FALSE EXPECTATIONS

So I’ve been waiting for the right opportunity to say this for quite a while. I think the time has come. Investors have been deceived by the financial services industry by setting false expectations regarding the relationship between risk and returns.

 

More Risk Does Not Equal More Return

 

2016 is staging to be a great opportunity to explain this reality. Investors have been told from their very formative years, that if one is willing to accept more risk, then one can expect more return – over time. I think this is really a structurally flawed relationship, which may be why so many investors have a long lasting sense of disappointment when it comes to their investments. Let me explain and give you a bunch of examples. As always, I’ll finish with a short statement about why this understanding is relevant to you or why you should care.

 

First, let’s get clear on some definitions. When we say risk, people think about two things; the natural volatility of whatever you own as well as the more permanent risk of lost capital. These two are often confused as the same thing. They are not. There is no investment that does not carry some risk of permanent loss of capital with a lifetime of experiences to prove it. Most recently, we’ve seen real estate, once thought of as an investment that never declines, prove otherwise. Technology and internet in the late 90’s was said to be almost impervious to loss following a “new era”. That didn’t work out either. Nothing is free from risk of loss over time. Conversely, volatility is a variable that any investor can dial in or out of depending on your comfort level. Holdings that have higher daily swings in value will necessarily increase your portfolio’s total volatility in terms of swings in your daily, weekly or monthly balance. So the two concepts of “risk” are really quite different. For this discussion, we are talking about risk in terms of the risk of losing significant investment capital by staying invested in the wrong things at the wrong time.

 

Also on the definitions front, we have to determine what we mean by “over time”. Over time, in the financial service industry, is really an excuse to justify relationships that have little bearing on your actual investing experience. “Over time” means you will not be alive long enough to recognize a promised outcome. “Over time” means, I can’t back this up with data in modern times but it fits my theory.

 

So today, we see several glaring examples to support the notion that taking on more risk with your investments does not necessarily yield more return. This is the case over short and longer term periods – Over time.

 

Bonds versus Stocks

 

Let’s pick on the very long lasting mantra that stocks are higher risk asset class than bonds and therefore they should produce higher returns. Is that the case?

Let’s take a look at a few statistics over different time frames. I’m going to compare two specific investments for this very dirty analysis, which should always be viewed with skepticism as anyone can curve fit an outcome using selective securities. But, in this case, I think we’re pretty safe. My two securities are the Pimco Total Return Bond fund (one of the largest in the world with the longest history) and the S&P 500 stock index. Pimco TR is about as close as you get to a pure aggregate bond index. The S&P 500 is of course representative of the US stock market. Here are the numbers through yesterday looking at long windows “over time”. Standard Deviation is a measure of regular volatility and Max Loss measures the largest loss from an all time high to a significant price low.

 

 

Security     Inception 9/1/1988     10 yr return     Standard Deviation     Max Loss
Pimco Total Return       7.92%       6.07%          1.31       -6.44%
S&P 500 Index       7.88%       4.84%          5.14       -55.1%

 

Our keen eyes recognize that over time, the promise that the much higher risk environment for stocks has not, at least back to September of 1988, in fact produced higher returns. Of course, the future will not repeat the past and it is quite likely that the near 30 year outperformance of bonds over stocks will switch back to favor stocks. But 30 years is a long long time! The point is that models and expectations built on the premise of these false relationships can and will again disappoint you over long, long periods of time in the investing world.

 

Growth Stocks Versus Value Stocks

 

Here’s another one that is especially relevant right now. Investors in things that are designed for growth like technology/ internet/ Biotech companies, etc. assume that they will be rewarded for taking on these additional risks. That is definitely the case during select periods of time, like the late 90’s. But, there are also very long time periods when value styles of investing, like boring consumer staples and other dividend paying stocks, wildly outperform growth. One could certainly even consider oversold sectors like materials, industrials, metals and energy services as value plays after the drubbing of the last 4-5 years. 2016 is beginning to shape up as a year where we’re seeing the market show a strong rotation from Growth and towards Value. Again, the promise of higher returns associated with growth investments is already busted this year. Investors in names like Netflix, Amazon and Apple are already starting to see and feel real selling pressure with those holdings. These are great companies and they are not going away anytime soon. But, the prices of their shares may not go anywhere for a while following the last several years of healthy gains. Companies that are showing better valuations or those in actual value based sectors continue to pick more and more investor interest and that applies to international indices as well. The point I make regularly in this update is that every investment has its time to shine and its time of falling out of favor. Assuming that the best returns will always come from the same areas of the market – like stocks or growth – is a set up for disappointment.

 

Why Should You Care?

 

As clients, most of our households understand the dynamic nature of what we do. That is, we are trend followers always watching for leadership and significant asset class rotations. As the financial environment completes this Transition Period (of which I have spoken at length) of moving from a system dependent on support from the Federal Reserve to one that is capable of growing on it’s own, we are sure to witness some very significant changes. These changes are likely to challenge less dynamic investment models, or those which rely on the types of relationships described above. For instance, as we continue to see growing evidence that inflation is coming, older investors with substantial holdings in Treasury bonds might need to find a new home for their life savings. Similarly, younger investors who have substantial holdings in lime light technology stocks like Apple and Netflix, might also need to reallocate to more cyclical value oriented positions among industrials, materials, commodities and energy. Knowing when to make significant changes among investment themes, asset classes and sectors is one of our strengths and one of the key value propositions we bring to our clients. 2016 is shaping up to be an important year to recognize and act on new leadership. Don’t let this opportunity slip away. Feel free to call us anytime if you would like us to consult with you regarding any of your “outside” holdings. We’re here to help.

 

Sincerely,

Sam Jones

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.

FROM THE TOP

As we know, the view “from the top” can be quite different. Today, we find the US stock market again approaching our previous tops made on June 21st (S&P 2130) and November 3rd (S&P 2109). Today the index is trading at 2051. This is a great moment to drop our packs and take a look at the distant landscape since our last visits.

 

Valuations – Still High

 

Despite the unsavory volatility of this quarter which included a near vertical decline of 12-15% and subsequent recovery by as much, you might not be surprised to hear that valuations are exactly where they were at the end of last year, perhaps a little higher if one is measuring against earnings per share on the S&P 500. Over the quarter, EPS on the S&P 500 index fell by 4% and prices are within a stone’s throw of the previous peak so it stands to reason that valuations are about the same. The important thing to remember is the market is still priced at a fairly rich level and no one should really be compelled to load up on stocks here. The best, most trustworthy valuations are those based on backwards looking data, like the last 6-12 months of earnings and price action. Forward EPS measures are always guesswork and can lead to some back decision-making. So we know that based on backwards looking data, valuations are not attractive at these levels (again). Now look forward (wink), we might be open to a more favorable outcome. Here’s why.

 

US Dollar Uptrend Has Stalled

 

If you were to read the actual earnings reports from various fortune 500 companies you would find a common issue for which they blamed poor or weak earnings. This has been the case since the second quarter of 2015. Over 65% of companies reporting cited the “strong US Dollar” as dilutive to their earnings, meaning our strong currency hurt their bottom line revenues. This is especially the case for large multinationals that generate significant revenue overseas but see those foreign revenues eroded when converting back to US dollars. Thankfully, near the middle of February, the uptrend in the US dollar stalled and our domestic currency has really traded in a sideways band, even declining slightly, since then. Looking forward then, one of the main blame centers for poor earnings could be going away. Of course, earnings can fall for other reasons like a slow down in global demand and we are seeing some of that as well.

 

Gaining Ground – From the Top

 

I find that ranking and sorting various sectors, indices, countries and asset classes from a certain point in time is a valuable exercise. The chosen point in time has to be relevant however, like a notable low or a notable high. Now that we’re back at the top, let’s see what “things” have actually gained ground relative to the dates of the previous market tops. I also like to add a ranking filter that shows which “things” are gaining ground above the last peaks with the last amount of weekly price volatility. In doing so, we can shorten up our list a bit to consider investments that are moving in the right direction without thrashing our portfolio balances. Here’s the short list among those sectors that have moved beyond the highs of June and November, 2015 and their corresponding ETF investment options:

 

Gold/ Precious Metals (GDX)

Japanese Yen (FXY)

Intermediate term Muni bond (MUB)

Treasury bonds – all (TLT, IEF, IEI)

Consumer Staples (XLP)

REITs (VNQ)

Utilities (XLU)

Dividend Payers (DVY, HDV, VIG)

Industrials (XLI)

Emerging Market Bonds (EMB)

Basic Materials (XLB)

Latin America (ILF)

Preferred Securities (PFF)

 

So that’s a pretty odd and defensive looking list of securities and sectors right? What you don’t see on the list in our view “from the top” is all the stuff that the financial media seems to be focusing on, like oil, small caps, high yield bonds, and yes of course, the S&P 500. None are on the list because all have simply recovered from some recent losses but made zero new headway since 2015. Let that sink in for a minute. In our view from the top, we recognize that the majority of equities and commodities are still in down trends and possibly carving out larger topping patterns. Some will argue that the correction is almost over and soon, so soon, the US stock market will blast out to all time new highs making this very large and substantial topping pattern look like an 18 month correction cycle. That might happen but as of right now, that is not happening.

Now we must remember and respect the fact that if we pick a date in time that corresponds to a stock market top, then of course, all things that look and act like the equity markets are going to look relatively poor and we would expect to see a list like the one above. If the markets do breakout to new highs, we can adjust by adding back exposure to the growth sectors as the list of winners will certainly change. In the meantime, I can see a fairly good looking, well constructed and diversified portfolio in the list above. Our Blended Asset strategies hold these securities almost exclusively and all are up YTD by 2-3% you’ll be happy to know.

 

Climbing Down

 

At this point, we are prepared to cut equity again if the markets run into trouble, especially among holdings with higher weekly volatility. This is that inflection point where we need to consider defense again if conditions warrant. Our Tactical Equity models are still 60-65% invested, with the remainder in cash and hedges but again, we are prepared to reduce that level to 50% again or add to our short positions. Timing is everything and so far, this year, we’re getting it right.

 

I’m thinking about the view from the top as I just returned from a ski trip to a remote Canadian lodge with my brother and 12 friends (http://www.kmhbc.com/) . I haven’t taken an off –the-grid vacation for over a decade and it did feel good. Don’t worry, decisions regarding your money were covered while I was gone. It was one of the best ski trips of my life and I found myself gaining some valuable life perspective – from the top. I’d recommend any adventure that allows you to truly get away from your phone, your computer, etc – at least once every 10 years. Get out and do it, life is short indeed.


 

Cheers

Sam Jones

LOW HANGING FRUIT

Investing is never easy and there really is no such thing as low hanging fruit. But there are times when valuations are stretched to the downside in certain sectors, stocks, asset classes and countries making it easy(er) to make a case for new purchases. Buyer beware, some of the low hangers are rotten and will hang even lower in the weeks and months to come.

 

Quick Performance Peek

 

As I discussed in the last update regarding a potential turning point for the markets, I thought this would be a good time to take a look at our various strategy performance numbers, of course shown as net of all fees, as well as some drawdown numbers YTD through last Friday, compared to our benchmarks. Drawdowns are a measure of how far something fell at it’s worst over a given date range (YTD). It’s a good way of seeing what kind of volatility is in the system or our strategies on a relative basis. Regular readers might remember that we entered 2016 with a bold statement. We said, 2015 was terrible for risk managers and trend followers. We struggled with them but thankfully experienced no blowups. We also projected that after such years, we often outperform significantly. Well so far, that seems to be the case. Shown below is a simple table of our performance numbers by strategy as well as our respective benchmarks for each Investment category. These are unofficial numbers but a good check up with one month to go in the quarter.

                                                                           YTD%                  Drawdown %

Income Strategies

ASFA Retirement Income                                +0.0%                    -0.60%

ASFA Freeway High Income                           +0.23%                   -0.00%

Benchmarks

Barclays Aggregate Bond (AGG)                     +1.68%                   -0.00%

High Yield Corporate Bond (HYG)                   +1.38%                   -5.72%

 

Blended Asset Strategies

 ASFA All Season                                            +0.03%                   -4.55%

ASFA Gain Keeper Annuity                             +0.87%                   -3.45%

ASFA Foundations                                           +0.10%                   -4.22%

Benchmarks

Dow Jones World Stock Index                         -2.98%                  -11.60%

Barclays Aggregate Bond (AGG)                      +1.68%                    -0.00%

 

Tactical Equity Strategies

ASFA Worldwide Sectors                                   -2.18%                    -6.28%

ASFA High Dividend                                           -2.13%                   -7.20%

Benchmark

Dow Jones World Stock Index                           -2.98%                 -11.60%

 

ASFA New Power                                               -10.05%                 -12.79%

Benchmark

Powershares Clean Energy ETF (PBW)             -12.45%                 -24.68%

 

Scanning across our strategies and benchmarks, I see several things that show favorable performance relative to our benchmarks and in some cases in absolute terms. I also see one weak spot.

