Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:19]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:37]

Thank you, Mary, and welcome to episode 70 of Risk Parity Radio. Today on Risk Parity Radio, we are going to follow up from an email from one of our listeners who is asking about the ETF iVOL, I-V-O-L, and we are going to begin a full analysis of that. using J. David Stein's 10 Questions to Master Successful Investing. But before we do that, it is time for our monthly rant about financial mis-wisdom. But to do that we need to get the music out. I could just push this little button here. And away we go. Today's rant will be a little bit subdued and we are going to talk about crystal balls. The impetus for this rant was me doing a little search on two terms, crystal balls and cape ratio. Now in case you didn't know what the cape ratio is, it is a ratio of price to earnings. Actually the name of it is cyclically adjusted PE ratio. And this was the brainchild of a Nobel Prize winner, Robert Shiller. So it is interesting from a historical perspective. But the question arises is whether this is a useful measure for predicting the future or going forward. Over the past 15 years, I would say, many people have tried to use this or infer something about future markets using this measure, and they've pretty much all been wrong, or at least all been wrong so far. And so as a practical matter, it does not appear to be a useful measure. Yet, despite that, it keeps reappearing because there is this psychological need we have to find these crystal balls to help us figure out what's going to happen in the future. What I want to talk through today is just a few of the missteps or articles I've seen where people have thought about this and tried to infer something from it. And so I picked four of them. And what's most interesting about these articles, if you go back to when they were written and then see what happened next, whether this was a useful thing. Now, the first one, and I will link to these in the show notes, is by a financial advisor, and I guess he's a radio personality in Atlanta. His name is Wes Moss. It's dated September 7th, 2017. and he writes this article about the CAPE ratio. He does say that it is a little bit suspect and it doesn't seem to have the predictive power that it might have, and he's specifically responding to a caller which said, I saw a scary article in the Market Watch based on the work of Nobel laureate Robert Shiller. It looks like the market is in for a crash. A crash! What do you think? And so remember, this is September of 2017. And he says, no doubt you have this worry on your mind, and this is a legitimate indicator, but he's more worried about North Korea at the time, believe it or not. That's what he says. And then he says, as a result, we seem to stand today in an economic environment where earnings are extraordinarily strong, and market gains over the next year or two are likely to be limited. Remember he's saying this September 2017, this is his best guess or future prognostication being an expensive financial advisor. Well, was he right or was he wrong? Obviously he was wrong. 2018 went kind of nowhere and then 2019 exploded. So what was the use of this? He writes, the CAPE ratio also suggests limited returns moving forward for stocks, meaning the subsequent few years end up being less impressive for earnings. Again, it was wrong. Makes me wonder, what are we paying these people for? They're relying on crystal balls that are wrong, and we're all looking at these crystal balls as if they're going to tell us something, and they're wrong. We need to stop looking at the crystal balls and hoping that we're going to learn something from them. Because if you followed this advice, you would have lost money. All right, next up, article from November 26, 2018 from another person in the financial services industry. His name is Grayson Blazek and I'll also list this in the show notes. He writes, Given the strong inverse correlation between starting CAPE and long-term expected returns, we find it a valuable indicator when identifying which equity markets are likely to offer the highest future return potential. Then he goes on to say that he does caveat his statements while the CAPE ratio has proven to be a sound long-term indicator over short-term periods performance is much more difficult to predict. And what he's basically saying in this article is he thinks that the foreign stocks are going to outperform US stocks. And then he says taking a tactical approach to allocating your portfolio towards less expensive areas of the market can prove valuable for long periods of time, although short term can result in missing out on further appreciation in expensive areas of the market. And we know From November 18, going through 2019, that's exactly what happened. And then even when you get to 2020, we'll just take COVID out of the picture because nobody was predicting that, and he certainly wasn't predicting that here. But what you have seen is, yeah, there's some rotation, but it's not the rotation he thought it was gonna be. The rotation has been out of large cap growth stocks and into small cap value stocks. International stocks have done well recently, but nothing compared to what actually outperformed, which was not predicted by the CAPE ratio and was not predicted by Mr. Grayson Blazek. All right, now let's go to 2019. An article by a CFA, David Ferguson, dated August 26, 2019, Does yous Wealth Manager Need a Crystal Ball or Just Balls of Steel? and I will link to this also in the show notes. And he writes, As at February 2018, the CAPE ratio is over 32. Apart from just prior to the dot-com crash, this is higher than it's ever been before, including just