Tuesday, February 27, 2018

This Week's Message: Rallying on the Wrong Theme!

Regular readers know that we remain constructive on global equity markets going forward. In fact, "constructive", frankly -- based on the weight of both the technical and fundamental evidence -- puts it mildly. I.e., We're -- heightened volatility notwithstanding -- downright bullish for the foreseeable future. That said, I find the otherwise impressive two-day (last Friday and yesterday) rally uninspiring. 

You see, while the distribution of gains among sectors Monday wasn't horrible, Friday's was downright inconsistent with what present conditions dictate. I.e., utilities outperformed all other sectors, while REITs came in third and bonds rallied in a big way; which essentially confirmed the media narrative that markets rallied on a pullback in interest rates. More accurately; rates pulled back (that is, bonds rallied) on Fed-member jawboning, which inspired an aggressive rally in stocks -- interest rate sensitive stocks in particular! 

To elaborate on my lack of inspiration, allow me to share a simplistic narrative on how stocks and bonds fit together over the life of the business cycle, as we see it: 

(We'll leave the more weedy narrative that includes how currencies and commodities fit into the cycle for another time)

How we got here:

Stocks and bonds had been trending higher in relative tandem for years as the fed eased and the economy maintained a slow, yet non-inflationary, rate of growth. The reason being; declining interest rates made existing bonds more attractive while both creating an environment of less competition for stocks and setting the stage for more robust economic growth down the road (ultimately leading to strong corporate profits).

Where here is:

That correlation is now breaking (has been subtly since February 2016) as economic growth accelerates with its attendant rise in interest rates. I.e., bond market participants are beginning to price in an acceleration of activity, and inflation, and the Fed is now naturally shifting to a gradual tightening stance in an effort to maintain growth coincident with a healthy/steady rate of inflation. This is a virtual no win scenario for bonds, while posing little threat to (in fact enhancing for certain sectors) the prospects for corporate earnings and continued stock market gains, save for the more interest rate sensitive sectors such as (in order of severity) utilities, reits, telecom and staples.

Then what?

Bonds and stocks will ultimately join forces again, albeit briefly, when the economy finally begins to top out and, stocks -- in anticipation of the next recession -- catch down to, and trend lower with bonds (before bonds wake up to the prospects for dramatically lower interest rates).

Then what?

The next phase of strong negative correlation (bond prices and stock prices moving in opposite directions) will follow as we enter the next recession and bonds move higher in anticipation of lower interest rates, while stocks continue to decline as the recession runs its course.

Then what?

The two will then remarry as stocks reverse course (higher) in anticipation of the end of the recession, while bonds continue to trend higher, reflecting what will be an extended period of lower interest rates.

So what do we do?

Major opportunities present themselves during those times when the correlation breaks, as market participants will continue to trade for a while on the old relationship.

For example (the current setup): As bonds react negatively to an accelerating economy and the end of Fed easing, stocks are sold off aggressively (the recent (or current) correction) as its assumed that share prices will follow bond prices lower. The next sustained reversal in stock prices -- the end of the initial correction -- comes as economic data continue to improve
, equating to higher corporate earnings, and market participants redirect their focus toward corporate results and away from simply interest rates (hence my skepticism over the present rally). Investors adding to positions here may be handsomely rewarded, as history suggests that under this scenario stocks can continue to trend higher for an extended period of time.

Patient long-term investors would generally do well to target the bulk of their equity exposure to cyclical sectors (financials, tech, materials, industrials, consumer discretionary), while limiting their exposure to defensive, interest rate sensitive sectors (utilities, REITs, consumer staples).

Then what?

The next opportunity occurs when -- as stated above -- the expansion peaks and stocks begin to follow bond prices lower. Here investors would generally do well to rebalance (and/or reduce) their equity exposure with a strong bias toward defensive sectors, while incrementally rotating their fixed income exposure away from cash and money market instruments and toward long-duration bonds (in anticipation of falling interest rates).

Then what?

And, finally, to come full circle, the next opportunity presents itself as -- per the above -- the positive bond/stock correlation once again breaks and bonds rise in anticipation of dramatically lower interest rates. In this phase, however, the negative correlation in and of itself is not a reason to begin rotating to cyclical stocks, as the recession likely has further to run. The time to begin the rotation is when stocks show clear technical signs of bottoming and when economic data begin to turn the corner. 

Waiting for technical signs in equities -- and fundamental signs in the economy -- before rotating to cyclical shares keeps the investor from buying the many false rallies that occur during typical bear markets. And waiting for stocks to trade higher (confirming the technical signals) before buying makes it more likely that the investor is buying close to the bottom. Buying stocks, or rotating away from defensive sectors, when bonds first begin to trend higher is not advisable as the bottom in stocks is virtually bound to be significantly lower.

And the cycle repeats...

Man, if it were only that easy! Alas, as we've learned, however, the best laid plans, and narratives, can be -- or for a time can appear to be -- laid to waste by the whims of a forever uncertain market. Which is why we remain open to all possibilities at all times. That said, the above narrative is consistent with market history and serves as a solid foundation for making general asset allocation decisions. 

Of course beneath the surface of every cycle the market responds to ever evolving technologies that require thoughtful analysis when making specific sector allocations. One example would be the headwinds presented to the energy sector from huge advancements in extraction as well as the now inexorable shift to renewables; dictating a notably lower target allocation than we had during prior expansions. 

Back to the present: I just took a break from typing and saw the following headline:

"Stock rally could depend on whether Powell is hands-off on policy for now"

That, in a nutshell, justifies my skepticism of the recent bounce back in equities. To repeat myself, if market participants (in the aggregate) are indeed fixated on whether the new Fed chair comes off tame or aggressive on the policy rate when he addresses Congress today, we should expect the market to take back recent gains, and some, in the near-term; despite the rally that would likely follow a "hands-off" presentation. In essence, higher rates are, at this juncture, a foregone conclusion regardless of how Powell presents himself today. And -- if you're the impatient sort -- the sooner the stock market (participants in the aggregate) gets its head around, and through, that, and onto the prospects for global economic growth and corporate earnings the better.

Me, I'm patient...

On a more inspiring note, also saw this headline in the same feed:

"Forget inflation fears -- Federated sees earnings as the market story of the year"

Now Federated's on the right track (theme)!

No need to google or read either article, they'll just mess with your head. Successful investors think for themselves, and/or hire advisers who do their own research and, thus, their own thinking.

Have a great week!

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