What Me Worry?
- The market tends to climb a wall of worry
- There was plenty to worry about during Q2
- ARS exited the quarter in the black YTD – with ½ the market risk
There’s an old Wall St. slogan which suggests that markets tend to “climb a wall of worry”. For many observers, that may be the only way to make sense of the domestic equity market’s behavior during the second quarter of 2016.
Although the stock market closed the 1st quarter on a strong note, bouncing like a trampoline off the February 11th lows, it mirrored crude oil and other hard commodities’ strength into the quarter’s close.
Still, for those in the cautious camp there was still plenty to worry about:
- An economic “hard landing” in China and how that would affect global demand
- A potential Federal Reserve rate hike at home and its global ramifications
- A corporate earnings “recession” and what that would mean for stock valuations
- And, last but not least, the “Brexit” – Brits couldn’t be crazy enough to bite off their financial nose to spite their immigration face, could they?
Altogether it added up to a worry wall that would impress Donald Trump fans and Mexican immigrants alike. Yet climb it, the markets did.
Equity markets got off to a sluggish start in April as witnessed by the Dow Jones Industrial Average (DJIA) rising all of 100 basis points, (1%) for the month. The building blocks of a successful quarter were being put in place, however.
Six of nine sectors had positive returns for the month, led by Energy’s 9% gain which signaled a marked change of direction for the “black gold.”
West Texas Intermediate crude oil rose 20% during April alone, driven by the triple-whammy of slackening production, a palpable decline in inventories, and signs of resurgence in global demand – spurred on by a report that China’s exports had increased by +11% in March.
Another signal vital for equity’s and commodities’ success blinked “green” – the U.S. dollar’s recent domination in the currency pits screeched to a halt as illustrated by the British pound’s appreciation of 2% vs. the greenback in the 1st month of Q2. Who’s worried about any scary, old Brexit anyway?
May kept the party going, with the S&P 500 up +2% for the month and the NASDAQ composite up double that.
U.S. economic data came in strong as: Q1 GNP was restated from negative to +0.8%; the price of oil (which has been positively correlated to equity markets) rose 7%; and Europe looked strong with the MSCI EAFE up nearly 2% in local currency, suggesting Europeans were either confident of a positive Brexit outcome or whistling past the proverbial graveyard.
Seven of nine sectors were higher for the month including Technology which rose 6% led by Apple, Microsoft, and Alphabet (formally Google).
Wouldn’t you know it, the Federal Reserve Board put a crimp in the party when the minutes from their April meeting revealed that they might raise rates sooner than expected. Their hawkish comments had a cascading effect: the dollar halted its fall, rising 3% vs. the euro; in turn, hard commodities (net oil) fell sharply, sending gold tumbling for the first time in five months, dragging Newmont Mining down 7% and copper-heavy Freeport-McMoRan off 20%.
Once again the Fed had shot its mouth off about an imminent rate hike only to have to walk their language back to dovish in embarrassingly short order. The May non-farm payroll employment report (which came out on June 3) was shockingly short of expectations, coming in at 38,000 vs. the consensus estimate of 162,000. Economists pointed the finger at the “labor participation rate” which hit a 40 year low. June wasn’t starting out so great.
In years to come, the month of June, 2016 will be recalled for one thing – Great Britain’s vote to leave the European Union
And it somehow came as a surprise as all the polls (which happened to be sponsored by the “stay” side and focused on London which was strongly in the “stay” camp) suggested that the “stay” camp was poised for a victory. Then “leave” won.
Flight to safety became the order of the day. Defensive havens like Utilities (up +7% for the quarter) and Consumer Staples, (up +5%) were reinforced as the place to be. Late cycle growers like Tech and Consumer Discretionary felt the biggest sting (down 4% and 1% respectively) ending the quarter as the only two sectors in the red. Oil closed the quarter up 25%; Gold leaped over $1,315.00, up 7% for the quarter and almost 25% year-to-date.
