It has been a while where the time delta between when I submit this weekly commentary to the powers that be who edit it, format it, and prep it for distribution, and when it hits your inbox, actually mattered. Generally, if I was wrapping up my writing mid-day Thursday for a mid-day Friday release, it was pretty inconsequential. Nowadays, that 24-28 hour delta may create a 700 point difference in markets (for good or for bad). This is all just a by-product of the resumption of volatility, long absent from markets, but now apparently making up for lost time.
Last week we saw markets down 700 points on Monday, only to come back in the final hour 250 points (still down 450). We see an entire day of see-saw action Tuesday, but ending up over 300 points. Then on Wednesday, we saw markets down over 600 points, only to end the day up over 225 points (an 800-point intra-day swing). These crazy intra-day moves are unpacked in this week's trip to the Dividend Café, along with the really important stuff that actually matters.
So markets dropped 700 points on Monday before settling down 450 points (admittedly, this seemed more due to the carnage in the "new technology" space than anything else), and then ended up nicely on Tuesday after a see-saw day. But Wednesday markets dropped 700 points on news that China was launching its second round of retaliatory tariffs (against our second round of the same), this time targeting soybeans, cars, whiskey, and chemicals. The targeted amount in their first strike was just $2-3 billion, and markets tanked. In round #2, they were targeting $50 billion of U.S. products (annually)!! 106 products were included in the tariff announcement.
Does this constitute a trade "war?" Maybe not. But I will borrow from what a Goldman Sachs strategist said on CNBC this week: "At the very least, it is a trade 'battle.'"
I don't think markets even want to comprehend what a full-blown trade war would look like. But what reversed markets Wednesday when the threat of China retaliation pushed markets down so violently? The new National Economic Council chair, Larry Kudlow, announcing that the tariffs were, in fact not final, that they are negotiating tactics, and that all parties hope to never see them imposed because some form of deal-making will take place.
So this is the lay of the land - a highly skittish and volatile market that one day wonders how serious the administration is, and the next day realizes it may be all bluster.
Reversing the market decline
So what would be a catalyst to reversing the present stock market distress? There are two possibilities as I see it: (1) A robust earnings season that launches late next week (and by robust, I mean, more so than markets already expect; (2) An effective, face-saving exit from this trade/tariff debacle the President has gotten us into. The combination of the two would be particularly bullish. Will one or both of these happen? Impossible to predict ... But those are the lowest hanging fruits in the short term for markets.
Forget Q2, let's talk about Q1
Before we begin the funeral processions, let's put some things into context. The S&P 500 and Dow Jones Industrial Average ended Q1 in negative territory (despite the melt-up of January). Yet this was the first negative quarter in TEN QUARTERS. Two and a half years without a negative quarter is an insanely long time. As the red circle below shows, the underlying fear and volatility in the market was just way too low for way too long, and yet the huge move up in volatility in the last two months have been quite an overreach itself. But 23 days with the markets up or down more than 1% in just one quarter, vs. a grand total of eight days all of last year, tells you that enhanced volatility is here, and may be here for a while.
So does this heightened volatility mean that the market is about to go way up, or does it mean there is more trouble around the corner, or does it mean I should sit on my hands, or does it mean I should actively trade? I mean, what's a daily "refresh-button-hitter" supposed to do in this market environment?
The very simple truth is that a properly built portfolio does not pretend to know what various market stimuli will mean in the short term. How many people said (accurately) that rates were going higher in Q1, and that higher rates were bad for bonds? (Actually, how many have been saying that for about seven years??) What has the bond market return been, though, since this volatility and mayhem began? Positive. Getting premises right in one week or one month periods of time is very difficult. But then applying those premises to accurate (and profitable) short-term conclusions is even more difficult. Why? Because markets often exist to humiliate you. To punish you for the sin of violating real investment disciplines and behaviors. But also because nothing is as easy as it seems, and if it were, everyone would do it, and then it wouldn't be easy anymore as the pricing took away whatever easy opportunity was supposedly there.
How do we respond to present levels of volatility? By being asset allocators - grateful that our alternatives and fixed income were such an effective hedge against equity distress last month. By building a portfolio for each client designed to withstand the volatility they can tolerate, and not push them into the "intolerable" zone. And by being a behavior-minded advisor - recognizing that the equity premium we seek to receive through time comes at the cost of volatility headaches. This is the playbook, friends. If there were a shortcut, I would tell you (or would I ???).
