Quarterly Perspective for 3Q15
Summary
Stock markets worldwide sold off during the third quarter. See Chart 1. July began with a modest rally, but it was confined to certain sectors and failed to lift the average stock. In mid-August the market completely rolled-over. The cause most frequently cited was global economic concerns, specifically China. While it is true that China’s demand for raw materials from the rest of the world continues to dwindle as they re-orient their economy toward domestic consumption, there were many other factors. Some investors were concerned that the Federal Reserve was finally going to raise interest rates in September (it didn’t), and others were alarmed by the amount of negative earnings surprises. After all, year-over-year corporate earnings are down close to 6%, so why should the stock market be higher?
Chart 1
Source: YCharts.com
The S&P 500 fell -6.48% over the full quarter. Large companies outpaced mid and small cap stocks, which declined -8.50% and -9.27% respectively[1]. The energy and mining industries fared the worst; each lost -20% or more. Toward the end of September, however, other sectors that had previously resisted the downturn finally capitulated; health care fell -14.53%, for example[2]. Real estate was the only equity sector able to post a gain for the quarter (1.25%), but it is still down -5.05% year-to-date.
International markets were even more affected by the threat of rising U.S. interest rates, because investors feared a flight to the dollar. The MSCI EAFE index of developed market stocks dropped -9.72% in dollar terms. Emerging markets performed even worse, plunging -17.3%.[3] Europe lost only modestly more than the U.S (off -8.69%), while Latin America was a disastrous -24.29% on the quarter. Brazil’s troubles weighed heavily on that region. [4]
The bond market saw a “flight to quality” as earnings concerns and oversupply led investors to shun corporate bonds in favor of AAA rated government debt (1.23%). Municipals (1.65%) also performed well. On the other hand, credit risk was really punished as the Barclays High Yield Index slid -4.86%. Many investors discovered that the extra yield that they were getting from “strategic income” and “multi-sector” bond funds also came with extra price volatility. [5]
Activity
This past quarter was about risk mitigation, and given the myriad opportunities to lose double digits last quarter I believe we did a good job. We trimmed exposure to the more volatile areas of the market, both foreign and domestic, and let cash build up in portfolios to the highest level since early 2009. We now hold very little exposure to emerging markets or high yield bonds, though we note that extreme price declines in the former are making them very intriguing for the patient, long term investor. We also trimmed exposure to the health care sector, which had a long overdue sell-off. We still see that sector as an earnings leader going forward, but valuations just got too high.
Outlook
By the end of the quarter the prices of many sectors had retreated, leading to more reasonable valuations. As a whole the stock market was still not cheap, but it was definitely oversold and due for a bounce. The catalyst occurred on October 2nd as a surprisingly weak unemployment report convinced global investors that the Federal Reserve was a long way from its next interest rate hike. We’re not sure the news that employment growth is so weak that the Federal Reserve cannot afford to raise rates above 0.25% is the kind of thing on which sustainable long term rallies are built, however. We would like to be proven wrong, but we believe this rally will peter out without markets making new highs. We don’t believe investors are comfortable trying to push the old leaders like health care and consumer technology to new highs, so unless fortunes can change in sectors of the market that are more reasonably valued – energy, materials, industrials, and financial services for example, which will require an upturn in global demand – we can’t see the market going much higher during the third quarter.
Commentary – Two Things You Should Know About Us
There are two things you should know about us in terms of how we manage money, (1) how we think about cash and (2) how we think about investing in general. I would like to address them separately, though they are somewhat related.
How We Think About Cash
Some clients ask about our cash management philosophy. During strong market periods they wonder why we have any money in cash, and during weak market periods they wonder why we don’t have most or all of the portfolios in cash. The answer lies in the fact that we do not know on any given day what the market is going to do, so being “all in” or “all out” (tactical trading) pre-supposes we have an insight that neither we, nor anyone else, has.
