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Commentary

Thursday
Jan172019

Q4 2018 Commentary

At the start of the year, popular market punditry focused on rapidly growing earnings backed by massive corporate tax cuts, business-friendly government and coordinated global growth.  The resulting popular narratives emphasized the lack of risks to markets, convincing investors to bid up stock prices to multiples not seen since the tech bubble.

At the time, the underlying picture looked rather strong, but there is a limit to just how much speculation markets will handle. 2018 was a stark reminder that valuations matter, sentiment is fickle, and the Federal Reserve is a dominant market force.

Markets dealt with heightened volatility throughout the year (particularly relative to the abnormally calm 2017), but still managed to enter the final quarter of 2018 with equity prices close to all-time highs.  Unfortunately, by the end of December, markets had wiped out over a year’s worth of gains, posting the worst quarter since the financial crisis and closing clearly in negative territory for the first time since 2008.

Most of our concerns from the start of the year resolved themselves largely in the manner that we expected based on market history. 

The Federal Reserve raised their benchmark interest rate four times (more than was anticipated at the start of 2018).  The final hike of the year sparked a massive selloff, with the S&P 500 falling more than 9% in under four trading sessions.  A tightening Fed was always going to be a headwind – to economic growth, valuations or both. 

The combination of significant earnings growth and falling stock prices in 2018 meant that price multiples have declined significantly.  Last quarter, even at record highs, price multiples had declined notably, but this commentary noted that the multiple contraction was not yet at a healthy phase and warranted more concern.  The abysmal price action of the fourth quarter finally brought the type of healthy multiple contraction we had expected.

The December market collapse also resolved what had been a wildly optimistic sentiment imbalance.  At the January highs, the Investors Intelligence survey showed a 5:1 ratio of bulls to bears – a record high reading.  In other words, only one out of six believed that stocks would lose value over the year.  Even through most of the year’s volatility, that ratio remained above 2:1.  The December weakness finally brought about the type of sentiment washout we look for at market lows, with the first survey of 2019 showing the bull:bear ratio below 1 for the first time since the 2016 lows.

We have seen the extreme sentiment shifts not only in survey data, but in actual money flows. In January, as investors chased markets to record highs, equity funds saw their largest inflows since 2002.  In December, as rattled investors sought safety, equity funds saw their largest weekly outflows on record.

The contrasts between the start and end of the year could not be any starker.

Meanwhile, as investors were panicking and selling stocks at a record pace, corporate insider activity was persistently positive (they had been sellers at the start of the year).  When the public is selling and insiders are buying, we generally know which side of the trade we want to be on.

All of our managed accounts were well prepared to deal with this market environment.  We began the year with our largest cash allocations since 2007.  All strategies did some buying throughout the year, but by the end of the third quarter, we were back at our most conservative positioning since 2018 began.

All strategies bought heavily throughout December, ending the year at or near full investment.

Our patience was well rewarded.

Our options-enhanced accounts finished the year outperforming traditional accounts by almost precisely the amount earned through options premiums, meaning that, though there were some divergences in underlying performance each quarter, options accounts are very closely mirroring the overall performance of traditional accounts, with the added benefit of collecting those premiums – just as designed.  Most importantly, this strategy performed as expected amidst significant market stress.

Global, ETF based accounts could not fully escape the weakness of international markets, but they avoided the double-digit losses of global indexes.

All strategies are now at their most aggressive positioning since 2015.  Given the dramatic reversal in most data sets, we feel very comfortable with high equity allocations at this point.  Sentiment and price data in the final week of the year closely resembled recent market bottoms in 2009, 2011 and 2016.  Depending on the data set, you can also draw close corollaries to the 1987 and 2002 lows.

That does not mean that markets are out of the woods yet.  The type of volatility we have seen recently tends to portend more volatility, and we would not be surprised to see stocks retest their lows (perhaps more than once) in the first quarter of the year.  We also remain quite concerned about valuations.  P/E multiples have come down more than 25% since the start of the 2018 and closed the year at their cheapest levels since 2013, yet multiples remain historically elevated.  Any sort of strong rally from here would place stocks firmly in “expensive” territory once again. 

