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How This Year’s Hottest Investment Could End Up Costing You

Cash has rarely been this hot on Wall Street. Financial advisers warn holding too much can burn a hole in your portfolio. With markets rocky and cash earning 5% or more, investors have boosted their holdings of money-market funds to a near-record $5.6 trillion, according to the Investment Company Institute. Both individuals and institutional investors are piling in—asset managers now have roughly one-fifth of their portfolios in money-market funds, State Street data show. Cash was trash for years on Wall Street, where low interest rates left investors buying every dip, saying there was no alternative to stocks. The prospect of a prolonged period of higher rates has upended that thinking, buffeting both stocks and bonds while increasing the returns offered by some of the safest, shortest-term investments such as money markets. Yields fluctuate with benchmark rates set by the Federal Reserve. Though considered to be among the safest of all investments, deposits in the funds aren’t insured and they have occasionally gone haywire in times of stress. The Fed’s most aggressive interest-rate campaign in decades has lifted rates near the returns many investors would expect from their portfolio on an average year. With the central bank expected to hold rates near this level for some time, money-market funds are now considered a viable investment rather than just a place to stuff cash. Fees are also relatively high. Investors pay annual expenses based on how much they have invested in a fund. Many large money-market funds charge 0.5% a year in fees, if not more, to support upkeep including administration, trading costs and employee salaries. Taxes are another consideration, and often a big one. Interest payments on money-market funds are generally taxed as ordinary income, not at dividend or capital-gain rates. How the income is taxed at the federal or state level will depend on the investments a fund holds. Interest from U.S. Treasury debt, for example, is taxable at the federal level, but not for states.

Investors Are Piling Into Actively Managed ETFs

Active funds still make up a sliver of the roughly $7 trillion ETF market—less than 6% of total assets—but have attracted about 30% of the total flows to ETFs so far this year, according to Bloomberg Intelligence. That follows a banner year for active ETFs in 2022, when they gathered roughly 14% of total flows. Investors are pouring money into actively managed exchange-traded funds, underscoring the appeal of active strategies after years of calls for passive index investing to take over. “Active ETFs are garnering more interest given the market volatility we’ve been in, and especially given there are so many leading players that people are familiar with that now offer an ETF version of their strategies,” said Todd Rosenbluth, head of research at VettaFi, a data and analytics firm. The popularity of active funds this year highlights their durability in the face of years of research showing actively managed stock funds underperforming broad indexes over long time horizons in the U.S. It also shows how ETFs are helping bring more complex trading strategies to the masses as individual investors buy stocks and ETFs at a record pace. JPMorgan’s Equity Premium Income ETF, which invests in defensive stocks and employs options strategies to generate income, has been the most popular active ETF by far in 2023, taking in $7.1 billion of fresh cash, according to FactSet. The fund, known by ticker symbol JEPI, provided a 12-month rolling dividend yield of 11.7% during the past year. It launched in 2020 and has exploded in popularity, roughly quadrupling its assets under management from $5.8 billion at the start of 2022 to $24.6 billion today. Another JPMorgan income-focused options strategy is among this year’s top 10 active ETFs for flows. Four of the other top 10 funds are fixed-income funds, while the remaining four are actively managed equity strategies. As economic conditions change, some active strategies are falling out of favor. Investors have fled State Street’s SPDR Blackstone Senior Loan ETF, which invests in loans issued by companies that typically have poor credit ratings. The fund’s $1 billion outflow this year is the biggest among active ETFs and represents about one-sixth of its assets at the start of the year. Cathie Wood’s ARK Innovation fund, perhaps the best known active ETF, has faced roughly $185 million of outflows. Ms. Wood’s fund, which invests mostly in unprofitable but fast-growing technology companies, has rallied 14% this year after a dismal 2022, in which it fell 67%.

