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Shaken But Not Disturbed

I have taken a few calls of concern from clients in the last month or so.  The questions are about what if scenarios with China, Greece and the pending move in raising interest rates by the Fed.  More directly, there have been some performance concerns surrounding our Blended Asset models.  For everyone’s benefit, I’m going to tackle all of these questions in a true Q and A format.

 

Q:  Is the new bear market in China going to spread to the US?

A:  The answer is no but let me explain.  The Shanghai Composite index was up nearly 60% YTD through June 12th.  Subsequently, the index fell almost -25% through the middle of last week.  Small caps in China are in bubble territory with a small number of retail investors pushing prices for relatively new company IPOs up to a P/E of 80 using forward earnings.   Large Caps in China by comparison, which have been around for years and sport very healthy revenues and earnings, are now trading at around a P/E of 14 (down from 18) again using forward earnings.  The S&P 500 trades at a P/E of nearly 20 today.  What we are seeing is a bit of an investor frenzy chasing returns in the Shanghai Composite, which has always been a gamblers paradise.  It just a little out of hand and is now correcting sharply.  I am doubtful that the bear market is over as these things can take a while to digest.  The Chinese government is meddling with mother market by forcing companies to buy and hold their own shares to simply avoid pain and support prices.  How could they do something so artificial?  Mandatory share purchases in China with $Billions are just a little less transparent than what our own Federal Reserve has been doing with the purchase of our Treasury Bonds in the $ Trillions.  Keep that in mind before throwing that first stone.  Economically, China is still very strong with a growth rate envied by much of the developed world and they continue to rise dramatically in their share of global GDP – at the expense of the US and developed Europe.  Their story is far from over in the long term but in the short term, we’re just witnessing what real market volatility looks like.

 

Q:  Is the situation in Greece serious enough to move to a more defensive portfolio position?

A:  Again, the question above is really about contagion.  Will the problems in Greece and the Eurozone spill overseas to the US?  I’m going to frame the answer in terms of a homeowner who is bankrupt and asking their lender for better terms of principle reduction before defaulting on payment.  This is exactly the situation right?  Greece is the bad borrower in this analogy.  They are asking/ demanding better terms or debt forgiveness using the only threat left to them;  default (or Exit from the Euro).  The Banker (Germany) did as any of our lenders have done and by working with the borrower who simply has no room to negotiate.  Eventually Greece will agree to payment terms or they be foreclosed on. At present, they have no means to make payments without an extension of loans or even taking on more debt.  As I said two weeks ago, Greece will continue suffering for years at least economically but the pain should stay in Greece.  Remember, there are not many Greece’s out there like there were homeowner’s going into foreclosure between 2006-10.   Furthermore, Greece only represents a very small 2% of Europe’s entire GDP and Europe represents less than 25% of total global GDP – and shrinking.   They can stay or go and frankly, it just won’t matter that much.  As I said before, we are dealing with headline risk and the markets did take a hit on all the Grexit news in June.

What really matters when it comes to Greece is the peripheral impact on the Euro and the US Dollar.  If Greece stays in the European Union and negotiates a continuation of Bail Out Nation, the value of the Euro will continue to fall as it has done somewhat sharply in the last 4-5 trading session.  A weak Euro necessary puts upward pressure on the US dollar as the Euro is one of the largest components in the US dollar index basket.  A falling Euro forces a higher US dollar.  This earnings season you will regularly hear commentary in reports and conference calls about the negative impact of the “Strong US Dollar” on US company earnings.  This will become almost a scapegoat for large multinationals who derive a large portion of their revenues overseas and give up their profits on conversion back to US dollars.  In a nutshell a strong US dollar is a headwind to earnings especially those coming from S&P 500 type companies. 

 

 

At the beginning of the 2015, we began oriented our portfolios away from multinational large caps and toward small cap names which continue to lead the way higher.  Small caps naturally have a lot more volatility than large caps which are a perfect segue into the performance question.

 

Q:  Why did my All Season account lose -2.7% last quarter, the market only lost -2%?

