For the moment, the widely heralded breakout to new highs on the 24th by a select few stock indices may have been just another short visit to the top of the trading range established in both December and February. The US stock market is just not ready to get off the treadmill quite yet. We are starting to see some dramatic moves and rotations in other asset classes and select sectors that are worth our attention in the meantime.
US Stock Market Still Range Bound
This is about that time when we all start to get a little tired of not making real headway in our portfolios. Range bound markets are tough, especially ones that trade within a 5% band like today. By the time you might consider buying something, the market is already at the top of the range. And just when you’re ready to sell, like last Thursday, buyers show up again at support. YTD, the S&P 500 has been trading in a range of -3% to +2.86%. Our strategies in aggregate have a slightly better looking range of -1% to + 3.5% . Remember of course, that statistically our returns are earned with a fraction of the embedded risk inherent to any fully invested stock only index like the S&P 500. Investor sentiment figures and consumer confidence are sort of telling the same story as I believe the two are highly correlated now. Both say that the guy on the street isn’t expecting much and tends to carry a negative bias toward the future. Fundamentally and technically, it’s hard to disagree with that opinion. The US economy really stalled out in the 4th quarter of 2014 and has been statistically working its way lower on practically every measure since. Technically the deterioration that began in February is still in place showing up in the price treadmill. Selectivity continues to be the theme of the year, consistent leadership is hard to find and cyclical groups are reflecting the obvious soft spot in the economy with consumer, transports and others still under selling pressure. But all is not lost.
The most important thing for all investors to see and understand now is that the primary trend of the GLOBAL financial stock markets is still up, thready but up. Some will suggest they know the future. They will appeal to your sense of fear and present speculative evidence that the market has peaked; time to get defensive! Sell in May and go away! Maybe they’re right, but we should also respect the fact that we have been in this situation four times over the last five years with economic conditions that were quite a bit less attractive (weaker labor market, soft housing market, stimulus propping things up). And from these moments of despair, the market found buyers. Prices subsequently pushed higher and higher. This is quite literally, the Wall of Worry that defines long term bull markets in stocks. We have been expecting a normal correction of at least 8-10% for over two years now and yet the US stock market hasn’t been able to pullback more than 5%. Even today, the S&P 500 is only 1.5% below its all time high. All of this talk makes me sound like a pure market timer which I despise so let’s get back to our regular focus on (Dynamic) Asset Allocation, Selection and Position Sizing to make sure our money is in the right place.
New Rotations and Possible Trend Changes
The big news is the short term reversal in the trend of the US dollar, which seems to be driving returns in many different areas of the financial markets. The new correction in the US dollar is probably just that within a longer term move higher in my opinion but for now, we have to respect the correction and what it means to our holdings. Small caps benefit from a rising dollar and large caps benefit from a falling dollar. In the last week, we have rotated from small cap growth to large cap growth and value positions. Also a falling US dollar tends to be supportive of commodity groups including oil and gas. Here again we have found good reason and solid entry points for new buys in the oversold energy sector, which offered some nice positive diversification to falling stocks and bonds last week. Energy and oil positions were up 2-3% on the week while everything else saw red. We aren’t yet ready to buy pure commodities funds, as our system doesn’t allow us to own things in defined downtrends. Commodities are still in a downtrend but working hard to find a bottom. Maybe soon.
Finally, a falling US dollar gives bonds sellers one more reason to dump and run. As I write, the 20 year US Treasury bond is now negative on the year, down 1.47% and most aggregate bond funds and ETFs are also slipping negative YTD. Bonds are in a tough spot with more than just the falling US dollar to worry about. They have additional headwinds coming from new inflationary pressure coming from wage growth and they have a potential bottom in the price of oil and gas, which is also inflationary. They have a Federal Reserve that has just told the world “Any time now” and finally they have their true value proposition, which is just unattractive from a risk and current yield perspective. As I have said many times in the last several years, bonds, specifically sovereign debt, will not offer investors the same safety net they have over the last 25 years. Perhaps as a sign of things to come, Euro zone bonds were crushed last week erasing over $60 Billion (USD) in value in just one day while their stocks markets sold off harder. Our own multi-Trillion dollar Treasury bond market is down over 10% now from the February highs. Again, both stocks and bonds sold off together here at home last week. I think we’re going to see more of that looking forward. Every pension plan, every foundation, every endowment and every investor who is relying on the long standing role of Treasury bonds as their only safety net, may be sorely disappointed. Returns for the standard 60/40 portfolio (stocks to bonds) are already tapering to an average annual 2-3% which may even fall below the inflation rate in the coming years. Those with conviction might even consider a short position against bonds now as small hedge and complementary diversifier. Right now, our hedges in both Income models represent almost 30% of the portfolio. They are by way of floating rate funds (Hartford and Guggenheim) and a single diversified Income fund with a net negative position against the 7-10 year Treasury bonds (Putnam Diversified Income Fund – PDINX). The chart below shows the 10-year Treasury bond in Green to our Floating rate funds in yellow and red and our Putnam fund in Purple over the last three months.
In addition to the obvious price trend advantages shown, our holdings are also paying 4-5% annual income while the 10-year Treasury bond rate is only 2.14%. All charts above reflect total returns including capital gains and income payments.
Dynamic Asset Allocation, Selection and Position Sizing
Most sophisticated asset management firms are now lightly moving into true alternative positions as a risk diversifier. We have been doing so ourselves for years and it’s nice to see so many liquid options now it the alternative space. We have nearly 400 investment choices in our evolving universe of alternative securities. These funds march to their own beat, have very low correlations to either bond or stock markets and offer an investor true diversification where it’s becoming scarce. But as you know our system also has a tactical foundation, which sort of makes our entire shop “alternative” to a degree. The dynamic changes in our asset allocation, described above, respond to changing market conditions. The selectivity of owning leading sectors and securities is also tactical and alternative. Position sizing is another of our dials in our tactical system but at the moment, we don’t have strong conviction in anything so nothing is really notably overweight or underweighted. I mention this in light of the current and future market conditions, which to me are clearly going to reward more sophisticated asset management systems. Treadmill conditions might persist for longer than most investors would like but there are other more sinister risks to ones portfolio especially for those relying on asset class relationships of the past. I am grateful to have my personal assets right next to those of our employees and all of our clients under the umbrella of our well seasoned system. I hope you share my enthusiasm and confidence.
Have a great week
Sam Jones
