The U.S. stock market has rebounded from the January and February sell-off with a powerful advance that seems to be a countertrend bounce…..so far. Coming off of an extremely oversold state, the rally has been on low volume and the fastest movers have mostly been those companies that were beaten down the most over the previous twelve months. Sharp, reflexive bounces similar to this one are predominantly found during markets that are in a downward trend. Additionally, the U.S. stock market has quickly moved from oversold to overbought during this bounce. I would anticipate volatility increasing over the next sixty days and believe we are at a critical point in the stock market structure. The primary trend since last spring has been lower, with each bounce ending at a lower level and each decline ending at roughly the same point. If this pattern continues, this bounce should be ending soon and a resumption of the downtrend could be at hand. If your investment portfolio is in line with your risk tolerance and income needs there is little to do at the moment but wait for the market to either confirm it is in a bear market or stabilize and begin to rebuild the bullish support necessary for increased equity exposure.
Is this already a bear market? In terms of price the answer is no. Each sell-off has ended roughly 14% below the 2015 market peak. But, in terms of time, for many investors it may well be. As a trend changes it takes a while for the mainstream herd to acknowledge it and by then it is often too late. One of my goals in this newsletter is to look at both economic and investment data real-time and provide probability analysis as to potential moves in the markets and how they can affect portfolios. Rather than investing and hoping for the best, I favor analysis that puts the highest probability in your favor.
The U.S. dollar continues its corrective, sideways move that has been in place since this time last year.
II. THE LONG TERM
I recently had the chance to see an interview with a firm that advises charities and university endowments on long term investing. Charities and universities have an infinite time horizon. Unlike you and me who may need our money for a certain goal, charitable endowments are funds designed to be in existance for hundred of years or even longer. Their purpose is often to provide a sustainable stream of capital to the charity or university to compliment donations. When donations are down (such as during a recession) the fund would in theory pick up the slack. When donations are up, more of the fund could remain invested. While similar to individual investors in the need for capital over time, the difference is that these institutions can invest with a mindset that capital should be very, very long term in nature. I believe that most individuals should think of the long term as a series of short terms of 4-7 years each. March Madness is upon us and the NCAA basketball tournament is beginning. Often when you hear a coach speak you hear them say you must take it one game at a time. That rings true in investing as well. There are no short cuts. You must deal with the current environment and make the best of the hand you are dealt. Only then can you advance.
“Long term” investing sounds great in theory and thus a higher allocation to risky assets on the surface makes sense. While many individuals believe they can weather market “storms” like 1987 or the tech bubble or the housing bubble, when you lose 30, 40 or 50% of your money plans often change. “Buy and hold” often becomes “buy and fold”. Why do many investors fail? In my view, investors often build portfolios that are too risky while things are going well, and then have a “come to religion” moment when things get tough. Without an investment strategy that they believe in, when times get tough, many investors abandon what they know they shoudn’t. Conversely, when in the eye of a storm, many investors create portfolios that are far too conservative and forgo the opportunity to invest in assets while they are cheap.
As an example, in my opinion, today’s energy markets are cheap and getting cheaper. While there are still problems there, and things could get worse before they get better, a more reasonable outlook is that the majority of the decline may be behind us. In the 1980s, high quality energy companies thrived when oil was below $20 a barrel. While costs are higher today, my point is that energy prices should stabilize at a level that enables companies to make decent long term profits. High quality companies should gather market share and prosper. In my opinion, when we look back 4-5 years from now, many investors will wish they would have allocated more capital while the industry is cheap.
A solid investment strategy has always been buy low and sell high, yet few investors follow it. It requires discipline and patience. “Buy when everyone else is selling and hold until everyone else is buying.” – J Paul Getty In building a long term portfolio, I believe in assembling diverse investments and strategies that have the potential to generate return but are less likely to all move in concert when markets are volatile. The long term result is often the ability for a portfolio to pursue solid returns in a less volatile fashion. Diversified portfolios aren’t designed to outperform or even match the DOW or the S&P 500 in rising markets. They are meant to participate in bull markets and strive to provide some cushioning in bear markets. What is your investment strategy?
