Market Volatility–October

I believe we’re seeing a large repricing of growth expectations. The one time tax reform boost will wear off into next year, and higher borrowing costs, fuel costs are reducing discretionary income. 

In addition there is a great deal of leverage in the markets which will exacerbate declines. 

Often, at the end of bull markets/beginning of bear markets we will see relatively large price movements, 6-12%, down and up. I believe this correction has a good chance of bottoming or at least slowing in the immediate term, and  it’s bounce back could be half the decline, maybe more, which will be several percentage points. 

 

Focusing on keeping portfolio declines to the single digits while raising cash to be able to redeploy later can aid longer term returns–one has to have cash in order to buy low!   There is a very large amount of ‘bond shorts’ in the market which could set up a large ‘short squeeze’. Bonds were positive today. This is reminiscent of other recent periods when many bond speculators saw bond prices move very rapidly against them (UP) as they rushed to cover their deteriorating short positions.

 

Inflation scare is not the culprit here as inflation rates are slowing in several areas.  Something recent is that with the Fed raising interest rates, the yield, on 1-year and longer bonds is greater than inflation,  a positive “real rate” which is new to this economic cycle and takes a lot away from the ‘bonds dont pay so buy stocks’ argument.  The Fed further reiterated that it currently plans to continue to raise rates through 2019–even though we have already raised rates MORE than in past rate-raising eras.  I will have a chart of this in my Observations and Outlook this weekend.

Please reach out to me with any comments or questions.

 

Adam Waszkowski, CFA

Observations and Outlook July 2018

July 5, 2018

Selected Index Returns Year to Date/ 2nd Quarter Returns

Dow Jones Industrials    -.73%/1.26%        S&P 500   2.65%/3.43% 

MSCI Europe   -3.23%/-1.27%         Small Cap (Russell 2000)   7.66%/7.75% 

Emerging Mkts -7.68%/-8.66%     High Yld Bonds  .08%/1.0%

US Aggregate Bond -1.7%/-.17%       US Treasury 20+Yr -2.66%/.07%  

Commodity (S&P GSCI) 5.47%/4.09%  

The second quarter ended with a sharp decline from the mid-June highs, with US stock indexes retreating about 4.5% and ex-U. S markets losing upwards of 6%.  This pulled year-to-date returns back close to zero in the broad stock market indexes.  The only areas doing well on a year to date basis are US small cap and the technology sector.  Equity markets outside the US are in the red year to date languishing under the burden of a strengthening US Dollar and the constant threat of a tit-for-tat Trade War.  Areas of the market with exposure to global trade (US large cap, emerging markets, eurozone stocks) have had marginal performances while areas perceived to be somewhat immune to concerns about a Trade War have fared better.

Additionally, the bond market has only recently seen a slight reprieve as interest rates have eased as economic data has consistently come in below expectations—still expanding, but not expanding more rapidly.   Job creation, wage growth, and GDP growth all continue to expand but only at a similar pace that we have seen over the past several years.  The stronger US Dollar has wreaked havoc on emerging market bond indexes have fallen by more than 12% year to date.  And in the U.S., investment grade bond prices have fallen by more than 5% year to date, hit by a double whammy of higher interest rates and a widening credit spread (risk of default vs. US treasuries) has edged up.

On the bright side, per share earnings continue to grow more than 20%, with second quarter earnings expected to climb more than 20%, thanks in large part to the Tax Reform passed late in 2017.    As earnings have climbed and prices remain subdued, the market Price to Earnings ratio (P/E) has fallen making the market appear relatively less expensive and sentiment as measured by the AAII (American Assoc. of Individual Investors) has fallen from near 60% bullish on January 4th to 28% on June 28th, a level equal to the May 3 reading when the February-April correction ended. The Dow is approximately 800 points higher than the May 3 intraday low.

