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Joseph L Shaefer
Joseph L Shaefer
Articles (105)  | Author's Website |

What A Wonderful Market (And Where This Leads Us)

  • I don't "know" what the market will do this week or this month and neither does anyone else.
  • I'd like to see a continued rise, but history and experience say there will soon be an Uh-Oh Moment.
  • Here's how we're investing for uncertainty: keeping dividend and income holdings as a cushion and buying from among this very small universe of ETFs.

Market results for the month of June has me regretting our decision to seek preservation ahead of The Crowd. (Now that we have the certainty of hindsight, that is!) Of course, if we hew to our discipline, but remain flexible, we'll always make more than the investor that just whines, "But the market did better than I did this month!"

I still do not see the public bidding up prices for another 3 months, 6 months, or 10 years as one wag hungry for air time recently predicted. For our Stanford Wealth clients, I have redeployed, with trailing stops in mind, some available cash into higher-yielding issues, sectors that will benefit as inflation is shown to be more virulent than reported, and those Big Sectors essential to the driving of the economy: industrials, materials, health care, energy, etc.

I try never to wear rose-colored glasses when looking at a market deeply in need of a correction. But by the same token I cannot ignore its momentum, particularly exemplified by its recent action. It may be illogical, it may be dangerous, and it may lead to heartache tomorrow, next week or next month, but woe be unto thee if you are correct about what the market should do and wrong about what it actually does. With corporate insiders selling their stock at an historically high rate while using their shareholders' money to effectively buy all the shares they are selling, thus reducing float and increasing their earnings per share (but not real earnings from revenues,) less knowledgeable investors are piling in.

This sort of thing always ends badly but anyone who notes it at the time is branded a Cassandra. Better to just quietly protect one's portfolio and wait for the inevitable. Companies ultimately advance based upon their ability to generate increasing revenues and increasing earnings. But they swing wildly around that trendline based upon the occasionally rational, more often irrational, behavior of buyers who just can't bear to miss anything. If the market is up, you want to be up with it, right? And when it goes down, you don't want to lose a penny, right? This in itself is completely irrational - if the level of risk is remote, so are the rewards. That's the basis of a self-correcting mechanism like the market.

If you feel whipsawed and confused, rejoice - you're not alone. What's best is sometimes to under-perform, knowing the risks far outweigh the rewards.

Where This Leads Us

We certainly haven't stopped investing, as our results show. But at this point, we are buying fewer individual companies in favor of only the most liquid of ETFs, those trading in the hundreds of thousands or millions of shares per day. That way, we still have the representation we want to at least match theS&P 500 if it continues its current advance. But if it declines, we have the satisfaction of knowing that when we pull the trigger to exit the positions, they will have no more than a penny spread or so between the bid and ask.

Either way this cat jumps, we will have greater liquidity. And rather than just buy the S&P 500 via the SPDR S&P 500 ETF (ARCA:SPY) or the Dow Industrials via the SPDR Dow Jones Industrial Average ETF (ARCA:DIA), we have selected those sectors that we believe offer still more gains than the market itself.

The universe we derive from this analysis is a small one - it includes 10 ETFS: VWO, EWC, EWA, EPP, VEU, IYE, XLI, XLB, XLF and XLV - the first five being non-U.S. and the next five U.S.

VWO is the Vanguard FTSE Emerging Markets ETF (ARCA:VWO). Its average daily trading volume is 16 million shares. It is comprised mostly of large cap names (about 86% of the portfolio,) with value stocks about 23%, growth 36% and a blend of the two 40%. Some 52% of its holdings are in Asia, 20% are in Latin America and 14% are in Europe, with the rest elsewhere. There are more Chinese companies than any other nation, at 19%. Their biggest sector exposure is in the financials, at 27%, followed by energy and technology, at 13% each. Emerging markets had a terrible year in 2013, tumbling across the board. I think they have some ground to make up.

EWC is the iShares MSCI Canada ETF (NYSE:EWC). It only trades a million or so shares a day but it gives, in my opinion, the best representation of Canadian stocks of any ETF. With about 95% large caps and just 5% mid-caps, these are the behemoths of Canada. About 20% are considered growth stocks, the other 80% a blend. As with many ETFs, their largest holdings are the financials. You may recall that Canada's tighter regulatory regime allowed their banks to shine during our recession, but they are also big in insurance and consumer finance.

What is unique about Canada is that following the banks, with 35% of the portfolio, energy comes next, at 28% and, combined with basic ma-
terials at 12%, is actually larger than the financial exposure. I believe in the future for Canada, a nation with less than 1/10th the population of the US, but with at least as many natural resources.

The iShares MSCI Australia ETF (ARCA:EWA), is a sister fund to EWC. My most egregious mistake of the past 20 years was to get involved with rare earth companies in Australia and elsewhere just as China lowered the boom by creating a glut of rare earths to drive the price down and non-Chinese competitors out of business. This painful memory aside, there is simply too much to recommend EWA not to include it here.

Pretty much all large cap (84%) and mid cap, value and growth both vie for portfolio dominance at 40% each with blended securities compris-
ing the rest. Banking (36%) dominates the financial sector and that sector is 44% of the portfolio, with metals, mining, energy and construction coming in next. Australia is an export economy, so it thrives on what it produces for sale elsewhere. With massive consumers like China, Japan and India nearby, I think their future is a secure one.

EPP is the iShares MSCI Pacific ex-Japan ETF (ARCA:EPP), but that name is something of a misnomer. Since 63% of its portfolio is in Australian companies, I think of it as "Australia +." Another 20% is in Hong Kong and 11% in Singapore, with others representing only small contributions. Having spent time in Oz, Hong Kong and Singapore, I remain a fan of all three. Primarily large cap, with an equal distribution of growth and value, EPP "only" trades about 700,000 shares a day, quite enough for the liquidity we are looking for in unsettled times.

