Spread Between US and German 10-Years Bonds At Widest Level Since 1989

On Tuesday, the spread between the US 10-year bond and the German 10-year bond reach 180 basis points (currently at 176 basis points). This was the widest spread since May 11, 1989.



The spread between the two countries 2-year bonds is at nearly an 8-year high and the spread between the two countries 5-year bonds is basically at its widest levels since 1999.





Historically, the spread between the US and German'y 10-year bond hasn't had any correlation to US stock prices. However, since 2009, the correlation between to the two series is an astonishingly high 0.88.

Knowledge Continues Outperforming In 2015

We have developed two indexes that are designed to track the world's leading innovators based on our proprietary intangible-adjusted data  We have a developed markets knowledge leader index and an emerging markets knowledge leader index. Both indexes are equal-weighted and are rebalanced twice a year (April and October). So far in 2015, knowledge has outperformed the general market (to learn even more about our indexes please click here and here).

The Gavekal Knowledge Leaders Developed World Index has returned 5.13% through the close yesterday. Meanwhile, the MSCI World Index has returned only 3.26%, leading to a 187 basis point outperformance through roughly the first month and half of the year. This is just a further continuation of the outperformance of the index since it was started in April 2007. Since that date, the Gavekal Knowledge Leaders Developed World Index has outperformed the MSCI World Index by over 42%.





The Gavekal Knowledge Leaders Emerging Market Index has gained 4.33% so far in 2015. During this same period, the MSCI Emerging Market Index has gain 3.16%. The Gavekal Knowledge Leaders Emerging Market Index has outperformed by 117 basis points. Similar to the developed markets index, the emerging markets index has significantly outperformed since its inception date in 2007.  The Gavekal Knowledge Leaders Emerging Market Index has managed to return 214.05% since April 1, 2007 which has led to 86.09% outperformance versus the MSCI Emerging Markets Index.





Both of the indexes are priced daily and can be found on your bloomberg terminal using the KNLGX Index or KNLGEX Index tickers.

Top Line Growth is Becoming More Bifurcated Across Economic Sectors

The growth leaders and laggards are becoming more apparent by the day - or at least analysts think so. In the below charts we show the median and average top line expected next twelve months growth estimates for certain economic sectors. The leaders are holding their own despite the strong dollar and persistent slow global growth while sales estimates for the laggards are accelerating to the downside. For what it's worth, the other economic sectors are still stuck in muddle through territory
(0-3% top line growth estimates), though expectations have been tempered of late.

Sales growth estimates leaders:






Sales growth estimates laggards:

Industrial And Materials Making The Most New Highs Since Last Summer

We have had a bit of cyclical bounce over the past month in the developed stock markets. Late cyclical sectors (energy, materials, industrials) are three of the top four performing sectors and the other top performing sector is an early cyclical sector (consumer discretionary).



The percent of issues making new 52-week highs has broken out somewhat in the industrial and material sectors. In both of these sectors, we see the greatest percentage of companies making new one-year highs since last July. 17% of industrial stocks are at its one-year high and 23% of material stocks are its one-year high. Overall, 18% of all MSCI World Index stocks are trading at its one-year high, the most since last December.

North American Growth Counter-Cyclicals Still Equity Leadership

We divide stocks in all ten economic sectors into four basic, equal weighted baskets:
1) Early Cyclicals: These are consumer discretionary companies.
2) Hyper Cyclicals: These are financial and technology companies.
3) Late Cyclicals: These are energy, material and industrial companies.
4) Counter-Cyclicals: These are telecom, utility, consumer staple and health care companies.

Beyond that, we sub-divide the counter-cyclical basket in a group of growth counter-cyclicals represented by the consumer staple and health care companies.  These counter-cyclicals have been the leadership group for the last five years.

Over the last month:
1) Late cyclicals in North America have outperformed the MSCI North America Index by around 2%, while they have outperformed the MSCI World Index by about 2.5%.  Yet, these stocks have been among the worst performers compared to the MSCI World Index over the last 5 years.
2) North American growth counter-cyclicals broke out to new all-time highs relative to both the MSCI North America and MSCI World Index.  These stocks have outperformed all cyclicals by about 30% since the beginning of 2011 and continue to trace out higher highs and higher lows.
3) North American early cyclicals have yet to eclipse their 2013 highs relative to the MSCI North America Index, but they are at new highs relative to the MSCI World Index.
4) North America hyper cyclicals are still locked in a long-term trading range relative to the MSCI North America but are in a 4 year period of relative outperformance compared to the MSCI World Index.

On balance it would appear there has not been any sort of leadership change among companies in North America.  Charts are available for download here: MSCI North America Baskets.

Intangible Case Study: Becton Dickinson (Ticker: BDX)

Our good friend Jeff Saut from Raymond James highlighted our favorite topic in his daily "Morning Tack" today. That topic of course is intangible capital! Our focus in Denver is finding companies that invest and create large reservoirs of intangible capital in order to deliver sustainable, growing earnings in the future. This stream of future earnings is underappreciated by the greater financial community due to conservative accounting practices (more on this in a minute).  We have deemed these type of companies Knowledge Leaders. You can learn more about  Knowledge Leaders here, here, and here.

