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2016 Best Bets - Part II

     After what now appears to be a very timely Part I update pointing to lower prices in the first quarter of 2016, let’s now move on to Part II where we’ll cover selectivity. Which asset classes, styles, sectors, or select industries are looking the most attractive?

 

Net Exposure Reduced Again

     Just a quick update for our current clients who are wondering what we think of the massive selling pressure in the first four days of 2016. Through much of November and into early December, 2015 we sat with a balanced allocation in our tactical equity and blended asset strategies. What does balanced mean? It means we were holding 20% cash with the remainder invested in conservative relative strength leaders (against the market or their own sectors). By the middle of December it became somewhat obvious that the widely anticipated Santa Claus rally would not happen and in the final days of the year, our Net Exposure screen pulled us toward a higher defensive position. Practically we sold a few things, raising our cash to 25% and replaced most “high beta” holdings with conservative/defensive things like consumer staples, healthcare and gold. Now in just the first few days of trading, we have raised cash again. Our Retirement Income strategy went to 80% cash last summer and our Freeway (tax efficient) income strategy is still sitting on high cash with 45% municipal bonds which are making all time new highs daily. As of YESTERDAY, this is the cash position of each of our strategies:

 

Tactical Equity Strategies

New Power – 20.2%

Worldwide Sectors – 36%

High Dividend – 31%

 

Blended Asset Strategies

All Season – 34% plus hedges like gold, long/ short funds and income

Foundations – 34%

Gain Keeper Annuity – 60%

 

Income Strategies

Retirement Income – 80% , since July of 2015, holding preferred securities

Freeway Income – 33% still holding preferred securities and muni bonds

Holding Tank – 100% cash

 

     All strategies are dynamically adjusting to market conditions on a daily basis based on our proprietary Net Exposure, Selection and Position Size criteria. In this case, that means becoming more and more defensive with an eye toward pending opportunities. Investment results are the residue of excellent design and execution over time and you are witnessing it all happening in this market.

 

Part II – Selection

 

Start Watching True Value

 

     Take a quick look at the five-year daily chart below. In red, I am showing the Nasdaq 100 index commonly owned through the QQQ ETF. This index represents the top 100 large cap growth stocks as a pure package. In green, I am showing an average of six mutual funds that I would consider pure value funds with diehard value fund managers. These guys sometimes do die hard as you can see from the green chart, which peaked in July of 2014 and is down a full 20%. Comparatively, the pure growth side of the market is up 15% since that same July peak.

 


 

     Near the end of raging bulls, we often see a strong preference for growth as “it” becomes more and more scarce. The run up in the FANG stocks (Facebook, Amazon, Netflix and Google) last year was a great example as some of the only names to generate positive returns. What you see is a wide gap in performance and one that will ultimately close again. When does that happen? It happens at a time like this when investors finally decide to take profits in their “growth” names with the type of fear and selling pressure we’re seeing now. Then there is a brief period (1-2 quarters) when both groups fall together as they did spectacularly in 2008 and then…. THEN we see the value group rise from the ashes taking over leadership at a time when recession starts to emerge. It is too early to buy pure value and the time frame for doing so looks more like the second half of 2016 than the first half. But the opportunity for a great buy in Value is coming.

 

Sectors

 

     Most of our sector decisions are based on intermediate term relative strength and when everything is falling, we don’t have much good information to derive decision-making. Leadership today takes the form of losing less than something else. Cold comfort right? That is a technical perspective only, so let’s take some time looking at which sector groups look the most attractive from a fundamental perspective. Here we look at dividend rates, P/E ratios, Price to Book ratios, free cash flow, earnings trends, market weightings, and stage of the economic cycle. I won’t bore you with the detail but here’s what our analysis points to on a weight of evidence basis. Sectors we like for 2016 are as follows (not in any order)

 

Technology

Consumer Staples

Consumer Retail

Healthcare

Materials

Services (business)

Telecom

Industrials

 

Things we don’t like for a variety of reasons – anytime in 2016

 

Energy

Utilities

Financials

 

I’ll breakdown a few of these to give you an example.

