There were few investment professionals who believed in exchange-traded funds (ETFs) back in 1993. In fact, you could count the early adopters on your keyboard-using fingers. For example, my friend and money manager Tom Lydon used ETFs before he created ETF Trends. Dave Fry gathered a following at ETF Digest. And “yours truly?” I regularly discussed the benefits of “SPY” and “QQQ” on financial talk radio across 70 or more affiliates around the nation.
In the 90s, ETF that tracked popular indices like the S&P 500 or NASDAQ 100 were not without their charm. They provided diversification with lower costs, greater tax-efficiency and total transparency. On the other hand, Vanguard’s suite of index funds offered the identical perks. And since buy-n-hold had been the predominant investing approach at the time, the desire for a diversified asset that traded throughout the day was skimpy at best.
Of course, the tech wreck (2000-2002) and the financial collapse (2007-2009) went a long way toward changing perceptions. Liquidity at a desirable price point became more important for managers of risk. By the end of 2009, nearly 1,000 exchange traded vehicles existed on the U.S. exchanges alone. In October of 2015? The $2.1 trillion industry has 1700-plus products and continues to grow, whereas the $12.9 trillion mutual fund business continues to lose assets under management.
Why am I bringing up the evolution of ETFs/ETNs? In essence, our late-stage bull market is favorable for the original game-changers – S&P 500 SPDR Trust (SPY) and PowerShares NASDAQ 100 (QQQ). You might own them as part of your current stock exposure. On the flip side? If you commit significant financial resources to any of the other 1700-plus ETFs in this investing environment, you may get burned.
In spite of CNBC’s enthusiasm for the superb October stock rally of popular benchmarks like the S&P 500 and the NASDAQ, very few companies are responsible for the success. Breadth remains extremely weak. In fact, one can look at an equal-weighting of S&P 500 components via Guggenheim S&P 500 Equal Weight (RSP) and compare it with the market-cap weighted SPY. When you do so with the RSP:SPY price ratio, one sees just how poorly individual companies are performing relative to heavily-weighted components in SPY (e.g., Facebook, Apple, Microsoft, etc.).
Consider the chart above. In a healthier bull market uptrend, the vast majority of S&P 500 components participate. This was the case from October of 2014 through March of 2015. Beginning in April, however, more and more components of the S&P 500 began to buckle. The deterioration occurred throughout the summertime until the evidence became overwhelming in mid-July; that is, the S&P 500 could not hold near the 2100 level (all-time highs) if the vast majority of S&P 500 companies were losing ground. During the October stock rally? Well, the first few weeks showed signs of a return to the good-old days. However, the last week has shown that underlying weakness has yet to be vanquished.
Why should one care about the possibility that market breadth is weakening once again? For one thing, when the canaries of the investment mines (e.g., U.S. small caps, emerging market stocks, high yield bonds, commodities, etc.) deteriorate, they eventually overwhelm the last holdouts. This is what transpired with the August-September corrective activity. Small companies faltered, emergers plummeted, high yield bonds dropped and commodities cratered. Eventually, the near-death experience of the investment mine canaries in June, July and early August acted like an anchor in bringing down the large-caps in the Dow, S&P 500 and NASDAQ.
It follows that one should not merely pay attention to the impressive price rally for the S&P 500 or NASDAQ. What about small caps? Are investors genuinely intrigued by the possibility of capital appreciation in the small corporations of the iShares Russell 2000 (IWM)?
Not unlike the RSP:SPY price ratio, we see a steady appetite for small company exposure (a.k.a. “risk) in the months leading up to the summertime. We then see deterioration of “risk-on” preferences well before the August-September correction in the S&P 500 and NASDAQ. And while investors have certainly pushed IWM far off those debilitating late September lows, IWM has not climbed above its September highs nor has it risen above its 200-day moving average.
The song is quite similar for high yield bonds in SPDR High Yield Bond (JNK):
And for commodities in PowerShares DB Commodity Tracking Index Fund (DBC):
Stated another way, the euphoria that many in the media are expressing over the recovery of SPY and the near record performance for QQQ may be premature. Small caps, high yield bonds and commodities are all lower in October than they were at their September high points; IWM, JNK and DBC are all below 200-day moving averages as well.
Regular readers will recall that I reduced risk in June and July while detailing the fundamental, technical and economic challenges straight up through mid-August. The tactical asset allocation shift was threefold. One, reduce the percentage weighting to riskier assets. Two, reduce the type of risk exposure. And three, raise cash for near-term preservation of capital as well as future buying opportunities.
For instance, a moderate growth/income client might typically have had 65%-70% stock (e.g., large, small, foreign, domestic) and 30%-35% income (e.g., investment grade, higher yielding, short, long, etc.). Prior to the August-September correction, we lowered the exposure to 50% equity (mostly large-cap domestic), 25% bond (mostly investment grade) and 25% cash/cash equivalents.
I am not convinced that re-establishing exposure to smaller companies via IWM or higher yielding bonds via JNK is sensible. And while I remain skeptical about market-cap weighted large-caps gaining significant ground in spite of ongoing signs of risk aversion, I did not ignore the successful retest of August lows for SPY and QQQ. The “original” ETFs and/or extremely similar ones like Vanguard Total Market (VTI) and iShares Large-Cap Growth (IWF) received incremental purchases here in October.
In sum, the 50% equity component has been raised to 60%, though it remains primarily dedicated to the large-cap domestic airspace. Small caps and foreign? The evidence of recovery is not compelling enough. What’s more, with high yield failing to break out, we are keeping the 25% allocation to investment grade bonds intact. This leaves 15% in cash/cash equivalents. And, due to fundamental, technical and economic warning signs, we are maintaining an overall risk profile that is less than what we might otherwise have.
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.