The last of our non-US ETFs is Vanguard's FTSE All-World ex-U.S. ETF (NYSE:VEU) offering. It covers the waterfront of international investing, but with a strong bias toward developed, rather than emerging, markets. Trading about a million shares a day, 50% of its portfolio is in companies based in Europe, 25% in Asia-Pacific and 12% more in Asia proper. More than 30 countries are represented and, as with most big ETFs, 87% of its holdings are large cap firms. Financials dominate at 23%, with industrials at 11% and consumer cyclicals and non-cyclicals at 11% each. Its big companies are household names: Nestle (OTC:NSRGF), Novartis (NYSE:NVS), Roche (OTC:RHHVF), HSBC (NYSE:HSBC), Toyota (NYSE:TM), BP (NYSE:BP), Royal Dutch Shell A (NYSE:RDSa) and so on. If you want big strong foreign exposure, VEU is for you.

On to the USA: the iShares US Energy ETF (NYSE:IYE), is remarkably similar in holdings to the SPDR Energy Select Sector Fund (ARCA:XLE), though it has lower volume (about 850,000 shares per day) and sells for about half the price. Market cap weighted, it has 84% of its holdings in the biggest of the big, but is well-diversified across the spectrum of energy industries. 38% is in the big integrated oil & gas firms, 28% in those dedicated to exploration and production, 18% in equipment and services, and single-digit amounts in pipelines and distribution, refining and marketing, and drilling. We have never lost money betting against the prevailing notion that the world is running out of fossil fuels. We don't plan to start now.

XLI is the Industrial Select Sector SPDR ETF (ARCA:XLI). It's here you find the companies that keep America building and moving. 84% large cap, with a slight bias toward growth rather than value, these are the companies that make up our aerospace, defense, diversified industries, railroad, trucking, machinery, engineering, air freight, logistics, airlines, and electrical equipment might. Some of the largest names in the portfolio are General Electric (NYSE:GE), United Technologies (NYSE:UTX), Union Pacific (NYSE:UNP), 3M (NYSE:MMM), Boeing (NYSE:BA), Honeywell (NYSE:HON) and United Parcel Service (NYSE:UPS).

XLB is the Materials Select Sector SPDR ETF (ARCA:XLB). Also growth-oriented and really big cap, this sector is dominated by the chemicals industry, with 31% in commodity chemicals, 28% in diversified chemicals, and 16% in agricultural chemicals. Packaging, metals and mining, steel, forestry, et al make up only a small portion of the portfolio. Given how much money I have made in timber and metals firms, I tended to think of these as dominators in the materials business. Not so! They are powerhouses in their industry, but not in the bigger sector, where top holdings include Monsanto (NYSE:MON), Dow Chemical (NYSE:DOW), and DuPont (NYSE:DD).

XLF is the Financial Select Sector SPDR ETF (ARCA:XLF). This may seem an odd choice for us. We've always enjoyed our best returns from smaller regional banks, brokerages, REITs, and insurers. Yet this one is dominated by big banks like Wells Fargo (NYSE:WFC), Berkshire Hathaway B (NYSE:BRKb) (an insurer, primarily, but one that operates like a banker,) JP Morgan Chase (NYSE:JPM), Citigroup (NYSE:C) and Bank of America (NYSE:BAC). Yet it is diversified enough to cover them all. Banks are just 38% of the portfolio, with insurers next at 18%, then REITs at 18%, and investment firms and financial services companies coming in at 9% each.

XLV is the Health Care Select Sector SPDR ETF (ARCA:XLV). It has as its biggest holdings Big Pharma. With a growth and large cap bias, pharmaceutical firms are 49% of this ETF's portfolio. With biotech gaining mainstream ascendancy, biotech companies are 19% of the portfolio. Health care services are next, at 16%, tied with medical equipment makers, bringing the total to 100%. The biggest names here include Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE), Merck (NYSE:MRK), Gilead Sciences (NASDAQ:GILD), Amgen (NASDAQ:AMGN), AbbVie (NYSE:ABBV) and UnitedHealth (NYSE:UNH). I'm not terribly excited about the pipeline for Merck and Pfizer but I believe they will bump along as cash cows and may well do better by acquisitions. But I am excited to see that biotech firms number 4 of the top 10 holdings. Average trading volume for all four of the final selections above range from 1 million to 12 million per day.

Income With a Growth Kicker

While we are fine-tuning client portfolios and our model portfolios this week, we are not eschewing strong dividend and interest paying investments. One of our old favorite timber firms, Weyerhaeuser (NYSE:WY) doesn't fit into our strategic approach now, though the upcoming spinoff of their aptly-named WRECO home-building subsidiary, might provide a nice catalyst for growth. Rather than bet on that possibility alone, however, we will invest in WY slightly differently.

They have an outstanding convertible preferred share, WY-A, currently yielding 5.7% with a mandatory conversion on July 1, 2016. It sells for 57 and can only be converted at its liquidation price, so why buy it rather than the common? After all, WY is currently just 33 and the conversion is 1.5015 shares, giving a price of just $49.55.

We are buying it, however, because we believe WY common will do really well sometime in the next two years as the global economy recovers and lumber prices firm. The amount we will receive for our convertible preferreds varies depending upon the price of the common up to and including the liquidation date, but if we assume conservatively that the stock will reach $43 sometime in the next couple years, we would convert at ~ $65 and have been paid to hold it. Our total return would be better than the common stock - and less nerve-wracking.

About the author:

Joseph L Shaefer
Former special ops/Intel Community. Thirty-six years active and reserve service. Retired Schwab senior exec. Geopolitical analyst, speaker and registered investment adviser.

Visit Joseph L Shaefer's Website

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