With reduced bullishness, increasing earnings, and expanding (albeit slow) GDP growth, there is room for equities to move up.  Bonds too have a chance for gains.  The meme of Global Synchronized Growth which justified the November-January run in stock prices and interest rates has all but died, given Europe’s frequent economic data misses and Japan’s negative GDP print in the first quarter.   This has taken pressure off interest rates and allowed the US 10-year Treasury yield to fall from a high of 3.11% on May 15 to 2.85% at quarter end.  I would not be surprised to see the 10-year yield fall further in the coming weeks.  Muted economic data with solid earnings growth would be beneficial to bonds and stocks respectively.

In my January Outlook I mentioned how the rise in ex-US stock markets followed closely the decline in the US Dollar.   The Dollar bottomed in late February and has gained dramatically since April.  This has been a weight around European and emerging market share prices and has been at the core of the emerging market debt problems mentioned above.  Fortunately, the Dollar’s climb has lost momentum and appears ready to pull back, likely offering a reprieve to shares priced in currencies other than the US Dollar.  It may also aid in US company earnings. So, while global economic and market conditions have changed since January, hindering prices of most assets, I believe we will see an echo of the 2016-2018 conditions that supported financial asset prices globally.   A declining dollar, muted investor bullishness, slowing global growth all should conspire to allow stock, bond and even precious metal prices to rise over the coming weeks, at least until investor bullishness gets well above average and the expectation of new lows for the US Dollar become entrenched again.

Looking Ahead

As second quarter earnings begin in earnest in mid-July, expectations are for approximately 20% climb in earnings.  A large portion is estimated to be due to tax reform passed late in 2017.  With market prices subdued and earnings climbing, the market’s valuation (Price to Earnings ratio) is looking more attractive.  While not cheap by any metric, this should give investors a reason to put money to work.  In the first quarter, analysts underestimated profits and had raised estimates all the way into the start of earnings season.  This is very rare.  The chart below shows us that generally analysts’ estimates decline going into earnings season.  Estimates start off high and then get lowered multiple times usually.   Second quarter of 2018 is setting up to be another rare event where we see again earnings estimates being raised into reporting season.
factset earnings 7 2018

The downside to the effect tax reform is having on earnings will be seen in 2019.   When comparisons to 2018 and 2019 quarterly earnings start to come out (in late 2018) the impact of lower taxes on the change in earnings will be gone.  In 2019 we will only see the change in earnings without the impact of tax reform.   Earnings growth will likely come down to the upper single digits.   How investors feel about this dramatic slowing in 2019 will dictate the path of stock prices.

Quantitative Tightening (QT) will dominate the headlines towards the end of the year.  Over the past 9 years central banks have pumped more than $12 trillion in liquidity into financial markets.  The US Fed stopped adding liquidity and has begun to let its balance sheet shrink, removing liquidity from financial markets.    During 2017 and 2018 the European Central bank and Bank of Japan more than made up for the US absence.   Europe and Japan are scheduled to reduce and eventually cease all new liquidity injections during 2019.  Combined with the Fed’s liquidity reductions, global financial markets will see a net reduction in liquidity.   This will have an impact on markets.  It is argued whether this will cause bond prices to fall (rates to rise) or it will have an impact on equity markets.   I believe it is likely this will impact both areas and the likelihood of falling bond and stock prices at the same time is significant.

US Dollar liquidity is another topic just starting to show up in the press.   The rise in 2018 of the US Dollar after a long decline has taken many market participants by surprise.  The “short US Dollar” and “short Treasury” trades were the most popular at the beginning of the year and have been upended.  It is often that once ‘everyone’ knows something, like that the US Dollar will continue to weaken, its about the time that area reverses and goes against how most are positioned.   The mystery really was given rising interest rates in the US and a stronger economy, why was the US Dollar weak to begin with?  Now the causes of a stronger Dollar are the weakness in Eurozone and Emerging market growth.    But which came first, the stronger Dollar or the weaker economies?

