As I mentioned a week ago, the US stock market gave us all another opportunity to cut out weaker positions or upgrade as desired with the revisit to the top of the range. Now, six trading days later, prices across the board are down hard and revisiting an important support level (2044 on the S&P 500). While a short-term bounce is likely now, more long-term warning flags are appearing, some for the first time since 2007. There are critical moments in an investor’s lifetime when decisions regarding net exposure to various asset classes determines the future of your investment portfolio and thereby your very sense of long term financial security. This is developing into one of those moments.
Who Is Driving the Markets?
I read an interesting statistic this week (can’t remember the source frankly) but I wrote it down. Over 2/3 of the liquid investment assets in the United States, are now held by owners who are over 62 years. Historically, that’s an incredibly high number and representative of our country’s demographics, which are relatively old by comparison to other parts of the world. Furthermore, the bulk of the 60 somethings are in the baby boomer generation, which has seen some of the greatest wealth accumulation at the household level of any in our country’s history. The point? By age, anyone in their mid to late 60’s is naturally close to or beyond their retirement year. These investors are naturally far more concerned about investment losses as they do not have the time horizon of a younger investor who is gainfully employed, nor do they have any further prospects for income by circumstance or choice. We should all know and respect the fact that retirees might be quick(er) to pull the trigger on investments at the first signs of trouble than a market dominated by younger, longer-term investors. With that said, it is becoming better understood that the next generation of younger investors fancy’s themselves to be “traders” not investors so perhaps the notion of investing for the long term is disappearing. Conclusion – expect big, gapping markets where persistent trends are elusive.
Understanding Asset Class Rotation
Take a moment to look at the three-year chart below. In purple, you see the S&P 500, Green, we have the Dow Jones Global Stock Index (our stock benchmark), in Yellow the Barclays Aggregate Bond index (our bond benchmark) and in Red the Commodities Index.
Three years ago, several months before the last presidential election, asset class performance began to diverge dramatically. Bonds essentially went flat and are producing less than 2% annually including all interest payments (zero price appreciation). Stocks across the globe surged higher until July of 2014 when most peaked as marked by the White pole in the middle of the graphic. Meanwhile everything that “hurts if you dropped it on your foot” like industrials, commodities, copper, gold, silver, materials, etc. began a dramatic decline that continues today. The downtrend in commodities really began accelerating also in July of 2014. So for the last 12 months, since July 1st of 2014, we have Commodities down -39%, Bonds up 2.46%, the Dow Jones World Stock Index down -2.04% and the S&P 500 index up 5.39%. If you have made any money in the last year, you have had nearly all of your money in stocks and even then portfolio returns are probably sub-par. Of course most portfolios hold a static group of diversified assets including stocks, internationals, bonds and commodities, increasing the odds of a negative return over the last year.
Now let’s look at what is likely to happen next…
With the Fed on deck to raise rates this fall and global economies continuing to chug higher, we should expect another significant cycle rotation, which includes both risks and opportunities. Stocks can continue to move higher but as we’ve already begun to see, returns will taper a bit and become the domain of selective stock pickers. Stock index portfolios will become frustrating to investors as they are simply too broad and inclusive of everything (good and bad stocks) to really make productive headway in the coming environment. Pickers will want to focus on quality companies with high free cash flow and lower relative valuations to peer groups without dipping too deep into the value pit. Focus should remain on the non-interest sensitive groups. Bonds should continue on their path of unproductive gains at best or begin to inflict some real pain. Outflows from bonds have begun in earnest but this will be a tidal wave of an outflow on a long-term basis. I believe this is just the beginning as the bond market represents the next area of real wealth destruction in the US looking forward. Rising rates will find their way into rising borrowing costs and inflation to some degree as employees demand higher wages to cover increasing costs of living. Higher wage expenses are passed on to consumers as higher prices – this is already happening. I continue to believe that real inflation is under-reported in an effort to keep bond investors happy and complacent. With or without inflation, US bond prices should head lower and interest rates move higher as long as the expansion in global economies continues. At present there are very few signs of recession in the system. Coinciding with a significant move down in bonds, cycle theory suggests that we should also look for a bottom in all things commodity oriented. Commodities are in a death spiral now, creating some real value, and some day they will turn up offering investors a unique chance to enter a new asset class bull market. Look for this moment on a failure in the bond market.
Also, coincident with the top in bonds and the bottom in commodities, we might expect to see the rise in the US dollar begin to stabilize a bit giving ground to many foreign currencies. A falling US dollar will be a nice headwind for international investments again and we might also look to the very oversold emerging markets and China again after a failed attempt earlier this year. Even Europe might find some footing again. Stock valuations are far more attractive outside of the US now so we’ll all want to keep our eye on an improvement in price patterns nearer to this cycle rotation.
Warning Flags and Playing Defense
As I said in the intro, warning flags are now appearing. While we still see the potential for new highs in the developed market indices as a final thrust in this six-year-old bull market, we are aware of the growing indications of deterioration in the current market. Since mid June, the majority of our net exposure indicators have moved into negative positions including adverse monetary environment, overly bullish sentiment (still!), an important crossing of buying and selling pressure (chart below), continued weakness in important indices like Transportation and Utilities, a notable increase in selectivity, loss of leadership and now another failed attempt to make a new high on the last run.
In the short term, stocks are again oversold and trading right at important support. In a healthier environment, absent all the negative evidence described above, I would be more optimistic and opportunistic about buying such dips. In these situations, we are planning to sit on our oversized cash position and defensive holdings (healthcare, staples, real estate and specialty bonds) until our set of indicators improves. Our all-stock tactical equity strategies are now 28-40% in cash. Our Blended Asset models are also sitting on 15-25% cash but also carry securities and hedges with much lower correlation to the US stock market. Income strategies are still sitting on nearly 60% cash. For us to become more defensive than this, we would have to see the June lows broken to the downside and more confirmation that a major market top is in. Neither has happened yet.
We must all remember that stocks and stock markets historically put in tops before the economic cycle. Investors often make the mistake of relying only on the economic news and thus sticking with stocks through some very nasty downtrends only to find themselves selling at the lows months later when the economy finally buckles – publically. Markets lead the economy by 4-6 months! We are quite aware of this fact and making adjustments as necessary on a daily basis now based on technical evidence.
Keep the faith, there are going to be some incredible investment opportunities coming out of the pending asset class rotation for those who know where to look and when to act. In the meantime, we’ll stick with our game of playing defense and positioning ourselves to avoid taking a big market loss.
Have a great week, enjoy some time with friend and family, and know that you are in good hands.
Cheers
Sam Jones
