Yesterday I received information from JPMorgan in their comprehensive quarterly Guide to the Market concerning the valuation of the market at year end 2015. They note the current forward P/E is 16.1 times earnings, and suggest that it is very reasonable by comparing it to the 25 year average of 15.8%. See Figure 1. Two things immediately jumped out at me. The first was the current P/E. Barrons has the trailing 12 month S&P 500 earnings as slightly under $95. With the S&P 500 having closed the year at 2044, this puts the 12 month trailing P/E at 21.5. In order to get 16.1 times earnings, you have to believe earnings will rise to $127 in 2016, a gain of over 32%. Or you have to have a more generous definition of earnings, one that allows companies a lot of leeway as far as non-recurring charges and other accounting gimmicks.
Figure 1
The second thing that I noticed was the decision to use a 25 year average. I’m sure JPMorgan knows that P/E ratios going back to 1927 (when they first started keeping reliable records) have averaged a lot lower than 15.8 times. Going back 25 years just confines data to the great disinflation era, when interest rates were in a fairly steady decline and P/E ratios have been elevated. Since disinflation has to end at some point, and from current levels is unlikely to persist over the next 10 years, why is this period the only guide we should use? Why not 1948 to 1971?
I believe that the assumption JPMorgan makes is that we are in a different age – one of technology and services rather than machines and factories. I would agree with those who say that technology allows us to manage inventories so much better than we used to, so companies are much more efficient now. I’d therefore be willing to accept a higher P/E today, all other things being equal. On the other hand, perhaps we are more aggressive with financing than the companies of 50 years ago. We certainly use leverage more than they did. In fact, many companies we think of as successful today are experts in the creative finance game. Home Depot, for example, reported record profits in 2014 and 2015 but in both years suffered a decline in book value. How? By using its cash flow to buy back tens of millions of dollars’ worth of stock. Home Depot stock is not cheap at 22 times earnings and more than 10 times book, so this is hardly a move that a long term profit maximizing entity would make. It does, however, boost current earnings per share. I would argue that a company using its cash to acquire stock at a high multiple deserves a lower P/E, not a higher one, since they are weakening the balance sheet. Ask Famous Dave’s how buying back its stock at high valuations ultimately worked out for shareholders.
Analysts have traditionally been willing to pay higher multiples for organic (higher sales and cash flow) growth as opposed to financially engineered growth. 2015, however, was not a particularly good year for people who value stocks in the traditional manner. Just ask Warren Buffett (Berkshire Hathaway declined over 12% in 2015) or such value managers as Longleaf Partners (LLPFX was down -18.8% in 2015) or Yacktman (YACKX was down -5.6% in 2015)<1>. It was about “buzz” or trendiness – if lots of people use it, it must be a good business, right? We’ll see how that plays out but I have a feeling I’ve seen that movie before.
What worked in 2015 was growth and low volatility. The large cap growth style box crushed the competition with a gain of 5.7%<2>. Seven of the other eight style boxes, including all three on the value side, were negative. Every domestic iteration of the low volatility strategy, be it large cap (USMV and SPLV), midcap (XMLV) or small cap (XSLV) performed in the top decile of its category. The EAFE Minimum Volatility ETF EFAV beat its benchmark (EAFE) by over 800 basis points. Of the two, I am more optimistic that the low volatility trend will persist than the growth trend.
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy. <1> Source: Morningstar Adviser Workstation
<2> Source: Goldman Sachs Asset Management
Unemployment
In the wake of the very strong November unemployment report, the stock market has swung to the belief that the Federal Reserve will tighten at its December meeting. This is very different than its outlook after the October unemployment report. I bring this up because monthly data varies widely, which is one of the reasons each initial report is revised in subsequent months. It is always better to average three or four months of data than rely on a single month. That said, the move has resulted in a significant jump in interest rates. Stock investors are trying to get a handle on this. Remember – stocks soared in October and it was presumably on the notion that the Fed was on hold at least through the end of the year. It should come as no surprise, therefore, that a change in the outlook for interest rates would mean a change in the short term direction of stocks. It should be noted that we will get the December Unemployment report before the next Federal Reserve meeting, so more twists and turns could be in store.
Active Management
Michael Mauboussin of Credit Suisse did a thorough study of active management that I found very interesting. Here is the Readers Digest version. He concluded that there were three ways for active managers to outperform: (1) market timing (strategic use of cash) (2) security selection and (3) portfolio construction (asset allocation).