 

  • 1.I see that all Income and Blended Asset strategies are positive YTD
  • 2.I see that drawdowns numbers for our strategies relative to benchmarks are quite a bit lower meaning the inherent risk structure of our strategies is significantly less than our benchmarks especially in the case of our Tactical Equity and Blended Asset strategies
  • 3.I see that New Power has not recovered from its January loss by much. However it is still outperforming (losing less than) the benchmark on both measures. See commentary below on Growth versus Value for an explanation.
  •  

Low Hanging Fruit

 

I chuckle when I read the shock and awe expressed by the financial media after seeing the value side of the stock market nearly explode to the upside in recent weeks. These are the low hanging fruit that we discussed several times including the very clear and lengthy commentary/ charts in our three part, Best Bets for 2016 series. This should not be a surprise to anyone as the market usually does a good job of allocating money to things that offer future growth and return opportunities. Meanwhile, the famous FANG (Facebook, Amazon, Netflix and Google) stocks can’t seem to stop losing money this year – also foretold and predictable. Neflix has already seen a drawdown of 27% this year. Amazon, 28%. Facebook and Google look relatively strong with drawdowns of only 10%. Only Facebook is positive YTD thus our maintenance of this position in our New Power strategy. The market is not looking for returns from the growth sector anymore as this style of investing has some of the worst optical valuations of any. I would throw biotech and consumer discretionary sectors into that statement as well. Now the low hanging fruit is in a different place. It’s in sectors like industrials, agriculture, materials, Emerging markets, high yield bonds, base metals and other things that have been slaughtered in the last 3-4 years on the back of waning global growth reports. Stocks in these sectors and countries are down 50,60 and 70% from their highs 2012. Many, including a majority of commodity ETFs, are actually trading solidly below the bear market lows of 2009! But as this fruit hangs lower and lower (in price) at some point, we need to say, that’s enough to factor in a total global financial depression. You can see why any indication that global demand is picking up would generate some enormous interest in these value plays. So investors are now aware that “Value” is back and a place to generate some real returns. Some piled on late to this trend with new investments in the last week or so. We did not, having made almost all “value” purchases between mid January and early February. Now, we could be seeing the first pullback following the initial thrust off the lows. It will tell us a lot about the sustainability of this new rally. We are watching closely to see which groups are holding up better than others during this much needed correction that really started yesterday.

 

Rotten Fruit

 

A sharp mind might have noticed that I didn’t list energy stocks in the list of low hanging fruit. Strangely, even after this generational wipe out in companies like Anadarko (APC), Devon (DVN), and Chesapeake Energy (CHK), the valuations here are still, at least optically, some of the highest out there. I see fast declining returns on capital, negative free cash flow, super high price to earnings ratios and a pile of debt. Coal companies are making Oil and Gas companies look fundamentally healthy. I see the gains in oil and oil related company shares. I hear the drop in rig counts and massive declines in cap ex spending. But I also see the supply of oil continue to rise month after month with no end in site. I see companies slashing dividends because they have no cash left. I see bankruptcies and mergers before I can believe that any of these will get up and go sustainably. I’ve been wrong on these things before but when there are so many other good values out there, why take the risk right? Not all O and G companies look the same and some may be worth your investment capital. Chevron (CVX) and Exxon (XOM) look fine, Phillips 66 (PSX) looks fine, as does Schlumberger LTD. (SLB) Full disclosure – we own PSX and SLB for our clients. Buyers beware.

 

2016, the Year of the Active Manager

 

On the other side of value based opportunity we find risk. On this limb, sticking far out, is the Growth sector, which was the darling of 2015 with a total of 6-10 stocks attracting Billions of investor capital. I spoke of this in regards to the FANG stocks above. But here’s the interesting thing about the impact of the growth sector on the US stock market indices. Over the last several years, a handful of stocks have taken over the performance of the S&P 500 as a cap weighted index. As these stocks became megatron, super nova stocks by market cap, they naturally became a larger and larger driver of index returns. Meanwhile, sectors like energy, industrials, telecom and materials are now only a fraction of the index by market cap. Effectively the biggest losers in 2016 are now dragging down the performance of the benchmark indices while the biggest winners by sector are barely having an effect. The insight should be obvious now. We might begin to recognize why “the market” is underperforming so many sectors and stocks now in 2016. In fact, in our Worldwide Sectors model, we just recently added a short position against “the market” (S&P 500) while buying and holding nearly 60% in value oriented individual stocks. It’s a really nice pairing strategy and one that should do quite well through this year both in generating returns with significantly reduced risk. We can adjust both sides of the portfolio as conditions warrant.

 

We could probably build the same type of paired strategy in the bond market although we haven’t done so yet. The pairing here would look like a short position against Treasury bonds, perhaps shorter term bonds like two or five year bonds. On the other side, we might own and accumulate high yield corporate bonds, preferred securities and emerging market debt all of which are now in uptrends in price and paying north of 5% interest. I would caution against taking a short position against anything in the Treasury bond market with a long maturity, like a 20 year bond. In fact, while I’m cautioning, I would NOT recommend you do any type of pairing trades with short positions on your own if you don’t know exactly what you’re doing. We’re comfortable with it but I wouldn’t try this at home frankly.

 

So far, 2016 is predictably shaping up to the year of the active manager (also one of our Best Bets for 2016). 2015 was clearly the opposite. Being able to shift assets into leadership groups on a timely basis is already paying off nicely. Being able to run a pairing strategy like those mentioned above is not the domain of the passive indexer. These are good days for our type of investment process and flexibility. I ran across a study from Hedge Fund Research that showed periods when active management has a history of outperforming more passive styles like indexing. The key variable turned out to be….. the Federal Reserve! During periods when the Fed is not easing, active managers like hedge funds (and us) are able to generate an annualized 3.5%- 9% in “alpha” which is a measure of excess returns over passive stock or bond indices. Today the Fed is raising rates aka tightening. I’m not smart enough to tell you why this happens, but we’re already seeing these results play out. Cheers to that!

 

 

Have a great week.

 

Sam Jones

ANOTHER IMPORTANT MOMENT

As promised, we’ll continue to send out timely information with this Red Sky Report on an as needed basis.Since the middle of February, when the market embarked on this predictable recovery rally, the only real news has been about politics and who needs to hear more of that?But now we have something to talk about.There may be decisions to be made in the near future.Here’s what we’re watching and what investors should consider now.

 

Market Approaching Another Inflection Point

 

Prices have jumped higher since the exhaustive lows on February 11th.The market as a whole has participated but our measures of demand in terms of volume and breadth have been less than impressive.Select sectors like those most beaten down in 2015 in industrials, materials, energy, metals and now banks are ripping higher putting in some incredible short-term gains.Many point to short covering in these sectors as the driver of recent gains, but every major turn begins with short covering so who knows.Lots of sectors and a growing number of indices are dancing across the zero line on a YTD basis after being down nearly 10-12% a few short weeks ago.Wow!

 

But let’s not get too excited yet.Bear markets are full of deception and this set up has the potential to be a trap for late buyers.After the S&P 500 has risen over 9% off the lows (still down 2% YTD), sentiment figures are starting to work back into the bullish camp again, which automatically makes me nervous.I hate to be the contrarian but sentiment is consistently one of the few things that we can rely on when it comes to predictability.Thankfully, these numbers are not yet at an extreme, see the chart below.There is room above for further price gains and even more bullishness as you can see.

 

 

From a technical perspective, prices in many areas have moved back UP to the break DOWN point.Effectively, this is the place when the markets failed at the first of the year.Those who were caught by the sell off now have an opportunity to bail without incurring too much damage YTD.Some will do so, others will hold on.It remains to be seen which group is the stronger force.But weekly charts are still down and negative for most of the US stock market as is the long term average on the S&P 500, which puts us in a precarious place.The obvious level of strong overhead resistance on the S&P 500 is now 2023-2040, not far from here.Here’s a closer look with noted long term averages.

 

 

Finally, we would have liked to see more basing action around the February lows before this current rally occurred.The longer the base, the more lasting the rally.We didn’t see much of a base which makes this entire rally look like a technical bounce in an ongoing bear market downtrend.That’s just the way it looks based on the technical evidence, which can change for the better for any number of reasons.We just need to be ready to hit the brakes hard again if sellers materialize in force in the next few sessions.We’re ready.So this is an important moment in time to pay very close attention to market action and the delicate balance between buyers and sellers.

 

What To Do

 

This is an excellent time to review your desired exposure to the markets.If, for whatever reason, you find that your investment portfolio is too heavy in stocks or stock funds, this may be one of those important and timely opportunities to reallocate to other options with better downside properties.We have been having quite a few conversations with clients in the last couple weeks along these lines getting ready to rebalance from stocks to one of our Income models in certain situations.Again, this type of change should only happen in recognition of a need to rebalance your established prescribed portfolio allocation among our various strategies, not because you think you know the future or find yourself afraid.I’ll give you an example.We have identified several households that have been pulling monthly withdrawals from their income accounts for the last several years.In the process, the income side of their portfolio has significantly declined as a percentage of the total.Meanwhile the equity side of their portfolio has become disproportionately larger.From a timing perspective, this is a great time to reallocate from stocks and put the proceeds back into the Income strategy.

 

Our Income strategies are not your Grandma’s “Income”

 

Our “Income” strategies are not your typical income strategies, which most people associate with different types of Treasury bonds.Our Income strategies come in two flavors.The first is called Freeway High Income and it is designed for taxable accounts where we seek tax efficient total returns investing in a large percentage of high yield and intermediate term tax-free municipal bond funds.The other portion of the portfolio tactically owns high yield corporate bonds now paying 6-7% annual interest.Money in the Freeway strategy often flows between these two groups, as they tend to respond differently according to primary market forces.Honestly, we love having the option to be defensive (with muni bonds) or offensive (with corporate bonds) depending on market trends.Occasionally, we might also take positions in inflation protected bonds, preferred securities, emerging market debt or floating rate funds as well.All options here are purposely not Treasury bond options and most pay far higher interest rates with stock market type returns when the trend is our friend.

 

Our second type of Income strategy is designed for our tax deferred retirement accounts like those with IRA, Roth, or SEP registrations.This strategy is called….. Retirement Income.I know, so creative.Retirement income has a much larger allocation to high yield corporate bonds but can own any income bearing securities on the Freeway list above, except municipal bonds.So again, Retirement Income is anything but your traditional “income” strategy.

 

In both Income strategies we have a tactical trading system that buys and owns these funds when the price trends are favorable.This has not been the case since June of 2015 and both strategies have remained largely in cash since then to our great pleasure.But now things have changed.In the last two weeks our tactical system has given us several confirming short term buy signals and we have taken entry level positions in both strategies, specifically in emerging market bonds and high yield corporate bonds.

Both income models are positive YTD and gaining ground daily.I will shamelessly offer that our Income strategies are both in excellent positions for investors looking to add new money to the markets, or find a new home for recently sold positions.Timing is everything as usual.

 

That’s it for now.Stay focused and avoid complacency at this important moment.We’re not out of the woods yet.

 

Have a great weekend!

 

Sam Jones

GETTING CLOSE

It’s been a good couple weeks for the global financial markets in an all-inclusive way. Stocks, bonds, commodities, oil, gold, and high yield credit have all been rebounding nicely off the 1/25 and 2/11 lows. As we discussed in early February, the set up for a stronger than expected rally was clear and obvious. Now we’re realizing that event. But we must keep our eyes on the bigger picture which still points to a potential tradable low in the broad stock market later, perhaps the end of the quarter.I’ve heard some argue that a low is already in for 2016.I’d say that’s optimistic but either way, I think we’re getting close.

 

New Lines in the Sand for the US Stock Market

 

Investors should always understand what kinds of potential risks and rewards they are taking when engaging with the stock market. We can measure that looking again at any of the broad indices by highlighting likely price resistance and support levels based on technical price patterns, valuations, and cycle work. I won’t bore you with the heavy brainwork, but for us, there appears to be some likely upside and downside targets establishing for the S&P 500. On the downside, we see a likely support level about 8% below where the S&P 500 is currently trading. That level is roughly 1790. On the upside, if this rally can run above the highs set last Friday (S&P 1945), then prices could push all the way up to 2000 on the index. Given all the issues we will be surprised if the US stock market has that kind of firepower now, but even if it did, the 2000 mark is going to be really hard to beat as it represents the falling 200-day moving average. So, from where we are today, the US stock market has just about an equal opportunity on the upside as it has to the downside in terms of percentage gain and loss. That’s still not a bad set up in terms of risk and reward but we would be very careful about any new additions from here. Most additions to net exposure should have already happened as we did in mid-February by about 10-15% across all strategies.

 

We should note that these lines are really heavily dependent on short term technical parameters for stocks. From a fundamental perspective, things are still not so favorable. Best estimates for downside risk bringing the S&P 500 and other benchmark US stock indices back to long term averages for valuation, would point to the 1500 level for the S&P. That’s a long way down, almost 22% lower than the close of last week. Our expectation remains the same as it has been for several years; We are expecting a quick and nasty garden variety bear market that is resolved to the upside. What does garden variety mean? It means the US stock market could ultimately see a loss of 15-25%, perhaps during the current downtrend. Garden variety means nothing “special” or similar to either of the two 50% wealth destruction events since year 2000.We do NOT subscribe to the fear mongers out there suggesting we are doomed to a 2008 scenario.More on this in a minute.

 

Getting Close to a Buy

 

Several updates ago, we offered a potential investment model for internationals.In that discussion, we purposely did not include emerging markets or Latin America specifically as the environment was poor for developing markets.But that is changing and we’re starting to see a potential set up for buys in Emerging markets, specifically Latin America.Several things need to happen.First we need to see their markets start new uptrends.At present, we are only seeing their market’s stabilize.Second, we would need to see some stability in commodities and energy as emerging market economies are still very much dependent on their exports of natural resources to survive.Finally, we would need to see the Federal Reserve lay off the rate hike pedal and give us some forward guidance suggesting they are done raising rates for the foreseeable future.We are the most skeptical of the last condition happening, as it seems the Fed is hell bent on throwing the US economy into recession.But oil and commodities seem to be finding a base in here and now that the US dollar is also in retreat, we have a potential set up to invest in emerging markets again.

 

High Yield Corporate and Emerging Market Bonds

 

I hate to even say this publically, but both of these asset classes have given us short term buy signals in the last week or two.It is not a strong enough buy signal to get really excited and we’re a bit skeptical that these buy signals will hold for very long considering the rising default risks.But it is what it is and most of the best investments you’ll ever make are the one’s where you are holding your nose and hitting the buy button.We have taken very small entry level positions in both high yield and emerging market debt funds in all Blended Asset and Income models in the last few days.We also now own Treasury Inflation Protected Bonds for the first time in many many years.What do you know, we own Gold and TIPS, and the smell of inflation is in the air.Treasury bonds conversely still look downright ugly from a set up perspective and we will be quick to cut our only exposure (BAB – Build America Bonds) if and when the trend turns south.

