In this post I discuss Index Dividend Yields, Index PE Multiples, Annualized Past Performance, Asset Allocation, Options & Derivative Securities.
As you can see the DJIA is quite reasonable in terms of PE Multiple, at just 16.19, with forward looking estimates placing its PE Multiple at 15.33 in twelve months time; while the DJIA’s dividend yield has actually increased over the past 12 months to 2.51% from 2.08 a year ago. This makes me most bullish on the DJIA, and I believe it will outperform the rest of the major U.S. stock indices in 2015 for this reason (the lower pe multiple, relative to other indices, and the strengthening dividend yield on this index). DIA is an etf that matches the performance of the DJIA, which is a basket of 30 large super capitalization stocks representative of the U.S. economy. Of course there are options on DIA, and also the CBOE has root symbol DJX and index options on the DJIA with 1256 contract status, which have preferential tax treatment, and cash settlement and European style assignment.
For educational and informational purposes, using options, one could hypothetically construct a portfolio with e.g. 20% allocation to index options achieving 5:1 enhancement, and then he/she could allocate the remainder, the 80% into e.g. high yield fixed income via etfs QLTC, EMB, PCY, JNK, and HYG (alternatively they could use Treasury etfs, e.g. AGG, IEF or TIP, or high quality corporate fixed income etfs e.g. LQD and many others). This would likely produce awesome gains annually, if rebalanced annually. This type of strategy is suitable for institutional trading, and it achieves the “best of both worlds” in terms of a large fixed income portfolio, for safety, and then an index option which would effectively capture the gains of the stock market over e.g. the course of a year or two. A lot of investors, including institutional investors, “dilute” their equity portfolio’s potential gains with fixed income, which over time can produce returns less than the stock market (assuming high yield bonds are not employed).
What most people don’t know is that e.g. the JPM EMBI [which stands for the J.P. Morgan Emerging Market Bond Index] (matched by etf EMB, and many other higher cost mutual funds, like FNMIX, PEMDX, and GSDAX) has produced annualized gains over the past which are awesome, sometimes beating stock indices. Over the past 12 months (according to https://fundresearch.fidelity.com/mutual-funds/performance-and-risk/315910836 the JPM EMBI has returned (through December 2014) +5.53%, and over the past 3 years the annualized return was +5.33%, over the past 5 years the annualized return was +7.21%, and over the past 10 years has produced annualized gains of +7.68%. The high yield bond markets and high yield fixed income indices (rated BB or better, and the etf EMB meets that requirement) have never returned a negative return over any rolling 18 month period of time. This means that if there ever is a selloff in these fixed income indices it’s most likely a major buying opportunity, and based on past performance since the stone age, that the index will strike a new all time high within 18 months. This is not the case for equity indices, which e.g. took 25 years from 1929 to 1954 to break even, even before inflation adjustments; also the Nasdaq Composite hasn’t reached it’s March 2000 levels of roughly 5,134, also before inflation adjustments, and it has been 15 years! The etf PCY is very similar to etf EMB and has a slightly longer average weighted maturity, compared to EMB; It was designed by Deutsche Bank to outperform the EMB by 200 bp per year. Other corporate U.S. high yield bond funds rated BB or better include JNK, and HYG; of course there are many others. There are also higher risk CCC rated fixed income mutual funds and etfs, including QLTC.
I have personally annualized the S&P500, and it has returned over the past ten years +5.238%, going from a December 31, 2004 value of 1,211.92 to the current 2,019.42 (derived from [2019.42/1211.92]^[1/10]). Yes, you’re reading this correctly, high yield fixed income (as measured by the JPM EMBI) has outperformed the S&P500 over the past 10 years, each and every year (on average) by nearly +2.44%, and an extra 244 bp adds up quick over long periods of time. It is said there’s nothing more powerful than compound returns. Over the past 20 years the S&P500 has risen from 459.27 to the current 2,019.42, which annualizes to +7.6857% over the past 20 years through today (derived from [2019.41/459]^[1/20]). I’d rather have bond market (aka fixed income) risk(s) than stock market risks.
Speaking of fixed income risk, here they are: Fixed Income Securities (including U.S. Treasury Securities) have default risk, interest rate risk, inflationary risk, liquidity risk, currency risk, credit quality risk, repayment or principal risk, streaming income risk, reinvestment risk, duration risk, convexity risk, maturity risk, market risk, political risk, and taxation adjustment risk, despite the caveat of “full faith and credit of the US Government” for US Treasuries. Makes you wonder doesn’t it! Just joking, obviously, fixed income is safer than equities, even when analyzing high yield fixed income indices.
Here’s the annualized data on the DJIA, which I have just personally calculated for you. It closed today at 17,511.57, and in December of 1994, the last trading day of the year it closed at 3,834.44. So for 20 years the annualized DJIA return has been +7.890% (calculated from [17511.57/3834.44]^[1/20]). For ten years the annualized return for the DJIA has been +4.968%, going from 10,783.01, on the last trading day of 2004, to the current 17,511.57 (calculated from [17511.57/10783.01]^[1/10]).
In December of 2004, on the last trading day of the year, the S&PMidCap400 closed at 663.31, today it closed at 1,430.89; This annualizes to +7.991%, derived from [1430.89/663.31]^[1/10].
This is why my main “master strategy” (which after trading options for ten years I believe to be the best) has been to amplify the stock indices (rebalanced annually) using stock index options (which for safety have an expiration date going out more than two years), with 10 to 25 percent allocations, and enhancement ratios of 5:1 to 7:1 (this would require a level II purchase of a deep in the money call index option, and perhaps the selling or writing of an out of the money call, to mitigate extrinsic value decay, by turning the trade into a level III e.g. vertical bull call debit spread— potentially making the options positions theta positive); while placing the remainder, the 75 to 90 percent, into high yield fixed income. I’m sure you can do the math, to discover what that hypothetical portfolio construction strategy annualizes, based on long term past performance figures. Amazing isn’t it?! Who can beat that?!
By Andrew G. Bernhardt
Bernhardt Capital Management LLC 