Stocks Turn Bearish

The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years.  As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.

Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher.    Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.

In terms of Monetary Policy (central banks), we are in uncharted territory.  On the one hand, market intervention potentially provides a mechanism to avoid financial contagion.  On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going.  The US and Europe are looking to reduce their exposure to globalization trends.

In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.

Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy.  Investors should expect more market intervention going forward.  My job is to manage the effects it has on investments and purchasing power.  Right now, it is looking like global markets are bracing for another round of asset deflation.

The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds.  With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall.  That is not happening.  Money is moving to the safety of the 10-year Treasury bond.  Money flows to 10-year Treasuries when it is concerned about asset deflation.  10-year Treasury bonds are again yielding less than 3%!  Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.

Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels.   It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.

For this reason, I believe it is a good time to be a bit more defensive and raise cash levels.  Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices.  Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.

2018 Investment Strategy Review

Stock and bond market performance has been more volatile in 2018.  After an amazing run in 2017 stocks have become more sensitive to interest rate hikes and potential disruptions in global trade because of ongoing trade negotiations by the Trump administration.

Bonds too have seen an increase in volatility as the Federal Reserve increases the Fed Funds rate and sell bonds from their balance sheet.

The start of the year was extremely volatile for both asset classes but over the last month U.S. stocks and bonds have settled down.  Other asset classes are still struggling.  Emerging market bonds are down over 4% and emerging market stocks have declined nearly 10% according to statistics from ETFReplay.com.

Over the years I have tracked the performance of 4 classical investment strategies from pillars in the industry. Here is a quick look at how they are doing so far in 2018.

Note:  This data is historical and does not reflect actual account performance.  Please see the performance disclosure below for additional detail.  The benchmark for each strategy is the iShares Moderate Growth ETF (AOM).  It is important to remember the CAGR (Compound Annual Growth Rate) for all these strategies are only  using approximately 6 months of data.  Year-To-Date (YTD) performance and volatility is provide below each summary.

We start with our baseline “Classic” Strategy Year-To-Date (YTD) performance.  This strategy is considered a blue-chip approach to investing by several well respected investors.  This mix of investments represents 60% U.S. stocks and 40% U.S. Bonds.

YTD:  Classic Return:  2.8% vs. AOM Return 0.0%     Volatility:  9.7% vs. AOM Volatility 6.0%

Next, we will look at the YTD performance 3-asset class strategy we call the “Cycle” strategy.  This strategy holds 5 investments from 3 asset classes.  It is the lowest volatility strategy I manage.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Cycle Return:  0.6% vs. AOM Return 0.0%    Volatility:  5.5% vs. AOM Volatility 6.0%

Adding more asset class, next we feature a “risk parity” strategy YTD performance.  In this approach 7 asset classes are weighted based on their volatility (or risk) with lower volatility investments receiving a higher weight.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Risk-Parity Return:  -1.7% vs. AOM Return 0.0%    Volatility:  4.1% vs. AOM Volatility 6.0%

Finally, the most diversified of the bunch, the 10-asset strategy YTD performance.  This approach invests equally in 10 asset classes.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Ten Asset Return:  -0.4% vs. AOM Return 0.0%    Volatility:  5.8% vs. AOM Volatility 6.0%

It is clear 2018 has not favored highly diversified strategies.  Those strategies that focus on U.S. stocks have performed better.

For a real shocker, here is how 10 select industry groups I incorporate into my strategies have performed YTD.  This is an all stock selection, so the benchmark has been changed to the S&P 500 (SPY).

YTD:  Industry Group Stocks Return:  16.3% vs. SPY Return 5.6%    Volatility*:  19.5% vs. SPY Volatility 16.1%

*Note the significant increase in volatility associated with the portfolio of Industry Groups.  That is the trade-off for exposure to high-growth areas of the economy.

We don’t know what the future holds but as we embark on a new generation of product and service innovation, along with stronger economic performance in the U.S., I have been guiding clients to overweight U.S. stocks and incorporate industry groups from areas of the economy expected to grow faster than the general economy.  It has been working well and has the potential to add value for years to come.  In addition, I can include industry group exposure to any of the strategies above where risk-management characteristics should generally reduce volatility.

