Train keeps a-rollin’


With market valuations at nosebleed levels and market sectors like technology going parabolic, it is easy to make a case that a correction must be immanent. This is not a good bet. The current bull market started in October of 2009 and is now the second longest rally in the last one hundred years. Just to be clear, a bull market is a period without any 20% declines. Now lasting almost 3,200 days, we only need this bull to run for about another THREE YEARS to become the longest of all time. Using financial management language, what we have here is a failure to understand Momentum.

In a nod to one of my favorite economists, newly minted Nobel Prize winner Richard Thaler, this current state of affairs shouldn’t be such a surprise. One of the biases he observed is called the “recency effect.” Simply put, we tend to think the future will look like the immediate past. So an assumption that after one of the worst financial crisis in U.S. history people should be fearful of stock markets makes intuitive sense. It would also be wrong. That this bull run has long been called “the most hated rally in history” tells us more about human behavior than how to successfully invest our money. Just ask the folks who have been waiting since 2010 for a market correction to start investing in stocks again.

Okay, then what do we do now? Think about diversification outside of indexed funds like ETFs, even as they remain our preference as the primary investment choice for individual investors here at Invest-Notes. As discussed previously, the idea that ETFs are in a bubble, or will lead to weird price distortions or even a market collapse are just wrong-headed. But history has demonstrated pretty impressively that buying equities when valuations are high tend to mean subpar returns over time. This is where the idea of adding some individual stocks or narrowly focused ETFs might make sense for adventurous investors.

That there are specialty ETFs almost sure to fail spectacularly shouldn’t be a surprise. There are ETFs holding the stocks of Nigeria or Egypt that have lost a quarter of their value over the last three years. And if you bet on gold miners or master limited partnerships (MLP) during this same timeframe there are ETFs sitting on losses of up to 90%. Of course anyone reading this blog should know better than to even think about an ETF called ProShares UltraPro Short Financial Select Sector (FINZ), down over 40% so far this year, just as in many past years. Conversely the plain-Jane financial services indexes (like XLF or VHF) are up over 15% year to date.

Which makes for a nice segue to offer an observation about a possible investment opportunity. In August of 2016, a change was made to indexed financial services ETFs, like XLF and VHF, for the first time since 1999. No longer included with banks and their ilk, Real Estate Investment Trusts (REIT) now have their own index. A detailed explanation can be found here:

“The Difference Between Banks and Buildings”

The quick take is that previously about 20% of financial index funds were composed of REITs that provided the bulk of the dividend income generated by these ETFs. The assumption at the time was that bank-only ETFs would offer lower dividends and more volatility when the REITs were spun off. As it turns out, 2017 has proven a challenging one for REIT-themed ETFs, like VNQ or ICF. Despite a big spread between the dividend yields (REIT = 4.5% while Banks = 1.5%) the REIT ETFs are mostly lower than at the start of the year, underperforming bank ETFs by a significant margin since their Independence Day.

Another curious result of this separation of banks and buildings is their seemingly inexplicable lack of correlation. As the Boys at Bespoke have discussed recently (, highly recommended), there are asset classes that move in tandem and others that move in opposite directions. A quick example of this is the impact of rising interest rates on two asset groups that wouldn’t normally be thought of as behaving similarly. Yet both utility company stocks and long-term bonds lose value as interest rates go up. So when (not if) interest rates finally start climbing, having invested in these types of stocks and bonds will provide very little safety despite the diversification normally associated with a stock/bond mix.

When comparing a list of 18 popular asset groups (bonds and indexed ETFs, but also oil, gold and Bitcoin), the two assets most likely to go in opposite directions on most days are the REIT and Financial Services indexed funds. As noted by Bespoke, just a year ago they were traded as one asset. This suggests that REITs could provide some valuable diversification if financial equities begin to lose some of their recent altitude. The caveat here being that rising interest rates tend to boost bank stocks while often pressuring REITs.

However, it is just possible that recent headlines about the death of physical retail outlets – versus the online variety – is greatly exaggerated. This red herring obfuscates the fact that most income-producing real estate is not shopping malls – office spaces, warehouses, data centers, apartment buildings, manufacturing facilities, hotels, gas stations and convenience stores – suggesting that the recent underperformance of REIT ETFs might be an opportunity to add both value and income (the 4.5% dividend) to a portfolio at decent valuations.

While I don’t currently own any REIT ETFs, VNQ is on my radar and starting to look interesting. As a side note, over 10% of my personal IRA is in individual REIT stocks that I have owned for over a decade. That the bulk of my personal assets are real estate investments also explains why I have not been in any hurry to add real estate exposure through these new ETFs. But that might be changing.

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One Response to Train keeps a-rollin’

  1. Frank Gaard says:

    As the tax bill is modified and the % of change for bizniss taxes goes up from 20% to save votes the optimism will start to erode. And if the bill fails the blossom will fade.

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