 

Commodities and Base Metals

 

There is also something happening here.Again, we do not have enough evidence to engage with commodities or base metals yet (like Steel and Copper) but we are seeing favorable price patterns develop at near 12 year lows.Many things would need to become more definitive for us to embrace this trade including a strong move in the inflation indicators, some signs of new and robust economic strength and of course an uptrend in prices.All things considered, it feels like investors are going to have to wait a while for any of these to happen but we do want to call out the potential for developing buys sometime in 2016 based on what’s happening on the price side of things.

 

Why this is NOT 2008 – Part 100

 

It does not take a genius to see the similarity in the current market trends to those of 2008.We see the same top in the stock market as everyone.But you must know that every stock market top has very similar features and looks.This one is no different than 2008, or 2000 or any of those in the 60s and 70’s.But bear markets come in all different shapes and sizes.It’s really the downside pattern and duration that makes them all unique and no one knows what that’s going to look like this time.Here’s what we see and believe.We believe that market returns since 2012 have been pulled forward to a degree on the back of years of quantitative easing by the Fed and subsequent substantial financial engineering on the back of an overextended zero interest rate policy.I’ve spoke to both of these issues at length in the past.It means that we have probably seen some unjustified gains in select mega cap stocks and sectors since 2012 that should be corrected.But not all stocks had unjustified gains.In fact several sectors have suffered badly or gone no where in the last 5-6 years and these are major food groups for the US stock market including financials, banks, energy, industrials, materials, and high yield credit not to mention the entire world of international markets.These present oversold opportunities for investors who are looking to invest in something cheap.So parts of the market could be overdone while other parts of the market may even be trading at unjustified LOW prices.This is not a market condition or environment that leads the major averages to 2008 style losses.

 

Industrial production has also been in the news a lot as an indicator pointing to recession in the US.Aggregate industrial production numbers are down but let’s pick it apart a bit.Take a look at this chart offered by Bespoke on Friday.

 

 

What we see is the devastating impact of the energy crisis on the aggregate numbers.If we remove energy from the equation, one would be hard pressed to say that industrial production is anything other than normal and certainly not recessionary.But with energy factored in, it looks terrible, like a recession.Look back at the period between 2008 and 2010.Here we see almost the opposite condition when energy was adding some buoyancy to the Industrial Production index.That is what recessionary pressure really looks like.

 

Finally take a look at another Bespoke chart below showing Initial Jobless Claims (inverted) next to the S&P 500.Jobless claims are making near all time lows now and typically, these claims begin to rise 3-6 months in advance of a peak in the stock market or the broad economy.Focus on the time period between March and Sept of 2011 when the S&P 500 fell 15.5% even while jobless claims made new lows.In the end, the stock market snapped back to match the trend of falling claims (rising in the inverted chart).Could it happen again?Now?Certainly.

 

I have to remind myself almost daily that I am the weakest link in the chain when I have some preconceived notion of how things will play out.There is a lot of conflicting evidence out there now, so I can safely say, I don’t have a solid feel for the future.But I wouldn’t be so quick to throw out this market’s potential.As usual, we’ll be playing things as they come, making all adjustments as necessary.

 

That’s it for now – stay tuned.

 

Sam Jones

RESISTANT

There is probably one word that describes what I see happening in this market. That word is RESISTANT.

 

Buyers Still Resistant

 

After a very strong up week for stocks (nearly +5%), I was surprised to see the degree to which short term traders appear resistant to change their defensive positioning. We looked at the inflow and outflow numbers to and from short positions, current cash as a percentage of portfolios, as well as short term sentiment numbers. All three show a short term trader who is literally and figuratively not buying this rally as anything more than a rebound within a larger downtrend (or bear market). They might be right, but usually they are not. Short term trader activity and sentiment have long histories of being excellent contrarian indicators. The fact that they have not engaged with this rally so far, given all the short term positive technical reasons to do so – as of 2/11- means there is the real possibility that prices will continue to rise, potentially taking out the early February highs. On Tuesday, our Net Exposure screen suggested that breadth, volume and price patterns were strong enough to add back SOME stock exposure. We did so across the board but only by 5-10%. Current cash (and short term bond) positions are now roughly 30-35% of total portfolios, down from 40-45%.

 

Energy Stocks Resistant to Going Lower

 

Energy, and the pain surrounding this generational industry disaster, has been the subject of daily headlines for nearly six months. Most watchers out there figured that energy would have put in a cyclical low way back at $50-$60/ barrel. Now with the current price hovering at $30/barrel, even the strong willed and vocally provocative Middle East suppliers are buckling with talks of a cut backs in supply. Still supply is a problem and still global demand is in decline. I will volunteer that oil producing companies and countries don’t really know how to do anything but produce oil. Cutting supply down to sustainable or economic levels basically means shutting down your company or your country for a while. Expect bankruptcies, mergers, acquisitions and even more social unrest in the Middle East to follow. But, we are also starting to see select US based energy stocks show a little resistance to going lower. In fact, several are now positive on the year by 3-5%, paying some very nice dividends and have broken their intermediate term downtrends – to the upside. Given the previous comments, we might think this show of technical strength is transitory. But it is also widely known that energy stock prices will bottom and rise dramatically in anticipation of a final low in the actual commodity by as much as 9-12 months. The companies that are behaving well are those that are broadly diversified, have stronger balance sheets, some free cash flow and not exclusively living or dying on production. This week, we took a small entry level position in Schlumberger LTD (SLB) adding to our only energy stock Phillips 66 (PSX) in our Worldwide Sectors strategy for combined total of 6%. SLB is now up 3.81% YTD paying 2.76% in dividend yield holding steady with high free cash flow, very low debt to equity and a 9% 3 yr. average return on capital. They are well diversified and the stock is trading off its highs by 35%. And now, we have a constructive price pattern while it’s outperforming the S&P 500. This is not a recommendation to buy SLB but rather an opportunity to illustrate the types of situations that we find appealing for one of our stock strategies measuring both fundamental and technical evidence. PSX is still down slightly YTD (-2.14%) but holding strong in terms of recent price action. With a Price to Earnings ratio of only 9, a healthy balance sheet and positive free cash flow, we’re giving this one a little wiggle room from our purchase late last year.

 

Perhaps the most important thing to consider with the recent strength in select energy stocks is the psychological benefit to the broad market. Energy and the US stock market have shown very high correlations in recent months. A bottom in energy could easily be a catalyst for at least an intermediate term bottom in the broad US stock market. It’s too early to make that call for either side however.

 

The Fed Now Resistant to Raising Rates

 

A rate hike in March is off the table, probably June as well but we’ll see. As I’ve said before, the new Federal Reserve seems more reactive to outside pressures than other reserve boards in the past. They are working overtime to justify what we all see as a reactive policy. One month, they can only talk about rising stock prices, full employment and rising wage pressure (hikes). The next, we hear only about the rising risk of global recession (no hikes) and the impact of currency spreads on the foreign central banks. So for now, the Fed is going to be resistant to raising interest rates which will keep the US dollar down or under pressure. Why should you care? Well if you remember from the last couple updates, the rising US dollar has been cited by almost 70% of companies reporting this quarter as negative force behind declining profits and revenue. If the US dollar is not rising, then of course, we might expect stronger earnings and revenue in the next couple quarters. Even so, the current earnings season has not been as terrible as (we) expected. 75% of large cap companies have already reported for this quarter. I won’t say it’s been an easy ride for stocks but most of the damage to the markets was done in the January, well before the reporting period. All things considered, the Fed’s resistance to raising rates for the foreseeable future, should also be supportive for the stock market especially those sectors like materials, industrials, commodities and internationals.

 

Resisting the Urge to Get Bullish (us)

 

We see the discount in the markets. We see the support level still in place marked by the lows of last August and again this January. We see three consecutive days of strong volume with 80-90% of advancing issues. But it’s not enough yet to change the intermediate term trend of the global financial markets. In fact, even if prices do manage to rise above the late January peak (S&P 500 – 1940) the trend will still be negative. The S&P 500 would need to rise and hold above 2005 for anyone to even consider the possibility of a trend reversal. At this point, we are looking at the potential for a stronger than expected rebound rally within a larger and longer decline. Selling and buying pressure indicators are in bear market mode. Long term moving averages are falling with prices trading below, pulling then down. Margin debt is contracting from a multi-year high, small caps are still a disaster, we have almost no leadership at the sector level and investors are still very spooked. We remain resistant to the concept that this is just a correction but rather continue to expect to see a bear market in US stocks unfold before we get an attractive moment to become fully invested again. The downside risk in the S&P 500 back to a valuation level that is reasonable, is about 1550 by most measures. That’s a lot of air between here and there. While we do not see a longer term opportunity in the broad US stock market yet, we do find lots to get excited about in individual oversold stocks. So our strategy remains the same; Carry high cash while remaining active in our selection criteria with exposed capital. It’s just going to be that kind of year.

 

Signing off for the week – from the drippy world of Steamboat Springs, CO.

Sam Jones

READY TO ACT

There are times when we need to be ready to act with our financial assets, whether we talking about investment choices, loans or cash. I think we’re getting close to one of those times.

 

Bonds- Getting Ready to Bail Again

 

Treasury Bonds have done a great job for investors in the last couple months as stocks have been in a near free fall. Today, the long term Treasury bond is up almost 11%, 10 year Treasuries are up 5.62% and (our choice) Build America Bonds paying 4.52% interest annually are also up 5.31% YTD. This is all great news but we need to remember that the bulk of these gains are really just recoveries from losses incurred in early 2015. In fact, the 20 year Treasury Bond is still below the level set on 1/30/2015 by 1.35%. Most regular readers know how I feel about US Treasury bonds or most sovereign debt for that matter. They are somewhere between unattractive and a disaster for longer term investors. We will own them selectively for a trade as we do now with the Build America Bonds (BAB) but just to generate a little income and hedge any equity holdings. Jared Dillon who writes an excellent and highly contrarian newsletter called the 10th Man from Mauldin Economics, put this out today

 

 

We now have an alarming $6 Trillion dollars worth of negative yielding government bonds floating out in the world. None of them are US based thankfully but we’re a global ecosystem remember. Assets classes like bonds and stocks are moving with high correlations across oceans. Some are arguing that the US will also eventually move to negative rates like Europe and Japan. That’s crazy and it won’t happen. Desperate countries do desperate things but we’re not that desperate. Negative yields on bonds mean that owners of bonds effectively pay interest to the bond issuer to own the bond. It would be the same as my bank paying me interest to give me a loan on my house. Crazy? That’s what’s happening and it can’t last because it is just as illogical as it sounds. So the only reason one would own a bond with a negative rate is because you are governed entirely by fear, you believe in the entrenched future of deflation forever or you must own them because you issued them (wink).

 

I will suggest that Government bonds are fast approaching bubble status. I can’t say how or when we should expect a spike higher in rates, (spike lower in bond prices) but I see something like that happening. This will not come from anything under the control of central banks but simply market forces at work. The action item here is simple. Get ready to exit your bond positions. Likewise, I would pick up the phone and call your lender and ask about refinancing options for homes or other properties. We’re very close to the lowest mortgage levels we have seen in the last five years (again). I shaved a full point (1%) off of our small commercial loan for our office building in Denver this am with a telephone call and signature. No charge. Done.

 

Bottom Developing in Commodities?

 

I should say some commodities. Energy is still a disaster. But while we’re hearing all this chatter about deflation and negative rates and global recession, I’m also watching Gold, Iron Ore, Copper, Basic Materials, Inflation Protected Bonds, Emerging Markets and select Industrials move quickly to the top of the performance charts. The market is visually telling us a different story than what we are hearing over the last three weeks. This is a story about inflation – coming. This is a story about opportunities in very oversold sectors that have been trading down hard for nearly five consecutive years. Something is very strange about what we’re seeing because it conflicts directly with the recession/ deflation thesis that seems to be firmly entrenched. Now that the US dollar has broken its uptrend, we also have some macro confirmation to start looking at commodities of all sorts for a meaningful low. The action item here is to be patient but perhaps consider building small entry level positions in gold and other inflation hedges.

 

Get Your Cash Ready

 

This is a very early call to make. Now that the broad US market has broken the August and February lows and International markets have touched the -20% decline mark, I think it’s time to identify cash to potentially add to any investment accounts and get it ready to move. We are NOT ready to say “Add money now” because this is a highly emotional market that is just now breaking support. The action item here is to find cash, free up cash, move cash into a place where it can be invested. Often this very act is by itself prohibitive to investors adding to their investment accounts in at important times. Then, they feel it’s too late after prices blast off the lows. So let’s be ready but not invest our cash yet.

 

As an aside commentary, this waterfall decline in stocks early in the year is very much a bear market pattern. Bear market years have very weak 1st and 4th quarters while the 2nd and 3rdquarters are typically much stronger and can have some impressive rebound rallies. A bull market pattern is exactly the opposite. Strong in the 1st and 4th quarters and weak in the middle. Think about the mantra sell in May and go Away. That’s a bull market theory that works terrible in a bear market pattern. Often, we see the first set of price lows in March or April during bear market years just as we did in 2001 and 2008. Then we get that relief rally which can carry right through the summer with some impressive gains. Finally, sellers reemerge and take prices down to lower lows in the final quarter. Thus far, we are looking at a very clear bear market pattern for stocks but that also means, we could have a tradable rally develop in the next 30-60 days giving us perhaps our only set up to make money in 2016. This is also very speculative commentary and a very blunt instrument for trading purposes. We’ll act according to actual market conditions as always.

 

That’s it for today and probably tomorrow- Have a nice long holiday weekend.

Sam Jones

WE’VE GOT THIS

My youngest son is putting grey hair on my head. He loves to do big jumps in ski terrain parks, launch huge rocks and make videos with his GoPro like every kid his age (12). Sometimes, I can’t watch. In one of his recent videos, I heard him confidently say to himself, “I’ve got this” as he was approaching a big drop. He nailed it – no problem.