All the statistics provided by ETFReplay.com.

Past performance does not guarantee future results.  Investments and the income derived from them fluctuate both up and down.  Investments at Dightman Capital are subject to risks including loss of principal.  No specific investment recommendations have been made to any person or entity in this written material.  This presentation is for informational purposes only and is neither an offer to sell or buy any securities.  Benchmarks or other measures of relative market performance over a specified time period are provided for informational purposes only.  Dightman Capital does not manage any strategy toward a specific benchmark index.   A variety of sources we consider reliable have provided information for this presentation, but we do not represent that the information is accurate or complete.  Dightman Capital Group does not provide tax advice to its clients.  Conduct your own research or engage an investment professional before making any investment decision.  Investors are encouraged to discuss any potential investment with their tax advisors.  The material provided herein is for informational purposes only.  Data Sources:  IDC, Dightman Capital.

North Korea Threat

There is no question the North Korea (NK) situation has deteriorated and could very well be headed to a conflict.  Outside of an offer of asylum for the Kim Jong Un regime there appear few options.  It is clear the current NK leadership is antagonistic and their arsenal now represents a clear and present danger.  President Trump has already demonstrated militarily he is not satisfied with appeasement in geopolitical negotiations.

When evaluating the potential impact on U.S. stocks it helps to look at these developments in context to the overall economy and stock market.  The economy continues a slow growth path with little threat of a rapidly rising interest rates, which combined represent a constructive environment for the stock market and helps explain its continued upward trend.  Corporate earnings are also healthy (Q2 earnings growth for the S&P 500 came in at 10.3% and projected earnings and revenue growth for Q3 are currently around 5%).  In addition, any positive developments on a Trump Tax Plan would most likely be viewed as bullish.  Taken as a whole, the market is going into this potential conflict in a positive environment.

The last time we experience a conflict like this was the Iraq ground war in March of 2003 (see chart below).  You may remember we were just coming out of a nasty recession and the market had started rallying as we moved into the new year.  2003 ended up being a strong year for the stock market.  Iraq did not represent a significant global economic component and the market was at the early stages of a recovery.

On the other hand, the 9-11 attack in 2001 hit the U.S. during a contraction in the economy and stock market after the dotcom bust (see chart below).  Because of the already weak state of economy and the direct hit to a global financial center, the implications were likely to be longer lasting and more severe.

Investors have to be very careful with defensive moves and a long-term perspective needs to be the dominant factor when making investment decisions.  Corrections are often short and markets can bounce back aggressively.  That being said, there are numerous periods historically where markets have not only sold off aggressively, they have done so over long period of time (multiple years).  Having a strategy in place for this type of environment will be helpful as you start to rely on your investment accounts for income.

The likelihood of a conflict with NK has increased significantly.  Kim Jong Un’s threats and acts are unacceptable and he seems unlikely to change his course.  NK economic impact globally is very limited and their military capabilities are antiquated.  I am not suggesting the possibility for significant damage resulting outside of NK doesn’t exist.  Each situation is different and the ICMB and nuclear capability of NK is a game changer, not to mention all their artillery on the DMZ aimed at Seoul.

The biggest issue now may be the U.S. having to calculate whether future ICBM “tests” are actually loaded with a nuke.  I won’t be surprised if we start shooting them down.

In summary, normally stocks have responded well to conflicts they believe will be resolved quickly and with little global economic impact when conditions are stable.  At present that appears how the market is responding to the NK situation.

How Markets Reacted To A Trump Victory

stock-market-gainsInstead of a Brexit market reaction last week investors appeared to position for the impact a Trump presidency could have on the U.S. economy and asset markets. There is a limit to how much any administration can accomplish during the first couple of years but investors appear to be favoring some asset classes while avoiding others.