before the 1929 crash. Fans of the CAPE ratio would say this gives plenty of reason to fear an impending correction. Well, they were wrong. And then he says, without putting a data or specific catalyst on a correction, we try to position our portfolios to prepare for a major correction based not only just on CAPE ratio, but on various other factors as well. So at least he's putting it a little bit in its place, but again, he's trying to predict when a correction will appear. And here's another indication that this advice is not really that sound. The next section he's talking about bonds. He says they are licensed to fall. And he's writing this in 2019, or 2018, it's unclear. And he writes, In the 2008 crisis when equity values plunged, central banks dramatically cut interest rates to arrest collapsing equity markets. an immediate effect of that was to increase the capital value of bond holdings in portfolios. What he means by that is bonds went up substantially and they did. The calamitous effect of the correction in shares was therefore diluted by the uplift in bond values. In the next crisis, can we be sure the same? It is unlikely, as with ZIRP or close to ZIRP still in operation, central banks can no longer have that weapon in their locker, and more likely scenario is for a double whammy of bond value falls and equity falls to hit portfolios simultaneously. And that was exactly wrong, exactly wrong. What happened in early 2020 is that bond prices went through the roof, they went up 25 to 30%, and if you would have followed this guy, you would have lost money. What's going on here is a form of groupthink. that seems to infect the financial services industry. They read one thing that comes out by a large organization and then they all have to dance around that thesis. Nobody wants to be the outlier because it's more comfortable and convenient for your business as a financial advisor to be wrong with the group than to be wrong alone because if you're wrong alone then your clients are going to flock away from you. So let's step away from the groupthink of financial services industries and go to somebody who might be more objective, a man named Theodore Wong who happens to be an engineer from MIT. I always find it interesting that the best thinkers in the financial area are often not people who come to finances directly. Bill Bengen was also, is also an engineer from MIT. William Bernstein is a neurologist by training. But I will link to this article in the show notes. And this is dated March 18, 2016, before the other articles. Apparently those other people didn't read this article. But this article goes through a nice analysis of why relying on the CAPE ratio is probably not a good idea from a statistical point of view. That it does not appear to have what you would call mean reversion properties. And that is the assumption in when people are using the CAPE ratio to try to predict the future. and he writes this. Generally, calibration relies on a universal assumption of mean reversion, which has been the norm for over a century since the mid-1990s. However, readings for many valuation metrics have failed to revert toward the century-old mean. Looking deep, one might ask whether current market is overvalued or the measuring gauges are off calibration due to a 20-year hiatus in the assumed mean reversion. and he says that what this is is called mean instability. It's not limited to the CAPE, but if you have a metric that does not have a stable mean to revert to, the mean moves around, you can see or understand that trying to use that as a measure is probably fraught with difficulty and not likely to give you good results. He's noticed that this mean reversion problem is also present in something called the Tobin's Q, which I won't go into right now, and also what is known as the Buffett indicator, which I won't go into right now. And he concludes that there may be or probably is a misguided faith in mean reversion with respect to this indicator. The market can be considered overvalued if the 20-year lofty readings of many valuations ratios are all statistical outliers and will eventually revert back to historical means. However, it's naive to think the last two decades were outliers. If the outliers were the results of randomness, they will regress to the mean. On the other hand, if they are caused by unidentified but non-random factors, then there may be no mean reversion. Indeed, Shiller proposed in 2014, the guy who came up with this, that the elevated CAPE may be driven by behavioral factors. Such factors may be irrational, but they are certainly not random. So he's pointing out that even the founder of this ratio is doubtful on its ultimate predictive abilities or the use that financial services have made of it. The misguided expectation faith in mean reversion has far reaching impacts in the field of investments beyond market valuations. That's the conclusion he makes. And this is the best crystal ball that we seem to have available, at least it's one of the most popular ones out there right now. So what this all comes down to is that relying on crystal balls or people that use them may be fraught with peril. That you are better off using those rules of thumb that we use here, to come up with reasonable allocations to portfolios that will perform decently in all kinds of environments, not just certain environments that certain people are predicting with their certain crystal balls. Because if you look at their historical records, the abilities of financial advisors in the financial services industry, to make these predictions is nil and is self-destructive if you were to follow the things that they say and write, particularly when they get into the groupthink. All right, that's