The U.S. jobs markets may still have some structural problems to work out, but cyclical trends in employment have been on an upward trajectory for most of this year. At Pinnacle we monitor a broad array of employment indicators that have been ticking in a positive direction; here are a few examples:
- Non-farm payrolls have been over 200,000 for nine straight months. The unemployment rate has decelerated to 5.8% and is clearly trending down.
- Unemployment Claims 4-Week Moving Average, one of our favorite leading indicators of the job market, has been persistently under the 300,000 level for many weeks.
- Surveys of jobs hard-to-get are falling while surveys of job openings are picking up.
- Employment components within small business and regional Federal Reserve surveys are trending up.
- The Employment Trends Index continues to move in a positive direction.
One of the more counterintuitive data points heavily watched by the Federal Reserve is called the “quit rate,” and it comes out of the Jobs Opening and Labor Turnover Survey (also known as the JOLTS report). The quit rate measures the number of people who are voluntary leaving their jobs, and while more people voluntarily leaving their jobs sounds like a terrible thing for the employment situation, that’s not how the Federal Reserve or economists view this statistic. Though this may be surprising, a higher voluntary quit rate is considered a positive for the jobs market on the theory that workers only feel confident enough to quit their current jobs if they believe they can get another one. The number of quits out of the latest JOLTS report has now risen to within a hair of pre-recession levels, and is currently at a mark that implies an unemployment rate well below current levels. The quit rate may not be the statistic most discussed on CNBC, but it helps to reinforce our view that cyclical momentum is picking up in the U.S. jobs market.
According to the National Association of Home Builders (NAHB):
The Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market. The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next six months as well as the traffic of prospective buyers of new homes.
Our proprietary work shows that the HMI Index is negatively correlated to changes in interest rates, with a lag of about one year. This means that when interest rates fall (or rise), the HMI index tends to move in the opposite direction a year later. The rationale behind this relationship is simple: lower interest rates make new homes more affordable, thus leading to a brighter outlook for housing, as measured by the HMI index. In turn, increases in the HMI index typically coincide with better performance for home builders stocks.
Looking at the most recent history shown in the chart to the right (highlighted by the green rectangle), we see that the year-over-year change in interest rates (the red line) went from roughly -50% in mid-2012 to almost +80% in mid-2013, turning from a strong tailwind into a strong headwind for home builders. Almost like clockwork, one year later, the HMI index (the blue line) peaked and subsequently suffered a significant decline, resulting in poor performance of home builders stocks over the same time frame.
However, interest rates peaked at the end of 2013 and have fallen sharply since then, pushing the year-over-year change into negative territory and turning into a tailwind for home builders once again. This is one of the reasons why we made an intra-consumer discretionary sector trade last week by swapping part of our position in the broad sector (XLY) for a position in the home building industry (ITB). Our other reasons in support of the trade included:
- There is a much more benign valuation profile compared to the broad consumer discretionary sector.
- U.S. banks are easing lending standards for prime mortgages at the most aggressive pace since the housing collapse.
- Housing affordability is still elevated by historical standards.
- There are continued improvements in jobs numbers.
Earlier this year, we perceived significant risk inside the oil market: Large speculators had made extreme bullish bets in the futures market, and there was reduced demand from emerging markets. In response, we took half of our energy stock exposure and invested it in Master Limited Partnerships (MLPs). MLPs are natural resource activity companies, mostly involved in the distribution of oil or natural gas through pipelines. This side of the energy business is not directly tied to the price of oil, as oil needs to pass through pipes regardless of price. Additionally, oil supply in our country is skyrocketing and demand for the pipes is increasing. These two factors are major reasons why we were attracted to the investment, and why we remain constructive on the future of MLPs.
Our timing was good: Starting in mid-June, crude oil entered a four month period in which the price dropped from $108 per barrel to $79 dollars per barrel. Gasoline prices in the U.S. have also fallen about 18% from $3.70 to $3 per gallon, which equates to about $84 billion in freed spending power (assuming every $.10 drop in gasoline prices leads to $12 billion in freed spending power for consumers). This economic stimulus is welcomed by everyone… except energy investors, whose stocks fell over 20%.
Because of our shift to MLPs, the energy section of our portfolio experienced significant outperformance, as the MLP fund only fell 7% during the same period.
