The S&P 500 ended the first quarter up 0.89%, this modest performance greatly understates the historic volatility that occurred. After a weak fourth quarter rally, the markets began 2016 with a sharp decline, as investors feared that deflationary pressures were accelerating and a global recession was imminent. By the middle of February, global financial markets were in turmoil and the S&P 500 and the Russell 2000 had declined by 14.5% and 21.6%, from their respective fourth quarter highs.
As the markets declined and the deflationary fears increased, the central bankers responded (intervened) by pushing monetary policy further into unprecedented territory. First, on January 28th, The Bank of Japan reduced short-term interest rates to below 0%, (a negative interest rate policy). Then, on February 11th, Sweden's central bank reduced short-term interest rates to minus 0.50% from minus 0.35%. Additionally, the European Central Bank (ECB) told investors that they would increase liquidity and the level of financial accommodation at their March 11th meeting. These central bank actions were enough to stop and reverse the market decline by mid- February. The central bank intervention continued in March. The ECB, at their March 10th meeting, provided more accommodation than the market expected: they cut interest rates to minus 0.40%, increased their assetpurchasing policy to 80 billion Euro a month from 60 billion Euro, and they declared that they will purchase investment-grade corporate bonds, in addition to, the sovereign bonds they were already buying. Finally, on March 16th, the Fed announced that due to the global uncertainty, they would be less aggressive in raising interest rates to a normal level (i.e., they plan to increase interest rates twice, instead of their December estimate of four increases in 2016).
From January through mid-February, the markets were driven lower due to weakening fundamentals and recessionary fears; then from mid-February through today, the markets were driven higher (S&P 500 up 14.5%) as central banks intervened with dubious short-term polices (negative interest rates and Quantitative Easing) to drive-up risk assets. In our view, central banks intervened again to drive stocks further from the fundamentals and their intrinsic value. Their attempt to manage price levels, may work in the short-term, but in the long-term these actions: lead to a misallocation of capital, create additional structural imbalances and only delay the market's inevitable regression back to the underlying fundamentals.
Our Liquid Alternative investment strategy performed well in the quarter and we had a positive return in each month, despite the market volatility. During the equity market decline of January to mid-February, the positive performance of our safe assets (U.S. Treasury bonds, Japanese yen and gold) more than offset the loss from our equity positions. During the current equity market rally, our safe assets have performed well and only reduced performance by a modest amount. We believe that our Liquid Alternative strategy that is diversified and balanced (stocks, bonds, currencies and commodities) is poised to perform well in today's volatile and uncertain investment environment. Since our asset allocation is driven by the market's risk-reward, we are confident that we will meet our goal of providing positive absolute returns, with reduced volatility and a low correlation to the risky stock market.
Investment Outlook Summary
We continue to believe that the stock market offers a very poor long-term risk-reward. More than seven years of easy money due to the Fed's policy of financial repression -- 0% interest rates, negative real rates, QE (creating money to buy financial assets), and jawboning the financial markets -- drove risk assets far from their intrinsic value. Currently, corporate earnings are in recession and the global economy continues to deteriorate. In our view, we are in a bear market that began in May 2015. While the typical bear market decline is 32.4% over 13 months, we estimate that fair value on the S&P 500 is 1265, down 41% from the all-time high set last May.
After a 15% decline during the first six weeks of 2016, central bank activism ignited the current 14.5% rally that has driven asset values further from their intrinsic value. After seven years of "unconventional monetary policies", it is clear they have had little positive impact on the economy and, in our view, these policies have actually led to a misallocation of capital and an increase in the long-term economic structural imbalances. One such imbalance, due to the Fed's artificially low rates (financial repression), is the near-record corporate stock buybacks that occurred last year and during the first quarter of 2016. Instead of investing and building for the future, corporate America continues to defer capital expenditures and borrow to buyback their overvalued stock. While repurchasing the shares outstanding improves earnings-per-share growth and boost the stock price in the short-term, the reduction in capital investment leads to slower growth, less productivity and lower profitability in the long-term.
While market based indicators -- credit spreads, the yield curve, inflation expectations and market breadth -- have modestly improved since the February nadir, they do not confirm the dramatic equity rally and continue to indicate that the economy is headed for a significant slowdown or recession. The Atlanta Fed's GDPNow Economic Model confirms this economic weakness and currently forecasts that the first quarter of 2016 will grow only 0.4% (down from an estimated 2.5% in mid-February).