 

We realize there is a great deal of trust involved when you hand someone your money to manage. For this update, I’m going to provide you with a detailed insight into our current positioning. The intention is to give you some peace of mind and earn that trust while it seems the financial world is crumbling. This will be especially relevant for our newer clients who haven’t had the tenure of our legacy clients.

 

N/S/P

 

As a reminder to all, our process in all strategies is based on three primary criteria. Net Exposure (N), Selection (S) and Position Sizing (P). One could go round and round with titles for all of this. Some would call it relative strength analysis, others might call it dynamic asset allocation or market timing. We think of it as prudent risk management with a focus on generating asymmetric results. Asymmetric results are a goal, which we state clearly in our Explicit Investing Creed nearly everywhere on-line and in print. This is a not a guarantee but a clear objective measured against an entire portfolio over a full market cycle, usually 5-6 years. Here’s how we define success:

 

Success (defn.) – Generating asymmetrical results across all investment strategies: to expose ourselves to return in a way that doesn’t expose us commensurately to risk, and to participate in gains when the market rises to a greater extent than we participate in losses when it falls.

 

So let’s dive into our current positioning using N/S/P to frame the discussion

 

Net Exposure

 

As of Friday last week, we raised our cash (money market fund) position again across almost all strategies. Today, we’re doing a little more selling as several positions are breaking stops. Remember that we have been selling to cash aggressively since last November and December in response to market conditions. Recently, we have just moderately increased that very large cash position. That’s all. At the end of today, the cash position for each of our strategies is listed below:

 

Holding Tank – 100% cash

Retirement Income – 83% cash

Freeway High Income – 38% + 62% muni bonds and government bonds

All Season – 46% cash

Foundations – 49% cash

Gain Keeper (Annuity) – 67% cash

Worldwide Sectors – 50% cash

High Dividend – 44% cash

New Power – 56% cash

 

That’s a lot of cash for any investment portfolio but under current circumstances, we can feel very confident that our client’s portfolios are NOT losing 2% / week like the stock market. Far from it. In fact, after today, our Freeway High Income strategy is likely to go positive YTD on the back of the very large bond position and several other strategies are only down 3-4% YTD while the US markets are down almost -10%. Foreign markets are approaching – 20% YTD. Total portfolio results for any of our households will of course vary depending on your specific mix and allocations to our strategies.

 

Selection

 

Our remaining holdings are generally very defensive positions, heavy in things like consumer staples, telecom, industrials, utilities, materials, low volatility index funds and select bonds. Frankly, each week in the past two months, we have lost holdings that are breaking stops, breaking long term uptrends or under heavy selling pressure. The things we have not lost yet are those that are still showing excellent relative strength, often still trading above rising moving averages, are in the right sectors or in some cases, making all time new highs like AT & T (T). Almost everything with a few exceptions is correcting down from the late 2015 price highs but rarely are they sinking like the markets. Instead, they are just down some and still trending higher. Last week I mentioned Dividend Paying ETFs as a place to consider holding some exposure. As an example, I want to highlight one ETF that we own just to show you the internal holdings and how the market is still showing strong preference for a certain type of defensive stock. That ETF is the I Shares Core High Dividend ETF (HDV). It seems to be invested in just the right place for this market and this fund is now our largest holding in our flagship All Season strategy. For compliance reasons, I cannot show you gain or loss on any one investments without showing the same for all positions so I’ll avoid that. But I will show you what is happening to the internal holdings of HDV on a day like today.

 

Today the market is down 2% as I write (again). At 10:00 am MST, I took this snapshot of the intraday performance of the top 10 holdings in this fund. Here’s what it looks like

 

 

5 of the top 10 holdings, which in aggregate represent more than 50% of total ETF assets, are UP today. That is just about as close to an investment magic trick as you can find while the S&P 500 is down 2% in aggregate. HDV, the ETF, is down 0.30% today by comparison. So there are still reasons to stay invested in things like HDV as money continues to flow to these specific defensive names.

 

Other positions that we continue to hold are those that are showing non-correlation to the stock markets of the world. Last week, we bought gold across several strategies for the first time in years. Why? Please cycle back to last week’s update for details. Gold funds are spiking higher 3-5%/ day. Of course this won’t last and gold is now wildly overbought in the short term. But for now, we look at gold as a reasonable hedge against a falling stock market and may add to these positions on a mild pullback (in Gold). We also own specialty liquid alternatives like the 361 Global Long/ Short fund and a new addition called the Direxion Managed Futures fund (bought today). Again, these positions, like gold, move to their own beat and are showing little to no correlation to the price action in the major stock indices.

 

Position Sizing

 

This criteria addresses our conviction in any investment. When our conviction is high, we develop and hold a larger allocation to the investment. When we are just entering a new sector or dipping our toes in the water of one thing or another, our conviction is low, so our allocation is low. A large investment in any one security might be close to 10% of a strategy. As I mentioned above, HDV has that type of allocation in our All Season strategy now. A small position might be 2-3% of a strategy. Today, we are dipping our toes into the oversold industrials and materials sectors taking very small positions in companies like Cummins (2%), QCOM (2%), ETN (3%) and CHRW (3%). If these companies prove themselves in terms of expected price action for their very strong fundamentals, we will add to their “position size”. This is pretty basic 101 investing stuff but this is another one of those dials we can turn to adjust to conditions as they develop.

 

Hopefully, this gives you a sense that you are in good hands with adjustments happening as they should to reflect current conditions. We do not sell everything in fear and we do not buy 100% on any given day. But we do follow a well-defined process that leads to excellent results over time. We’ve got this  

 

Sincerely,

Sam Jones

BIG CHANGES

There are some big things happening in the market suddenly. If they hold and persist, investors will have many more options to make money in 2016 than current sentiment would imply. Here’s what’s happening and where those opportunities are developing.

 

US Dollar Just Broke Down

 

The theme of the rising US dollar has been one of the most widely covered topics in the financial media. Corporations have blamed the strengthening dollar for much of their earnings erosion for the last 6-7 quarters including the current one. The entire commodities, energy, industrials and materials complex has also pointed to the rising dollar as a headwind to their profits. Likewise investors have watched their US dollar based international investments experience true bear market losses. The rising US dollar has also put a lid on bond performance across all maturities as well as other interest sensitive sectors like Utilities as investors responded to the risks of higher rates (the Federal Reserve). Currently, there is real sensitivity to the strong dollar and rising rates as our economic recovery is just not strong enough to handle these headwinds yet. Later, these won’t be as much of an issue. In the short term, the rising trend of the US dollar seems to have come to swift end with yesterday’s 1.6% plunge and break of the intermediate term trend.

 

Currency trends tend to track the economy for any given country. For the last 5-6 years, we have seen the US dollar stabilize and begin to rise strongly indicating the US economy was moving from recovery to actual growth. Now, the US economy is clearly getting weaker but is not recessionary (yet) and thus it makes sense that the US dollar would follow the economy lower. We don’t know if the US will slip into recession but it is angling that way. What we do know is that the market has corrected significantly already, enormously in certain sectors and indices, and may be approaching a buy zone as early as March or April. There are opportunities developing now on the back of a weaker US dollar. Tomorrow, if the Non Farm Payroll numbers come out as expected (200k ish, maybe less = pretty weak), then these opportunities will begin to solidify.

 

The Opportunities

 

1. Earnings Revival

This speaks to the overall market for larger multinational companies like those in the Dow Jones Industrial Average who could see earnings surprises associated with more favorable currency exchange from foreign revenues. We would not expect a broad market rally higher until we saw an earnings revival. For now, earnings growth is down and falling and we need to respect that reality. But if the US economy can avoid a recession and if the US dollar trend remains lower, earnings could see a nice boost and all of this unpleasant market action will just look like a garden variety bear market (15-20% decline) within a longer term uptrend. This is, and has been, our long view expectation for several years. We believe this is a “Transition” market associated with a mid cycle economic pause within a much larger economic growth cycle. Wow, what a mouthful.

 

2. Energy/ Materials/ Industrials/ Commodities/ Metals and Gold/ Internationals

These sectors are the home to some of the best values out there. They have been pounded into the dirt for the last three years trading a 10 and 12 year price lows. We have all heard of the pain. But a falling dollar provides the right macro backdrop for these companies to get up and run higher. I am probably the least confident in a lasting rally from the oil and gas companies but they are certainly seeing some very nice gains suddenly. Oversold industrials and materials companies are probably the most compelling of the groups based on current dividends and valuations. They are just so darn cheap! Last week I also offered a potential investment allocation for internationals, which present some compelling value for investors right now. Again, the falling US dollar would be boost to returns for US investors. Even gold and gold miners are getting a tremendous lift now – up another 6% today. In the short term miners and gold bullion are overbought so buyers should wait for a pullback.

 

3. High Yield Bonds – Corporate and Emerging Market

I have mentioned this for weeks but there is a buy coming in the high yield bond market. Yield spreads are now attractive again and price trends are getting close to confirming a new buy signal. Nothing yet, but getting close. Emerging market bonds actually did trip our short term buy signal on Friday and we took a small position in our Blended Asset and Income strategies. As a quick reminder, High yield bonds have never lost money on a total return basis for two consecutive years. Last year, they lost almost 8% and are down another 3% YTD. 2016 should be good for this sector.

 

4. Dividend Payers

Dividend paying stocks tend to get hurt when rates are rising as they have been since February of last year. Now that the US economy is getting weaker, bond prices have moved up, rates have fallen and we now have a better backdrop to look for dividend payers. Again, many of the best names from a value perspective are in the industrials and materials sectors but also utilities and select consumer staples. Energy company dividends are suspect and being cut daily so again; we’re not going there. Three of the best dividend paying ETFs with the right mix of internal holdings for this market are HDV, DVY and SDY. We own the first two in several of our strategies. Both are nearly positive on the year, strongly outperforming the broad US stock indices and paying almost 4% annual dividends.

 

5. Value over Growth

This has been another topic of discussion in the last couple months but here again we have the right backdrop for a strong surge in the value side of the market at the expense of Growth. That transition has not happened yet but we’re seeing some early indications of a rotation in play. Make a list of your favorite Value mutual fund managers and keep them on deck.

 

Again, all of these opportunities really need the backdrop of a falling or even flat US dollar to move sustainably higher in the weeks and months to come. If this is just a correction in the US dollar and the uptrend reasserts itself, these same groups will fall out of favor again. It’s sort of strange to talk about opportunities on the back of a weaker US economy but that the enormous disconnect between Wall Street and Main Street. Some of the very best moments to be a buyer of stocks are just as the economy approaches a recessionary state.

 

Stay tuned

 

Sam Jones

2016 BEST BETS – PART III

Before we get too far into the year, we need to get out one more edition of our 2016 Best Bets series. The focus for this update will be internationals, specifically which countries are the most attractive from a fundamental perspective as well as some suggestions for how, and to what degree, you might own them in your portfolio. I’ll finish with a very rare political statement connecting “The Decline and Fall of the Athenian Republic” and Donald Trump’s public appeal. What the?

 

Most Attractive Internationals

 

I want to preface this section by making a strong statement. A country, or any investment for that matter, can be attractive for fundamental reasons and yet the trend of that investment can still be down and negative. This is the primary weakness of a pure fundamental approach to investing. One of my professors in business school, Tom Marsico, was a die-hard growth manager (then with Janus) and always held the line on owning companies with strong balance sheets, high free cash and competitive advantage. I watched his growth funds lose nearly 60%, twice in subsequent years. Great companies and great countries can fall in price much further than most investors can tolerate. Anything can lose value as a pure function of an investor’s unwillingness to own stock, pushing cheap companies to become even cheaper. As we like to say in our office, zero is also cheap. There are so many examples right now of companies and entire sectors that are incredibly attractive in terms of their valuations and yet every day they fall under selling pressure. So the answer for investors, and the root of our disciplined process, is to understand, recognize and identify value from a fundamental perspective. But ownership should be restricted to periods of time when the price is moving UP. We do this through basic technical analysis of price trends using momentum, breadth and volume to confirm. Enough on that. So which countries are the most attractive from a fundamental, value based perspective?

 

To answer this question, we looked at each country from several different valuation perspectives including dividend yields, 12 month trailing Price to Earnings ratios, Price to Earnings Growth (PEG ratios). We also looked at trends in share of global GDP asking the very high level question; which countries are increasing their share and which are participating less? We looked at country index performance over the last 3-5 years identifying those that are trading at discounts from previous peaks as of the end of 2015. Are they oversold or overbought on a long term basis? Finally, we looked at demographics and other external factors like currency and political risk. We put all of this information on the table, turn on our brains, have a little quiet moment of reflection using a weight of evidence approach and make our choices. I won’t bore you with the data but rather just get to the results, which may surprise you. All things considered, we feel these countries offer investors the most attractive prospects – listing only those that are attractive in order of most attractive first:

 

Hong Kong

Singapore

Taiwan

Korea

India

Japan

Sweden

Europe (diversified)

United States (barely made the list)

 

I know, we were sort of surprised to see so much of an orientation to Asia, especially China at the top of the list. China’s stock market is obviously in a period of heavy consolidation and correction after gaining 35% in 2014 into the final peak in early 2015. China is still the fastest growing country in the world assuming their reporting is accurate. They have the demographics and the firepower to continue taking more and more share of global GDP at the expense of the developed world, like the US and Europe. Meanwhile, valuations are now almost 40% lower than most of the developed world. Close trading partners like Japan, Taiwan and India are living and benefiting from the growth in China. We see fast growth, attractive values and now a developing buying opportunity into an oversold price condition.

