It Doesnt Take a Weatherman….

Volatility Continues

2018 is sizing up to be a very volatile year.  Including today, there have been 11 2% down days this year.  There were 0 in 2017, 0 in 2006, and 11 in 2007.

The major indices are currently holding their lows from late October and Thanksgiving week, approximately 2625 on the SP500.  The interim highs were just over 2800, a 6% swing.

The big question of the quarter is if the highs or lows will break first.  Volume today is extremely heavy, so if the markets can close in the top half of todays range, that should bode well for the next few days.

Looking at the big picture, the 200- and 100- day moving averages are flat, the 50 day is sloping downward.  We see the longer term trend is flat while the short term trend is down.  The 50 day and 200 day are at the same level and the 100 day is near 2815.   The averages are clustered together near current prices while the markets intraday are given to large swings in both directions.

Concurrent news topics are the recent good news item of a 90- day trade war truce, and the bad news topics are the problems with Brexit, and the arrest of the vice-chairperson of Huawei, China’s largest cell phone maker.  She is a Party member, daughter of the founder who is also a Party member and has close ties to China’s military.  Maybe not the best person to arrest if one is trying to negotiate a Trade Truce.

My forecast from late 2017 was for large swings in market prices and we have certainly seen this play out.  When compared to past market tops, 2001 and 2007, one can plainly see plus and minus 10% moves as the market tops out then finally breaks down.  Its my opinion that a bear market has likely started, and we have a few opportunities to sell at “high” prices, and get positioned for 2019.

Fundamentally while employment and earnings are good, these are backwards looking indicators.  These are the results of a good economy, not indicators it will persist.  Housing and autos are slowing; defensive stocks are outperforming growth stocks, and forecasts for 2019 earnings range from 0% to 8%, a far cry from 2018’s +20% earnings growth rate.

So, what to do?  Is it more difficult to ‘sell high’ or ‘buy low’?   One is fraught with fears of missing out, the other fears of further declines.   Selling into market strength and perceived ‘resolutions’ to our economic headwinds might be the best bet.  Especially considering the chart below, where in 2019 the global Central Banks will be withdrawing liquidity until further notice, while the Fed insists on raising rates further.

cb balance sheets QT

Was that the Top or the Bottom?

The Wall Street Journal had a very good article detailing one of the root causes of the February decline.  A classic ‘tail-wagging-the dog’ story about derivatives and how they can impact other markets that are seemingly unrelated.  While the outlook for global equities informs the level of the VIX, we have just seen an incident where forced trades of VIX futures impacted futures prices of equity markets.   Its as though the cost of insuring against market declines went up so much that it caused the event it was insuring against.

Even with that being known, the impact to market sentiment has been dramatic.  Most sentiment indices went from extremely optimistic to extreme fear in a matter of days.  This change in attitude by market participants may have a lasting impact.  A rapid decline like we saw in February will reduce optimism and confidence (which underpin a bull market rise), and increase fear and pessimism, which are the hallmarks of a bear market.   Short term indicators turned very negative and now are more neutral, but longer-term sentiment indicators will take a longer decline to move negative.

Often the end of a bull market is marked by a rise in volatility, with equity prices falling 5-10%, then climbing back up only to get knocked down again, until finally prices cease climbing back up.  This can take several weeks or months.  We can see this in the market tops in 2000 and 2007.  This may be occurring now.  Many of the market commentary I follows the approximate theme of ‘markets likely to test the 200-day moving average’.  This is the level the February decline found support.  This would be about 7% below current prices, and have the makings of a completed correction, finding support once and then retesting.

Since the market highs in late January the major stock indices fell 12%, then gained 6-10% depending on the index.  Since that bottom and top; markets moved down about 4.5%, then again up into yesterday (3/13/2018) gaining 4% to 7%.  Tech shares and small caps have outperformed large cap along the way, rising more, but falling the same during this series.   Recognizing the size of these moves and the time frame can help manage one’s risk and exposure without getting overly concerned with a 2-3% move in prices.  But if one is not aware of how the 3% moves are part of the larger moves, one might wait through a series of small declines and find themselves uncomfortable just as a decline is ending—contemplating selling at lower prices as opposed to looking to buy at lower prices.  Hedging is a process to dampen the markets impact on a portfolio in the short term while looking for larger longer-term trend turning points. The high in January and current decline and bounce are likely a turning point over the longer term and in the near term provide investors with parameters to determine if the bull trend is still intact.

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.

 

The Definition of “Long Term Investor”

What is the difference between long-term characteristics of the market, and owning the market for a long term and how can an investor benefit from knowing the difference.

The phrase “Long Term Investor” is used quite often, and there are many definitions.  The IRS defines a long-term investment as anything held more than 1 year.  Most people though would agree that long-term refers to a much longer time frame, usually at least 5 years.  However, when we read about equity market statistics, we are shown 30 and often 70 or even 100-year time spans.  I saw a recent article with a 500-year time span.  Given the average human life span, and that our peak earning and accumulation years are from our mid-40s to mid-60’s, most investors actually have about a 20-year time horizon of accumulation.