Everybody, on both sides of the pond, held their breath when it was announced that the impossible had happened: the bloke in the street had taught those haughty Europeans and their London puppets a rough lesson in democracy.
But what would be the consequences? As many predicted, equity markets swooned and dooms-dayers pronounced it the beginning on the end. Stocks fell roughly 5%, egged on by a crash in the British pound that brought the once legendary currency to levels not witnessed since the 1980s.
Then, suddenly, a miracle happened. Within a few days of the knee-jerk reaction, the sun came out again, the equity flower bloomed, and the markets erased all the early losses, sprinting ahead to a +2.5% gain for the quarter. Somehow, with all the worry in the world there for all to see, the U.S. equity market shrugged it off and closed only percentage points away from an all-time high.
At Alpha Risk, we employ a proprietary algorithm that steers us into and out of the nine sectors in the U.S. stock market, even allocating 100% to cash when market conditions indicate periods of extreme risk. During the quarter, ARS’ proprietary algorithm signaled seven sector rotations as it sought to de-risk the portfolio mid-quarter, yet added market exposure (beta) in the latter weeks.
The ARS Sector Rotation Strategy opened the 2nd Quarter in a risk barbell – with a big overweight to Utilities and Consumer Staples on the conservative end, and exposure to the high-risk, high-reward Tech and Consumer Discretionary sectors on the risk-assumptive end
The action began right off the bat as the 3rd highest beta sector – Industrials – kicked on during the first week of the quarter. The portfolio stayed positioned with 5 sectors on and 4 off for the next 5 weeks, although in the 3rd week of April we swapped Tech for Financials, actually increasing the market exposure by adding the highest beta sector to the portfolio.
Exposure to Financials didn’t last long – in fact only a couple of weeks. By the 3rd week of May Financials had been turned off as the system got more cautious, falling back to its defensive positioning of overweights in Utilities, Staples and this time Industrials, plus 25% cash. From here until the close of the quarter, our algorithm called for greater market exposure every week, ending the quarter in the 7 best sectors – everything but Energy and a still-momentum-free Healthcare.
Publicly traded Real Estate Investment Trusts (REITS) were the best performing industry in the Financials sector, gaining 6% for the quarter and 11.1% YTD –that’s better than 22% annualized. Over the last twenty years REITS have outperformed the S&P 500 by 128 basis points a year, (11.13% to 9.85%), fortifying the argument that they should stand as their own sector. Here’s the good news: on August 31 equity REITS will be elevated to full “sector” status in the Global Industry Classification System (GICS),putting them on equal footing with Energy, Technology, Healthcare, etc. Many investors are expected to raise their allocations as a result.
During the quarter the ARS Sector Rotation Strategy was like a watchdog with its snout in the air, constantly sniffing for danger; and there was plenty of danger to be had. Yet, in the end, it couldn’t keep a strong, determined market down – with rates this low there was really no other place to go. The ARS Sector Rotation Index was fractionally in the black for the period and year-to-date (YTD). It did achieve those positive returns with less the ½ of the risk of the S&P 500 as measured by beta (averaging .48 YTD) and with 63% of the standard deviation of the broad stock market. During the last quarter, as our algorithm scrambled to raise equity exposure, the portfolio’s average beta rose to .77. The watchdog was still on alert.
Recent equity markets have been fraught with danger, yet investors need equity exposure as they live longer productive lives. Thus, the need for risk management has never been greater.
This quarterly market recap is offered for informational purposes only as a review of current and historic economic and market events; no discussions or comments herein are in any way intended to be forward-looking or predictive and nothing should be interpreted that way. Although all data, information, inferences, and conclusions found within it are based on information derived from reliable sources, in no way can ARS or anyone else warranty its accuracy in any way. Also, in no way does this blog offer investment advice and nothing within it should be taken as such. At no time should this document be considered an endorsement for any investment product, methodology, philosophy, or index and always remember that indexes are not investable and most investment returns include fees whereas most indexes do not.