Market Forecast 2016 and 2017
MARKET STRATEGY: The opinions outlined in this two year forecast reflect the views of the portfolio management team as we enter into a potential new market cycle after an unprecedented eight year bull phase. We were correctly positioned over the last eight years on the long-side of the market. However, the length of the bull phase, the amount of global uncertainty and the possibility of a yield curve adjustment has us cautious with respect to directional certainty.
The market cycle above has played out over a longer than normal eight year bull phase and will either continue on its growth trajectory or will finally roll over if the financial markets reset due to the concerns stated above. If momentum weakens, due to uncertainty and the weakening of internal market variables, markets tend to reset or revert to the mean. This market has continually advanced at a pace well above the mean for an extended period of time.
Our goal is to evaluate opportunities, be aware of systemic risks and prepared to take action in an effort to protect our portfolios through risk mitigation while seeking income and growth appreciation by careful deployment of capital in markets that may become increasingly chaotic in the years ahead.
We believe that the markets (and the FED) are complacent, and in our opinion, are in need of a reset. We feel it would be healthy if the market had a technical correction of -10% to -15% to take some of the froth (potential bubble) out of the market which could happen in the late fourth quarter or early first quarter of 2017. If the market corrects and can withstand the FED’s adjustment to higher interest rates, we believe that the foundation of a continued bull cycle will remain in place.
Markets move in cycles and now is a great time to plan for the next few years. These cycles repeat themselves and we believe the market has broken out of the 16 year secular bear market. The stock market appears to be at the beginning of the longer-term secular bull market that may have many years of potentially positive results ahead. However, past secular bull periods have not been straight-up affairs and tend to have many pullback periods that can keep the trend confusing for investors, but in time can become more obvious once the business cycle and the economic backdrop improve. For now, we suspect that further gains in the market will continue to be met with a fair amount of skepticism and even pessimism.
In the next few years the markets have the potential to confirm the shift into a secular bull phase that could last for multiple years. Our strategy is to position our portfolios properly to take advantage of the next cyclical change.
CALENDAR EVENTS: The following is a list of potential market moving events that we will be watching through year end. We will report in future Blogs the market reaction and impact of these events.
|October 11||Unofficial Kick off to Q3 earnings season|
|October 12||FOMC Minutes|
|October 20||ECB Interest Rate Decision|
|October 28||U.S. Q3 GDP|
|November 1||Bank of Japan Interest Rate Decision|
|November 2||FOMC Decision|
|November 7||Bank of Japan minutes from comprehensive review|
|November 8||U.S. Elections|
|November||Late in the month | OPEC Meeting|
|December 4||Italy Referendum|
|December 14||FOMC Rate Decision|
VOLATILITY: Volatility, as measured by the VIX, is a statistical measure of the dispersion of returns for the S&P 500 index. This index is the standardized barometer for volatility used by most institutional and private investors worldwide.
The VIX has had a weighted average over the past several years between 12-15. This means that there is a 67% chance the S&P 500 will fluctuate in a range between 12-15% over the next year, either upward and/or downwards. We are expecting that this range over the next 2-5 years will increase by at least 50% thereby increasing the weighted average of the VIX to 18-22. This is a most significant change representing an increasing importance on individual stock selection, risk mitigation and the increased potential for overall systemic failures. We do not believe passive investing, or buy and hold, will prove beneficial either financially or psychologically over the next 2-5 years or the foreseeable future. Volatility among all asset classes will rise, creating opportunities in the active equity management, commodity and futures management and hedge fund landscape.
EQUITIES: As mentioned in the discussion regarding volatility above, equities globally could be in for a roller coaster ride. One thing for certain, passive investing in equities will not be rewarded anywhere near the value of a seasoned active money manager or advisor. Buy and hold strategies may get tossed out the window in favor of periodic, if not frequent, rotations of industry groups and individual stocks held within as the stock market’s gyrations occur with more frequency and greater amplitudes.
The reason to own equities as a substitute for the near zero yield environment of debt instruments will become increasingly harder to justify due to the dramatic expected rise in the standard deviation of returns owning stocks. As a subclass within the equity space, the dividend stocks may cause the most concern in the months and years ahead due to that fact that this is a crowded trade. Buying stocks for “yield” while ignoring the fundamentals of the company’s balance sheet leverage and price multiples are sure to catch many investors off guard. These dividend stocks are subject to even greater downside moves than the overall market primarily because they are, by subclass, over owned. This is notwithstanding the probability that the dividends are cut, if not eliminated for the especially high yielders (REITS, energy, utilities). Once the yield curve shifts upward, these stocks will become less attractive and selling pressure will occur.