One of the most welcome surprises was the terrific performance of small cap stocks, up 2-3% on Wednesday, outperforming all the other broad U.S. stock indexes. For the week the Russell 2000 (IWM) was up 10%. The potential for a reduced regulatory burden appears to have given this group of companies a big boost.

International stocks, on the other hand, did not fare well last week based on potential changes to international trade. It does not sound like this is going to be an initial focus other than trying to bring trillions is cash from U.S. companies being held abroad. International developed market stocks (EFA) ended the week up just under 1% while emerging market stocks (EEM) took a hit, down -4%.

In addition to the stock market sending a positive message about future economic growth, the sentiment was echoed in the Bond market. A December rate hike was already priced in U.S. Aggregate Bonds (AGG), down just over 1% since highs this summer. They fell an additional 1% following election results. An expected fiscal stimulus package is likely the culprit sending bond prices lower. 10yr Treasury yields (IEF) have moved back above 2% and look headed higher.

Industry group rallies were also evident last week. One of the more promising may be the move in Community (QABA) and Regional Banks (KRE) both up about 15%. One of the biggest moves was in Biotech (XBI), up over 20%. Metals and Minerals (XME) had a big move as well, up nearly 11% on potential infrastructure spending. Retail (XRT) was also up over 8%.

In other asset classes, gold (GLD) was hammered indicating the rise in yields is based on rate normalization and not inflation. Gold has rallied strongly this year and remains above intermediate term support around $1,200 an OZ.

In currencies the U.S. Dollar (UUP) was a big winner, up 2% for the week. Interestingly, the British Pound (FXB) rallied in tandem with the dollar last week but is down significantly since Brexit. The Yen (FXY) and Euro (FXE) turned in losses for the week.

There are many remaining issues that could derail what looks like a market expecting positive developments from a Trump administration. With a considerable amount of capital on the sidelines investors can expect more money to come back into the market and push some investments still higher. Given the pre-election concern about a Trump victory, the market vote of confidence last week was a great way to get started.

The Stock Market After Brexit

Last week’s Brexit vote has cast a cloud of uncertainty over global markets.  The decisions direct impact is largely a regional one but as new information arrives we are learning the outcome calls into question the entire European Union concept and that has rattled markets globally.

It is unfortunate timing.  Stocks were starting to show some resilience after two brutal market declines in the last year, the IPO market was starting to warm again and international stocks rallied strongly into the vote.  The vote may also turn out to be just what is needed to bring back vibrant economic growth.

The challenge for European Union members is the ability to sustain rich social programs in the face of stagnating incomes and productivity.  We face similar problems here in the U.S. from local government pensions all the way up to Medicare and Social Security.

UKBrexitCentral banks have been in the driver’s seat since 2008 and their policies have pushed asset prices to levels where fundamentals are stretched.  Economic stimulus efforts to date have fallen short.  New programs designed to inject liquidity directly into consumers’ pockets are likely under active discussion although Europe may find it difficult to implement new policy at a time when many factions have proposed new agendas.  Central bankers no doubt have their work cut out.

At present the overall stock market environment contains far more negatives than positives.  Technical characteristics of the market have deteriorated significantly and now suggests more declines may follow.  It could also get worse if economic growth slows.  There has been little evidence that U.S. corporate sales and earnings have started a recovery after one of the longest periods of contraction on record without a recession.  Banks in Europe remain undercapitalized and slowing growth in China remains a concern.

Innovation and market expansion is alive and well and we can expect a more robust economic environment to return eventually.  The task at hand is to determine how much of an interruption to the global economy the Brexit saga likely to cause before we finally exit the malaise affecting this market.

Investment management has become more complex in the era of hyper-policy action lowering confidence intervals for decisions.  We have had a long market run, a mediocre economic recovery and a very long list of problems yet to be solved.  The likelihood of the market taking matters into its own hand and again serving up a steep correction has risen significantly.

A couple years from now we may look back on this event as a small blip in market history.  The innovation and market expansion on the horizon may need to take a pause as excesses are removed and reforms implemented.  While investing is a long-term pursuit there may be times where playing some defense pays off. This may be one of those times.