Below we can see the relationship of the US Dollar (UUP) and the TED Spread which is the difference in short term rates in the US and Europe.  The recent spike in funding costs (rates) parallels the rise in the Dollar index.  The rapid Dollar rise in 2014 was partly responsible for the Earnings Recession we saw in 2015.  There’s about 6 months to a year lag from when the Dollar strengthens to its impact on earnings.

ted spread july 2018

Ironically, part of the Tax Reform passed is a cause of poor Dollar liquidity (higher short-term rates result) and the strengthening Dollar.  The ability for US firms to repatriate earnings from abroad at a lower tax rate is causing Dollars to move from Eurozone back to the US.  Additionally, the $1 trillion plus budget deficit the US will run in 2018 and on into the future is also soaking up liquidity.  Repatriation, US deficits, and Fed tightening are all pushing the US Dollar up, and will likely see the Dollar stronger in 2019, which may impact US earnings in 2019.

Finally, there is China.   China is the largest consumer of raw materials.  Besides US PMI, the China Credit Impulse impacts base metals and other raw materials that other emerging market economies export.  When China is creating more, new credit we can see a rise in prices and in the growth of raw material exporting countries and a rise in US PMI with about a 12-month lag.  The chart below indicates that beyond the first half of 2018 the impact from the past China impulse will be fading.   This fade is happening at the same time global Central banks will be withdrawing liquidity and the US Dollar likely strengthening.   This scenario doesn’t bode well for risk assets in 2019.

china credit impulse pmi

Adam Waszkowski, CFA

Observations and Outlook April 2017

Equity prices peaked on March 1 and have been sideways to down since.  Interest rates (10-yr treasury) peaked on December 16 and were nearly matched on March 10, but since then have declined, going slightly below the range we have seen since November 22.  Gold bottomed in mid-December (along with bond prices), climbed to a high in late February and as of today, is pushing through that high mark.    On balance, risk assets have ebbed lower while bonds and gold have increased in price since the end of February.  Bond and gold prices have climbed back to their mid and early November (post-election) levels.  This price action speaks directly to the “Trump/Reflation Trade” we hear about in the news.

Trump Trade Withers

trump trade

Source: heisenbergreport.com
The “Trump Trade” is seen to manifest itself in a rising US Dollar (green), higher stock prices (purple) and higher interest rates (blue).  The Trade has gone nowhere since mid-December, and was decidedly weaker as ACA reform failed to pass in Congress

The past five months’ gains in the stock markets have been widely attributed to the policies the new administration hopes to implement.   At the same time, U.S. corporate earnings ended an Earnings Recession, that had pulled down earnings to 2012 levels.   In the fourth quarter of 2016 the earnings recession ended and had been forecast to do so since early in 2016.   Most of the gain in earnings was due to the base-effect seen in the energy sector.  Energy sector earnings plummeted in 2015 and provided a low bar for earnings to cease its ‘negative growth’.     The two concurrent topics that coincided with the latest rapid climb in stock prices were the cessation of declining earnings, and anticipated policy changes along with their presumed financial impacts.

For the remainder of the year, the focus will remain on these two areas:  earnings and implementation of Trump’s promised policy changes.  The repeal and replacement of the ACA (Obamacare) did not occur and its unknown when it may.  Recently this was seen as the gateway to then reforming the tax code followed by a fiscal spending plan focused around a decrease in social programs, a large increase in defense spending and a $1T to $2T ‘infrastructure’ plan.   With the defeat of the first attempt to repeal and replace ACA, the collective Trump Trade was dealt a blow and the remaining policies passage and implementation are less certain.

Tax policy and regulatory reform are next up and as the conversation around these begins, it’s likely that hope of tax law change will increase. The expectation that these changes will have a meaningful impact on earnings and disposable income will buoy stock prices in the short term.  Passage, implementation, and resulting impacts of policy changes are literally a multi-quarter process.  During that time, as I indicated in January, markets are likely to swing up and down several percentage points as hope of passage and fear of failure compete for investors’ attention.