[Energy stocks comprise 9.8% of the S&P 500, which means that a Pinnacle DMG client is benchmarked to 4.3% U.S. energy stocks (44% of the DMG benchmark is the S&P 500).]
Renewed signs of economic weakness in Europe have spooked investors and led to a significant correction in European stocks. In particular, there has been a spate of disappointing economic releases from Germany with industrial production, exports, and business confidence all coming in below expectations. This is concerning because Germany has been the backbone of the overall recovery with better growth relative to other European countries.
There are still some bright spots, however: Bond yields across the Eurozone are low and falling, which is a much different backdrop compared to 2010 – 12 when yields in some countries were soaring due to fears of widespread defaults. Low interest rates should be helpful for consumers and business. In addition, the value of the euro has declined by nearly 10% relative to the dollar since June, which should make their export sector more competitive. Finally, and perhaps most importantly, monetary policy is becoming increasingly supportive with the European Central Bank announcing a series of new measures designed to give a boost to the recovery (including an asset purchase program that just commenced this week), with assurances that they’re prepared to do more if necessary.
Overall, while risks to the outlook have risen, we still believe that the evidence on balance suggests that the recovery should continue, although third quarter growth may have stagnated. Faster economic growth would certainly be welcome, but as was the case here in the U.S. for the past several years, slow growth combined with increasing policy support may yet be a potent combination for European risk assets.
With markets moving and volatility picking up, the investment team has had some lively discussions recently. When turbulence breaks out there is often a tangled web of items to sort through in determining what is the major driver. Our summary view is that we’ve had a collision between complacent markets that have lost momentum as the Federal Reserve’s quantitative easing program winds down, and a European growth scare that has moved to the forefront. Negative daily news headlines don’t help either (e.g., Ebola), though these are likely temporary factors.
Our current base case is that the U.S. economy is likely strong enough to handle the potential for the Fed to begin raising interest rates sometime in the next couple of quarters, as long as Europe doesn’t slide into another recession. While Europe has exhibited renewed weakness recently, the decline should compel European authorities to take additional monetary (and perhaps fiscal) action to support the recovery.
The Correction and Our Mission
In terms of the current correction, it’s helpful to reflect on the ongoing bull market we’ve experienced since 2009 (see the chart on the right). A little perspective shows this 6-7% decline in the S&P 500 Index doesn’t look much different than a number of other corrections that have occurred during the overall bull run. Keep in mind that the market hasn’t had a 10% correction in a couple of years, and that certainly seems to be amplifying fears in this market retracement. When correction fears take hold, it is important to remember that an occasional pullback is usually healthy for markets and more often than not serves to shake out the weak hands and refresh stocks for more gains.
It’s important to remember here that our investment method is not intended to catch smaller moves or corrections. Despite the current feeling that the world is coming apart, the reality is that what we have experienced so far doesn’t even qualify as a bonafide “correction” for most analysts, as they would reserve that term for declines of at least 10%. Our process is designed to guard against major turns in the market cycle (in our definition, a major turn from bull to bear market entails a move of at least 20%). The chart to the right offers a good illustration of what we’re defending against.
Since we make our investment decisions based on the weight of the market evidence, let’s look at that now.
A New Message?
In terms of the evidence, technical conditions have been deteriorating slowly over a period of months, and we rate that input as mildly bearish. (The term “mildly” is close to being downgraded to simply “bearish” if the market declines much further.)
After weighing the evidence, we’ve concluded that the backdrop has gotten marginally worse, and we should take an incremental step in regards to portfolio positioning to reflect that change. Because we’re already very close to neutral from a volatility standpoint, this can be accomplished easily by purchasing longer duration bonds with cash-like instruments that are in most portfolios. This approach allows us to keep the rest of the allocation fully intact to try to ride out what may be a deep correction. If the correction runs its course without getting much deeper, it should be relatively easy to sell this position out of the portfolio if necessary. Like all hedges, it has a cost in the form of interest rates potentially moving higher in a market recovery, which would hurt bonds. Unfortunately, there’s no free lunch with hedges since they involve a tradeoff between helping to insulate the overall portfolio against declines versus the possibility of losing money on the hedge if things quickly rebound.
