Quarterly Perspective for 2Q15
Summary
Financial assets had a tough second quarter. Interest rates rose while corporate profits dipped. Greece was once again in the headlines, this time joined by Puerto Rico and China. Those negatives were offset by continued growth and rising employment in the U.S. economy combined with economic improvement in Japan and Europe. It seems like we have been on the verge of a Greek default since 2012 and an interest rate hike since the summer of 2013. At some point, investors got tired of the “crying wolf” aspect of these two crises, lifting stocks up over 60% since the summer of 2012. Now, however, those situations are too pressing to ignore, and that is proving to be an increasingly strong headwind for both bonds and stocks.
The major U.S. stock index, the S&P 500, did eke out a slight gain (0.28%)[1]. (See Figure 1) Increasingly, however, the market is being driven by a handful of larger consumer names like Disney, Nike, Facebook, and Apple. On an equal-weighted basis, the market would have declined -1.09%[2]. Health care was the top sector once again with a gain of 2.8%, while the biggest loser was real estate (-10.69%)[3]. With the Dow Transportation Index off -7.12% and the Dow Jones Utilities Index down -6.26%, it felt like the losers lost more than the winners gained. (See Figure 2)
Figure 1
Source: YCharts.com
Figure 2
Source: YCharts.com
Foreign stocks were a very mixed bag. Overall they gained 0.62% in U.S. dollar terms. Japan and Latin America each rose more than 3%.[4] For Japan it was the continuation of gains made over the past three years as the yen has declined, whereas for Latin America it was a bounce off deeply oversold levels. Latin America has struggled mightily since commodity prices peaked in 2011. China is probably the most interesting market. It shot up more than 42% from March 11th to June 12, only to give almost all of it back by the second week of July. China’s economy is slowing, and the volatility associated with this is playing havoc with countries whose economies have become somewhat dependent on supplying it raw materials, such as Australia, Chile, South Korea, and Canada.
As for fixed income, this was the quarter that the bond bears had warned us about for the last six years. The Barclays Capital Aggregate Bond Index sank -2.11%. (See Figure 3) Bonds had their worst three months since the second quarter of 2013. Interest rates rose across the board and credit concerns increased as well. This meant that neither Treasuries, nor municipal bonds, nor corporate bonds (whether investment grade or high yield), nor international bonds posted a gain. Obviously, shorter duration bonds had less interest rate sensitivity so they performed better.
Figure 3
Source: YCharts.com
Activity
The most important thing to do this past quarter was to monitor exposure to interest rates. Interest rate exposure will hurt you when rates rise, of course, but long duration bonds are usually the best possible asset during periods of economic or political instability. For most investors, we trimmed existing bond positions because their upside is limited in most scenarios. For more aggressive investors, however, we actually bought long bonds in order to offset some of the risk of our foreign stock positions. We also reduced our weighting in interest rate sensitive equities like REITs and utilities and in global bonds. Some of the proceeds went into mid cap stock funds that emphasized health care, but in most cases we held on to the cash to await better entry points. We are increasing cash levels because our concerns are growing and we want to have money on the “sideline” to invest if and when prices fall.
Outlook
We have written about the U.S. stock market being overvalued for several years now. With the Federal Reserve maintaining very low interest rates and the economy continuing to expand modestly however, there has been little to indicate that stock prices were about to fall toward fair value anytime soon. Bear markets tend to need a catalyst. Greece has danced in and out of the headlines since 2011, but it does not seem likely that its troubles (in and of themselves) could cause more than a modest correction unless the rest of the European Union really screws things up. A crash in the Chinese stock market, on the other hand, could be the catalyst to a broader global decline because it is not priced in. China is experiencing at least a partial unwind of a speculative mania which started last summer and then went parabolic in March. The plunge since June 12th has been frightful, and the authorities have had only modest success in halting it. Because we are concerned about China we are raising a little more cash. That said, it is not our policy to sell everything when market conditions deteriorate. We’d like to explain our reasons below.
Commentary – Nobody Has a Crystal Ball
We do not go “all in” or “all out”. There are several reasons for this:
- Conditions may change very rapidly.
- Almost nothing happens in the market that doesn’t benefit at least somebody.
- Frequent trading isn’t tax efficient.
- Frequent trading increases costs.
- Frequent trading has never been shown to be effective over the long term.
Let’s discuss each of these points in detail.
Conditions may change very rapidly.
We are in an age of extremely interventionist central banks. Whether here, in Europe, in Japan, or in China, market troubles seem to be met with aggressive measures to halt the slide. Each of our “quantitative easings” has come as a result of stock market weakness and been quite effective (at least in the short run). The same can be said of European interventions in 2012 and earlier this year. Recently the Chinese government brought a stop to its stock plunge by banning short selling and buying stocks. Even if you believe that all of these measures are ultimately doomed to fail, they can and have been very successful at delaying any potential day of reckoning. Selling into a market correction has been a very unprofitable strategy over the past six years.
