I admit, I've been missing in action. I took a prolonged summer break and have been traveling Europe for months now. As a matter of fact, I've been traveling the world for 11 months now and have not yet returned back to Australia. Last newsletter, which initially did not work properly due to technical issues (but works now), showed a few places I recently visited including the beautiful Adriatic coastline.
Since I haven't properly commented on asset class performance in awhile, today's post will be more in-depth than usual. Furthermore, in coming posts I will also be diving into some commentary that covers various portfolio returns, and not just classic tactical opinions. There are many ways to do this, but I shall try to track the "imitational lookalike" performance of several famous asset allocators and comparing them against the way I invest my own capital. But for now, let us cover recent market conditions.
2016 has been a great year for asset classes, in particular the bond market. Federal Reserve raised rates at precisely the wrong time at the end of 2015, just as the global economy continued to slow. What followed was a nasty equity market correction in January and February, which pushed the Fed back into the dovish corner. The bond market started a powerful rally, sensing that the US central bank was in a "one-and-done" case scenario.
The chart above shows annualised performance for Treasuries, Treasury Inflation Linkers, Investment Grade bonds, Emerging Market bonds and High Yield Junk. While EM debt has outperformed over the last 12 months (up 15.3%), every other sector of the bond market has done very well, including Junk Bonds (up 7.3%). This is precisely why we made a tactical call in early July that the bond market and other safe havens should correct.
On the risk asset side (not shown in the chart above), we have sound performing assets as well. On an annualised basis US equities are up 12.9%, EAFE equities are up 1.0%, EM equities are up 16.3%, US commercial real estate is up 18.3% and finally gold is up 15.5%. Please note that all data above is from the middle of August. Basically, it's been difficult to lose money in 2016, not matter what one did. But the question is, what should we expect from here onwards?
First and foremost, it seems to me that we are still in a yield flattening environment. In plain English, this has almost always meant tighter monetary and credit conditions. The spread between the 2s and 10s, as well as the 5s and 30s seen in the chart above, continues to narrow. Every student of market history should know that an inverted yield curve has been a pretty decent predictor of recessions and the last two occurrences (in 1999 prior to the Tech crash & in 2006 prior to the Lehman crash) are no different. While we are not there yet (still another 105 basis points left), the recent consolidation of yield spreads narrowed within a small triangle and broke downwards. This breakdown has been linked to the recent comments by Janet Yellen & Co. Hawkish comments could be preparing us for a rate hike after the elections, as long as economic data continues to improve.
This could be a bit of a worry for the Treasury bond market investors, which on aggregate hold a decently bullish position within the futures market. Treasury COT data can sometimes send wrong signals, so I like to focus on the group known as Non Reportables or Small Speculators. When we combine the positioning throughout the whole yield curve, we can see that Specs aren't net long so extreme optimism isn't a worry here.
However, they do hold only a small net short position relative to other major extremes such as early 2007, middle of 2008, early 2011, late 2013 and late 2015 (all of those marked major bond market bottoms). Therefore, if the Fed was to move rates higher in coming months, there is a chance that hedge funds will be forced to increase their Treasury net shorts as prices correct.
At this point, I know that some readers will automatically assume that shorting the US Treasury market, in particular the very volatile long duration maturity, could be a slam dunk play. However, that is very far from certain. Over the last three years, we have seen the Fed move slowly towards tighter monetary policy.
Firstly, we had the tapering of the QE, where Mr. Bernanke decided to stop printing money. Afterwards, we had the Federal Reserve start its tightening cycle, admittedly at a very slow pace. So how did bond bears do over the last 3 years? Not so well, to be quite honest. The 30 Year Long Bond has produced a 12.8% compound annual growth rate (CAGR).
One could argue that this is the slowest and most dovish tightening cycle in Federal Reserve history (dating back to 1913). I wouldn't argue against that. Therefore, let us focus on the tightening cycle prior to this one, where Ben Bernanke & Co. raised rates multiple times during mid 2000s and yet the 30 Year Long Bond never lost money when held over that 3 year rolling period as well.
As a matter of fact, the last time longest maturity total return declined in any meaningful way was during inflationary periods of the 1970s (Oil Embargo I & II). Even then, nominal losses were only around 5 percent per annum (very different story when adjusted for inflation).
I am not suggesting that the 30 Year Bond cannot drop in price. Long term bond investors suffered serious corrections in 1973, 1979/81, 1987, 1994, 1999, 2009 and 2013. However, unless you are an amazing market timer, shorting bonds isn't for the faint-hearted investors. The same case could be made with the ML Junk Bond Total Return Index. Expectations by bearish investors that high yielding bond market will implode in similar fashion to 2008 was short lived… very short lived. Once again, great market timers would have made a nice profit by shorting in May 2015 (around the same time MSCI World peaked out) and closing those shorts in early 2016 (around the same time crude oil bottomed out).
But how many of us are truly capable of doing that on a consistent basis? On the other hand, long term investors who earn interest and reinvest proceeds back into the index, have done great over the last two decades. Let us remember that to achieve this return, one must be able to ride though the volatile periods of 1998 Asian Financial Crisis, 2001 US Recession & Tech Crash, 2008 Global Financial Crisis, 2011 Eurozone Debt Crisis and finally the 2015 China Slowdown & Commodities Crash. So…should we be surprised that the High Yield market is now posting yet another record high in August?
As a result of the Federal Reserve turning dovish and backing away from aggressive rate hikes in the first half of 2016, credit spreads have narrowed dramatically. Worst quality high yielding bonds (CCC Or Below) have narrowed from 20.2% all the way to 12.5% against equivalent maturity risk free Treasuries, while BBBs have come down from 3% towards 1.8% last week. Finally, the recent commodity collapse did not put much pressure on the highest quality bonds and the spreads in this area have not been affected much since the Eurozone Debt crisis in 2011/12.