 

     Telecom has one of the smallest weightings in terms of market cap and therefore offers one of the lowest correlations to the broad US stock market. It also offers the highest dividends and is trading at one of the lowest valuations of all sectors. The only metric we don’t like with telecom is its relatively high debt to equity ratios. It is a hybrid sector that offers both defensive and offensive properties. Sounds good.

 

     Now let’s look at energy. Energy has negative free cash flow and is miraculously still one of the most overvalued sectors by P/E even after a 50% decline. Debt to Equity is one of the worst and there seems to be almost no catalyst for improving prices with supply and demand as they are. Dividend payouts are healthy but falling and suspect. The only thing we like about energy is that prices have already fallen significantly (but can fall much further) and that energy is typically one of the late stage leaders in a maturing economy cycle. All things considered, we’re (still) not looking to make money in energy in 2016.

 

     One more – Industrials. This sector is under persistent selling pressure now but we’re watching it closely for a buy in the first quarter of 2016. Why? Valuations are some of the most attractive with single digit P/Es, high free cash flow and very high return on equity. Debt to Equity is also below market. Dividends are also above market and industrials typically do well in late stage economic cycles especially as interest rates are rising. Not all industrials are created equally however so investors will want to buy individual names here rather than via an “industrial” sector fund. All three of our Tactical Equity strategies will be looking to buy individual names once the technical price patterns turn up.

 

Housing

 

     Housing and real estate are of course a sector but deserve their own commentary. At our 2005 annual meeting, I spent a majority of our presentation on the obvious credit bubble that would lead to a very tough real estate market environment. I showed a picture from the cover of the Economist entitled, “The Houses That Saved the World” alluding to the near euphoria at the time.

 

 

 

 

I also said that the pending housing crisis could last at least 10 years. Well now, let’s fast forward to today – ten years later. With the exception of just a few regional markets, housing prices, new home starts, current supply, has yet to exceed the peak levels established in 2006 and 2007. Strange as it may seem, it now looks like housing and real estate might be one of the bright spots in 2016. I might go as far to say that the sector looks like it could even be recession proof (don’t hold me to that). In a nutshell, this sector is still recovering and may have further to run. The analysis is based on the current status of variables like the very low percent of GDP represented by housing. It is based on demographics, as the biggest generation of all time, the Millennials, are just now becoming first time homebuyers. It is based on the fact that the monthly supply of available homes is just now turning up from a low in 2013 meaning we still have very low inventory.

 

 

 

Bespoke 2016 Annual Report

 

 Is it also based on the fact that the median age of a home in the US is 39 year old! What we see is a multiyear investment cycle that will favor home builders and all those companies that live in the wake of real estate trends like furniture, wood, roofing materials, paint, mortgage companies, etc. It looks to us like the music will play on for housing at least in the residential world. The only area that is now absurdly overdone in price and oversupply is multi-unit housing like giant apartment complexes. I can see all of our Denver clients nodding their heads.

 

High Yield Bonds

 

     High yield bonds were hammered in 2015 and continue to fall in price today. I would describe the situation in the middle of last year as the only clear bubble. Now it all comes down as all bubbles do. Price and wealth deterioration is in progress and we’re not done yet as default rates associated with high yield energy and technology bonds are likely to get much higher. What we’re really seeing is the fallout from years of near zero interest rates. Companies were more than happy to issue bonds at 4-5% instead of borrowing from a bank for 6-7% and investors were hungry for yields paying 4-5% when they couldn’t get income anywhere else. The perfect storm! Debt issuance was at an all time high in 2014 and most of it was truly “junk” (aka Junk bonds with BBB or lower ratings). High yield corporate bonds finished 2015 down hard and yields are now on the rise, pushing up to 8%. If the historic pattern prevails, we’ll see 10-12% yields at the bottom giving us one of those multi-year buying opportunities. Both of our Income models and large pieces of our Blended Asset strategies can invest in corporate bonds liberally. Again, the time to do so is not now but it’s coming. I will actively and shamelessly recommend an investment in either of our Income strategies now as we remain in cash waiting for the opportunity to present itself.

 

That’s it for Part II of our 2016 Best Bets series with more coming, stay tuned.

 

Sincerely,

 

Sam Jones