Jeff mentioned a few specific stock examples, including the one we highlight below, that are Knowledge Leaders. So today we thought we would look at Becton Dickinson (Ticker: BDX)* and see how intangible investment affects a company's financial statements.

*BDX is a global medical technology company that develops, manufactures and sells medical devices, instrument systems and reagents used by healthcare institutions 

Under traditional company accounting practices, intangible investments are treated as a current expense rather than as an investment in a company's future. Thus, investments in research and development, employee training, brand building, and codified information reduce current income instead of increasing the asset base in which a company derives its future earnings from. The academic community as well as government agencies such as the Bureau of Economic Analysis (BEA) are leading the charge in educating the greater financial community about the importance of intangible capital. The most high profile case has been the inclusion of R&D and artistic originals in the calculation of GDP  by the BEA instead of treating them as intermediary expense as they previously did.

We have taken over 2400 company financial statements and adjusted them to properly include investments in intangibles going back to 1980 where the data is available. In the tables below, we will look at how much BDX"s financial statements and profitability changes after properly capitalizing intangibles.

At the heart of this story is the fact that intangibles are in investment and should be treated similar to traditional capital expenditures (albeit with a shorter useful life) from an accounting standpoint. Let's begin by analyzing BDX's current investment approach. Under traditional accounting, it looks as if BDX only invests about 7.7% of its sales. A relatively low number considering BDX is in a highly competitive and profitable industry that commands 51% gross margins. However, after including intangibles investments we see that BDX actually is investing nearly 3x that level in order to keep one step ahead of the competition. They spend 6.2% of sales on R&D and 7.4% on brand building and other firm specific resources. In total, they spend 21.4% of sales on investments for future growth.

Traditional Accounting Technique



Intangible-Adjusted Results


By consistently investing about 13.5% of their sales in intangible capital over the past decade, BDX has created a large long-term asset on its balance sheet that will produce income for years to come. We can see this by analyzing their balance sheet before and after you adjust for intangible capital. Under traditional account practices, BDX has about 22% of its assets in cash, 29% of its assets in PPE and 29% of its assets in long-term assets. However, after adjusting for intangibles, we see that BDX has a much greater percentage of its assets in long-term assets. In fact, nearly 42% of its assets are in long-term assets and nearly 18% of its assets are intellectual property and only 23.8% are in PPE.

Traditional Accounting Technique


Intangible-Adjusted Results


These long-term assets increase operating cash flow and increase margins of BDX. BDX looks as if it only generates about 20 cents in operating cash flow for every dollar in sales. However, after adjusting for intangibles we see that it actually generates about 34 cents in operating cash flow for every dollar of sales. In addition, BDX's EBITDA margin increases from 26.7% to 40.3% and net profit margin increased slightly from 14% to 15.4%. This is a more profitable company when intangibles are properly included than is generally perceived.

Traditional Accounting Technique


Intangible-Adjusted Results


Traditional Accounting Technique


Intangible-Adjusted Results


A sustainable competitive advantage, or a large moat as Warren Buffet puts it, is key for a company to deliver future earnings growth. As financial analysts and investors it is our job to understand where that competitive advantage comes from and figure out how sustainable it is. We believe the first step in identify future investments is to properly calculate financial statements that reflect true investments in the future. After doing this, it becomes more apparent why knowledge leaders continue to be industry leaders.

Commercial Traders The Most Long 30Y Treasuries Since Early 2014

Over the last five years the signal given by investor positioning in options and futures contracts on the 30-year treasury bond has proven prescient. Each time commercial traders have moved to a long position in the long bond rates have been near a peak. Over the last few weeks the commercials have shifted their positioning dramatically, moving from one of the largest short positions to a net long position for the first time in almost a year. If history is a guide then we may be near an intermediate term peak in rates.

Review of the Mathematical Distortions of Market Cap Weighted Indexes

Earlier today we had a client ask us to verify a statistic they came across showing that the few largest companies in the world were responsible for the vast majority of the total return of the stock market over the last year. We took that prompt as a great opportunity to review the massive distortions created by market cap weighted indexes (which is most indexes).

In the table below we break out the companies in the MSCI All Country World Index (ACWI) into buckets. We then compare the aggregate bucket market cap weighting in the index (2nd column) to the bucket's percent of the index on an equal weighted basis (3rd column) and then finally we show the market cap weighted contribution to the total return of the ACWI over the last year (last column).

What we show is that the largest 25 companies in the ACWI comprise 15.6% of the market capitalization of the index, but on an equal weighted basis this group accounts for only 1% of all the investable stocks in this universe. Further, over the last year this small group of companies has accounted for 23% of the entire total return of this global benchmark.

