A Reborn Secular Market And A Dozen ETF Investment Templates

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Includes: BND, BNDX, BWX, SCHB, SCHC, SCHF, SCHP, SCHZ, TIP, VTI, VXF, VXUS
by: O. Young Kwon

Summary

The three pillars of my Top-Down Approach are explained.

The selection among 12 templates are advised.

A secular bull market began in 2017.

Knut Wicksell's natural interest is reviewed.

A new Fed's policy direction is introduced.

The three pillars of my Top-Down Approach are: (1) The Treasury Yield Curve ("TYC"), (2) The 10-Year TYC Litmus ("L") Test, and (3) The Permanent Free ETF Allocation.

Pillar A: The Treasury Yield Curve

Checking the normality of the TYC is the prerequisite for Pillar B (The L Test). As shown in Treasury yield curve (The WSJ, Feb. 21, 2017, p.B7), The TYC on Feb. 17 is smoothly sloping upward to the right. In comparison with the TYC on Feb. 17, 2016, not only this year TYC is shifted upward, but also the differences between two TYCs become bigger from the shorter end to the longer end. Therefore, this year TYC is more optimistic than last year TYC.

Table 1: The Annual TYC From 1997 TO 2017

Year

1 m

3 m

6 m

1 yr

2 yr

3 yr

5 yr

7 yr

10 yr

20 yr

30 yr

BLM

YCS

1997

N/A

5.22

5.41

5.65

6.01

6.13

6.25

6.35

6.38

6.71

6.63

0.36

N/A

1998

N/A

4.79

4.99

5.14

5.52

5.59

5.65

5.89

5.74

6.24

5.91

0.22

N/A

1999

N?A

4.78

4.95

5.09

5.44

5.50

5.55

5.79

5.65

6.20

5.88

0.21

N/A

2000

N/A

6.00

6.17

6.11

6.26

6.22

6.16

6.20

6.03

6.23

5.94

-0.23

N/A

2001

2.42

3.48

3.45

3.49

3.83

4.09

4.56

4.88

5.02

5.63

5.49

1.19

N/A

2002

1.63

1.63

1.72

2.00

2.64

3.10

3.81

4.30

4.61

5.43

N/V

1.98

N/A

2003

1.02

1.03

1.08

1.24

1.65

2.10

2.97

3.52

4.01

4.96

N/A

2.36

N/A

2004

1.27

1.40

1.62

1.90

2.39

2.79

3.44

3.88

4.29

5.06

N/A

1.90

N/A

2005

3.00

3.22

3.50

3.62

3.85

3.93

4.05

4.15

4.29

4.64

N?A

0.43

N/A

2006

4.75

4.85

5.00

4.94

4.82

4.77

4.75

4.76

4.80

5.00

4.90

-0.02

0.15

2007

4.41

4.48

4.62

4.53

4.36

4.35

4.43

4.51

4.63

4.91

4.84

0.27

0.43

2008

1.29

1.40

1.66

1.83

2.01

2.24

2.80

3.17

3.66

4.36

4.28

1.65

2.98

2009

0.10

0.15

0.28

0.47

0.96

1.43

2.20

2.82

3.26

4.11

4.08

2.31

3.98

2010

0.11

0.14

0.20

0.32

0.70

1.10

1.92

2.61

3.20

4.01

4.23

2.50

4.12

2011

0.04

0.05

0.10

0.18

0.45

0.75

1.52

2.16

2.78

3.62

3.91

2.33

3.87

2012

0.07

0.09

0.13

0.17

0.28

0.38

0.76

1.22

1.80

2.54

2.92

1.53

2.85

2013

0.05

0.06

0.09

0.13

0.31

0.54

1.17

1.74

2.35

3.12

3.45

2.04

3.40

2014

0.03

0.03

0.06

0.12

0.46

0.90

1.64

2.14

2.54

3.07

3.34

2.08

3.31

2015

0.04

0.05

0.17

0.32

0.69

1.02

1.53

1.89

2.14

2.55

2.84

1.45

2.80

2016

0.25

0.32

0.46

0.61

0.83

1.00

1.33

1.63

1.84

2.22

2.59

1.00

2.34

2017

0.50

0.53

0.66

0.82

1.21

1.48

1.92

2.23

2.42

2.78

3.03

1.21

2.53

AVE

1.28

2.16

2.28

2.39

2.67

2.90

3.32

3.68

3.95

4.53

4.45

1.28

3.17

Note:

1. The 2017 average is from 1/2/2017 to 2/17/2017.

(Source: Treasury Department)

Table 1 proves the upbeat optimism because the steepness ("BLM") of the 2017 average (2.53) is higher than that of 2016 (2.34). The loan margin of banks ("YCS") of 2017 (1.21) is also higher than that of 2016 (1.00).

