Download Third Quarter 2015 Securities Markets Commentary Index

THIRD QUARTER 2015 SECURITIES MARKETS COMMENTARY
Index Performance
Major stock indexes posted their worst quarterly performance in four years. The long-in-the-tooth bull
market retreated during the third quarter with some signs of the bear coming out of its prolonged
hibernation. The Dow Jones Industrial Average fell year-to-date by -6.9% and lost -7% in the third quarter
alone. The S&P 500 finished down -5.3% year-to-date. The technology-heavy Nasdaq was pummeled during
the third quarter, down -7.4% for a negative year-to-date return of -2.5%. This snaps the Nasdaq’s streak of
ten straight quarters of positive performance. Indexes that track smaller growth-oriented company stocks
were not spared from the drubbing. The Russell 2000 index lost -12% for the quarter for a year-to-date loss
of -8.6%. And the Investor’s Business Daily Mutual Fund Index, which tracks the best (in their estimation)
growth mutual funds, was off -8% for the quarter and -3.4% for the year. Bonds, usually a safe and
productive defensive position, offered minimal refuge for investors seeking some return on their principal.
The Barclays Aggregate Bond Index saw a meager year-to-date return of 1.1%. In the following we will
examine where the markets have been, where they may go, and offer our opinion as how best to navigate this
transitional period from bull to bear.
Domestic Developments
The market storm clouds that had been gathering on the shores of the United States for the past year finally
rolled through and let loose this past August and September. For the first half of the year the market moved
only sideways in what we called the doldrums of neither vigor nor impotence. This sideways movement was
quintessential “toppish” market behavior—that is, like a rocket with no more fuel, the market has sputtered
at its peak and is now being pulled back down to earth. In this sixth year of recovery the American optimists
could no longer remain willfully blind to the substantial negative economic news coming from all corners of
the globe. And so we have recently experienced a correction with over a month’s worth of negative price
movement that has put a stop to the previously ever-upward moving markets. While a correction had been
predicted for some time—as six years of near-zero interest rates are bound to overheat equity markets—it is
difficult to identify from what sectors of the economy the growth necessary for a bounce back recovery will
come. The rocket that is the American economy is falling back to the real world and from our vantage point
we cannot see where any rocket fuel is available to keep it flying to new heights.
Now that is not to say that there is no growth to be seen in our economy, because indeed there is. Inwardfacing domestic consumer spending has been the singular sector of the economy that has shown positive
momentum. Americans are spending more on discretionary items, having been encouraged by a variety of
factors including savings at the gas pump, mildly improving wage growth, and an appreciating dollar. Home
prices have also made steady gains this year. Thus our economy has responded to the crises abroad by
becoming more insular. This is positive for maintaining modest GDP growth (see below) though it may not
be fruitful for the economy in the long term. We see, then, U.S. exports limited by the rise of the dollar with
total exports falling this year for the first time since 2008. And American manufacturers are being undercut by
cheaply imported foreign goods. Consumer spending, therefore, is propping up economic growth while
financial markets navigate international tumult and central bank uncertainty.
In mid-September the Federal Open Markets Committee (FOMC) of the Federal Reserve again decided to
leave the short term federal-funds rate unchanged. Last quarter we, along with most everybody else, put odds
on a September rate rise. Fed Chair Janet Yellen and company cited a parade of horribles in explaining the
FOMC’s hesitance to ratchet rates up: global markets faltered, China’s growth deteriorated, and inflation
refused to move up into normal range. As the Fed noted in its post-conference press release, “Recent global
economic and financial developments may restrain economic activity somewhat and are likely to put further
downward pressure on inflation in the near term.” Equity markets responded to this repeated indecision with
characteristic hostility. Yellen attempted to introduce more certainty to the markets in a speech at the
University of Massachusetts Amherst all but stating that interest rates would be raised by year end: “It will
likely be appropriate to raise the target range of the federal-funds rate sometime later this year.” Futures
traders at the Chicago Mercantile Exchange—the futures traded assess the probability of a rate hike—have
perhaps gotten used to the Fed saying one thing and doing another, and most recently (as of this writing and
after the dismal September jobs report) put odds of a rate rise before the end of the year at just 29%.