Climate Risk Is Becoming Uninsurable

Floods, electrical storms and wildfires, together with raw-material inflation, are pushing up premiums for so-called catastrophe insurance. For insurers, average annual losses—a conceptual long-run estimate of future losses—could reach a record $133 billion, according to risk-assessment firm Verisk Analytics. Uninsured losses will be even higher. In North America, only 51% of natural-catastrophe risk is covered. In Europe, it is 44%, and in Asia a paltry 12%. The fear is that more areas could become uninsurable. Underwriting requires confidence that models somewhat accurately reflect risks, which climate change is amplifying in scary, unknown ways. Forecasters are starting to marry both methods, with some startups promising transformative results. Other startups specialize in disasters that are too unpredictable for many insurance policies, with protection often depending on limited government support. U.K.-based CatRisk Solutions, for example, provides an earthquake-loss model covering 155 countries. In 2020, New York-based First Street Foundation released an online application where anyone can check their property’s flood exposure. It suggested that federal maps severely underestimate risks. The rising cost of disasters is more about population increases in hazardous areas than climate change itself. Inigo’s research suggests that demographic shifts have caused more than a doubling in expected annual losses since 1970, compared with a 25% increase from climate change.

When Investors Do the Most Harm With Market Timing

Last year was a disaster in the markets across all asset classes. Unfortunately, the average mutual-fund investor fared even worse than market indexes would have predicted. This phenomenon is known as the “return gap” or “investor gap.” This gap captures the difference between the average return for a mutual fund and what an average investor in that fund actually earns. A mutual fund’s stated return will reflect the average return of its stock or bond holdings over a period, assuming an investor puts in a lump sum of money and leaves it alone. But because investors on average tend to move in and out of investments and often at the wrong time—such as selling when the market has already hit a bottom and buying back in when the market is at the top—they often don’t experience this stated return in full. Thus, what investors on average are actually experiencing in the fund is better captured by its asset-weighted return, a measure that gives more weight to returns when there is more money in the fund, and less weight to returns when there is less money in the fund. The first interesting finding is that in general, the return gap for an investor is worse in down years than up years. For instance, for small-cap equities the average return gap in down years is 1.19 percentage points and the average return gap in up years is 0.76 percentage point. This means that the average investor does 0.43 percentage point more damage to a small-cap portfolio in down years versus up years due to poor market timing. The three exceptions to this finding, according to our research, were: fixed income, emerging markets and value equity. As it turns out, for these asset classes, up years actually have higher return gaps than down years. As for market volatility, high-volatility years have higher return gaps than low-volatility years across all asset classes. Volatility seems to induce poor decisions in investors—people tend to get spooked at the bottom and abandon their positions, and then enter back into the positions when the market has already rebounded. The biggest gap was found in funds focused on value stocks, which are those perceived to be trading at a lower price relative to their fundamentals. The average value equity fund has a return gap of 1.46 percentage points in high-volatility years—the biggest gap we identified in our study—and a return gap of 0.58 during low-volatility years. This means the average investor loses an extra 0.88 percentage point in high-volatility years in a value equity portfolio.

America’s Oil Patch Loses Its Luster

The oil-field services sector is still humming along, but its clients are casting their gaze past America’s once-booming shale patch. U.S. benchmark natural-gas futures have been hovering just above $2 per million British thermal units recently, well below the $3.45 per million British thermal units that price producers say they need on average for drilling to be profitable, according to a first-quarter energy survey by the Kansas City Federal Reserve. Domestic oil-drilling activity has also been weak. The U.S. oil rig count has dropped almost every week since early February, according to Baker Hughes data. This might reflect caution and price sensitivity from private drillers, which had been quick to add rigs last year but were also quick to drop them when oil prices declined in parts of this year. After some steep cost inflation last year, break-even prices have risen for producers, according to Kansas City Fed survey results. Major international oil companies that previously held back on expensive, long-cycle offshore drilling projects have again embraced it after generating prodigious cash flows last year. Investors have become more receptive to such projects after Russia’s invasion of Ukraine highlighted the importance of energy security. Weakness in North American short-cycle activity notwithstanding, oil-field services firms’ unwavering pipeline of long-cycle contracts signal that the world’s producers, whether major European oil companies or national oil companies, are still in the fossil-fuel business for the long haul.

