What’s the Risk?
Perhaps a better question is, where is the risk in the market today? I see a lot of herd type investor activity in today’s market that is largely reacting to headlines and negative news. As such, this is an important moment for investors to reaffirm their investment process and their tolerance for volatility (not risk). Without these guidelines, you are going to serially make bad decisions with your money (buying high and selling low). Here’s what our clients should know in relation to today’s market conditions.
The Bull Market is Still Alive and Well
In the last few days, we’ve seen some volatility in the markets, all markets. This includes stocks, bonds and commodities. We’ve seen some heavy, indiscriminant selling across every sector, country and asset class in the range of 2-3%. The anxiety in the system is almost tangible but few can really explain why the herd is suddenly on the run. The hard down day of last Friday was like a loud rifle shot in the early am hours – and the herd is now on the run.
What happened last Friday? Nothing, beyond the fact that there are more sellers than buyers looking for an opportunity to lighten up ahead of the Fed, Elections and Earnings. Let’s make up an acronym shall we? Let’s call it FEEAR (Fed, Elections and EARnings). But let’s back up and look where we are in the bigger picture. Stock markets across the globe have just recently broken up out of a consolidation and deep correction that lasted nearly two years dating back to the middle of 2014. And the breakout to all time new highs (US market) happened with all the thrust, breadth, volume and fanfare that we usually see at the very beginning of new bull markets! Wow, what a nice surprise to see a healthy surge this late in the game. While stocks are not cheap, there is very little technically that indicates, so far, that this new surge is over or that a bull market peak is in. In fact, what we are seeing so far is a rather orderly round of normal market volatility following a rather lengthy period of abnormally low volatility.
As I mentioned last week, we do see the “risk” structure of the markets rising a bit as well but only slightly and mostly due to widely anticipated FEEAR events in the coming months. This is a time to raise SOME cash as I said last week but we’re a long way from enough evidence to get really defensive. Remember volatility and risk are two different things. Volatility is something every investor must tolerate to various degrees. Risk, which we think of as the event that causes significant, or semi-permanent harm to your financial situation, is to be avoided. So far, we see volatility but not so much risk in the system. When does volatility become risk? It happens when the long term price trends turn down. Today, you would be hard pressed to find a chart that is a downtrend.
Opportunity to Upgrade
As I mentioned last week, we have raised about 25% cash in recent weeks from a nearly 100% invested position. This is prudent given the rise in volatility and a subtle increase in market risk looking ahead. This event has also presented us with an opportunity to potentially upgrade our positions. Let me be specific. Since the second half of 2015, the market has shown a strong preference for a certain side of the market. Specifically, we have seen defensive, income-bearing securities capture the lion’s share of capital as investors chase yield among “safe” things like consumer staples, utilities, healthcare, dividend paying funds, Treasury bonds and preferred securities. It’s been a nice ride and we’ve enjoyed healthy gains from these sectors in our clients’ portfolios as well. In the process, this side of the market has become overvalued on an historic level. Utilities, for instance, as a sector is trading at a forward P/E of nearly 20! That is absurd for an industry that rarely sees more than 5% return on Capital. Consumer staples aren’t much better from a valuation perspective. If one is convinced that the US economy is going recessionary (and we’re not in that camp), then defensive sectors are often seen as a good safe harbor for your money. But, at these prices, you might be putting your money where the real risk lies. Dividend paying funds and stocks have also been the darlings of the last 12 months. Now with the prospects of higher rates ahead, dividend payers are likely to come under pressure, leading the markets lower. And thus, this time of increased volatility presents a great opportunity to upgrade these positions. Recent sales in our portfolios have been among dividend payers, REITS, investment grade corporate bonds and preferred securities. As this pullback within a bull market runs its course, we’ll work to identify new leadership that is a better value and perhaps better aligned with a developing cycle of tighter monetary conditions, and get that money back to work. We are still in the mode of buying dips until further notice.
Looking at New Value
We still see opportunities from a value perspective in commodities, emerging markets, energy (to some degree), financials, banks, industrials, materials and oversold technology. These are likely to be in our focused universe as we look to deploy some of the cash from recent sales. Remember that the US stock market in aggregate is still expensive however, and forward returns given valuations for US stocks are in the low single digits (2-3%) until we see our next deep correction or bear market. Outside of emerging market debt, I would say that sovereign debt of any kind is unattractive, including all forms of bonds offered by the US government. But there is real growth and real value outside the US and in oversold hard asset groups.
Queue Up Cash Now
If I were to offer all investors some advice, it would be this: Find and identify cash that is idle, sitting in banks earning nothing or otherwise earmarked for longer term investment. Get it in a place where it can be deployed quickly. In our shop, we have our Holding Tank strategy at Fidelity that serves this purpose and is now earning some nice returns again (about 4%/ year). Holding Tank is free for all clients of ASFA. There will be an attractive moment to deploy this cash into longer term investments in the next several months, perhaps on the other side of elections or sometime in the 4th quarter of this year. For our 529 investors and any who are looking to add cash to passive investments, like 401k accounts, we’ll plan to send out a “Calling All Cars” instruction if and when the markets provide a lower risk entry point.
Just a brief update to offer a little perspective.
Have a great week
Sam Jones
