While 2015 had its share of volatility and ended with virtually no gains in stocks, 2016 sprinted to the downside with volatile global markets, a bifurcated U.S. economy, and the first rate hike in a decade.
The third quarter came in like a lamb and went out like a lion, as the return of volatility hit risk assets hard across the globe. As in previous quarters, emerging market stocks and commodities suffered double digit declines as markets continue to deal with the end of the commodity super-cycle and the mix of structural and cyclical problems reverberating throughout the emerging market complex. But the big news of the quarter was a catch up in developed markets that had previously appeared impervious to the problems that were festering in the developing world.
We’ve recently changed our cyclical view, as we don’t think the recent downdraft we’ve been experiencing is over yet. In fact, while many believe we’re experiencing a ‘garden variety pullback’ that provides us with a buying opportunity, we believe there’s a growing probability that the long running cyclical bull market may be transitioning into a cyclical bear market. We could be wrong—and hope that we are. But hope is not a strategy and we need to align with the evidence that calls for playing defense and protecting against a possible change in the market cycle.
It is hard to believe that in three trading days, the market has penned its first 10% correction in over 900 trading days. This decline may be an unfortunate reminder of the last bear market, and if you are feeling anxious about your portfolio, don’t worry—you have lots of company. In fact, the market has set a new record for the speed and breadth of market volatility.
Not only has the market dropped, but we have also witnessed several areas of the evidence we follow move into bearish territory. Given this recent downgrade, we now believe the probabilities are high that we are transitioning from a bull market to a bear market cycle.
In the remainder of this post, I’ll summarize our response to the recent market events in each of our three Pinnacle strategies.
Rates are hopping, markets are churning, and investment positions are coming under challenge. Today we’ll have an investment meeting that challenges one of the bigger themes that we have in our portfolio: investing a strong dollar bias.
Inflection Point: (N) – Mathematics – A point on a curve at which the curvature changes from convex to concave or vice versa.
In describing our current thinking, I have to resort to an investment writing cliché where the financial markets are described as being “at an inflection point.” While the mathematical definition for an inflection point is presented above, in the business of investing inflection points occur where there is a change in the long-term trend or momentum of the financial markets, economy, or price of an individual security. Inflection points are critically important because if you recognize one and if you understand the significance of the change, then you can make a lot of money.
Markets are continuing to react and adjust, mostly in a negative manner, to the Federal Reserve’s announcement about their intention to wind down their quantitative easing program later this year. Volatility, as it is known to do, popped back up in fairly short order after a steady decline through the first five months of the year. The S&P 500 Index is now off by more than -5% from its high on May 21, and interest rates on the 10-Year U.S. Treasury are high by almost 1% from their low on May 2nd. While corrections and pullbacks are always unsettling, the moves so far in the U.S. have been fairly run of the mill. After all, the S&P is still up more than 10% on the year, and bonds, at 2.58%, are still at extraordinarily low levels.
Today you’ll hear the term ‘triple witching’ a lot in the media — it refers to four Fridays a year when stock index futures, stock index options, and stock options all expire on the same day. The expiration can lead to unusual volatility in markets as traders scramble to offset positions. This could make things quite bumpy, but I think there may be a more important triple witch – one that has provided the catalyst for a deep correction in U.S. markets.
Over the past few weeks our proprietary quantitative model has experienced a significant decline, falling from an almost unequivocally bullish reading of 7.45/10 to a lower neutral reading of 4.33/10. The deterioration in the overall score was caused by a broad-based decline in several important variables including, among others, the relative momentum in early cyclical, late cyclical, and defensive sectors, the steepening of the yield curve, the growth-sensitive Australian dollar to Canadian dollar exchange rate, and implied volatility.
The overdue market correction analysts and pundits have been waiting for may have arrived with the breakdown of the S&P. It has been a two stage process, with Japan breaking first and the U.S. and the rest of the world following suit. One of the interesting aspects of this correction is that bond yields are moving higher as stock prices have been moving lower. In Japan the focus has been on a bond yield rising in a nation with very high debt levels. In the U.S. yields have been going up too, and the buzz has been that the Federal Reserve may start “tapering” down their $85 billion bond buying spree (known as QE Infinity).