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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.

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