enough ranting. And now we are going to go to our main event here today. This is from a email I received from Boone B. And Boone B writes, Subject：IVAL, I-V-O-L. I heard about this fund from a SeekingAlpha.com podcast. Honestly, when I get too far into the weeds evaluating this fund, my head starts to hurt. But since listening to your podcast, I did what you recommended and checked portfoliovisualizer.com for correlations and performance. I think it might actually be a good addition to a portfolio. Whether this was part of a bond component or just its own segment of a portfolio might be an academic exercise. It doesn't really seem to correlate to anything. Honestly, the biggest problem is that it's a very new fund. I'm not really sure we can make any determinations about correlation that wouldn't be attributed to chance. Could this act in the same way that VXX does in the ultimate risk parity portfolio, 1 to 2% of the total portfolio, and add another axis of movement? And then he gives a link to the fact sheet for this fund. I'd be interested to hear your thoughts on this. Sign Boone PS I'm currently putting together my own portfolio using bits and pieces from multiple portfolios. I may send it to you when it has become more finalized. Well that would be fun to look at. I have an interesting idea what's fun. But now let's go ahead and analyze this fund, IVOL, using the 10 Questions to Master Investing from David Stein. And we'll start with some of the questions today and then finish with the remaining questions next week. And the first question, question number one, is what is it? Well, it's an exchange-traded fund. The full name of it is Quadratic Interest Rate Volatility an inflation hedge ETF. It doesn't exactly roll off your tongue. But more important is to look at what's in it, and I will link to some of these materials in the show notes. And it's less complicated than you might think it is. About 85% of this fund is actually just a Schwab TIPS fund, SCHP. And so 85% of it is attributable just to that TIPS fund, which you could go off and buy by yourself. About 10% of it is just in cash, I suppose waiting for it. And then we get to the interesting part of this. 5% of it is in options. And these are not your typical options. What these options are doing is making a bet on the credit spread between the two-year Treasury note and the 10-year Treasury note. And this is also referred to as part of the yield curve. Now, let me just talk about what those things are. The credit spread is just literally the difference between the 10-year yield and the two-year yield. Right now, for example, the 10-year yield is about 1.65%. The two-year yield is down there about 0.1%. So the spread is about 1.55%. And that spread can go up or down over time. Now, when people talk about the yield curve, what they're talking about is a little drawing of a graph that has the durations of bonds, typically treasury bonds on the x-axis going from zero to 30 years. And then on the y-axis it has a interest rate measure. And when you plot the various bonds on this and then draw a line that goes through them, usually it looks like an upward sloping curve. that it starts very low and gets a little higher, and then when you get out to the 30-year bond, it's at its highest point. Now that is the ordinary picture of this, but it varies a lot over time. And a couple of years ago, you may have remembered talk about what is called the inverted yield curve. And when the Fed was raising the interest rates, which attacked the short end of it, Sometimes the short end of the curve can be higher than the longer end of the curve, and that's called an inverted yield curve. And usually when that happens, people start getting anxious because oftentimes within the next year or two, the stock market goes down until this thing writes itself. Because in theory, loaning money for longer periods of time should get you more interest than loaning money for shorter periods of time. And so having an inverted yield curve is not a healthy economy or doesn't show a healthy economy. That longer end of the curve generally reflects the overall consensus of the world as to how much growth there will be in the future. And when it goes down, it means that everybody thinks that the future is going to have less growth and be more recessionary. And when it's going up, they think it's more growth and more inflationary. So what do these options do? How do these options work? Basically what these options are on that credit spread. So they are betting that the credit spread is going to widen that between the two and ten year bonds that instead of having a 1% credit spread, we're going to have a 1.5 or a 2% credit spread in the future. And that's what has happened actually since the crisis and since 2019 when we had that inverted yield curve. The Fed reduced the interest rates, reducing that two-year marker. But then what also happened at the same time is we had COVID and so the other end of the curve also crashed. So last year it got to the point where the two-year was close to zero and the 10-year was 0.5. So the credit spread there was about plus 0.5, half a percent. Now since that time, since that crisis, the credit spread has widened as the economy has improved and so now that credit spread is up to 1.55 say. All that's to say is the last 12 months has been very good for this fund because that's the bet it was making that the the credit spread would widen. If you looked at this fund, these options would have been poorer investments if you had started where the curve is now and then gone to that flattened or inverted curve would be very bad for this fund. So what we know from this is that the recent performance has been very favorable for this kind of