It’s better to be out, wanting to be in, than in, wanting to be out
Summary: We expect the recent weakness in the Equity markets to continue for a while longer and that there could be some form of re-test of the December lows in the S&P. While we may not see a full re-test on the short term, at least a further 5 to 10% fall in stocks should be expected given the rapidity of the market’s strength YTD.
Until last week and the tweet storm over trade, the global equity market was up over 15%. The S&P500 was up over 17%. Now, just a short week and tweet later, risk assets are back under pressure.
What was the market expecting? Has anything really changed since the December equity market lows in the US?
- The trade war has not been resolved and, as I have mentioned before in prior posts, is unlikely to be resolved any time soon.
- Brexit is still undecided, though it is worth noting the success of the Brexit party led by Nigel Farage.
- Russia and China continue to rattle the cage, with new hypersonic missiles and aircraft carriers being announced. They also appear to be working behind the scenes in Venezuela and North Korea.
The only real catalyst for the equity market’s sudden change in direction from its December bottom, was the Fed coming out and saying they have the ‘market’s back’. Well, we knew that all along.
In reality though, they won’t implement any new QE or MMT until there is major weakness in the economy or the Equity markets are much lower. With the US economy still relatively healthy and operating at close to full employment, we are not at that point. Indeed, however unlikely it may be in your view, there is still some risk that rates have higher to go.
What we have seen since the beginning of the year is a massive run up in ‘hope’. That all the risks have been mitigated and that business cycle will be extended that much longer. Liquidity from China and significant share buy backs no doubt helped as well.
There is also a significant divergence between the US Equity and the Bond markets. The US bond market became inverted, reflecting the expectation of lower inflation and rates, than it did earlier in 2018. This is hardly supportive of an Equity market rally, as yield curve inversion is usually a good leading indicator of a recession a few years out.
The Bond market is telling us that in the next year, or two, inflation is going to be lower and that the Fed will cut rates, to help flagging growth. This is a far cry from what the Equity market is reflecting.
Who should we believe? We expect the bond market has a better handle on where the economy is going in the next few years – it may not be a severe slowdown, but yield curve inversion should be a key indicator for any investor.
It is though, only one indicator and we tend not to invest around the macro only. We focus on the opportunity set, as reflected by company valuations. What we see is equity prices at fairly unattractive levels.
Indeed, we find that many stocks that have performed well, have done so largely on the back of an expansion of their valuation multiples, not underlying EPS growth. And that doesn’t consider the enormous amount of share buybacks and the expansion of corporate debt. The following charts for the SPY highlight this:
Given the run up in the markets and the lack of, at least in our view, real value in the Equity markets we have been cutting Equity exposure.
In those Equity long only accounts that we manage, we have been very aggressive in taking risk off the table and were cutting back last week, after enjoying the run up in the markets. In other accounts, we had already cut exposure back.
In terms of our Fixed Income allocations, we added to mid duration US government bonds late last year, close to when yields seemed to have peaked. We were lucky and got our timing right and have been waiting for a rebound to add further to our positions here. Unfortunately, though, we haven’t seen much of rebound in yields and are now considering moving a little further out on the yield curve in terms of adding duration.
Given our Equity view, we maintain our Overweight to Alternatives and Gold. They provide us in most part with steady uncorrelated returns. Below shows the correlation of some of our allocations relative to the S&P and Credit. We favour those assets that have low correlation to the main markets.
Our Alternatives focused account is up around 3.4% YTD, but this is with a volatility of only 1.7% (compared to Equities at c.15%). Given the account was up last year, this is a reasonable return for very low volatility and drawdown.
Gold continues to be viewed by us as a hedge against the eventual inflation that we see on the horizon. It was instrumental to note Gold’s outperformance during the Equity slump of late 2018, a reflection perhaps of the expectation rates will go lower and more money will be printed. Given our expectation that the Fed and other Central Banks will announce QE and MMT in the next recession, we envisage higher prices for the precious metal.
To summarize our position on asset allocation:
- We would advocate that investors should always have a balanced portfolio, with a blend of risk assets such as Equities (which provide growth longer term), Bonds (which provide yield and a source of liquidity), as well as Gold and Alternatives (for uncorrelated returns).
- If an investor is too skewed one way or the other, they are likely giving up some performance or taking on too much risk. Your exposure to each asset class should thus be a reflection of your risk tolerance and time horizon – no one glove fits all and it’s the same when it comes to allocating across asset classes.
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