The low bar for the energy sector remains low, and analysts’ expectations for earnings to grow remains intact, supported by the lower-than-usual reduction in earnings forecast.  Often a full year’s earnings forecast can drop by 1/4 through the course of the year, and when we see earnings estimates decline less rapidly the end of year reduction is often more like only a 1/8 reduction from beginning of year estimates to end of year final numbers.   Current 2017 earnings estimates are $119.80, which is about 5% lower than forecast a year ago and 1% lower than forecast at the end of 2016.   Continuing this pace of reduction, an estimate for 2017 earnings is $112.50.    IF that number is accurate it puts the forward Price to Earnings ratio at 20.9, which is higher than 90% of all other time periods since 1900.   Longer term forward returns from this level are often in the low single digits.

Over short periods of time (less than 3 years) investors often bid up prices well above longer term averages, which we have seen since 2014 and the start of the earnings recession.  Stock prices have risen far faster than earnings have over the past 4 years and its likely with growth resuming we could see even more extended valuations.

Other Considerations

The 30-year bond bull market is not dead.   Over the past few years, the idea that low interest rates were the ‘reason’ one should be accepting of high stock valuations (high p/e ratio, low earnings and dividend yields).  More recently we are hearing that increasing rates are also good for stock prices.   For rising rates and rising stock prices to occur together, there is a fine line to be tread.  Not too much inflation, not too much of an increase in rates while companies grow sales and earnings.   Essentially, we need the rate of change in the growth rate to be bigger than the change in interest rates.   Given the Atlanta Fed’s GDP Now Forecast shows only .6% rate of growth estimated for the first quarter.   This rate is lower than the past few quarters while the yield on the 10-yr Treasury has gone from 1.33% to 2.37%.    It’s more likely that along with stock prices, bond prices will vacillate within a range as policy expectations evolve and we await economic growth.

10yr tsy yld

Additionally, we have seen this, and higher increases in nominal rates without the bond bull dying out.  Some may say that as our national debt and aging demographics continue, our interest rate outlook may be similar to Japan’s experience over the past 20+ years.

While the US Fed has ended, its bond buying (“QE”) the eurozone and Japan continue to add liquidity by buying government and corporate debt of approximately $300 billion per quarter.

central bank buying 4 2017

This is referred to as “Policy Divergence”.  While the ECB and Japan ‘liquidate’ their bond markets, the US has ceased and expectations are that the Fed will tighten/raise rates while Japan holds their 10yr at 0%.  This expected interest rate differential leads to changes in exchange rates.  The changes we have seen since mid-2014 is a much stronger US dollar.   There is nothing on the horizon that indicates this Policy Divergence will end, which should indicate a continued strengthening of the US Dollar.

usd eur bund rate differentialSource: SocGen

This chart shows how the relationship between interest rates corresponds (currently very tightly) with the exchange rate, EUR/USD.  The future path of the US dollar will be determined by US economic and Federal Reserve policy vs.  ECB and eurozone policy and rate of growth.  Since the US has the early lead, ceasing QE and beginning to tighten, along with a new pro-growth President, it’s hard to see how the US Dollar will weaken without dramatic shifts in US and ECB policies.

In Summary

The outlook for stocks and bonds remains:  choppy with large swells.   Since November, markets have priced in passage of, and perfectly positive impacts from, Trumps tax and reform policies.   While at the same time, earnings have begun to grow anew, but are only at 2015 levels.   This combination has made today’s equity prices among the most expensive in history.   The Hope and Expectations born from Trump’s election are still with us, despite the recent healthcare setback.  As such, stock prices may very likely become even more stretched (higher) as debate regarding taxes begins and evolves into the summer months.

Bonds were sold off very dramatically post-election and will likely continue to gain in price as uninspiring economic data comes in while we continue in our multi-year vision of “growth in the second half of the year”.

