Forget Banks and Worry About High Stock Prices

It’s time for investors to stop fighting the last war. The next downturn most likely won’t be triggered by another meltdown of the financial system.

The Federal Reserve has concluded its stress test of big banks, a look into whether they have enough money set aside to withstand another 2008-type financial crisis. The Fed announced last week that all 35 banks examined are sufficiently capitalized. It disclosedthe second and final round of results on Thursday afternoon, giving all but one bank a passing grade and the go-ahead to return money to shareholders.

Investors didn’t need the Fed to tell them that banks are in better shape than they were a decade ago. The signs are everywhere. Profits have fallen across the industry since the financial crisis, an indication that banks are taking on less risk. Profit margins for the S&P 500 Financials Index averaged 9.3 percent from 2008 to 2017, down from an average of 13.8 percent from 2003 to 2007, the years leading up to the crisis. Return on equity is down to an average of 5.2 percent from 14.5 percent over the same periods.

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How Index Funds Can Combat This Hidden Cost

Friday was a big day in the world of indexes. It was also a costly one for index investors.

I’m referring to the annual reconstitution of the FTSE Russell indexes — the day that the index provider officially updates the components and allocations of its indexes, such as the popular Russell 1000 Index and Russell 2000 Index.

It’s also the day mutual funds and exchange-traded funds that track a FTSE Russell index revamp their portfolios to match it. The result is a torrent of trading. Roughly 1.9 billion shares of common stock traded on the New York Stock Exchange on Friday, according to volume calculated by Bloomberg. It was the second-busiest trading day of the year and nearly triple this year’s average daily volume of 712 million shares.

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China Takes an Edge in Stocks to a Trade War

The saber-rattling for a U.S.-China trade war is becoming louder, and many observers are speculating about which country will blink first. One important variable will be the resilience of each country’s stock market, given the potential for mayhem from a melting market. So it’s worth asking which one is more likely to stand its ground.

There are several considerations, most prominently quality, free float and valuation. Let’s see how they stack up for each country.

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Trade War Would Cause Trouble on Home Front for U.S. Investors

President Donald Trump’s looming trade war is no friend of the U.S. stock market, and that’s bad news for U.S. investors who like to keep their money at home.

Free trade is under siege. The White House imposed $50 billion in tariffs on Chinese imports on Friday. China responded in kind. President Trump is now threatening up to $400 billion in additional tariffs, and China is vowing to retaliate again. Its Ministry of Commerce called for “comprehensive quantitative and qualitative measures” if the U.S. imposes additional tariffs.

The intensifying trade dispute should worry investors who are reluctant to venture overseas, and there are many of them. According to one estimate, U.S. investors, on average, allocate just 15 percent of their stocks to foreign markets. That’s a huge home bias given that the U.S. accounts for roughly half of global stocks by market value and a quarter of the world’s economic output.

Proponents of home bias argue that U.S. stocks provide plenty of exposure to foreign markets because large U.S. companies sell their wares all over the world. The percentage of S&P 500 sales from foreign countries was 43.2 percent in 2016, according to S&P’s most recent global sales report. That percentage has been reliably between 43 percent and 48 percent since 2006.

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Bring Harvard and Yale Investing to the People

Lots of people want to invest like elite university endowments, but securities laws don’t allow it. It’s time to remove those barriers.

But it’s worth asking whether investors should aspire to the so-called endowment model in the first place. According to numbers compiled by the National Association of College and University Business Officers, universities with the biggest endowments generated an average return of 9.7 percent annually over the last 30 years through June 2017 — the longest period for which annual returns are available — slightly edging out the S&P 500 Index’s return of 9.6 percent, including dividends.

Admirers of the endowment model are quick to point out that it’s less volatile than the stock market. The better comparison, they say, is a traditional 60/40 portfolio of stocks and bonds. That mix, as represented by the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index, returned just 8.6 percent over those three decades, or 1.1 percentage points a year less than endowments.

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Funds Like Magellan Need Gamblers Like Bill Gross

I know why investors don’t care about Fidelity Magellan’s comeback.