The TYC has been a reliable leading indicator for a recession. The TYCs in 2006 and 2007 were flat and inverted in some sections to indicate the coming Great Recession in 2008. For the 2000 recession, the TYC in the earlier years (1997 to 1999), however, were not flat or inverted. That's why Greenspan mentioned it was a puzzle. We anticipate a recession in several years in the down road. The TYC would warn a recession in the coming years, so we have to watch the TYC carefully.

Pillar B: The L Test

Given assurance of the normality of the TYC, the 10-year Treasury yield ("10-Y TY") is used for the L Test. Table 2 shows a long-run downtrend of the 10-Y TY started as 6.38 in 1997, five reverses (in 2000, 2004, 2006, 2013, and 2015), and finally ended as 1.84 in 2016. This downtrend reflects the low growth and rate era since 2007. This year (up to 2/17/2017), the two-year downtrend was reversed again thanks mainly to Trump election.

Table 2: The 10-Year Treasury Note Yields (1997 - Present)

Year

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Yield

6.38

5.74

5.65

6.03

5.02

4.61

4.01

4.29

4.29

4.80

Year

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Yield

4.63

3.66

3.36

3.20

2.78

1.80

2.35

2.54

2.14

1.84

Year

2017

Yield

2.42

Note:

1. The Yields (1997 - 2016) are the annual averages.

2. The yield in 2017 is the average (1/3/2017 - 2/17/2017).

(Source: Treasury Department)

The 10-Y TY has been moving around a 2.5% since mid-December last year. The 10-year breakeven inflation rate (which is the spread between Treasury notes and Treasury inflation-protected securities) is about 2% now. "In the long run when all adjustments have occurred, an increase in inflation is reflected fully in nominal interest rate." (The Fisher Equation in Macroeconomics, 4th Ed., Rudiger Dornbusch and Stanley Fischer, McGraw-Hill, p. 631) As a result, U.S. economic growth, inflation, and short-term interest rates are expected to be a 2.5%, a 2%, and a 2%, respectively, over the next decade.

Pillar C: Free-Commission ETF Allocation

Asset allocation is crucial to achieve your long-term investment goals. Investors have a variety of choices, including investment advisers, mutual funds, brokerages, and self-management. For self-directed investors, 12 portfolio templates are offered.

A Dozen ETF Portfolio Templates

For long-term investors, 12 investment templates with six TD ETFs and six CS ETFs are introduced. All ETFs are commission-free. (An exception is TD charges a 2.99% commission when any holding is sold less than one month.)

  • Six CS ETFs: Schwab U.S. Broad Market ETF (NYSEARCA:SCHB), Schwab Short-Term International Small-Cap ETF (NYSEARCA:SCHC), Schwab International Equities ETF (NYSEARCA:SCHF), Schwab U.S. Aggregate Bond ETF (NYSEARCA:SCHZ), Schwab U.S. TIPS ETF (NYSEARCA:SCHP), and SPDR Barclays Capital International Treasury Bond ETF (NYSEARCA:BWX)
  • Six TD ETFs: Vanguard Total Stock Market ETF (NYSEARCA:VTI), Vanguard Extended Market ETF (NYSEARCA:VXF), Vanguard All Except U.S. ETF (NASDAQ:VXUS), Vanguard Total Bond Market ETF (NYSEARCA:BND), iShares Barclays TIPS Bond ETF (NYSEARCA:TIP), and Vanguard Total International Bond ETF (NASDAQ:BNDX)

Six CS Portfolios:

  • (1) CS.A (50:50.2): SCHB (50%) SCHZ (50%)
  • (2) CS.B (50:50.4): SCHB (30%) SCHC (15%) SCHZ (40%) BWX (10%)
  • (3) CS.C (50:50.6): SCHB (30%) SCHC (15%) SCHF (5%) SCHZ (30%) SCHP (15%) BWX (5%)
  • (7) CS.D (60:40.2): SCHB (60%) SCHZ (40%)
  • (8) CS.E (60:40.4): SCHB (35%) SCHC (25%) SCHZ (35%) BWX (5%)
  • (9) CS.F (60:40.6): SCHB (35%) SCHC (20%) SCHF (5%) SCHZ (30%) SCHP (5%) BWX (5%)

Six TD Portfolios:

  • (4) TS.A (50:50.2) VTI (50%) BND (50%)
  • (5) TS.B (50:50.4) VTI (30%) VXF (15%) BND (40%) BNDX (10%)
  • (6) TS.C (50:50.6) VTI (30%) VXF (15%) VXUS (5%) BND (30%) TIP (15%) BNDX (5%)
  • (10) TS.D (60:40.2) VTI (60%) BND (40%)
  • (11) TS.E (60:40.4) VTI (35%) VXF (25%) BND (35%) BNDX (5%)
  • (12) TS.F (60:40.6) VTI (35%) VXF (20%) VXUS (5%) BND (30%) TIP (5%) BNDX (5%)

These 12 ETF templates would have an important built-in advantage over other portfolio strategies, namely an almost no expense ("ANE"). The ANE would work out tremendously for long-run investors.