Regardless of what the futures traders think, we still believe the highly unusual economic environment favors
a rate rise before 2016. Rates have been too low for too long and the indicators the FOMC looks at to
determine its policy (its so-called “dual mandate”) continue to level out. There is still slack in the employment
situation but the numbers are much improved since the Great Recession and inflation is slowly creeping up.
To be sure, the economy is far from perfect and technical indicators are signaling the beginning of a bear
market. However bitter a pill to swallow the rate hike will be, it is necessary medicine for the long term health
of the economy. As famed bond fund manager Bill Gross stated in his most recent missive on the essential
rate hike: “Near term pain? Yes. Long term gain? Almost certainly.”
International Developments
The straw that broke the bull market’s back was dropped by China. In a testament to just how intertwined
and interdependent the global economy has become, desperate Chinese government policy had a devastating
effect on global markets in the third quarter. Following the crash of their stock market that we reported in the
last newsletter, the Chinese communists panicked at the sheer volatility and uncertainty inherent in the stock
market, that fixture of capitalism. President Xi Jinping and his cohort instituted trade restrictions and
authorized state police to go after hedge funds and institutional investors merely for short-selling. What’s
more, Goldman Sachs estimates the Chinese government and its various appendages have spent over $200
billion to buy shares in order to prop up the languishing market. Lest we forget precisely what kind of
government we are beholden to, journalists and others have been jailed or otherwise punished for negative
reporting of the crash and the government’s heavy-handed attempts to fix it.
What has global markets roiled, though, is exactly why China is panicked and going to such drastic measures.
The reason, simply put, is that the Chinese economy is slowing down. China has the reputation for cooking
its books, particularly when it comes to reporting its growth rate. Outside observers typically shave several
percentage points off of China’s official numbers to get to the actual uninflated rate. Even with the bookcooking, China asserted a 7% growth rate in the second quarter, which, though comparatively high, is still the
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slowest Chinese asserted rate in six years. To boost the number and help their markets, China’s central bank
abruptly devalued the currency—the yuan or renminbi—in early August. This move, aimed at making
Chinese goods cheaper to export (thereby adding a little juice to the 7% number), looked to investors like a
latent admission that the Chinese economy was in trouble and beginning to stall. Global markets had gotten
used to the outsize performance of China with its ravenous appetite for oil and other commodities. Markets
did not react favorably to the prospect of the Chinese juggernaut fading away and have not yet recovered in a
meaningful way. Investors should expect a new normal of slower global growth as the market readjusts to a
tamer, less voracious China.
Elsewhere in the world we observe other regions digesting the news from China and following China’s lead in
slower growth and stagnation. Having reached a deal on Greek debt, Europe had cruised through the first
three quarters of 2015 with a bang spurred on by the European Central Bank’s (ECB) injection of cash into
the economy through its quantitative easing (QE) program. You’ll recall that this entails the central bank
printing money to purchase sovereign debt. But a host of headwinds have battered the continent this past
quarter: China, the ongoing migrant crisis, the Volkswagen emission scandal, and the ongoing threat of
deflation. Nevertheless European indexes remain positive for the year and investors anticipate modest growth
thanks to the ECB’s QE set to continue through next year.
In the Middle East we find OPEC not only maintaining oil production levels but actually increasing
production since March. The oil rich Gulf States are doing this to preserve their market share and also to
further squeeze American producers by making it economically impractical to extract oil through shale and
fracking. The price per barrel of oil, therefore, is not expected to increase significantly in the near term.
Factor in the phasing-out of sanctions against oil-flush Iran and we see even more downward pressure on
future energy prices. However, Russian President Vladimir Putin’s escalating involvement in the Syrian civil
war may have the potential to impact future oil prices. Putin’s support of Syrian dictator Bashar al-Assad puts
Russia on the side of Shiite Iran and Hezbollah, who in turn are the regional rivals of Saudi Arabia and the
Sunni Gulf States. Note also that Russia has massive oil reserves and relies almost completely on oil exports
to sustain its economic growth. We can expect, then, even more volatility in the oil markets.