III. MARKET ACTION
The following are updates to three charts I posted here last month. I think it makes sense to continue to update these charts as we move forward because they may help in the efficient deployment of hard earned savings in the coming year.
I believe that markets don’t move in straight lines. Markets like life, are cyclical. Wave theory attempts to describe the way in which market cycles evolve. In general, according to wave theory, assets move in five waves in the primary trend and in three waves in a corrective trend. One can use market action, sentiment levels and momentum to provide clues where we might be in a given market cycle. Let’s take a look at some different charts.
This chart of the S&P 500 shows key support and resistance levels of the stock market.
You will notice that by watching the top and the bottom indicators they may give you signals of the markets being overbought and oversold in the short term. This helps give an idea of where we are in the move. It looks like to me that we may be in the beginning of a larger move lower, but for now, the support level of the 2015 and 2016 sell-offs has held at about 1,820. We seem to be in the latter stages of a bounce that pushed through resistance but has now become overbought. I will be watching to see if in the next correction if we can stay above that 2,000 level on the S&P 500.
Next is a three year chart of the S&P 500 going back to 2013.
You can see how the chart appears to be rolling over in a topping process. Each time the market reached oversold conditions it bounced back up. Further, each time it sold off it stopped at the 1,880 weekly closing level. At that 1,880 level the market would be 12% below its all-time high. A weekly break of this level would signal to me a more nasty bear market is unfolding and increased risk management may be necessary. Investors would be wise to use the bounce we are getting to make sure they are not too risky for their tolerance to withstand volatility.
And finally lets go back and look over the past twenty years.
In the past, this chart has been able to show deterioration in the markets prior to the market sustainng major losses. What has me concerned is the continued deterioration since the middle of 2015 in all the indicators. This makes me think that whatever is coming might be more than a garden variety correction. If you are an investor that was able to hold through the previous downturns, didn’t panic and even added to your risk positions then you should be fine. But, if you are at all concerned I feel as though this bounce may be the last, best chance to position your portfolio.
IV. BANKING SECTOR
Throughout the 1990s and into 2007 the banking sector became a bigger and bigger portion of our economy. In fact, at its peak before the financial crisis, the banking sector represented almost 50% of the S&P 500. That fact alone should have been cause for concern. After the massive tax payer bailouts in the financial crisis the banks began a process of rebuilding themselves, albeit from much lower levels. Banking is now even more concentrated than it was before the financial crisis as the large money center banks and low interest rates have driven consolidation and the closing of many smaller banks.
The Wall Street consensus in 2015 and into 2016 was that if the Federal Reserve is tightening monetary policy, the banking sector should benefit from the higher interest rates. Sounded great when the raionale was given. While many investors and funds migrated to the sector I have generally tried to steer clear due to the opacity of their balance sheets, high derivative exposure and lower earnings power. The media has called this chart “one of the biggest surprises of 2016.” The decline of the banking sector as exhibited by the KBW Banking Index.
The latest Thompson Reuters estimates forecast bank earnings to decline in Q1 and Q2. Recently there has been an increase in the low/no money down loans, zero-percent interst for 60 months and sub prime credit loans that were the hallmark of the last crisis. It seems, lessons were not learned and the need to generate sales of homes and cars once again has trumped common sense. Lending money to people and companies who can’t or have no intention of paying it back is not a sound strategy. Additionally negative interest rates are potentially a big reason why earnings are forecast to decline. According to Bank of America, 489 million people now live in countries with negative interest rate policies! In my opinion the banking industry should remain under pressure and who knows what lurks under the hood. Tread carefully in this sector.
V. RETIREMENT PLANNING THOUGHTS
Saving money for retirement has always been a hard endeavor. It requires one to sacrifice today for the future. No longer are pensions provided by many companies and those that are provided are shall we say, less than stable. Social security has been a safety net and is currently an important part of many people’s financial plan. But, it seems to be under attack and in my opinion will continue being whittled down as Congress attempts to stabilize its sustainability. More and more, it is up to us to save for and provide for our own retirement.
When I started in the business in the year 2000, clients could lock in an FDIC insured CD, a Treasury bond or maybe a tax-advantaged municipal bond at 5% or more. Suppose you saved your entire career and amassed $1 million dollars. Putting your entire nest egg in these low risk assets netted you $50,000 a year on top of social security. Also, 15 years ago living costs were much lower (just look at healthcare). For many, that provided a comfortable but not luxurious retirement. The hardest part was accumulating the nest egg.
