The summer heat has finally arrived, and it’s naturally coincided with lower volume markets that are prone to the rumor mill and news flow. The second quarter of 2015 was choppy, but included some reversals in behavior across asset classes. Domestic equity markets bounced around in a flat range, while broad emerging equity markets declined slightly on the quarter. The big shifts arrived in commodity, currency and fixed markets, as commodities reversed their slide and enjoyed a sol- id quarter, the dollar softened, and bond yields rose producing sizeable losses at the longest end of the yield curve. The weight of the evidence that dictates our asset allocation was not with- out some volatility, as well. But despite mild shifting and softening in the rating of some sub-categories we follow, the cumulative message of the evidence is still mixed enough to keep us positioned at roughly neutral levels of volatility in client portfolios. A neutral volatility and asset allocation profile puts more pressure on our sector rotation strategies to try and earn risk- adjusted returns, and there continue to be several relative value opportunities that we are positioned to take advantage of.
The Bull Keeps Aging; We’re Still Riding
When reflecting on the bull market in stocks, the pessimistic view is that the rally that started in March 2009 is now aged, and with every passing day the risks grow that mean reversion and high valuations will ultimately catch up and end this bull run. On the other hand, the optimists contend that the current backdrop of low growth and high liquidity should give this bull market longevity, and market bulls are quick to point out that there have been similar historical backdrops that produced bull markets longer than the current one.
At Pinnacle, we consider ourselves realists and believe both views have some merit. As risk managers, we are not blind to risk, and we fully realize that at some point there will be a powerful shift that ends this torrid bull run. But given the amount of liquidity being pumped into global markets, we also acknowledge that there is a risk of being early to exit, as well. Flush valuations and an aging backdrop do provide a ceiling on how much risk we are willing to take at this stage of the cycle, but beyond that we continue to ride the bull market and look for more warning signs to develop before really pulling on the reigns and getting more defensive.
Central Banks Still Dominate Backdrop
In the pre-crisis world, raw economic fundamentals may have been the dominant force behind earnings and asset market appreciation, but we’re clearly in an unusual period where economic fundamentals are taking a backseat to central bank liquidity. As we wrote in our May 2013 Market Update (“The Twilight Zone Market”):
This disconnect between poor growth dynamics and red hot equity markets does at first blush seem odd, but things begin to make sense when you consider the fact that central bankers and unprecedented liquidity are currently in charge of financial markets. When viewing the behavior of markets through this lens, anything that encourages central bankers to keep priming the pump is likely to temporarily be good for markets.
Although the Federal Reserve seems to be preparing to be the first central bank to start slowly shifting away from massive liquidity, central banks in Japan and Europe are ready and willing to keep priming the pump through massive asset purchase programs. Given an increasingly gloomy backdrop, even China has begun to pour more liquid fuel on the fire in order to arrest a vicious slide in their equity markets. In short, world dynamics continue to support our theme of following central banks.
Recently Europe has been the source of headline news thanks to the latest chapter in the Greek drama. If our thesis is correct, the problems in Greece and the Euro- zone will only encourage the European Central Bank (ECB) to do more to support the system. Therefore, though exhausting, it may be that the recent Greek acrimony has led to another good buying opportunity within Europe. We are currently staying the course in Europe and looking to slowly build into our theme of following central bank liquidity.
Dollar: Staying Bullish
Major divergences in monetary policy are one reason we continue to like the U.S. dollar. Given that the U.S. is much farther along in its post-crisis adjustment phase, it is natural that the Fed appears ready to begin the process of slowly normalizing interest rates. At the same time, many countries across the globe are in a vicious cycle of policy easing to combat slow growth rates, and various structural, geopolitical, and political headwinds. Currently there seems to be no end in sight to the quantitative easing programs that the Bank of Japan and the ECB are pursuing, which means the dollar should remain firm versus the yen and euro over time. Additionally, emerging market currency weak- ness against the dollar is likely to continue given the weakening in China and a commodity super-cycle that appears to be dead. The dollar may still be caught in a lateral digestion phase that was preceded by its enormous run up in recent quarters, but looking out over the next few years, we are staying the course with a pro-dollar investment stance.
Value Traps Show Their True Colors
It’s been a whippy year in many asset markets, and we continue to think that investors need to be wary of markets that appear cheap on the surface, but will likely continue to disappoint. Commodities, the energy space, and broad emerging markets that contain healthy percentages of the BRICs (Brazil, Russia, India, and China) are a few value traps that have been on our list, and we believe that they should continue to be avoided. In a business that focuses on returns that are driven by what is owned, sometimes an underappreciated aspect of manager skill is knowing what segments of the market not to own.