Green Energy Is Stuck at a Financial Red Light

The wind and solar industries have always suffered from the short-term nature of subsidies, with federal tax credits often extended in nail-biting one-year increments. Last year’s climate bill changed that, giving the industry subsidies that last at least a decade. But just as policy winds blow in their favor, two critical growth drivers—interest rates and equipment costs—are moving in the wrong direction. Wind and solar projects are especially sensitive to rates because debt can comprise as much as 85% to 90% of capital expenditures. Renewable developers have known only low rates for most of their history. Nearly all U.S. utility-scale solar facilities and 85% of onshore wind farms were installed since 2009, during which period the target federal-funds rate was close to 0% in eight out of 13 years. Not any more: After the most recent hike, rates are the highest since 2007. Renewable energy projects tend to be financed with floating-rate loans that rise and fall with the benchmark interest rate. Thankfully, most of those projects are well-shielded from rate risk because lenders require them to hedge at least 75% of their loans through swaps, according to Elizabeth Waters, managing director of project finance at MUFG. Most ended up hedging 90-95% to lock in low rates, she noted. But those swaps won’t help new projects. Some new solar and wind projects facing higher borrowing costs than when they were planned might not make it off the drawing board. Borrowing isn’t the only thing that costs more. Following years of price declines thanks to technology and economies of scale, equipment is getting more expensive too. Trade policies aimed at Chinese manufacturers have caused delays and shortages for the solar industry, which relies heavily on the country for its components. German utility RWE, an active developer in the U.S., said in its annual report released last week that imports of solar modules from Asia are now subject to “stringent checks” and said it could fall behind on its expansion plans if the U.S. continues to “impede the procurement of solar panels.” After falling to a record low in 2020, the average price of a solar photovoltaic system rose in 2021 and then again in 2022, according to data from the Solar Energy Industries Association and Wood Mackenzie. Meanwhile, the average cost to build an onshore wind farm in the U.S. rose in 2020 and 2021 before leveling off last year, according to data from BloombergNEF. Supply-chain issues and interconnection delays already started slowing the clean power industry last year: In 2022 it installed 25.1 Gigawatts of total capacity, a 16% decline from a year earlier, according to the American Clean Power Association, which tracks solar, wind and energy storage. While that’s still enough to meet roughly half of Texas’ electricity demand, it was nonetheless below expectations–though part of the drop was driven by an preplanned phase-down for tax credits commonly used by the wind industry before the Inflation Reduction Act was passed. Ultimately, solar and wind’s ability to absorb cost and interest-rate hikes depends on how willing utilities and corporations are to pay higher prices. Many onshore wind and solar projects have been able to renegotiate pricing on their power purchase agreements because demand is robust, according to industry executives. But cracks are showing for offshore wind, which is more exposed to rising costs and rates because it takes longer to develop. BloombergNEF estimates that the weighted average cost of capital for U.S. offshore wind projects rose to 5.25% in 2022 from 4.41% in 2020.

Are Stocks Undervalued Yet?