We expect U.S Treasury Bonds will continue to perform well in such a sluggish economic environment and we expect bonds to effectively hedge our equity exposure in periods of market weakness (i.e., an equity hedge that pays 2% annually). Additionally, 10-year U.S. Treasury bonds, which currently yield 1.75%, offer good relative value when compared to other major economies: Germany (10-year bonds yield 0.10%), Switzerland (10-year bonds yield minus 0.35%) and Japan (10-year bonds yield minus 0.05%).
Additionally, in the first quarter, economic uncertainty and central bank activism led to gold's best quarter since the third quarter of 1986. As the global economy struggles and the central bankers go further into unchartered territory, we expect gold -- as an alternative currency -- will perform very well. In the short-term, the market has appreciated a dramatic 14.5% over the past seven weeks and recent market-based divergences indicated to us that stocks are due for a correction and possibly begin the next leg down in this 10-month old bear market.
Asset Allocation: As value investors, the market's long-term risk-reward drives our strategic asset allocation, which remains defensive and positioned to perform well during periods of slowing economic environment and rising market volatility. Our tactical risk management overlay, which is based on volatility, trend and rate-ofchange, continues to partially hedge our equity exposure.
|Current Asset Allocation:|
|Large Cap Equity||30.0%||Long-term U.S. Gov. Bonds||17.0%|
|Small Cap Equity||0.0%||Int-term U.S. Gov. Bonds||15.0%|
|International Equity||0.0%||Municipal Bonds||11.0%|
|Equity Hedge (small-cap and volatility)||(11.0%)||Commodity||0.0%|
|RISK ASSETS||19.0%||SAFE ASSETS||65.0%|
Equity Market Outlook: In our view, more than seven years of the Fed induced financial repression -- 0% interest rates, negative real rates and Quantitative Easing -- has greatly distorted the financial markets, driven stock valuations far from their underlying fundamentals and created an extremely poor long-term risk-reward for stocks. Also, despite the recent central bank induced market rally, we believe that stocks are in a bear market that began last summer. Historically, the average bear market decline is 32.4% over 13 months and since we estimate that fair value for the S&P 500 is 1265 (a decline of 41.0%), we expect the S&P 500 to decline by 30% to 40% by the end of 2016.
The recent intervention by the global central bankers has ignited a dramatic 14.5% rally over the past sevenweeks, and in our view is another example of central bankers trading a short-term benefit for a negative longterm consequence. By setting interest rates below zero and promising to purchase investment grade corporate debt, central bankers have gone further into unchartered territory in an effort to delay the inevitable. While such aggressive monetary measures will drive risk assets higher in the short-term, they also reduce future growth by creating additional uncertainty, which leads to: less consumption, a misallocation of capital and encourages corporations to buy (share repurchases, mergers and takeovers), not build (capital investment for future growth and profitability).
In our view, central bankers have been "pushing on a string" and the recent advent of negative interest rates indicates a level of desperation, which will ultimately undermine the financial system they are attempting to prop up. Because negative interest rates hurt banks by reducing their profitability, future interest rate reductions will only lead to lower bank profits and less lending.
We believe the global credit cycle is over -- spreads are widening while debt downgrades and defaults are rising -- and the central bankers' virtuous cycle of weak economic data, increased monetary accommodation, and higher asset prices has reached its endgame. In our view, we are in a bear market and the central bank interventions provide nothing more than counter-trend rallies that only temporarily delay the inevitable regression to the mean.
While many pundits believe that we are not in a bear market because the recent decline in the S&P500 was only 15% and the index is currently only 4.0% below its May all-time-high, we believe that most stocks are in a bear market and the S&P 500's resilience is temporary and due to investor's "flight to quality" and the near-record amount of corporate share buybacks during the first quarter. Also, we are clearly in a earnings recession -- first quarter earnings are expected to decline by 8.5% year-over-year and this will be the fourth quarter in-a-row of declining earnings -- it is extremely rare to have an earnings recession without a bear market.
Since small-cap companies are considered lower quality and their stocks prices are more volatile and risky than large companies, investors typically sell their small stocks first to reduce their risk exposure. For this reason, small cap stocks have historically been a good leading indicator of both investors' risk preferences and the stock market. Unfortunately, the Russell 2000 has underperformed the S&P 500 for nearly two years, and while the S&P 500 declined 15% from its May all-time-high, the R2000 fell more than 27%. Given the dramatic weakness and underperformance by small cap stocks, we are confident that we are in a bear market, which will soon negatively affect large cap stocks.
