It was a tale of two half quarters. The first six weeks saw equities sell off on fears that the Federal Reserve would continue hiking interest rates in 2016 and the result would be a global recession led by the emerging markets. The last seven weeks of the quarter produced a spectacular rally as the Fed backed away from its planned rate hikes and risky assets began to recover. As the dollar fell, the pressure on global currencies was reduced considerably. Emerging markets (particularly Latin America) soared. Oil prices began to recover. Such is the power that monetary authorities wield today.
Putting the two pieces of the quarter together, stocks put in a mixed performance overall. The S&P 500 rose 1.42% for the quarter, while the Russell 2000 small cap stock index was off -1.47%. The technology-heavy NASDAQ Composite fell -2.09% as “growth” stocks under-performed “value” stocks for the first time in two years. See Figure 1. The strong decline early in the quarter caused investors to prefer high dividend paying stocks to rapidly growing companies, and that bias persisted even as stock recovered. The utility and precious metals sectors performed the best last quarter, which makes little sense if you consider gold an inflation hedge. Financial stocks did the worst once again, as investors remain wary of a sector so sensitive to government interference.
Latin America finally posted a sharp rally after five years of absolutely hideous performance. A modest recovery in commodity prices and the possible impeachment of the Brazilian president was behind the surge. Despite the 6.40% gain from emerging market, international stocks as a whole posted another quarterly decline (-0.33%). Japan was the leading culprit as even negative interest rates don’t seem to be able to spark inflation or depress the Yen. Europe was down -2.75%. See Figure 2.
The aggressive use of monetary policy to combat weak global growth was again positive for bonds, especially high quality bonds. The interest rate sensitive Barclays Aggregate Index gained 3.03%, its best quarterly performance in several years. Anyone who has warned investors over the last five years not to invest in bonds has done them a great disservice; yields have gone lower (not necessary in a straight line of course) and prices have gone higher. Even sectors that struggled mightily in 2015 – high yield corporate bonds, emerging market debt, and inflation protected bonds – each posted solid returns.
Our trend-sensitive indicators led us to reduce stock exposure in January and begin to build it back up in March. Since we bought at a higher price than we sold, this hurt performance modestly. Our key objective is to make sure we are on the right side of the big moves. Had the -11% decline early in the quarter persisted or turned into a 20% or 30% decline, we would have lost quite a bit less. When the market began to recover we had to become buyers to make sure we didn’t fail to participate if stocks rallied 20% or 30%. The process of selling and later buying, even if the buys turn out to be at higher levels, has the benefit of allowing us to sell weak relative performers (in January this was mid- and small cap growth stock funds and certain international funds) and eventually buy into areas with better relative strength (dividend payers and low volatility stocks).
The market clearly likes the idea the Federal Reserve is not going to increase interest rates for at least the next two months. Many strategists think the Fed is on hold for the rest of the year. It may be hard to justify current U.S. stock prices based on earnings or cash flow growth, but there is no questioning the fact that Fed induced momentum is currently positive. Moreover, many people who sold stocks late last year or early this year have missed the rally and are hoping for a pullback in order to buy. This is what has kept stocks from declining more than a percent or two over the last nine weeks. That said, bears are counting on the following factors to ultimately push stocks lower:
- Weak corporate earnings and falling future earnings expectations;
- Seasonally, late spring and summer are weak periods for stocks (especially in an election year);
- None of the remaining four U.S. presidential candidates is viewed as market friendly;
- Central bank policies to stimulate the various economies have shown little results other than to transfer money from savers to investors/speculators. Political developments in the U.S. and Europe strongly suggest that the public has lost patience with these policies.
The upshot is that in the very short term, technical and seasonal factors suggest that the upward trend continues. Looking toward the rest of this year, however, if people in the U.S. and Europe don’t start to see tangible signs of their economies picking up (i.e. higher wages, more interest on savings), they may force political changes that would not be market friendly.
Commentary – Let’s Play Twister!
We prepared for the worst three months ago as U.S. corporate earnings were set to fall for the fourth consecutive quarter and the rising dollar made the global market scenario even worse. In February action by the European Central Bank and non-action by the Federal Reserve completely changed the tone of the market. Whether or not this should have produced such a rally is beside the point – for the last six years investors have been rewarded for dancing to the central banks’ tune, regardless of what they think of the underlying economy. More than a few veteran market participants are concerned that this is not the way that investment markets ought to work and at some point central bank activities will lose their effectiveness.