Table 3: The 2016 Growth Rates of S&P 500 & 12 Templates

S & T

S&P

T (1)

T (2)

T (3)

T (4)

T (5)

T (6)

T (7)

T (8)

T (9)

T (10)

T (11)

T (12)

G Rate

9.1

5.1

3.3

3.7

5.6

6.1

5.9

6.0

3.9

4.0

6.2

7.2

6.9

Rank

0

8

12

11

7

4

6

5

10

9

3

1

2

Note:

1. S & T: S&P 500 & 12 Templates.

2. G Rate: Growth Rate

3

T (1):CS.A (50:50.2)

T (2):CS.B (50:50.4)

T (3):CS.C (50:50.6)

T (4):TD.A (50:50.2)

T (5):TD.B (50:50.4)

T (6):TD.C (50:50.6)

T (7):CS.D (60:40.2)

T (8):CS.E (60:40.4)

T (9):CS.F (60:40.6)

T (10):TD.D (60:40.2)

T (11):TD.E (60:40.4)

T (12):TD.F (60:40.6)

The Table 3 summarizes the annual growth rates of S&P 500 and 12 Templates. S&P grew 9.1% while 12 Templates gained a wide range between 7.2% and 3.3%. What would you select? It's not easy. All I can say is that you can select the top three if you are a momentum player for a relatively short term. If you are a longer-term investor or a contrarian, you would go with the bottom three. But if your investment horizon is longer than five years, you may choose any Template. If you are younger than 50, you might increase the equity allocation to 70%, or more, or even 100%.

ETFs are more tax efficient than counterpart mutual funds. If you allocate permanently as I do, the power of tax savings enhances. Also, you don't have to worry about trade mistakes or market timing for rebalancing.

A Secular Bull Market in 2017

After the Dow Jones Industrials, the S&P 500 index, and the Nasdaq composite were closed at their all-time highs simultaneously on Aug. 15, 2016, as shown in Table 4, these three indexes have made their fresh records together 14 times more. This kind of longest string of consecutive trifecta is extremely rare, it would have perhaps not been seen since 1992. The current markets are described as "meltup."

Why does it happen this time? The reasons are threefold. First, the courageous and innovative monetary policy carried by Ben Bernanke and Co. over last eight years has brought its fruits in recent years, making the economy on a firm footing. Second, the historical maneuver in fiscal policy (tax cuts, infrastructure spending, and rollbacks of regulations) which is unfolding by the Trump administration and Congress vigorously and swiftly every week.

Third, investors are responding with their optimism about the potential of economic growth, corporate earnings, and consumer spending. As a consequence, a new secular bull market has been reborn, by extending the current bull market (started in March 2009) that is already the second longest bull market.

Table 4: 15 Records of Trifecta Of DOW, S&P 500 & Nasdaq

Date

DOW

S&P

NASDAQ

8/15/2016

18,636.05

2,190.15

5,262.02

11/21/2016

18,956.69

2,198.18

53.68.86

11/22/2016

19,023.87

2,202.94

5,386.35

11/25/2017

19,152.14

2,213.35

5,398.92

12/8/2016

19,614.68

2,246.18

5,417.36

12/9/2016

19,756.85

2,259.53

5,444.50

12/13/2016

19,911.21

2,271.72

5,463.83

1/25/2017

20,068.51

2,298.37

5,656.34

2/9/2017

20,172.40

2,307.87

5,715.18

2/10/2017

20,269.37

2,316.00

5,734.13

2/13/2017

20,412.16

2,328.25

5,763.96

2/14/2017

20,504.41

2,337.58

5,782.57

2/15/2017

20,611.86

2,349.25

5,819.44

2/17/2017

20,624.05

2,351.16

5,838.58

2/21/2017

20,743.00

2,365.38

5,865.95

Note

1. The three indexes were closed at all-time highs. On each date.

2. These records are the first time since 1993.

(Source: TD Ameritrade)

The details of the Litmus Test are:

  • The fiscal policy measures would stimulate growth and exports. Increased imports, however, would affect trade balance immediately while increased exports would do with a significant time lag. Therefore, a trade deficit would partially offset a positive growth. A 2.5% growth rate would be plausible. (A 3% or higher growth rates would be expected next year.)
  • Inflation would be around the Fed's inflation target (2%) because inflation expectations of consumers and businesses are well-anchored due critically to the credibility of the Fed, as a quasi-government institution, which is independent from the political influence.
  • The Fed, as a de facto global central bank, plans to make three 0.25 rate increases in 2017. The Fed might be forced to raise rates more to curb inflation pressure. The Fed, however, would be constrained by the impact of the dollar strength. Therefore, the Fed would raise rates less than three times, and short-term interest rates would be a 1.5% or lower at the end of this year.

