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The Plot Sickens

If you didn't spend the time to read last week’s Change of Seasons report, you should do so.  At the request of our advisory board, made up of client households just like you, we have made a great effort to explain our methods and define our unique process behind investment decisions.  What you’ll learn is how our system identifies opportunities to adjust “Net Exposure” to the markets, uses “Selection” to keep assets in the leading sector and asset classes and focuses holdings on our strongest convictions through “Position Size”.  All three variables tell a similar story in terms of the conditions of the markets and where you should be (and not be) invested.  Today, that plot has seen further deterioration from conditions at the end of the year.  I see a lot of complacency toward the markets now and I want to say WAKE UP! with this update.

Excerpt from Change of Seasons Report -   January, 2015


Summary With Confirmation Across our Process

There is increasing evidence that the US financial markets are approaching the final stages of long bull markets for both Treasury bonds and Stocks. Economic fundamentals are still healthy but valuations and technical indicators are not as constructive so our Net Exposure screen dictates a less “exposed” allocation. Instead of carrying more cash, we are actively moving assets to become less correlated with the US stock and bond markets now. When markets approach the final stages of a bull market, there are fewer and fewer sectors making new highs. We are seeing this happen now. Therefore, proper security Selection is going to highly dictate relative performance in 2015 at least for the first half of the year. Our only overweight positions now based on favorable risk adjusted returns are real estate and healthcare. All other Position Sizes are normal as real value with strong price trends, is becoming harder to find. Net Exposure, Selection and Position Size results are all confirming the same story. If the story changes, our allocations will adjust as needed.


Well the story is changing a bit and for the worse.  Many of our intermediate term indicators have moved down to the make or break position as of last week.  All things considered looking at fundamentals, valuations, technical and sentiment figures, a break down below 1975 on the S&P 500 would change the picture from a technical correction (now), to a significant market trend change angling toward real bear market conditions.  I am doubtful this will happen now but that’s a line in the sand.   There are important things to understand regarding cycles now both long term and short term.  It is highly likely that years of quantitative easing from our own Federal Reserve have accelerated the natural price gains of the market relative to the state of the economy.  We should all expect the markets to rest, fall, consolidate or whatever while the economy plays catch up now.  It is also noteworthy that the US stock market has rarely generated 7 consecutive years of gains.  It has happened once in the last century in fact.  2015 would be the 7th year in our current bull market so I am expecting a negative year for the US stock market, contrary to the very widely accepted view of a +8% “steady as she goes” year for investors.  In the shorter term, there is also some erroneous thought regarding the month of January.  Common thinking is that January is typically a good month for stocks.  That’s not the case anymore – not for the last 20 years in fact.  Bespoke did this nice analysis of monthly gains over different periods of times. 

So a negative January is not necessarily a death bell for the market trend (January was negative in 2014 as well).  In fact, February, March and April are still some of the most consistently positive and strong months of the year.  From a cycle standpoint, I won’t be surprised to see a nice rebound over the course of the next 2-3 months, but unless our story line improves, we would want to sell into that strength and cut net exposure further. Remember, major market tops are long and bouncy affairs spanning months and quarters and recent action is just what we would expect to see.  Conversely, bear market bottoms are easy to spot but nasty, dark and spikey events.

Sectors/ Asset Classes/ Specific Ideas

Our “Selection” screens are also confirming the same deteriorating story based on leadership and relative strength winners and losers.  Financials are a critical piece of the US stock market and its weakness as a sector is literally weighing down the S&P 500 performance (now -3% YTD).  Technology has also been an under-performer this year which is frankly a bit of a surprise considering it is one of the truly non-interest sensitive sectors out there showing robust growth still.   Combined, the Financials and Technology sectors weigh in at over 34% of the S&P 500.  It will be hard for the US stock market to make any sustainable new highs without some leadership from either or both groups.  In 2007, the last major market peak, Financials (shown in Red below) put in a secondary peak in late May and never recovered.  The stock market (shown in Green Below) put in a final peak four months later in early October.  Are we seeing a repeat?

Healthcare, Utilities and Consumer groups are still the leaders in the market but also the most overbought, overvalued by a long shot.  These situations are a bit difficult for investors as it becomes a bit of a game of chicken – who can hold on to the most overbought sectors the longest?  Meanwhile, energy, telecom, materials and financials are now the most oversold and offer the best values.  Everything else isn't really much different from the S&P 500 or any other major market index.  We’ll be watchful for any signs of relative strength shifting to the more attractive groups and ready to rotate if necessary.

Asset class analysis shows that bonds and stocks are still in uptrends, commodities of all sorts are still in down trends.  Our money should be allocated as such and it is.  But those married to the notion that modern portfolio theory (MPT) will hold the line again in terms of mitigating portfolio losses might not be happy with the next down cycle.  You see, bonds and stocks have been trending together with very high correlation now.  When bonds finally peak and head south, stocks will follow.  MPT suggests that owning a magical combination of stocks and bonds will keep an investor diversified and buffered against major losses.  I will say, this time is going to be different.  I think we’ll see losses in both asset classes and real diversification will only come from our style of tactical asset management and alternatives generating real non-correlated returns.  Thankfully, there are now plenty of options here.  Who knows, maybe we’ll even get a run up in commodities (hint).  We’re still not expecting any sort of bear market to materialize in either bonds or stocks until later in the year.  When the Fed puts off raising rates in June  - until November, bonds and stocks should respond favorably or at least put off the next bear market for a while longer. 

Specific ideas for investors should be concentrated among things that have had a hard period recently.  Amazon is a great example of a stock we talked about late last year.  Amazon was down over 20% in 2014, consolidated some very strong gains of the previous 3-4 years and was up a shocking 11% last week.  Google had a similar experience in 2014 and now looks poised for an upside breakout as well.  Growth At a Reasonable Price (GARP) is one of my favorite investment themes for stock buys next to Dividend growth and there are some attractive looking plays developing now.  Overall, we are also closely watching high yield bonds, real estate and small caps for an indication of the primary market trend.  All three are now canaries and worth our attention. 

Hurray! For Denver Real Estate

As a final note for our Denver clients, you might be happy to learn that Denver is now one of two cities that has now fully recovered its real estate losses dating back to 2006.  The other is Dallas. 

Denver did so, not through robust growth and crazy price appreciation in recent years but, by avoiding the large losses and disastrous price drops seen in places like Arizona, Nevada and Florida.  Chasing gains, chewing off too much, selling in fear and looking for get rich quick schemes always end badly.  Denver has proved to be a very boring and very profitable real estate market over time.   Remember, successful wealth accumulation comes from the balance of avoiding major losses and earning modest consistent gains.  Sound familiar?  

That’s it for this week

Cheers


Sam Jones