65 is set to skyrocket within a few years, as will the number of countries with negative population growth. That means the demographic problems that have almost crippled Japan in the past few decades (such as fewer and fewer people available to fund senior programs) will affect 40 percent of all countries by 2050.

Quote of the Week

"Friendship is like money, easier made than kept."

-Samuel Butler

Securities and advisory services are offered through Madison Avenue Securities, LLC, a member of FINRA and SIPC, a registered investment advisor.

This report provides general information only and is based upon current public information we consider reliable. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment or any options, futures or derivatives related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Diversification does not guaranty against loss in declining markets.

Madison Weekly Market Wrap June 13, 2016

Market Snapshot

Back to Where We Started

The major equity benchmarks closed last week mostly flat after drops on Thursday and Friday largely erased earlier gains. The large-cap S&P 500 managed to reach its highest level since last July on Wednesday before falling back. The gains also lifted the S&P to a point roughly 15 percent above the lows it reached in February. But it also suffered its first one percent down day in 45 sessions on Friday when the VIX popped 17 percent, the highest daily gain since January 7 -- 107 trading days ago. The tech-heavy Nasdaq underperformed to record a loss on the week. The smaller-cap benchmarks were also relatively weak.

The strong start to the week appeared to be due, at least in part, to reassuring comments from Fed Chair Janet Yellen. In a highly anticipated speech on Monday, Yellen confirmed her faith in the strength of the labor market and did not waver in her view that the Fed was set on a path of gradually raising short-term interest rates. However, she did concede that economic risks exist and that tighter policy is not on a preset course.

Some favorable macroeconomic trends might have also boosted market sentiment early in the week. Crude oil prices rose above $50 per barrel for the first time in eight months at midweek. Energy stocks had a mixed reaction, however, with traders seeming to swap out of exploration and production firms into services shares. The falling U.S. dollar also helped materials and industrials shares, and good news on weekly jobless claims and job openings may have helped ease fear over the labor market sparked by the previous week's odd monthly payrolls report.

Global economic worries resurfaced late in the week, however, pushing stocks lower.

Wall Street opened sharply lower on Friday morning, following a big drop in European markets. European stocks were under pressure pretty much all week as energy, commodity, and financials shares weighed on markets. Questions about the strength of the world's economies, particularly the U.S., and growing fears that the UK would vote to leave the European Union appeared to drive a global rise in risk aversion. A drop in oil prices below $50 per barrel at the end of the week also seemed to weigh on sentiment.

The benchmark 10-year U.S. Treasury note yield fell last week. This decline seemed to be driven more by sinking global yields than by economic data. High yield bonds produced a strong gain last week amid positive flows, a healthy risk appetite, and steady interest in new deals. Energy credits were bolstered by the recent oil price rally (before Friday), and spreads across most below investment-grade sectors narrowed. The ECB started buying corporate bonds last week, pushing some European yields into record negative territory.

Charts of the Week

Good Reads

The following recent articles are well worth your time.

Explaining Investing in Ways That Make Sense (Morgan Housel)
11 signs that you own the right investment portfolio (Jonathan Clements)
Alpha Wounds: Lack of Independent Judgment (Jason Voss)
The Upside of Academic Finance (Ben Carlson)
Rob Arnott: Capital Markets Expectations (Rob Arnott via The Big Picture)
What you're not hearing about George Soros today (Josh Brown)
Mount Investmore (Phil Huber)

Book of the Week

So called "experts" make erroneous forecasts all the time --such forecasts are ubiquitous in our world and especially in the media. Yet the vast majority of these pundits are wrong much more often than they are right. In this insightful book, Philip Tetlock explores what constitutes good judgment in the prediction of future events and looks at why experts are so often wrong in their projections. He notes a perversely inverse relationship between the best scientific indicators of good judgment and the qualities that the media most prizes in pundits -- most prominently the single-minded determination required to prevail in ideological combat. He also provides a good model for evaluation expert opinion. Everyone should read Philip Tetlock's excellent Expert Political Judgment

Fact of the Week

The price appreciation of the S&P 500 has been roughly 65 percent over the past ten years (that performance measure doesn't include dividends, of course). Only one industry sector of the index is down over that period. It's not Energy; that group is actually up 23 percent on a price basis. Nor is it Materials, up 48 percent. Those levels underperform the index but they're still in positive territory. The right answer is Financials. Over the last ten years S&P 500 Financials are down 29 percent. Not too that that sector includes REITs, which are up 28 percent on a price basis (and more with dividends) over the last decade. Since REITs are more than 10 percent of the Financials group over the period, traditional banks/brokers/insurance/card companies are down more like 33 percent over the last ten years. That oddity will no longer be possible come September as REITs will be separated from the Financials and will become the S&P 500's 11th sector. 

Quote of the Week

"A moderate addiction to money may not always be hurtful but when taken in excess it is nearly always bad for the health."

-Clarence Day

Securities and advisory services are offered through Madison Avenue Securities, LLC, a member of FINRA and SIPC, a registered investment advisor.

This report provides general information only and is based upon current public information we consider reliable. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment or any options, futures or derivatives related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Diversification does not guaranty against loss in declining markets.