Almost nothing happens in the market that doesn’t benefit at least somebody.
It is extremely rare that everything in the stock or bond market goes up or down at the same time. Typically, markets go back and forth between a “risk on” mode and a “risk off” mode. The risk in question may be economic, interest rate, liquidity, or something else. For example, when the Greek crisis hit, there were elements of economic and liquidity risk involved, so investors sold European stocks aggressively and to a lesser extent U.S. stocks and Asian stocks. They were hardest on stocks that benefitted from global growth and Euro-denominated securities. On the other hand, they bought Yen and Dollar denominated government bonds, and they bought higher yielding domestically focused stocks in both the U.S. and Japan, such as utilities and real estate.
Money is constantly flowing, seeking the best payoff for a given level of risk. These calculations are made and remade with every new piece of information that comes out. When we calculate capture ratios, we are basically looking at how each security does when the tide is rolling in versus how it performs when the tide is rolling out. [5] Volatility gives active strategies more of a chance to shine. If we can find a mutual fund or ETF that tends to consistently make a little more or give back a little less, we get interested in looking more closely at the strategy.
Frequent trading isn’t tax efficient.
If you trade frequently, all of your profits will be taxed at the higher short term tax rates. For taxable investors in higher tax brackets, the savings could be as much as 19.6%.
Frequent trading increases costs.
Frequent trading can be expensive. Most brokerages will not let you trade for free and those that do will not let you do it frequently. At TD Ameritrade, for example, the vast majority of trades we make do not carry a transaction fee. The fund or ETF we purchase, however, may have a restriction that allows them to retroactively charge a fee if we don’t hold it for a certain period of time. In addition, TD itself will charge us a separate fee if we do not hold a fund at least 90 days. Mutual fund and variable annuity companies typically allow free trading within their family, but they generally limit the number of trades you can make in a twelve month period.
Frequent trading has never been shown to be effective over the long term.
The most important reason we don’t make large “in or out” market calls is that they usually don’t work. I’ve been in the securities industry since the mid-1980s and I remember exactly two professionals getting the 1987 crash right and neither ever had a timely call like that again. Several people were right about the tech crash in 2000 but they were not the same people who were right about the sub-prime crash in 2007 and in each case the people that were right were early enough to have to endure some real pain first. But oh, there were so many more people over my nearly thirty years that were disastrously wrong! I remember the gold bugs who were wrong for 16 years and missed a stock market run from Dow 1500 to over 10000 before their ship finally came in in 2001. I remember for years hearing that bond yields had nowhere to go but up while bond yields were busy falling to 5%, 4%, 3%, and lower (greatly enriching bond investors). Inflation didn’t come back when the Federal Reserve started quantitative easing back in 2010 and the stock market didn’t crash either, though both were widely predicted by the folks who run scary advertisements on CNBC.
Jumping in and out of the market requires being right not only about the “what” but the “when”. The best investors in the world do not try to do this. They focus on getting the “what” and the “how much” right, because the “when” is notoriously unpredictable. Financial writer John Mauldin has often used an avalanche metaphor to indicate that imbalances in markets are relatively easy to spot, but knowing what will finally set them off and what kind of collateral damage they will do is the hard part. It is impossible to react to breaking news faster than the market; the only possible advantage we can create is to react more thoughtfully.
So what do we do instead? It is Trademark’s practice to carefully decide what to buy, and then modestly add to or subtract from those positions as conditions warrant. From time to time we have to replace securities either because something happened at the fund (manager change, deviation from the stated investment process, etc.) that causes us to believe the fund’s track record cannot be maintained, or because the fund’s particular approach is less suited to the current environment as one of its competitors. We may under or overweight sectors or regions because of economic fundamentals, but we don’t put all of our eggs in one basket. For us, it is not about making the biggest profits when we are right; it is about being in the right asset class and the right funds as often as we can while trying to limit the consequences when we are wrong. Nobody has a crystal ball. The biggest investing mistakes are made by those that think they know what is going to happen and therefore don’t have a strategy when things inevitably move against them.
[1] S&P 500 Index per Morningstar
[2] S&P 500 Equal Weight Index per Morningstar
[3] Sector returns courtesy of FactSet and Russell per JP Morgan’s quarterly report
[4] Foreign stock returns from MSCI per Morningstar
[5] Upside/downside capture ratio show you whether a given fund has outperformed–gained more or lost less than–a broad market benchmark during periods of market strength and weakness, and if so, by how much