I’m sure his conclusions come as no surprise. Also not surprising is that there is little evidence that market timing works over the long term. It works during certain periods of time marked by trending markets (in either direction) and tends to do quite poorly in choppy, directionless markets. Active management can add value through superior security selection during periods of wide dispersion, the study showed. They also tend to do better when small company stocks outperform larger ones. When stock dispersion is low (as it has been for most of the past two years), passive is a superior strategy. Dispersion is also the key to adding value through asset allocation, in that wide dispersion creates a better opportunity for under- or over-weighting an asset class to add alpha.
This translates into today’s market in that dispersion has been widening since mid-summer, giving active managers a theoretical opportunity to out-perform. Sadly for them, there has been a fairly strong trend toward larger stocks and growth stocks, which is the opposite direction that active managers tend to go. Investors have been trying to avoid having “land mines” in their portfolio (Sequoia and Fairholme are counter to that trend and have paid the price), so they are cutting down on tracking error. This means more money invested passively. We have seen in the last several weeks more stocks advance than decline, but the average decliner loses more than the average gainer. This is late cycle behavior (value typically does poorly in relative terms near market tops, and momentum is typically strongest). Investors love consumer-oriented secular growth stories like Starbucks and Home Depot, but they seem to hate industrial cyclicals (companies that sell to other companies, especially if they are smaller and/or their customers are overseas).
Earnings
It is so hard to know what to believe when market pundits talk about “earnings”. There is all the difference in the world between reported earnings and operating earnings. CEOs want to pay taxes on reported earnings (all the bad stuff included) but want to be judged on operating earnings (all the bad stuff removed). We also get misleading information about earnings “beats” and “misses”, as if that is important information. Everybody should know by now that any competent CFO knows well before the end of a given quarter whether things are tracking well or not. If not, the company will simply guide estimates lower. That way a month later when earnings are released, they are much less likely to surprise on the downside. So when a mutual fund company strategist tells you that the economy is strong because a high percentage of firms met or exceeded earnings estimates, he or she assumes that their audience is comprised of IDIOTS. Happily, whenever this happens you now know who to NEVER LISTEN TO AGAIN FOR ANY REASON. That means you Mr. Doll.
Value Investing
Chuck Carnevale of FastGraphs posts articles on Advisor Perspectives from time to time. In his piece Retired Investors: Apply a Value Investing Strategy and Earn More Income and Higher Returns, he used the examples of Northrup Grumman and Medtronic to show how good companies with growing earnings and dividends can remain unloved and out of favor for four years or more before the market finally “discovers” them. Value investing is not for the impatient or faint hearted, but it does offer the opportunity for added performance. In my experience, the alpha comes from the fact that value has a negative skew (most of the time it modestly underperforms but when it is in favor it tends to do much better). Most investors are more psychologically suited to momentum, because that strategy has a positive skew.
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Here’s a look at trends in October:
High quality companies performed much better than lower quality companies.
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Why? Lower qualities companies had a sharp rally in late September after the Fed held rates unchanged, but quality re-asserted itself firmly by the third week of October.
Lower quality bonds outperformed investment grade bonds this month.
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Why? Junk bond spreads peaked on October 2nd and contracted steadily throughout the month.
Capitalization-weighted indices beat equal-weighted indices with the same objective once again.
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Why? The trend towards large companies continues as larger companies typically have stronger balance sheets, allowing them to more effectively use leverage.
Asia outperformed Europe again, but both indices gained over 8%
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Why? More re-assuring news from China, more stimulus from the European Central Bank.
Frontier markets lagged emerging markets for the first time in several months.
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Why? Both gained, but neither rose nearly as much as developed markets.
Hedged foreign funds beat un-hedged foreign funds
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Why? The currency markets were volatile in October with the dollar losing ground after the weak U.S. employment report, then gaining strength on Draghi’s extension of QE in Europe and the Fed’s hawkish comments last week.
Small cap companies edged out mid-size companies in performance, but the difference was small.
As one might expect from a market up almost 9%, “risk on” industries materials, energy, and technology foremost crushed risk off industries.
Growth modestly outperformed value for the first time in three months. It appears as though the growth trend remains in place.
The trend continues.
The stock market failed to make new lows in September, signaling a possible bullish trend change. That change appears to have been confirmed in October as S&P 500 came very close to its all-time highs on Wednesday the 28th. (See Chart 1) The NASDAQ came even closer. (As of today, 11/2 the indices are again testing their all-time highs.) Price and breadth action argues for the market to go higher in the short term.
