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Week of March 6, 2017
INSIDE THIS EDITION:
Record Highs And Future Returns
Chart Of The Week “2017 Investment Themes And A Case For Active Management”
401k Plan Manager
Weekly Technical Comment
Weekly Snapshot of Global Asset Class Performance
Record Highs And Future Returns
It was another positive week for larger stocks. The large-cap S&P 500 gained 0.7% while the smaller stocks of the Russell 2000 were essentially flat. In fact, the S&P 500 is on a five week winning spree. I’m not sure what new incremental information there was to be had in February, but an already overextended U.S. stock market managed to become even more overextended. The Dow tacked on 948 points (+4.8%) in the just ended month; the S&P 500 logged its best advance since last March with a 3.7% run-up.
Of course most of the market’s advance came the day after President Trump’s address to Congress. Reactionary investors obviously liked the tenor of the President’s speech, but we heard few details on important items like the new health care law or tax reform. One should assume the eventual release of details and possible passage of new laws will trump rhetoric.
As we mentioned in last week’s commentary, market valuations are expensive and may leave stocks vulnerable to shocks. However, there is another concern; too much enthusiasm. Investors Intelligence tracks the opinions of institutional advisors. They note bullish readings over 60% are rare events. Presently, 63.1% are bullish, the highest level since 1987. Too many bulls!
And now, eight years into this bull market and more than a tripling in the major indices, the retail investor said “enough is enough” and has decided to jump in with both feet. Investors have plowed almost $80 billion into U.S.-based equity funds since the election – $6.7 billion of that chunk came last week alone.
As for valuations, they indeed are a poor timing device but are useful insofar as acting as a constraint (2000, 2007) or a launching pad (1982, 2009). In fact, looking at the historical record, when forward-looking P/E multiples are in the current range of between 18x and 20x, returns in the coming year average out to be 1.1% and muted 4.5% per annum over five years. By way of comparison, when the starting point on the the multiples is between 10x and 12x, the one-year mean return was 17.0% and the five-year return per annum was 10.8%
Another concern for March is the Federal Reserve. The markets now suggest there is a 94% likelihood the Fed will hike the Fed Funds Rate. This would be the third rate hike without a rate cut. Historically the third rate hike has been troublesome for stock investors. Since 1973 a third hike has been associated with declining stock values in the next 12 weeks.
Because of issues like expensive valuations, excessive optimism, and potential troubles from the Fed we judge this as a time of elevated risks. We believe risk levels are elevated and this is the reason we have been getting more cautious where appropriate for your portfolios. Although a topping phase can last for weeks or months this is not the time to chase equities.
Chart of Week: “2017 Investment Themes And A Case For Active Management”
Shortly after the US election, the Dow Jones Industrial Average Index breached 19,000 and climbed to a record-high in late November. For investors who paid attention only to the headlines, it seemed like a reasonable time to cash-out, realize gains, and wait for the next market correction. At the time, that seemed like a solid idea at a time when the market reached all-time highs and many investment professionals argued that markets were too expensive.
We took a contrarian view by arguing that the market was not in bubble territory. In our weekly market report published on Dec 6th (click here to see report), we expressed an optimistic but cautious view on the market at that time saying: “Easy monetary policy has created a strong stock bull market since the end of the last recession. In fact, the S&P 500 has rallied more than 200% from March 2009 to March 2015. However, absent real economic growth, the money printed by central banks may simply be borrowing today’s returns from the future by elevating the P/E ratio. As a result, investors should expect lower long-term future returns than historical averages. This also means that investors will get a smaller reward by taking incremental risk. On the other hand, not all new money rushes into risk assets, as indicated by the relatively flat risk ratio in both the US and other developed countries. Large amounts of cash remain on the sidelines, which can potentially fuel a market rally when investor’s sentiment swings to the upside. The post-US election bull market has clearly demonstrated this point. Portfolio construction thus remains key in participating in whatever upside is left while also being allocated appropriately for a potential sell off. In other words, as we head into 2017, investors should balance their return expectations and portfolio risk levels.”
Three months later, the Dow has passed both 20,000 and 21,000. Is the market now in bubble territory? From where we sit, it doesn’t look that way as we have seen a meaningful improvement of economic fundamentals, globally. Is the market too expensive? On a relative basis, it certainly looks expensive, especially if future reality falls short of today’s optimistic sentiment. Regardless, whether you are in the bullish or bearish camp, we know one thing for sure: the market has become more uncertain in 2017. Market performance is likely to be determined by the unfolding of outcomes of these uncertainties. Using investment jargon, we would say that both positive tail risks (market outperforms expectation) and negative tail risks (market underperforms expectation) have significantly increased since the US election (Figure 1).
