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Commentary

Monday
Apr182016

Q1 2016 Commentary

In our last quarterly commentary, we noted how little prices changed in 2015, despite some of the interim chaos.

This quarter was no different. 

Twelve trading days into the year, 2016 was off to the worst start in market history.  The pace of decline slowed, but stocks continued to fall into the second half of February. 

Along the way, the major averages crossed the 200-day moving average, turning most of the technical trading community bearish.  Couple the price action with the resurgence of storylines from last Fall (China, oil, manufacturing), and panic spread quickly.  

By the end of the quarter, however, the S&P 500 had managed to put together a net gain of 0.77%.

If we take a distant view of things, it is easy to view the moves as just another correction driven by a growth scare.  Stocks reversed course and we can seemingly put it behind us.

Those of us who dealt with it on a daily basis, however, witnessed some pretty historic moves that should not be overlooked

The stock market saw a relatively swift correction. Though it was widely sensationalized, in a historical context, the price action never looked too ugly.  Equities were down just over 10% on the year at their lows, and only 14% off of all-time highs.  This may have seemed dramatic compared to the mild pullbacks of recent years, but since 1950, stocks have spent nearly 40% of the time in correction territory.

While the stock moves were actually quite mild, the action in market internals and fixed income reflected historic levels of panic on par with the financial crisis.

Looking at sentiment surveys (which are admittedly unscientific, but quite telling at extremes), we saw bullishness fall below the readings from the financial crisis lows.  Keep in mind that the low bullish readings from March 2009 precisely coincided with the market lows.  When we broke below those levels in January, the sentiment surveys were largely written off by pundits despite flashing a clear buy signal.  Stocks would only decline another 3% before bottoming and posting one of the biggest quarterly comebacks in history.

It wasn’t just the surveys that reflected panic.  You could also see it in investors' actions.  The pace of withdrawals from equity funds was the most dramatic since 2008. Put/Call ratios reached an extreme on par with the Lehman Brothers collapse, and Treasury Yields, which fall as money seeks safety, saw their steepest decline since 2011.

There has been much autopsying of the panic, but judging from fundamentals, market headlines, and ephemeral correlations, we can draw some significant conclusions.  There were three widely cited catalysts: market turmoil in China, collapsing commodity prices, and a strong dollar.  All of these had brief correlations with stock prices, which helped create and reinforce narratives.  The most notably persistent has been the correlation between stocks and oil prices, but belief that this correlation will continue is based on little more than faith.  As with Chinese stocks and the dollar, there is virtually no long term historical correlation between equities and oil prices. All of these factors posed some real headwinds, but none justified the domestic equity response.

Because the United States remains a net oil importer, we still believe that lower oil prices are stimulative in the intermediate term.  Shorter term, however, the massive decline in oil prices led to the deterioration of secondary data that, to some, indicated a recession was imminent.  Among that data was corporate profits, credit spreads, and manufacturing data.  All of these indicators have the potential to signal economic/market woes, as they have in the past, but this time, all were heavily skewed by the energy and commodity space.

Earnings for the energy sector were virtually wiped out over the last year, drawing down S&P 500 profits more than 15% below their 2014 highs.  The earnings weakness was widely reported, most often ignoring the fact that earnings outside the energy space were holding up quite well.  The same went for credit spreads.  Junk spreads skyrocketed – a move typical of widespread economic weakness, yet almost all of the worry came from the energy sector.  Credit spreads elsewhere climbed, but only modestly. 

Finally, the strength of the U.S. dollar was genuinely dragging on corporate profits abroad, but major currency moves that dramatic are more often than not unsustainable.  Even if they were, as mentioned above, earnings outside of energy were holding their own, despite currency effects.

Heading into the year, a growing portion of the market was already increasingly cautious.  Much of that caution, including our own, was based on legitimate data such as valuations and Fed tightening.  Once the technicians joined the bearish crowd, there was little optimism on the punditry front.  Add on the headlines above, and it is not too surprising that markets grew quite anxious. 