BREXIT UPDATE – Q&A

Is BREXIT Europe’s “Lehman” event?

Britain’s vote to leave the European Union is nowhere near the impact of the Lehman Brothers bankruptcy back in 2008.  The BREXIT situation at this point is not a financial disaster.  How market respond going to forward will tell us more about the impact this development is going to have than today’s reaction.  Over the weekend policy makers will be busy working on responses; programs put in place between banks (from the 2008 Credit Crisis) appear to have provided some stabilization, especially in currency markets where price swings were abnormal.

How much will BREXIT impact the U.S.?

This is a Britain/Europe development and has very little to do with the U.S.  Thankfully the U.S. won’t be on the hook for a bailout (at least so far).

How much will BREXIT impact the U.K.?

It is impossible to know how this will impact the UK and we won’t know for some time.  Like most outcomes there will be some positives and some negatives for the country as a whole and for its citizens.  We will have to wait to see where the balance falls.  Nothing has changed in the immediate future.  The exit will take years.

Brexit2Is there a risk of other countries “exiting”?

It is a European problem if other countries push for an exit.  Greece did not leave partially because they were the recipient of aid.  Germany is now the sole country with any real economic strength in the union.  Germany now decides if the European Union survives.  Who knows, fewer regulations and a more sovereign identity in the region might provide needed stimulus.

Why did stocks react so poorly?

Stocks fell because of a sudden economic change they did not expect.  Once the details are better understood the manner in which stocks behave will tell us more about the near-term direction for the market.

Is there a risk this could push the global economy into a recession?

There is always a possibility global economic activity will slow in response to a significant economic development.  The global economy is in a fragile state with corporate earnings and sales here in the U.S. already in decline.  Again, how stocks respond over the coming days and weeks will indicate the markets view of this development going forward.  Up to this point central banks have been very successful at supporting asset prices.

Is there a silver lining?

U.S. companies could ultimately benefit from the disruption created by British companies renegotiating new trade deals.

What should I do this weekend?

Relax with friends and family.  Have some fun.  Monday will be here soon enough.

Brexit Referendum

In a little over a week British voters will decide whether or not to stay in the European Union.  There is a lot of media attention around the event and investors are wondering what it will mean for Europe and stocks.

Market fear levels are already high.  The fear here may not be so much Britain’s potential exit.  If they do vote to leave an adjustment period could be bumpy but it’s not likely to be disastrous.  An exit vote would trigger a two-year period where negotiations would take place allowing markets to adjust.  The European Union policy makers real fear may be the potential for other countries to consider an exit.

BrexitAlthough history is limited in the area of independence votes, back in 2014 the Scottish independence vote failed to win enough support.  Voters generally prefer the status quo which may provide the stay camp a slight edge when ballots are finally cast.

In terms of the economic impact, Britain has strong trade relationships outside of Europe.  Their geographical proximity to the region suggest they will be able to maintain their trade agreements within the region.  Since Britain is not part of the Eurozone (they are part of the European Union) they do not use the Euro currency.  Britain pays around $10B a year for their membership in the European Union.

Whatever the outcome it will likely have less impact outside of the region. European stocks have already experienced more volatility than U.S. stocks and have under-performed U.S. markets since the 2009 recovery.

Once the outcome is known it will fall by the wayside which could end up boosting stocks.  The vote takes place on June 23rd.

Don’t Let An Old 401k Languish

Old 401kAfter a 25+ year career it is not uncommon for an individual to have worked at several different employers and each employer may represent an old retirement account.  Many times I have helped a client consolidate old retirement accounts (401k, 403b, 457, and others) into an IRA or Roth.  The process is often referred to as a “rollover”.

There are a lot of factors to take into consideration when making the decisions to rollover an old retirement account.  Factors like the control, expenses and investment options.

There are tax considerations as well.

