The U.S. stock market continues to enjoy a strong 2013 so far. Unfortunately, the rays of sunshine emanating from stocks are obscuring increasingly ominous and dangerous clouds looming on the horizon. And just as a pleasant summer day is quickly transformed upon the arrival of a severe thunderstorm, so to is the threat that is currently building for investment markets in general and the U.S. stock market in particular today.
While U.S. stocks have performed reasonably well over the last few months, their gains essentially stand alone across what has otherwise been a widely disrupted global investment landscape. The following are the rates of return for the second quarter to date through June 26 across a number of primary asset classes that make up investment markets today.
+2.75% U.S. Stocks
-3.66% Developed International Stocks
-12.27% Emerging Market Stocks
-10.32% China Stocks
-8.19% U.S. Treasury Inflation Protected Securities (TIPS)
-4.54% Intermediate-Term U.S. Treasuries
-7.17% Long-Term U.S. Treasuries
-5.14% Investment Grade Corporate Bonds
-2.00% High Yield Bonds
-3.26% Developed International Bonds
-8.00% Emerging Market Bonds
-13.25% Natural Gas
In short, outside of the U.S. stock market, virtually every other major investment category across the broad range of global asset classes was down for the second quarter. And in many cases, the declines were meaningful.
This broad ranging decline outside of U.S. stocks resulted in an unwelcome and frustrating decline in portfolio values during the quarter. Since the outbreak of the financial crisis, portfolios have been managed under an absolute returns strategy that is broadly diversified across many of the wide ranging and distinctly different asset classes listed above. The purpose of this diversification is to try and minimize the risk of loss during turbulent periods while also generating a consistently positive long-term rate of return. And in the time since the financial crisis in late 2008, this strategy had been largely successful in providing this downside protection. That is, of course, until the current quarter, as the declines across nearly all asset classes greatly undermined the typical diversification benefit enjoyed under this approach and resulted in declines in portfolio value of more than 5% during the period. For context, leading hedge funds such as Bridgewater, AQR Capital and First Quadrant that implement a similar risk parity approach experienced comparable results during the quarter according to the Wall Street Journal. I am disappointed by this outcome and am making adjustments to the strategy in an effort to prevent a similar result in the future while at the same time working to improve overall returns performance. I will discuss these changes in more detail below.
So what exactly is happening across investment markets that has led to these broad based declines across asset classes and why does it matter for U.S. stocks going forward? In short, these declines have been a result of a wave of mass liquidations that occurred during the second quarter that have the potential to continue as we move through the summer and into the fall. And while the U.S. stock market has managed to escape relatively unscathed to this point, it is now trading well above the range implied by what all other global asset classes are signaling at this point. More importantly, stocks in general are often the last to decline in a rolling mass liquidation cycle, and they often fall the hardest once they finally break.
The recent turbulence for global investment markets began in mid April not long after the Bank of Japan announced their extraordinarily aggressive monetary stimulus program. This included plans to double the amount of yen in circulation by the end of next year (imagine if the U.S. government announced that they were going to give you an additional dollar for every dollar already in your possession – this is a big deal) and to push the inflation rate in Japan up to 2%. Given that Japanese 10-year government bonds were only yielding 0.54% at the time of the announcement, this development caused an eruption of volatility in the Japanese bond market (understandably, many investors do not want to own something that is set to earn only 0.54% over the next decade when prices are going up by 2%). But given that the major Japanese banks that own these bonds could not risk their survival by allowing to let these bond prices collapse, they have been forced to raise cash by selling other assets in order to defend these positions, hence the mass liquidation that followed. In mid April, the assets of choice were gold and silver, which was not surprising given that the precious metals are highly liquid and are often the first assets sold in a liquidation cycle. After a period of stabilization, these liquidation pressures spread to the bond market in early May including U.S. Treasuries, as Japan and its institutions are major holders of U.S. debt. And by late May, liquidation pressures began to surface in global stock markets. The impact was first felt in Chinese and other emerging market stocks in early May and spread to the developed markets including the U.S. by late May once U.S. Federal Reserve Chairman Ben Bernanke first signaled plans to begin scaling back on the Fed’s QE3 monetary stimulus program in the coming months.
Mass liquidation cycles are not uncommon during secular bear markets like we have been experiencing since the bursting of the tech bubble over a decade ago in 2000. And the progression of how assets were liquidating in the most recent cycle also followed the typical pattern. Precious metals typically lead the sell off followed by bonds and lastly stocks. When the selling pressure moves on from one category to another (i.e. precious metals to bonds, bonds to stocks), the selling pressure in the previous category abates as the new category begins to decline (once your done selling your gold, you start selling your bonds; once you’re done selling your bonds, you start selling your stocks). This was also the pattern seen for most of the second quarter – gold was trading higher from its mid April lows through mid June while silver was essentially flat over the same time period. And bonds began stabilizing in late May and early June as global stocks began to accelerate their move to the downside. Everything was progressing predictably, that is of course until the Wednesday afternoon before last when a second mass liquidation phase suddenly exploded.
