Covenant’s Weekly Market Synopsis as of June 9, 2017

June 12, 2017

Another week of potential market moving events (more terrorism in the UK, the British election and former FBI director Comey’s congressional testimony) had little impact on equities, which treaded water for much of the week. Yet, a routine research piece released Friday by Goldman Sachs evidently found the sensitive spot in investors’ psyche catalyzing a volatile sell-off in highflying tech names. It’s not that research can’t move markets occasionally, but there are literally hundreds of reports issued on a weekly basis, and this research didn’t reveal much new information. Rather, it summarized a point that everyone already knows – FANG (Facebook, Amazon, Netflix and Google) stocks are expensive. The selloff in tech names was largely confined to the Nasdaq Index, which fell 1.8% on Friday, while the more concentrated and largely non-tech Dow Jones Industrial Average gained 0.4% to close at a new high. It’s also worth noting that Value stocks, while underperforming Growth stocks year-to-date, gained 0.7% on the week vs. a decline of -1.3% for Growth stocks. Friday’s action may mark the beginning of a rotation into less expensive/overpriced sectors of the market.

Developed international stocks declined on the week (-1.2%), while Emerging Markets gained 0.4%, largely on the back of a 3.2% gain in China’s main equity index. Interest rates on US Treasuries moved higher by about 0.05% across the yield curve, though yields on 10 and 30-year bonds remain lower than at the start of the year (signaling market expectations for low inflation and economic growth ahead). Precious metals declined (Gold -1%, Silver -2%) along with WTI Crude (-3.8% to $45.83 per barrel) as rig counts continue to rise in the U.S. shale plays.

The Fed meets this week and is widely expected to raise their target interest rate by 0.25% (to 1.25%). They may also hint at plans for beginning to reduce their balance sheet towards the end of the year.

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

 

Views from the Empire State – Spent last week in what CNBC has dubbed the “most powerful city in the world”, visiting with money managers large and small. Re-underwriting existing investments, exploring new opportunities….learning from the frontline generals who battle in the markets on a daily basis. Asked all of the managers a version of the following question: what keeps you up at night? Some were quick to respond with a laundry list of concerns, while others pondered the question before answering. Some managers cited statistical anomalies in the markets, while others provided subjective assessments honed through decades of trading experience. The result, a scatterplot/mosaic of opinions on prevalent market risks, including:

  • No one is pricing the left tail [bad market outcomes] and it is much fatter than the market thinks it is.
  • Investors are generally complacent, yet G7 countries (on average) have experienced dramatic equity drawdowns every 7 to 8 years through history
  • Difficult to see credit spreads getting tighter – asymmetric trade with little upside and lots of downside
  • Markets “feel” full
  • Volatility is extremely low and that is, itself, a risk
  • Typical credit cycles include 20 quarters of expansion – we are 17 quarters into the current cycle and default rates at about 0.45% are as low as they are likely to get. Expect defaults to begin rising in the next year and ultimately reach 5x their current level.
  • The connection between interest rates, debt and foreign policy. Would a massive tax cut force the U.S. government to issue more bonds that no one buys? Lack of bond demand would push interest rates higher impacting the delicate balance between high debt levels and the ability to service that debt.

 

The level of concern within this manager group varies, none of them are alarmists, and not all of them are bearish…but they all are vigilant. Yet, at the same time, few of the managers have had to significantly modify their investment approach in light of these risks. You see, they built their strategies, achieved successful track records and collectively amassed hundreds of billions of client-capital by following a disciplined approach to investing with a common thread of portfolio diversification and managing downside risk. This strategy has allowed them to sidestep periods of financial distress, deploying capital into ideas and markets when others are forced to sell and the upside potential is meaningful… the other side of the coin that is the market today. Most see opportunities to make money, a lot of them on the short side. Yet they know they must be patient. Even if the fundamentals dictate that a stock should roll over, a currency crash, or a commodity crater, asset flows matter. And right now, assets are flowing into risky assets creating a Teflon Market where terrorism, geopolitics and disappointing economic data have, to this point, created only a short-term impact, if any impact at all. These managers recognize, as do most of their clients, that there will be periods to be ultra-aggressive and periods, like now, to be more cautious. Likewise, and in a somewhat correlated manner, there will be periods of above average performance and periods of below average performance for their respective strategy. Yet, after a full market cycle, their returns will stand above those of the popular equity indices, even if the ride is not as “exciting”.

Most of the managers are as surprised as anyone that the market continues to levitate higher… seemingly following a late-cycle pattern in which investors are continually able to sell to someone willing to pay an ever-higher price. All the managers stated explicitly or implicitly that this would end at some point, but with humility they readily admit they do not know the approximate, let alone precise, timing. Echoing a comment you have seen peppered in our communications over the last two quarters, the business cycle is not dead and this time is not different.

One manager at a Top 3 global quant fund shared: “If you focus on building robust models, though they may not be the best performing at certain times they do well over longer timeframes. So we don’t overreact when a model is ‘underperforming’ relative to other models in the portfolio. We understand that we need to hold to our beliefs and convictions. We are statisticians at heart and are playing the numbers.” His insight can be applied to diversified portfolios. It’s not about the performance of any individual asset class, and certainly not when measured in a short timeframe (which should be measured on the order of years, not months or quarters), but rather how the various components of the asset allocation harmonize over a long timeframe to compound value with fewer downside surprises.

What many miss, especially when in the midst of a protracted period of rising markets and low volatility, is that you diversify for the capital destroying end of the cycle. Not the beginning, not the middle. Unfortunately, no one can predict when a cycle will end and, typically the longer the swing up, the more violent the swing down. So what can be gleaned from the decades of experience transcending multiple cycles of these managers we interviewed last week? In sum, be alert, be patient, diversify. And for whatever it’s worth, don’t lose sight of the fact that nothing goes up (and with few exceptions) down forever.

Be well,

Jp.