T.Rowe Says Invest With Caution in 2014

Invest with caution was the theme of T. Rowe Price’s annual Investment and Economic Outlook briefing in New York today.

With equity valuations at, or above, long-term averages, the mutual fund giant’s experts stressed that investors need to be careful. At 57 months, the bull market has officially hit middle age. And you can be sure the next five years aren’t going to look like the previous five, during which the S&P 500 Index rocketed 164%.

“Risk/reward is more balanced, and we should be risk aware,” said Bill Stromberg, the Baltimore firm’s head of equity. “Investors are finally rotating back to equities and may be too late.”

Stromberg said signs of speculative excess are appearing with margin debt on the New York Stock Exchange passing $400 billion, more than the peaks in 2000 and 2007. Still, U.S. stocks could move higher it they “truly regain favor with investors. Favor large-caps.”

Since the market never posted a decline of 5% this year, Stromberg said, “don’t be surprised by non-recessionary corrections.” However, be ready to buy stocks if the market falls between 10% and 20%.

While consumers and corporations have delevered their debt, reducing their financial risk, governments around the world have taken on more debt to provide stimulus. Central banks can’t continue this pace of borrowing and T.Rowe says the Federal Reserve Bank will begin tapering its quantitative easing strategy of bond purchases in the next six months. Even so, interest rates should stay low throughout 2014.

John Linehan, T. Rowe’s Head of U.S. Equity, said over the past three years the firm has been positive on U.S. stocks because of attractive valuations and strengthening corporate fundaments. But headwinds are coming in the form of more neutral valuations, tepid topline growth, historically high profit margins and expanding price-to-earnings (P/E) ratios.

Since the S&P 500’s most recent trough in October 2011, the index has soared 60%. During that time, P/E multiples on the benchmark climbed 41%, while earnings per shares grew only 13%. Linehan said multiple expansions like this tend to happen late in a stock market’s cycle.

He said stock prices are “not stretched,” and “still look attractive relative to bonds,” but they are “not attractive relative to history.”

“As a result, our green light is turning yellow,” said Linehan.

However, companies still have a lot of cash on their books. If companies use the cash for capital spending, mergers, acquisitions, dividends or share repurchases this could be a tailwind for the economy and the stock market.

Other attractive themes for the market going forward include the renaissance in U.S. manufacturing, the North American energy boom, and the improving U.S. economy.

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Does Hedge Fund Replication Work?

Just days after the stock market hit its March 2009 bottom, IndexIQ, a tiny index provider, launched its first exchange-traded fund, the IQ Hedge Multi-Strategy Tracker ETF (QAI). As far as attracting investors, the timing proved inauspicious. Most investors were shellshocked after witnessing the stock market plummet more than 50 percent in 18 months. However, inside the ETF industry, the fund’s hedge fund replication strategy drew much interest. In April, the ETF won Most Innovative ETF and its eponymous index won Most Innovative Index at the 9th Annual Closed-End Funds & Global ETFs Forum, the first time a single firm won awards in both categories.

It’s no wonder. Hedge funds are sexy. These aggressively managed portfolios use sophisticated strategies to generate market-beating returns, otherwise known as alpha. Also, they’re very exclusive. Called “mutual funds for the super rich” by Investopedia, hedge fund investors need to be accredited. This means investors must not only be knowledgeable, but they must have a net worth greater than $1 million and make a certain amount of money. Unlike mutual funds, hedge funds aren’t regulated, so they have the flexibility to invest in many kinds of assets.

Hedge fund ETFs like QAI were supposed to solve all that. Democratize the space. Lower costs. Increase transparency.

It was “hedge funds for the rest of us.”

But do they deliver?

Now that the IQ Hedge Multi-Strategy Tracker and its brother, the IQ Hedge Macro Tracker ETF (MCRO), have passed their first birthdays, it’s possible to perform data comparisons to see if they actually deliver. Do these funds provide the pattern of returns that investors want when accessing the hedge fund space?

The first thing one needs to know is that, contrary to conventional wisdom, hedge fund ETFs aren’t charged with maximizing return on investment. They follow the strategy of the original hedge funds, reducing risk and minimizing losses by shorting and holding a combination of asset classes not correlated to the broad market. Of course, reducing risk means dampening potential profits, which means when the S&P 500 Index goes straight up on a bull rally, hedge fund ETFs will lag the market’s returns.