Speaking of the Eurozone debt crisis, 2015 was the worst performing year for global equities since the 2011/12 period. As I've written many times before on my blog, the US has outperformed and continues to outperform, posting new record highs. This is the stock market that has been tricking all the global macro investors. If one was to closely observe the chart above, other Developed Markets including Japan suffered throughout 2015, while Emerging Markets (and in particular China) went through an outright crash.
After the February lows, global equities have staged a seriously strong comeback. The S&P 500 has broken out of its trading range, while the MSCI All Country World Index is playing catch up and is trading at the highest level since the middle of 2015. Technical analysts could make a case that the ACWI has now successfully completed an inverse head & shoulders bottom and new highs may lay ahead.
Additionally, February also marked the low in breadth readings and for the first time since mid 2014 we have 100% of major global indices (priced in USD) trading above their respective 200 day moving average. While this does signal short term overbought readings (and a potential for a pullback), it also tends to signal wide participation rate over the medium to long term (and a potential for higher prices ahead).
Over the short term time frame, breadth isn't the only important indicator signalling a potential for a pullback. Volume and volatility have dropped to levels which indicate that complacency is widespread (especially volume on the QQQ ETF). Furthermore, while "Sell in May and go away" has not worked this year, it is important to remember that September is traditionally and historically the worst month for equities.
Finally, looking at the NAAIM survey and to a lesser extent II survey, bullish sentiment has returned to levels where equity pullbacks tend to occur. As a result of these indicators, and several others not discussed here, I wouldn't chase equities immediately despite a bullish S&P breakout from an 18 month trading range.
While my personal message and tone is leaning more towards a bullish stance, and a cautiously bullish one at that, certain readers will disagree. Don't worry, all it takes is for me to look at the extremely high equity valuations by any one of the more widely followed metrics (CAPE, PB ratio, Price to Sales, etc, etc) and I will also disagree with myself too. Having said that, here I would like to add a few points.
Firstly, sentiment was universally bullish coming into late 2014 and early 2015. At the same time, breadth was very weak as far more NYSE stocks declined during 2014/15 period than rose. As we noted above, credit spreads were already widening. Also of importance was the decline in company earnings and slowdown in economic growth (in particular places outside of the US like China).
Many famous investors, "celebrity" hedge fund managers and widely followed "gurus" called for the S&P 500 to decline and yet over the last 3 years US equities have managed to achieve an 11.8% compound annual return…slaughtering the bears. And now we have a two year long consolidation, which has been broken to the upside and could have bullish consequences.
A very successful and wise investor once told me that "good traders get out when the market moves against them, while great traders reverse their position." I believe that US equities' resilience is a surprise to just about all of us. So maybe if it doesn't want to go down, it still wants to go up?
One way to play the remaining innings of the bull market could be via value stocks instead of chasing market darlings and momentum. More depressed sectors, such as Energy, have gone through a serious bear market while S&P 500 traded sideways. We discussed how the Large Cap index posted impressive compound returns over the last 3 or even 5 years, but obviously this is not the case for commodity producers and other related sectors. I would argue that the US Energy sector is now attractive both nominally as well as relatively.
There is an above average probability that we have seen the bottom in this downhearted part of the market and on any meaningful pullback, I would start to acquire some positions. The sector is so oversold (even despite a strong rebound in the first half) that the 3 year rolling CAGR remains one and a half standard deviations below the 50 year mean. Such dreadful performance happens during major oil busts like we saw in the mid 1980s, early 2000s and during the 2008 GFC…and that is usually the best time to buy.
Keeping value as the central point and emphasis, certain investors could make a case that relative to both US stocks and US bonds (which are at all time record highs) gold remains very attractive. The bear market from September 2011 until December 2015 shed more than 40% (on monthly closing basis) of yellow metals value. Furthermore, despite a robust first half performance, the precious metal is still in a drawdown of almost 30%.
There are merits to this argument, however I would like to add a few important pieces of information. Historically, gold investors have accepted the same risk and volatility of EM equities, but for only half the return. Observing the chart above, some readers might come to a conclusion that gold is possibly one of the more lousy asset classes for the long run, providing the worst risk relative to reward.
Furthermore, consider the fact that over any 2 year rolling period within the last 50 years, global equities tend to achieve positive returns 83% of the time while gold does so only 56% of the time. By the same token, record highs are achieved only 9% of the time and drawdowns can last for generations (please refer to the first gold chart). Obviously, past performance isn't a good predictor of the future and at times this precious metal has done fabulously well. Sometimes up 11 years in the row, like from 2001 until 2012.
I believe that we are now at an important cross road for gold, as well as the overall precious metals sector. Last week's technical bullish reversal on the USD Index could mean that the bull market in the reserve currency is resuming (the chart below shows a consolation period over the last 18 months).
I wonder if we will look back on the current gold & silver rally as a dead cat bounce or the start of a new bull market? If it's the former, quite a few people will be wrong. So many reports have been published about how gold has started a new bull market. So many speculators and hedge funds have jumped into futures contracts and ETFs (chart above).
Nevertheless, we live in strange times as global central banks continue their monetary policy experiments. In the world of negative interest rates, bonds aren't an asset but an actual liability (and a money losing proposition). Over and above that, in the world of negative interest rates, gold is actually a positive yielding asset class. Finally, there have been periods in time when both the dollar and gold rose as safe havens (even though they are quite rare), so there should always be a place for gold in any asset allocation strategy.
Holidays are always great. Amazing food, green & blue crystal clear waters and wonderful weather is always a blessing…what more could we ask from our life? But I am very happy to be back in work mode and fully focused.