In addition to investors' "flight to quality", massive corporate buybacks may help explain the S&P 500's resilience. It is estimated that companies in the S&P 500 repurchased a near-record $165 billion worth of stock in the first quarter. While share repurchases boost the stock price and help earnings-per-share growth in the short-term, the corresponding reduction in capital investment lowers future profitability and potential growth. Given that stocks are historically expensive and earnings are declining, we expect the recent record buybacks will not seem prudent in hindsight. Also, as earnings decline and the corporate credit market tightens, we expect that companies will be less willing (or unable) to repurchase shares in the future, which will remove a major support for the large cap indices.
Also, it would be very unusual to be in an earnings recession but not a bear market, especially when stocks are overvalued. GAAP earnings-per-share for the S&P 500 peaked in September of 2014 at $105.96 and have declined by 18.3% to $86.53 for the fourth quarter of 2015. While many believe that the current weak earnings are confined to the energy and industrial sectors of the economy, we are concerned that revenue growth and profit margins have each contracted for the last five quarters (S&P 500 operating margins declined to 7.98% from 10.1%). Despite five quarters of contraction, profit margins remain unsustainably high and as they continue to regresses back to a normal level, earnings are poised to disappoint complacent investors and lead to lower stock prices.
Finally, the significant weakness in the global equity markets supports our view that the resilient S&P500 is masking a bear market. Most major global equity markets peaked last summer, in unison with our equity markets, but suffered more dramatic peak-to-trough declines: China's Shanghai Stock Exchange (-49.4%), Japan's Nikkei (-29.4%), Germany's DAX Composite (-29.6%), UK's FTSE 100 (-23.2%), France's CAC 40 Index (-27.3%). Globalization has led to increased correlations between countries and markets and we believe that the bear market in foreign markets reflects the significant global economic problems and growing deflationary risk, which will continue to negatively impact our economy and financial markets.
Chart 1: Russell 2000 Small Cap Index
The R2000 index, which is comprised of 2000 small-cap companies, has been a solid leading indicator for the market and investor's risk preferences. The R2000 has underperformed the S&P 500 since March of 2014 and has declined 27% from its June 2015 high. Despite the central bank interventions, the R2000 has retraced only 50% of its bear market decline and remains 15% below its alltime- high.
Chart 2: Market Capitalization to GDP
Despite the market's recent decline, stocks remain expensive. In a 2001 Fortune Magazine article, Warren Buffet stated that market capitalization relative to GDP "is probably the best single measure of where valuations stand at any given moment." Currently, stock market capitalization is 116% of GDP; this is significantly above the 50-year average of 65%. Based on this valuation measure, stocks would need to decline by 44% to be considered fairly valued.
Chart 3: S&P 500 and GAAP Earnings
Over the past twelve months, the S&P 500 is essentially flat, while GAAP earnings have declined 15.5% from a year ago and have fallen 18% from the September of 2014 cyclical peak (S&P 500 earnings declined to $86.53 from $105.96). In our view, stocks remain detached from their fundamentals due to central bank activism and complacent investors.
Chart 4: Corporate Profits to GDP
It appears that profitability has peaked for this cycle. Currently, corporate profits are 9.0% of GDP, which remains significantly above the historic average of 6.5%. We expect earnings growth will continue to disappoint investors as profitability returns to a normal level.
Chart 5: Global Equity Markets
Most global equity markets peaked in unison last summer and had severe bear market declines of 23%-to-49% over the following eight months. Despite central bank actions, fundamentals continue to deteriorate and we believe the global markets are poised for another leg down in the bear market.
Economic Outlook: While market-based indicators (the yield curve, credit spreads, inflation expectation, market breadth and gold's twelve-month rate-of-change) have modestly improved from the mid-February market lows, they still point to economic weakness and do not confirm the Fed's recent guidance of two (previously four) interest rate increases this year. Additionally, the Atlanta Fed's GDPNow Model is forecasting first quarter GDP growth of 0.40% for the first quarter, which is significantly below previous expectations of 2.5%
It has been our belief that economic growth peaked in late 2014 and now the economy is in the early stages of its down cycle. The previous expansionary cycle was muted because of our excessive debt burden, the increase in the tax and regulatory burden and the Fed's QE program, which reduced productivity by incentivizing corporate America to grow earnings through financial engineering rather than capital investment.
