Client Brief: Dealing With Uncertainty
In my November 11th weekly missive I stated: "I highly believe that the market will bounce in the coming days ahead simply as a resolution to the very over stretched and oversold condition of the market. Sellers have likely been exhausted in the short term." While there were several reasons for this call, including the market trading 2-standard deviations below the moving average, bullish sentiment had gotten to very negative levels. When bulllish sentiment falls to very low levels it is usually indicative of a market that is getting overly bearish - which is bullish from a contrarian viewpoint.
The chart below is the composite bullish sentiment index which is the average of the AAII and the Institutional Investors bullish sentiment indexes. This is a weekly chart of the sentiment data as compared to the S&P 500.
Historically, peaks in the sentiment index have generally been associated with market tops and vice versa. Three weeks ago the bullish sentiment composite had reached levels of extreme bearishness which had set the market up for a rally from the oversold levels following the post-QE3 announcement slide. The rally from those oversold levels has now reversed those extreme levels of bearishness as bullish sentiment has risen with the recent market rally.
However, therein lies the rub. While investor sentiment is rising (a positive for the market in the short term) there are numerous headwinds facing investors in the months ahead. Whether it is the "fiscal cliff", the impending debt ceiling, the continuation of the debt crisis and recession in the Eurozone or the slowdown in corporate earnings and the domestic economy are just a few of the worries at the top of the list. This leaves investors faced with a mounting level of uncertainty with regards to portfolio allocations.
Investing For Uncertainty
Whether the economy is either in, about to be in or not even close to a recession is an ongoing debate that rages between economists, and analysts, as the economy has remained mired in a perpetual state of stagnant growth. Professional organizations like the Economic Cycle Research Institute, ECRI, to mutual fund managers like John Hussman of Hussman Funds, all the way to blog sites such as RecessionAlert.com have all published research, and analysis, in the debate of the ongoing economic cycle.
First, while the media despises the "R" word, it is important to remember that recessions, by their very nature, are part of the normal economic and business cycle. However, while recessions are the cleansing process to remove economic excesses - it is the impact to the financial markets that is of the most concern to investors and portfolio managers alike.
The chart below shows the S&P 500 and its reaction to recessionary drags in the economy.
The table below shows a complete listing of all recessions going back to 1873. The point is clear - waiting to long to recognize the onset of recession can be hazardous to your investment health.
I make this point because the argument over the current state of the economy is causing further investor uncertainty. While the analyses of incomes, production, employment and sales currently give clear signals of economic weakness - they are not recessionary as of yet. However, until the back revisions to the data, particularly employment, are released next year a real determination can not be made.
So, while the raging debate makes for interesting reading, it is useless unless it is tied back to an investment thesis. Without an investment thesis - the victory of pinpointing the beginning of the next recession, as shown above, will be a hollow one as investors will have already absorbed the bulk of the destruction to their investment capital.
This is why we focus our analysis on the underlying "trends" of the economic, fundamental and market data. As we continuously repeat - change happens at the margin and the analysis of data trends can identify the turning point of the economy and the financial markets.
An Investment Thesis For An Uncertain Outlook
Investing for uncertainty is largely different from a normal cyclical market. Recessionary draw downs tend to be quick, and brutal, so there is generally precious little time to make portfolio adjustments before it is too late.
Therefore, our macro-investment allocation thesis for 2013 is currently based on weakening economic, and earnings, trends due to the headwinds, as discussed above, that currently exist.
- Be overweight cash as it remains an excellent hedge against market volatility.
- Individual bonds, versus bond funds, should remain a target portfolio weights to overweight. The income yield and the "return of principal" function will lower portfolio volatility and reduce emotional investment mistakes. We continue to focus on corporate bonds at the lower end of the investment grade rating scale that have "A" rated balance sheets.
- Underweight the equity portion of the portfolio with low volatility equity investments primarily focused in defensive, dividend yielding, areas.
If I am right, and the market is affected by a slowing economy, an earnings' recession and continued pressure from the Eurozone; then the defensive posture in portfolios should limit the downside investment risk. As always – "risk" is about what you will LOSE if you are wrong. Missing out on gains is not being wrong. Opportunities to make money in the market come, and go, as often as taxicabs in New York. However, being wrong not only results in lost capital but lost time. While capital can eventually be made up – lost "time" is gone forever.
So, assuming the economy is pushed into a recession by the impact of the "fiscal cliff", the debt ceiling debate, resurgence in the Eurozone crisis or some other exogenous event not yet on our radar – the following investment guidelines should perform well.
- Rebalance portfolios
- Sell losers
- Overweight strong fixed income credits
- Sell "high yield" (junk) credits
- Sell small and mid-cap stocks (highest risk to earnings' recession)
- Sell international and emerging market exposure
- Evaluate fundamentals of large cap exposure.
- Overweight US dollar
- Overweight US Treasuries
- Sell Homebuilders & REITS
- Underweight Technology, Energy and Finance
- Overweight Utilities and Staples
In golf there is a saying that you "drive for show and putt for dough" meaning that it is not necessary to be able to drive a golf ball 300 yards down range - it is the putting that will win the game. Investing is much the same - being invested in the market is one thing but understanding the "short game" of investing is what is important to win.
Focus on managing the "risk" of the portfolio rather than chasing "returns." If the economy begins to miraculously strengthen, the market turns up onto solid buy signals and earnings begin a solid recovery then we will change our investment stance to more aggressive holdings. Currently, that scenario is not existing and "hoping" it will occur is not an investment strategy.
By minimizing the risk of loss over time the returns will come as a function of a solid asset allocation and risk management protocol. While the media, and Wall Street, focus on the daily "noise" of headlines - most investors will be significantly better off turning off the television, putting down the newspaper and focusing on the objectives of the portfolio, managing the risk, saving more and letting commonsense guide investment decisions.
It is your money after all. If you do not pay attention to it - it is unlikely that anyone else with either.