A:  Most of our blended Asset strategies took an abnormal hit last quarter for several reasons.  Without making excuses or trying to sound defensive in any way, there is an explanation.  First, let’s remember that we’re talking about less than 3% in terms of a periodic drawdown, much of which has already been recovered as I write.  Second, blended asset strategies necessarily own many things from many different asset classes of course.  Strangely, almost on the order of the perfect storm, each one of our asset class buckets within these strategies took a turn beating up the whole portfolio over the course of the second quarter, especially in June.  As I mentioned last update, diversification only helps control portfolio volatility in 30-40% of all market conditions when systematic risk is present.  The second quarter of 2015, was a perfect example of a type of market prone to non-systematic risks (like wild currency swings, panic 90% down days, headline risk from Greece, China and the Fed). 

 

All Season has five investment buckets, we think of them as asset classes.  They are as follows:

High Dividend Equity stocks and ETFs

Equity Index ETFs

Equity Sector ETFs

Liquid Alternative Funds

High Income Funds and ETFs

 

As a point of example, Four out of five of our high dividend stocks lost 8-10% at some point during the quarter, many tripped stops and were sold off the highs.  These were replaced with SDY, the dividend growth aristocrats ETF, a much lower volatility fund that still pays a healthy dividend.  Nevertheless, the damage was done.  Similarly, our Equity Index and Equity Sector funds all gave up as much or more than the broad US market during the June selling.  This was to be expected but also contributed to the small loss.   As I mentioned above, we also own a bunch of small caps which naturally have more weekly and monthly volatility, both on the upside and downside.  In addition, three of our four liquid alternative funds also suddenly became highly correlated with US stocks after marching very nicely higher with nearly zero correlation for months.  And finally, our High Income allocation was already 100% in cash after hitting a sell signal in late May.  Very often, our high income bonds act as ballast to our equity side of the portfolio providing stability and some gains when stocks are losing.  Not so this time as our bonds were sold to cash.  The situation has improved dramatically since the middle of last week and we’re back on the upswing in terms of returns but the damage to our very well-diversified and well designed blended asset strategies was both unwanted and somewhat circumstantial.  We have made only a few changes to our holdings during all of this turmoil which is exactly what our Net Exposure system dictates as it sits directly on “neutral”.  We are to hold what we have and upgrade as necessary to maintain exposure unless we can find no viable options.  Given the fact that the markets just put in three of the strongest up days in the year, I’m glad we didn’t cut exposure radically.  That day may be coming soon but for now, we remain shaken, but not disturbed.

 

Q:  Is the beginning of the bear market?

A:  That question is always a tough one as every real bear market begins with something that looks like a standard market correction.  Here’s what our system is telling us.  Our technical indicators in aggregate have been deteriorating since last April down to the current neutral status, that condition still exists.  Sentiment measures (bearishness and bullishness) hit extremes with the panic selling on July 8th.  Selling pressure and other measure of panic selling also hit extremes on June 29th and again on July 8th.  Historically, these events have been enough to mark intermediate term lows.  Yesterday (Monday), our system actually generated both short and intermediate term buy signal for US stocks following three very sharp rally days in the markets.  Volume has been unimpressive on this up day however so we should expect some consolidation of prices this week and then hopefully a very robust blast out to new highs for most major indices.  Meanwhile, the fundamental picture continues to improve and recover from a nearly recessionary status over the course of the last two quarters.  We may very well see another economic surge higher in the coming months and earnings are poised to beat a very low bar in expectations this quarter. All in, I do not see the environment as ripe for the beginning of a bear market now but the situation is tenuous.  Several things need to improve now if this bull market is to continue higher including stronger leadership, big buying volume, improvement in the breadth of securities moving higher, participation by the transportation and utilities sectors and a pile of strong earnings that support higher prices.  A tall order but not out of the question.

 

I hope that answers some of your primary questions.  As always, we’ll do our best to keep your informed and up to date with full transparency regardless of the situation.

 

Have a great week!

Sam Jones