Market Perspective for 10/9/16

October 9, 2016
Zach Desmond

Friday’s Unemployment Report

No surprises either way. Very little impact on the market’s narrow belief in a December hike. Doesn’t give either candidate an advantage going into the final month.

Thoughts on the Market

The U.S. stock market has mostly been treading water ahead of the election. Stock prices remain elevated, but without a negative economic surprise or a spike in interest rates they are likely to maintain these levels. Neither sell-offs nor rallies have been able to gain traction of late, though the recent upturn in rates has brought about a small downtick in P/E multiples. The all-time high was made on August 23; we have mostly chopped around within two percent of that level ever since. In a low growth, high leverage world, small movements in interest rates can become magnified. Markets overreact to market noise – a hint from a Fed governor, a comment by the head of the BOJ, ECB, or high ranking Chinese authority – but ultimately retrace those moves as they are revealed to be just noise.

It continues to be extremely hard to add value in an environment where time horizons have become so short. This past Tuesday I was at a CFA meeting where an oil industry insider discussed the current energy environment. He said that public (mutual fund and ETF) money was flowing into companies that had a higher percentage of their oil production in the Permian Basin and Eagle Ford fields, where the cost of production is lower. Private money, on the other hand, was going into the Bakken and other areas where the cost of production is higher but the cost per acre was so much lower. Later that same day I had a conversation with a mutual fund company representative about the tremendous value discrepancy today between higher yielding real estate investments (REITs) and lowering yielding real estate operating companies. Let’s call all of this the ETF effect, because it is a function of how lower rates have pushed up multiples on stocks and how ETFs have been the perfect vehicle to capitalize. Performance pressures on active funds have been so great that fund managers (and advisors) would rather gain a penny today at the cost of a nickel in the future, because if they don’t get that penny they might not be around to see the future.

All that said, as long as rates stay artificially low, chasing yield at the expense of underlying value is probably going to continue to work. The risk (and it is increasing) is that rates don’t stay low. Utilities gave back over 5% last quarter on a fairly modest uptick in rates, and REITs are off over 5% through yesterday[1]. Statistically, rising rates benefit value investing and active managers.

Thoughts on specific sectors:

Gold has sold off sharply on the breakout of the U.S. dollar. K. Prime Minister May has called for Brexit talks to begin in March 2017 at the latest. This broke a state of Brexit complacency (“it will take at least two years to sort out all the agreements”) that had prevailed since mid-July. The pound hit multi-decade lows today under $1.24. The dollar has smaller gains against the euro and yen. The belief is now that no matter who wins the U.S. election, fiscal policy (government spending) is going to replace monetary policy as the primary tool to stimulate the economy. I’m sure the Fed would be delighted if the pressure on it to lift the economy could be diminished.

“Assets can be very safe or very popular, but rarely both”[2]. The low volatility effect (low volatility stocks outperform high volatility stocks over time) was documented several years ago, but only recently has the market had the tools to really take advantage. Low volatility ETFs have been all the rage lately because they performed much better across every single equity asset class in 2015 – large cap, midcap, small cap, international developed, and emerging markets – and they continued to beat capitalization weighted benchmarks well into 2016. Not lately, see the three month chart below. The correction in defensive industries like utilities, consumer staples, and real estate that began in July has re-accelerated this month. The beneficiaries have been energy, financial services, technology and materials, each of which should benefit from a strong economy and mildly higher interest rates. This plays out more dramatically in the large cap value area. Some LV funds are very dividend-oriented, and others rely more on traditional value metrics like P/E and price to sales. For example, Dodge & Cox Stock (DODGX) and Invesco Diversified Dividend (LCEAX) are technically both large cap value funds. Both are up roughly 9% this year through September 30th. DODGX earned almost all of that (8.79%) in the third quarter, benefitting from over weights to Financial Services, Technology and Health Care. LCEAX made almost nothing in the third quarter (0.12%), since its only over-weights were to consumer staples and utilities. The market may look like its treading water, but knowing what you own can still be very important.[3]

EFAV: iShares MSCI Min Vol ETF, EFA: iShares MSCI EAFE, USMV: iShares MSCI Min Vol USA, IVV: iShares Core S&P 500. Source: YCharts.com

Knowing the percentage of your international fund that is in emerging markets can be very significant as well. Vanguard Developed Markets is up 3.95% though the end of September, while Vanguard Emerging Markets is up 16.20%. It should be no surprise then that American Funds Europacific Growth (22.4% emerging) is up 5.1% while Artisan International (1.4% emerging) is down -1.3%.[4]

TIPs are looking more interesting with the downtrend in inflation quite possibly over. Labor prices and commodities in the U.S. have appeared to have made a bottom. Even mildly upward inflationary pressure would improve the attractiveness of TIPs relative to regular coupon bonds, and trailing one month prices show this (ishares TIPS +0.06% versus Barclays Aggregate -0.36%).[5]

Given concern over rising interest rates (duration risk) and due to the effect upcoming changes in money market rules in the U.S. are having on LIBOR rates, floating rate debt might be in the sweet spot on the fixed income side right now.

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[1] Dow Jones Utility Average per Morningstar; Vanguard REIT Index ETF

[2] Marketfield, “Weekly Speculator” 10/06/2016

[3] Performance information per Morningstar

[4] Performance information per Morningstar

[5] Performance information per Morningstar