NAVIGATING THE SHORT-TERM TO PROFIT IN THE LONG-TERM
Short-term events can create long-term opportunities - as an investor you have to be able to recognize how to take advantage of this. In April, over a seven-day period, we experienced a terrorist bombing, an industrial explosion, and a downward trending market that sent large US stocks down over 3% and small US stocks and mid-cap US stocks down more than 4%. For some investors, the recent market shocks were seen as the beginning of the overdue pullback in equities and the perfect opportunity to take profits. Others saw it as a minor pause in an otherwise strong bull market.
We think it is neither. The markets are getting more volatile because there is increased short-term risk from sluggish economic indicators and a growing perception that asset bubbles are starting to form on the horizon. However, many asset classes remain fairly valued and therefore pullbacks create opportunities for nimble investors to enhance their portfolios for the long-term.
UNDERSTANDING THE MACRO
After a raucous 1st Quarter led by US equities, the 2nd Quarter is off to a bumpy start with lackluster economic data coming out of the US, China and Europe. In the US, the employment recovery lost steam in March with a tepid 88,000 new jobs added versus an estimated 190,000 jobs2. In addition, March retail sales data showed the biggest drop in nine months as consumers digested reinstated payroll taxes and anticipated additional impacts from the sequester. After a very difficult quarter for emerging markets, China reported a less than expected GDP number of 7.6%3. A slowing China coupled with the recent Cyprus banking crisis has reignited fear of another post March pullback in the markets.
Although the catalyst for the pullbacks in each year was somewhat different, they all occurred on the back of specific macro challenges. In 2010, the flash crash on May 6th started a fear spiral that drove the markets down almost 10% from its high. In 2011, it was the US debt downgrade and heightened recessionary fears that sent the US market down 18% from its April 2011 market high. In 2012, the May swoon was driven primarily by escalating concerns about the Eurozone debt crisis, with Spain and Greece keeping contagion worries front and center. Given the strong housing rebound and continued intervention by the Fed, we do not see a magnitude correction of over 10% as in past cycles. Instead, we see the potential for specific dislocations (ie: gold, emerging markets, and select opportunistic yield strategies) to create great opportunities to tactically shift our allocations for the long-term.
In the post-2008 investment environment, volatility is a constant and so it is not surprising to see extreme moves in many asset classes than can quickly eclipse their expected returns over several years. These dislocations require action. It isn't "timing the market," but simply a necessary component of a sound investment strategy. Below is a snapshot of the most recent tactical trades we have made for clients in the wake of the recent run-up in US equities:
Bought the Volatility Index (NYSEARCA:VXX) on 4/12 and sold it on 4/18 for a gain of approximately +17.5%
Rationale: Downside protection tool in wake of S&P500 run-up
Maintained overweight to Utilities allocation (NYSEARCA:XLU) which was up over 16% including dividends YTD through April 23rd
Rationale: Fiscal Cliff tax concerns and Hurricane Sandy dragged down performance late in 2012 creating an attractive entry point
Rationale: Decreased overall higher beta US exposure due to expected earnings challenges
Bought iShares 20 Year Treasury (NYSEARCA:TLT)
Rationale: Hedge against market correction
Bought the US Energy Sector ETF (NYSEARCA:XLE)
Rationale: Bought after the Sector corrected over 6% in the first two weeks of April
REBALANCING FOR THE LONG TERM
Short-term moves in prices give us ideal opportunities to rebalance and achieve our long-term portfolio objectives.
Source: Ibbotson Indexes, US LT Govt Bond TR is annualized from 1952 to 1982 and 1982 to 2009
Over the last several months, we have spoken with clients about the eventual impact of rising interest rates on the total return of traditional bond portfolios. The reason for today's unsustainably low long-term rates is not complicated. We are at the end of a 30 year bull market cycle for bond yields which has been driven by a falling rate environment. T-Bills have averaged over 10% annual returns for the past 30 year cycle vs. just over 2% in a rising rate environment (yes, that is what is coming next).