While earnings may be increasing, the age-old question of how much are investors willing pay for $1 of earnings persists.   Their ‘willingness’ is often derived from feelings and expectations of the future.  If the future appears bright, prices can appreciate.  Sometimes this appreciation begets its own feelings and can lead to further appreciation without commensurate changes in earnings.  The risk there is that of an ‘air-pocket’ where future expectations are cut to match a duller present and prices move accordingly.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

 

Observations and Outlook January 2017

While 2016 ended on a positive note, market volatility has arrived.

 

Selected Index Returns 4th Quarter/ 2016

Dow Jones Industrials    8.6%/ 16.5%                                       S&P 500   3.8%/11.96%       MSCI Europe   -.4%/-.4%
Small Cap (Russell 2000)  8.83%/21.31%     Emerging Mkts  -4.2%/11.2%     High Yld Bonds   1.37%/15.3%
US Aggregate Bond -2.98%/2.65%   US Treasury 20+Yr   -12.16%/1.4%                        DJ/UBS Commodity 2.7%/11.8%

A brief perusal of the above numbers clearly shows 2016 was a “Risk-On” kind of year with small cap stocks and junk bonds putting up substantial returns.  The U.S. markets in general were the place to be outpacing emerging markets and European shares as well.  What isn’t quite as clear is the fact that investors who were geographically diversified and sought to own lower risk/higher quality bonds are feeling a strong dose of ‘return envy’.  An investor with a 50% S&P 500 and 50% Aggregate bond portfolio saw ‘only’ a 7.5% return for the year.  What is also not seen is that the ‘risk on’ investor spent the first half of 2016 with negative returns with the post-election period accounting for approximately 80% of the year’s total gains.  To summarize 2016 in one word: volatile.   While the volatility ended the year on the plus side, it should give investors a moment to reflect on what they are willing to endure to see outsized gains.

Forecast 2017: Large Swells and Wind Gusts to the North and South

Often after a rapid decline in stock prices, conditions become “oversold”.  In the near term, oversold conditions often lead to a bounce or snapback in prices.  The opposite is also seen when prices advance too far too fast.  The rapid rise in equity prices has put the market into an “overbought” condition and, given the rise in stock prices based on expectations of tax relief and government spending to boost the economy, hope once again springs forth that today’s extreme valuations will be justified with a rapid rise in corporate earnings in 2017.  In the meantime, prices have already risen and like bond prices in 2016 are likely to fluctuate greatly.

Actually, prices in both stocks and bonds have already begun to make large swings down and up.  The year ended up, so the tendency is to assume rapid ‘up’ moves are natural, and of course welcome.   Early 2016 bonds and gold did extremely well as stock prices fell.  The roles were reversed in the second half with bonds and gold declining through the second half, while stocks edged up and the lurched up in the last two months.  So, in fact, we have already begun a period of greater market volatility.   It’s likely to see prices swing between Hope and Anxiety as we await the actual changes and impacts of the change in monetary policy (tightening from the Fed) and fiscal policy (lower taxes, increased deficit spending).

What outside issues might impact global markets?

China Overnight Interbank Lending Rate Soars to 105%

Money markets are the source of short term funding for the financial system.  Recently the HIBOR, Hong Kong Interbank Overnight Rate, has soared to unprecedented levels, yet very little has been talked about in the US financial press. This is the rate to borrow yuan overnight, for banks in Hong Kong- known as the offshore yuan rate.   This was likely due to the PBOC intervening to make is cost prohibitive to short China’s currency.  In the U.S., though,  we seem to be preoccupied with the number 20,000 to observe severe stress in the world’s second largest economy.

