We have been very busy in recent weeks repositioning client accounts for what we see as a difficult year in the stock market in 2016. With the Federal Reserve embarking on an interest rate tightening cycle, the dollar continuing to strengthen and regulatory compliance costs increasing, all resulting in corporate earnings continuing their slide, all happening at a time when stock price valuations are pushing historic highs and global economic activity is slowing, a more conservative posture to portfolio management is the focus of our 2016 strategy.
Toward that end, we are focusing our efforts on moving our overall asset allocation within each investment objective to its minimum level of equity allocation and maximum level of fixed income and cash equivalents. That means, if a client investment objective is 65% Equity / 35% Fixed Income / 0% Cash Equivalents, it will move to 53.50% Equity / 41.5% Fixed Income / 5% Cash Equivalents. The change is formula driven, but in essence, the equity exposure is reduced by a flat 5% (which is moved to cash equivalents) plus 10% of the original equity exposure (or 6.5% in this example) is moved into fixed income.
Within the equity allocation, we have increased our exposure to companies that will benefit from increasing interest rates – like banks, brokerages, life insurance, and payroll processing companies, all of which traditionally experience increased earnings due to higher levels of interest income – and more defensive holdings like consumer staples and utilities.
We have also been selling holdings that have higher than average leverage on their balance sheets since higher interest rates will increase their expenses and lower their net income.
In a typical interest rate increase cycle, you would avoid longer term fixed income and utilities investments as the entire rate curve shifts higher, not just the short term rates that the Federal Reserve dictates. However, I believe this time, given the low level of economic activity we have been experiencing and the fact that we have the potential for a recession later in 2016 or early 2017, we will see longer term interest rates hold steady or even fall. This scenario is very positive for fixed income and utilities investments, and it has in fact been playing out in this manner over since the Federal Reserve increased rates in mid-December.
On the bar graph above, I have charted the price performance of the various economic sectors of the stock market. You can see that consumer staples and utilities stocks have far outperformed the rest of the market since the Federal Reserve increased rates in mid-December. The odd thing is that financial stocks have under-performed, but when quarterly earnings are reported in April and the positive impact of the rate increase is shown in their bottom line numbers, that situation should reverse itself.
We have been incrementally making changes to implement this strategy over the past few weeks, but will implement this strategy in full during our semi-annual account rebalancing process this month.
Given the outlook for a potential recession later this year or early 2017 (just so you know, I am not being a rebel on this issue, Citigroup has already issued a report predicting one and various other economist have started to incorporate this scenario in their forecasts) I will be monitoring economic conditions closely. As the economy continues to deteriorate, I will take the appropriate actions to protect client portfolios.
In order to monitor the probability of a recession, one tool I use is the St. Louis Fed’s own Smoothed Recession Probabilities indicator (see below):
Another indicator we follow fairly closely is the TED spread. This represents the yield differential between treasury bills and eurodollar deposits (or the yield spread between a risk free asset and one with short term risk). When that line of the graph below gets elevated, that is an indication that there is some amount of stress in the financial system (see below):
You can see that the line has started to rise, but is no where near to the level it reached before and during the 2008 crash. To me, this is just a sign that caution is called for at the current time.
Sam Zell, a man who has rightly attained billionaire investor fame, recently was on
Bloomberg TV stating that the US economy could go into a recession in the next year. Zell has been putting his money where is mouth is, selling significant real estate holdings to raise cash. He adopted this same stance prior to the 2008 market crash, selling a significant amount of his holdings at the top of the market. He was then able to take advantage of rock bottom prices after the crash, being a buyer with cash when everyone else needed to be a seller to pay down their debt.
When we look at the various indicators of economic activity, many are under pressure and already in recession territory:
(1) Construction spending was down 0.4% in November;
(2) Energy, Mining and Commodities have been contracting for a couple of years, with layoffs and bankruptcies hitting the weakest of companies in those industries;
(3) Manufacturing is contracting, with the ISM Survey reading 48.2 (below 50 is recessionary) and the Markit Manufacturing Purchasing Managers Index also giving a similar reading; and
(4) The services sector, the largest part of our economy, remains in growth territory but has dropped to a 55.3 reading in the ISM Survey – the weakness in other areas of the economy will continue to negatively impact the services sector until we are in a fully recognized economic recession.
We hear a lot about how unemployment is at low levels. The indicator is in deed reading a low level of unemployment, but there are so many people, particularly young Americans, older workers, and others who are not counted in this because they have dropped out of the pool of people looking for work. The indicator for this is at levels not seen since the 1970’s and continues to fall. For an economy to be healthy and growing, we need both indicators to show healthy readings not just one or the other.
2016 will be a year of challenges in the economy and the stock market, its not a year to act like heroes with wildly aggressive allocations, but rather a focus on conservative investments that will allow us to weather the storm. We recognize this and have already taken action to protect client accounts from what we see on the horizon. If there are changes to the current situation and economic times get worse, we will act to protect client funds in the most prudent manner possible.
Best wishes for a happy and productive 2016 – and allow me to worry about the investment markets on your behalf!
RIP: The many faces of David Bowie…