fund. Incidentally and separately, this is also why you've seen some of the small cap value funds go up in value because a lot of the companies in those funds are banks or small financial institutions and they are more profitable when there is a more steep yield curve when this credit spread is wider because they can borrow at the short end and borrow at low rates, loan at the longer end, get higher rates, and that difference essentially affects the profits in their bottom line. So that's what it is. It's a fund that has tips and options on credit spreads. Question two, is it an investment, a speculation, or a gamble? We would have to put this in the investment category because it's basically bonds paying interest rate, although the interest rate on TIPS is not so hot, but it does fall into that category. If it were all of those options, then you would probably call the whole thing a speculation, but on balance, it's an investment. That options part of it is a speculative part of it because in theory, if the credit spreads fall or go inverted, some of those options could become worthless. Okay, question three, what is the upside? Well, we've seen the upside. First of all, you just have the TIPS fund, which TIPS funds are not very exciting on their own. They don't move around a whole lot at these low interest rates. Some of their yields are negative on some of these TIPS because TIPS are Treasury inflation protected securities. their interest rate is divided into two components, a fixed component and then a component that varies with the CPI, the measure of inflation that the government uses. And so that part of it is not very exciting. Most of the upside for this fund comes out of those options. And this fund has only been in existence since 2019. But over that period, this has in fact been a very good period for this kind of fund because the yield curve was flat to down or inverted around the time this fund came into being, flattened out even more, and then went steeper and steeper. So the past 12 months in particular have been a particularly favorable environment for this kind of fund. And if yield spreads continue to widen, then it would still be a favorable environment for this fund. If the yield spreads or credit spreads do not widen anymore, then it becomes more just like a plain old tips fund. And if they go the other way, then this fund will not perform well and will probably lose money. But it is up. On average, 10.93% annualized since inception. And over the past year, going to March 31, 2021, it is up 13.65%, which is a nice performance for this kind of fund. But you have to take into account that it is probably the most favorable kind of environment you can imagine. for this kind of fund due to those options and the way they work. All right, that's question three. Let's go to question four. What is the downside? There are essentially two downsides. First of all, this fund does charge a relatively high expense ratio. It is around 1% for this fund. And if it was just the TIPS fund, you would expect it to charge, you know, down there 0.01.015% as an index fund, because that's essentially what a plain old TIPS fund is. It's just an index of these Treasury inflation protected bonds. So all of the cost really is built in here on the options side of this and managing that. And these are not, these are complex instruments. And so that is a substantial cost for a fund like this. particularly when you think of the idea that it's not likely to continue to generate the kind of returns it has in the recent past. It's more likely to generate returns that are more like half of that over time. And so that other downside is that you would expect this fund to do poorly in deflationary environments or whenever We have another recession and the yield curve goes the other way, the credit spreads get smaller, then this fund probably will lose money during that portion in time. And unfortunately, when we get to the correlation analysis, that may also impact how helpful it is to hold when you're also holding stocks that may not be doing as well during that time. But other than that, it really doesn't have a big downside. You can buy and sell this on any brokerage. There's no transaction fees these days. You could buy fractional shares in it if you really wanted to. And so the two downsides are essentially the risk and the fee. All right, question five. Who is on the other side of the trade? And the other side of the trade here, well, you could think about it in two ways. There's the market for these things, and I think at this point it's mostly institutions that are buying this sort of thing because it's kind of esoteric and relatively new. The other side of the trade, if you go into the guts of it, are the fact that somebody is selling these options, and I think it's a bank that's generally selling these options to the operators of this fund. And so that's the other side of the trade. But now I see our signal is beginning to fade, so we're going to pick up with the last five questions in our episode next week. The next episode will be our weekly portfolio review, and then we have some emails that are Piling up in the mailbag, I think we have one from Julie and one from Anita and one from Ethan. There may be others. So we'll address those as well. If you have questions or comments, I welcome them and you can send them to me at frank@riskparityradio.com that's frank@riskparityradio.com or you can go to the website and fill out the contact form. The website is www.riskparadioradio.com and if you fill out the contact form there, I will get your message that way. Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Mary [30:25]

The Risk Parity Radio show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.