7 January 2017 | Market Update

Stiff Upper Lip

Executive Summary

It would have been almost impossible to predict how 2016 would have ended – that stocks would end up and bonds down. With unpredictable events likely to continue with greater frequency in our interconnected world, there is a need to remain unemotional when it comes to investing. Investors who had pulled out in the early part of 2016 when stocks plummeted, or during Brexit or before Trump was elected, would be left kicking themselves as they would have had no way to make any gains for the year. When there is peak pessimism and it appears that the world is about to end, the light at the end of the tunnel always appears. We strongly advocate paying less attention to the market distractions around us – news headlines, noise, gossip and focus on things that truly matter. At the current time, we do not see any reason not to remain invested as market risks remain low. So, our advice is to keep calm, carry on and keep a stiff upper lip!

Article

The curtain has just come down on 2016 and there was no shortage of excitement for investors who had been following market events closely. Fig 1 shows the tale of three thirds in 2016.

The main takeaway from these three big events was that doing absolutely nothing would have been the wisest choice for investing in 2016. For our investors, we take comfort that our Risk Matrix© had proven to be an excellent emotionless bellwether in 2016. Had we listened to economists, market pundits and investment strategists, we would have succumbed to the same fears being propagated, staying out of the market at key junctures and hence suffered as a result.

Fig 1: Three Big Market Events in 2016; Our Risk Matrix© Did Not Highlight Any Market Collapse – Out Of Synch With the Consensus, But Was True in the End As Each Trough Led to a Recovery and Subsequent High

How Does 2017 Look?

Whilst we loathe to predict how markets will fare in the future, we would invariably be drawn into this discussion at some point. We defer all our immediate investment decision making to our Risk Matrix© and offer some views on the prospects for 2017 to let our investors decide for themselves.

A favourite chart of ours, Fig 2 shows long term trends in asset classes. This helps us keep everything in perspective and not chase short term ideas or themes. In a very broad sense, equities, despite worries about earnings and valuations, remain in a bull market and there should not be any reason not to invest there. Bonds appear near the end of its massive bull run since the 80’s and that is why we had been very wary of bonds since early 2015 despite investors continuing to chase the yield theme. With commodities in a bear market since 2011, it also does not make sense to invest there as it could lead to a multi-year stagnation. The current market situation has parallels to what happened in the 1950’s. Whilst there is no guarantee that the outcome will be similar, it does seem that we could still look forward to a decent 2017 for equities, but a poor year for bonds and commodities.

Fig 2: The Current Market Situation – Bull Market in Equities, Bear Market for Commodities, Turning Point for Bonds Has Parallels to the 1950’s.

In Dec 2015, we wrote (Upside Down, 31 Dec 2015) that we would go against general consensus and view 2016 as a good year to invest despite the US elections. Little did we know that Jan/Feb 2016 would start so badly, but by taking an overall “weight of the evidence” approach to markets, coupled with our Risk Matrix©, we felt that the risks in 2016 were overblown. Sticking to our guns has allowed us to eke out gains for the majority of our investors in 2016.

Viewing equity markets in 4-year cycles with reference to historical data, it appears that the current positive momentum will carry on into 2017, allowing the market to trend higher before coming unstuck in 2018 (Fig 3). Of course, we should not be too adamant about this, and will look for signs of trouble in 2017 by deferring to our Risk Matrix©, and other measurements of market health.

Fig 3: We Expect Equity Momentum to Continue In The First Year of This 4 Year Cycle

The possibility of 2017 being a good year for equities is supported by excessive liquidity from central bank support (Fig 4) and a positive earnings cycle for the new year. Tightening liquidity is typically negative for the equity market, and despite the tightening stance of the Fed, there are many friendly central banks in the world like the ECB, BOJ and BoE. Such policies will continue to provide support for stocks.

Fig 4: Excess Liquidity Usually Favours Stocks Relative to Bonds.

We have just come out of an earnings recession in late 2015/2016 as seen through the trailing earnings column. However, the forward estimate is positive for the new year (Fig 5). With the continuation of this earnings recovery, coupled with better global economic signs, worries over equity market valuations are likely to subside and will provide support to the market’s upside potential. Of course, earnings estimates are always prone to be revised downwards, but by starting from quite a high base, this provides a lot of room for positive surprise.

Fig 5: 2017 Earnings Estimates For All But A Few Markets Are Very Positive.

The outlook for fixed income in 2017 is less than stellar. The FOMC, in their Dec 2016 meeting had raised their target range for the fed funds rate, interest on reserve balances and discount rate by 25bps. The dot plot estimate for 2017 was also increased, and targets 3 rate hikes in 2017 – versus the current market consensus of two hikes in 2017. Fig 6 shows the FOMC dot plot and fair value for 10 year treasuries at 2.80% yield (at time of writing, yields are 2.14%). The rise in US rates will definitely put some upward pressure on global bond yields (which results in capital losses for bonds) and as such, we continue to advise investors not to take excessive interest rate or bond yield risk just for the sake of coupons. Taking reference from our earlier chart in Fig 2 on the bond market trend, we are likely to be at the end of a very nice bull run for fixed income and it would not be wise to take too much bond risk at this juncture.

Fig 6: Fed Hiking Path Assumes 3 Rate Hikes Per Year and 10-Year Treasury Yield Expected to Rise Leading to Losses for Bondholders

Short Term Risks We Are Watching

With a generally bright outlook for the equity market in 2017, we are still watching some short-term risks which could lead to a broader market sell-off. For one, valuation still presents a stumbling block for further equity market upside (Fig 7). As such, we are hopeful for the earnings recovery (discussed earlier) to relieve some of this pressure. The downside is that if companies continue to report declining earnings, markets with high valuations will face downside pressure.

Fig 7: Various Measurements of Valuation (P/E, P/CF, P/S) All Point to Some Level of Overvaluation.

Currently, the level of extreme optimism from both investors and consumers makes the market susceptible to some form of pullback (Fig 8) in the event of any disappointing news.

Fig 8: The Left Clip Shows Investor Optimism Just Into Extreme Levels, Right Clip Shows Consumer Confidence.

Weight of the Evidence Leans Bullish For Now

With the multitude of data points and measureable signals, we prefer to take the overall ‘weight of the evidence’ approach and lean to where the majority of the signals point to. Despite some worries over sentiment and valuation, the majority of the signals are still bullish. We will turn negative if we see deterioration in some of these models, as well as a spike in market and financial risk, which will show up on our Risk Matrix©. Fig 9 below shows a long-term momentum model of the US market which has had a good track record in highlighting weakness in the S&P 500, invariably leading to weakness in other parts of the world. At present, it is bullish.

Fig 9: Momentum of the US Equity Market (which leads global markets) Still Remains Strong.

In addition, measurements of bear market risk in global stocks is negligible, which is a positive sign (Fig 10).

Fig 10: Bear Market Signals Remain Negligible, Whilst Rally Signals Are Still Moderately Bullish.

Conclusion

Coming out of a volatile, albeit positive 2016 into a new year, we remain confident that equity markets will continue to provide investors with the best risk-adjusted returns in the market. We continue to advocate that investors hold globally diversified portfolios, as events of the past year have proved impossible to predict and there would have been no way for investors to have timed their entry perfectly nor have guessed which market would have outperformed. We will continue to be un-emotional investors and follow our Risk Matrix© signals closely, together with other market indicator models, as they provide the best assessment of the investing climate, while avoiding financial media, investment strategists and economists. In the face of adversity or turbulence, don’t forget to keep a stiff upper lip.

Here’s to a profitable 2017!

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