 

How To Own and How Much To Own

 

Now we’re really going to go out on a limb and suggest what we feel are the best ways to own these countries and propose a simple weighted allocation to the same. Please remember that any recommendations here do NOT factor in any investors’ tolerance for risk, time horizon or total portfolio objectives. This is just a very high level suggestion to consider giving you an idea of how WE might split the pie. We would recommend only using international ETFs (exchange traded funds) for this adventure because they are nearly free to own with tiny internal expenses and can be traded freely without hold periods, redemption fees or other mutual fund imposed BS. We would also recommend a TOTAL and maximum allocation of 20% of total portfolio value allocated at this time. These positions should NOT be purchase at one time nor should they be purchased tomorrow. All investors should limit ownership to any of these once they stop falling and develop identifiable up trends in price. At present, not one satisfies that criteria, so we watch and wait but we know where our money is going. Ok?

 

AAXJ – Asia Pacific ex Japan ETF – 6%

This ETF has the right mix and weightings to Hong Kong, Singapore, Taiwan and Korea. It is really quite perfect. Other Asia funds and ETFs have all sorts of crazy mixes including heavy weightings in Australia (like EPP) or purely China. AAXJ is also on our list of free ETFs for institutional money managers at Fidelity = no transaction fee. We plan to buy this incrementally in pieces and accumulate over time.

 

IEFA – Europe, Australasia and the Far East – 6%

This is the classic EAFE index which covers our exposure to all of Europe, Australia and Japan. We don’t love these countries but they are better looking than the US at present. We need to carry some exposure here and choose to do it in the most broad and diversified way possible. IEFA is also on our list of free ETFs at Fidelity

 

MCHI – China Index ETF – 3%

Again, this is just to get a toe-hold in China directly, coming off a deep discount. At present the chart pattern for China is very negative so this opportunity may present itself later in 2016 or beyond. But we plan to keep it on the list until the weight of evidence suggests otherwise.

 

INDY – India ETF – 3%

We want to own India directly and with some conviction as India is the second fastest “gobbler” of global GDP next to China. They have the right demographics, the right valuations, pay one of the highest dividend yields and they are in a position to grow substantially. INDY is still in a downtrend so we’ll wait. This is another free ETF for us at Fidelity.

 

EWD – Sweden ETF – 2%

We would describe this as our wildcard play. Sweden, just continued to rank highly in our research and we feel there may be a unique opportunity here. We doubled back a few times just to make sure the data was good and without anomalies. It looks good. Typically, we would not choose to get this granular but there are exceptional opportunities like this periodically and we can own it easily through this single ETF.

 

Note – the rising trend of the US dollar has made international investing a bit of a challenge for investors buying shares in US dollars. This is one reason why we recommend smaller allocations as a percent of total portfolio. Remember that the US dollar has been rising versus all other currencies for almost two years now. The Canadian dollar for instance is trading at nearly $1.40 meaning 40% lower than the US dollar. $1 USD buys you $1.40 worth of Canadian goods and services. Canadian and US currencies have been on par for as long as I can remember – not any more. So, there is a wide gap in currencies now that is likely to become wider. But a lot of the spread is already out there now for most foreign countries. What if internationals starting gaining in price with a flat or declining US dollar?  Talk about the Big Bang!

 

Trump and Athenia ( a rare and personal political opinion – feel free to skip)

 

In 1776, yes the same year as our Declaration of Independence, a European historian named Alexander Tytler wrote a notable summary about the cycles of empire called, “The Decline and Fall of the Athenian Republic”. Bare with me. In that piece, he outlined what he saw as the life stages of all democracies. Since his work was published we have seen these trends and cycles play out over time, mostly in Europe. This was probably his most famous quote along with the sequence of the cycle he outlines.

 

“A democracy cannot exist as a permanent form of government. It can only exist until the voters discover they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising them the most benefits from the public treasury, with the result that a democracy always collapses over a loss of fiscal responsibility, always followed by a dictatorship. The average of the world’s great civilizations before they decline has been 200 years.”

 

These nations have progressed in this sequence:

From bondage to spiritual faith,

From spiritual faith to great courage,

From courage to liberty,

From liberty to abundance,

From abundance to selfishness,

From selfishness to complacency,

From complacency to apathy,

From apathy to dependency,

From dependency back again to bondage

 

A little math for you. 2016 – 1776 = 240 years – we’re overdue.

 

Bondage is another word for dictatorship and enslavement. From a European history perspective, the most glaring example of a recent dictator was Hitler and Nazism. Perhaps it’s just coincidence and perhaps I am just reading too many books about events leading up to WWII like “The Boys in the Boat” and ” All the Light We Cannot See”. But, these stories speak of a public psychology that accepted and was almost willing to embrace the rise of a dictator like Hitler. Hitler and Nazism germinated in a fertile environment of discontent and hopelessness associated with a deep depression in Germany. Hitler offered to “Make Germany Great Again”. You know where I’m going with this. Hitler declared that certain unappealing members of their culture (Jews and anyone that did not fit his vision of the perfect race) were responsible for Germany’s failure. He declared that Germany had become weak in its policies and practices. Germany needed to get tough and tear down the self-serving political and cultural institutions that had brought the country to its knees. Sound familiar? This promise to “Make Germany Great” lead to some very unattractive new social standards which turned Germany to a state of martial law very quickly. A military state ensued and Germany attempted to take over Europe leading eventually to WWII. But the amazing part of this European history lesson was the German people’s early acceptance and spirited appeal of a new conservative leader called Adolf Hitler. He just told the people what they wanted to hear without really clarifying the horrors of HOW he planned to do it.

 

 

Now circle back to the last line of the progression of democracy. If I had to put a red “you are here” dot, it would be on the last line, where we are sitting with a system that has become fully dependent. Today, we have massive debt spending by governments and quantitative easing that makes us all dependent on low rates and that same spending standard. We have a very large population who are almost completely dependent on social security and Medicare. We have a public pension system that promises unsustainable payments for lifetimes. And we have a very robust welfare state with safety nets like unemployment benefits. I would have to lump in the Affordable Care Act as a new form of heavily subsidized welfare as well. Make no mistake, we are country that has become dependent on government programs. These are products of a democracy that have run amuck for nearly four decades.

 

Meanwhile, we have a middle class working man that still can’t seem to make ends meet. He is angry and frustrated that he works so hard but never has enough while others are getting handouts. He doesn’t care if the system fails because the system has already failed him. Now, we have a strong new conservative voice that promises to end it all, to burn down these failing institutions and do things like put up walls against immigrants. Side note – remember that a majority of the greatest companies in the US were founded by first generation immigrants (Google for instance). He promises to “Make America Great” by rooting weakness out of our system (like women, minorities, gays, undesirable politicians, or ineffective business people). After all, Trump did have a reality TV show called “The Apprentice” where he reveled in saying “You’re Fired!”. So he is the expert and he’s the guy who decides! He promises to end dependency and failure. What he doesn’t say is that he could/would do so by putting many into “bondage” and ending democracy at the same time. Spend a minute reading through the posts of those who declare allegiance to Trump in the Atlantic.

 

 

 

http://www.theatlantic.com/politics/archive/2015/08/donald-trump-voters/401408/

See if you can find these themes, they are not hard to find with quotes like “I just want it all to burn” or “Trump will tell us how to be great”. This is a population that is ready for bondage.

 

I believe that Trump is The Angel. We cannot blame him for what he is but rather we should blame ourselves for our willingness to even entertain his message. He is appealing to the collective outcry of an angry population and make good on his promises through some form of dictatorship and bondage. I know that sounds paranoid but if you hear his agenda, you must know that many in our country could find themselves at the end of his pointy finger. How safe are any of us? Who is in, who is out? I don’t believe democracy has to fail but it sure feels like Trump could put it to the test if he were elected president. Never in the history of mankind has a population ever been better off under a dictatorship and we would be better served trying everything we can to gradually unwind our state of dependency than to go down this road. As a registered Independent, I will likely vote Republican this election as I feel our country needs to swing back away from a state of dependency. Sanders would certainly push us deeper into that state. But I will not vote for Trump.

 

I hope the good folks in Iowa can see him for what he really is.

 

Sincerely,

Sam Jones

The bear market that began in late December is following the script of previous bear markets pretty closely including a very predictable short term low that developed late last week. If things play out as they have in the past in terms of investor behavior, price patterns and timing, then we should still be looking out several months from now for our first opportunity to add back some market exposure. Should you buy now? Not Yet.

 

Bear Market?

 

Regular readers might have caught the label. Yes this is a bear market and not a correction. The process of this market top began in July of 2014 (not 2015), and completed the topping process in December of 2015 after a long, painful, “flat” 12 months of churn. Price patterns, loss of leadership, average declines across a majority of stocks, sentiment, breadth and volume all confirm what we would describe as bear market conditions. The financial media is still waiting for the S&P 500 or the Dow to cross below the -20% level before giving it the title but those are really just silly benchmarks. If history repeats, these are always the last indices to fall into bear market loss territory. The average stock in the NYSE and the NASDAQ are already down well over 20% from the highs, while the average small cap stock is down 30% or more. Global stock indices are down 15-17% from the highs with several less developed countries down in the 20’s and 30’s in percentage terms. I’m being non-specific about numbers on purpose. These are bear market conditions with bear market losses everywhere so waiting for one index or another to ring the bell in order to give the whole environment a title is somewhere between denial and not paying attention. Let’s accept it and move on.

 

Short Term Low in Place

 

Starting on January 15th, extremes began to show up for those of us watching technical indicators like sentiment, breadth, overbought/ oversold, price support and volume. We spoke specifically about a target of 1850 on the S&P 500 as a likely short term stop and indeed the S&P 500 hit that mark almost exactly at the lows, closing at 1859. The doomsdayers hit the media over the Martin Luther King weekend, calling for a crash and the end of modern day capitalism as we know it. By the end of the next short market week, stocks finished up 1.4% on average breaking the panic and fear in the system. So where are we now? How does the pattern play out from here? Well the short term bear market bounce should continue into early February or so pushing prices up to 1950 – 1972 on the S&P 500 before sellers take control again. The average bear market rebound is between +6.5% and +8%, which would almost erase the YTD losses. We’re not expecting that much of a bounce but those are the stats. This week, our fearful Federal Reserve will once again bend to the will of foreign central banks and talk down their conviction to raise interest rates in 2016. I will be very surprised at this point to see a rate hike until June. Q4 earnings hit the market in February and March and given the challenging year over year comps (Q4/2015 vs. Q4/2014), I’m going to say the market will be volatile. This morning, Lowry’s Research made a very bold statement saying the conditions for a sustainable low in stocks are not present, not really even close. They pointed to two dominant variables that suggest the markets are still in a very high risk place. The first is the state of the their proprietary Buying and Selling pressure indices (sell below). Notice how the Buying Pressure made a new low last week while Selling Pressure made a new high. At sustainable market lows, these trends are reversed even as prices continue to fall marginally or carve out a multi month bottom. Also notice how the two indicators did not definitively separate until December of 2015, as the NYSE was still trading marginally above the 200 day moving average. These are the twilight zones of a top and one of the reasons we have been reluctant to say we were in a bear market – until now.

 

 

 

The other condition presented by Lowry’s was the state of something called the Operating Companies Only (OCO) Advanced Decline line which broke below the August, 2015 and October 2014 lows last week. This indicator has unfortunately been pretty good at forecasting the future of the markets not in timing but in magnitude. In other words, following this lead we should not expect the August lows to hold before we see the development of a sustainable bottom. High yield corporate bonds and small caps are also telling of the same outcome. Technicians will describe the current short term level as an “internal” low or a momentum low, but not the final “external” low.

 

Investor Options in the Weeks Ahead

 

There are several options now available to all investors depending on your views and expectations. They are as follows:

  • 1.Do nothing

This is the option for the folks who are passive investors, who stay the course no matter what. They believe generally that markets always go up and that any effort to manage risk is futile. Adjusting exposure is not part of this investor’s process beyond timely rebalances. Those rebalancing windows should happen at market extremes when bonds are high and stocks are low (by selling bond positions and buying more stock). As mentioned above, we don’t believe we’ve seen those price extremes yet in either asset class.

    • 2.Prepare to cut exposure on a rebound

Investors, who are still feeling overexposed to equities and have a clear process in place for risk management, could use any rebound as an opportunity to reduce exposure. You will need to sell into strength, which is difficult for most as we feel that tomorrow’s gain could be even better than today’s gain right? Determine now how much net exposure you want to the financial markets and plan to be at that level as (if) stocks rebound from here. In our all equity models, we are sitting on 40-45% cash. Remember, in a bear market, selection matters much less than exposure, as all ships tend to move up and down together in a highly correlated dance. In fact all global stock markets are now moving very much in sync in both timing and magnitude so there isn’t much use in shifting your money across oceans either. I took a snapshot of the end of day move from a basic Fidelity app on Friday as the picture was worth a thousand words. All up, all by the same amount, across the globe. These blue circles are periodically different colors and sizes based on the various price action in different parts of the world but more and more often, they all look the same. It is truly a global stock market these days and frankly has been for the last several years. As a side note, this is one of the primary reasons we changed our equity benchmark to the Dow Jones World Stock Index (50% US/ 50% the rest of the world)

 

 

    • 3.Hedge

This is also an option on any rebound but generally not one I would recommend unless you know what you’re doing. This involves buying a short market position against your own internal “long” positions in order to hedge out the systematic risk in your portfolio without necessarily selling positions and potentially generating tax liability. We have the capacity, the will and the experience to this in our Tactical Equity and Blended Asset models.

 

We’ll Let You Know

 

As always, we try to be good about telling our clients when to add new money to your investment portfolios via our “Calling All Cars” message. Last August, before we had enough evidence to support the current bear market thesis, we saw a clear opportunity to recommend adding new money to investment accounts and we did so. At present the market is still trading slightly above those levels. That recommendation may or may not prove to be a good one considering our expectation of lower lows. But conditions were discounted then and conditions are discounted now. In the current environment, we think there will be better discounts available in the 2nd quarter or even the 2nd half of the year. So for now, we’re not recommending adding new money to investment accounts. We’ll let you know.

 

That’s it for now, stay tuned

 

Sincerely,

Sam Jones

WWBD?

