Updating the January 18th post:
- Low volatility strategies continue to lose less. They are down roughly -1.79% so far this month, versus -3.63% for the S&P 500 and -2.65% for the Dow. See Figure 1. The Dow is outperforming the S&P 500 because it benefits from having a higher dividend yield, and high dividend stocks are performing relatively better.
- The best performance this quarter has come from gold mining stocks which continue to benefit from declining faith in world central banks and from a surprisingly weak dollar. Currency markets priced in multiple rate hikes by the Federal Reserve in 2016, and that looks less likely every day. Dollar sentiment was fantastically bullish at the end of 2015, so in the absence of aggressive action by one of the world’s other major central banks, it was set up to fall.
- The surprising global economic weakness to start 2016 led to a sharp decline in interest rates. The U.S. 10 year yields 1.75% but last Thursday’s low was around 1.55%. The massive compression of yield spreads has really hurt financial stocks, most of which depend on the ability to borrow at short term rates and lend at intermediate or long term rates. Next to health care, financial services stocks have been the worst performers in 2016.
- The other problem with the sharp fall in interest rates worldwide is that more debt is trading at negative interest rates, which punishes the debt holder. In Europe this means banks must hold high quality paper to meet capital standards. I don’t believe it has worked anywhere, anytime in history to try to achieve prosperity by abusing one’s financial services industry. The ability to extend credit where it is needed and at prices and terms that are mutually beneficial is so critical to a country’s economy that most advanced nations have long understood that no one government agency or bank has the capability to get it right. We need a financial system where more decisions are made by empowered but competently regulated local entities. Unfortunately, post-2008 developed nations have been moving toward greater centralization of credit decisions in reaction to frustration over the inability to hold anyone responsible for the widespread malfeasance that caused the financial crisis.
Oil prices have fallen under $30 per barrel. Obviously, this continues to be an existential problem for many smaller and/or more poorly capitalized entities in that industry. That said, the decline might be close to over for the major players. Perhaps on the idea that big oil can pick up assets cheap during the bankruptcy process, ExxonMobil is up 4.08% in February and Chevron is only off -1.19%. At the very least, I would suggest underweighting energy will not in and of itself lead to outperformance going forward.
Growth vs. Value
Growth’s relative strength to value is slipping as value is a superior performer on a year-to-date basis. We are seeing portfolios heavily tilted toward growth move rapidly back toward style neutrality. The traditional value sectors that investors normally gravitate toward when growth goes out of favor have been a mixed bag; some have been good some have been terrible. Financial services are typically the biggest sector weighting in value portfolios and, as explained above, this year has been a disaster. Real estate is very weak this month and energy is just starting to bottom out. The biggest winners from the growth to value shift have been utilities, consumer staples, and telecoms. While this is understandable given their dividends, I’m not confident those sectors can sustain outperformance. Those are very slow growth sectors whose fundamentals suggest they’re quite expensive. Everything else that was once expensive – health care, retail, online services, etc. has been dealt with harshly.
Credit spreads continue to widen this month. We have be inundated with calls and emails from firms pounding the table on how cheap high yield credit is right now. I will absolutely grant that prices are the most attractive since at least the summer of 2011. If this turns out to be a garden variety economic slowdown and default rates don’t climb much above 6%, this will have been a good opportunity to buy high yield. I’m just not sure I believe things won’t get worse, given the almost complete lack of good news outside of the United States and the continuing lack of corporate bond liquidity. I will say this though – the risk-reward on high yield debt may well be more attractive than that of large cap U.S. stocks due to better valuation and much higher yields.
As noted above gold has been the best performing sector this quarter. If stocks put together a strong bounce off support (1815 on the S&P 500; see Figure 2), gold will almost certainly lag. That said, the crisis of confidence in central bankers might well be in a secular bull market as no-one considers negative interest rates a sustainable long term policy. A modest position as a hedge may be a good idea.
We write a lot about valuation in these updates. The purpose is to establish where the market is fundamentally trading as a way to determine what the magnitude of a potential move in either direction might be. If markets are cheap, for example, one should have less concern if the next move were be to the downside (as upside potential is far greater than downside risk). This year’s pullback makes the market look much less expensive and I believe overvalued securities now make up less than 10% of the broad market. An undervalued market eventually tips the performance pendulum back towards active managers, but I’m not ready to make that call yet.
 As measured by the following ETF’s: SPDR Dow Jones Industrial Average (DIA), SPDR S&P 500 (SPY), PowerShares S&P 500 Low Volatility (SPLV)
 Source: Barron’s Online, as of 12/12/16
 As measured by Select Sector Spiders. Source: YCharts.com
 Source: Google.com/finance. Period: 2/1/2016 – 2/12/2016
 Large cap growth is down -9.69% compared to values -8.85%. Source: Goldman Sachs February 12th Market Monitor.
 The dramatic outperformance of the “Nifty 50” leading up to the 1973-74 bear market resulted in spectacularly better returns for the broad market from 1975 to 1984. This was largely repeated between 1995 and 2000 as large growth stock returns dominated. Large cap indices were then then the worst performing area of the investment spectrum from 2000 through 2009.