As the global economy slowly recovers, the Fed will eventually have to wind down its "long-term asset purchases," also known as "quantitative easing" which have kept rates artificially low. The Fed is buying Treasury bonds and long-term mortgage-backed securities at a rate of $85 billion a month, equivalent to an annual rate of $1,020 billion - not sustainable.
Although it has not indicated just when rates will rise or how high they will go, the Congressional Budget Office (CBO) projects that the rate on ten-year Treasuries will rise above 5% by 2019 and remain above that level for the next five years4. If any of the CBOE projections ring partially true, the loss in the price of the bonds will wipe out most of the gains earned in interest for clients.
Given these potential challenges facing traditional bondholders, we do not believe that clients can depend solely on traditional fixed income portfolios to produce the 4-7% total return numbers that they have produced over the past decades. As a result, we have used the recent pullback as an opportunity to continue our broader shift away from more traditional fixed income and defensive holdings to higher yielding income allocations in other asset classes (see table). The net result will be to replace core fixed income yields with other assets without materially changing the overall risk profile of the portfolio.
Another long-term theme we build on is our belief in emerging market growth. In the short-term, emerging markets have significantly underperformed the US creating increasingly attractive valuations on a relative basis. When these markets diverge by over 15% as they have this year, it creates a clear opportunity.
In Warren Buffett's recent annual letter to investors of Berkshire Hathaway, he once again addressed the uncertainty that preoccupies many members of the media and has dampened the willingness of American business to invest. He points out that uncertainty has been a constant in the United States since 1776; the only variable is whether people ignore the uncertainty or fixate on it5. In practice, it is probably best to do neither. We pay attention to uncertainty, especially in the short-term, as it does create opportunities to tactically make money for clients. And in the coming weeks we expect more volatility and potential sell offs but no big structural failure like in 2008 or 2011. It is hard to believe that the mere 3-4% pullback last week represents the big pullback that every technical strategist has been predicting. After a surprising first quarter equity run led by defensive sectors, we will be anxiously analyzing macro and micro factors this earnings season for further proof of sustainable growth in the equity markets.
The views of Miracle Mile Advisors, LLC ("MMA") may change depending on market conditions, the assets presented to us, and your objectives. This research is based on market conditions as of the printing date. The materials contained above are solely informational, based upon publicly available information believed to be reliable, and may change without notice. MMA makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change.
MMA shall not in any way be liable for claims relating to these materials, and makes no express or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in, or omissions from, them. This report does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this report may not be suitable for all investors. MMA recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives.
This report is not an offer to buy or sell any security or to participate in any trading strategy. In addition to any holdings that may be disclosed above, owners of MMA may have investments in securities or derivatives of securities mentioned in this report, and may trade them in ways different from those discussed in this report. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in your securities transactions. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data.
The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances; accordingly, you should consult your own tax, legal, investment or other advisors, at both the outset of any transaction and on an ongoing basis, to determine such suitability. Legal, accounting and tax restrictions, transaction costs and changes to any assumptions may significantly affect the economics of any transaction. MMA does not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws.
The projections or other information shown in the report regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
Other Important Disclosures
Physical precious metals are non-regulated products. Precious metals are speculative investments and, as such, their value can be subject to declining market conditions. Real estate investments are subject to special risks, including interest rate and property value fluctuations as well as risks related to general and local economic conditions. Foreign/Emerging Markets: Foreign investing involves certain risks, such as currency fluctuations and controls, restrictions on foreign investments, less governmental supervision and regulation, and the potential for political instability. In addition, the securities markets of many of the emerging markets are substantially smaller, less developed, less liquid and more volatile than the securities of the U.S. and other more developed countries. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of MMA.
2 Bloomberg, Job Gains Slow Amid U.S Unemployment at Four-Year Low. April 5, 2013.
3 Reuters, China Growth Risk in Focus as First Quarter Data Falls Short. April 15, 2013.
4 Congress of the United States Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013-2023. February 5, 2013.
5 Warren Buffett's Annual Letter to Berkshire Shareholders. March 1, 2013.
*30-Day SEC Yields as of 3/28/12 except: XLE as of 4/22/2013 and TLT as of 4/19/2013.
Copyright © 2013 Miracle Mile Advisors, LLC