If you are interested in learning more about your rollover options let me know and I will pass along a report on “Consolidating Old Employer Retirement Accounts”.  It provides more detail on the decision.  I’m also available to discuss the subject so give me a call at 877-874-1133 or email me at INFO at DightmanCapital.com

To Raise Or Not To Raise, That Is The Question

The on again of again posture of The Federal Reserve is apparently back “on” again regarding an interest rate hike in June.  At least that is what they are signaling this week.  Apparently they are seeing enough strength in the U.S. economy to feel confident another small increase from already very low rates should not derail the economy; they are probably right.  Another reason they may be focused on normalizing rates is so they have the ability to lower rates during the next recession.  The one thing they cannot risk is a slowdown in real estate activity.  If higher rates cause a slowdown in construction, remodeling, refi and resale activity, one of the few areas of strength at present, that could be problematic for the broader economy.  Rates are probably low enough that another rate hike or two is not going to crush real estate but if it turns out the reason they are raising is to normalize rates versus respond to economic growth they may create a problem as the perception of a less accommodative environment causes a slowdown in real estate activity.  At present the futures market does not believe a rate hike is going to happen in June but that does not mean that it won’t.  There is plenty of time between now and the next meeting for data to impact the decision.

The last time The Fed raise rates back in December stocks corrected briefly.  That was the second correction.  Stocks also sold off last summer when The Fed started discussing the idea.  Late winter and into the spring stocks staged a strong rally with the S&P 500 touching on all-time highs.  Stocks have pulled back during Q1 earnings season, which is coming to a close, where results have been mixed but not a disaster.  With two recent corrections and a generally improving economy it is remarkable stocks have held up which is reason to believe there won’t be another steep correction.

If the U.S. economy has more strength than is currently realized, small rate hikes at current low levels should have little impact on economic activity.  Therefore, we would expect a recovery in earnings to materialize which should lead to higher stock prices.

The other factor that makes this particular round of market analysis more difficult than the environment that led up to the 2008 bear market is there is no obvious market threat the way the subprime market was a potential problem back then.  Sure, there are lots of possible culprits but no one central market risk that could send stocks into a bear market at least here in the U.S.  There are some who suggest the next market collapse will be sparked in Japan, China or a coffee shop in Venezuela.  It is true, most of the rest of the world is a mess.

It is interesting that Walmart reported earning this morning and the stock was up 8.6% as I wrote this note.  If the price holds it will be their best one-day gain since 2008.

NOBODY knows what is NEXT

NOBODY knows Jack or Jill about what is next for markets or the economy, I don’t care what people say or how convicted they are in their belief. Investors that make big investments on their best guess (or forecast, projection, thesis, etc.) are having a very tough go of it in this market.  Very popular mutual funds and hedge funds have suffered big losses in the last year and many have closed.  When central bank intervention dominates asset markets traditional methods like fundamental and technical analysis do not work well.  Eventually market forces correct imbalances and policy makers hope they can correct some of those imbalances before they self-correct.  All we really know is what we can observe right NOW.  Even history can’t be relied upon to guide decisions because, while this time may not be any different, the timing may be very different.  Meaning, markets can stay disconnected from reality for much longer than anyone expects.  Then again, they could self-correction tomorrow.  Or, they could move in very unexpected direction.  For example, not many people are suggesting Treasury yields will rise the balance of 2016 but it could happen especially if the Fed does end up raising rates throughout the balance of the year.

One way to address all the market uncertainty is to deploy several different investment strategies with various levels of risk aimed at navigating different outcomes over the long-term.  That is the approach I have developed at Dightman Capital.  It is really quite straight forward and uses basic index oriented asset classes in unique combination.  One set of strategies maintains exposure to asset class but combines the investments in very unique ways.  Another strategy uses a timing mechanism designed to avoid sustained market declines.  The outcome when these strategies are combined may represent an overall lower correlation to the stock market, lower downside volatility and a higher overall risk-adjusted return.

