Simple Tests Of When To Add To Or Pull Back From Your ETFs

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 |  Includes: AGG, BND, HYG, SPY
by: Tom Madell

Maintaining a high exposure to the stock market has been a winning strategy since March 2009 when the market reached its low following the financial crisis. As a result, investors who opted for a high allocation to stock ETFs and stock mutual funds have made out well. But how much longer is it wise for the average investor to assume allocations at high levels will continue to pay off?

Of course, a parallel question relates to the bond market. In this regard, a high allocation to bonds, when considered on a 5 year or even longer-term basis, has proven to be a lower risk, and in some cases, a better performing strategy than investing in many varieties of stock ETFs/funds. But is it now too late to expect further gains, and should bond ETF/fund investors instead seriously consider reducing their exposure?

This article will attempt to answer these questions, always bearing in mind that people (even experts) who try to divine these answers are often on the wrong track to begin with. Why? Because how the markets will perform, especially based on short-term considerations, are typically irrelevant for long-term investors and often take your eye off the bigger question: Will you be better off in a year or two (or even more so in 5 or more years) if you simply stick with a strategy of keeping most of your money invested in a diversified portfolio, typically consisting of mainly stocks, a modicum of bonds, and very little cash, than when you are prone to make wholesale moves altering this formula too much.

Stocks

During the last 50+ months post the March 9, 2009 low, stocks have gained about the same amount as during the huge tech bubble that ran from early 1996 to March 2000, that is, in excess of 25% annualized. Of course, that streak ended badly when the bubble subsequently popped. While the same may not happen this time, since the current market doesn't appear to be overvalued as the prior period proved to be, the outsized gains should be viewed in historical perspective to see just how far we have come.

Subsequent to its closing low, the return including dividends on the S&P 500 index over the period as of this writing has been a staggering 165%. It turns out that such a gain without the onset of a 20% drop signifying a bear market is among the biggest since 1929, surpassed only by the long-term performance of the late '87 to 2000 market, as well as two periods in the 40s and 50s, and the 5 years that preceded the '87 crash.

Each calendar quarter, my Newsletter issues a new set of allocations to stocks, bonds, and cash along with a Model Portfolio of recommended funds and ETFs. Ever since April 2009, my recommendations have been to continuously raise the allocation made to stocks or at least hold them steady.

While new allocations will not appear until next month, the question that should currently be on many investors minds is this: Given the huge gains described above, is it now the time to suggest that investors should seriously consider cutting back stock allocations that I have continued to recommend at these high levels?

My research suggests, in agreement with quite a few other sources, that most categories of stock funds are not currently near being overvalued, at least not yet. Further, the strong momentum apparently caused by investors now adding to their stock positions tends to create a virtuous cycle. But at a certain point, stocks will start to become overvalued and it may be crucial for investors to recognize when this overvaluation stage is reached.

According to my empirical data, that point might arrive some time this fall, whether stocks continue rising at their current pace or even if they remain near their late-May levels until then. While I will not make a specific prediction that stocks are likely to fall at that time, since stocks can stay overvalued for an indefinite amount of time, I will continue to monitor the situation and alert my subscribers if and when any thresholds are reached resulting in SELL signals.

My SELL signals, just like my prior BUY signals (which have been plentiful stretching back to Feb. 2009), are geared for long-term investors. They can't pinpoint exactly when a impending drop will occur, but indicate an expectation, based on my proprietary long-term research, that stocks are unlikely to do particularly well in the forthcoming years ahead. In the meantime, I continue to feel that remaining constant with a stock portfolio allocated similarly to my most recent suggestions made in April is the best course of action.

Bonds

The Barclays U.S. Aggregate Bond Index, consisting of a broad mix of bonds, and which serves as the benchmark for many fund companies bond index ETFs or funds such as the iShares Core Total U.S. Bond Market (NYSEARCA:AGG) and the Vanguard Total Bond Market ETF (NYSEARCA:BND), has had only two years in which the annual total returns were negative going back to 1976. Over that period, the index has had an average annual return of over 7.5%. No wonder investors have come to assume that investing in many types of bond ETFs/funds are close to a guarantee of success.

