Financial markets are sending a message to policymakers (read, the FOMC members) that U.S. interest rates, the Chinese currency and the OPEC oil decisions are fraught with deflationary risks. Markets are sending a cautionary message to policymakers that they need to stop with the rhetoric about eight Fed rate hikes in the next two years, especially since the rest of the world is tilting towards a deflationary environment.
The markets have been in a “rioting” mode since the December announcement about the rate increase. While 25 basis points, or one quarter of one percent should not slow our recovery down, the fact that the Fed “signaled” that they were on course to do four more rate hikes in 2016 has spooked the market. In our opinion, what the Fed needs to do is just telegraph that they are on hold “for the foreseeable future.”
In addition, the Chinese need to say that the yuan or RMB’s downward adjustment (to help their exports) is on hold for the foreseeable future and the Saudis need to say that their strategy of “market share at any cost” has gone far enough. If these issues can be successfully communicated then the markets (both stock and bond) should settle down and volatility should decrease.
The S&P 500
As one can see from the Bank Credit Analyst graph below, the S&P 500 has not retreated that much because it is “cap weighted,” meaning that the bigger the company, the more weight it carries in the index. For example, in 2015 the top 7 stocks representing 13% of the S&P 500 had an average total return of 41%, while the remaining 493 stocks had a total return of -1.4%.
What is more telling is how the equal weighted Value Line Index (blue line) performed, compared to the S&P 500 since early 2014. Looking at the Value Line Index it appears that we have been in a stealth bear market for many individual stocks for the last 12-18 months. This is one reason why we have been slowly reducing volatility in our portfolios throughout 2015. This chart starts in 2010 where you can see that the S&P 500 and equal weighted Value Line pretty much moved together until early 2014.
As a result of the sell-off of risk assets so far in 2016, the question is…should we “bottom fish” with what we have in cash (money market funds) now? We don’t think so as the stock market can always get cheaper. Even if we are wrong, we take solace in what the famous investor Bernard Baruch said almost 100 years ago…“I will give you the first 20% of a stock’s move and the last 20% and I will be happy with the middle 60%.”
As a result, we are looking for more confirmation that the “bottom” of this sell-off has been reached. While we will not catch the absolute bottom, that is okay with us, as we are more interested in waiting for the market to start moving up again than trying to catch the very bottom.
While we are not market timers or traders, when the environment dictates action we are not hesitant to make some changes, as we did in 2008. In the second half of 2015 we made a number of adjustments:
- Moved the portfolios to a 5% equity underweight, now at 7-8% underweight.
- Changed our value/growth mix from 60/40 to 55/45; now at 50/50.
- Completely exited emerging markets and high yield bonds.
- Added a market neutral fund to reduce volatility.
- Moved our cash position to 11-12% from the 2-4% area.
- Eliminated several fixed income funds to reduce volatility and moved the proceeds to the more intermediate term area.
Following our first quarter IPC meeting, a few more changes will be made as we still think we are in a volatile market where we could potentially see some more market downdrafts.
Please contact us at (972) 684-5923 if you have any questions.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.