In terms of timing, we will likely give the market a chance to bounce off severely oversold levels in the short-term, but institute a stop-loss point to limit its drop before we move to a fully neutral position. Hopefully the pain is almost over, the market can reestablish its trend, and we can look forward to the best seasonal part of the year beginning in November. If not, we will be properly hedged for the evidence as it stands today.
While we’re prepared to bring the portfolio in line with the evidence from an overall volatility level, that doesn’t mean we aren’t looking for opportunities. Here are some specific ideas that we believe might be great multi-year opportunities, so long as our base case stands and the evidence doesn’t continue to deteriorate.
Technology is one of our favorite U.S. sectors. It’s cheap, well liked by independent reads, and fits into an expanding capital expenditures and stronger dollar story. We’re already overweight and are feeling some short-term pain as those stocks have declined, but rather than cut this we will likely use additional selling as an opportunity to build into a bigger exposure in this area.
Europe has underperformed in the short-term, but it may represent one of the best opportunities for us on a multi-year horizon. Europe is cheaper than the U.S., and the weak economic data will likely force their authorities to expand monetary (and maybe fiscal) policy at a time when the policy impulse is beginning to fade in the U.S. It’s easy to view Europe skeptically in the short-term because the interim results are negative, but we view it as a potential opportunity over a multi-year horizon on the basis of attractive relative valuation and increasing policy support.
We also believe the U.S. dollar may have made a longer-term bottom and might be starting a multiyear bull market. Some of this comes as a result of diverging monetary policy and relative growth rates, and some of it has to do with a sounder structural footing for the U.S. economy through improvements in twin deficits, a stronger banking system, etc. At the moment the dollar is coming off very short-term overbought levels and seems like a poor entry point from a timing perspective, but we’ll be watching for a pullback that may provide an opportunity to enter. That trade may come in many forms — less international holdings versus domestic, currency hedged foreign positions, below benchmark weightings in commodities, and maybe even positions that track the value of the dollar as a fixed income alternative. We haven’t made any firm decisions on these, but analysts are watching their sectors to see how a multi-year trend higher in the dollar might be reflected in portfolio allocations.
Volatility is tiresome for everyone, and the short-term pain is not helping our cause for this calendar year. But perspective is important, and volatility often creates lasting opportunities. Most importantly, our investment process will continue to dictate broader portfolio changes; if this is truly the beginning of the next major bear market, we’re confident that our process will help position us more defensively as the evidence emerges.
The second quarter started in somewhat choppy fashion as small cap and other high flying momentum stocks continued to face pressure as investors decided to shed stocks with swollen valuation multiples. The major averages fared better than their risky counterparts, and after a brief dip stocks began their ascent towards record breaking highs on the back on improving economic data, decent earnings growth, and continuing liquidity support from global central banks.
Meanwhile commodity markets appeared to work off some of their overbought readings from earlier in the year as they treaded mostly sideways during the quarter. Within fixed income, the bond market also fared well as investors continued to flock towards anything with a yield, foreign bond markets bubbled, and a number of technical factors came together to keep bond investors satisfied despite meager nominal yields.
NOTE: There is a 100% probability that bull markets will be followed by bear markets. This article is not a forecast about imminent market behavior. For our latest views on markets, clients should read our market review. Financial fire drills are all about testing your emotional response to a bear market, which you should be doing all the time. (And it’s not a bad idea to check your emotional reaction to bull markets, as well.)
When I was a kid, my family lived in a two-story colonial in South Jersey. Once each year, to the great excitement of all concerned, my parents had my brother, sister, and me conduct a fire drill. We got to climb out of our bedroom window onto the roof of the garage, and then down from there.
Our house never suffered a serious fire, and we never had to make a rooftop escape, but my parents were still glad that we’d practiced what we had to do, just in case. It was a very good idea.
Governor Martin O’Malley recently signed a new law that will reduce the sting of estate taxes over the next several years for Maryland residents. So how does the Maryland tax compare with the federal version? As defined by the IRS, “The Estate Tax is a tax on your right to transfer property at your death.” The federal government imposes a tax on taxable estates in excess of $5.34 million (the individual federal exemption amount, which increases for inflation annually). Maryland currently imposes an estate tax on taxable estates in excess of $1 million (the state exemption amount).