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Change of Seasons Quarterly Report l 1st Quarter 2016 - Making The Turn

     The purpose of this quarterly report is to help guide our current and prospective clients specifically regarding the design, methodology, and process behind our investment strategies. We also work to offer a higher level of transparency into our investment strategies by showing unique perspectives on returns and risk profiles. Subjectively, this is a self-effacing report openly critical of areas in which we still need work and similarly patting ourselves on the back when appropriate. While we are proud of our historical returns, future returns are what really matters. We believe that investment success is the direct result of excellent design, solid execution and regular self-critical evaluation. That’s what this report is all about.



Making the Turn


     First let me start with a quick and very basic overview of market and economic cycles. Why should you care about cycles? Well for one, not knowing where you are in relationship to the larger economic cycle would be the same as driving a car without a gas (or battery life) gauge with the same unsavory outcome. It gives us a fighting chance to have our money in the right place as investors in terms of sectors and asset classes. Second, understanding this big picture helps us make better life oriented financial decisions. For instance, in our regular financial planning sessions, we often hear statements/ questions like, “I’m thinking of buying a house. Should I take money out of my investments or leave it there and get a bigger mortgage?” Another might ask, “ I’m thinking about hiring a few people and expanding my business but I’m worried that we’re about to enter a recession”. Of course, no one can answer these questions with perfect certainty, but understanding where we are in the bigger economic cycle can at least help us make well-informed judgments. So let’s take a look at this overly simplistic chart provided by Martin Pring that maps out the six phases of a full business cycle and point to where we think we might be now.


 

     

     Our assumption remains the same as it was near the end of 2015, despite the wild market ride during the first quarter of 2016. As I penned in January, we are likely in the “mature phase of a mid-cycle expansion”. Graphically above, that would put us on the right side of Stage 3, which is a very robust and healthy time for investors across all asset classes. In this stage, we have a strong buy in Commodities while bonds are getting tired and stock investors need to be a little more selective in their holdings. During this phase, we should be carrying some legacy cash but looking to deploy it in the oversold commodity space (oil, metals, agriculture and materials). In the mature phase of a mid-cycle expansion, we begin to see inflation creep into the system while a significant portion of the media is still concerned about an economy that is too weak to stand on it’s own. Sound familiar? The same situation happened in 1994, where the economy actually did slip toward zero growth (zero GDP) for a few months before charging up again. Today, estimates for US GDP are 0.20% - let’s call it zero. 1994 was a nightmare, much like 2015 for most of the financial world; Lots of chop, lots of volatility, and many cross currents. But ultimately, the markets proved resilient setting the stage for another six years of incredible returns. That is not a forecast for today’s market but it is a good history lesson.


     Positives supporting the idea that we are still in a mid cycle expansionary phase are still very present. We are at full employment with some early signs of wage inflation. Commodity and other input prices from things like gasoline and lending rates are at historic lows. Real estate has almost fully recovered and we are beginning to see signs of a mild wealth effect again from pricing gains. Some of the main fear points for investors coming from falling oil and a rising dollar are also going away, especially in the last couple months. Valuations are reasonable and the Federal Reserve is now on hold for tightening interest rates which provides that all important liquidity to the economy and financial markets. On the expectations front, analysts have again lowered their estimates for earning by an enormous 9% (S&P 500), which potentially sets the stage for upside surprises starting right now.


     Negatives are still mostly technical as they have been for over a year. You don’t have to be a market genius to see the potential rounding long term top that has developed across practically every index both domestic and internationally.


 


And as we might expect, aggregate selling pressure has been on the rise (shown in Red below) for the last 12 months as indicated from the fine work of Lowry’s Research.


 

 

     If we had to summarize our view and our position to set expectations for our clients, it would be this. We see, recognize and respect the potential for a current market top. Our investment strategies remain defensive in terms of our net exposure while paying close attention to selection criteria. Thus far, that stance has been favorable and productive. At the same time, we’re also aware of the potential for a significant upside move in the broad US market lead by new late cycle sector groups (materials, industrials and technology) including the potential for a commodity run that hasn’t happened in nearly five years. If we were to see the market “make the turn”, we would also expect to see some weakness in the defensive side of the market including bonds, consumer staples and utilities. The second quarter of 2016 will be one for the history books without meaning to sound overdramatic. As always, we remain gratefully committed to our process, which allows for a great deal of flexibility and adjustment in our positions as market conditions unfold. Those who have staked themselves to one directional outcome are rolling the dice with their financial futures.


     A sincere thank you to all of our clients who have been patient and trusting through this messy market cycle. We believe the worst of this condition is behind us as we now have more clarity and productive opportunities that play well with our risk management systems.



Respectfully,

Sam Jones

President, All Season Financial Advisors, Inc.