And that’s exactly what happened for the 12 months ending June 30: When the S&P 500 leapt 14.4 percent, the IQ Hedge Multi-Strategy Tracker inched up 2.2 percent and the IQ Hedge Macro Tracker gained 3.9 percent.

“Nothing is designed to shoot the lights out,” said Adam Patti, chief executive officer at IndexIQ. “I look at stress periods in the market as where hedge funds should be doing well.”

The hedge worked during the second quarter of 2010 when the S&P 500 tumbled 11.4 percent into a market correction. QAI slid 2.6 percent and MCRO lost just 2.1 percent. The ETFs also reduced volatility for the six months ended June 30. The S&P fell 6.7 percent during that period, while the QAI and MCRO posted negative returns of 2.5 percent and 2.3 percent, respectively.

“They are trying to produce a return pattern of the average hedge fund,” said Kevin Malone, president of Greenrock Research, a Chicago research firm. “The reason to consider this is to get a return pattern different from stocks and bonds; better than bonds but not as good as stocks.”

Originally published in ETF Report. For the full story click here.

Call It a Hunch, We’re In For a Tumble

I don’t have any complicated quantitative models at my disposal. I read, I think, and then I have a hunch. Then I have lunch.

I think the market rose too far, too fast and that we are going to test the March 9 low. The economy is not growing as fast as many had expected.

This morning the Federal Reserve Bank of New York released its’ Empire State Manufacturing Survey. This index of general business conditions fell to -9.41 in June, down from -4.55 in May. Economists expected a slight dip to -4.6 in this measure of regional manufacturing conditions.

It’s midday Monday. After a 40% rally since the March lows, the S&P 500 is down 2.5% today. The Dow, which was just 5 points from breaking even for the year, is down 200 points, or 2.3%. The Nasdaq is down 2.7%.

The Wall Street Journal asks is this a bull or bear market? Signs Suggest Stocks’ Surge Is Blip Within a Bear; Still, There’s Opportunity.

This would seem to prove my theory from last week, when I decided that all the outflows from the large-cap U.S. stocks was a sign that the market had topped. I think we’re going to go back to near 7,000 on the Dow. Good time to take profits and wait for the sale to begin again.

Funds Hold GM to the Bitter End

What does a company need to do to get kicked off of an index around here?

As of Friday, General Motors was still in the S&P 500 and the Dow Jones Industrial Average. If the indexes hold the stock until the company declares bankruptcy are the index funds and ETFs that track indexes with GM as a component obligated to hold it to the bitter end? Are they are allowed to sell it ahead of time or do they have to suck up the loss, even though everyone saw this coming from a mile away?

According to AOL Money & Finance, all of GM’s shares are now owned by large block holders. Institutions hold 36%, mutual funds, which includes ETFs, hold 62% and the rest with others like the executives. State Street Global Advisors hold the most GM shares of any institution, 26.9 million, or 4.37% of all the GM shares outstanding. Surprisingly, only 5.26 million of those shares reside in the SPDR Trust (SPY). Still that’s a big loss for one fund no matter how you slice it. Vanguard Group has the second most shares, 23.99 million, or 3.93% of the shares outstanding. However, four of its funds are in the top 10 holders, the Vanguard 500 Index (VFINX) has the most shares of any fund, 5.8 million. This is followed by Vanguard Mid-Cap Index Fund (VO), Vanguard Total Stock Market Index Fund (VTI) and Vanguard Institutional Index Fund. Barclays Global Investors, owner still of the iShares ETF family, comes in third with 17.8 million shares.

The shocking part is that according to Standard & Poor’s, a component of the S&P 500 needs to have a market cap of at least $3 billion. With 610 million shares outstanding, GM would have to trade at $5 to make that. But GM last saw $5 on its shares on Dec. 8, 2008, more than five months ago. It’s not like S&P doesn’t remove stocks from the index. It’s deleted nine companies already this year.

Peter Cohan knows how to evaluate a company. He’s amazing at looking under the hood and breaking apart a company’s financial statements to see the rotting husk of a business. At Daily Finance, he says the failure of GM matters because it shows of success can lead to failure and how now the U.S. can’t even fail right. Companies can’t shut down without government intervention. He adds that the U.S. system of economic growth, venture-backed innovation, has been nearly snuffed out and that is not good news.