Emerging markets present a good example of how important this can be. Since peaking relative to U.S. markets in late 2010, an index of emerging markets has trailed U.S. markets by about 100%, and other developed international markets by roughly 40%. Even worse, investors in emerging markets have actually lost about 12% during that time when they could have made about 88% in a simple S&P 500 ETF, or 27% in the EAFE index of developed international markets.
Emerging market equities are not part of our bench- mark but they are on the menu of asset classes that we can invest in as global investors. We think it is safe to say our clients’ overall wealth has certainly benefited from our decision not to be invested in emerging markets for the last 4 years, even if we have received no benchmark gratification from our prior positioning. We will continue to pay attention to what we don’t want to own, and we continue to believe that staying the course in our theme of avoiding value traps should pay dividends over the next few years.
Fixed Income: Sticking with Barbell While Increasing Alternatives
The thirty-year bond bull market is no spring chicken, and so we understand why many clients and investors fear higher yields and lower bond prices. Despite the low yield cushion in global bond markets, the world still has many deflationary tendencies, particularly in a world where China’s growth rate is decelerating, commodities will likely churn lower, and inflation stays subdued. In this environment where central banks are out of normal policy ammunition and have resorted to using unconventional weapons to control asset prices, owning a few chips to help defend the portfolio against a potential deflationary shock still seems prudent to us. Eventually, classic inflationary pressures will begin to build in a manner that will make it more compelling to reduce bond exposure, but we don’t believe that growth is likely to accelerate by enough to create that risk in the near-term.
On the other hand, as long as the growth is able to maintain its moderate pace of the past few years, de- fault rates should stay low and credit sensitive fixed income securities should be able to outperform treasuries over time. For now, we are staying the course with our barbell approach to fixed income portfolios, but we are also beginning to build an alternative buck- et within fixed income that consists of dollar positions and merger arbitrage. Both of these alternatives have very little correlation to bonds over time, and should benefit if the short end of the U.S. yield curve does begin to rise in September (or soon after).
Staying the Course Not Easy, but Still Makes Sense
Sometimes doing nothing is the hardest thing to do as an investment manager. After all, every day is full of news stories, changing data points, dire predictions, and emotional events. Particularly during low volume summer markets, news stories can whip up volatility and increase overall anxiety. As longer-term investors, we have to be able to separate the noise from the signals, and the reality is that there is far more noise in most short-term data and news flow than there is signal. We’ve written several times about some of the bigger themes that we believe are shaping markets, and at the halfway point of the year, we’re confident those themes will be great guides in helping us shape portfolio asset allocations over the rest of the year. At some point we’ll be forced to make major changes based on a shifting view of the market cycle, but until sufficient evidence arrives we will continue to stay the course and ride the themes that we have conviction in over the next few years.
Note: The above discussion applies to the management of Pinnacle’s Dynamic Prime models. Below is a brief description of changes during the quarter to Pinnacle’s new investment strategies that were introduced earlier this year. The Dynamic Market Series and the quantitative component of the Dynamic Quant are not managed according to Pinnacle’s macro outlook. (see disclosures related to the new in- vestment strategies)
Dynamic Market Series
The satellite of the Dynamic Market strategies, comprising 30% of the portfolios, remained on a defensive posture throughout the second quarter. Such posture was driven by our valuation model for the S&P 500 index, which continues to indicate that the market is presently overvalued, implying poor prospects for expected returns over the intermediate to long term. As a result, during most of the quarter the satellite was allocated to bonds. However, the gradual downtrend in bonds (i.e., rise in yields) that started in the first quarter of the year caused the technical component for bonds to eventually move from a “buy” signal to a “sell” signal near the end of the second quarter (on June 30th to be exact). As a result, the entire satellite of the Dynamic Market strategies moved from bonds to cash on the same day, and remains in cash at present.
Dynamic Quant Series
The allocation of the quantitative satellite, comprising 37.5% of the Dynamic Quant strategy, was unchanged during the second quarter. The little turbulence that the stock market experienced during the quarter was not enough to budge the technical component, which remained on a firm “buy” signal. As a result, the strategy remained on an aggressive posture and the quantitative satellite was allocated according to the sector rotation component. During the entire quarter, the two largest overweight’s carried by the satellite were in the Technology and Energy sectors, mostly thanks to attractive valuation scores. While the Technology sector was approximately a market performer, the Energy sector faced renewed pressure after rebounding in April, and was one of the most significant drivers of the strategy’s underperformance during the quarter. In addition, the satellite continues to carry two mild overweight’s in the Financials and Consumer Staples sectors, as well as a neutral weight in Telecom.