Against that fundamental backdrop, long term equity return prospects remain below average and risks remain elevated.  Our long-held belief that stocks could revisit early 2016 prices (about another 15% lower from here) is still well within the realm of possibility. With that in mind, we will likely be quick to sell into any considerable market strength, locking in gains and re-allocating to cash when prudent. 

As always, we encourage our clients to reach out to discuss how we can best balance our investment approaches to suit your needs, and thank you for your continued trust

Wishing you a happy and prosperous New Year,

 

Robert B. Drach

Drach Advisors LLC

Thursday
Jan102019

Q3 2018 Commentary

It was a strong quarter for stocks, with major indices setting aside their first half malaise and working back to the January highs.  The moves come against a backdrop of continued strong economic data and corporate earnings growth. 

Though stock prices are back at their highs, it is a very different environment from the January peak. 

Gone is the euphoric fervor that erupted at the start of the year, when sentiment measures across the board were at extreme highs.  That peak in optimism also came with a peak in price multiples.  At the January highs, the S&P 500 was trading at a trailing P/E ratio over 25.  The only other time in history that multiples climbed that high was in the early days of the tech bubble.

Even if you tried to factor in the benefit of tax cuts, the trailing P/E multiple was over 24 – still a tech bubble era valuation. 

Today, stocks are cheaper by most measures. Year to date, domestic stocks are up nearly 9%, but earnings are up even more.  This has allowed P/E multiples to fall nearly 8%.  Many are casting this price action as “normalization,” but the moves have been rather extreme by historical standards.  The last time stocks were able to advance this much in nine months with price/peak earnings multiples contracting as much as they have (all adjusted for tax cuts) was over a century ago (1916).

The only modern periods that come close to this performance: the end of 2006 (less than a year from the financial bubble peak) and mid-2000 (near the tech bubble peak).  In both cases, stock prices were rising, but earnings were rising faster – a combination that many interpreted as a “goldilocks” scenario. In each case, however, stocks would soon fall more than 45% – evidence that “normalizing multiples” do not tend to end in soft landings.  Looking at all past instances of rising real prices and falling multiples, future risks have been highly elevated.

Contrary to the popular interpretations, this type of multiple compression is likely to mark the beginning of the end of bull markets.

While this type of multiple erosion fits our broad view that the market is overpriced (no price/peak earnings multiple over 19 has been sustainable), there were reasons to be optimistic in the third quarter.  As we regained new highs, sentiment was nowhere near the euphoric levels from the start of the year.  More moderate sentiment tends to correlate with lower downside risks.

Among the most positive developments in the third quarter was a healthy rotation in market leadership.  Momentum stocks, which had led the market since 2016, took a back seat in the third quarter. As stocks reclaimed new highs, several other sectors had their turn with impressive relative strength.  From our standpoint, the most important shift in relative strength was a rotation into higher quality companies, which showed signs of outperformance for the first time since 2016.

This shift in market leadership was encouraging, but the trend had eroded by the end of the quarter.  At the end of September, major indices were hitting record highs, but only half of those stocks on our Master List of quality companies were up in the month. 

Further undercutting the record highs was the performance from financials.  The sector has lagged most of the year, but that underperformance accelerated as financials fell over 4% during the final week of the quarter.

Financials can be volatile and their lack of participation alone is not necessarily a poor omen, but over the past decade, these divergences have been concerning. On average, when the S&P 500 is near its recent high while financials are more than 4% off their recent highs, future risks are elevated across all time periods.  Average S&P 500 declines within the next quarter have exceeded 10%. This number is a bit skewed by peak financial crisis losses, but even median losses within the next have carried eight times the typical downside risk.