Bear markets push our buttons. They shake our commitments, our conviction and our investment compass. They lead us emotionally to that dark place where we ask, is investing just a sucker’s game? Let this update serve as a reaffirmation for why we invest in the stock or bond markets and how to do it the right way. What Would Buffett Do?

 

Investment Realities

 

Most of the world stock indices including those in the US are now showing negative results over the last 24 months (two years). If you’re feeling like you haven’t made money in the last two years, it’s probably the truth. Yes, there are lengthy periods of time without gains or even losses. When we go through these cycles, we are often reminded that we should invest for the long term. What does that really mean? We don’t interpret that to mean ‘stay with the same holdings or even fully invested through all markets’. That means stick with your discipline, your risk tolerance and your process for the long term, through all markets. If you’re a buy and hold, passive investor, then you hold and hope in periods like these. If you’re an active manager (us), you adjust as conditions warrant. Both have risks and pitfalls. In times like these we have that voice in the back of our minds saying, ‘just sell everything.’ Selling everything in a fit of emotional despair regularly proves to be an act of financial suicide, especially when it happens at the bottom. Furthermore, your portfolio will never recover sitting in cash and you will have the added difficult decision of when to get back in.

 

At the same time, the financial services industry does a great job convincing the masses that “the markets” generate a 7-8% return. Here’s the reality check. That 7-8% number is valid only when looking at long, long, long term averages, typically longer than the investing careers of most participants. It includes runaway bull markets like the 90’s, which did generate 15-18% average gains for a decade. It also includes generational bear market cycles like we have seen twice in the last 15 years when average returns get very close to zero. Here’s another reality check; there is no guarantee of success with investing. Your experience and success are purely a function of the many decisions you (we) make along the way rather than the false promise of gains just because the industry says it is so.

 

Add Money on Market Discounts (if possible)

 

If I could change one thing about the client investment experience, it would be this. I would create a system that only allows new investments into the markets at times when the market is attractive and selling at a discount. The markets are currently working their way toward that moment. In 22 years of managing money professionally, I’ve never seen it happen. Money always arrives at our door (consistent with net inflows to equities among the masses) within 12-18 months of every bull market peak. Investors of all kinds would do themselves an incredible favor if they could be more disciplined and patient in their decisions of when to add new money to investments. Forget the sell high bit, your success, as an investor is so much more dependent on buying low. We can handle the piece of buying securities for our clients at market lows, but we can’t force or entice “new investment” at those same times. We try very hard to make it clear to our clients via our Calling All Cars emails alerting them when to add new money. This is the time to queue up your cash now that the market is finally developing some upside opportunity. I suspect, sometime in the first quarter of 2016, we’ll be sending out another alert but it’s too early to make that call.  Of course not everyone has the capacity to add money at their discretion, especially those in retirement. But doing so provides an incredible boost to your portfolio for the ride back up.

 

What Would Buffett Do?

 

Some people don’t like Buffett. That’s fine, but you have to respect his value based discipline especially in the face of terrifying conditions. He and his team at Berkshire Hathaway truly have ice in their veins, regularly buying stocks and entire companies aggressively while the masses are selling in fear. Buffett would be the first to tell you that investment returns come from smart buying. He waits, and waits and waits and waits until the thing he wants becomes attractive. Then he buys a huge position with 20 year goggles firmly in place. He is not perfect, no one is. Berkshire Hathaway (B) lost 12.06% last year. BRK/B is the 4th largest security in the US stock market by market cap so we’re talking about some very real loss of capital and wealth destruction associated with that negative performance. But Berkshire investors remain steadfast and trust that Buffett is not thinking about changing his 50 year old strategy or selling companies just to stop the pain. No doubt, he’s on the hunt, looking for deals, sitting with a pile of cash that he has patiently accumulated through much of the last couple years. Warren Buffett has his process for investing that remains rigid through all markets. That is his discipline. Ours is different to a degree in that we do work to cut exposure during bear markets and raise exposure during bull markets in an attempt to smooth our investor’s returns. Our process remains rigid in all markets. As we have said many times, attractive long term results are the residue of excellent process. Like Berkshire Hathaway, sometimes those results are not so attractive in the short term. We remain unwavering in our commitment to our process.

 

The Magic is in the Mix

 

Every one of our profiles has a prescriptive allocation for our clients meaning some percentage recommendation to tactical equity, blended asset, and income strategies. Importantly, we structure each profile to have some exposure to our income models, which are our best performers over the last 12-18 months now. Even the youngest investor profile, our “Plant” investors, has a 10% recommended allocation to either of our Income strategies just for balance and diversification when stocks are falling as they are. On the other end of the spectrum our “Harvest” clients, those in retirement, have a recommended Income allocation of 40% of total portfolio values. Sticking with the right mix of diversified strategies is critical to your peace of mind during deep corrections or bear markets. After years of a rising stock market, it’s very easy to let your portfolio slight toward a larger stock allocation without managing the mix as well as we should. Feel free to check in with us regarding your current mix of strategies and we can make quick adjustments if you’re not in the prescribed allocations.

 

What Are Your Options?

 

As I said earlier, bear markets can shake our base conviction of why we invest in stocks, bonds and commodities. There must be better options out there right? Well a lot depends on your level of expertise and the landscape for alternative ways to build wealth. Real estate is a big one and perceptively THE alternative to traditional investment securities. But with only three regional markets pushing out to new price highs beyond those set in 2005, we have to respect the fact that timing also matters a great deal with real estate. Is real estate a good deal? That’s a tough question and a complex answer. Arguably, I think there will be a better time to buy real estate following the standard 18 month cycle of rising interest rates but there are a lot of other variables that go into price. I do know two things; The first is that is real estate is an illiquid asset, meaning it cannot be sold quickly if necessary and transaction costs are prohibitive. A losing “investment” in real estate that can’t be sold at your discretion carries a special kind of anxiety and financial stress. Second, we know that any form of hard asset like real estate can have some very high carrying costs (utilities, landscaping, window coverings, furniture, paint, plumbing, replacing dead appliances, etc). My investment in my home came with a notice a year later from my HOA notifying me a $10,000 assessment to replace old water pipes in the community. So far, the only notices I receive regarding our stock holdings are for dividend payments received!

 

We might also look at various forms of fixed income including CD’s or buying individual bonds held to maturity as a “safe” investment. The well known problem here is that the current interest rates offered for such investments are so small that they aren’t even covering the meager 2% inflation cost of living increase; most pay less than 2%/ yr. CDs and money markets pay virtually zero. For those interested in owning higher yielding income securities on a tactical basis, we have our two Income models, which are performing very well.

 

In a nutshell, the landscape outside of the financial markets is, and has been, pretty bleak for almost a decade. We are empathetic to this conundrum as we feel it ourselves, almost trapped into parking our money in the financial markets. As such, we do the best we can for our clients to make the experience tolerable while focusing on real wealth accumulation over time.

 

A discussion of your options wouldn’t be complete if we didn’t include the option to manage your own money without paying someone like us to do it. That is always an option. You might have the skills, time, energy, economic background, financial knowledge and real time experience to do it well and save 1-2%/ year in management fees. Personally, I know that we work hard to add value in managing assets with expertise and integrity for our clients. But we also provide financial planning advice, tax strategy and filing preparation, estate planning and keep your financial world orderly with our excellent service team often for the same low fee.

 

2008 All Over Again?

 

It’s almost comic how many times I’ve heard this in the last 48 hours. Why do so many look at the 2008 bear market and assume we are just going to do it all over again now? Well first the media isn’t helping with entertaining reminders like the HBO film “Too Big to Fail” followed by the big screen debut of “The Big Short”. But mostly, it’s all just human psychology. When we are afraid, we want to put our finger on the thing that makes us afraid. That’s why traffic slows down to see a traffic accident. 2008 and events surrounding that 58% drop in stocks and the Great Recession are the modern day boogie men. As the most recent and close “accident”, we turn our gaze to see it again and extrapolate that outcome to today.

 

We see very little in today’s economic or financial landscape that resembles anything close to the conditions present in 2008. Margin debt is perhaps the only metric that is similar. Housing starts, non farm payrolls, industrial production, leading economic indicators, the shape of the yield curve, available supply of personal and corporate cash, household debt are all in very distinctly different positions and trends than they were in 2007. That was a credit and banking liquidity crisis with an associated real estate bubble. Where’s the bubble today? Where’s the liquidity crisis? Of course anything can happen, but we would say with strong conviction that if a bear market were to occur now, it would not be for the same reasons as our last bear market. Since 2014, we have spoken at length of the high likelihood of a “Garden variety” (15-20%) bear market that resets values, creates some real doubt and sets us up for the next bull market leg higher. So far, that’s all we see.

 

We’re empathetic to all investors including our clients. We know this is an emotionally tough time and one that requires a great deal of trust on your part. Any loss, even something small and recoverable isn’t desirable. As managers, we get it as our personal money is right in their with yours feeling each day’s gain and loss just the same. But, these are the very days that will define your success or failure looking forward. Be disciplined and strong now. Be objective in your decision-making and let fear come and go without reaction.

 

Very sincerely,

 

Sam Jones

CHANGE OF SEASONS QUARTERLY REPORT | 4TH QUARTER 2015 – THE YEAR FOR ACTIVE MANAGEMENT

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.

In the last two quarterly updates, this report has focused on preparation for the type of market we are now seeing in full color. In Q2 of 2015 , we discussed our “Best Fit” prescriptive allocations among our strategies for different stages of life, age, risk tolerance, etc. The point was to make sure your investment allocation was suitable for you. In Q3 of 2015, we discussed the importance of understanding “Relative Returns” and why comparisons to indices aren’t really a great measuring stick, especially during bear markets. For this update, we’ll make a case for why 2016 is likely to be a year that benefits active management styles over passive indexing.

Our Explicit Investing Creed

We are seeking “Success” over a reasonable “Judgment Period” by knowing when to embrace and reject conventional wisdom regarding perceived market trends, “Risk” and opportunities. Superior, above average, results over time are only achievable through unconventional decision-making, experience, and discipline.

Risk (defn.) – The probability of unrecoverable or semi-permanent loss of capital, not to be confused with variable degrees of periodic volatility.

Success (defn.) – Generating asymmetrical results across all investment strategies: to expose ourselves to return in a way that doesn’t expose us commensurately to risk, and to participate in gains when the market rises to a greater extent than we participate in losses when it falls.

Judgment Period (defn.) – A period of time that captures a full investing cycle including both bull and bear markets – typically any rolling 5-6 year period


2016 – The Year For Active Management

At a recent holiday party, a friend asked how my year went for business. It was just small talk but I found myself giving him a lot more information than I planned. I said it was terrible, one of the hardest and worst years in my career. Eyebrows raised, he said, “Oh I didn’t think things were that bad in the markets”. My answer was pretty simpe. I said, we lost money in all of our investment strategies and I hate losing money, especially when there is a perception that “things weren’t that bad”. After all, most benchmark stock indices like the Dow and S&P 500 were only down 2% or less right? Treasury bonds weren’t a lot different either finishing down only slightly. If one were sitting on a passive portfolio of stock and bond indices and didn’t look at their portfolio once until year end, they might yawn and think, what a boring year and accept the small loss. You probably wouldn’t have felt the 13.5% decline in the broad US stock market that occurred over the span of 5 days. You might not know that the average stock is down 26% from its 52 week high in price and continues to lose ground to this day (see chart below from Bespoke)

Over the year, we saw asset groups like High Yield corporate bonds enter bear market downs trends. Others like commodities, energy or basic materials have been in bear markets for several years now and the losses here seem to be accelerating in 2016. You might also not really grasp that world stock indices in 2015 are making the US stock market look like a fun park especially China and Emerging markets. No, we are in a very ugly phase of the market cycle and have been really since July of 2014, almost eighteen months. When we look at our tactical equity or blended asset strategies losing 4-6% over the year and even our income strategies giving up 1-2% in 2015, we aren’t happy but strangely feel grateful that it wasn’t worse all things considered. But without a doubt, the dumbest of investment strategies that own just a few low cost stock and bond funds probably did the best in 2015 with very little brain damage, cost or worry.

I will say with high confidence that 2016 will be quite different; it already is. Active styles of investment management with the capacity to focus capital on the right asset groups while avoiding others, will be the winners. Passive styles that own “the market” through indices will be challenged. Here’s why.


The case for active management styles in 2016 comes from several perspectives. These are the current stage of the economic cycle, historical precedent, greater expected dispersion of asset class returns, and potential massive rotations in market themes.

The Evidence

The current evidence suggests that the US economy is now it the “mature phase of a mid-cycle expansion”. The status of leading economic indicators, consumer confidence, employment, household debt, housing and shape of the interest rate yield curve all confirm. What does mature mid-cycle expansion mean? It’s a fancy phase for “Transition Year” which I have spoken of at length since 2014. It means, the economy is gradually transitioning from one that is dependent on stimulus and outside help, recovering from a deep recessionary phase, to one that is just now standing on it’s own. However, this is still an expansionary phase. It is “mature” in the sense that we have achieved near full employment – at least among those looking for work and not retiring, and a long way in terms of time from the dark days of illiquidity associated with the banking and real estate crash. Deflation is no longer a real issue in the US and we are even beginning to see the first sparks of wage inflation in the system. The Federal Reserve acknowledges these changes and has formally begun raising short term interest rates consistent with the mid-cycle expansion theme. Despite market behavior in the last 3-6 months, we believe there is a very low chance of a US recession in 2016. With that said, we must know and understand that markets and economy do not always sync up in terms of magnitude or timing. At present, it appears we are beginning a corporate profits’ contraction and the markets are certainly pricing that in! Perhaps the market is telling us that an economic recession is coming in the future. Or perhaps this is just a pause in the market cycle ahead of the next bull market phase. The point is these periods are not clear. We simply don’t know. There are substantial risks as well as significant opportunities. An active approach to investing gives you a fighting chance to adjust as conditions become more clear. The passive approach gambles on the single outcome of a rising market.

