6 June 2016

Keep Calm and Carry On

Executive Summary

We believe that the equity market could be on the cusp of a new secular trend, breaking out after being stuck in a sideways movement for the past 15 years. However, investors remain pessimistic and funds continue to suffer equity outflows. We do not share this pessimism and are comfortable with near full equity allocations for now. In the bond market, the risks appear asymmetric, especially as yields are near record lows coupled with more Fed rate hikes on the horizon. We fear that the market is complacent in assessing these dangers and we are prepared should the worst happen in bond markets with short duration exposure and flexible multi-strategy fixed income. In the near term, there could be some volatility due to Brexit worries, Fed rate hike worries and US Presidential election worries. We are ready to pull all risky assets out of the market should any event cause contagion.

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In this update, we do a quick reality check and ask a few important questions:

  1. Is the equity market on the cusp of a secular bull, which nobody seems to believe?
  2. Is a bear market about to occur just under our noses?
  3. Does anyone realise that buying longer-dated, higher-yielding bonds in this present market is akin to picking up pennies in front of a train?

Secular Trends – Equity Market

In a way, all three questions are related. The chart below (Fig 1) is one of our favourites, as it shows the performance of the three major asset classes over a very long period of time. It also shows that investors have to be patient to weather certain periods, especially over the last 15 years as we had essentially been in a very tough sideways market (which recently broke out in early 2015 but then stalled in the face of mounting worries). Whether this breakout could continue is anyone’s guess, but there are positive signs that it is still possible.

Fig 1: Long Term Charts Show Secular Trends Very Well. Cyclical Bull and Bear Markets Are Merely a Small Blip Within.

The chart below (Fig 2) looks at secular bull markets for equities from a different perspective. Here, cyclical corrections of approximately 20% are normal within a long term secular bull. We believe that we are still in the midst of the secular bull market for equities and that it still has some room to run. We would not turn bearish (unless our Risk Matrix© signals otherwise), and investors should look past all the present noise.

Fig 2: Cyclical Corrections Are Normal Within a Secular Bull Market and There Have Always Been 1 or 2 Medium Sized Corrections During the Secular Trend.

Secular Trends – Bond Market

What continues to worry us is how investors continue to seek yield without any regard to the current state of the bond market. Investors seem unaware that we are near the end of the cycle and there is no way but up for bond yields – which means that investors will have to take losses on a seemingly safe instrument. Despite what the Fed has said about the economy and the number of rate hikes this year, we feel that investors are still complacent and not well positioned. Money market futures have not priced in the 2 rate hikes (Fig 3) that Fed members have been highlighting in various forums (let’s not forget that the Fed originally wanted to do 4 rate hikes for 2016!).

Fig 3: Investors Are Not Positioned For The 2 Rate Hikes Which The Fed Has Mentioned as Quite Likely. This Will Definitely Introduce Some Shocks Throughout The Fixed Income Market When It Happens.

Likewise, the investment grade sovereign market is also not pricing in a similar level of rate hikes (Fig 4). Any re-pricing of the investment grade market will reverberate to the other segments of the fixed income world, ultimately affecting riskier bonds like longer duration, Emerging Market and segments of the high yield market. We feel that this is a big asymmetric risk that investors should not take as there are just too many headwinds facing bonds over the near term. Investors should also be wary of recent high-yield bond issues that have come into the market. The quality of these companies are poor, with the big majority being quite heavily indebted. Should the economy take a turn for the worse, we do not see any possibility that these corporates will be able to pay the coupons, let alone return the principal.

Fig 4: Investment Grade Market Is Still Overvalued With Extremely Low Yields Even With Hikes on the Horizon.

Is There a Bear Hiding Somewhere?

We have mentioned many times this year that we would like to err on the side of the bulls. So, what are we watching for before we turn bearish? The first thing we are watching is the bond yield curve (which is also one of the components of our Risk Matrix©) as it has proved to be quite a good leading indicator for recessions and big fundamental bear markets. Whilst the curve has been flattening since 2014, we are still quite far from levels where credit conditions become too difficult for businesses to continue (Fig 5).

Fig 5: Whilst the Yield Curve Has Been Flattening, We Are Still Quite Far From Levels Which Have Typically Preceded Recessions and Big Bear Markets

The second thing we are monitoring is equity market valuations. Although we are in the bull-camp, we acknowledge that present equity valuations pose some headwinds to further gains in stock prices (Fig 6). Whilst markets can remain overvalued for many years, the only thing that can correct this would be a market sell-off or an improvement in company earnings. Although our models and Risk Matrix© will warn us of a bear market, we have been keenly watching for an improvement in earnings (Fig 7) which will provide more fuel for our bull market thesis.

Fig 6: Equity Market Valuations Pose Some Headwinds. The Only Way To Correct It Would be From Improving Corporate Earnings or a Large Sell-Off (Which We Do Not Subscribe To Currently)

Fig 7: Stabilising Commodity Prices and Improving Economy Provides a Case for an Improvement in Corporate Earnings.

Near Term Worries – Brexit

The immediate knee-jerk reaction from a Brexit would be a sell-off on the currency (GBP) and stock market (FTSE). We modelled the possibility of a 10% loss each on the GBP and FTSE100, and the impact on some of our aggressive portfolios is a 1.5-2.5% loss. It is unlikely that this whole issue would lead to a global contagion but we will be on alert if it does. The loser from this would be the UK and possibly Europe as it leads to longer term structural labor and productivity issues (Fig 8).

Fig 8: Economic Growth in the UK Would Very Likely Be Impacted From a Brexit.

Short Term Worries – Rate Hikes

Unlike the rest of the market, we need to be prepared for the rate hikes. There are many reasons to support this, e.g. the job market has been in a constantly-improving trajectory since the financial crisis. Another reason is that there are signs of inflation picking up as the economy nicely accelerates (Fig 9). There appears to be very little reason for the Fed to continue holding off for too long. Investors should not be too concerned about the rate hikes taking place as long as it is not too quick. If it is too quick, the market may not have time to digest it, which would lead to negative knock-on effects in the economy.

Fig 9: Many Signs Point To An Improving Economy Which Would Allow the Fed to Continue to Raise Rates

Fig 10: Rate Hikes Do Not Derail the Equity Market, Unless the Speed of the Hikes is Too Fast.

Medium-Term Worries – US Elections

Interestingly, the typical “sell in May” seasonally-weak period is not so apparent during US presidential election years. A very long term study on the stock market performance since the 1900’s show that during election years, the stock market is range-bound between Apr to Jul, but as primaries are concluded and the candidates become clear, the market does well when the incumbent wins and does poorly when the opposing party wins (Fig 10). Logically, it makes sense, as a new party would likely renege on many agreements put in place by the predecessor.

Fig 11: Market Does Well Into Nov/Dec if Incumbents Win and Does the Opposite When They Lose.

Conclusion

We reaffirm our belief that we are still in a secular bull market for equities and at the likely start of a secular bear for bond markets. The risk and reward ratio for holding equities currently far outweighs that of fixed income. Whilst we are leaning bullish on stocks, we are also watching out for developments that could derail it, namely valuations, earnings, Brexit worries, Fed hikes and the US presidential election cycle. In any case, we are still relying on our Risk Matrix© to provide us with timely cues on when to exit the market should financial market stress rise together with a slowing momentum in the equity market.

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