Eight valuation models suggest that even after recent declines, the stock market isn’t a good value The sobering news is that even at its lowest point in mid-May, the S&P 500 index wasn’t even close to being undervalued according to any of eight valuation models that my research shows have the best long-term track records. The eight valuation indicators that have proved best at predicting 10-year returns, inflation-adjusted, for the stock market are a subject I have covered before. And while it is possible that other valuation models exist that are just as good at predicting bull markets, I haven’t discovered any. On balance, these eight indicators at the mid-May low stood at more than twice the average valuation of the bear-market bottoms seen in the past 50 years. And, seen in comparison with all monthly readings of the past 50 years, the average of the eight measurements was in the 88th percentile. Let’s start by looking at the cyclically adjusted price/earnings ratio, or CAPE, made famous by Yale University finance professor (and Nobel laureate) Robert Shiller. It is similar to the traditional P/E ratio, except that the denominator is based on 10-year average inflation-adjusted earnings instead of trailing one-year earnings. As with the traditional P/E, the higher the CAPE ratio, the more overvalued the market. On May 19, the CAPE ratio stood at 30.4. That is more than double the average CAPE ratio at all bear-market bottoms since 1900, according to an analysis by my firm, Hulbert Ratings, of bear markets included in a calendar maintained by Ned Davis Research. While some might think comparisons from so long ago aren’t relevant under current conditions, a comparison with more-recent decades yields a similar conclusion. The average CAPE ratio at bear-market bottoms over the past 50 years, for example, is still 17.0. Another perspective is gained by comparing the CAPE’s reading at the May low with all monthly readings over the past 50 years. Even at the recent low, the CAPE was in the 95th percentile of all results—more overvalued than 95% of all the other months over the past 50 years. This message of extreme overvaluation isn’t easily dismissed, since the CAPE ratio has an impressive record predicting the stock market’s 10-year return. You can see that when looking at a statistic known as the R-squared, which ranges from 0% to 100% and measures the degree to which one data series explains or predicts another. When measured over the past 50 years, according to my firm’s analysis, the CAPE’s R-squared is 52%, which is very significant at the 95% confidence level that statisticians often use when determining if a correlation is genuine. Many nevertheless reject the CAPE for various reasons. Some argue that the ratio needs to be adjusted to take into account today’s interest rates which, though higher than they were a year ago, are still low by historical standards. Others contend that accounting changes make earnings calculations from previous decades incomparable with today’s. Here are those seven indicators, listed from high to low in terms of their accuracy over the past 50 years at predicting the stock market’s subsequent 10-year return, and showing by how much each indicates that the stock market remains overvalued: • Average investor equity allocation. This is calculated as the percentage of the average investor’s financial assets—equities, debt and cash—that is allocated to stocks. The Federal Reserve releases this data quarterly, and even then with a time lag, so there is no way of knowing where it stood on the day of the mid-May market low. But at the end of last year it was 68% higher than the average of the past 50 years’ bear-market bottoms, and at the 99th percentile of the 50-year distribution. • Price-to-book ratio. This is the ratio of the S&P 500 to per-share book value, which is a measure of net worth. At the mid-May low, this indicator was 95% higher than it was at the past bear-market bottoms, and was in the 90th percentile of the distribution. • Buffett Indicator. This is the ratio of the stock market’s total market capitalization to GDP. It is named for Berkshire Hathaway CEO Warren Buffett because, two decades ago, he said that the indicator is “probably the best single measure of where [stock market] valuations stand at any given moment.” At May’s market low, the Buffett Indicator was 145% higher than at the average of past bear-market lows, and at the 95th percentile of the historical distribution. • Price-to-sales ratio. This is the ratio of the S&P 500 to per-share sales. At the mid-May low it was 162% higher than at the past 50 years’ bear-market bottoms, and at the 94th percentile of the historical distribution. • Q ratio. This indicator is based on research conducted by the late James Tobin, the 1981 Nobel laureate in economics. It is the ratio of market value to the replacement cost of assets. At the mid-May low it was 142% higher than at the bottoms of the past 50 years’ bear markets, and in the 94th percentile of the historical distribution. • Dividend yield. This is the ratio of dividends per share to the S&P 500’s level. It suggests that the stock market is 121% overvalued compared with the past 50 years’ bear-market lows, and in the 87th percentile of the 50-year distribution. • P/E ratio. This is perhaps the most widely followed of valuation indicators, calculated by dividing the S&P 500 by component companies’ trailing 12 months’ earnings per share. It currently is 16% above its average level at the lows of the past 50 years’ bear markets, and at the 58th percentile of the distribution of monthly readings.