Now historically, we see passive index investing styles do very well in the first half of a major recovery cycle. In the present secular bull market that period would extend back to March of 2009 and continue through 2014. In other words, that period is behind us. In a perfect world, investors would simply load up on index funds at the bear market lows – back in 2009 and just let it ride. Of course that never happens as fear and distrust remain in the system for years after a bear market keeping investors’ money on the sidelines while stocks rise month over month and year over year. As a matter of fact, it wasn’t until late 2013 that we even saw positive inflows of investor capital into the stock market. Before then, net outflows were the standard all the way back to 2008. So while passive styles of just owning a standard mix of stock and bond funds would have provided excellent returns, few actually benefitted from that approach due to disengagement and fear of the markets. But now that the economic cycle is more mature and we embark on the mid to late stage, we know from history that active styles begin to outperform passive styles of investment. Why is that the case?

The main reason is that net exposure and selectivity becomes more important in the later stages of an economic expansion and market cycle. 2015 was again a strange and abnormal year. Perceptively, the broad market averages which we know as indices like the S&P 500 had an equal number of winners and losers under the hood, the average of which turned out to be a wash (-0.74%). Bonds saw the same thing with big winners like municipal bonds and big losers like high yield corporates while a standard aggregate diversified bond fund might have averaged only a slight gain or loss for the year. Major asset classes like stocks and bonds as measured by average indices saw a very flat year. In 2016, we expect to see a much wider range of asset class return dispersion, meaning anything but flat. We will see big winners and big losers. Thus far, we’re seeing stocks get hammered with their worst start to any year in history, while bonds are rising (associated fear trade). Commodities of all sorts are sticking with their trend of the last two years – straight down. Active managers like us have been cutting stock exposure again since December, which is the right thing to do considering the technical deterioration. For now, the active manager is already adding value by keeping losses contained and recoverable.

Regular readers of the Red Sky Report know that we could be back in the buyer’s seat by March or April with a potential market bottom developing. As you saw above, the average stock is down over 20% from the highs. But again, these are just averages and there are individual names out there that are still trending higher, albeit with more daily and weekly volatility. There are also currencies like the US dollar that we can invest in as well as specialty long/ short funds that march to their own beat. Our job as active managers is to find that leadership and stick with it while adjusting overall exposure to the markets as needed. Conversely, any passive approach is going to hold fully invested stock and bond index funds. Index funds by nature do not have a manager who even has the potential to do some good stock picking and/or change exposure. Indices are just a list of stocks and you own all of them all the time with 100% of your investment. The yin and yang of stock index investing is that you get 100% of the market’s gain; you also get 100% of the market’s loss.

Finally for those following our recent “Best Bets for 2016” series on the Red Sky Report, you know that we are watching for a potential significant shift in market themes during the year. This could mean a rotation into non-us investments, it could mean rebuilding our high yield corporate bond exposure. It could mean shifting from growth to value, or from large caps to small caps. Even the unthinkable could happen in the form of a long term low in energy stocks. We are seeing the potential for a significant rotation in leadership beginning in 2016 and these are the moments when you want an active manager in your pocket who is paying attention and willing to make those changes. I cannot reiterate enough how devastating it is to an investor’s wealth to sit with a portfolio of yesterday’s investment themes hoping that someday it will come back.

After an unwelcome and lengthy response to my friend’s simple question, I finished by saying this. I’m actually looking forward to 2016 because I know that the most challenging years for active managers are usually followed by some of the best years. Cheers to that.

Please stay tuned to the Red Sky Report for timely market alerts and updates.

Sincerely,
Sam Jones

SIGNS OF A WASHOUT

These are the hard days for investors. We all want to pull the plug, sell everything, cut and run. Fear and doubt start to creep into our thinking, hourly, in the dark hours. I’m going to interrupt our 2016 Best Bets Series to provide a little emotional peace of mind.

 

You may have seen this headline come across your screen or email. It was an article provided by CNNmoney.com referencing some RBS broker’s very strong directive.

 

CNN: Sell everything! 2016 will be a “cataclysmic year,” warns RBS

 

Now, we know the history of headlines and we know the contrarian nature of sentiment and we also know that the average stock is already in a bear market (-20% or more from the highs). The last time I heard anything like this in headline fashion was August 24th, which proved to be one day from the lows last summer. Then, we had an indicator ripping around that talked of massive short selling in the markets and high likelihood of an imminent CRASH or Black Swan event. Strangely, I’m always thankful to finally see these headlines as they are typically associated with a short term low (+\- a week). Let’s see if the magic works again.

 

Other things I’m seeing during this very heavy and persistent selling cycle for global stocks. I’m seeing the energy sector give up, completely. Energy stocks are down another 10% in aggregate but select names like Marathon (MRO) and Anadarko are down 20-30% or more YTD. Losses in the energy sector as a whole from the highs are approaching -76%. If the history of bubbles and major asset class disasters repeats like we saw with semiconductors in the early 2000’s or homebuilders in 2008, energy will fall another 9% before finding a long term bottom. Note – the bottoming process can also take several years after the final low. The same thing is happening with select basic materials, with companies like Freeport McMoRan, the largest copper mining company in the world, now down -44% YTD. Arch Coal, one of the largest producers of coal in the world is filing for bankruptcy. Again, what we’re seeing is the end game phase for a generational grade commodity wipe out. Note, we don’t own any of these sectors or types of companies because they have been in downtrends for nearly two and half years. But someone does, a lot of someones, and they are capitulating in mass. Massive selling is a necessary ingredient to every tradable low in the markets and we’re seeing it happen now across multiple sectors and indices.

 

I’m also seeing some massive profit taking in last year’s winners like the FANG stocks. Regular readers might remember commentary on 12/3/2015 “There is no Bell” when we spoke specifically about the risks in Facebook, Amazon, Netflix and Google (FANG). At that time we sold 50% of our position in Amazon and Facebook retaining only our long term holding positions. Now, these stocks are down 13-15% in just a few days. I have no doubt, they will be names to own and love in years to come but investors need to understand that nothing goes straight up forever. These were our leaders in 2015, keeping “things” looking deceptively ok from an index perspective. Now these same names are leading to the downside tearing apart the same indices. Oddly enough the market indices are now doing worse than a lot of individual names and sectors YTD.

 

Also from the technical side of things, the market is working it’s way quickly back to the August lows. Honestly, we’re surprised it has gotten this far (down) in barely two weeks of trading. Nevertheless, the market is approaching a very strong level of support. We are agnostic about the prospects of that support level holding. I’ll leave those predictions to the “experts”. We are simply aware of the oversold nature of things and the fact that price support is approaching fast (S&P 1870). Also from a historical perspective, we know that the market’s reaction to the first rate hike by the Fed is almost exactly an average loss of 9%. As of yesterday’s close, the S&P 500 is down 8.91% from the highs. And here’s the good news. The average 12 month gain following those reactionary lows is 15% for the S&P 500 (Bespoke). These are just averages and historical probabilities, not rules or guarantees by any means. Anything can happen, I’m just offering some perspective here.

 

Developing Buy for Income Strategies

 

This is very early in the cycle to say this but I’m starting to see the signs of a developing buying opportunity in corporate bonds. Regular readers know that we have been largely in cash (80%+) since July of last year in our Retirement Income model, which tactically owns high yield corporate bonds. Tactical means there is a buy and a sell signal associated with price trends. Our other income model called Freeway High Income is designed for taxable accounts and has held a nice 50% allocation to municipal bonds (high yield and intermediate term), which continue to make new highs every week. Both models have been waiting and watching corporate bonds fall in prices and rise in yield for nearly eight months. One of our clients recently made the comment that they didn’t like the fact that the strategy was sitting in cash while she was paying management fees. We respectfully would argue that sitting in cash while our primary return generating asset class is falling in price is precisely what our clients pay us to do. We trade away the risk of capital loss during periods like this while watching daily for that best buy to develop. Everyday, the gap in performance widens simply by avoiding loss and we’ll finish the play by loading up on cheap corporate bonds paying 8-10% yields. That day is coming and it might happen sooner than we think. Here’s another tidbit. High yield corporate bonds have never put in two consecutive years of losses (ever). 2015 was a negative year for high yield corporate bonds. YTD, they are down another 2%. Here’s my recommendation. I would add money to either of our Income strategies now as I see the opportunity for a potential double-digit gain from these levels. I can’t say with confidence when we might see the actual buy happen but conditions are becoming ripe so the time to add money is now.

 

Adding money to a strategy should generally come from cash or other sideline money that is not invested or has been waiting patiently for an opportunity of some sort. Shifting strategies internally in your portfolio can make sense but only if you have found yourself uncomfortably overweight in stock strategies (by our prescriptions). If you don’t know what I’m talking about, please revisit the 2nd quarter, 2015 Change of Season’s update called “Best Fit. Otherwise, we’re generally going to argue that you sit tight with your current strategy allocations and avoid the trap of risk tolerance shifting just because the market is down.

 

That’s it for today – just some feel good info for another red market day

 

Sam Jones

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

2016 BEST BETS, PART I

After spending thousands of hours working to make money unproductively, we’re more than happy to close up 2015 and are looking forward to the next year of investing. This update will begin a series that focuses on developing opportunities as we see them in 2016. Thankfully, as we complete our analysis, we find that our view is comfortably on the contrarian side to what we’re seeing in the mass financial media. Part I will take a very high level view of the larger market and economic cycle in the US, including the risks of recession, historical probabilities, key drivers of returns and timing considerations. On with the show!

 

The Bigger Cycle – Buying Into End of Q1?

 

As I write this first edition, global financial markets are having one of their worst starts of the year since 2001 (down 2-4%). As such, it seems almost silly to say that we expect more weakness and continuation of the correction that began in July of last year. As I mentioned a couple of weeks ago, the markets seem to be pricing in a higher risk of a global recession. For instance, Treasury bonds are up, Gold is up, Short sellers are getting excited, defensive sectors like healthcare and consumer staples are doing the best, etc. While recession risk is certainly on the rise, looking out over the course of 2016, the evidence does NOT support that outcome – at least not yet. Beyond the nastiness in the energy and high yield credit market (which are highly related issues) as well some very weak manufacturing reports; we just don’t see leading indicators supporting the recessionary theme. Auto sales, strong employment, housing, spending, household debt, a rising US dollar, strong service sector, the shape of the yield curve and other leading indicators are still pointing to a tepid but healthy economic recovery here in the US. We see this as a mid to late cycle expansion in the US and the Fed supports that view with their most recent rate hike. The bond market is pricing in additional rate hikes totaling 0.75 though 2016, probably .15-.20 at a time.

 

Issues that will be the key drivers of returns for 2016 are the Federal Reserve policy changes (obviously), trends in the energy sector (can we find stability?), and valuations. I’ll focus for a moment on the last one. Valuations for most of the developed world stock markets are no longer attractive and this remains a concern. Select foreign and developing markets are far more attractive now and will be the subject of a pending “2016 Best Bets” report as we build out our optimal international investment guidelines. According to our trusted research sources, the S&P 500 would need to pull back to around 1884 to return to the average post WWII valuation of 15 times earnings. The index is now trading at 19 x earnings on a trailing 12-month basis, which is in the 80-90thpercentile of all market conditions for high valuations. The 1884 level represents a loss of 8% from the 2015 year end close and coincidentally brings us back to the August lows. Remember, this is just to get back to an average stock market valuation. Downside risk is therefore a minimum 8%, but likely more. Now for some upside good news. The US market has been here before and done remarkable well at least until valuations have pushed into the 90-100th percentile. Take a look at this chart provided by Bespoke Research.

 

 

 

The left chart shows forward one year returns for various percentile ranks based on valuations. Remember, we are in the column second to the right (80-90th percentile). Average returns have been lower at these levels but still positive (~5%). Now look at the right chart. Strangely, the “percent of time positive” shows that when the markets are at this HIGH valuation, the odds of a positive year are actually also one of the highest (74.5%). Obviously, we need to be watchful for the condition when valuations truly hit historic extremes and push us in that zone of serious risk of loss. Along those lines, we also have not seen that bull ending frenzy of euphoria and bullishness among investors. Some would argue that we did see it in concentrated form with significant gains in names like Facebook, Amazon, Netflix and Google (FANG). We don’t think strong moves in a select few names are enough to create a frenzy of mass investor bullishness, quite the opposite in fact from analysis of Sentiment trader.com. 2016 could be the year where we see a surprising exhaustive move that blows out valuations and witnesses that bull ending euphoria in investor sentiment.

 

Timing is everything so let’s spend some ink on that. The first quarter of 2016 could be tough as I said and the basis of that comment is year over year comparisons in earnings from Q4, 2015 (weak) to Q4, 2014 (strong). Estimates from earnings from last quarter are still strongly negative especially compared to the same period 2014. But beyond the pending earnings reporting period starting next week, things look better again. We should not be surprised to see the market trade lower in the first 3-4 months of 2016 but ultimately finding an attractive bottom that takes prices higher all the way into elections. This is guesswork at best but the technical pattern would also confirm an end to the market correction cycle that began in July of 2014 (yes 2014!). July of 2014 marked the end of the three-year strong uptrend in a MAJORITY of market indices. Yes, most indices made very marginal new highs in June of 2015 but those proved to be just part of a larger topping process and unsustainable. From a timing perspective, I am reminded of 2009 which saw an exhaustive move lower into March following one of the worst 18 months in stock market history. That low, in March of 2009, was the generational low!

 

I’ll finish with some quick commentary on historical odds regarding percentage moves for the broad US stock market. The average of all big brokerage shops says the US stock market will finish 2016 with a gain of 7%. They are punting. They have no idea, so they went with the long long long term average for the US stock market. Using volatility measures, valuations, election cycles and stage of the Federal Reserve interest rate policy, there is a 76% chance that we’ll see the US market finish the year at greater, or less than, 10% in 2016. We have little doubt we’ll see both during the year. With that said, I’ll reiterate our gratitude and commitment to our process which remains focused on dynamically allocated assets according to market conditions. Our net exposure, selectivity and position size daily analysis should do their job in mitigating risk of significant loss while taking advantage of buying opportunities when they come. Frankly, I would not want to be a passive investor of any type in 2016 despite the relatively poor performance of most active managers in 2015.