Figure 1. Probabilities of upside surprise and downside disappointment have both increased.
In fact, we are experiencing an interesting transition stage with several themes playing out at the same time (Figure 2).
In the post-crisis era, investors have celebrated strong returns from almost all asset classes, ranging from stocks to bonds to real assets. These gains have been fueled in large part by easy monetary policy, including near-zero or even negative policy rates and quantitative easing in the U.S., Europe, and Japan. These measures lowered the risk-free rate for asset valuations and literally inflated prices for all major asset classes. The result has been a boom in passive index investing.
With a brighter domestic growth outlook, the US Federal Reserve is getting ready to accelerate rate-hiking in 2017. Deflationary pressure and an improved economy in Europe also make QE tapering a remote possibility in 2018. At the same time, fiscal policy is likely to kick in and play a big role in supporting economic growth as central banks step back.
The second theme, the rise of protectionism and anti-globalization sentiment, is likely to impede the flow of goods and services across borders and become a major theme of a euro-centric political calendar, with presidential elections in France and general elections in both the Netherlands and Germany. The political outcomes will certainly shape European markets and ripple through other markets.
Third, worries tied to a sudden Chinese currency devaluation has receded, at least temporarily. However, how the Chinese government manages a smooth transition from a manufacture/export-driven to a service-oriented economy in next few years is still unknown. One thing we do know is that the transition will be a key factor for the global economic outlook, given China is the second largest economy in the world and has growing influence on the world economy.
Finally, the transition from a world economy experiencing disinflation to one seeing reflation threatens to dilute the wealth of investors who are sitting on the sidelines and waiting for the next market correction, as inflation erodes their purchasing power overtime.
Figure 2. Transition of investment themes in 2017.
There is no doubt that passive market exposures have delivered satisfactory returns in the current business cycle, largely fueled by Central Bank policies (Figure 3). However, it is our view that the substantial uncertainty surrounding the global outlook will increase market return dispersion among winners and losers (Figure 4). This type of environment, if it plays out as we see it, will present plentiful investment opportunities, where experienced active managers can outperform the broad markets and generate excess returns by tactically shifting asset allocations, taking advantage of price dislocations, and carefully managing tail risks.
Figure 3. The relative performance cycles.
Figure 4. Dispersion in equity returns across sectors has increased since the election.
Weekly Technical Comment
Stocks Backing Off Recent Records
It was another positive week for larger stocks. The large-cap S&P 500 gained 0.7% while the smaller stocks of the Russell 2000 were essentially flat. In fact, the S&P 500 is on a five week winning spree but during this time the number of stocks advancing and declining was in close balance. Last week saw more stocks heading lower than heading up. Early this week we see markets off their recent record high levels. The market seems to be wobbling a bit at these levels and caution is prudent. Don’t go chasing equities here.
Ten-Year Yield Threatens Resistance
Last week I highlighted how Treasury bond yields peaked in mid-December and have been trading sideways since then. Last week, the 10-Year T-Note yield (TNX) was threatening the lower end of its 2017 trading range. The pullback in yields had been accompanied by a rebound in bond prices, along with bond proxies like staples and utilities that I also covered last week. We have recently seen a pick up in the 10-Year T-Note yield to the upper range (or resistance) indicated in the chart. Some of this move higher is due to the markets expectation of a Fed Funds rate hike next week. The TNX still needs to clear its February high (2.52%) to resume its uptrend.
Weekly Snapshot of Global Asset Class Performance
Sector Relative Rotation Model
The Sector Relative Rotation Model shows what sectors of the S&P 500 are strengthening and what sectors are weakening relative to the index. In other words, what is driving returns versus detracting from them.
The chart below (updated through March 7, 2017) indicates relative strength (relative to the S&P 500 Index). Technology is leading relative to the S&P 500. Energy is currently lagging. Financials, Materials, Industrials, and Small Cap Stocks indicate weakening, with Healthcare, Utilities, Consumer Staples, and REIT stocks indicate improvement in the model. Keep in mind while this model is helpful to analyze sector strength in the S&P 500, it is one tool and should be used with a comprehensive investment discipline.
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STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Michael Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)
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