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Change of Seasons Report: January 18, 2019

2018 Good Riddance

     Most will be glad to have 2018 in the rearview mirror.

     There were some historic moves in equities and commodities that made it difficult to earn any return last year. The attitude has shifted to managing risk for the time being, until some of the volatility subsides.

     Diversification is one of the pillars of managing money for the long term. Not in the sense of buy-and-hold, but in the sense of holding different securities and asset classes that will deliver returns at different times. Last year nothing worked. It is extremely rare, but it does happen.  Let’s look at a graphic from Deutsche Bank showing what percentage of assets that were down on the year:

Some Drawdown Comparisons

     From 2009 to 2017 the structure of markets was well worn. Interest rates were headed to zero—or negative in some cases (here’s looking at you Europe)— AND central banks bought bonds through quantitative easing (QE) in the open market to take asset prices higher. Mechanically, central banks would buy bonds from banks with newly created money. In turn, those banks would buy more assets and/or make loans with the newly created cash. The net goal was to use the QE lever to further lower interest rates and raise asset prices. Which assets? Pretty much all of them—stocks, corporate bonds, oil, real estate, land, art, you name it. 

     Now, we clearly have higher interest rates (not high, but higher), and central banks are shrinking their balance sheets:

     It goes without saying, if you reverse one of the largest influences behind asset prices, at a minimum one should expect an opposite reaction. The wrinkle is that the reaction may not be an EQUAL and opposite—both in terms of time and price. The fourth quarter of 2018—and December in particular— made the history books. The S&P just recorded its second worst monthly performance since the Depression: 

     US small caps just registered their largest quarterly decline since the inception of that index in the 1970’s. Was this correction different than a garden variety pullback? The answer is yes. 

     Our goal is to always try and mitigate drawdowns especially compared to the broad market. That doesn’t mean we won’t lose money, but we try to lose less. Let’s compare the performance of our equity and All Season (blended asset) models from the market high of 9/20/18 through the market low of 12/24/18:

S&P 500-19.8%
High Dividend-10.5%
New Power-16.5%
All Season-7.2%

** Please note these drawdowns are approximations for several model accounts. 

The drawdown in High Dividend and WWS was roughly half of the market.

Our Blended Asset approach drawdowns were roughly 1/3 of the market. 

New Power, our most speculative model, is the only model that approached anything close to the market drawdown. 

     Judiciously holding cash is an effective way to limit drawdowns and await better opportunities. It also is very rare in today’s investment landscape. More than ever, most financial pundits are preaching the buy-and-hold philosophy. 

     Rather than always being fully invested, we try to play the odds when assessing how much risk to take in portfolios. We use fundamentals, technical indicators, and sentiment to assess both the macro environment and prospects for each asset class. Certain environments are better than others for stocks, bonds, and/or commodities. 

Risks in US Stock Markets

     Extrapolation is one of the most dangerous habits in the investment world. When things are going well, most expect them to continue—almost out of habit. Earnings estimates have rarely been higher:

     Yes, equity prices are lower, giving us a bit more value to work with, but equities are anything but cheap at this point. Based on this pullback and current expectations, the S&P, for example, is at the upper edge of fair value:

     As equity valuations move from high to low—and vice versa— valuations tend to overshoot. Markets are the sum-total of human emotion. Fear and greed are the drivers. At market tops there is almost an insatiable desire to earn more, get richer, and add more wealth. The feelings at market lows are exactly the opposite. Everyone wants to go to cash to preserve what they have left. A search for opportunity turns into a desire for safety. Obviously, neither sentiment is correct, but human nature drives investors into these states of mind. Once these ideas take root, they are hard to reverse.

Current Market Opportunities

     Despite our concern for the overall US stock market, there have been some things worth buying, even if it is for a shorter-term timeframe. We have been rebuilding our positions over the last couple of weeks and currently have several things on our radar:

  1. Crude oil. Oil is an important indicator for the health of the economy. Crude oil prices peaked mid-year and now sit roughly 33% below their recent highs:

     That is a huge decline. We added back our commodity index exposure—of which oil is a large part-- after the first of the year to try and take advantage of this discount. As always, we will manage the risk accordingly, if this is just a temporary pause in the decline. 

  1. Yield curve. All else equal, a flat yield curve is a symptom for an impending slow-down in the global economy. We have added some exposure to US Treasuries to our portfolios to benefit from this potential slower growth.
  1. Corporate Credit. Credit markets have the highest risk associated with them since the Global Financial Crisis in 2008. There was a lot of issuance when interest rates were near zero. We are now heading into a multi-year period where those companies will need to refinance. Below is a chart of corporate bonds coming due:

     As you can see, there is a wall of maturities coming due in the next 3-5 years. The supply / demand for credit doesn’t suit us at these levels. In fact, we currently have a small short on the US high yield credit market in our Blended Asset models.

  1. Emerging markets. Emerging market valuations continue to be cheaper than developed markets. Emerging market indexes are sporting roughly a 13x P/E compared to a 18x P/E for the US. Plus, the technical picture looks a lot healthier as well:

     We have been adding to our emerging market positions across Worldwide Sectors and our Blended Asset strategies (All Season / Foundations).


     In summary, our approach has us holding cash (currently earning over 2%), while opportunistically adding select equity positions (both individual value stocks and certain equity sectors), precious metals, and emerging market stocks and bonds. 

     We always approach portfolios with our process in hand. That process is born of experience, analysis, and discipline, and the key is to stay the course.

We plan to do just that.

Have a good weekend, 

Sean Powers, CIO