Though we entered the year in the cautious camp with a large cash allocation, we were prepared to take advantage of market volatility.  While the rest of the market was panicking, we saw plenty of reasons for an optimistic short term outlook.

At the top of the list was the excessive pessimism noted above.  We do not like to place too much emphasis on one data set, but when sentiment reaches the extremes we saw earlier this year it is a very strong contrarian indicator.  Beyond sentiment, we were also seeing continued growth in virtually every economic data set that excluded energy and commodities.  The jobs market was particularly resilient, allaying any recession concerns.  While the public was selling, corporate insiders were buying, further boosting our confidence.  Finally, even our biggest fears were somewhat relieved as valuations came back down to more reasonable levels and the Fed showed it would be receptive to market volatility. 

On the back of this data, we put most of our cash to use, targeting ~90% equity exposure.  By allocating this money to some of the most discounted areas of the market, we were able to capitalize on irrational market fears.  

After benefitting from a dramatic turnaround in stocks, we are again raising our cash levels.  Traditional Time Overlay accounts now hold more cash than we did at the start of the year, and our target investment levels are even lower.  In other words, for most clients further sale proceeds are unlikely to be reinvested in the current environment.  Global accounts are more heavily invested but are similarly in cash raising mode. 

Last quarter we predicted that 2016 would be challenging for investors.  It has more than fulfilled those expectations, whipsawing momentum investors and spreading fears to most corners of the market. Even though things seem back to normal, the volatility has had lasting paralyzing effects as evidenced by continued low levels of optimism and low treasury yields. 

While some may feel that the worst is behind us, the rest of the year may not be any easier as we are back at unsustainable valuations.  

Earnings are currently sitting about 15% below all-time highs.  In similar earnings environments we have only seen valuations this high from 1997-2001 and briefly at the end of 2003.  Both times the market subsequently crashed, taking out these levels.  While this may sound like a call to sell everything, it is also worth noting that after reaching such lofty valuations, stocks rallied nearly 50% before peaking. 

While we are not in the business of taking that type of risk, we are not in a rush to liquidate our portfolios.  After all, there are plenty of positives out there.  Domestic economic data remains resilient.  The Fed, though they are attuned towards tightening, has proven to be patient.  And despite recent price gains, equities still have quite a wall of worry to climb (approximately $80 billion has fled the market since the 2015 highs). 

As it was going into the year, our plan is to be more conservative, but not be afraid to capitalize on volatility and pricing dislocations. 

Our approach heading into the year was to own a portfolio of stocks that yielded more than the market and traded at a notable discount to the market.  These were the same types of names we continued to accumulate into the February lows, and the same types of names we will be eying in the face of any future pullbacks.

In the meantime, we must inoculate ourselves from the anxieties of being in or out of the market.  We bore the brunt of investor pessimism early this year, and it paid off well, but we cannot ignore the major headwinds posed by the Fed and valuations.  We will remain patient.

 

Robert B. Drach

Managing Member

Drach Advisors LLC

Friday
Jan152016

Q4 2015 Commentary

Depending on where you look, things haven’t changed much in the past year.

In the world of equity prices, the S&P 500 declined by an insignificant 0.73%. 

The big story of 2015 could be said to be the first Fed rate hike in nearly 10 years – but even the Fed Funds rate does not look much different than it did a year ago – sitting at a very low effective rate of 0.36% (versus 0.12%).

Allocation-wise, managed accounts look very similar to the way they were positioned at the start of 2015 (though we generally have a bit more cash on hand).

The headline numbers, however, mask what was quite an interesting year, and a particularly exciting 2nd half.

We began last year with a sizable cash position.  By the end of the first half, it had grown to our largest cash position in over two years (the second largest since 2007).

In late August/early September we witnessed a brief crash in equities, which resulted in the worst quarter for U.S. stocks since 2011.  It also provided an opportunity to put our cash to work, and we entered the fourth quarter with all accounts targeting full investment.  As the short term probabilities suggested, stocks recovered sharply from their late summer swoon, allowing us to capture a fair amount of gains before the December Fed meeting. 