Fast forward to 2008 and the zero interest rate world. None of that is possible today. It is basically impossible to generate low risk retirement income to assure a comfortable retirement…..and that is by design. Our government instituted this policy attempting to reinvigorate our economy. Retirees and pensioners were essentially, as John Mauldin puts it, “sacrificed for what now passes as the greater good.” When they dropped rates to zero, the intention was to raise them back to normal levels within a few years when growth returned. Well, we are now 8 years into this experiment and beginning to ponder whether negative rates make sense. It truly is an amazing monetary time we are living in.
Retirement plans put together prior to 2008 were based on “reasonable” rates of return on generally low risk invstments. Those are now gone. Americans are faced with the following options…
- save more
- work longer
- spend less
- take more risk than normal and hope for the best
I believe that many retirement plans have overly optimistic assumptions and those need to be ratcheted down. Rather than pursuing 6-7% annual retirement returns maybe 3-5% makes more sense. If you can’t pursue decent low risk returns (1-2% seems likely), can you make up the difference in more risky stock investments? Over time, in aggregate, the stock market can’t outpace the economy in which they operate. Sure a handful of companies can outperform, but in total the stock market grows with the economy. If we have slow economic growth then stock values should grow slowly as well. The reality is that these low interest rates seem here to stay. As long as we have massive debt levels, low rates are a necessary evil until they are paid off.
Review your retirement plans, review your investment portfolio and make sure you goals are realistic in this new, low interest rate world. If you would like help analyzing your situation feel free to give me a call or shoot me an email.
VI. INVESTMENT IDEAS
- Rather than trying to “beat the market”, focus on beating inflation and the rate on cash. Plan for safety and liquidity while seeking positive returns.
- Equity valuations are very rich but masked due to the distortion of the Treasury curve. Volatility is returning to the markets and I think long/short managers are best positioned to capture this volatility by owning companies with strong businesses, barriers to entry, and good valuations and selling short weaker companies with high debt loads that have risen sharply with the broad market rally. I think this strategy of hedged equity may have the potential to produce attractive risk-adjusted returns if and when investors begin to question the valuations of companies. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Long positions may decline as short positions rise, thereby accelerating potential losses to the investor.
- (NEW) Monsoon country investments. Attempting to take advantage of demographic, educational and investment possibilities in the countries surrounding the old spice routes of the Indian Ocean
- In 2013, the Affordable Care Act began implementation. There will be many winners and losers in the healthcare industry as a result of the biggest change in the healthcare industry’s history. With the largest portion of the U.S. population entering their golden years, healthcare needs will become even more important. Long/short Healthcare seems to be a very attractive way to invest in a sector with lots of potential and lots of potential pitfalls. Investing in a specific sector involves additional risk and will be subject to greater volatility than investing more broadly.
- Supply problems remain high across the energy asset class. While there isn’t a current shortage of energy on the planet, it is taking more and more energy and capital to discover, drill, transport and refine it. Long term Demand should continue to grow globally, particularly in China, India, and other developing countries.
- Potential food shortages due to inclement weather and higher demand from the emerging Asian middle class could result in a boon to agricultural land and potash fertilizer companies. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- Tight supply and a depressed single family home market are combining to keep apartment buildings full while driving rents higher. The number of potential renters continues to expand as a large cohort or echo boomers enters the workforce. Rents have been increasing as the desire to remain mobile and inability to secure home financing keeps renting attractive. In addition, low supply of new rental units should allow this space to flourish. Apartment REITS typically offer dividends and potential appreciation opportunities. Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
- Precious metals mining companies have been extremely beaten down over the past four years. Mining is an industry that spans hundreds of years. Companies that mine for commodities are often highly cyclical, meaning they have sustained moves both up and down. When investing in the mining space it is important to be a contrarian. Ideally, you would want to accumulate miners when sentiment is poor around them and sell them when sentiment is positive. Historically this has been a good strategy.
No strategy ensures success or protects against a loss.
Colin B. Exelby
Celestial Wealth Management
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