While writing today’s market commentary and building the macro economic data set based on recentupdates, we find ourselves reflecting on recent market movements, and looking ahead to what may be next for equity markets. In doing so, we consider whether the decision to go defensive at the beginning of December was correct or not in hindsight.
As it stands, after an awful Q4 in 2018, global equities have staged a fierce comeback. The S&P 500 Index which we tend to focus on (as the US economy tends to be one of the main drivers of the global economy), has notched a record high over the last few days. As an index, it is up 25% from its Christmas Eve nadir, placing the 85-day advance among the top 2 percent strongest rallies since 1928. Predictably, bulls and bears are already arguing about the market’s next move. It is key to bear in mindhowever that all we have done is recover the losses experienced to that point, so in reality over 6 months, the S&P 500 has gone nowhere, and many other global indices are still in negative territory.
In hindsight, based solely on market movements, going defensive was not the right decision, but faced with the same mandate, data, fiscal tightening and market volatility, we would make the same decision so using hindsight and market movements as a means of questioning the logic of the decision Is not correct. Not every decision we make will be right when hindsight is used as measure and as always, the thesis drives the decisions not markets.
This is because hindsight is using market movement immediately post the decision as the measure and these are often the last to reflect a change in outlook, with market peaks often being followed by swift
and sharp declines. In contrast the economic data allows us to forecast movements based on global trade and economic health. On this basis, we maintain the current defensive positioning as we believe that risks of a significant market decline are still prevalent and therefore portfolios should be protected, based on high equity valuations and a weak global economic outlook, despite the fact that the outlook in the short term we see today may not be as bad as it was first anticipated to be. At the same time, we will be adding to some positions and reducing cash on the basis that we believe the risk of a hard Brexit and a subsequent UK recession is off the table.
As we react to new developments in the global economy, all clients see is the market and market movements, but from our perspective, we have to look through the movements in indices and instead at what the underlying economic data is telling us, will happen next. In our opinion, what happens next has been changing over time (as is typical of the late cycle phase), however it is still our belief that this rally is a bull market trap, and one that if chased due to FOMO, would prove very costly and
could take years to recover from. The debate may be entertaining between the bulls and the bears, but the market does not drive long term investment decisions, data does, and risks do not currently compensate for potential risks, particularly given high valuations.
Our Value at Risk (VAR) analysis tells us when markets are cheap and expensive given the risks, allowing us to make tactical decisions, however overall, day-to-day market movements are irrelevant, and the data is key.
Going back to the S&P 500, the simple reasons why we do not want to buy US equities today (ignoring the impact of currency movements) despite some data being better than expected, is that U.S. stocks are expensive, thanks to a historic rally in which the market has more than quadrupled in value since the financial crisis eased in March 2009. Additionally, as investors are constantly told but never quite seem to believe, frothy stock prices tend to be followed by subpar returns. In an article published in March by Bloomberg, before the markets rallied further to the highs seen last week on the S&P 500, one measure being the cyclically adjusted price to earnings (CAPE) is now flashing a very significant warning signal.
The CAPE ratio
This ratio founded by Yale professor Robert Shiller has reached 30 for only the third time since 1881 when it first became a well- regarded economic measure. The other two occasions werejustbeforetheGreatCrashin1929andintherun-uptothedot-comcrashin2000. AsCarlson who wrote the article correctly points out, comparisons with those two infamous market crashes, however warranted, are hardly proof another crash is imminent or even inevitable,however there’s a more dispiriting lesson lurking in the historical CAPE ratios. Namely, thatreturns from stocks tend to decrease over the medium term as the CAPE ratio rises.
One of the key takeaways from the article was that valuations have a meaningful impact on future returns. As valuations rise, the probability of high returns gradually diminishes and is eventually replaced with low or negative returns. A CAPE ratio of 30 or greater — which is where we are now — has historically been followed by low single-digit or negative 10-year annual returns, mainly because there is a significant fall that follows and then gradual recovery.
The historical relationship between valuations and returns isn’t just a coincidence. Here’s how it worksin real life: Say, for example, that a stock sells for $10 and has $1 of annual earnings. That investment has a P/E ratio of 10 and a yield of 10 percent ($1 divided by $10). A yield that high is likely to attract new investors, which raises the price of the stock — and its P/E ratio — and adds to the hefty 10 percent yield enjoyed by current shareholders. But the valuation can only climb so high. Once the stock pricereaches $30, let’s say, the P/E ratio jumps to 30 and the yield drops to just 3.3 percent. A yield that lowisn’t likely to attract many investors, and some shareholders will inevitably sell the stock and chase a higher yield elsewhere. The resulting decline in the stock price leaves late arriving shareholders with losses that further reduce their paltry 3.3 percent yield.
As we look at the data that is detailed in the Macro Analysis document accompanying this market commentary, we are again seeing mixed economic news coming from different parts of the world with some good, some bad and some ugly. The data seen in April has been more positive than that which preceded it in some parts of the world and more negative in others.