The overplayed trading style of consistently “buying the dips” may soon be replaced with “sell the rallies”. “What could go wrong” may be overshadowed with “I need to get out”. Complacency may yield to fear as volatility ratchets higher.
There is a counterintuitive argument to make in favor of US equities specifically and in particular. This argument is in parallel with the tenet that the USD (US Dollar) will remain the global reserve currency. So long as the dollar remains preeminent and so long as the sovereign interest rate spreads favor the US treasuries, then dollar assets will be sought after for investors worldwide seeking a haven for their wealth and diversification from their homelands’ currency.
Coupling this “bid for USD’s” and the possible repatriation of trillions of dollars held in non-US banks if those monies have some form of tax amnesty for US multi-nationals; the most probable benefactor of a significant amount of those dollars would be invested into US equities. A huge upside breakout could occur if either or both of these circumstances took hold. If these signs confirm, we must remain vigilant as demand for equities could surprise to the upside.
ATTRACTIVE SECTORS DURING A BULL CYCLE: Based on historical data with a normalized yield curve in place, the best sectors in the early to mid-stages of a bull cycle to invest in are growth related sectors that are rewarded by economic expansion. Technology, Materials, Industrials and Financials should be considered and over-weighted in the portfolio. Non-growth related (defensive sectors) such as Utilities, Health Care and Consumer Staples should be under-weighted in the portfolio. The chart below highlights our basic framework of over weighted and underweighted sector allocations.
THE FUTURE OF INTEREST RATES: This chart reflects the historically low interest rates that has been reached in the last eight years. The Fed is in their final stage of artificially keeping rates low with their third quantitative easing investment program. We feel that rates will begin to move higher by the end of first quarter 2017. Typically and again in a normalized yield curve structure, money that exits bonds typically find its way into equities furthering a bullish strategy to own stocks. However, due to the unprecedented length of time that the FED has held near zero yields, when yields begin to rise, we could see all asset classes being sold including equities in the short term. The chart below shows just how low rates are relative to history.
SOVEREIGN DEBT: Without comparison, the most underappreciated and under-owned asset class by investors and investment advisors is, and has been, sovereign debt of developed nations especially the United States and Germany. The chant has been “who would loan money to the United States for 25 years for a ridiculous yield of just 2.5% or thereabouts”. The hidden answer is that U.S. and German treasuries have been the best performing asset class without comparison on a risk-adjusted return basis over the past 5 years. Forget about the comparatively low yields, the appreciation has averaged greater than 8% for the last 5 years running.
We do not believe this will continue going forward. Again for several reasons not the least of which the central bankers may very well lose control of the yield curve once and for all. The cross current that sovereign debt faces going forward, especially here in the United States, is on one hand, risk premia should begin to normalize despite the relative strength or weakness of the US economy. This is true from the standpoint of how many assets have been mispriced, or valuations deformed, because of ultra-low interest rates. On the other hand, we cannot discount and should remain aware of the future actions of the Fed in their continued guidance of “data dependence” thus “kicking the can” down the road for normalizing rates.
These “cross currents” should reflect our theme of higher volatilities across all asset classes, inclusive of sovereign debt, especially that of the United States. The biggest problem we perceive in the sovereign debt market is liquidity. Incidentally, this is much more profound in corporate and municipal debt instruments. Back out the central bankers bid and there is a pronounced liquidity gap. Back out the central bankers telegraphing by announcement of their intentions to either quantitatively add additional securities to their balance sheet or continue to rollover maturing securities and the front running of these purchases will cease from the money center banks and leveraged hedge funds now guilty of bidding up prices. We will be watching this asset class carefully.
CURRENCIES: The dollar should remain king and will continue as the reserve currency for world trade despite much hyperbole to the contrary. The fact that U.S. sovereign rates are at a positive spread differential to most all major developed nations should provide a continuous bid for dollars. The fact that it remains, without any practical alternative currently, the reserve currency of the world for trade and transference of goods will also underscore the dollar’s bid and prominence.
We will stay long or hedge long the dollar index. Double up on this bet if Trump prevails in November. If Clinton wins, then double up on the hedged long of the dollar as more stimulus, government spending and globalism will prevail along with the backing of Keynesian theorist Janet Yellen.