U.S. stocks, as measured by the S&P 500, have done quite well over the last several years. In fact, they have more than doubled (counting dividends) since the summer of 2010. See Figure 3. The pattern is familiar. We rally for a few months in anticipation of an economic recovery but the recovery comes up short of expectations and stocks sell off. Each time, in the face of a slumping market and lackluster economy, the Federal Reserve has stepped in. As nice as this is for investors, one has to question whether this is the proper role of the Fed. There are some very sharp minds out there – John Hussman, Ben Hunt, Vitaly Katzenelson, and John Mauldin come to mind – who warn that central bank actions are not sustainable. At some point a market driven by price discovery and fundamental analysis, rather than central bank liquidity, needs to be restored. If not, investors have to allow for the possibility that there will be a time when the central bankers make a move and it doesn’t work. At that point, faced with dependence on an institution that has no arrows left in its proverbial quiver, we could be in for a significant decline. This is the basis for most of the dire warnings you see on the right margins of your internet browsing.
Until that day comes, however, if we want to keep up with the market we have to play what amounts to be financial Twister. Investment strategist David Zervos has been the most successful market strategist over the past several years by repeatedly telling us to forget the fundamentals and watch the central banks. The ECB is pushing rates further into negative territory? Left hand blue! Buy gold and global equities, sell the Euro and European bank stocks. The Fed has put interest rate hikes back on the table as early as June? Right leg yellow! Sell domestic and emerging market bonds, buy defensive stocks. It doesn’t matter what any individual security might be worth. Stocks, bonds, and currencies are all asset classes to be bought or sold as a play on what any particular central bank is doing. And incidentally, this is killing active value managers. You found a small cap auto parts company growing at 12% annually and trading at 10.5 times earnings? Nobody cares, unless the stock can get itself into an index that will rise on the “risk-on” trade the next time Janet Yellen says the Fed remains “on hold”.
It has always been our preference to have good fundamental support (either reasonable stock valuations or the expectation of higher earnings) when we buy stocks – as opposed to low interest rates and the promise of a friendly Fed, which is what we have now. U.S. stock prices, at over 20 times trailing earnings, are fairly expensive by historical standards. Investors really need to see a sharp earnings recovery to justify current prices, but so far companies are not indicating that this is likely. That encourages us to build in a little extra margin of safety in the form of a higher than normal cash position. We aren’t doing it because we think we know when the next market decline is coming – I can assure you that we don’t. We are doing so because the scope for investor disappointment seems unusually high. It’s a long way from here to normal valuations.
In the end it comes down to what you believe your role as an investment professional to be. If it is to squeeze every dollar of potential return from markets, then we certainly should follow Zervos and fully embrace the central bank following game. However, we tend to agree with Hussman, Hunt, Katzenelson and Mauldin that central bank policies are ultimately destabilizing and cannot last. Therefore, we believe caution is warranted. We have to take seriously each market decline (in other words, we sell stocks to raise cash at the margin – as we’ve stated in the past we’ll never move to 100% cash) on the thought that this time maybe Janet Yellen or Mario Dragi and the other central bankers have nothing left up their sleeves. If they do engineer the turn-around, then we’ll buy stocks back and suffer only modestly for our caution. That’s okay if its helps us avoid fully participating in a 2008 style loss. I believe this is what our clients are really looking for us to do.
Thanks for your continued trust in our management program,
Mark Carlton, CFA
 Total return as measured by the following ETF proxies: iShares Core S&P 500 (IVV), iShares Russell 2000 (IWM), PowerShares Nasdaq QQQ (QQQ). Source: YCharts.com
 Total return as measured by the following ETF proxies: iShares MSCI Emerging Markets (EEM), iShares MSCI ACWI ex US Index (ACWX), iShares Core MSCI Europe (IEUR) Source:YCharts.com
 Source: Morningstar Adviser Workstation
 Source: YCharts.com as measured by iShares Core S&P 500 ETF
 A game popular in the 1960s and 1970s in which players placed arms and legs on the colored dots as specified by a spinner. If you could not contort yourself in such a way as to touch the right dots, you were out.