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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.

Sam Jones