Expect the S&P to retest its 200dma
Equity markets were down yesterday around 2%. This brings the S&P into negative territory for the year. Many other markets are already in negative territory including EURONEXT, the FTSE (UK index), the MSCI China and the Nikkei 225.
Looking at the technicals, I would expect the S&P to fall further and retest its 200dma.
Some of the other markets are also looking vulnerable from a technical aspect. The one outlier is the China market – MSCI and Golden Dragon index – which are both a long way off their 200dma.
Weakness is not just reserved for equities. We have also seen the High Yield market come off with the HYG ETF coming under some pressure.
So what’s driving the weakness? It’s likely a mixture of issues:
For a while now, we have been talking about liquidity tightening as the central banks shift from providing accomodation to more normalisation. Even though this will be a slow process, the impact is starting to be seen as market participants start to price in the impact of higher rates and the eventual reversal of quantitative easing. We are also seeing a marked increase in the spread between Libor and the Overnight Index Swap (OIS), which is a reflection of some liquidity pressure in the market.
A number of capable analysts, have also been highlighting that the money supply is continuing to weaken. Weaker money supply is usually deflationary.
In Japan Abenomics are losing some of their appeal (and Abe has legal issues), so rates may rise faster than currently expected. In China we have seen credit growth come off significantly
Source: BCA research
Inflation is also starting to pick up, but we are still at relatively benign levels.
Trade wars are also not positive for economic growth, but I believe that these are more a side show to the liquidity story.
So how are we playing the market?
We take the view that the current business cycle is long in the tooth, but not necessarily over. We are not yet forecasting an imminent crisis, for the simple reason that while malinvestment is high, the central banks are still very committed to keeping things moving. And don’t forget the tax cuts and increase in fiscal spend in the US, which are positives on the short and medium term.. Yes, a trade war is damaging longer term, but will not cause a major correction in the market near term.
To be clear though, we are not advocates of buying a general ‘basket‘ of equity or bonds. We take the view that one should be far more selective in what one buys/owns at this stage in the cycle and that taking exposure to uncorrelated assets is a must.
For our core portfolio, we have around 50% allocated to what the market likes to term ‘alternatives’.
In this allocation we have exposure to Hedge Equity managers that run long and short books. Their net market exposure is between 25% and 90% so they are not simply capturing beta but are looking for stock picking to add alpha and are adjusting their exposure according to market valuation.
We also have exposure to Fixed Income managers. This is a mix of more traditional managers and those that are actively playing the yield curve and FX (more macro). The latter have done very well for us year to date, with one manager being up over 10% YTD, as at the 20/03/18. This is a 7% allocation for us.
The traditional managers we prefer, are themselves diversified, holding loan portfolios and various other credit instruments.
We have also allocated to macro strategies and will be adding to this area.
The rest of the portfolio is a mixture of gold (7%), cash, private loans and private equity. Gold continues to trade in an upward channel and we are holders as a form of hedge against higher inflation and also potential loss of confidence in the central banks.
Technical charts courtesy of Stockcharts.com
In a nutshell, our core portfolio is a diverse mix of asset classes that demonstrate a low level of correlation to the underlying market. If our manager selection works, we will generate good returns in an up market, reasonable returns in a flat market and protect capital in a down market.
While we don’t have daily performance reporting, I would expect that we are still up for the year even after yesterday’s sell off.
We are now running a Fund of Funds that can be very easily replicated for clients. Let me know if you have an interest to discuss further.
So when will we change our view or become a lot more cautious?:
A mixtures of technicals, valuations and macro outlook are the three key determinants for deciding market exposure.
Having invested in the markets for over 20yrs though, I’ve come to the conclusion that technicals are perhaps the most important, in terms of establishing the rules for cutting or adding exposure..
While interpreting the macro and focussing on valuations can add value, we have seen many examples of where investors ‘read’ the market wrong and exit, or go short, well before market tops. This can destroy returns and a good example is Tiger management which went short Technology in 1998 on the back of valuations and eventually closed in 2000. If Julian Robertson, one of the best investors out there, can get it so wrong, it would be somewhat egotistical to claim one can do better.
We have various in-house technical factors we focus on and, at the moment, they are not flashing ‘red’ to move more to cash. We are though more cautious on high yield exposure and would keep duration very short here.
Pls share if you found this useful. We will be following up next week with our top guidelines for increasing market returns – watch out for that.
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