Market Overview & Commentary
The term Irrational Exuberance was made famous by Alan Greenspan during the dot-com boom when rapidly rising market prices became disconnected from the reality of unsustainable or non-existent profit levels. During 2013, most global markets have reasonably priced in underlying fundamentals. However, US equity markets have displaying an uncanny (or perhaps irrational) exuberance through both good and bad news alike. It can be exciting for thrill seekers who jump into a rising market as it gets more and more expensive, but it typically ends badly when the music stops, reality sets in, and declines ensue.
September marked the 55th month of US market gains since the March 2009 lows, 13 months longer than the average bull cycle of 42 months. Additionally, valuations for US equities hit levels 15-42% above historical averages (depending on which valuation method is used). Finally, levels of profitability have slowed down, an early-warning sign that a peak is likely near.
So why does the US market continue to rise, in spite of the challenges faced? We believe that a large part of the answer lies in the unprecedented Quantitative Easing of the Federal Reserve. The $3.7 Trillion of stimulus has resulted in record low interest rates for a long duration of time. With interest rates so low, investors have been forced up the risk curve, moving out of low-yielding fixed income and into large cap US dividend stocks, MLPs, and other equity-like choices. Equities are therefore simultaneously expensive based on fundamental analysis, but relatively inexpensive when compared to the alternatives that investors have to choose from. Consequently, many investors are chasing after this yield, all the while pushing the market to high levels of overvaluation. Furthermore, market gains beget more market gains as hot money chases after rising asset classes in a classic momentum bubble trade (see Chart I below for where we are most likely situated in the market cycle).
There are many reasons to be unhappy with the actions of our Federal Reserve. Reasons include the manipulation of capitalism that causes a misallocation of resources to lower yielding projects, and consequently overcapacity in our society. If interest rates are so low, projects only have to look marginally profitable in order to be undertaken. However, when rates rise in the future, these projects are no longer profitable and the bust cycle is amplified with massive layoffs and wasted capital. The Fed manipulation also exacerbates our national income gap disparity, as the wealthy are able to fund their investments at incredibly low rates, whereas low-income and retired individuals are receiving lower returns then they would normally receive in their bank accounts, CDs, and other low-risk fixed income assets. The Fed basically is facilitating a drain of yield away from low-income folks and retirees to wealthier individuals and corporations. This is not a good solution…in fact it is part of the problem…and once again attempts to ease our situation today, at the expense of our future.
However, the most relevant impact of the Fed’s actions to our client discussions is around the overvaluation that is created in equity markets. US markets are likely 30% higher than they would be without the Fed’s QE. This bubble / bust approach ultimately hurts investors who let their emotions dictate decisions. Those who once were fearful and sold their assets near lows, are now getting greedy and buying into markets at too high prices.
We humans are emotional, herd-like creatures, typically using logic to justify our feelings after the fact. So while we should logically be looking at the current situation and understanding that US equities don’t represent a very good deal at today’s prices…instead, we buy stocks when others are buying, regardless of price, especially if we feel like we are missing out on something. This of course is a recipe for disaster.
So how can we take advantage of the current environment with our investing? The solution isn’t complicated, but it also isn’t easy to follow. We must be logical, not emotional. We also must be willing to do things differently than others when it makes sense. And we must be able to act, even if we may temporarily be “wrong” relative to others. Just like eating healthy requires the strength to turn down a beer with friends, successful investing requires discipline.
Take a look back at Chart I . As you will see, we must be able to do the opposite of what emotional investors do. We must buy into valleys (as we did in ‘08-‘09). We must also sell into peaks, despite markets continuing to run up (as we did in ’07 and are doing now). The result of these activities is almost always a short-term relative underperformance (see red bars in Chart I). This can be difficult for some, as emotionally we may feel like we are missing out, especially relative to our peers. Over the long-term, however, it is the right thing to do and results in relative outperformance (see green shade in Chart I).
Markets Ignore Risks in Rise
Portfolio Review Q3 2013
We have been defensive in client portfolios since late Q1/2013, having missed out on some of the gains in US equity markets, while sidestepping declines in fixed income and a large number of overseas markets. With only minor market pullbacks during Q2, we continued to measure equity markets as reasonably overvalued and largely overbought heading into Q3. Additionally, there were a large number of events likely to negatively affect the market, such as the highly expected removal of Fed stimulus, the government shutdown possibility, and the expected debt ceiling fights. Consequently, we maintained a conservative positioning heading into Q3, with high levels of cash and lower levels of both equities and fixed income.
During Q3 2013, our conservative positioning did not pay off. Investment markets surged to ever higher levels of overvaluation, despite weakening economic news. Sentiment also surged impressively higher, and negative market events failed to materialize (e.g. at the last minute the Fed decided to continue stimulating, despite an unprecedented $3.7 trillion of bonds already purchased through their QE programs). In other instances, negative events were simply ignored by investment markets (e.g. shutdown worries were all ignored, with the expectations that Congress was again just crying wolf).