The biggest losers in the Chinese slowdown have been emerging market commodity producers. Countries like
Brazil, Chile, Russia, and South Africa have seen their currencies drop further and further because their
economies had been almost completely dependent on China purchasing their plentiful commodities. The
floundering of these emerging markets has worldwide effects: from the declines in transnational corporations
like Caterpillar, BHP Billiton, and Rio Tinto, to run of the mill bond funds holding emerging markets debt,
the global economy truly has become interconnected. So to borrow and modify a tired cliché, China sneezed
and the world caught a cold.
Consumer Confidence
Here at home American consumers remain reasonably confident in the economy, though they are beginning
to take notice of the disturbances going on abroad. The University Of Michigan Survey Of Consumer
Sentiment for September was at 87.2, a continual drop from January’s reading of 98.1. Still, this most recent
reading is within the range of the non-recessionary year average of 87.4, so while consumers have noted the
negatives of the worldwide market and sagging U.S. stock prices they do not seem to view these events
necessarily as crippling to the economy. Indeed this perspective is bolstered by the steady increase in
consumer spending and the recent upward revisions of gross domestic product.
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Gross Domestic Product
Thanks mainly to the American consumer, the rate of GDP growth for the first half of the year steadily
increased. The Bureau of Economic Analysis estimates the economy grew at a satisfactory rate of 3.9% for
the second quarter. Additionally, the Bureau revised the first quarter’s rate upward: instead of a contraction of
-.2% minor growth was eked out at a rate of .6%. Buoyed by cheap gas prices, consumers ignored
international news and spent generously. Roughly two thirds of GDP is based on personal consumption so
the unexpected savings at the gas pump has gone a long way toward sustaining the slow, steady GDP growth
in this sixth post-recession year. The first estimate for third quarter growth will be October 29th. The most
optimistic forecasts still predict a drop to around 2% and the Federal Reserve Bank of Atlanta predicts 1.8%
growth.
Employment/Labor Force Participation
It might be that the downward GDP revision can be attributed to the wholly uninspiring employment
situation. American consumers did not shy from spending this past quarter but employers did shy from
hiring. The unemployment rate has fallen to 5.1% but this consistently falling rate is in all probability because
of the declining labor force participation (LFP) rate. The LFP rate has again shown a decline, regressing even
further to levels last seen in the late-1970s. This discouraging fact does not instill much confidence about
strong growth in the immediate future. All told, employers added only 142,000 jobs in September—the
consensus prediction was for a gain of 201,000—and the Bureau of Labor Statistics revised down previous
numbers for July and August. As noted by the Wall Street Journal, job creation last year averaged 260,000 jobs
per month. The past three months saw an average of only 167,000 jobs created. The recent global turmoil, it
seems, has had a significant effect on our economy even outside of equity markets. We will wait and see how
the Federal Reserve interprets these bleak numbers: the slowdown could be a mere blip on the resilient
American economy, or perhaps slow is the new normal such that plodding growth is better than backward
moving contraction. We will find out before the end of the year.
Technical Markets Overview
For the first time since early August 2011 the S&P 500 index 200 day moving average is in decline. The 200
day moving average is a long-term trend indicator and it is now trending down. The 200 MA of the S&P 500
first turned negative on August 24th. This, combined with the Dow Jones Industrials 200 day moving average
exhibiting a negative trend on August 20th, the Russell 2000 on August 28th, and the Nasdaq on September
23rd, indicate that virtually all domestic equity markets have entered the early stages of decline. The 200 day
moving average is calculated in such a way so as to remove short-term blips, either up or down, in an effort
to uncover the underlying long-term trend. The calculation simply takes the average of the last 200 days
closing price of an index and compares it to the closing price of the most recent market close. If today’s
market closes lower than the average price of the past 200 days, then the indicator is considered to be
negative. Conversely, if today’s price is higher than the average price of the past 200 days, then the indicator is
considered to be positive. As with any indicator the 200 day MA is not flawless and does not necessarily make
a long-term negative market inevitable. However, the combination of all the indexes mentioned above
moving below their 200 day MA and the extreme volatility in recent market sessions at the very least attests
that the markets are both very concerned and have been quite confused. The traditional interpretation of the
200 day MA of these various indexes would lead one to believe that limited exposure to the equity markets
may be the most reasonable approach until the markets establish a more consistent trajectory.
