There’s a lot I don’t like about the market action since my last update on 6/8, which admittedly had a bullish tone to it. Such is the plight of anyone attempting to provide a written analysis of current market conditions, as we can easily look silly the moment we hit “send”. Nevertheless, the market theme of resilience in the fact of massively negative sentiment and several serious headwinds still seems to be intact – for now. I’ll review some of what I do and don’t like about this market and finish with some guidance for our clients regarding changes we’re making to our tactical equity strategies in an effort to improve our upside/downside metrics (aka asymmetric returns).
On the Upside
I like the fact that our market canaries are still singing. These are the more sensitive sides to the market that typically cave before we see a final top in the larger, broader stock market. These are high yield corporate bonds and small caps both of which have seen mild pullbacks in the last couple weeks but only back to their rising moving averages and newly established uptrend lines. So far, this is constructive but we do need to see some strength in both asset classes right here, right now if the market rally is to continue.
I also like seeing a great many stocks and equity-income oriented groups continue to push higher, many making all time new highs. This is constructive and gives investors a reason to stay engaged with investing. Dividend payers, REITS, consumer staples, utilities and telecom are all up double digits YTD. This is not a recommendation to buy these as much as calling out the real performance. It really feels like a free lunch in terms of the risk and reward metrics coming from these sectors, which don’t typically offer investors such a profitable experience. Reminder- there is no free lunch in investing, usually someone is eating your lunch as a matter of fact.
I like the fact that sentiment is still remarkably negative as shown by the near multi year lows in the number of bulls among AAII sentiment surveys. As I mentioned last update, negative sentiment is the hallmark of new, healthy market rallies, not the beginning of terrible bear markets. Is the AAII group suddenly right on the future direction of the markets? Not likely as they are just as human as they ever were, hating markets that are trading lower and loving markets that are trading higher. The hate today simply reflects nearly 24 months of unproductive markets. The question is, has this cycle also produced some new upside opportunities? Sentiment contrarians would say yes.
I also like the fact that the Fed is most likely on hold now in terms of their rate hike schedule probably until the end of 2016 given the slew of issues affecting their policy decisions. We must remember that this Fed, under Yellen, is probably one of the most sensitive we have seen in modern history to global events. They see and recognize that we have become a global economic ecosystem with very clear cause and effect impacts of currency, trade, politics, commodity prices, wars, etc. across borders. I’m not saying they are wrong in doing so, in fact I think it’s about time they did. But, US Federal Reserve policy will not longer operate in a vacuum. It will factor in things like the Brexit vote next week. It will factor the flow of money across nations driven by currency differences. It will factor in negative interest rate credit markets showing up all over the world now. With all those factors, we shouldn’t be surprised if the Fed goes down this path VERY slowly. As investors, we like liquidity and supportive monetary policy and that’s what we have now for the foreseeable future.
On the Downside
I don’t like the fact that Oil prices have seen some very real technical damage in the last week. The market wants to see stability in the energy sector and this isn’t helping. I don’t like that economically sensitive sectors like transportation look like they want to break down through significant support. I don’t like that financials continue to lead lower as they still represent one of the largest weights in the US markets. Along those lines, some of leadership is also starting to look terrible like the FANG stocks of last year (Facebook, Amazon, Netflix and Google). Europe completely fell out of bed in the last week and broke a four month uptrend. But we’ll see what happens on the Brexit vote. I expect a “no” vote and I expect Europe to rally strongly (just a guess) as a result. I also don’t like seeing the VIX volatility index spiking like it did, up nearly 30% in a just a few days and it did so as Treasury bonds made a strong all time new high. This type of market action has come with heavy down moves in stocks in the past, give or take a week. Technically, I also don’t like seeing our breadth measures turn negative which they did on Wednesday and sell side volume has been on the rise confirming the down move as potentially something more than just a correction.
Needless to say, we’re on edge now with the markets hovering again at the same highs of the last two years where we have seen failures in the past. June is statistically the worst month of the year for stocks with an average loss for the month of -2%. Perhaps we’re just seeing a little seasonal weakness, or perhaps it will devolve into something more. At this point, we just have to wait and see.
The Quest for Asymmetric Returns
We have three strategies that fall into our “Tactical Equity” investment category. They are New Power, High Dividend and Worldwide Sectors. All three are equity only strategies using individual stocks and ETFs. All three approach the markets from a different angle focusing on different types of equities. New Power is purely speculative investing in game changers, newer companies and emerging technologies. High Dividend chases leadership in the dividend growth world. And Worldwide sectors owns “sector” funds adjusting weightings according to the market and economic cycle. Worldwide, also has a growing allocation to international index ETFs, now up to 30% of the strategy. All three strategies in our tactical equity category are under scrutiny by our management team as we feel we need to do better at generating asymmetric returns for our clients. These strategies have made nice gains during this bull market but they have also seen more downside losses in the process than we like. The age old quest is on – How can we make more and lose less? The holy grail right? Our quest is now a daily research project. We are looking at asset class returns and risk metrics, the impact of manager subjectivity, the impact of hedging and adjusting exposure for better or for worse. We are looking at the impacts of trading in terms of costs, taxes, etc. We are considering the degree to which our clients can tolerate downside losses in pursuit of gains. In essence, we are working to evaluate was is working well and what is not in terms of upside and downside capture ratios. In all honesty, we don’t like much of what we see with these strategies in recent years. Our tactical equity strategies are not providing the types of asymmetric returns that we’re clearly getting out of our blended asset and Income strategies at least in the last 4-5 years. The upside is not enough and the downside is too much for our liking.
Here’s the good news; we’re starting to see and find some very attractive new approaches that have more to do with portfolio construction and less to do with trading or manager subjectivity. We’re getting close to finding solutions for each of the three tactical equity strategies that should dramatically improve our asymmetry. As clients, you should be smiling. We feel confident that the changes we’re working on and developing now will be more appropriate and productive looking forward as they will be more aligned with market opportunities and trends. Remember, there is no investment strategy that works well in all markets nor is there an investment strategy that never needs adjustment. Think about how the markets move today, the securities we use and the near perfect efficiency we see in processing information. The internal features of the market today are vastly different than the past and thus the methods behind our strategies need to be adjusted over time as well. I’m thankful we have that flexibility. We will have more detail on strategy changes as they are defined and integrated.
That’s it for now, stay tuned!
Sam Jones