A “long term investor” isn’t one who buys and holds for a long span of time.  A long-term investor recognizes the long-term characteristics of equity (and other) markets.  For example, over the very long term (+20yrs), earnings per share follow GDP growth, the average 20yr annualized return is just over 7% (with dividends adding to this), and that over shorter periods of time, actual returns can vary greatly from the average.  The long-term investor also understands that the averages over the more volatile shorter periods of time are the pieces that create the 20-year average. One can see the volatility, or range of returns, over shorter periods below.

1-3-5-10-20-yr-avg-returns-schwab-ctr-for-financial-research      Source: http://www.investopedia.com/articles/stocks/08/passive-active-investing.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186

The periods when we most often hear the phrase “I’m a long-term investor” being used, unfortunately, are when stock markets have experienced a significant decline.  To assuage the pain of real or paper losses, investors will often claim this characterization, with the unspoken assumption that ‘it will come back’.  And it always has, if you waited long enough.   From Charles Schwab Inc., via Investopedia.com we can see that yes, over very long periods of time, 20 years in this case, the market always has a positive return.

The chart below shows us the extremes. The low seen in 1979 to 1982 at about a 3% 20-year annualized returns, and the late 1990’s, from 1998 to 2001 which saw 20 year annualized returns over 13%.  While still positive, it’s much more helpful for an investor to invest over the right period! But how can one tell when ‘the right period’ might be at hand? Or even better, when the ‘wrong time’ might, so one can avoid a period of poor returns.  While not widely disseminated, missing the bad times has a far more powerful impact than staying invested, per this study by Meb Faber of Cambria Investment Management https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1908469

avg-20-yr-returnsSource: https://www.quora.com/What-is-the-average-S-P-500-return-over-20-years

So, while it is clear that, ‘in the long run’, if you wait long enough you will have positive returns.  From the chart above we can see that there are periods when long term returns are well below and above the 7% average.   How can we avoid being drawn into the low return eras?   Another long-term characteristic of equity markets is that Price to Earnings (P/E) ratios expand and contract.  That is for $1 in earnings, sometimes people pay $25 in price (a 25 P/E ratio) and other times less than $10.

For those well versed in market history, we know that the exemplary 20 year annualized returns seen in the late 1990’s, saw their birth in the low Price to Earnings era of the early 1980’s.  There are many studies showing how long term returns are borne from low P/E multiples.   Given that currently we are only beginning to enter the 20-years-later period after the dot.com bubble, we only have the first 20-year cycle from 1995, which gave us 7.3% annualized price growth.  Given that the late 1990’s saw large price appreciation, this acts as a headwind to the 20yr annualized returns in the next few years.  The S&P 500 started 1997 at 766 and if we end at 2200 in 2016 that will give us only 5.4% 20yr returns.  The S&P500 started 1998 at 963, and to maintain the 5.4% 20yr returns, the S&P500 would need to end 2017 at 2765, a gain of more than 25%!    The propensity is for the 20 year annualized returns to continue the downward slope that began in 2002 and likely repeat the bottoms like 1980, 1949 and four other periods where long term (20yr+) returns were very low.  The chart below is from Barry Ritholtz.

rolling-20-yr-returns-ritholzSource: http://ritholtz.com/2011/12/dow-jones-industial-average/

The results since this chart was created in 2010 are indeed following the red dashed line down.  Knowing that the market in 2000 was amongst the most expensive ever (highest P/E ratio) it should be considered that the 20 years ending in 2020 may see results that are amongst the worst in the past 100 years.  To have 0% return from 2000 to 2020, the S&P 500 would only need to decline by 31%, about the average for a bear market.   To have 2.5% annualized return from January 2000 to January 2020, the S&P500 would end 2019 at 2335, a change of about 6%, or only 2% annually.    The moral of the story is outlook for equity returns over the next 2-3 years is low and likely volatile, not a good risk to return prospect.

What Should One Do?

While 20yr annualized returns are slow moving data points, it’s clear that the long-term average is in decline.  Paying a high price (high P/E multiple) leads to poor long term returns is a slow lesson investors simply don’t have the time to learn from experience, and that many Baby Boomers can ill afford to learn now.

Knowing, or rather, expecting returns from stocks to be low going forward will enable an investor to seek returns from other asset classes.   Few Investment Advisors currently work with models outside of the traditional stock/bond portfolio mix.   An Advisor who recognizes that there are indeed 7 asset classes with which to pursue returns has an advantage.  Being successful at putting that understanding to work, is, indeed, the work of portfolio management.

Investors who want to earn returns in the medium term should look to other asset classes for returns, ideally ones that meet the ‘low’ metric for their markets.   True diversification is the call today, not simply bonds and stocks, but also commodities like oil and agriculture, precious metals and even cash.

If you would like more information on my Volatility Based Dynamic Asset Allocation process that seeks positive gains regardless of how equity or bond markets perform, contact me via email at awaszkowski@namcoa.com.

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.