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By Minyi Chen, CFA

Since Federal Reserve Chairman Ben Bernanke suggested on May 22, 2013, that the Federal Reserve (the Fed) could begin tapering its bond purchases, the stock market has stumbled, and bond yields have spiked. According to JPMorgan and Deutsche Bank estimates, the central banks of G7 nations have pumped $10 trillion of liquidity into the financial system since 2008. Years of cheap money have made global investors addicted to it. While most investors agree that quantitative easing (QE) must stop in some point, opinions are divided on whether a smooth exit is possible.

While the Fed has not changed what it is doing since May, the taper talk has sent various global markets into a tailspin. If the reaction in the past few weeks is an indication of what lies ahead as QE diminishes, many popular investment strategies will lose their allure.

For instance, investors may no longer achieve downside risk mitigation from low volatility strategies. Large redemptions from low volatility stock funds in the past two months boosted the volatility of these funds significantly. The graph below shows how the 30-day volatility of the S&P 500 Low Volatility Index and the MSCI USA Minimum Volatility Index have converged with that of the S&P 500 Index.

sp50030dayvolatility

Source: Bloomberg, as of June 30, 2013.

We believe market conditions are becoming increasingly favorable toward companies that reduce their equity float through organic growth. S&P 500 companies spent $99.97 billion on stock buybacks in Q1 2013, up 18.59% from Q1 2012. By contrast, spending on dividends was $70.86 billion in Q1 2013, up only 10.59% from Q1 2012. In fact, quarterly payouts from buybacks have been an average of 51.5% higher than the quarterly payouts from dividends since 2010. Companies’ commitment to repurchase their own stocks under buyback programs is vital to this bull market as other traditional sources of demand for stocks remain subdued. For example, domestic equity mutual funds received inflows in only two of the past 26 months.

sp500buybackdividendratio

Source: S&P Dow Jones Indices as of March 31, 2013.

Swings in interest rates should have a far smaller impact on the strategy’s performance than that of high dividend stocks or bonds. In addition to screening for float shrink, we also screen for leverage, so we avoid investing in companies that lever up aggressively. We expect such fundamental screens to widen the strategies performance lead if volatility and inflation expectations increase.

Disclaimer: This post is a publication of TrimTabs Asset Management. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Information presented does not involve the rendering of personalized investment advice. Content should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. The Russell 3000 TR USD is not the only index that can be used as a benchmark for measuring the performance of a portfolio. Depending upon the holdings in your portfolio, your investment objectives, and your risk temperament, it may be more appropriate to measure performance against a different benchmark. There are no assurances that an investment or strategy will match or outperform any particular benchmark. All TrimTabs Float Shrink ETF returns are presented net-of-fees and include reinvestment of dividends and capital gains. Performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing performance returns. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Past performance may not be indicative of future results. Therefore, no investor should assume that the future performance of any specific investment or investment strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals, and economic conditions, may materially alter the performance of an investor’s portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for an investor’s portfolio.

Source: Fed Commentary - July 2013