September 2016

……………..Thoughts and Comments


It is September, not long after Labor Day: the end of the year will be here before you know it. Is your portfolio properly positioned or are you going to react to whatever happens, rather than anticipate it?

Every year, toward December, you will read advice about positioning your portfolio for the new year. This year, it is more critical than ever to be planning and positioning in advance. Waiting for December will be too late.

Issues the markets will address in the next four months – that we know of

1) Between now and January, we will have four Fed meetings – this means four more times the Fed will discuss whether to raise interest rates.

2) There is the Presidential election in November with the swearing in to take place January 20 (a week before the January Fed meeting).

3) Third quarter earnings will start to be reported in mid-October and fourth quarter earnings in mid-January.

4) The ECB will discuss whether to extend their QE beyond mid-2017 and will discuss purchasing stocks in addition to bonds over the next six months. The Bank of England has started their own QE                           and this will be reviewed over this same time period.

5) The Bank of Japan is conflicted: half of its members believe that they should continue buying stocks and bonds and lower interest rates, while the other half believes that after three years of trying                         to raise inflation and stimulate the economy, Abe’s plan has not worked. Many traders are waiting to see what they decide in September (the same time as our own Fed meets).

6) Italian banks are struggling, Greece still has not gotten their bail-out, and there are elections all over Europe where anti-immigration and anti-globalism sentiment has been rising.


Quarterly results have been slowing for five quarters and we don’t expect either third or fourth quarter earnings to be better. The following graphs show trailing twelve-month growth rates for the S&P 500 on an equal-weighted basis. Notice that the trend in all cases has been down since the end of 2014. Margins have been falling more quickly since the middle of 2015. While the impact of currency valuations had a large impact in the past twelve months, the impact will be muted on a going-forward basis. However, wages and healthcare costs are increasing and that will have a negative impact on margins.





Looking at the two graphs that follow, notice that both multiples and debt levels continue to climb while revenues, income, and margins fall. This is a warning sign for a fundamental investor. Typically, when earnings and margins peak, investors start to sell so that P/Es start dropping while earnings still look good (all about anticipation rather than reaction).

Currently, however, investors are paying up for weaker earnings, so unless you expect a change in the earnings picture pretty soon, this is very dangerous. Why is this happening? Because of the central bank money policies around the world.




Central Bank Plans

If history is any guide (and it usually is), then central banks will wait until it is too late before reacting. This time there is the added concern that if central banks raise rates as much as they should, they could bankrupt many governments due to all of the QE. Instead, they will devalue their currency in a race to inflate away the cost of the borrowed debt.

Unfortunately, the entire world is busy trying to do the same thing at the same time. Furthermore, their experimentation has not been successful. General economic growth has not gotten stronger anywhere, even with negative interest rates and central bank purchases of stocks and bonds. In fact, the Japanese stock market is down over 12% even with all of their central bank’s purchases.

More of the Same?

You are now thinking, “what Alan is really saying is we should expect the markets to continue just as they have all year, right? Nothing has changed!” Ah ha! I have caught you in the classic writer’s whodunnit misdirection!

Actually, there has been a big change in the way the markets have acted this year from prior years, and another big change has taken place since June. Understanding this will help explain how to position your portfolio going forward.

At the end of last year and for the first several months of this year, the markets almost behaved rationally (well, relatively speaking anyway). Stocks sold off in the first quarter after the Fed raised rates in December. At the same time, oil inventories were very high and rising, while prices were falling. This led to a number of bankruptcies in the energy space, and a number of bad loans amongst the banks. At the same time, bonds rallied out of fear of the falling stock market and worries about the economy.

Then the markets reversed in late February and went straight up. First, because economic numbers got weak so everyone expected the Fed to sit tight and not raise rates again soon (so much for fundamentals). Bond traders took profits but then kept bonds in a range for the same reason.

However, in June, everything seemed to change. Instead of lower correlations, stocks and bonds and commodities started correlating again. Stocks bonds and commodities all started rising together. Then as we got closer to Fed meetings (June 14-15, July 26-27 and September 20-21) the markets all sold off as the Fed talked tough but promptly rallied after it was seen as simply that – talk.



What seems to have begun to change is the traders are less convinced that the central banks will keep increasing the pace of their QE and negative interest rate policies (“NIRP”) to keep the party going.

The downside to these games has been felt most recently in the violent sell off in 10-year government debt around the world. Just last week the German, Japanese and U.S. 10-year notes all dropped precipitously because of worries about continued QE. Which drove all the other markets down as well. As yields have rallied back a bit, so have the other markets.





Portfolio Strategy

Given that world economies are weak, I do not expect any central bank to act aggressively to normalize interest rates. The Fed will not raise rates in either September or October. They may raise 25 basis points (0.0025%) in either December or January, but not both. However, the posturing by the Fed and by traders will likely lead to increase volatility around the Fed meetings in September, October, December, and January. Markets will sell off into the meetings (stocks, bonds and gold) and rally when the Fed does not act.

Under this scenario, indexes will likely slowly (very slowly) trend higher over time, with a lot of volatility in between. The reason for the rise will be a purchases made by central banks or on central banks’ behalf, as they continue to keep rates artificially low and force investors to put their savings somewhere. The longer the central bank games continue, the more investors will capitulate and buy anything with a yield (already happening).

This will be offset by slower earnings growth in the stock markets, which will keep a lid on gains and will lead to increased volatility and losses inside the index. In other words, investors will be at risk of losing money even if the indexes are slowly rising. This will lead to further demand for passive investing, which will set up more investors to fail when a market turn finally happens.

Under this scenario, we will continue with our strategy of Risk-Averse Investing: 70% in fixed income of investment grade quality with average durations of about 2 years. Instead of investing in indexes, we will continue to use individual bonds and stocks where we can analyze the risks better. Our stock analysis is based on growth characteristics, not just based on dividend yields. This makes up approximately 20% of the portfolio of which part will be in gold mining stocks as a hedge and as a good fundamental investment (remember, these are miners, which is a real business as opposed to owning a gold or silver nugget), and part will be in hedges in various industry groups that are showing economic weakness or strength. The rest will be in cash as another hedge and to take advantage of opportunities.

The ECB and the Bank of Japan will likely find ways to increase their QE programs, which should help the markets as detailed above. However, if they do not, or if traders believe that they are starting to give up, then expect sell offs like in the bond charts above.

The same will be true if and when central banks ever really start to raise rates. In either case, our current portfolio will work well with some miner (the pun was intentional) adjustments.

Because of the short durations, if rates rise we will still be earning a return and as individual securities mature we can roll them into ever higher rates. The stocks will likely lose money, but increased hedging positions should insulate this to a large degree. Cash is always a good thing is a weak market and when prices become too extreme on the downside – as they always do – we will have plenty of capital to start buying attractive businesses as bargain prices.

The Bottom Line…

Our goal is to grow clients’ capital when we can do it within reasonable risk parameters and to protect it when we can’t. The key is twofold: 1) patience; and 2) stick with investment rules that haven proven successful over many years. In preparing for the various upcoming events, discretion is the better part of valor and advanced planning critical.

Given the high correlation of differing assets and the greater volatility being experienced, a more defensive, risk-averse mentality is in order and is likely to be the best idea until fundamentals are back in control.


Alan E. Rosenfield, Managing Director

September 2016



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