Source: fxstreet.com

The last time an extreme liquidity crunch was seen was one year ago, and global equity markets became very ‘nervous’.   This also coincides with the annual reset of how much money China’s citizens can send out of the country.  The Chinese are allowed to take the equivalent of $50,000 per person per year out of the country. There has been a significant weakening of the Chinese yuan vs the US dollar in an attempt to keep the yuan’s strength versus other currencies low.  Foreign exchange takes some effort to get one’s head around, but in a world of paper money, it’s an important factor in trade, profits and interest rates.

China is at the same time trying to slowly deflate a massive real estate bubble, while not effecting other areas of the economy.  Leverage, aka credit, is fuel for higher prices in all assets like real estate and equities, as well as some areas of the bond market (borrow short term, buy long term bonds and earn ‘carry’ profits).   It is extremely difficult to remove leverage and not have prices decline, yet this is what China is trying to do, while also defending its currency.  China is using its massive reserves of Treasuries to manage its currency depreciation vs the US dollar, and going through it at a rapid rate.  IF the rate at which its spending its reserves continues, China, could see its reserves decline by 50% in as little as 2 years, which is very significant.

China being a closed, autocratic society means data can be obfuscated, changed, and outright fabricated with very little complaint.  As such China is a ripe source of potential Black Swans in 2017.  We are already seeing very strange, even for China, developments in its money markets.

The Big Picture

Here it is…….

Take a moment and understand what this chart says.

Given the level of household exposure to equities, or put another way, the percentage of stocks in portfolios, has had a very strong predictive value upon the next 10 years’ returns.  As household become more heavily weight towards equities, the lower the next 10 years returns from equities.  The dashed line ends in mid-2006 because there was return data for the following 10 years, through mid-2016.

Households’ exposure to equities was very low at the 2009 market lows (people tend to sell after prices go down unfortunately), and indicated a forward 10-year annualized return approaching 15%.  If the S&P 500 achieved this, it points to approximately 2800 by mid-2019, an increase of 23% from current levels over the next 2.5 years.  The gap between the dashed and blue lines shows this is not an exact science.

I apologize in advance for the math here.  23% over 2.5 years is about 8.6% annualized.  If the margin of error from our chart above gives us only 13% annualized from 2009, that points to about 2270, an increase of 0% over the next 2.5 years; and if our chart ends up at 11% 10yr annualized rate, we will be at 1987 in 2.5 years, a decline of almost 13%.

A range over the next 2.5 years of +23% or -13% is much lower than the return the market has given us over the past few years.   The past 2 years has seen the S&P 500 swing from 2130 to 1850 to 2280 currently, while corporate earnings have been declining and recently grew back to a level seen in early 2015.  While 2014 was a good year, the past two years have seen major price swings and rewarded investors with only 5.5% annually for the past two years.   It’s my opinion that this kind of earnings levelling off, slowing of annualized returns, compounded by very high current valuations are indicative of a late stage bull market.   Past Price to Earnings ratios (see my blog post Definition of Long Term Investor), and the chart above also point to reduced returns from equities in the next few years.

What Can Be Done

If one suspects returns will be lackluster, and prices volatile, should one endure it?  The solution is at once simple and difficult at the same time given our cultural of equity ownership and the media’s constant focus on one asset class: equities.

Diversifying amongst the other 6 asset classes is a start.  Most advice revolves around 2, stocks and bonds.  If one truly wants to buy low and sell high, one must identify the other areas that are “low”, increase exposure there, and reduce exposure to “high” asset classes.  Not only does this smooth out volatility but can increase long term returns.   Given the outlook for more volatility in stock and bond prices; very low prices (historically and relative to other assets) in precious metals, agriculture and oil; there should be many opportunities to take advantage of short term swings to benefit and move some ‘eggs’ from the equity side into other, non- and lower-correlated asset classes that are currently much lower in price.

Easier said than done, yes.  This is exactly why investors should seek out Investment Advisors willing to do this difficult work and that have a strategy to deal with changing markets.  For more information on how I am doing this for my clients, please contact me.

Adam Waszkowski, CFA 

awaszkowski@namcoa.com

239.410.6555

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.