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Planning Ahead

          Today is the fall Equinox, the official first day of fall.  For the cosmically inclined, this is a day of balance with equal emphasis on high energy (the sun) and restoration (the moon).  So as we respect the change of seasons and natural transition to the other side, I’m going to spend this update looking forward and do some investment planning.  Of course with investing, predictive work is just a guide and should not replace prudent action based on real observations. 


Large Caps to Small Caps?


            It is no secret that small caps have been in the dog house all year, now down 2% YTD, while large caps like those found in the Dow and the S&P 500, are up between 4-8%.  Historically, in healthy markets, small caps outperform as the sector representing a “risk on” sentiment among investors.  No so this year.  I think there are several things going on that might shed some light on this.  Many are looking at small cap underperformance as an indication that the market is putting in a major top, right here, right now.  If that bit of evidence were surrounded by other bits of evidence saying the same thing, I would agree.  Our longer-term indicators are giving few warnings of a major market top as you know so I think there are other things going on.  One plausible answer is that small caps ran so strong in 2013, they are simply taking more of a rest in 2014.  Coincidently, valuations for small caps coming into 2013 were much higher than large caps and logically investors would take profits, giving the proceeds to cheaper large caps.  Finally, the value of the US Dollar prior to the last 10 weeks was sitting at historic lows.  A low US dollar tends to support large cap multinational companies who generate great gobs of their revenue overseas. Small caps have a tougher time.  But that was all before this quarter when the US dollar rose nearly 5% against a basket of foreign currencies.  This has been an incredible move!  In stock price terms, such a move would correspond to roughly 25 or 30% in the S&P 500 (haven’t done the math, but heard it on CNBC). 


Now let’s do some planning.  If we recognize that small caps might be simply oversold within a longer term bull market and that current price trends are still reacting to earnings from all the way back in June, then we might be open to the possibility that large caps earnings starting in three short weeks, are going to be adversely impacted by recent events in the US dollar.  We might not be surprised to see earnings from small caps coming in above expectations for the same reasons.  The smart investor will be very careful now about adding to overbought large caps and be ready to shift into oversold small caps early in the fourth quarter.  The only caveat is that small caps must not break trend, meaning trade below the August lows.  If that happens in the next several weeks, I’ll take it as a more bearish indication for the market trend as a whole. 


Sector Performance Ahead of Upcoming Rate Hike


            Of course the Federal Reserve will raise the federal funds rate.  They will do so sometime in 2015, probably mid year according to the median forecast.  Strangely, it appears that the market or most market participants are just now starting to orient their portfolios toward that reality.  Let’s do the same right?  So what does that mean?  Well using history as our guide, we know that in the nine months prior to the first rate hike by the Fed, there are certain sectors that outperform and others that underperform (the market).  Now remember, that our market trend doesn’t have to be positive, although it almost always is leading up to the first rate hike.  But for this discussion, be clear that we are simply talking about relative performance.  Less bad, is “outperforming” in other words.  In our world of wealth management and risk controls, we don’t like losing less as an acceptable option.  We look at losing money, or really the risk of unrecoverable loss, as something to avoid.  Short term volatility, is different and something we often put up with as long as the primary trend is up.  Back to the script.  So the best sectors to own leading up to the first rate hike are Financials, Technology and Energy in that order.  On the underperformance side, we have consumer discretionary, healthcare, telecom and utilities in order of best to worst.


            Again, let’s look forward and do some planning.  If we own big or oversized positions in the groups likely to underperform, then we might consider cutting back or eliminating them from our portfolios in the next month or two.  Consumer discretionary and healthcare are the most overbought of the losing group, so they should be first on the chopping block.  Telecom and utilities are currently neutral so we can be patient about any sells here.  On the buy side, energy is the only sector that is currently oversold and relatively attractive.  Energy has been hit hard by recent geopolitical events and some currency issues but really this sector doesn’t seem to have major structural problems and is in the right place considering the current stage of the business and market cycle.  Financials and Technology are pretty overbought now, so again, the smart investor will be patient about buying until we get some meaningful declines here. 


Steve’s Notes


            Steve Blumenthal is the president and CEO of CMG capital (www.cmgwealth.com ) in PA, an excellent money manager and good friend.  He was recently speaking at the Morningstar ETF conference and had the opportunity to listen to the long term and short term outlook offered by Pimco.  I’m going to offer Steve’s notes on Pimco’s Outlook here because they are great ( thanks Pimco) and brief (thanks Steve!).  Use this information to guide your expectations and your appetite for risk taking.  In fact, I would encourage you to read it several times as you’ll begin to get a feel for where growth lives both in time and location.  Hint, the easy money is behind us in both long and short term windows.


Secular View (long-term):

• Private debt improving, government debt is not.
• Debt remains a large overhang.
• In developed economies – low inflation and they want more, but can’t get it.
• In emerging market economies – want less inflation and can’t get rid of it.
• EM can drive global growth – Pimco sees it as 50% of global GDP by 2016 (but EM is still dependent on the developed world.
• The eurozone economy should grow by about 1% in the next 12 months, continuing a painfully slow climb out of a double-dip recession.
• We expect Japan will grow by around 1% to 1.5% in the next 12 months and China’s growth is likely to slow to around 6.5%. The outcomes for other developing economies will be tied to what happens in China next year.
• Pimco’s economic forecast for the next 12 months calls for a continuation of a low amplitude, long frequency U.S. business cycle recovery, with growth between 2.5% and 3.0%.
• Demographics are a negative in the developed world as working age population will continue to decline up to 2029.
• A significant growth headwind. Older population spends less and earns less. Pimco expects 2% nominal GDP while Wall Street expects 3½% to 4% – expect Wall Streets estimates to be lowered.


Cyclical View (short-term 12 month view)

• Current GDP of 2 ¾% – a bit better than their prior estimate.
• Positive trends have emerged: Consumer confidence is up and they see diminishing policy uncertainty leading to stronger investor confidence.
• US household net worth is improving and higher than the 2007 high.
• US household debt service is now lower than it was in 1980. Better individual balance sheets – more money in the pockets.
• Housing affordability is good – a positive.
• Government spending is becoming less contractionary.
• Corporations yet to spend on capital expenditures have yet to materialize. Pimco is expecting this to pick up and continue to improve over the next two years.
• Central Bank policy to diverge (driving divergent currency moves)

• Federal Reserve – rising rates
• Bank of Japan – flat
• Bank of England – rising rates
• European Central Bank – flat and accommodative


Several additional notes:

• What happens when the Fed takes the punch bowl away? Exit the great experiment?
• Regulatory environment constraints: money market reform and Basel III – changes coming in the money markets – going to be gates put up upon exit, money market (MM) funds will move off the $1 peg value
• There are not enough assets available to put into MM funds compared to the large demand. MM portfolios have stepped into greater risks.  It is a demand and supply mismatch.  Risk up, liquidity down.
• In the past, banks were willing to take risks and make markets – that is now GONE (due to increased capital requirements – regulations)
• Banks are moving capital toward higher profit markets. No longer making markets.  Market dynamics have changed.  Few bids in times of crisis.  Markets more apt to dislocate.
• Liquidity continues to decline.



• 1¾% to 2% modest inflation expected
• 2 ¾% current GDP expectation, longer-term 2% nominal GDP for a number of years
• Fed begins to raise rates in mid-2015


Happy Fall Equinox – stay balanced!


Sam Jones