 

Happy New Year to everyone and we look forward to serving you again in 2016.

 

Cheers!

Sam Jones

REACTION TO THE FED

Market volatility is on the rise with 200+/- point days on the Dow becoming standard. The market has taken back all of the short term gains leading up to the Fed’s decision this week plus a few points. For all the chatter about a rate hike being completely factored in, I am seeing some wild price action. Believe it or not, there is a critical level of support for the market almost exactly at the lows of today.

 

 

Reaction

 

 

Since the Fed raised rates on Wednesday, we have seen several things happen that have spooked the market, none of which are very surprising to us but seemed to have caught the market off guard. For one, we saw the energy sector make a hard new low for the year, make that the last 5 years. We also saw selling again in the high yield bond market. Both have been on the media radar for a few weeks. As I’ve heard it, we must see stability in the energy and high yield bond markets. …. Or else. First of all, these two investment groups are related in their pain as many high yield bond funds have become overweight in soon to default energy bond issues. They have been tracking together for nearly two years. They are also likely to bottom at the same time as well which is on our watch list for potential buys in 2016.

 

Stocks have also sold off sharply in the last two days with things like Industrials, materials and technology leading the way lower. Recession trades in defensive sectors like consumer staples, healthcare and utilities have held up well or even moved higher. The market seems to think that the Fed’s rate hike will accelerate our economy’s slide toward recession. That may prove to be the case but even if the stock market is smart enough to forecast a recession 6-9 months out, that potential reality seems more likely in 2017 after elections, all things considered.

 

Treasury bonds have done nothing – as usual supporting my working theme that Treasury bond money is dead money (at best). Commodities have fallen again to marginal new lows but gold found buyers today while stocks got hammered. The gold miners index actually looks constructive at this level and seems unwilling to follow actual gold or the commodities complex lower. We took a small position (2%) in the GDX exchange traded fund in a couple portfolios last week that have space for “alternatives”.

 

Support Is Right Here!

 

Take a quick look at the chart below of the S&P 500 index. Way back on January 15th of 2015, the S&P 500 dropped quickly to 1992 (shown as the white line). This level also served as a short term peak on the first rebound from the August lows and now, after today, here we are again approaching the 1992 level. This is a critical support level and one that has the potential to hold. Why? Often we see a wrong way reaction to the Fed in the few days that follow a change of policy. Now, we have seen the negative reaction and push down to critical support with a market that is now approaching an extreme oversold condition. Sentiment has also swung back to an extreme in the last three weeks and everyone expects the worst at this point. I don’t want to sound too bullish because I’m not but this is a sweet setup for a strong run in the final nine days of the year and possibly well into 2016.

 

 

If the consensus view is right, and this very important level of short support is broken, then the likelihood of a heavy selling cycle into April of 2016 becomes more real – see last week’s update.

 

 

 

Being A Mature Investor – 101

 

I’ve had several conversations with clients recently with some common themes. I thought I would share those for everyone’s education. The general concern among our clients when looking back over the last 12-18 months is regarding the lack of returns or modest losses in total portfolio value. This is absolutely the case as most portfolios we have reviewed in the last several months are showing YTD returns of -3 or 4% nearly erasing gains made in 2014 in the process. The questions that follow are generally these:

 

  •      Is there something wrong with my portfolio?

Why don’t we just sell everything and wait until the coast is clear?

Should I be invested in other strategies?

 

Investors who have been at this game for years know that returns do not come in a straight line. There are regularly periods of time, sometimes 2-3 years! where gains are elusive and we get frustrated. We feel like something is broken or wrong when our money is not appreciating, especially after doing so for the previous five years. Mature investors are patient investors and do not switch strategies or take on extra risks in a failing attempt to continue making returns on their portfolio. They stick to their process and their plan in rising and falling markets. Mature investors do not go from 100% cash to 100% invested in leveraged stock ETFs either. This is the definition of gambling with emotional guessing at the root of all decisions. Selling all is guessing. Buying with all is guessing and I’ve never ever seen anyone do it with any level of consistent success in my career. Mature investors do not shift their risk tolerance just because the market is behaving badly. Risk tolerance is a function of your age, your wealth and income and your ability to tolerate losses of different magnitudes in the pursuit of desired gains. Mature investors know that a crappy year like 2015 creates real opportunities and they are always on the lookout to buy them when others are selling in fear and disgust. Mature investors know that the best way to increase your wealth is to add money to investment accounts when prices are low, not high.

 

I humbly offer this information as a gentle reminder because these are the days when investors of all types make reactive decisions regarding their investment strategies and investment process. This is not to be confused with unproductive investments. We all make investments or trades that lose money. We’ve had more this year than in any year of the last decade. But we don’t look at those as bad trades or bad process or bad decision-making but rather the cost of doing business in a market that lacks direction. But our process of Net Exposure, Selection and Position Sizing behind our portfolio remains exactly the same. Nothing is broken about any of our strategies and I will shamelessly tell you that I have more confidence in what we are doing today than at any time in our company’s history. Results will follow excellent process in the longer term. You can bank on that!

 

I wish everyone a warm and peaceful holiday week surrounded by good friends and family.

 

Cheers

 

Sam Jones

GET READY TO ACT IN 2016

In 2014, when I first broadcast the notion of this year being a “Transition Year”, I probably understated what we’re actually seeing today. We have seen some wild moves that are far beyond the forecasts calling for slightly higher volatility. But from the wreckage, we find opportunity and I’m beginning to see some nice set ups for bold investors who know where to look. I’m going to force myself to take a stab at likely outcomes for 2016, purely for your entertainment, while we wait for the market’s reaction to the Fed’s rate hike tomorrow.

 

Current Market Conditions

 

I can describe them easily – UGLY. We have pockets of things that are not as bad as others, but that’s probably the most positive thing I can say. Last week was a bone crusher as the markets broke decisively below long term averages (again) fleshing out what now looks like a larger market top in stocks. The waterfall decline in August is also now looking like a brief acceleration period among sellers within a larger developing peak for many sectors and investment styles. As I said two weeks ago, the set up in late November was WORSE looking from a sentiment perspective, as bullishness was much HIGHER than in July before the summer slam. High bullishness is a negative factor for stocks and contrarian by nature. There was a lot of Red ink on the board last week. For those who have some lingering notion that 2015 is an up year, take a look at this matrix provided by Bespoke Investment Group. Hard to find any love this year, in any country, any sector, any asset class.

 

 

Over the last couple weeks, we have been selling and cutting our net exposure to the markets as evidence began to mount that our short-term recovery was fading quickly. Cash levels are back up to nearly 30% (or more) in our tactical equity models. Blended asset strategies have cash of 25-45% and Income models are still 60-75% in cash. Remaining holdings are still those trading above their long term moving averages but we’re losing positions regularly as stops are broken. Again, this is our process at work, making incremental changes and adjustments as market conditions unfold. In hindsight everyone is a genius and of course, we could have guessed at this outcome. Then again, we could have guessed that the market would put in a top every year since 2011 – except it didn’t. We try not to use guessing as a market strategy. So is this time different? I’m going to answer that question by tearing it apart looking at the broad US stock market first and then focusing on select internal pieces of the market.

 

Is This The Top for the US Stock Market?

 

All things considered, I think there is growing evidence that 2016 could be tough for the US stock market in aggregate, at least into the summer. Investech Research did a nice job of summarizing the state of things offering “6 More-Compelling Reasons to be Cautious in 2016”. I’ll list them here and am happy to provide more details upon request:

    •      1.  This bull market is now the second longest in duration since 1932.
  •      2.  Gains have been the 4th largest since 1932 (now behind us)
  •      3.  Margin Debt still looks like it’s putting in a top – typical at market peaks
  •      4.  Speculation in a few names is high (Facebook, Amazon, Netflix, Google), the FANG trade has been carrying the market – masking weakness
  •      5.  Corporate profits have peaked – leads a final price peak by a few months.
  •      6.  Long-term momentum indicators have negative bear market patterns.

 

Also, regular readers might remember the status of Lowry’s Buying and Selling pressure index which flipped negative in July and never returned to positive (sadly). So the weight of evidence points to lower prices in early 2016, perhaps with some follow through basing price patterns into the summer. This is just the way things sit now, subject to change at any time. But here’s the good news;

 

I don’t currently see the potential for a global stock market decline that will be anything other than a garden variety bear market (15-20%). We’ve all heard the doomsayers proclaim the END is upon us and to expect another bear market that is worse than anything we have seen in modern history. I don’t think so. There are three reasons why we could expect a just as shallow bear market.

 

First, I still see a tremendous pile of cash sitting on the sidelines, both in households, bank deposits and corporate cash. Cash is fuel for investments and it will jump at virtually anything offering a reasonable return opportunity. I call this Cash Anxiety. We’ve been in this environment for nearly four years and I will openly blame the Fed’s extended stay at zero interest rates as the root cause. In fact, we are seeing the fallout from this anxiety played out in the high yield bond market now as people have reached way out on that brittle limb to find yield. Now the limb has broken and high yield corporate bonds are crashing to the ground – more on this “opportunity” in a minute. So cash hates to earn nothing and investors are actively looking for places to put it. Remember most investors don’t know much more than to buy market index funds, so any price decline in the corresponding market indices will be bought offering some support to limit the magnitude of bear market declines.

 

Second, I see a rotation of investment capital rather than exit from global stock markets. Circle back to the Bespoke matrix above and focus on the internationals for a second. Wow! Brazil down -38% YTD, China down -17% YTD, India down -14% YTD, Canada down -25% YTD. 2014 wasn’t much better for internationals in a lot of cases. Europe suffered badly in 2014 but seems to be recovering, at least from a stock market perspective, as they are only down -6% YTD now. The US has been the best looking horse in the glue factory for the last 12-18 months but common sense says we could see a great deal of money rotate to internationals in 2016. One could argue this will drive prices even lower in the US but you have to remember that the investing world is much more linked globally in terms of price action, revenue and economics than anytime in recent history. Remember, more than 50% of the S&P 500 company revenues are derived from overseas now. A healthy resurgence in international economies and indices should also provide a limit to any downside in our domestic markets.

 

Finally, like internationals, we are already seeing deep discounts at the sector and asset class level in our own markets. These are in obvious places like commodities, energy, materials, industrials, high yield bonds, small caps and classic Value funds (like Berkshire Hathaway!). Bubbles in the credit markets are popping and they look to be contained to the junk bond space. We exited all junk bonds in June and July – FYI. The energy sector is having a generational moment of pain as the industry adjusts to the ramifications of unchecked supply and production. Drill Baby Drill ? remember that?   History is full of painful stories surrounding supply-side disasters. If one does not read history, one is doomed to repeat it. Required reading for anyone in the oil and gas business – Niall Ferguson’s “Ascent of Money”. Nevertheless, it is extremely difficult for a major sector to work its way all the way down to making a 5-6 year new low in prices. The energy sector (stock averages) has just done that while the price of crude itself is close to a 12 year new low – also very rare! I expect we’ll see some massive M and A activity in the energy space in 2016, like the airlines did in 2009. We will not have more than 2-3 major integrated oil and gas companies in the end. We will only have 1-2 coal companies left in the end. We have not seen the end of this story yet but we should be alert to generational investment opportunities in the energy sector as early as next year.

 

High yield bonds are also angling toward another incredible buying zone although I think we’ll have to see 2-3 rate hikes in the rear view mirror before high yield bonds will actually move higher in price sustainably. Already, we are seeing corporate bond yields push up to 8% (from 4%) and prices are down 12-15% from the highs. Ultimately, junk bond yields will reach 10-12% and that should be the time to consider reloading. Both of our High Income strategies are capable of getting aggressively invested in high yield corporate bonds and both strategies have generated some of their best double digit returns in years following these set ups. I am openly recommending that all of our clients review their exposure to our High Income strategies and consider an allocation if you are underweight or have none – maybe for some sideline cash (wink).

 

Again, investment opportunities have been developing for the last couple years and these will keep investor capital engaged. If money just sloshes from one sector to another, rather than leaving the market altogether, we don’t have to see declines like those of 2001 or 2008. One more reason why we might expect a more tepid broad market decline in the broad market averages.

 

In summary, the weight of evidence for the US stock market is still down and the intermediate term price pattern is no longer constructive. We do expect a short term bounce in prices starting almost immediately, perhaps a relief rally with the Fed Decision tomorrow.  The set up is not favorable anymore and still points down; we must remember that we are now in a new secular bull market that will be interrupted by cyclical, “garden variety” bear markets. We saw this condition last from 1982 to the year 2000. We saw it happen from 1948 to 1966. It can happen again. With our twenty year goggles firmly in place, we want to use deep corrections and even mild bear markets, as opportunities to add cash, to invest in deep discounts, to find value and make some long term investments.  In the meantime, we’ll continue to play defense with the primary intent of having our emotional and physical capital intact when we need it. Buy discounts in a primary bull market!

 

That’s it for now. We’ll be watching for the market’s reaction to the Fed tomorrow along with the rest of the world

 

Cheers

Sam Jones

SAVED BY THE BELL

As I mentioned Thursday, “If we don’t see a quick rebound in stocks like tomorrow or early next week, the weight of this evidence will become heavy indeed.” Well, it looks like we got that quick rebound and it happened at a good spot. For now, the (selling) pressure is off but the negative conditions that we outlined Thursday are still present and worth regular monitoring. Assuming the markets can navigate through the Federal Reserve meeting on the 16th of December without falling apart (S&P below 2020), the next critical test will be a break above the highs of the year, marked as a close on the S&P 500 above 2130. A breakout to all time new highs would no doubt put the bull back in the driver’s seat. Until then, we’ll remain ready to cut and run. Just a quick note, so you can breathe a little easier.

Cheers!

Sam Jones