As Bloomberg News reported on Monday, the mutual fund made famous by hall-of-fame stock picker Peter Lynch is enjoying a resurgence after years of mediocre performance. The fund fell into a “15-year funk” after Lynch’s successor, Jeffrey Vinik, left in 1996. But ever since current manager Jeffrey Feingold took over in September 2011, “Magellan has bested the S&P 500 index every full year but 2016.” The fund has also “outdone more than 90 percent of funds with a similar investing style over the past one, three, and five years.”

Despite Feingold’s apparent success, however, investors are yanking money from the fund. The knee-jerk explanation is that investors have lost faith in active management, no matter what the results. A more accurate one is that investors no longer need the vast majority of actively managed funds, including Magellan.

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Emerging-Market Currency Fears Aren’t Wrong, Just Misplaced

There’s a reason to worry about emerging-market currencies, but not the one investors have in mind.

Some developing countries are stumbling, and their currencies aren’t taking it well. Turkey’s lira is down 16 percent against the dollar since its peak on Feb. 1 through Wednesday, and Brazil’s real is also down 16 percent since Jan. 24.

The declines have recently spread to other EM currencies. The MSCI Emerging Markets Currency Index — a basket of currencies that tracks the country allocations in the MSCI Emerging Markets Index — is down 3.5 percent since its peak on April 3 through Wednesday.

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Welcome to the Alternative-Investment Party. You’re Late.

If you want to get rich, here’s one way to do it:

  1. Find an investment that few investors know about.
  2. Write a pitch book laying out why that investment is likely to work.
  3. Sell your idea to rich institutional investors.
  4. Charge absurd fees.
  5. Let everyone know that your investment made lots of money for lots of investors.
  6. When your investment becomes too crowded to produce outsized returns, sell it to unsuspecting individuals.

Steps one through five are a brief history of so-called alternative investments, such as hedge funds, private equity and real estate. And now, thanks to JPMorgan Chase & Co., step six is underway.

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No Need to Panic About Emerging Markets

No, it’s not 2008 for emerging markets — at least not in the way investors fear.

Harvard economist Carmen Reinhart stoked investors’ anxiety last week, saying that emerging markets are in worse shape now than during the 2008 financial crisis. Among Reinhart’s long list of concerns are a stronger dollar, mounting debt and various and sundry problems in Brazil, Chile, Argentina, Turkey, sub-Saharan Africa and the Middle East.

In response, Bloomberg News looked at a group of developing countries and found that they are, in fact, worse off now than during the financial crisis in some important ways. The group, for example, has a modest current-account deficit, whereas it boasted a big surplus in 2008. The countries’ economic growth is also lower than it was during the crisis, and their government debt-to-GDP ratio is higher.

It all sounds worrisome, but the relevance of Reinhart’s concerns to investors is questionable. For starters, most investors dabble in emerging markets through mutual funds and exchange-traded funds, and most of those investments are in stocks. There’s $588 billion invested in emerging-market stock funds and $92 billion in bond funds, according to Morningstar data.

Those stock funds have nominal exposure — or none at all — to the countries that Reinhart is concerned about. The biggest emerging-market stock fund is the Vanguard FTSE Emerging Markets ETF, with $66 billion in assets. Sixty percent of the fund is invested in China, Taiwan and India. Its combined exposure to South America, Turkey and the Middle East is just 13 percent, and 8 percent of that is in Brazil. (Disclosure: I own Vanguard funds and my asset-management firm buys them for investors.)

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Investors Can Miss the Forest for the Smart Beta Trees

A battle is raging among finance theoreticians, and investors should stay out of it.

There’s a growing recognition that a handful of active investing styles — also known as factor investing or smart beta — can be expected to beat the market over time. Among them are value (buying cheap stocks), quality (buying profitable and stable companies), momentum (following the trend) and size (buying small companies).

The evidence is compelling. The cheapest 10 percent of U.S. stocks — sorted on price-to-book ratio and then weighted by market capitalization —  returned 11.9 percent annually from July 1926 through March, including dividends, according to numbers compiled by Dartmouth professor Kenneth French. That’s 1.8 percentage points a year better than the S&P 500 Index during those nine decades and 3.1 percentage points a year better than the most expensive 10 percent of stocks.

Value also won over shorter periods. The cheapest 10 percent of stocks beat the S&P 500 roughly 72 percent of the time over rolling 10-year periods, and they beat the most expensive 10 percent of stocks 73 percent of the time.

The results are similar for stocks sorted on profitability, momentum and size.

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