We believe the central bankers' monetary illusion, which stimulates asset prices but not the economy, is coming to an end because: negative interest rates -- their new monetary tool -- hurt the financial sector that they are trying to support, and QE creates misallocations of capital and wealth inequality (elevated asset values make the rich become richer, while the main street economy receives little benefit).
As we have argued for a long time, solid fiscal policy, not unprecedented monetary policy, is the solution to the repair our economic problems. In our view, it is essential that central bankers "get out of the way" and let the markets work. Once the free markets adjust and clear, they will give investors and corporations valid economic signals and the confidence to make long-term investment decisions that will spur economic growth.
Additionally, if simple fiscal measures are enacted, such as, simplify and reduce the tax and regulatory burden, while adopting a rules-based monetary policy, we are confident that the significant pent-up demand (i.e., seven years of underinvestment) would lead to very robust growth -- similar to the early-to-mid-1980s.
Chart 6: Atlanta Fed GDPNow GDP Forecast
The S&P 500 has rallied 14.5% over the past seven-weeks, while the economy has continued to deteriorate. During this period, the GDP growth forecast for the first quarter has declined from 2.5% to 0.40%. This forecast confirms the action in market-based indicators and validates are defensive investment posture.
Source: Atlanta Fed
Chart 7: Yield Curve (2-year to 10-year)
A flattening yield curve does not bode well for economic growth. The yield curve has flattened dramatically since its January 2014 high, and has flattened by 30bps over the past year to its lowest level since the 2008 recession.
Chart 8: High-Yield Credit Spreads
While investment grade spreads have modestly improved since the equity market's February low, high yield spreads remain elevated and continue to indicate a change in investors' risk tolerance, and a reduction in market liquidity, which will provide a difficult environment for equities.
Chart 9: Nominal GDP
Nominal GDP growth continues to grow at less than 3%. Historically, this is a level that only occurs during recessions and is another indication of the deflationary pressure in the global economy. Solid fiscal policy, not unchartered monetary policy, is the only cure for this dismal growth.
Short Term View (three months): We expect that the recent central bank induced rally is nearly complete and the markets are poised for the next leg down in the bear market. While the stock market has been very strong, divergences are appearing, which lead us to believe the seven-week-rally is essentially over. Market breadth (advance-decline ratio), foreign markets, commodity prices and the high-yield-debt market have not confirmed the recent equity market's strength. A weekly close below 2000 on the S&P 500 would increase our confidence that the next leg of the bear market has arrived.
Chart 10: S&P500 and Negative Divergences
While the S&P500 remains in rally mode, both the market's breadth and the riskier markets (oil, commodities, and high yield) have begun to divergence from the S&P 500. This divergence signals a short-term shift in investors' risk preferences and may presage a stock market correction.
Summary: The new year began on a sour note as disappointing fundamentals and deflationary fears led to a sharp equity market decline. By mid-February, central banks intervened and pushed monetary policy to an unprecedented level, in an attempt to mitigate the decline. We believe the central bankers' new policy of negative interest rates is a sign of desperation and that they are out of monetary tools, because future interest rate reductions (further below 0.0%) will only hurt the financial sector they are desperately trying to prop up. We remain circumspect and believe that stocks offer a very poor long-term risk-reward. Despite the recent central bank induced rally, earnings are in recession and we are confident that we are in a global bear market. Our asset allocation remains defensively postured: underweight equities and overweight "safe asset" (U.S. Treasury bonds, gold and Japanese yen). We are focused on protecting capital, reducing volatility and providing positive absolute returns. Strategically, we will remain defensively postured until equities provide a favorable long-term risk-reward.
Our core philosophy is that the best way to grow wealth is: have a long-term investment horizon, invest in a diversified and economically balanced (stocks, bonds, currencies and commodities) portfolio and avoid major losses. In our view, we are in a bear market, corporate revenues, profit margins and earnings are contracting; yet the equity markets remain overvalued and offer a very poor risk-reward. We believe prudent investors should reduce their exposure to risky assets and be patient until the risk-reward improves and investors are adequately rewarded for assuming equity risk. Historically, liquidity-driven bull markets deflate quickly, and patient investors will be rewarded with great values and significant long-term opportunities.
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All information disclosed in this statement is accurate and complete to the best of our knowledge. Past performance is no guarantee of future results, and there is no assurance that the firm or client's investment objectives will be achieved.