The Fed’s policy shift seemed to play out smoothly in the markets (there was some volatility, but nothing too dramatic). This can be credited to an effective PR campaign to clearly telegraph the FOMC’s intentions.

Whether liftoff from zero-interest rate policy is truly successful or not remains to be seen.  Regardless of the fate of the current hiking cycle, 2015 will long serve as a case study in central banking.  It also marked a fundamental shift in our investment approach.

Since the Fed began easing in 2007, we have maintained above average market exposure – spending most of the past eight years at or near full investment.  Exceptionally accommodative monetary policy in the United States has always resulted in dramatic bull markets, and this cycle – nearly seven years long, with stocks more than three times higher than their financial crisis lows – has been no exception. Given the magnitude of stimulus, we had hoped for even more dramatic results, but the rally has been historic. 

The Fed, however, is now tightening,  This shift brings an end to the high probabilities that have been driving our investment philosophy for years.  With the monetary infusion cycle now officially over, we will continue to adjust to lower base investment levels, and we will see more variability in market exposure as dictated by standard cycle data. 

This is not a call for pessimism.  The Fed funds rate remains low, and the Fed’s commitment to data dependence likely means they will take a very measured approach to future hikes.  We can simply no longer rely on the residual effects of monetary easing at home, and we also cannot fully trust the Fed to not overshoot their goals.

While the Fed simply becomes another data set, our greatest source of apprehension comes from valuations.  We first became concerned with valuations in the summer of 2014, while noting that stocks can remain expensive for prolonged periods (often testing the logic of “rational” markets).  Since first entering warning territory 18 months ago, stocks have gained a meager 3%.  While there is potential to climb much higher temporarily, probabilities suggest lower returns over the next decade.

Maximizing returns going forward will involve significantly more patience and discipline.  Buying quality stocks in weakness and reducing exposure into strength.  While it would be great to assume the current bull market can continue unimpeded, we must follow the data.  

2015 was a great dry run for what lies ahead.  Looking back at the year, we put forth a lot of effort to stay in place.  We anticipate future discipline to be more rewarding, but patience and adhering to time-tested strategies will be key.

Difficulty and frustration with the current market environment was widespread, with 75% of large-cap fund managers lagging their benchmarks for the year. A fair amount of this difficulty stems from some significant divergences in the market, which has been led by a small group of stocks.  In a year of worryingly high valuations, value stocks only fell further out of favor.  S&P value stocks declined more than 3%, while S&P growth stocks gained more than 5%.  Of those 5% gains, virtually all were driven by only four stocks – whose average P/E ratio is over 300.

Despite these concerns, there is still plenty to be optimistic about.  The domestic economy continues to grow.  Employment numbers have been remarkably resilient, with weekly jobless claims below 300,000 for 43 consecutive weeks – the longest streak since records began 49 years ago. 

Individual investors still hold a fair amount of cash, and the AAII sentiment survey showed the most “neutral” responses in more than 12 years.  High uncertainty from the public has traditionally been quite positive for future stock returns.

In order to balance longer term concerns with some of the more positive data, we enter 2016 with a fair amount of cash on hand, though all accounts remain more than 50% invested.  That exposure is heavily tilted towards higher yielding discounted stocks.  Of our twelve largest stock positions, the average dividend yield is more than 40% higher than the S&P 500, while the average P/E ratio is more than 25% below the market as a whole. 

Our global, ETF based accounts, after a more difficult 2015, are taking a similar stance, with a nearly identical value profile.

2016 is setting up to be another frustrating year for many investors, but I am looking forward to working hard to protect our client’s capital while prudently taking advantage of volatility ahead.

Wishing you all a happy and prosperous New Year.

Robert B. Drach

Managing Member

Drach Advisors LLC

Wednesday
Apr082015

Q1 2015 Commentary

At the core of our investment approach is a series of data sets. 