But during this year's first quarter, the Index actually declined by a small amount. And over the last 12 months, the 2.2% total return has been much lower than the 7.5% historical average. While this return is still better than returns for those who remained in money markets or CDs, the question looking ahead is whether returns might wind up negative over the course of the full year, or even over longer periods. This would most likely occur if and when interest rates begin rising, either because investors start switching out of their bonds in hopes of joining the stock surge, or the Fed starts sending clearer indications it is actually about to halt bond purchases (or is closer to the point of actually beginning to raise interest rates).

A Simple Test of Your Bond ETF's/Fund's Prospects

Down through the years, I have come to put a lot of faith in a simple test of whether bonds look like a good investment ahead. Here it is: Look at how your bond ETF/fund has performed over the last one year on a website such as morningstar.com. Then look at how it did over the last 3 and 5 years to see if there is a trend over these three figures in one direction or another. A 2 to 4% (or bigger) negative change in the most recent year can be regarded as likely important and suggests the fund may be running out of gas and that you may want to lighten up on it or exit it altogether.

For example, the Vanguard Total Bond Market ETF 1, 3, and 5 year past performance results currently show the following total return numbers: 2.1, 4.5, and 5.3%. The trend is clearly for smaller and smaller returns, with the 1 year return substantially below that of the 5 year return, which incidentally incorporates the 1 year return within its calculation. This indicates that over a now fairly well-established period of time, investors are getting less and less. In such cases, the odds would appear to favor a continuation of these low returns and also suggest that returns could even be less than 2.1% over the next 12 months if the downward trend continues. Of course, if some now unseen event happens that causes interest rates to drop precipitously such as a major U.S. or even world calamity, or we enter what appears to be a serious period of deflation, investors might rush back to the safety of bonds, perhaps causing returns to rise more than expected.

Contrast these results with the same data for the largest high yield ETF by assets, iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG), namely 14.3, 11.8, and 8.0%. Not only are the absolute levels higher than for BND, but the current 1 year performance is doing better than its own longer-term results. The fact that the fund is showing an improving trend suggests that the investment is enjoying a relative "sweet spot." The odds would seem to favor a continuation of good performance under such conditions. Of course, at some point, this fund may appear to be on the verge of being overvalued, but I would guess not just yet in light of the fact that its 5 year performance is not even as great as is the case of long-term treasury bonds, in spite of HYG being a considerably riskier type of investment than treasuries.

This Simple Test Can Also Be Used With Stock ETFs/Funds

Applying the above method may also be useful to judge a stock ETF's/fund's prospects. For example, to estimate the prospects for the SPDR S&P 500 ETF (NYSEARCA:SPY) which mirrors the S&P 500 index, look at the current 1, 3, and 5 year returns. These are 27.5, 17.8, and 6.0% respectively.

In spite of the big recent run-up, the numbers would appear to reflect a favorable trend that could continue, assuming that the 5 year figure still suggests that the index is not overheated when considered on a longer-term basis. In using this test with stock ETFs/funds, an approximate positive 15% (or more) discrepancy between the 1 and 5 year return, as seen here, can be used to argue for highly favorable prospects, while an equal sized (or more) negative discrepancy argues for highly unfavorable prospects. If, however, at some point any ETF's/fund's long-term performance equals or exceeds an annualized 15% or more a year over a 5 year period, it has highly likely become overvalued; chances are that within the next 12 months, it will begin to fall off its perch.

This is exactly what happened by the start of October, 2007; overvaluation of almost all categories of stock ETFs/funds was followed by one of the worst bear markets since the Great Depression. But, to recap, we are not yet in such an over-extended position at present. However, alert investors should keep an eye out for this 15% per year for 5 years demarcation line which my research shows is when the market, a fund category, or any particular ETF/fund showing those performance numbers, enters a truly dangerous stage.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: While I don't own the ETFs mentioned in this article, I am long in funds that are quite similar such as S&P 500 index and bond index mutual funds.