Consider international stock markets that are either flat or down since 2008.  Despite massive policy intervention designed to lift markets, international stocks remain a challenging investment.  What worked in the U.S. (QE, ZIRP) clearly did not work in many other countries.  Of course, some countries also implemented austerity measures and Japan is in a completely different league overall.  Here is the thing, despite EEMEFA2008being “cheap” at times it has been difficult to generate gains from international markets during the last 8 years!  There have been periods where international markets outperformed U.S. markets and it is likely that dynamic will one day return but it is impossible to know WHEN.  Some exposure to international market for long-term growth investors probably makes since but one thing to keep in mind.  The benchmarks we use to measure long-term stock market performance here in the U.S. is generally based on the S&P 500, which is a U.S. based stock index.

(EFA – International Developed Stock Markets, EEM – International Emerging Stock Markets)

In terms of the U.S. stock market, it has pulled back the last several weeks after a strong recovery rally that kicked off in February.  Many commentators have predicted a total collapse of the market any day and while that could certainly happen, so far U.S. stocks have held up.  One thing investors can do to potentially avoid sustained bear market declines is to deploy a simple timing based system.  I used one very successfully in 2008.

For example, downside volatility in the U.S. stock market the last 9 months has put my Adaptive Growth timing system in a transition mode.  Meaning, it triggered a reduction in risk last summer when markets started to fall.  You can see in the graph where the black line crosses below the blue line.  While the strategy is nearly fully invested now as a result of the black line moving above the blue line, some cash has been held back in case stocks do not fully escape the current correction.  The Adaptive Growth strategy is suggesting stocks remain in a transition mode and until they clearly move out of this status the strategy will remain a little defensive.

$SPXTrig1

$SPXTrig2The Adaptive Growth strategy also incorporates another signal that has recently signaled a defensive move.  This is a longer-term trigger and suggests more declines may be ahead.  However, since the Adaptive Growth strategy is in a transition period I don’t have to take immediate action because I am already under invested and prepared to take further defensive action if conditions deteriorate.  If markets continue to rally I am already participating and ready to add more growth investments.  If a more conservative move is signaled here too I ready to take action.  This is not a purely mechanical system.  As I have described there is an element of interpretation involved but overall it is a pretty simple and straight forward system and I have been using it for years.

In terms of economic data driving corporate earnings, we continue to take two steps forward and one step back.  Most of the economic data suggests a mildly improving environment accompanied by an occasional disappointment.  The construction industry appears to be one of the primary contributors to current economic growth.  Both new construction along with remodeling appear to be helping companies like Home Depot  (HD) and material suppliers like Vulcan Materials Co. (VMC) perform well in this market.HD_VMC

The chart of Vulcan and Home Depot show their prices rising steadily the last three years and near all time highs.  As both companies move into new high territory, along with many other stocks, there is reason to believe stocks could rally into the summer.  At least that is what is happening NOW.

In terms of new innovation, General Electric (GE) is busy reinventing itself and its latest announcement could be a game changer.  After trimming its financial unit and selling the home appliance division the company aims to leverage its massive industrial knowledge based by becoming an Industrial Internet Powerhouse, a new direction with potential promise.  Investor’s Business Daily details more here.  General Electric is not currently included in my favorite dividend stock investments but that may change if the new initiatives improve the company’s rank relative to other dividend paying stocks.  The real takeaway is this, despite all the challenges faced 124-year old companies like G.E., companies are finding ways to position their businesses for future growth opportunities.

Stocks had a great start to the week.  My favorite growth investment closed up 1.25% Monday.  This performance is so ironic.  Just this past Friday I was contemplating a short position for the Adaptive Growth strategy based on the ongoing deterioration of my second trigger measurement.  Just when you think it is about to get a lot worse it gets better which is typical in this market.  I have found this particular market environment requires a little more patience then usual.  Everything could change in the near future and I admit there are a lot of reasons to suggest markets are going to go through another correction.  However, markets have a tendency to do their own thing so a summer rally is not out of the question either.

NOBODY knows what tomorrow will bring and with stakes potentially higher than usual, based on risks that may have been introduced to the market by Central Bank intervention, using multiple strategies I believe is an effective approach for navigating the current uncertainty while positing for potential opportunities.

Have a great week!