Transcending volatility into a bear market
Perhaps you think (as I do), that these short-lived gyrations and zigs and zags around trade threats and so forth are not the real fear, but the possibility of an actual bear market - a 20%+ decline in stocks that actually lasts for a while, and maybe even gets worse than -20%. After all, this bull market has been on for quite some time, and "panic attacks" notwithstanding, let alone the couple "corrections," we may just "be due" for a bear market. The reason we do not see it that way is that there is just no economic catalyst we see for such at this time. A recession is not on the horizon, and in fact, economic activity is picking up. On the inflation front, there has been a pick-up in "conversation," but there hasn't been a pick-up in real inflation, and certainly not to the level that would remotely create bear market worries. And on the Federal Reserve front, there are no indicators that they plan to "shock" markets, or take excessive monetary actions that would force us into contraction. Finally, the "euphoria" one generally sees when a bull market is ready to switch to bear has been noticeably absent, as it has been throughout the last nine years.
I respect bear markets (and markets in general) too much to say that something can't happen. But if one believes the old Peter Lynch adage (which I also do) that "far more money has been lost preparing for a bear market than from a bear market," one has to invest off of sensible frameworks, probabilities, and risk/reward trade-offs. To those ends, we work.
Remind me again why central banks are not the death of this bull market?
A popular chorus from the choir of bull market skeptics is that the new era of Fed (and other central banks) tightening will kill this bull market, as liquidity (and the fun stuff in the punch bowl) is removed from the economy. In theory, there is reasonable sense to it. However, the fatal flaw is that it likely requires one to believe that the Fed was entirely behind the bull market expansion of the last nine years (a preposterous and deeply fallacious idea). Essentially, a Fed reaction that proves to be overdone or excessive would likely be the catalyst to a bull market ending. But right now we see balance sheet reduction moving at hyper-slow speed. We see the Fed Funds rate still below 0% (net of inflation) - a negative real rate. Europe's tapering of their quantitative easing also hyper-slow. The Bank of Japan is in extremely accommodative level too. The fact that deflation has ended in Japan is a positive, not a negative.
There are pretty much no macroeconomic areas I study more than monetary policy and believe with guns a blazing that the central bank environment will have much to do with how capital markets perform. Indeed, in a critical sense, their distortions in markets (even when creating short-term positives) often prove to be long-term disastrous ... I am not belittling the significance of monetary policy in our present strategy and positioning; I am just stating that, for the time being, including central bank machinations in one's calculus would create a bullish tilt, not a bearish one (for now).
Pretend with me for a second
Of course, for many of you (hopefully all clients of The Bahnsen Group), this isn't pretending at all. But let's ignore the short-term noise and enhanced volatility of the market for a moment, and just keep our eye on the prize of the long game. If one has an asset allocation designed in line with their own needs and goals and liquidity profile, etc., what would be the thesis right now for maintaining the risk asset portion of their portfolio? Going out beyond 1 month or 3 months or even 1 year, what makes sense as a catalyst to a new leg up in the secular bull market that we began in March of 2009? If one believes that capex spending is being revived, they have a very defensible and compelling reason to be invested in stocks. Capex expansion boosts productivity, and higher productivity boosts wages. It is a picture perfect virtuous cycle, and it is, indeed, the one we forecast. It just doesn't have in a clean or linear manner. So "pretend" short-term noise is the enemy of your investment results (there's no pretending there - it's reality) - the capex expansion thesis is a highly compelling one and will say a lot about what markets do over the next two to five years.
An "Alternative" frame of mind
The basic thesis around investments with little, no, or even negative correlation to traditional stock and bond investments is alive and well. Bonds have a place in a balanced portfolio, but undoubtedly have risk around risk interest rates and/or inflation. And stocks offer the most risk premium historically, serve as the core anchor of most institutional and retail portfolios (for good reason), and yet, carry a volatility risk that generally needs some mitigation. With alternatives, we do not enter a magic land of risk-free returns. Rather, we accept "manager risk" or "strategy risk" as a replacement to broad market risk. The selection of talent - the monitoring and due diligence that goes therewith - is our responsibility. We are in an environment where our alternative strategies are very much living up to expectations - adding a return, reducing volatility, and capitalizing on inefficiencies while substantially lowering portfolio beta. Critics of the alternative world who have said over the course of a secular bull market with unprecedented low volatility - "wait a second, they charge higher fees and are not performing as well as the S&P 500" are starting to see the folly of their thinking. A bad selection can be a killer, but the proper alternatives philosophy has never been about "outperforming the market" - it has been about diversifying sources of risk and reward.
Chart of the Week
Where do I get my optimism about pending growth of capital expenditures and business investment? Besides the economic logic of it out of tax reform, the trend line and spending plans themselves reinforce the thesis.
Quote of the Week
-- Greek Proverb
“Guide your learning through pain,” or, “Things suffered; things learned”