Nauset Wealth Managment

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Category: Investment

Waiting for Godot?

The chorus of investment pundits calling for an end to the current US stock rally has grown larger and louder and yet, the market continues higher. Let’s examine why a correction will happen, why predicting it is hard (and potentially hazardous to your portfolio) and how we think about it.

Corrections have a strong track record of showing up (unlike Godot), as part of a normal market. A correction is commonly defined as a -10% decline. The average intra-year decline is historically -14%. Even in positive years, it is unusual not to experience a mid-to-high single digit decline. (See chart).

We have been waiting for a correction (like Godot), but not for very long. The last S&P 500 correction began in the summer 2015 and hit its low for the year in October. The drop happened to be a decline of about -12%. From November 2015 until February 2016 the market again took a double-digit dive. Since then the market has climbed +33% with fresh highs being set on July 12, experiencing one measly -6% drop along the way.

Based on history we expect a correction to occur before the end of the year. However, timing and duration are elusive and we are not trying to predict it. A correction may be triggered by almost any event – Fed Reserve action, oil prices, a poor jobs report, or a geopolitical incident. Rather than trying to guess the timing, the key is to understand the drivers of any correction in order to assess new investment opportunities.

Post-election Views or Much Ado About…

Well, we can’t say nothing. We aren’t going to rehash the election surprise. What we will do is share our views on the post-election market behavior, outline a possible scenario and actions we are considering and what we will be watching for over the coming months and years.

What happened? Virtually no one in the financial world predicted a rally immediately following a Trump victory, which also very few people predicted. For the record, the S&P 500 opened the day after the election, November 8, at 2130 and closed at 2182 on November 16. This equates to a +2.4% rally that leaves us just below the all-time market highs hit this past August. Now the underlying story is a bit different. During this same 8-day period financial stocks, particularly banks, rallied over +10% and some individual stocks by close to +20%, but many tech companies like Amazon fell by -3% or more. Healthcare and bio tech have also experienced a nice bump up. Bond prices have been knocked down driving yields on the 10-year Treasury bond from 1.88% to 2.35%; right at the 1-year high.

It’s important to note that other than bank stocks making a very decisive move up, none of these numbers are, in and of themselves, eye-catching from an absolute perspective. We have seen most of them in the past 12 months.

What do we see driving this behavior?  Right now we surmise the biggest driver is speculation on the third derivative of policy expectations. It is clearly not investing based on observed facts. Many market participants have made big rotations based on policies President-elect Trump hasn’t made clear, haven’t been implemented and whose effects are just hypotheses, i.e., speculation on the third derivative. Here is a summary of the big themes:

  1. Bank regulations get relaxed or go away so banks are more profitable
  2. Obamacare gets changed or eliminated and capping drug prices is not on the agenda, helping health care and biotech companies
  3. Fiscal stimulus, primarily through infrastructure spending goes up, international trade gets choked off, taxes are lower, all driving inflation and interest rates which helps banks and generally hurts bonds.

Now we don’t argue that these sound directionally right. However, the market movement was quick and in some areas sharp. Quick and sharp are not words often associated with governmental change and therefore we believe the market has over-reacted.

What do we hypothesize will happen over the next 12 months?  Here is a working, third derivative hypothesis, roughly in order of our conviction. It is not precise as we are using the third derivative —  think compass orientation not laser targeting.

  1. We get fiscal stimulus and lower taxes
  2. Rates and inflation rise, but not dramatically
  3. Bank regulations get tweaked not thrown out
  4. The economy improves a bit.
  5. Obamacare gets changed. What’s the effect? See the third derivative, i.e., who knows?

So what are we doing?  We have not been making major investment decisions. As investors, not speculators, we don’t react to quick market moves driven by assumptions from third derivative hypotheses. We are spending a lot of time looking at how we implement our existing overweight positions to technology, healthcare and biotech. We are also looking at financials as a possible overweight. We have been selectively adding to real asset positions due to higher expected inflation and what we believe has been undo pressure on REITs and our infrastructure positions. We have been selectively selling out of some fixed income positions.

What will we be watching? We will be watching measures of economic activity that might indicate a coming recession because we haven’t had one in over 7 years. We will be looking for dislocations in the market to add/rebalance to core positions. We will be listening and looking for real policy statements and activity that give us a better idea as to how those policies will eventually be implemented. We are particularly intrigued to see what happens to US Treasury rates as they will be a good indicator of how the world judges the relative safety of our markets versus all others.

In dealing with the next few years, it will be best to embrace Confucius’ blessing (curse?): “May you live in interesting times,” and to maintain a diversified and carefully monitored portfolio. 

Private Investment Update

As a result of our continued search for investments that can provide true diversification, Nauset recently worked with Calare Properties to present our clients with an opportunity to invest in a multi-use, multi-lessee commercial property in the Boston area. The expected return profile of this private investment is driven primarily by rental income with the added benefit of potential capital appreciation at exit. Calare Properties is a leading commercial real estate investment and management company.

Why we do like this investment? It is ownership in a real business with a real cash flow underpinned by a real asset. It’s actively and professionally managed by a specialized firm with its own capital at risk. As an illiquid investment it isn’t subject to the whims of capital flight from one part of the market to another.

Nauset did not receive any financial consideration from Calare, nor do we promote any private investments. Our clients invest directly in these private investment funds with no sales charge.

Author: Nauset Investment Committee
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Tags: Investment

When Investing Feels Like Trading.