Where things really get interesting is looking at the smallest 2389 stocks (out of 2589) that compose the ACWI. This group accounts for 92% of the developed and emerging market stock universe, but only accounts for 50% of the market capitalization of the index and only about 41% of the cap weighted total return of the index over the last year.

Needless to say, the capitalization weighting of the major global benchmarks can create some serious mathematical distortions that need to be considered by investors. From an investment execution perspective, investors need to be aware of the underlying position sizes and exposures created by market cap weighted ETFs and mutual funds.

Short-term Momentum of MSCI Developed Countries

Everyday we calculate the percent of stocks in every country within the MSCI World Index that are over their 50-day moving average.  Generally, when 80% of stocks in a given country are over their 50-day moving average, this is a short-term overbought signal.  Conversely, when only 20% of stocks in a given country are above the moving average, this is a short-term oversold signal.

As of today, only the following countries are in short-term overbought territory:
1) Belgium
2) France
3) Norway
4) United Kingdom

As of today, there are no countries that are short-term oversold, but Ireland is the closest with only 25% of stocks over their 50-day moving average.

Charts are available for download here: MSCI DM Countries Percent Over 50-Day Moving Average

Fed PMIs Were Almost Universally Weaker In January

We had our first look at manufacturing conditions in February (NY Fed Empire Survey came in below consensus by a few points) and tomorrow we have the industrial production report for the US. What should we expect when that report comes out? Well, if the recent results out of the regional Fed PMI surveys are any indication, industrial production might disappoint.

We have created several diffusion indexes measure the 1-month, 3-month, 6-month and 12-month change in 12 federal reserve PMI surveys. When a survey improves over a given time frame, it registers are +1 and when a survey deteriorates over a given time frame it registers a -1. For January, 11 out of the 12 Fed surveys declined from the previous month. Over the past three months and six months, nine out of the twelve surveys have declined. Finally, over the past year, eight surveys are lower and four surveys are higher.

Is That Leveraged ETF Worth It? Comparing SSO and VOO

As ETFs control a larger number of assets under management, it is no surprise that the options available to investors are getting ever more exotic. One of the early examples (and thus we actually have history available) of exotic ETFs are leveraged ETFs. Leveraged ETFs attempt to to mimic the daily change in an index, in today's case the S&P 500, by a defined multiple (i.e. 2x, 3x, etc). Today, we will look at one of the more highly used leveraged ETF: Proshares Ultra S&P 500 (ticker: SSO).

According to the ProShares website, SSO has been around since June 2006 and charges a fee of 89 basis points. The goal, again as stated on the website, is to return two times the DAILY return of the S&P 500. We emphasize daily, as does ProShares on their website, because as we all know due to the power of compounding a security with similar daily returns can have very different returns over longer periods.  As of the end of last year, SSO had a little over $2.3 billion under management.

To add a little context to how SSO has performed, we will compare it to the low cost, "gorilla" in the room: Vanguard 500 Index Fund (ticker VOO). VOO's "admiral shares" (minimum investment is $10,000) have a ridiculously low fee of 5 basis points and manages an enormous $196 billion. Let's take a look at how these two ETFs compare on a four-year, annualized basis.

Over the past four years, SSO has returned 26.1%, while the VOO has returned 14.4%. SOO hasn't quite delivered 200% of the return of VOO but it has returned 180%. While SSO's return hasn't been twice as much of VOO's, the volatility has been. SOO has had an annualized standard deviation of 23.1% while VOO standard deviation has been just 11.4%. The max drawdown of SOO has been slightly more than 2x the max drawdown of VOO. The max drawdown of SOO over the past four years is 13.9% while the max drawdown of VOO has been 6.8%.



From a risk-adjusted perspective, SOO has delivered a higher annualized alpha of 7.7% versus VOO's annualized alpha of 5.4%. SSO's Sharpe Ratio is lower, however, it is still above 1. SSO has had a Sharpe Ratio of 1.13 while VOO has had a Sharpe Ratio of 1.27. SOO has also had a lower Treynor Ratio than VOO (14.9 vs 16.69).  Surprisingly, SSO has a higher Information Ratio than VOO (8.1 vs 7.7).



When we look at the active management statistics, we see where the leverage really comes into play. SOO has a much higher tracking error (11.6% vs 3.7%). It has has an upside capture ratio that is 2.14x as great as VOO's and a downside capture ratio that is 2.06x as great as VOO's. The good news for SOO investors is that it is at least capturing more upside than downside. SSO has a Up/Down Capture Ratio of 1.46 while SSO has an Up/DOwn Capture Ratio of 1.40.



So breaking it all down, is SOO worth it?  SOO isn't quite delivering 2x the returns over a four year period but its volatility and max drawdown is over 2x as high. From a risk-adjusted perspective, the plain vanilla VOO delivers a higher Sharpe Ratio and Treynor Ratio but its annualized alpha is lower. As with a lot of things with life, it all comes down to price. The fee of SOO is nearly 18x greater than VOO so investors need to really make sure that what the leveraged ETF is actually delivering makes sense in their portfolio.