STA Weekly Report – Don’t Forget the Value of Alternative Investments
Written by Luke Patterson | Thursday, May 2nd, 2019
INSIDE THIS EDITION: Commodity Prices Weaken The Uptrend in Oil is Being Tested Energy Sector SPDR Falls Below Moving Average Lines Weekly Snapshot of Global Asset Class Performance Portfolio Stress Test 401k Plan Manager*Updated on 12/31/2018
World equity markets have been on a tear for the first four months of the year. The S&P 500, MSCI All Country World, and Nasdaq are all up double digits so far in 2019.
It appears that most investors have entirely shrugged off the risks posed by trade disputes, BREXIT uncertainty, and geopolitics while forgetting the pain that the fourth quarter of 2018 brought.
In other words, instead of focusing on the potential
downside from catalysts of risk, investors have set their gaze on the risk of
missing out on the recent rally. In fact, many investors have been asking to
increase equity risk and to allocate to overvalued areas of the market that at
this point may offer more risk than return. We caution investors that
performance chasing like this is very risky business.
Along the same lines of thinking, investors have also been
frustrated by the performance of liquid alternatives relative to equities and
have started abandoning them.
While we understand that it is frustrating to have exposure
to assets that are posting high single digit returns when equities are posting
mid-teens returns, we have conviction that rotating from underperforming assets
to assets that have already appreciated substantially is the wrong move. In fact, even when the returns look paltry on
liquid alternatives, they do provide some key benefits to the portfolio that
may not be entirely apparent on the surface.
Low Correlation to
Stocks and Bonds
Over the last 10 years, it is quite apparent that liquid
alternative strategies have delivered low correlations to equities. While most
equities including emerging markets, developed international stocks (EAFE), and
REIT’s have exhibited correlations approaching or exceeding 0.80, alternatives
like managed futures, market neutral strategies, hedged strategies and hedge
funds have remained below 0.60.
Ability to Reduce
Risk in a Portfolio
When implemented correctly, liquid alternatives also help
reduce portfolio risk. The chart below shows three hedge fund strategies found
in liquid alternative fund formats compared to the S&P 500. From 2002 through 2018, each of the liquid
alternative strategies highlighted saw drawdowns less severe than the S&P
What this means is that if a liquid alternatives strategy is constructed correctly, the drawdown potential to the overall portfolio should be greatly reduced. Take for example, a traditional 60/40 portfolio. When a portion of the overall allocation is carved away and allocated to liquid alternatives, we would see a reduction in the annualized volatility experienced by the portfolio.
Potential to Enhance
Similarly, by including an allocation to liquid
alternatives, it would be expected that over time, the portfolio would realize
higher returns. In the balanced portfolio depicted below we can see that the
portfolio sees a boost to the annualized return profile from what it would be
in a traditional stock and bond mix.
As a result, we urge investors to constantly think about what comes next. Especially when thinking about a portfolio’s allocation to liquid alternatives. We have written before about the concept of mean reversion and how it applies to markets. If you believe at all in that concept, then liquid alternatives may be positioned to regain their shine.
Commodity Prices Weaken
One of the factors the Fed is now considering to help formulate its monetary policy for the rest of the year is the question of inflation. Rising inflation puts pressure on the Fed to raise rates.
Flat or falling inflation allows the Fed to stick with its current policy of keeping rates flat for the foreseeable future. Commodity prices are one of the best ways to monitor inflation trends. Which is why the Fed can take some comfort from the recent drop in commodity prices. Chart 1 shows the Bloomberg Commodity Index ($BCOM) dropping over the past month after meeting resistance at its 200-day moving average (red line) near the start of April. The BCOM has also fallen back below its 50-day average (blue line). That drop over the past month has been led by agricultural prices, as well as industrial and precious metals. The three charts below Chart 1 show agricultural prices leading the commodity drop, followed by industrial and precious metals. An upside breakout in the U.S. Dollar Index to a two-year high during the month probably contributed to some of that selling. The one commodity group that held up better was energy. But that rally is now being challenged. And that’s putting energy shares under pressure.
The Uptrend in Oil is Being Tested
Chart 5 shows the United States Oil Fund (USO) having recently traded at a six-month high. In so doing, the USO has also risen above its red 200-day moving average. The ability of the USO to stay above that important support line will help determine if the price of oil is going to follow other commodity prices lower. Short-term momentum indicators aren’t very encouraging. The 14-day RSI line (upper box) is in danger of falling below its midpoint 50 line for the first time since the start of January. Daily MACD lines (lower box) have already turned negative. The direction of oil is the one of the main gauges of inflation that the Fed looks at. The recent dip in the price oil is already taking a negative toll on energy shares.
Energy Sector SPDR Falls Below Moving Average Lines
Chart 6 shows the Energy
Sector SPDR (XLE) falling back below its 50-day
and 200-day moving average lines. To make matters worse, the XLE/SPX
ratio (solid line) has fallen to the lowest level
of the year. That’s not good either. Materials stocks tied to base and precious
metals have also been dropping. That may not be a good sign for holders of
those stocks or their commodities. But it might be viewed as good news for the
Fed because it implies that inflationary pressures are still not a threat to
the economic recovery. And allows the Fed to stick with its current holding
pattern on interest rates. Falling commodity prices are also helping keep bond
yields down which is supporting bond prices and stocks tied to them. That
includes dividend-paying consumer staples, utilities, and REITs which continue to attract investor attention. They’ve
been among this week’s strongest stock sectors. While stocks tied to energy
and materials have been the weakest.
Andrei Costas, Senior
Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment
Analyst (Fixed Income Strategies)
STA Wealth Management – Portfolio Stress Test By Scott Bishop, MBA, CPA/PFS, CFP® Executive VP of Financial Planning
Although the markets have had a nice run since bottoming in March of 2009 (after the 2008 Global Crisis – see chart below), many are feeling that they are due for a correction based on time, valuations, “headline” risks, etc.
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