If Trump does win, albeit the probabilities are decreasing significantly, then expect the Russian Ruble to spike higher and the Mexican Peso to drop significantly versus the dollar. Otherwise, expect the “America First” mantra to extend the dollar’s strength and amplitude higher over the next four years minimum.
The British Pound. The Brexit has introduced a lot of downside volatility; expect this to continue up through six months following the UK actually invoking Article 50 of the Treaty of Lisbon thus officially leaving the EU. Theresa May, Prime Minister of the UK, has recently indicated this will occur in the first quarter of 2017. Although Sterling may continue to be under pressure through September of 2017, odds favor a pronounced rebound sometime after the invocation of Article 50 for reasons that the Bank of England will finally have divorced themselves from the irrational path of NIRP (Negative Interest Rates Policy) promulgated by the global elites in control of the ECB; and the UK will renegotiate trade deals that will be “UK First” much like the Donald is advocating. We expect this Sterling appreciation most significantly when measured against the Euro not the USD. Therefore, a long Sterling/short Euro position should be most rewarding in the years ahead.
The Euro versus the USD. Expect this trend to continue lower … much lower. Perhaps through its all-time low versus the USD at or below $0.80/USD. The EU is in trouble with the Brexit potentially morphing into Ireland, Italy, Spain, Portugal and yes, even Greece calculating the benefits of leaving Brussels to command and condemn themselves thus leaving Germany to hold the bag on billions of non-performing toxic debt as seen with Germany’s, and the EU’s largest bank, Deutsche Bank.
The Japanese Yen. Perhaps the most perplexing of all currency crosses involves the Yen. Fundamentally, its weak, but it is resilient despite having the highest debt/GDP in the free world ever; despite having one of the worst demographics amongst developed nations with over 25% of its population over 65; and despite requiring the importation of every commodity on earth necessary for energy, industry and technology. Why the Yen acts as a “safe haven” in times of global stress or systemic failures is perplexing to most until you understand the psychology of the Japanese people. They are savers and they distrust every nation except themselves. Therefore as savers, the currency has a built in bid from the Japanese people despite the efforts of the Bank of Japan (BOJ) to depreciate the Yen in favor of international trade. The “safe haven” bid comes from the people of Japan immediately repatriating currency back to Yen denominated assets especially when global systemic risk is perceived, regardless of the source(s).
ENERGIES: When measured in US Dollars (USD), crude oil and the entire energy complex could remain held back from significantly rising in the foreseeable future. The reasons are several but most importantly fundamental based on the laws of supply and demand. There are oceans of crude oil underground and nearly an ocean above ground sitting in tankers waiting to be refined. The problem is the demand curve is decelerating and is likely to decelerate faster if a global financial crisis ensues.
Crude oil and the remainder of the energy patch (natural gas, reformulated gas and heating oil) are also experiencing price inelasticity; the higher the price, the less demand and the higher the price, the more supply is available. Beyond temporary price spikes due to perceived supply interruptions, expect the normalized price (inflation adjusted) of the energy complex to trend sideways in the intermediate term.
PRECIOUS METALS: Gold and silver have long been the icons of safe haven due to currency collapse, gold in particular. We do not expect a USD currency collapse but we expect interest rates to normalize higher thus increasing the cost of carry of these “safe haven” precious metals. We also expect real risk premia yield spreads to come back into favor, further dampening upside price appreciation for precious metals. There may be trading opportunities at times, but as an asset allocation position we remain on the sidelines.
INDUSTRIAL METALS: Expect progressively lower prices for the industrial complex of metals such as copper, lead, iron ore, aluminum, palladium, tin, zinc, etc. The reasons are entirely based on demand. With global economies contracting and some, if not most, already experiencing signs of recession, demand for industrial metals will be under pressure. If we experience even a fraction of global deleveraging similar to 2008-09, then the downside price pressure should exacerbate. Copper may be the “canary in the coal mine” as copper, especially in China, has been leveraged and hypothecated as an instrument of shadow banking collateral for several years. Until global growth and demand find a base we remain cautious and choose to trade the instrument rather than an asset allocation position.
CURRENT TRADING UPDATE: Given the trading range in the markets, the length of the eight year bull phase, the amount of global uncertainty, the chaotic election climate and the possibility of a yield curve adjustment, our overall trading strategy of holding an above-average allocation in cash and exercising patience has changed little over the past few months. Using a bottom-up approach to security selection, we are taking advantage of shorter term equity investment opportunities as they present themselves, while keeping cash on the sidelines. When we feel the markets have stabilized we will be reducing our cash weighting and increasing our market exposure.