These data sets largely fall into three categories:  those that deal with market fundamentals, those that track investor sentiment/behavior, and those that deal with market structure (how are assets being allocated, and by whom).

Certain indicators have more predictive power over shorter time horizons. Others are more predictive long-term.  Generally, any one data set contains a fair amount of noise, meaning they usually cannot be used on their own.  That is why we analyze them as a group.  There are rare occasions, however, when certain data sets reach extreme levels that they alone can be associated with high probability market moves.  Even less often, these data sets can tell us with high probability what we should expect over multi-year time horizons.

Today, we are dealing with two such data sets: the Federal Reserve, and Fundamentals (valuations).

Federal Reserve policy has been historically accommodative for nearly seven years.  The Fed funds rate is near zero, and the balance sheet of the Federal Reserve has quintupled to over $4.5 trillion.  The effects of monetary stimulus from the Fed have been evident in the tripling of stock prices and the outperformance of the domestic economy versus other developed countries (where less accommodative global central banks are now playing catch up).  This monetary stimulus has the ability to resonate in the economy for years to come.

We adhere to the axiom that you do not fight the Fed.  Our belief in the power of the Fed (in conjunction with fiscal stimulus) to inflate equity prices has been a driving theme in our investment approach since the Financial Crisis. Every time you have seen such coordinated stimulus in history the result has been dramatically higher equity prices. Adhering to this data set allowed us to participate in the recovery at a time when pessimism prevailed and money was flowing out of equity funds. 

While Federal Reserve policy remains accommodative, tightening is on the horizon.  Though they are unlikely to do so, the Fed has not ruled out raising rates at their June meeting.  This means that it is possible that we will be discussing the fallout of a rate hike in next quarter’s comments.  The narrative that is being pushed by the Fed (and becoming widely accepted) is that any hike in rates will still leave Fed policy in the “accommodative” category.  That may be true, but we are facing an inflection point from zero-interest rate policy.  When that inflection happens, risks will be to the downside – a lesson we learned in 1937 (a lesson also learned by Japan and Sweden in more recent history).  Even if we avert the worst (which the Fed is trying/hoping to do), we will no longer be able to count on the positive probabilities we have seen the past several years.

As one rare data extreme is set to fade, another one is emerging.

Domestic equity valuations are now at extreme levels. 

The common wisdom is that stocks are only slightly more expensive than their historical average (using a trailing 12 month price/earnings ratio). 

Unfortunately, the “historical average” of P/E ratios is largely meaningless.  The numbers must be looked at in terms of the market context.  High P/E ratios are generally in place when markets are anticipating significant growth ahead, but we are already near record highs in both earnings and stock prices.  It is very difficult for stocks to continue strong performance from these levels.  Historically, any rally from similar values for record earnings has been fleeting, with gains ending in a major crash and longer term returns languishing over the next decade or more. 

With two high probability long term data sets telling very different stories, we must carefully decide where to go from here. 

Valuations are worrisome, but the last two times that markets were commanding these types of prices for record earnings, stocks rallied considerably higher for multiple years before crashing.  We prefer to be anticipatory than reactionary, but there is no sense to panic at this juncture.  The downside risks, however, are enough for us to be holding at least 20% of client assets in cash across all domestically focused accounts (global accounts remain more heavily invested based on relative valuations).

Our next steps will be largely Fed/market dependent.  The Fed’s next step is likely to be heavily dependent on market expectations/reactions.  The Fed has telegraphed their willingness to raise rates, and any continued resilience in equities will strengthen the Fed’s case that markets can handle a policy shift –bringing the date of liftoff (and higher downside risks) closer.   We will likely take any notable market strength from this point forward as a selling opportunity to lower our equity exposure.

The first quarter gave us plenty of lackluster economic data, yet stocks managed to finish the quarter basically unchanged.  If economic weakness persists and equities see further losses, it likely implies that the Fed will keep interest rates at zero for longer, which would encourage us to put some of our cash to work.