Chart 1
Source: Stockcharts.com
How do we interpret this?
If stocks would have gone on in September or October to fall below their August lows, it would have been a strong signal to us that the primary trend was bearish and that a more defensive posture was prudent. Obviously, that didn’t happen. We have experienced a nice recovery in October to the point that we are 2-3% from all-time highs. That puts us back where we were in July: a long-in-the-tooth bull market with fairly expensive valuations, interest rates that are likely to begin moving higher in the next couple of months and corporate profit margins showing signs of coming down from record levels. Many investment professionals wanted the market to retreat this past summer because we were uncomfortable investing new money at such lofty valuation levels. For better or worse, it is Groundhogs Day all over again.
I believe that a fair number of the pundits who keep arguing for the Fed to raise rates are thinking the same way, namely that we need to start having business cycles again. Yes, that would mean a more pronounced sell-off at some point, but it also means that rather than perpetual slow growth such that businesses fear to invest for the future, we would see both recessions and booms. Booms are essential for the success of deep cyclical industries like engineering, construction, and mining because it takes time for capital spending in these areas to pay off.
As I said, the bull market seems to have re-exerted itself. Best then to continue to play the current trend, investing in industries where the return on a dollar invested in the business is fairly immediate. That means consumer-oriented firms, technology firms, and those companies with the balance sheet flexibility to borrow at low rates to buy back enough stock to improve per share comparisons.
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Summary
Stock markets worldwide sold off during the third quarter. See Chart 1. July began with a modest rally, but it was confined to certain sectors and failed to lift the average stock. In mid-August the market completely rolled-over. The cause most frequently cited was global economic concerns, specifically China. While it is true that China’s demand for raw materials from the rest of the world continues to dwindle as they re-orient their economy toward domestic consumption, there were many other factors. Some investors were concerned that the Federal Reserve was finally going to raise interest rates in September (it didn’t), and others were alarmed by the amount of negative earnings surprises. After all, year-over-year corporate earnings are down close to 6%, so why should the stock market be higher?
Chart 1
Source: YCharts.com
The S&P 500 fell -6.48% over the full quarter. Large companies outpaced mid and small cap stocks, which declined -8.50% and -9.27% respectively<1>. The energy and mining industries fared the worst; each lost -20% or more. Toward the end of September, however, other sectors that had previously resisted the downturn finally capitulated; health care fell -14.53%, for example<2>. Real estate was the only equity sector able to post a gain for the quarter (1.25%), but it is still down -5.05% year-to-date.
International markets were even more affected by the threat of rising U.S. interest rates, because investors feared a flight to the dollar. The MSCI EAFE index of developed market stocks dropped -9.72% in dollar terms. Emerging markets performed even worse, plunging -17.3%.<3> Europe lost only modestly more than the U.S (off -8.69%), while Latin America was a disastrous -24.29% on the quarter. Brazil’s troubles weighed heavily on that region. <4>
The bond market saw a “flight to quality” as earnings concerns and oversupply led investors to shun corporate bonds in favor of AAA rated government debt (1.23%). Municipals (1.65%) also performed well. On the other hand, credit risk was really punished as the Barclays High Yield Index slid -4.86%. Many investors discovered that the extra yield that they were getting from “strategic income” and “multi-sector” bond funds also came with extra price volatility. <5> Activity
This past quarter was about risk mitigation, and given the myriad opportunities to lose double digits last quarter I believe we did a good job. We trimmed exposure to the more volatile areas of the market, both foreign and domestic, and let cash build up in portfolios to the highest level since early 2009. We now hold very little exposure to emerging markets or high yield bonds, though we note that extreme price declines in the former are making them very intriguing for the patient, long term investor. We also trimmed exposure to the health care sector, which had a long overdue sell-off. We still see that sector as an earnings leader going forward, but valuations just got too high.
Outlook
By the end of the quarter the prices of many sectors had retreated, leading to more reasonable valuations. As a whole the stock market was still not cheap, but it was definitely oversold and due for a bounce. The catalyst occurred on October 2nd as a surprisingly weak unemployment report convinced global investors that the Federal Reserve was a long way from its next interest rate hike. We’re not sure the news that employment growth is so weak that the Federal Reserve cannot afford to raise rates above 0.25% is the kind of thing on which sustainable long term rallies are built, however. We would like to be proven wrong, but we believe this rally will peter out without markets making new highs. We don’t believe investors are comfortable trying to push the old leaders like health care and consumer technology to new highs, so unless fortunes can change in sectors of the market that are more reasonably valued – energy, materials, industrials, and financial services for example, which will require an upturn in global demand – we can’t see the market going much higher during the third quarter.