Big Tech Depends on AI Shining Through Cloud Haze

Amazon’s AWS, Microsoft’s Azure and Google’s Cloud segments generated a combined $157 billion in revenue last year. But, according to consensus estimates from FactSet and Visible Alpha, that combined revenue is expected to show 21% year-over-year growth for the March quarter—4 percentage points lower than the growth shown in the December quarter and the lowest combined growth on record for the three. The June quarter is expected to show further deceleration, with combined revenue growth falling below the 20% threshold. Amazon’s AWS—the largest of the three—is expected to increase first-quarter revenue by just 15% year over year, which would be its slowest growth on record. Operating earnings for that segment are also expected to slide by 17%, year over year. Analysts also expect record-low growth for Microsoft’s Azure of 27% year over year. Google Cloud, a little over half the size of Azure, is expected to increase revenue at only a slightly better pace of 29% for the first quarter. But the search giant might have some better news on its bottom line, at least optically. According to a filing Thursday, Google is reallocating some expenses from its cloud business to its core search segment. The reclassifications trimmed more than $1 billion from the cloud segment’s reported operating loss for 2022 and will likely help the unit tip into profitability sooner. Microsoft was the first to hop on the bandwagon, with Chief Executive Officer Satya Nadella announcing in mid-January a plan to adopt the popular ChatGPT technology from OpenAI across its products. It is too early for generative AI technology to be driving much if any revenue for all three companies, but it isn’t too early for the costs of those projects to start hitting their bottom lines. And those higher costs will come as the slumping economy compels more large companies to slow down their tech spending. Tim Horan of Oppenheimer trimmed his estimates for Amazon’s AWS and Microsoft’s Azure businesses earlier this month, noting that “enterprises are sweating legacy on-prem infrastructure longer as they take a wait-and-see approach to the economy.”

Silicon Valley Investors Give Startups Survival Advice for Downturn

After years of funneling cash into startups’ grand ambitions, Silicon Valley’s SIVB 4.00% investors are engaging in the grim ritual of delivering survival advice to their portfolio companies. In recent online slide presentations, blog posts and social-media threads, venture-capital doyens including Lightspeed Venture Partners, Craft Ventures, Sequoia Capital and Y Combinator are telling the founders that they need to take emergency action for what could be the sharpest turn in more than a decade. Their advice includes cutting costs, preserving cash and jettisoning hopes that hedge funds or other investors will swoop in with big checks. The investors’ admonitions are a departure from the growth-above-all mantra for startups in recent years, and come as the venture market is showing signs of sputtering. Funding for global startups—at around $58 billion in commitments midway through the second quarter—is on pace to drop by about one-fifth in the period compared with the previous quarter, according to analytics firm CB Insights. The tech-heavy Nasdaq Composite Index is down about 25% from its all-time high in November, and SoftBank Group Corp. , which has poured more than $100 billion into investments, this month reported a $26.2 billion loss in the first quarter as valuations plummeted in its portfolio of tech companies. Startup investors have sounded alarm bells in previous moments of financial and economic tumult, including the start of the Covid-19 pandemic. But partners at venture funds say the current situation is different. In past downturns, the Federal Reserve cut rates and pumped money into markets to support the economy, providing liquidity and cheap capital. This time, the central bank has been raising rates and taking money out of the system in a bid to tame inflation. The Fed’s moves are making capital more expensive, and increasing the pressure on companies to preserve their cash. Sequoia, one of Silicon Valley’s most storied firms, warned founders and CEOs in a March 2020 memo about the risks to businesses from the looming global health crisis, including supply-chain issues and canceled travel. The latest presentation mirrors the message in a 50-slide presentation Sequoia sent to founders in October 2008, saying a housing-led recession and overleveraged financials—which it illustrated with a butchered carcass and a gravestone—meant that companies needed to control spending, focus on quality and lower risk. Some big deals are still getting done. Space Exploration Technologies Corp., or SpaceX, Elon Musk’s rocket company, just raised a fresh round of upward of $1.5 billion in funding, for instance. And many startups stockpiled enough cash from the gusher of fundraising last year to continue operating for several more years on existing funds, said Neeraj Agrawal, a general partner at Boston-based Battery Ventures.

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