Our shorter term data has been largely neutral throughout March.  Seeing an alignment of the short term data with either the Fed or valuations will be the impetus for our next move.  

Tuesday
Jan202015

Q4 2014 Comments

For over six years now, our equity allocation has largely been predicated on a belief that massive monetary and fiscal stimulus would result in dramatically higher nominal equity prices.

This phenomenon, which we call a “monetary infusion cycle,” has only occurred a few times in modern history, but each instance has had similarly dramatic results for the stock market: +370% over 5 years after the 2nd New Deal, +129% over 4 years after World War II, and +295% over 8 years in the 1990s (this excludes the bubble peak in 1999-2000).

Alongside gains in equities, such stimulus also has broad but variable macroeconomic effects, generally resulting in some blend of productivity (GDP growth) and inflation.  Despite the impressive run in stock prices in 2013, GDP and inflation had been rather muted.  This lackluster economic performance, combined with the end of the Fed’s quantitative easing program (which we have contended did not qualify as “tightening” policy), set up 2014 to be the biggest test of the monetary infusion cycle theory since 2009. 

And it passed.

A notable characteristic of the final phase of a monetary infusion cycle is a broad, smooth ascent in equity prices.  Despite a few scares, 2014 continued the trend that began in late 2012, setting new records without seeing a 10% correction.

Despite widespread fears that the tapering of bond purchases by the Fed would cause skyrocketing interest rates and falling stocks, the exact opposite happened.  Despite fears that we were stuck in a period of secular stagnation, the U.S. posted its strongest year of job gains since 1999, and the past two quarters were the strongest in terms of GDP growth since 2003.  The labor force participation rate has held steady for over a year, while unemployment has dropped 1.4% in that same timeframe.

One of our only fears going into 2013 was the drag that the “sequester” would have on GDP growth.  While on the surface it did not appear to do any damage, we have now seen an acceleration in economic growth since government spending again began adding to GDP in 2014.  Many of the domestic macroeconomic headwinds seem to be behind us, and easy monetary policy can continue to echo through the economy for years.  This is certainly a positive, and the domestic economic picture is likely to be the most significant factor in future equity gains. 

The next most significant catalyst to any upside move will be sentiment.  Investor sentiment can be gauged a few ways, including investor surveys, percentage of wealth in stocks, and stock valuations.  Via all of these measures, investors are more confident in equities than they have been at any time during the recovery.  Such optimism has a tendency to result in a feedback loop of higher prices and higher confidence, which can persist for years (though it tends to end badly). 

While we know the two most likely drivers of a positive market, we must keep in mind that the stock market is not the economy and sentiment can polarize rapidly.  So while the combination of the two can make for some convincing headlines and dramatic price increases, equity gains based on either are tenuous.  Sentiment shifts are self-explanatory, but we have to remember that stocks tend to anticipate future economic moves.  If one is awaiting signs of an economic slowdown before shifting their equity allocation, they are likely to be too late.

Last year, our traditional (domestic) Time Overlay accounts began the year rather conservatively because of a build in short term negative data, though our long term view was notably positive.  This year we are starting with an almost identical equity allocation, but this time, it is the long term data that has us becoming more cautious.

Of the three positive drivers we were eyeing at this point last year, none are negative, but the positive probabilities associated with them are now in flux.  As mentioned above, the macroeconomic data is unflinchingly positive (though economic shifts are generally tough to predict), but the other two factors: The Fed and public cash on the sidelines are no longer sure things.

The market expects the Fed to begin raising interest rates as soon as late April.  While the long term effects of near-zero interest rates could persist for some time (years even), once the Fed begins tightening policy, the probabilities of further market gains decline notably.  There is a historical tendency for equities to rally well into a Fed tightening cycle.  That could certainly be the case again this time, but the only time we have tried exiting a zero-interest rate environment (1937), things did not go well.  Because of the conflicting data, rather than turn our outlook negative on rising rates, we will simply declare the infusion cycle over. The Fed will go from being the cornerstone of our thesis to merely one of several data sets that we follow.   Though the market consensus expects rate hikes in mid-2015, it remains possible that a dovish Fed could continue to push back hikes into 2016 – so there is no need for investors to act too quickly in anticipation of future monetary policy.

