Another Squall
It’s been smooth sailing since July for global financial markets, a little too smooth. Now we find ourselves facing another healthy squall as sellers are taking some profits ahead of the Fed meeting on the 20th, the end of the quarter and the election in November. While we’re not at all surprised to see this happening, there was something very notable about the character of last week’s declines.
Net Exposure Model Moves Us to 25% Cash
By the end of today, our strategies will be roughly 25% in cash, 29% in some cases. The weight of evidence generated by a several key indicators suggests that carrying SOME higher cash beyond the middle of September is now prudent. We’re jumping the gun a bit given the Federal Reserve calendar and the market’s apparent sensitivity to the prospect of higher rates. And we have no idea if the Fed will act or not on the 20th, but there are other things beyond the Fed that are driving the risk structure of the markets higher. One is valuation, which we have spoken of at length. The “market” is overvalued by practically any metric. However, there are still pockets of attractive sectors like industrials, energy and financials.
Unfortunately, when the “the market” decides to sell off, it takes the good and the bad with it. A highly valued market struggles to move higher sustainably and is simply more prone to selling pressure. This is the situation we are in today and we view this entire “surge” from the lows in February as an extension of a very old and tired long term bull market. Is it over? We have no idea but market risk is obviously on the rise. Second is the state of the economy. In recent weeks, we’ve seen some pretty terrible reports released, especially among manufacturing and service sectors as well as over all business condition surveys. Consumer confidence is hanging in there, barely. Momentum models have been on buy signals but are now fading fast. So strangely, just as the Fed is talking up the prospect of an improving economy, the recent stats aren’t very impressive. Tough job to be a Fed Governor right now.
Finally, we see some price deterioration happening among the canaries. These are high yield credit securities like junk bonds as well as small caps and other assets classes that tend to be more sensitive to market jitters. With breadth and volume measures confirming the selling pressure of last week as significant, we have enough evidence in our Net Exposure model to raise a little cash now.
The Regime of Lower Inflation
I mentioned in the intro that there was something very notable about last week’s selling. This has been the subject of several past updates but I want to reiterate here again. The entire financial services industry, which includes the do-it-yourself investor all the way through the huge financial institutions managing Trillions for large pensions, endowments and foundations, is still largely built on the foundation of modern portfolio theory. The theory says that if one is good about maintaining a diversified mix of global securities across multiple asset classes (stocks, bonds, commodities, real estate, etc) then we should enjoy healthy total returns while minimizing the downside risk of loss. That is true and has been true for nearly 30 years. 30 years seems like a long time but really we’re talking about the experience of one, maybe two generations of investors. So in economic time, this is actually a very short history. During this time, we have seen the likes of John Bogle and the Vanguard funds make indexing seem like a no-brainer, where the only consideration is cost. Less cost is better right because we assume that the design of our diversified global securities portfolio will manage all risk. But this widely accepted truth relies on an environment of lower inflation or deflation and now zero or even negative interest rates (borrowing costs).
Tom Brakke, author of The Research Puzzle, said it well in his post on 9/8/2016.
“It has all been part of one economic regime of lower inflation, lower interest rates, and globalization, accompanied by a flood of assets into the investment industry and the erection of the superstructures of practice and belief that grew along with it. It’s really not much of a slice of history — yet that’s the limited window that supports most investment recommendations and plans.”
Last week, stock markets felt some pain for sure with the S&P 500 losing 2.39%. But what really hurt was the fact that bonds also lost 2.25% on the week. Bond positions are held for their safety net features. We put up with their lousy, or near zero interest payments, because we “know” that they will provide some ballast to wavering stock portfolio during stock market squalls. But critical investors will note that during each sell off in stocks since 2014, the effectiveness of that ballast has been less and less. And last week for nearly the first time in recent history, we saw the safety side of most “modern” portfolios lose just as much as the stock side. We have seen only squalls in stocks in recent years, but nothing really devastating. Our concern is that too many portfolios, and vast sums of market capital, are not built to weather a different type of storm when it finally comes.
So if bonds are no longer going to be an effective hedge or non-correlated asset class against a stock portfolio, what is an investor to do? This is a huge question and quite possible the driver behind the incredible growth of the liquid alternatives securities in recent years. Everyone is a self proclaim quant now. Everyone thinks they have the secret recipe were they can simply trade away market risk without relying on non-correlated asset classes like bonds. They assume that their system will get them out just in time. The reality is that very few have any experience with this beyond the last couple years. Furthermore, risk managers in aggregate, are just as guilty of building their long/short, arbitrage and managed futures and momentum models on the back of the same falling interest rate environment as the passive index investor crowd. The path forward will not be the same as the path we have just traveled. Perhaps we are coming up on a crossroads? This will be time when all market participants must be open to the unknown, recognizing perhaps a new regime and putting our hard earned capital where it needs to go, rather than relying on models that suddenly don’t work anymore. We humbly offer that we do not have the answers because we haven’t seen the real face of the new environment yet. No one has. But, it seems inevitable that we will in the coming years. Perhaps sooner than most are prepared for. This is where our experience and flexibility in portfolio design matters. We are prepared, willing and able to evolve as risk managers, which is likely to be the most important stance an investor can take as we looking forward. We will find a way that allows us to continue generating asymmetric returns for our clients just as we have done since the mid 90’s.
More on that as conditions unfold.
Have a great week and know that you are in good hands as we make portfolio adjustments according to current market conditions – as always.
Cheers
Sam Jones
