Covenant Weekly Market Synopsis as of October 14, 2016

October 17, 2016

Following an up and down week, equity markets (for the most part) closed in the red adding to losses from the previous week. Overall, it has been a tepid transition to the fourth quarter. Domestically, the immediate concern seemed to be potentially weak earnings as Alcoa kicked off the Q3 earnings season missing on profits expectations and lowering its revenue forecast (the stock fell 16% on the news). Relatively unimpressive economic data released last for both the U.S. and China did not help matters. Through six consecutive quarters of declining quarterly earnings, the S&P 500 has gained 3.4% (inclusive of dividends) stretching the valuation of the popular benchmark. After such a poor stretch for earnings, the Q3 earnings reports need only be good, not great, to give investors some relief and position the market for further gains. On the other hand, if earnings disappoint already lowered expectations this quarter, equity markets are likely to pullback as investors reassess forward earnings guidance in an economy growing at less than 2% per year.

Meanwhile, interest rates for US Treasuries continue to rise. The yield on the 10-year UST has increased 0.2% (to 1.8%) in just two weeks’ time as the market positions for a Fed rate increase in December. While the market believes the Fed will raise rates, recent economic data does not support such a move. Indeed. Q3 GDP forecasts have been cut by almost half since August from nearly 4% to around 2% today. Yet, after talking so long about doing it, the Fed may “go” whether it is economically warranted or not, in an effort to salvage their waning credibility.

For a more detailed view of weekly, month-to-date and year-to-date asset class performance, please click here.

Big Brains I– Spent a week in NY meeting with a group of the best and brightest in the investment industry.  Some are experiencing eye-popping performance, but for most of these big brains the last 18 months have been a grind.  In spite of performance being below their high expectations (which are informed by their own long term track records), nobody’s panicking. Are they frustrated?  Yes.  Some more than others.  But these managers take a more enlightened and humble long-term approach (a good reminder for all investors), recognizing that changing their strategy to maximize profitability in the historically unusual environment of the last 18 months would set them up for future failure and, perhaps even, result in becoming a hedge fund blow-up statistic.  During the week, the most oft cited feature of today’s markets I heard from managers is that fundamentals are currently being ignored, therein preventing true price discovery as markets are buffeted this way and that by every new utterance from a central banker concerning increasing or decreasing monetary stimulus.  In the short-run (even over a multi-year time frame) markets can ignore fundamentals, but over the longer-term fundamentals matter and when fundamentals reassert themselves, these managers expect to profit handsomely by doing what they have always done: in depth research to identify mispriced assets.  So they stay calm and research on.  Yes, some are tweaking their strategies or adding trading teams focused on complementary markets, but out of 20 odd meetings, not one manager has made any wholesale changes to their proven investment approach. Having traded markets for 15, 20, or 25+ years, they all know inherently and share explicitly that the key to long-term success is investment discipline.

Big Brains II – Having heard from enough managers that price discovery was not occurring in the markets the way that it should, it begged the question: “What will the catalyst be for true price discovery to occur again?”   To which one highly experienced manager replied:

With all humility, I don’t know.  No one knows. My opinion is that there are significant tail risks around the world, as high as they have ever been.  I am reminded of the first quarter of 2007 when no one believed the US could go into a recession, that housing prices could never go down, etc.  Complacency was extreme [not unlike now].  Witness the recent travails of Deutsche Bank [DB] – I am very surprised and even wary that DB did not spark more of a reaction.  Three years ago there were a lot of concerns around banks, including DB, and potential systemic risk to Greece and Italy that would ripple throughout European banks [a different manager suggested DB has more than 50% downside from today’s price].  Those problems have not gone away, but the level of monetary policy involvement in the global economy is at an all-time high.  Monetary policy hasn’t solved these problems; it has merely pushed them below the surface where they continue to fester.  When central banks are no longer able to paper over these issues, there will be significant pain for investors who are not positioned correctly.

Economic Wrap-up: The National Federation of Independent Business (NFIB) Uncertainty Index for September remained near a four-decade high as concerns around the election and a weak economic environment weigh on business owners’ outlooks for their companies. A high level of uncertainty makes it difficult for management teams to rationalize investing in their companies, be it human or physical capital. The NFIB’s chief economist Bill Dunkelberg remarked “If you can’t even say if you think things will be better or worse, you don’t do anything. You can’t fire or hire people, allocate or reduce inventory. You just tread water and that’s a recipe for muddling-along growth”. In other words, management teams are effectively paralyzed, which does not bode well for boosting GDP growth. Supporting Mr. Dunkelberg’s comments, the Job Opening and Labor Turnover (JOLT) survey for August showed a marked decline in job openings to 5.4mm (vs. expectations of 5.8mm). In spite of that relatively weak data point, other indicators show that the labor market continues to exhibit steady growth. Retail Sales for September were in line with expectations, revealing stable consumer demand, but lacked acceleration that could meaningfully boost GDP growth above its recent trend line.

Be well and Godspeed,

Jp.