Nauset Wealth Managment

☰

Category: Market Update

Nauset Market & Strategy Update

Key takeaways regarding recent market activity:

  • The market’s old companion volatility is back and likely with us in 2018
  • Rising rates and inflation concerns will continue to be a key concern for all stock markets
  • Despite solid US and global economic fundamentals, potential for market gains are lower than in 2017
  • Our approach is to stay diversified and rebalance as opportunities occur

What Happened: Welcome Back Volatility

A market correction can be unsettling but it’s important to remember it is normal. We haven’t seen one in a while as we have been in an unprecedented period of low volatility. The market sell-off of the past week was swift and appeared just days after a new market high. The S&P 500 stock index hit a new all-time high of 2873 on January 26. Thirteen days later on February 8, the S&P 500 was down -10.2% from that high, mostly from losses in the past five trading sessions. To put this into perspective, the S&P 500 is down -3.5% for 2018 due to the spike up in the first three weeks of the year.

The reason for the sell-off: rising interest rates on the 10-year Treasury bond along with a whiff of wage inflation from the Feb 2 jobs report got the attention of stock investors. Higher rates are generally negative for equities, especially after the prolonged period of historically low rates. The 10-year Treasury yield moved up from 2.4% at the end of 2017 to 2.8% in early February. And when coupled with a forward P/E ratio on S&P 500 stocks at the upper end of its historic range, investors got nervous. Add to this mix, the intention of the Fed to push up short-term rates at least 3 times this year, and the stage was set for a sell-off. The sell-off itself was likely amplified by short-term trading programs and hedging activity, which often dominate daily trading.

The irony of the situation is that S&P 500 earnings have been excellent this quarter and are projected to continue to be strong in the near term. And that is usually positive for stocks. We believe that the positive economic environment will likely limit the decline in equities. However, the bottom line is that rising rates will likely make it difficult for markets to move up in 2018 as the current US economic cycle, now almost nine years old, may finally be in its late stage.

Going Forward: Why Stay Invested?

So, what happens now? The economic backdrop continues to be positive, which will support markets. While growth is almost always a good occurrence, too much growth and earnings momentum can cause inflation to rise, which above a certain level is problematic. Some analysts believe the recent cut in corporate tax rates may push the economy toward an overheating phase. We are not in full agreement with this view, as the impact of tax reform on both consumers and corporations is still unclear. However, if inflation does rise, the Fed would address it by raising rates more quickly, which in turn would push up interest rates in general. And that scenario would likely be negative for stocks.

Under almost all scenarios, we do see rates and inflation rising. The concern for the markets is how much and how quickly. Right now, the bond market is expecting the Fed to tighten 2-3 times this year, up from lower assumptions only six months ago. That means that the bond market’s expectations are much closer to the Fed’s projected tightening path. Which, in turn, suggests that the 10-year yield may now be closer to “fair value” than it has been, and interest rates may settle in the current range and perhaps move slowly to the upside. As such, we will keep a close eye on both inflation and rates.

Even with rate and inflation concerns, the solid economy and earnings picture does provide a way forward that may result in gains for stocks this year. It just won’t be the smooth ride of 2017. Whether the market settles down from here or continues to exhibit high volatility is not knowable. Our view is that it will stay choppy for a while. The recent whipsaw is a reminder that volatility and pullbacks are the price we pay for the excellent returns that stocks can produce over the long run.

The chart below shows that sizeable sell-offs and pullbacks are normal even in years where the market is positive.

 

Finally, let’s put some context around the current market sell-off. The US stock market has had a strong run over the past 15 months without even a -10% market pullback. As a result, the S&P 500 was up over +30% in that period. Corrections of -10% are normal and happen about every 2-3 years, so it is no surprise that one would occur now. Over the past 50 years corrections, defined as a -10% to -20% price drop from the peak level of the market, have averaged about -14% and bottomed in about five months.

While we can’t predict what will eventually happen, this provides some context. At worst, a bear market, defined as a drop of -20%+ in the broad index, could develop from this correction. We put a low probability on that occurring given the US economy is on solid footing and not showing any signs of a recession, which usually accompanies a bear market. In summary, a correction is normal, and for long-term investors who stay the course, it’s often a healthy development that can help markets consolidate and eventually move higher.

Current Investment Strategy: Keeping Our Balance

As we have noted at volatile times in the past, we at Nauset are long-term investors, not traders, so our mantra is to stay balanced, diversified and disciplined. Our advantage is that we are long-term investors and we can handle short-term volatility as we manage positions for the long-term. 

We build clients’ portfolios for the long run and to fit clients’ financial plans. As part of that approach, we weather market corrections like the current sell-off, and as conditions evolve, we adjust to new market realities. While a market correction may be unsettling, we have a bias to action around the following three areas:

  1. Rebalancing – we continuously monitor our clients’ portfolios and will take steps to rebalance to specific client asset allocation target ranges and risk profiles. 
  2. Tax-loss harvesting – With the recent sell-off, recently purchased positions may be in a loss position. We may sell these positions from taxable accounts to create a capital loss and buy back the same security 31 days later, or buy a similar security, to replace it in the allocation. This will provide clients with a tax offset for a portion of earned income or gains we take in the future.
  3. Opportunistic buying – Volatility and sell-offs often create price distortions and thus opportunities in individual securities, subsectors or sectors. We are monitoring the market for the opportunity to add to areas that we find attractive, such as cyclical and growth stocks in tech, financials and consumer discretionary sectors.

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. 

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.

Happy (Choppy) New Year

The holiday decorations are barely put away and the market has stopped wishing us a good start to the New Year. The news cycle is feasting on Chinese economic slowdown, stock market volatility, oil prices and currency devaluation. As we often do during times like these we remind ourselves that we are long-term investors. What does it mean to be a long-term investor? A long-term investor is someone who believes that over time the global economy will grow and valuations on equity investments will appreciate. If we no longer believe that this will occur then it would be time to completely rethink our expectations on working, spending, and saving, not just our investment strategy. Let’s look at what happened this week and ask ourselves whether we should abandon the long-term promise.

China

China had a difficult week due to a number of factors not least of which is the Chinese are still trying to figure out how to actually run a stock market. Our stock market is nearly 200 years old. China’s is less than 25 years old. We should expect that they aren’t going to every move right. They are starting to lift some trading restrictions and this created selling pressure. Yes, their economy is slowing down. We’ve know this for a while. The specifics on the Chinese economy are also hard to discern given the government’s control over most everything. Until the markets get more comfortable with China’s actual impact on the US and other markets, China will, at various times, create market volatility.

The US Economy

The US economy continues to give mixed signals. Improving employment numbers today! Slower manufacturing numbers tomorrow? For some time we have voiced our agreement with the lower, slower camp and still believe that will be the case for the foreseeable future. Maybe not great for stocks but not a set up for disaster either. So is it time to abandon our long-term approach? Is this the beginning of a deep bear market? We don’t believe so. It is much better to be patient during the difficult markets so that we don’t miss the good markets. To this point see the chart below. Forget about the impact on missing the best years. Look at the difference it makes to miss the best days!

This not to say we are sitting on our hands. We will send out our annual review and our outlook for 2016 in a few days and identify changes to our strategy in light of our view that this will likely be a choppy year even if eventually markets rise.

Time in mkt more valuable timing market

Source: Wells Fargo Investment Institute, November 2015
Stocks are represented by the S&P 500 Index. The data assumes reinvestment of income and does not account for taxes or transaction costs. Past performance is no guarantee of future results.
Chart is for illustrative purposes only and is not meant to represent the performance of any particular investment. An index is unmanaged and not available for direct investment.