Cohan also list the five big reasons why GM didn’t have to fail and squarely lays the blame at the feat of managers who were overly impressed with themselves for no good reason. The five reasons: 1) bad financial policies, 2) Uncompetitive vehicles, 3) ignoring competition, 4) failure to innovate, 5) managing the bubble. Ignoring the competition and failure to innovate are the worst crimes and that should justify Rick Wagoner’s firing pretty easily.

Qubes Celebrate 10th Birthday

The Qubes, one of the most famous ETFs in the world, celebrated its 10-year anniversary yesterday.

The PowerShares QQQ (QQQQ), formerly known as the Nasdaq 100 Index Tracking Stock, hit the market March 10, 1999, in what remains the biggest most successful launch of a single U.S. ETF. Today, it is one of the most actively traded securities in the world.

“It is the most traded security in shares and dollar volume over the last ten years,” says John Jacobs, executive vice president of NASDAQ OMX Global Index Group and the man who created the fund.

While it currently trades on the NASDAQ Stock Market, originally it launched on the American Stock Exchange with the ticker symbol QQQ. This gave the ETF, then called a tracking stock, the nicknames of the “QQQ”, the “Triple Q” and the “Qubes.”

Launched at the height of the Internet stock market bubble, the Qubes fed the investing public’s desire for an easy to trade instrument that held the fastest growing stocks in the world. The NASDAQ 100 index holds the 100 largest non-financial stocks listed on the NASDAQ. That’s a lot of technology, biotechnology and retail.

It’s first day, it traded 2.6 million shares, 53 percent more than the record set two years earlier by the DIAmond Trust (DIA), the first ETF to track the Dow Jones Industrial Average. After just two hours, the NASDAQ 100 ETF, blew away the DIAmond’s first-day total volume of 1.7 shares. Within two weeks, it had traded 30 million shares. At the end of 2000, the Qubes held more than $6 billion in assets. A little more than two months later, on its first anniversary, the Qubes held more than $12 billion.

For a while, it surpassed the assets and daily volume of the first ETF, the Standard & Poor’s Depositary Receipts, or SPDR Trust, (SPY). Yesterday, it held $10.26 billion in assets.

“The Qubes stellar rise signaled to Wall Street that exchange-traded funds were not just a one-hit wonder. It showed potential sponsors there was a market for these products if the index was right.” (For more on the birth of the Qubes, the history of the ETF industry, and why the NYSE refused to let this ETF use the single “Q” ticker symbol, grab a copy of ETFs for the Long Run.) A little more than a year later, Barclays Global Investors launched its iShares family of ETFs. By the end of 2000, there would be 55 iShares.

Ironically, on the Qubes’ first anniversary, March 10, 2000, the NASDAQ Composite Index, which tracks every stock on the NASDAQ, hit its all-time high of 5048.62. The Qubes posted a 12-month return of 125%. The next trading session, the Internet bubble popped, sending the entire stock market into a two-year decline.

On the tenth anniversary, the Nasdaq soared 89.64 points, or 7.1%, to 1358.28, and the ETF jumped $1.59, or 6.2% to $27.33 on volume of 175 million shares. Did the excitement over the Qubes anniversary spark a huge rally in the market? Don’t laugh so quickly. Currently, the NASDAQ-100 Index is the basis for more than 900 products in 34 countries with about $490 billion dollars in notional value tied to it. To date, the index has traded more than 600 million futures contracts with a notional value of more than $25 trillion. Options experts SchaeffersResearch.com says the Qubes saw call buying activity early yesterday.

Of course, Citigroup (C), one of the country’s largest banks, did raise its head from its deathbed to say it was doing very well the first two months of the year, sparking a huge rally in the financial sector. The Dow Jones Industrial Averaged surged 5.8% to 6926 and the S&P 500 leapt 6.4% to 720.

Invesco PowerShares bought the NASDAQ’s ETF business in 2006. It changed the name of the ETF to the PowerShares QQQ in honor of what most people called the fund. However, the ticker has changed to QQQQ because it trades on the NASDAQ Stock Market, which uses four letters in its tickers. The NASDAQ says its market share of U.S. ETFs is more than any other U.S. exchange. In January 2009, volume grew 22% year-over-year to 655 million shares.

The NASDAQ OMX Global Index Group, a unit of the NASDAQ’s parent company, the NASDAQ OMX Group, remains a global leader in creating and licensing strategy indexes. Its most recent being the Government Relief Index and the European Government Relief Index, which include companies currently being bailed out by their governments.