Even the economic picture, which has been rather unblemished, has been showing cracks.  Most notable is an emerging weakness in housing data – most of which seems to have peaked at the end of 2017.  Similarly, auto sales are well off of their levels from one year ago.  When both housing starts and auto sales are this far off their one-year highs, coincident equity losses have generally been larger than average, as have future drawdowns.  The last time we saw these two post such weakness (in 2010) stocks corrected more than 10%

It is important to keep perspective here.  Stocks closed the quarter near all-time highs, and most economic data is indicative of a strong underlying economy.  The small cracks, however, mean the future is perhaps the most uncertain it has been at any point since at least early 2016.

The rotation into quality stocks meant that core-strategy Time Overlay accounts posted their strongest quarter since the election.  All Time Overlay strategies, however, maintained large cash allocations, meaning that returns remain somewhat muted while we avoid the volatility of the market.

The options-enhanced version of our traditional approach managed to outperform for a third consecutive quarter. 

All strategies enter the fourth quarter at our most conservative positioning since the start of the year.

 

Robert B. Drach

Drach Advisors LLC

Thursday
Jan102019

Q2 2018 Commentary

For everyone who got excited in the first quarter (either pessimist or optimist), the second quarter was a bit of a dud. 

Broad markets improved on their first quarter performance, allowing the S&P 500 to close the first half up 1.67% – a far cry from last year’s first half gain of 8.24%.  The Dow, meanwhile, closed the first half in negative territory (-1.81%), its worst H1 since 2010.

There were bright spots, with the tech-heavy Nasdaq and the small-cap Russell 2000 posting solid gains. There was also weakness, with foreign stocks falling more than 5%, led by emerging markets, which lost 10%.  As a whole, global stocks (inclusive of U.S.) are negative for the year (like the Dow, the worst start since 2010).  To add to the sources of pain, bonds remain a losing bet for the year as well.

What may be most striking to investors so far this year is the massive disconnect between the perceived strong domestic fundamentals and the weak performance from equities. 

Corporate earnings are growing at a substantial pace, where underlying fundamental growth is being supplemented by large corporate tax cuts.  Economic growth is accelerating.  Unemployment is low.  It is hard to find anything tangible to be negative about.

Yet market performance has failed to track these fundamentals.

In trying to draft a narrative, the most popular media culprit for this disconnect is the threat of trade war.  It is true that tariff announcements have coincided with many of the selloffs of the first half.  Trade protectionism is certainly a friction to global economic growth, but it is not clear that the state of trade conflict alone is significant enough to justify the duration of this pullback.

Instead, the difficulties in the markets likely extend to the one thing that we have been repeatedly discussing the last couple of years: valuations.

Valuations reached a new extreme in early January, hitting multiples last seen during the tech bubble.  The negative price action since the January highs, combined with rising earnings, has allowed valuations to normalize to a significant degree. On a trailing P/E basis, the S&P 500 is about 15% cheaper than it was at the highs. Despite the decline in multiples, stock prices remain extended by virtually every measure.

While we do not believe that tariff threats are the fundamental cause of the decline, they were a clear catalyst in the sense that they created a wrinkle in the unrealistic, unblemished expectations markets held in January – the types of expectations that allow multiples to rise in the first place.

We have argued that, at points in this rally, stocks were “priced for perfection.”  With massive corporate tax breaks on the back of an already strong profit picture, things were going about as perfectly as they could.  And while there are few blemishes in the current economic and profit performance, there are emerging flaws in the outlook.  That is where trade tensions have come in. They have cast a cloud on the sunny forecast. 

It is not only tariffs. Economic data was crushing expectations at the end of 2017 at the best pace in over five years.  Expectation beats, however, are generally followed by even higher expectations. At some point those expectations become too high, and by the end of the first half, the Citi Economic Surprise Index was negative following a stretch of disappointing data.  The data is still positive, but it is failing to meet expectations.

Market corrections do not generally wait for negative data, they look for cracks in the narrative.  The loftier the valuations are when those cracks emerge, the more downside markets have.  These are the risks we were dealing with at the start of the year, and though valuations have come down a degree, they remain historically high.

Our preferred valuation measure shows stocks to be trading at a 10% premium to the most expensive sustainable market in history (that is after adjusting for tax breaks).  And while it is always possible to set a new paradigm, there is plenty of evidence that higher valuations are correlated with lower long-term returns. 

