Markets are volatile and in corrective mode, and investors are nervous. Are we witnessing the start of a cyclical bear market, or is this just another correction within a bull market and an opportunity to add risk assets to our portfolios? These are the questions the Pinnacle Investment Team is wrestling with right now, and they’re critical as we position portfolios for our clients.
After all, if we’re in another market correction, then it’s already too late to get really defensive, and we’re probably better served looking for bargains that U.S. politicians are creating for us. But if we conclude that a cyclical bear market has begun, then it’s not too late to sell considering that the typical bear market runs about 35%.
Making this kind of call is always difficult; here are a few of the events that we’re sifting through as we come to a decision:
The Fiscal Cliff
If it doesn’t get resolved, we’re going to have to change our view regarding the bull market, because a recession would be a foregone conclusion. But if a deal gets done, the market may experience a major relief rally. The current 24/7 media coverage helps perpetuate the fear that we may go over the cliff, but we still think a deal will get done. In the end, no party has constituents who will stand for their representatives deciding it was okay to put them into recession. How volatile the markets become before a deal gets done remains a question we’re pondering right now.
Disruptions in the Data
The last few economic data points in the U.S. have undermined some of the strengthening in data that we’ve witnessed over the last few months, so should we interpret this as the start of a recession in the U.S.? Too soon to say, but it seems more likely that there will be some temporary weakness in the data over the next month due to Hurricane Sandy. On the bright side, going out past a month or two, there’s a decent possibility that the rebuilding from Sandy will become a tailwind that sets up positive economic surprises.
Rising Geopolitical Tensions
Israel has decided to launch attacks on Hamas now that the U.S. elections are over. This has quickly raised fears that an escalation in Middle East tensions could disrupt oil supplies. Though oil has climbed off its recent lows, the current rise will not move the dial on a rate of change basis, and if tensions cool this will likely blow over — just another outbreak in a part of the world prone to occasional flair ups. Any geopolitical risk premium baked into markets could quickly reverse, and it’s probably not worth altering the portfolio allocation at this time.
There is always something to fret about in Europe, and European volatility based on news flow is now embedded into the market’s muscle memory. The good news is that we’re not seeing signs that serious system risk is escalating in Europe, and the value that has built in the continent continues to give us a chance that we’ll get some diversification and a margin of safety out of international positions.
There is plenty to worry about in the current landscape, but at the moment we continue to give the uptrend in markets the benefit of the doubt. Based on that view, we’re starting to eye up some investment babies that might be getting thrown out with the bath water. While we hold to a mostly constructive view, it’s important to note that we hold roughly 13% of our portfolios in a variety of hedges that are designed to cushion our portfolios against volatile times just like this. That should give our portfolios some ability to withstand the current shock as we sift through the issues and attempt to separate important market signals from the sea of noise.