A New Direction of Monetary Policy

The Fed monetary policy would not be the only player in the Trump era. The Trump administration would conduct fiscal policy which not only public-work programs during a recession but also would cooperate with monetary policy, making a long-overdue optimal policy mix. The Fed Chairwoman Janet Yellen talked about the Fed's new policy direction:

"To sustain a strong job market with inflation at our 2 percent objective, policy must gradually shift toward a neutral stance, where 'neutral' is defined as a level of the federal funds rate that is neither expansionary nor contractionary when the economy is operating near its potential…In particular, the path of the neutral federal funds rate, which plays an important role in determining the appropriate policy path, is highly uncertain. For example, productivity growth is a key determinant of the neutral rate, and while most forecasters expect productivity growth to pick up from its recent unusually slow pace, the timing of such a pickup is highly uncertain. Indeed, there is little consensus among researchers about the causes of the recent slowdown in productivity growth that has occurred both at home and abroad. The strength of global growth will also have an important bearing on the neutral rate through both trade and financial channels, and here, too, the scope for surprises is considerable. Finally, I would mention the potential for changes in fiscal policy to affect the economic outlook and the appropriate policy path. At this point, however, the size, timing, and composition of such changes remain uncertain. However, as this discussion highlights, the course of monetary policy over the next few years will depend on many different factors, of which fiscal policy is just one." ("The Economic Outlook and the Conduct of Monetary Policy," Speech at the Stanford Institute for Economic Policy Research, Stanford University, Stanford, California, Jan. 19, 2017)

The Fed Vice Chairman Stanley Fischer called for "improved public infrastructure, better education, more encouragement for private investment, and more effective regulation." (Speech at the Council on Foreign Relations, Nov. 21, 2016)

Fischer introduced Knut Wicksell, a classic Swedish economist in the late 19th century, regarding the "natural rate" (which is the "neutral rate" in Yellen's Speech):

"Knut Wicksell…emphasized the concept of an equilibrium level of interest rate…In his 1898 book, Interest and Prices, he wrote that 'there is a certain level of the average rate of interest which is such that the general prices has no tendency to move either upwards or downwards.'…In modern language, this level of the interest rate is usually referred to as the natural rate of interest…If we know the natural rate precisely, conducting monetary policy would be relatively straight forward…Wicksell proposed that the central bank follow a simple interest rate rule…[T]he central bank should raise the interest rate if inflation is above target and reduce the interest rate if inflation is below target…Instead of backing out the value of the natural rate of interest by following Wicksell's rule-based approach, one could try to estimate the natural rate directly with the help of an economic model." (Speech at the 40th Annual Central Banking Seminar, sponsored by the New York Fed.)

Fischer described the Fed's model to estimate the natural rate in his another Speech on Feb. 11, 2017:

"Models and the Modeling of Monetary Policy
Now, that is a lot of talk about the process of monetary policymaking. Let me turn to some of the machinery behind that process--in particular, to macroeconomic models and their role in assisting the FOMC's decision-making. The Board staff maintains several models; I will focus on the FRB/US model, the best known and most used of the models the Board staff has at its disposal FRB/US is an estimated, large-scale, general-equilibrium, New Keynesian model." (Speech at the Warwick Economics Summit, Coventry, United Kingdom, emphases are mine)

A Deal between Trump and The Fed

Donald Luskin of Trend Macrolytics LLC posted a timely insightful suggestion on the relationship between the Fed and the government, explaining:

"Wicksell's natural-rate rule requires no discretionary variables at all, only the observation of inflation, which is surely the Fed's proper business…So how about this for an artful deal: Mr. Trump and Ms. Yellen jointly endorse a bipartisan act of Congress to replace the Fed's impossible 'dual mandate' with a directive to follow the natural interest rate. Mr. Trump then thanks her with another term as chair. Heresy for Mr. Trump to reappoint the liberal Democrat? Not at all. If this bell rings, an angel should get her wings." ("Yellen Gives Conservatives Something to Cheer." The WSJ, Feb. 17, 2017, p. A15)

I endorse the recommendation with no reservation for the Fed's uncompromising independency (not influenced by politics) and more important for President Trump's legend to make the Fed the most admirable central bank in the world.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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