Commentary – Two Things You Should Know About Us
There are two things you should know about us in terms of how we manage money, (1) how we think about cash and (2) how we think about investing in general. I would like to address them separately, though they are somewhat related.
How We Think About Cash
Some clients ask about our cash management philosophy. During strong market periods they wonder why we have any money in cash, and during weak market periods they wonder why we don’t have most or all of the portfolios in cash. The answer lies in the fact that we do not know on any given day what the market is going to do, so being “all in” or “all out” (tactical trading) pre-supposes we have an insight that neither we, nor anyone else, has.
Take last quarter, for example. Between the 20th of July and the 29th of September, the S&P 500 declined -11.5% from 2128 to 1882. Between September 29th and October 8th when it closed at 2013, it gained about 6.5%. In retrospect there was almost nothing to indicate that stocks were ready to rally on September 29th. The conditions that supposedly led to the -12% market slide, namely slowing global growth, interest rate uncertainty, and declining corporate earnings, were still in place on September 30th but investors had evidently decided enough was enough. It is extremely difficult (if not impossible) to forecast these changes in market psychology, so if you are out of the market you miss out on the upside. Chart 2 highlights the annual return of the S&P 500 against its intra-year declines. (Red dots indicate the max drawdown during a calendar year and the gray histogram represents the annual return on the S&P 500) As you can see, poorly timed tactical trades aimed at reducing downside capture are accompanied by massive opportunity cost. That said, we did raise cash this past quarter as noted in the Activity section above. You might wonder what the difference is between raising cash levels as part of our asset allocation targets and tactical trading (moving to 100% cash). The answer is optionality.
Chart 2
Source: J.P. Morgan Asset Management
Optionality refers to the ability to deploy money anywhere and anytime. There are certain times that this really comes in handy. We might believe that a certain area of the market, say energy stocks or emerging markets, are attractively priced due to their recent sharp declines. On the other hand, we might have reason to believe that in the near term their prices may go even lower. Holding extra cash in portfolios allows us to pursue either of these investment opportunities (or a different one, or both) at an advantageous time to be a buyer, without having to sell something else at what would be an inopportune time. Put another way, if we can sell something where my upside potential is limited relative to the downside risk, we can create an opportunity to improve the expected return characteristics of the portfolio. Even if we receive basically no return from cash while the proceeds are “parked”, we expect to more than make up for that by buying an unspecified but more promising asset in the future. If the market goes down during the period that we are holding extra cash (as was the case last quarter) so much the better, but we really made the sale because we felt the upside potential of the asset we sold was limited.
How We Think About Investing
I had a conversation with an Adviser recently who asked me about another asset manager, one with a high exposure to emerging markets. My thoughts went to Charles Ellis, who wrote an investment book several decades ago that argued portfolio management is a loser’s game. A loser’s game is defined as one in which you win by not losing. This is opposed to a winner’s game, where you have to play to win. Professional golf or tennis are winner’s games. You cannot win a PGA tournament playing to par every hole, nor can you win a pro tennis tournament simply by getting the ball back over the net consistently. Amateur sports, on the other hand, are usually loser’s games. More points are lost hitting the ball into the net or wide of the court than are won by hitting unreturnable shots.
I tend to believe Charles Ellis is correct and let me explain how that relates to the conversation the between the Adviser and me. Statistically speaking, right now emerging markets represent the most attractive opportunity in the financial markets on a long term basis. Having declined sharply over the last quarter, year, and three year time periods, they trade at roughly half the valuation of U.S. stocks from a price-to-earnings standpoint. On the other hand, they are quite a bit more volatile than U.S. stocks (best case) and worst case quite likely much more risky due to currency fluctuation and political instability. Excessive volatility causes most investors discomfort which often leads to selling at an inopportune time. It came as no surprise that the Adviser was thinking of selling the portfolio because the client was very unhappy.
Charles Ellis recognized that allocating a large piece of a portfolio to a volatile asset class is like trying to hit a perfect golf shot out of the rough, over a water hazard, to the back right corner of the green – a high risk proposition. To be sure, even the best pros don’t try to make a perfect shot every time. They know if they hit one or more very good shots it will set up the opportunity to go for a winner. In the investment world, for most people and under most circumstances, you “win” by avoiding large mistakes that shake your confidence in your portfolio. Put another way, always needing to hit a difficult, perfect shot actually reduces your chances for long term success because even a small miscalculation can have outsized effects.