Although the picture remains mixed, the general theme is a weaker global economy which does not support equities rising from levels they are at today, so in our opinion we may be at the cross roads indicted by the CAPE worst case (which we do not think we are), or at a point when valuations will just fall from overly elevated levels and become more realistic and with no inflation and no more rate rises from the Fed. As such, we may be looking at a repeat of 1995 when the markets fell black and rallied again before finally capitulating. Either way, staying defensive is still going to be our position considering the risks.
As I write, we have just had two further data sets out of the US showing a sharp decline in the US ISM Manufacturing PMI and US Construction spending. The decline in PMI saw it fall to 52.8 in April 2019 from 55.3 in March, well below market expectations of 55. The latest reading pointed to the weakest growth in factory activity since October 2016, amid a slower increase in new orders, production and employment. The Construction spending decreased 0.9 percent from a month earlier to a seasonally adjusted annual rate of USD 1.28 trillion in March of 2019, following a downwardly revised 0.7 percent rise in the previous month and missing market expectations of a 0.1 percent gain. Investment in public construction dropped 1.3 percent after rising 3.2 percent in February and spending on private construction declined 0.7 percent to the lowest level since August of 2017, after slipping 0.2 percent in the prior month. Both sets of data only reinforce the conclusion in the attached thesis.
For many investors, whose time in the market numbers in years rather than months, the more useful question is how equities will fare over the longer term, and the most likely answer is not well. Those that have been clients of OCM for over a decade have seen us take these defensive positions before and have questioned the logic of not buying at the end of a cycle when the lemmings are. Many do buy at this juncture as a result of FOMO, just prior to a sharp and swift capitulation. In our opinion, the fear of not losing money continues to trump the fear of missing out because the market is reacting irrationally, and that always comes before a fall when looking back at valuation levels similar to these historically.
Our advice is to be patient and please do not worry about missing out over the short term, as missing some upside in the short term is the cost of protecting against the downside and we are still comfortable that our positions will do what they are intended and protect assets as the rally falls away and reality sets back in with equity valuations falling to more realistic levels. As we see it, the worst thing that can happen over this 12-month period is we gain nothing and lose nothing. The best is that the market falls significantly, and we gain before getting an entry point which means we get a significant upside whilst everyone else sees declines. Overall, I can live with that and we hope you can,have faith and ignore the short-term market movements and look at the data which is nowhere near as good as the market is hoping for.
If as a client, losing out on the upside makes you feel uncomfortable and you are accepting of the downside risks and would prefer to ride the roller coaster then please advise and we will invest you in a bespoke model that takes a long hold view and rides the roller coaster and only using capital preservation at the extremes being 9/11 or Lehman. As always, OBI may not be everything to everyone and for some it is marmite so flexibility to deliver for those that feel we are being too defensive is always an option.
Model Portfolios & Indices
At OCM, based on the movements in the UK parliament in the last few months and another Brexit extension and no hard Brexit, we no longer feel that a hard Brexit or any Brexit that does not have a customs arrangement of some sort is going to be palatable for parliament. On that basis, we no longer see the hard Brexit scenario as a risk that will stop us from allocating to assets and staying in cash. As a result, we are now happy to invest the majority of the cash held inside client portfolios into UK Commercial Property and UK Property assets that are able to generate a yield or return of circa 5% per annum as well as some more high yield assets that are globally focussed but hedged against any rise in sterling.
As regards to equities, we are still light on those and positioned to gain if markets fall and lose if markets rise (noting the bar bell approach in portfolios), with the loss balanced off against other assets rising in the portfolio. We are holding back some cash because if we do get a deal on the withdrawal agreement that parliament approves, this will result in the UK Chancellor spending money and investment in UK corporates rising in both the small cap and mid cap space, noting that we still feel the FTSE 100 will at the same time fall due a strengthening in sterling.
The small caps and mid-caps are less exposed to a rise in sterling as less of the revenue is coming from overseas. For the FTSE 100 as the revenue comes from overseas if sterling rises 10% from here that will result in an earnings reduction that will be structural and immediately impact on headline profits. It is therefore our view in the event of a deal on Brexit that involves the customs union that Sterling will rise, FTSE 100 fall and the mid cap / small caps rise. Over the coming few weeks therefore we will be adding positions to portfolios and keeping some cash (circa 10%)
Since we last wrote, we have seen the indices exhibit mixed performances and model portfolios remaining moderately benign with no real movements either way. As we progress from here, it is important to recognise that we should ignore the performance of the benchmark and not let it make us feel like we have missed out on anything because although you / we have in the short term, as stated at the start of this market commentary, if faced with the same data I would do the same again.
For all the reasons stated above, as we feel the rally has no foundation and will fall back over the coming months and give us a point when based on some solid data and resolution to the currency risks we will again start beating the benchmark and then we will as always recover what has bene lost either because the benchmark will capitulate fully or because sterling will rise and assets value reduction as a result will pull it back or we will just do a better job as we always over the medium term.
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested.
Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
The Treaty of Edinburgh–Northampton was a peace treaty signed in 1328 between the Kingdoms of England and Scotland. It brought an end to the First War of the Scottish which had begun with the English invasion of Scotland in 1296. The treaty was signed in Edinburgh by Robert de Bruce King of Scotland, on 17 March 1328, and was ratified by the English parliament at Northampton (the home of OCM and Northampton Saints) on 1 May.
CEO & CIO