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.