The equity markets sold off heavily yesterday, with the S&P down 3% and the Nasdaq 4.4%. This brings the S&P and Dow into negative territory YTD (to close 24thOctober 2018).
European and Emerging market equities are performing even worse, down close to 15% (EZU ETF) and 20% (EEM ETF) respectively, in USD terms.
The fixed income market is also not unscathed. Rising yields in the US have pushed bond prices lower, with the TLT ETF for example being down some 8.5% YTD.
Our core accounts are significantly outperforming. As at mid-October, our core account (low vol strategy) was up 2.7% in USD, on a fully invested basis. While we have delays in reporting given exposures in alternatives, our exposure to gold has been a key positive and many of our managers have performed well in this environment. Our dedicated FoF account is up around 1.9% in USD, which is ahead of most, if not all, relevant indices.
Our focus now is to figure out how best to work through the current environment and hold onto our performance edge.
We are also very happy to engage with readers and see how we can help. We don’t charge for the initial review and are only to happy to have the dialogue.
So what’s happening?:
To us, this feels a little like the second half of 2015. We saw the Emerging markets sell-off significantly by around 30% from their highs earlier in the year. The US markets also sold off, but only around 10%. Sound familiar? So far the current move is less severe.
The current sell-off also has some similarities with ‘87, though the starting point is clearly not as exuberant or elevated. Many blamed the algos for the sell-off then. We are seeing the same sentiment again, with a few notable investors taking the view that the ‘market mechanism is broken’, with algos selling into weakness making it very difficult for more traditional investors to read the market.
I’m less inclined to reach out for conclusions as to why we have these market shocks. If the market mechanism is flawed and markets sell off more than they ‘normally’ should, this presents an opportunity for investors to buy in at lower levels. What works against some, works for others.
There are many ‘concerns’ the market can focus on –
- Italian bond yields spiking higher and the slow bank run there that has started.
- The trade war with China, which is slowing the economy.
- The level of USD debt in Turkey and Argentina and other EMs.
- A stronger USD which impacts EM debt and offshore earnings,
- A hard Brexit.
- A slowing housing market in the US and cracks in other markets – Canada and Australia
- Tightening in the US with rates rising and many indicators showing we are, at or close to, the end of the business cycle there.
- The tensions with Russia which could potentially restart an arms race.
Market technicals can also be considered weak. Large cap names like Amazon could potentially fall a lot lower. Its share price may find support at the 200dma, but take a look at a longer dated chart and the technicals look less supportive. Same is true for the S&P.
Are we buyers right now?:
In my last note, Market and economic outlook – what next’ I highlighted that we are very underweight equities and are looking to buy into weakness, with a focus on China technology. This is still the case, but I have not yet pulled the trigger on this. Thankfully, as the space continues to get mauled.
China technology names, such as CTrip, JD, Tencent to name a few have been hammered in the last few months, down over 30% YTD. They were down again heavily yesterday. While these names and others like them have been sold down to reflect weaker dynamics in the China economy for the year ahead, what holds me back is the potential for these names to be rerated lower, as the market factors in a potentially significant devaluation of the Chinese yuan.
Like Kyle Bass, we’re also forecasting the Yuan to depreciate on the back of further liquidity provision by the Chinese government. We don’t try and get clever in terms of playing this in the portfolios, but we are very much still in the USD bull camp for the moment.
An area that does concern us and has held up reasonable well is High Yield debt. Normally, when pricing in an economic slowdown, the market will reprice both equities and high yield lower. The correlation is usually very high.
This hasn’t occurred to the same extent we’d expect, based on historical review. So, either the High yield market will break lower, which will confirm that a slowdown is being priced in, or the equity market is being sold down due to a technical retracement, rather than anything more sinister.
We would hence be cautious on high yield in general at this stage in the cycle and would be selective. Yields may be high, but when asset quality comes into question the bonds can decline significantly.
We would thus advocate shifting exposure here, looking to take more of a barbell type of approach – selective stock picks for beta to capture a potential retracement higher; and low risk alternatives and increasingly Treasury notes (mid duration of c.5yrs) to protect capital in the event of an economic slowdown.
What’s the market going to do?
Markets move in cycles and this cycle is stale. There is heightened risk of a slowdown in 2019 or the year after.
- We can either get a sharp adjustment lower and move forward from there on a much better footing, with the Fed and other central banks holding back until we see much better valuations before piping in liquidity. The economy would still be very much intact, but market valuations would be favourable. We favor this option, but the eventual bust further out would be that much greater, as zombie companies would not have left the system.
- Or, we have a snap back rally because the Fed or other central banks (such as the BoC) step in aggressively now. Or the market expects them to. This may be the worst outcome for investors longer term, as valuations would be maintained at high levels and the central banks would likely have limited firepower next time round. The proverbial can being kicked down the road, one more time.
- Or, we are at the start of the recession and data starts worsening from here causing a gradual spiral down like we saw in 2000 with the Fed and other central banks slow to step in. This would be a little like 1937-1938. This scenario would be the most painful option near term.
- Or, some other combination of the above.
A critical lesson that I’ve learnt is not to be too confident in one’s prediction of the market direction. One should have a view and a clear process. But one also needs to be flexible and not fight the market when one’s view doesn’t play out.
There is an enormous amount of Buddhist wisdom that can not only be applied to life, but to investing as well. Being able to better understand our, and the market’s psychology, and manage our basic emotions of fear and greed are critical to achieving success as an investor.
We should all remember the mantras –
“It’s like this now’…and …..’this too shall pass’
Markets will move, cycles will change. Being prepared ahead of such moves is critical.
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