Take last quarter, for example. Between the 20th of July and the 29th of September, the S&P 500 declined -11.5% from 2128 to 1882. Between September 29th and October 8th when it closed at 2013, it gained about 6.5%. In retrospect there was almost nothing to indicate that stocks were ready to rally on September 29th. The conditions that supposedly led to the -12% market slide, namely slowing global growth, interest rate uncertainty, and declining corporate earnings, were still in place on September 30th but investors had evidently decided enough was enough. It is extremely difficult (if not impossible) to forecast these changes in market psychology, so if you are out of the market you miss out on the upside. Chart 2 highlights the annual return of the S&P 500 against its intra-year declines. (Red dots indicate the max drawdown during a calendar year and the gray histogram represents the annual return on the S&P 500) As you can see, poorly timed tactical trades aimed at reducing downside capture are accompanied by massive opportunity cost. That said, we did raise cash this past quarter as noted in the Activity section above. You might wonder what the difference is between raising cash levels as part of our asset allocation targets and tactical trading (moving to 100% cash). The answer is optionality.
Chart 2
Source: J.P. Morgan Asset Management
Optionality refers to the ability to deploy money anywhere and anytime. There are certain times that this really comes in handy. We might believe that a certain area of the market, say energy stocks or emerging markets, are attractively priced due to their recent sharp declines. On the other hand, we might have reason to believe that in the near term their prices may go even lower. Holding extra cash in portfolios allows us to pursue either of these investment opportunities (or a different one, or both) at an advantageous time to be a buyer, without having to sell something else at what would be an inopportune time. Put another way, if we can sell something where my upside potential is limited relative to the downside risk, we can create an opportunity to improve the expected return characteristics of the portfolio. Even if we receive basically no return from cash while the proceeds are “parked”, we expect to more than make up for that by buying an unspecified but more promising asset in the future. If the market goes down during the period that we are holding extra cash (as was the case last quarter) so much the better, but we really made the sale because we felt the upside potential of the asset we sold was limited.
How We Think About Investing
I had a conversation with an Adviser recently who asked me about another asset manager, one with a high exposure to emerging markets. My thoughts went to Charles Ellis, who wrote an investment book several decades ago that argued portfolio management is a loser’s game. A loser’s game is defined as one in which you win by not losing. This is opposed to a winner’s game, where you have to play to win. Professional golf or tennis are winner’s games. You cannot win a PGA tournament playing to par every hole, nor can you win a pro tennis tournament simply by getting the ball back over the net consistently. Amateur sports, on the other hand, are usually loser’s games. More points are lost hitting the ball into the net or wide of the court than are won by hitting unreturnable shots.
I tend to believe Charles Ellis is correct and let me explain how that relates to the conversation the between the Adviser and me. Statistically speaking, right now emerging markets represent the most attractive opportunity in the financial markets on a long term basis. Having declined sharply over the last quarter, year, and three year time periods, they trade at roughly half the valuation of U.S. stocks from a price-to-earnings standpoint. On the other hand, they are quite a bit more volatile than U.S. stocks (best case) and worst case quite likely much more risky due to currency fluctuation and political instability. Excessive volatility causes most investors discomfort which often leads to selling at an inopportune time. It came as no surprise that the Adviser was thinking of selling the portfolio because the client was very unhappy.
Charles Ellis recognized that allocating a large piece of a portfolio to a volatile asset class is like trying to hit a perfect golf shot out of the rough, over a water hazard, to the back right corner of the green – a high risk proposition. To be sure, even the best pros don’t try to make a perfect shot every time. They know if they hit one or more very good shots it will set up the opportunity to go for a winner. In the investment world, for most people and under most circumstances, you “win” by avoiding large mistakes that shake your confidence in your portfolio. Put another way, always needing to hit a difficult, perfect shot actually reduces your chances for long term success because even a small miscalculation can have outsized effects.
Because Trademark’s roots are in the financial planning side of the business (as opposed to the trading arm of a large financial firm), we try to make sure we don’t let our investors exceed their downside threshold. Sometimes that means not taking shots we might have made. The bottom line is, if in trying to maximize return we subject your portfolio to more fluctuation than you can handle, you are likely to bail out at the point of maximum stress (the bottom of the market). We don’t want that to happen because it turns short or intermediate term volatility into a permanent impairment of capital.
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[1] All S&P performance is from S&P via Morningstar
[2] Sector performance is from Lipper via Barrons, 10/12/15
[3] The tracking ETF for the MSCI International and Emerging Market Indices (EFA and EEM, respectively).
[4] MSCI International Indices as per Morningstar Adviser Workstation
[5] Bond performance is from Barclays via Morningstar Adviser Workstation