Another major driver heading into 2014 was public cash on the sidelines.  After years of withdrawing money from equities, the public began buying aggressively in late 2012.  Funds continued to flow steadily into the stock market throughout 2013 and the first half of 2014, but since then the pace has notably slowed. 

This coincided with a significant shift in sentiment.  Throughout the recovery, investors have been very skittish.  At new highs, investors have been very bullish and adding significant amounts of money to stocks.  During pullbacks (and remember, all pullbacks since 2012 have been quite small) investors were quickly turning negative and withdrawing money.  The 2nd half of 2014 gave us two pullbacks, but the reaction was notably different.  In neither instance did sentiment turn negative.  So when investors are admittedly optimistic, but are adding fewer dollars to the market, it could be a sign that the “cash on the sidelines” is running out.  It could also simply be a reflection of strong performance in bonds luring money into less risky assets.  Only time will tell, but with considerable inflows behind us, probabilities going forward are less favorable.

While positives wane, one significant risk indicator continues to weigh heavy on our long term outlook: valuations.  It is a common narrative that equities are “fairly valued” at today’s levels.  Financial theory may agree, but history does not. 

Our approach to 2015 will be similar to 2014.  We will continue to buy dips, though as rate hikes get closer and valuations go higher, our base investment level is likely to slowly trend lower.  

One final note: as you may have noticed in the letterhead, Drach Market Research Advisors is now Drach Advisors – a long overdue abridgement.

Thursday
Dec152011

The Lost Decade?

This entry is part of a monthly finance blog I will be writing for Access Tallahassee (a division of the Greater Tallahassee Chamber of Commerce).  You can view the post on their website, alongside other blogs from the region's young professionals.

Historically, stocks have made for great long term investments.  After the financial collapse of 2008, however, many market analysts stopped to reflect on traditional investment approaches.  Stocks had seen two dramatic crashes in under 10 years.  Even today, stocks values are about 20% below their peak in March of 2000.  In Fact, the tech heavy NASDAQ composite is nearly 50% below its all time high.

It is rare to find stocks cheaper than they were 10 years ago, but here we are, looking back on what many have dubbed a “Lost Decade.”

But was the decade really lost to investors?  If you took all your money and put it into the market at its peak, there is no doubt that you have lost out, but that’s not how investors typically invest.

The average investor invests via “Dollar Cost Averaging.”  Dollar cost averaging is a fancy way of saying you put a little money aside periodically, whether it be each month, paycheck, etc.  The draw of dollar cost averaging is that it is simple, intuitive and doesn’t require much thought or worry.  Even better, over time, an investor that simply follows this strategy tends to do just as well as the average professional investor.

So how has that strategy worked out during the “lost decade?”  Let’s assume that you started investing back in 2000, and continued to invest some fixed sum each month.  You didn’t invest in anything fancy – just put your money in a diversified index fund that tracks the market.  You didn’t get overly optimistic in good times, and you didn’t panic in bad times.  Just steady, boring investing.

Such an account would currently be up over 20%.  That’s right, by following the most laid back, plain vanilla investment approach, the average investor could have grown their investments by 20%.  Certainly, this is not impressive in terms of historical market returns, but it far outpaces the dire picture painted by most headlines over the past three years.  Most importantly, despite the market being down 20%, this common sense investment approach has investors ahead, meaning for many investors, the decade was not lost after all.

The message? Even in the worst of times, well informed, common sense investment approaches can still help investors grow their assets.  It can be done without “hot” investments like gold or other commodities or paying high management fees for expert advice.  Being armed with a level head can even help individual investors outperform many professionals over time.