In fact, if you look at just about any study trying to link today’s valuations to future risk/reward projections, U.S. equities are firmly in the wrong quadrant – signaling above average risk and below average returns. If you focus only on U.S. Growth stocks, the picture is even worse.

Because of these widespread valuation issues and the risks of tightening monetary policy, our default approach continues to be cautious.  After restrained buying in February, we have maintained a limited equity position.  As we enter the second half, however, we are more likely to sell into strength and again raise additional cash.

Despite our caution, there are some positive signals out there.  Out-of-favor quality stocks, our preferred value vehicle, had largely been left behind in recent rallies.  The end of the quarter, however, saw some long-overdue outperformance from many of these names.  Though there is a long way to go, some normalization between momentum and value strategies is a constructive sign.

We would certainly like to see some orderly normalization, but this market has already shown that it may not reward such hopes.  We cannot forget that the rapidity of the plunge earlier this year broke nearly 100 years of precedent – further evidence that restraint is prudent.

As we move towards the second half, we will continue to await prudent entry points, which have largely eluded us at recent price multiples.  We are in a period that suggests equities may carry historic risks, and our short-term focus is on the preservation of capital.

As always, we encourage our clients to reach out to discuss how we can best balance our investment approaches to suit your needs.  Thank you for your continued trust.

 

Robert B. Drach

Drach Advisors LLC

Thursday
Jan102019

Q1 2018 Commentary

We entered 2018 holding more cash across all strategies than we have at any point in over a decade. 

Last quarter’s comments outlined a laundry list of excesses in the market – most of which were also at their most extreme levels of the recovery. 

Over the first three weeks of the year, virtually every extreme that had previously concerned us only grew further untethered from norms. 

Things changed rapidly.  It began with a 1000 point down week for the Dow – a fall in excess of 4%.    The decline was initially minimalized in the financial media, but only took a few more trading days for stocks to fall a total of 10% from their highs. 

The rapidity of the decline was notable but was widely framed as a “typical correction.”  This characterization, however, included a major, underreported oversight:  stocks fell this rapidly from all-time record highs – something that most serious market watchers would have told you doesn’t happen.  In fact, many seasoned market veterans, even those who believed markets valuations were stretched, found solace in this common wisdom early in the year.  There was a popular belief that once markets topped, there would be plenty of time to get out. 

The historical record was supportive of this belief, as virtually every major decline (1929, 1987, 1974, the tech and financial crashes) all began with more modest reversals.  The last time stocks fell this far this fast from record highs was in 1919.

This belies and important point: unique and unprecedented markets (like last year’s rise), coupled with unique and nearly unprecedented valuations were highly likely to be accompanied by unique and nearly unprecedented risks. 

The problem often lies in anticipating exactly what these risks are.  There is a common belief that the inability to predict and identify risks means that investors should not try to adjust their investments based on perceived risks.  History tells us, however, that there are many predictors of future market risk, including high valuations.  And while there is no precise tool for determining exactly when equity markets will peak or exactly what the risk-drivers will be, there is a blunt tool we can use to protect ourselves: cash.

Despite the pullback lasting nearly two months, we have only employed a limited amount of our accumulated cash positions.

Recommitting capital here is always a gradual process that requires the correct alignment of data and prices.  The volatile price action has meant that entry points have been short-lived, while other data sets, such as sentiment, have failed to fully support increased exposure.  Meanwhile, global accounts, which adapt to changing market environments, have raised their threshold for further investment in this market due to the volatility spike – preventing an accelerated entry.

There are plenty of technical reasons that we are being cautious getting back into the market in the short run, but they align with some longer-term concerns. 

First, of course, are valuations. Stocks have provided the perfect mix of rising earnings and falling prices to make equities their cheapest since July of last year (after adjusting for tax cuts).  Even with those adjustments, however, earnings multiples remain at historically unsustainable levels.