Because Trademark’s roots are in the financial planning side of the business (as opposed to the trading arm of a large financial firm), we try to make sure we don’t let our investors exceed their downside threshold. Sometimes that means not taking shots we might have made. The bottom line is, if in trying to maximize return we subject your portfolio to more fluctuation than you can handle, you are likely to bail out at the point of maximum stress (the bottom of the market). We don’t want that to happen because it turns short or intermediate term volatility into a permanent impairment of capital.
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy. <1> All S&P performance is from S&P via Morningstar
<2> Sector performance is from Lipper via Barrons, 10/12/15
<3> The tracking ETF for the MSCI International and Emerging Market Indices (EFA and EEM, respectively).
<4> MSCI International Indices as per Morningstar Adviser Workstation
<5> Bond performance is from Barclays via Morningstar Adviser Workstation
Here’s what worked and what didn’t in August:
Quality, large cap companies did not perform better than market as a whole.
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Why? Growth is preferred over safety. Investors see this as a correction, not the start of a bear market.Higher quality bonds outperformed lower quality bonds of similar duration.
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Why? Fear persists that some companies have too much leverage.Capitalization-weighted indices did not beat equal-weighted indices with the same objective.
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Why? In a sell-off, larger, more liquid companies are easier to sell closer to the last trade.Europe outperformed Asia.
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Why? China continues to be global issue #1; Greece relegated to back burner.Frontier markets outperformed emerging markets.
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Why? Both did poorly, but selling was more urgent in emerging markets.Un–hedged foreign fund beat currency-hedged foreign funds.
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Why? As the correction spread to the U.S., markets preferred the euro and yen to the dollar.Large company stocks slightly underperformed small and mid-cap stocks.
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Why? Liquidity and foreign exposure were more important considerations last month than business risk.“New economy” stocks slightly outperformed “old economy” stocks.
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Why? But the edge was dwindling rapidly and over the last week of the month old economy actually did better.There was no clear performance advantage for “risk off” industries like utilities and consumer staples.
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Why? Utilities really struggled last month, as did real estate, while energy stocks surged in the finally three days. Health care may be breaking down as sector leader. No clear trend right now.Growth slightly underperformed value.
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Why? Too early to tell, but we may be on the cusp of a major market change.A Note on Market Leadership
A market without clear leadership that has technically broken through support is a dangerous one in that it is less likely to hold rallies. Be careful.
The Golden Cross
The Golden Cross is a measure of distance between the S&P 500’s 13 and 34 week moving averages. It is a useful tool to determine long term market direction. The level of the spread is also an indicator of the overall tone of the market. Levels greater than zero indicate bullish market sentiment and levels below zero indicate bearish market sentiment.
A bearish signal, known as a Golden Cross” is generated when the 13 week moving average crossed below the 34 week moving average. At that point the spread between the two moves negative. That occurred early last week and was confirmed when the spread remained negative on Friday (a weekly bearish close). This week the spread continues to negatively strengthen; further indicating of bearishness in the market. We look at this technical development as an indication that underlying market dynamics are fundamentally changing.
Chart 1 looks at the history of the Golden Cross back to 1997. The cart at top is the S&P 500 (gray line), the 13 week moving average (dark blue line), and the 34 week moving average (red line). The chart at the bottom is the measure of the distance between the two moving averages. When the black line on the bottom chart crosses below zero (the solid blue line) it indicates a Golden Cross has occurred. As you can see, that happened last week and it very strong indication that the market trend is changing. As of yesterday’s S&P 500 close, the distance between the lines was -12.17. I’ve highlighted in yellow the last three major crosses and, as you can see the indicator has done a reasonably good job of signaling changes in market trend.
Chart 1
Source: Stockcharts.com
Like all technical analysis work, however, false signals (known as a ‘whipsaw’) occur from time to time. In 1998 and 2010 a shallow cross occurred only to snap back as the uptrend aggressively re-asserted itself. In 2011 a more pronounced Golden Cross occurred only to be reversed as the Fed announced quantitative easing.
It’s important to remember that the Golden Cross is a trend following indicator. It is a necessary, but not sufficient condition, of a bear market. It does, however, give us a very strong indication that something about this selloff is different and bears close monitoring. As a result, we are raising cash at the margin and the longer the indicator stays negative the more we will gravitate toward managers with favorable downside capture ratios.
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