It is our opinion that without a healthy correction, markets are once again being set up for a major fall. Before this occurs, late-to-the-game investors will be lured back in, seeking quick profits. On the economic side, our Federal Reserve and Congress/President continue to kick our debt and deficit problems down the road, which will result in an even larger blow-up when the day of reckoning arrives.
We recognize that our client portfolios have been missing out on some of these late stage returns. However, we feel that it is our fiduciary duty to make sure a strong defense is on the field when the investment outlook overheats, as is the case now. The best time to invest is immediately after a major correction, when valuations are inexpensively priced, sentiment is highly negative, and a floor in markets has been established. While these characteristics were evident during the mid 2009 time period, they are certainly not evident today. This does not mean that we can’t find pockets of interesting investments to put money to work. However, it does mean that we need to temper our enthusiasm and put money to work sparingly. We know there will come a time when securities go “on sale” again, and we will be ready to step up to the plate at such time.
Please refer to the following sections which are broken down by client segment. If you are a client with < $150K in assets at TDA, we use our “Emerging” model. For clients with > $150K at TDA, we deploy our “Active” model. And for those with > $1MM having an ultra-conservative goal, we employ our Multi-Strategy approach. Below, you will find insights about our net results for each client category, and specifics about what worked, what didn’t during Q3:
Q3 2013 Results – Emerging Clients
Emerging client portfolios generated returns that were generally in line with market indexes, despite a lower risk profile over the course of the quarter. This result is somewhat the best of all worlds, as the returns were similar to full market returns, but the risk that was taken throughout the quarter was lower, which would have been quite advantageous if there had been a major market decline. Specifically:
Our allocation to global equities worked well during Q3. Undervalued assets rebounded from their lows, while US equities continued a steady advance. Additionally, our allocation to gold miners had reached an oversold level in Q2, and rebounded sharply during Q3 to generate some nice gains for client portfolios. Finally, our decision to underweight real estate and fixed income helped to side-step declines in those asset classes.
What didn’t work?
Our conservative under-allocation to risk assets resulted in some lost opportunity, as our higher levels of cash were not fully deployed to investable assets. Otherwise, the majority of our investments not only contributed, but generated larger gains than US assets; and consequently, made up for our under-risked positioning.
Q3 2013 Results – Active Clients
Active client portfolios were mostly flat for the quarter, due predominantly to our conservative positioning relative to riskier assets like equities. Additionally, a number of market-worrying events caused volatility that churned some of our positions. For example, markets declined heading into an expected Fed taper of stimulus. During this decline, some of our protective trailing stops triggered, causing sales of assets…and our volatility model signaled the need to protectively hedge. Immediately, upon the announcement that the Fed would not taper, markets rebounded, causing us to miss returns for the positions we sold, and to close our hedges for mild losses. As a result, our conservative positioning didn’t hurt us on an absolute basis, but we did miss out on some relative returns. Specifically:
Our small allocation to global equities worked well during Q3, as undervalued assets rebounded from lows. Mid-quarter, one of our trading models signaled a purchase and then a subsequent sale in emerging markets, which netted out a positive return.
What didn’t work?
Our conservative under-allocation to equities resulted in lost opportunity. Additionally, we had some churn in our positions when markets temporarily dipped downwards and then subsequently rebounded (as highlighted in an earlier paragraph). In the commodities space, our trading models attempted to catch two breakouts in gold and miners, but both failed to materialize a durable trend. Finally, we had a few individual stock positions that experienced sharp declines when interest rates spiked intra-quarter. We protected portfolios by selling these securities at their trailing stops, though they still netted a small loss for the quarter.
Q3 2013 Results – Multi-Strategy Asset Preservation Portfolio
Multi-Strategy clients were flat to mildly down for the quarter (-0.3 to -0.6% declines). Not only were we risk averse on the equities side which minimized upside returns, but fixed income continued to struggle in a rising rate environment. Given these client’s benchmark to 65% fixed income, our combination of fixed income, diversifiers, and cash did not generate much yield for clients during Q3. Our high income breakout strategy also yielded little in terms of return, as the quarter was more choppy than it was trending, a required dynamic for success with breakouts.
Despite the sleepy quarter for Multi-Strategy clients, we began deploying some of their cash late in August-September, as rising rates presented us with more interesting entry points on the fixed income side. In muni’s, we moved a third of our allocation out of its conservatively parked space (short-duration and high-quality) and into longer dated and higher yielding securities. Rising rates and fears of greater defaults caused prices for these high-yielders to come down nearly 10% in the last 6 months, while we were parked in the safer sectors and in cash. Additionally, our closed-end-fund scalping model offered opportunities for us to deploy cash, as many of these funds moved from 3-4% effective yields up to a very attractive 15-20% level.
While we deployed cash to both of these areas late in Q3, we expect to see benefits realized in the quarters ahead.