In addition to valuations, we are dealing with rapidly rising interest rates, which both slow growth and erode a primary argument for the high valuation multiples mentioned above.  In late March, 1 month Treasury bills were yielding nearly 40 basis points more than 10 year Treasuries had been yielding in July 2016, and were yielding only 30 basis points less than where 10 year yields were just last September. It is the fastest relative pace of tightening since 2007.

Finally, there is the fact that rapid pullbacks from record highs are not generally good buying opportunities.  Similar pullbacks in 2000 and 2007 proved to be great short-term trading opportunities, with stocks reaching new highs within months. But both drops ultimately presaged significant market tops.  In other words, even if stocks regain their January highs, it is not an all-clear for investors. 

Even if we are not in the midst of a major market reversal, corrections on the order of what we witnessed in the first quarter often take quite a while to sort themselves out.  Initially months, but often years before stocks are setting new permanent highs.

Though we added to our equity allocations in the first quarter, our investment activity was rather limited (domestic strategies targeting close to 33%, global strategies, 25%).

We were much more active in launching our options-supplemented domestic approach.  Options-enhanced accounts began trading in early February.  These first months of live-investing have gone as expected while alleviating some concerns with execution and options market liquidity.  We hope to significantly expand this strategy in the quarters ahead*.

Beyond our options strategy, we have expanded use of our Global ETF based approach, which outperformed domestic approaches for the quarter.  This strategy remains best suited for small accounts and as a great diversification tool for clients already employing our traditional approach.

We continue to look to ways to optimize client returns, while remaining prepared for what is likely to be a volatile road ahead.

 

Robert B. Drach

Drach Advisors LLC

Thursday
Jan112018

Q4 2017 Commentary

2017 was an extraordinary year for the stock market. 

The gains were strong, but not exceptionally so (it was the 11th best year of the last 30).  Rather, it was the path that equities took that was remarkable.  Stocks began the year positive and never looked back.  The S&P 500 was never red for the year, rising every single calendar month for the first time in history.  The index never saw a pullback greater that 3%.

It did all of this in the face of Fed tightening and high valuations. Though we repeatedly describe these two data points as headwinds, markets rising in this type of environment is not wholly atypical.  Historically, even if stocks are bucking these headwinds, we have been able to participate on some meaningful level.  Looking back to 2016, for example, despite our underlying caution, we were awarded multiple buying opportunities, which spurred double-digit returns in our traditional accounts. 

 This year, however, there were no such opportunities.  Rather than attempt to chase markets higher, in the absence of opportunities we prefer to do what the fundamentals tell us in such an environment: eschew market risk.  The reason that we take this approach is because, as historic as the moves seem, rising prices at this stage also come with historic risks.

Virtually every metric that had us cautious going into the year is more extreme today.

 We can start with valuations.  Our preferred valuation metric, price/peak earnings, started the year just over 21 and closed the year 11% higher, north of 23.  In other words, more than half of the gains this year came from multiple expansion rather than actual earnings growth.  Another word for multiple expansion at these levels: speculation.

 It is not hard to argue that tax cuts could make up for that 11% going forward, but we take two issues with this valuation boost.  First, this is piled on top of already lofty valuations – levels that have only been reached in 1929, 1965 and 1997 – that have always been followed by a lost decade (or more). The other issue is that It is tough to argue that earnings from tax cuts deserve to be priced at the same multiples as organic earnings.

Beyond valuations, our other major concern has been rising interest rates and tightening monetary policy.  On this front it was also a pretty remarkable year, with the Fed managing to create real separation from a zero interest rate environment.  This feat has been difficult for central banks around the world going back to the 1930s, often ending in recession.  2-year Treasury rates have risen tenfold since their 2011 lows and are 50% higher than they were just a few months ago, but markets have not flinched.

At the same time, the Fed has begun reducing their balance sheet, which is flirting with 2014 levels.   

It does not look like the Fed will be much more accommodative in 2018, as they are forecasting three rate hikes, and market expectations aren’t far behind.  With the two most dovish FOMC members from 2017 rotating off the voting committee, the tone is likely to be more hawkish, not less.