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Looking Forward
The recent behavior we’ve experienced in the equity markets seems to have all the earmarks of the early
stages of a traditional bear market. All indications, including the deceleration in the economic growth in
China, Europe teetering on recession (not helped by the recent admission by VW that it manipulated data
related to their pollution output on their diesel cars), and an inevitable increase in interest rates by the Federal
Reserve Bank, point to lower equity prices in the near term. The recent collapse in commodity prices—not
the least of which being the fall of oil—and many industrial metals is a further indicator that economic
activity is slowing. In an effort to stimulate exports China took a bold and somewhat unprecedented move to
devalue their currency relative to other currencies. It remains to be seen if this will be a successful strategy,
my own belief is that it will not.
Management/Investment Strategy
Setting reasonable expectations for any portfolio strategy is always important. Let’s take a moment to explain
what we can and cannot expect from the portfolio management tools we use. It is important to realize that
the technology used to manage portfolios does not endeavor to “time the market” by predicting future price
movement based on analyzing various types of macroeconomic and/or internal market dynamic data. The
process used is one that endeavors to identify trends. Having said that, it does not predict market behavior; it
recognizes market behavior and reallocates portfolio assets accordingly. This means that the models must
recognize or participate in a negative price pattern in an effort to reallocate assets to more
conservative/defensive investment options. In recent weeks we have seen violent swings in all the major
market indexes, at one point we even saw 200 to 300 point swings within a single trading session. This kind
of erratic behavior is difficult for any process or trading methodology to navigate. It is important to
remember that open-end mutual funds, which comprise most of the portfolios, are only available to trade at
the close of business. So if the market falls precipitously during the trading day, no matter when we would
initiate a sale, that sale would only be executed at the close of business that trade day.
From time to time the modeling system will recognize a negative trading pattern and recommend a sale of the
securities held in a portfolio in order to reallocate resources to a money market fund only to see a market
rebound the very next day. These erratic short-term trading patterns are not unusual in the early stages of a
declining market. It is unreasonable to expect to have reallocations occur only when the markets are rising,
expecting to exit positions at higher prices and always reentering the markets at significantly lower prices. Our
process is designed to reduce exposure to asset classes that could have a negative effect on a portfolio as the
market declines and reenter asset classes that have potential to bring appreciation as the market ultimately
resumes an upward path. Many of the portfolios we manage currently have as many as eight positions out of
eleven or about 70% of portfolio assets in a money market instrument. Once the market stabilizes and begins
a more positive trajectory the models will recommend reinvesting in more growth-oriented investment
options. It is important to realize that when the market does ultimately bottom and begin to move forward
the models will require observing and identifying positive price patterns before they will recommend reentry
into the market. They do not anticipate market movement either up or down, they identify trends and make
recommendations accordingly. Essentially, the process must observe declining prices before taking a more
defensive position. Likewise, the process must observe rising prices before making reallocation
recommendations into the rising market. This observational characteristic requires identifying trends either
positive or negative before it can recommend any portfolio adjustments. It does not make predictions based
on how far the market has fallen, internal market dynamics, Federal Reserve Board interest rate policy, nor
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macroeconomic data. The portfolio management process we use observes emerging price trends and makes
allocation recommendations according to these identified trends. It is of paramount importance to
understand that the emerging trends may not unfold in such a way that the trend is long enough to allow for a
profitable allocation. This is particularly true in environments exhibiting high volatility like the markets have
experienced recently.
Performance Disclaimer
No investment strategy or methodology can guarantee profits or protect against losses. Investment
risk includes the uncertainty and volatility of potential returns for a portfolio or an individual investment over
time. Investment risk is inherent in every individual portfolio and no computer model or modeling program
used or relied upon in making investment choices for a portfolio can eliminate risk. A computer modeling
program may not reflect actual risk and return parameters applicable to any particular portfolio or investor.
Actual investment decisions made on the basis of a computer generated model or modeling program may be
materially different from expected or intended results, and any computer modeling program is subject to
errors in the program and system failures at any time.
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