The capital markets have changed. It is remarkable how much ground they cover in a day, week or month. You see a good opportunity to enter or increase a position but before you implement the buy, 50% of the expected gain is gone. Or you actually get to implementation and you reach your expected return/valuation metric – or whatever target – but it’s in two months, not two years. In this environment investing can start to feel like trading. 

I am not advocating trading as a way to manage your assets, and Nauset has NOT become a trading shop. We believe smart diversification and valuation are the keys to building and managing wealth. That said, we can’t dismiss these market changes. They are the reality we have right now. 

So why has this happened? Beyond that fact that money flows around the world 24 hours a day with the click of a mouse, we see two primary factors in charge of market movements:

  1. The narrative rules. One month its oil. Next it’s China. There’s always the central banks. And whatever happened to Ebola destroying the world? Maybe market participants aren’t sleeping in front of CNBC, but maybe they have become a pack of fast moving zombies that change direction based on whatever sound they hear coming from the so-called experts. And even the experts are susceptible to the narrative. I’m not saying there aren’t people worth listening to. What I am saying is there is no one who has lived through a sustained but middling recovery, with zero interest rates, in an environment where any major central bank can affect every market in the world instantaneously. So everyone is looking for a story about what is going to happen that makes sense to them. And if enough talking heads say the same thing, suddenly it doesn’t matter what the underlying truth is. The talk becomes the truth and markets move with the talk, and they do so quickly. Ben Hunt of Salient Partners has an entire blog, The Epsilon Theory, dedicated to the topic of the narrative that is worth reading. 

  2. Quants rule (at least day to day). They pick up on some trend or narrative and move on it. And when they all get behind one, the effect is like a football team pushing a Prius downhill. You don’t want to get in the way of these elephants on a daily or even monthly basis. That said, they can open up big holes or close them down with amazing speed.

At Nauset, we are looking at three adaptations in our process to respond to this environment: 

  1. Look at risk through the narrative. My old firm Barra had a great ad that said, “Risk: the other side of return.” At Nauset, we have always taken a risk-based approach to allocation, but given that narrative now rules, we need to look harder at how the narrative can impact all positions, regardless of the fundamentals.

  2. Be ready to strike. We still believe that valuation dispersion creates opportunities. Given how quickly valuations can suddenly open up, we want to be better prepared to implement against these opportunities (ETFs v. mutual funds v. single stocks).

  3. Take what you get (when you get it) and don’t get upset. The majority of our clients have long-time horizons. We will continue to look at opportunities relative to their return potential over years, not days or weeks or months. But if those returns are realized in weeks or months because of the narrative, we want to take them even though it feels like (gasp!) trading.

We all hope the market goes back to the way it was, but hope is not strategy. Our strategy is to protect our clients’ wealth by seeing the market for what it is, and prudently adjusting.

Proceed With Caution.

Major US and global stock and bond indices ended 2015 flat or negative for the year despite a solid recovery in the fourth quarter. With a lackluster December and volatile start to 2016, investors remain concerned about growth, central bank policy and energy prices in the US and the rest of the world.

Our 2016 Outlook

Looking over the next twelve months we are focused on four big themes: (1) caution, more volatility ahead; (2) US equity: from leader to laggard? (3) live local, think global; and (4) can alternatives shine?

  • Caution, more volatility ahead – After an up and down 2015, we foresee more of the same ahead this year. Investors are nervous as the effects of slow global growth have seeped into many sectors and regions. As we already seen in the opening days of 2016, investors are skittish and quick to sell on a variety of factors – China slowdown, geopolitics, oil dynamics or the next poor economic report. As long-term investors we don’t overreact to every zig or zag, but we do search for attractive values in favored sectors or subsectors amid the choppiness.
  • US Equity: From Leader to Laggard? – We assess the prospects of US equities on three key factors. Two factors are slight negatives weighing on stocks – most valuation measures are high historically and the Fed has begun raising interest rates. The third factor, earnings growth, could provide support for gains in 2016. If reported profits hit the forecast range of +5% to +8%, then positive stock returns may follow. While the path won’t be smooth, we believe there is opportunity for gains in some sectors.
  • Live Local, Think Global – While the US central bank has taken its foot off the stimulus accelerator, other central banks, such as the Bank of Japan and the ECB, are still looking for levers to stimulate their economies. Emerging markets have taken a beating and their near term prospects look weak given their exposure to China and to commodities. That said, valuations are becoming more interesting and not all of them are handcuffed to China or commodities. While perhaps not attractive for near-term performance, we see hints of opportunities on the horizon for long term investors.
  • Can alternatives shine? – Alternative investments try to produce returns that are not correlated to general stock and bond market indices. Given the current low market return expectations, we are overweighting portfolio allocations with a set of non-traditional investments that seek positive returns with risk-buffering benefits. This could be an area of relative opportunity this year.

Casting a Wide Net

Our managed risk asset allocation portfolio strategy is based on using a diversified set of investments. In today’s environment, we believe that using a wide range of return opportunities is critical to deliver both returns and manage risk. At present, we are taking action in the following areas:

  • Over- and underweighting key sectors – Based on our market view, we are overweight growth stock sectors and high yield, and underweight government and corporate bond holdings.
  • Increase alternative investments – We are increasing the number and use of alternative investments, such as long-short equity funds, with the objective of producing positive returns while buffering market risk.
  • Opportunistic buying – Market volatility often creates opportunities in areas that we find attractive, like high quality growth stocks in tech, health care and financial stocks.

While we are following this scenario, we are constantly monitoring market developments, and remain flexible to adjust to new data as the year unfolds.