In addition to the larger forces, much of the other data we track took a cautious turn at the end of the year. 

Sentiment data reached extremes.  The AAII sentiment survey rose sharply, with nearly 60% of investors expecting stocks to rise.  This number had been relatively suppressed most of the year, but skyrocketed in recent weeks.  The two closest analogs: July of 2000, just months before the tech bubble peaked, and September of 1987, one month before the ’87 crash.  The median net decline after such bullish readings is 39%, versus only 9% in all other environments. Another popular sentiment survey from Investors’ Intelligence (this one of newsletter writers) has consistently shown bulls outnumbering bears 4:1 in the last dew weeks – levels not seen since 1987.

It is not just talk. Investors added more money to stocks the final week of the year than at any other point in three years.  According to the Federal Reserve, more investor money is tied up in equities than at any point since the tech bubble – a reading backed up by the AAII’s allocation survey.  Oh, and it is fueled in part by record high margin debt.

This type of optimism has never before been sustainable.

On top of all the retail euphoria, specialists closed the year heavily shorting the market and corporate insiders started the year selling. We generally do not want to be on the opposite side of these insiders.

In the face of all this data, all of our managed strategies are targeting cash allocations over 80% – the highest of the recovery. This means that we will only have limited exposure to short term gains, but that does not mean we will be left behind. By limiting our market exposure and positioning ourselves to take advantage of a market decline, we are going by the playbook that has made our approach successful for the last forty years. 

The last time that stocks closed the year at valuations this high, Time Overlay accounts lagged in the short run, but outperformed the S&P 500 by over 90% over the next five years*. 

By sticking to our core principles, we believe we remain well suited to maximize client returns while minimizing the market risks that lie ahead.

Despite confidence in our core philosophy, we continue to adapt our applications.

In the past, Time Overlay has opted for cash substitutes in times of caution. In recent years, however, cash substitutes have provided historically low returns.  Prior to 2017, this low return was not very consequential, but was significant this year, as it was the first year where we continuously held large cash positions in a low rate environment. 

As mentioned last quarter, we are taking this environment as an opportunity to explore methods of enhancing client returns.  We hope to begin employing conservative options strategies, including selling covered calls and cash-secured puts in eligible accounts†.  These income-producing strategies can be used in a way that enhance returns while closely following our traditional approach.

We are also working to expand the use of our ETF-based global equity approach.  This approach has been used for over ten years in various functions for our clients, most widely among smaller accounts. 

Our global approach has adapted to the changing ETF landscape over time, and in 2015, we re-tooled the portfolio construction process (we have not altered the core strategy). After two years of implementation, we are prepared to make this approach fully available to all clients. 

This global approach has shown similar risk metrics to traditional Time Overlay over time.  In low investment environments, such as in 2017, it has shown itself to carry less risk.  In fact, despite closing the year with more than 80% allocated to cash, global accounts returned over 5% this year, with less than half of the volatility of our traditional approach. Including backtesting, this approach has outperformed its benchmark with 30% less volatility*. 

Though both our traditional approach and global approach are based on very similar fundamentals and track similar cycles, variance among returns means that a combination of the two approaches is likely to provide smoother returns over time. 

As we look to optimize client returns going forward, I encourage all clients to contact me to discuss whether expanding the scope of their investments is suitable.     

Wishing you a happy and prosperous New Year,

Robert B. Drach

Drach Advisors LLC

 

†Options strategies require custodian approval and an account balance over $400,000.

*Returns reflect the equal time-weighted account performance for accounts that have not deviated significantly from the core Time Overlay strategy, and may include performance under previous advisors. Performance results have not been audited by a third party. Performance and holdings of other accounts pursuing the same strategies may vary. All performance is based on data provided to the preparer by advisors/brokerages that have applied the technique and is believed to be accurate. All efforts are made to assure its accuracy, but no guarantee is made by preparer. Past Performance does not guarantee future performance. No Representation is being made that any account will achieve profits or losses similar to those shown.