On the afternoon of June 20, Ben Bernanke made official the Fed’s intent to begin phasing out their QE3 stimulus program. This rattled investment markets, as many wrongly anticipated that further monetary support would continue uninterrupted given the still fragile state of the U.S. economy. At the around same time as the Fed’s announcement, the Chinese economy was coping with a spiraling problem of its own, as its banking system was seizing as institutions were increasingly unwilling to lend money to each other (this is what happened following the Lehman collapse in late 2008) and liquidity within the Chinese financial system was quickly drying up. Thus, another mass liquidation cycle erupted through the end of the previous week and into this past week. While both Chinese and U.S. policy makers eventually calmed investor nerves as the week progressed, the signal to investment markets are now abundantly clear that the five year wave of money printing by major global central banks to try and revive the global economy may soon be finally drawing to a close. And as market participants slowly adapt to this new reality, signs of stress are likely to continue to linger and further aftershock effects will remain a high probability as we move into the second half of 2013.
The latest mass liquidation phase that began last week is notable for the following reason. Given that precious metals and bonds had already fully liquidated during the previous cycle that started in April while stocks had not, the likely outcome would have been for stocks to sustain the brunt of the pressure during the second liquidation phase while precious metals and bonds rallied in a flight to quality. This sequence is what took place during the darkest days of the financial crisis back in late 2008 into early 2009. Instead, all major asset classes – precious metals, bonds and stocks – all plunged sharply and all at once, which is highly unusual. The only destination where capital felt safe to find refuge during the sell off was cash. And while bonds and stocks have stabilized over the last few days, precious metals have been crushed even further, suggesting that we may now be just starting into another prolonged liquidation cycle on top of the one that was already underway in April. It remains to be seen how things ultimately play out, but this is a meaningful short-term risk that warrants attention as we move through the summer.
Before going any further, it should be noted that the decision by global central banks to finally begin working to ween the financial system off of monetary stimulus is a positive long-term development, for this is a critical step in moving away from dependency on monetary stimulus and policy maker jawboning and returning capital markets to more normal functioning. And it could be argued that a successful transition will ultimately lead us to the beginning of the next secular bull market and prolonged upturn for the economy and financial markets. But the transition itself along the way to this positive endpoint is likely to be filled with extended stretches that are both challenging and volatile for capital markets.
So what can we reasonably expect from the various asset classes over the next 3-6 months? And how are portfolios being positioned to recover the recent decline in value and capitalize going forward? I will explore the three major investment categories – stocks, bonds and commodities – in order below.
Stocks remain at risk for a sizable correction in the months ahead. This is particularly true of the U.S. stock market, which has thus far avoided the extreme stress and volatility that has afflicted nearly every other major stock, bond and commodity market around the world to this point. The fact that underlying fundamentals for stocks are generally weak and valuations are already expensive from a historical perspective only adds pressure to the downside going forward. It could be argued that this correction is already underway, with stocks already in a short-term downtrend with a 5% decline since their May 22 peaks. Whether the current decline continues much further remains to be seen, as U.S. stocks have shown tremendous resilience in recent years in rebounding from short-term setbacks to continue on their long-term trajectory higher. Two key indicators are being monitored to signal whether a return to broad based stock positions are warranted or if it is better to remain in cash for now. If stocks as measured by the S&P 500 Index are able to break out decisively above its 20-day and 50-day moving averages, this would likely signal the end of the recent correction and that stocks are set to resume their ascent higher at least for the time being. However, as long as stocks are unable to reclaim these technical levels, the decline is likely to continue and maintaining cash positions is warranted. It is worth noting that the S&P 500 Index made its first attempt to break above the 20-day and 50-day moving averages on the last two trading days in June and failed, suggesting that the short-term correction may continue into July.
Bonds face continued short-term volatility but still enjoy long-term appeal. Recent volatility in the bond market has been extreme. For example, the more than 60% rise in 10-year Treasury yields from 1.6% in early May to 2.6% in late June is the biggest move (and loss in value) over a comparable time period in over 50 years. As would be expected, a great deal of technical damage was done in the process. This included bond yields breaking through critical long-term support levels at 2.40% on 10-year U.S. Treasuries and 3.50% on 30-year U.S. Treasuries. Thus, from a short-term perspective, Treasury yields will either need to decisively reclaim these important levels soon or will need to continue rising to the next major support levels before it is prudent to deploy cash back into the bond market. From a long-term perspective, however, the outlook for bonds remains positive over the next few years. This is due to the fact that economic growth is likely to disappoint expectations due to the adjustment of policy makers withdrawing stimulus, which is favorable for bonds at the expense of stocks. As a result, bonds are likely to continue to have an important role in portfolios going forward despite recent volatility.
Commodities were left in shambles during the second quarter. Leading among these was the precious metals market including gold and silver. A particularly unusual characteristic about this dramatic decline in the price of precious metals was the fact that it occurred in an environment of rising physical demand and flat to declining physical supply globally. In other words, the price is being slashed on a product that people want more of and is becoming harder to obtain. This is a counterintuitive pricing dynamic, but such is nature of mass liquidation selling as stock investors came to know all too well back in late 2008. At some point, this is likely to lead to a violent snapback rally in the precious metals, but this could easily come at considerably lower price levels given the persistence, magnitude and severity of the current price decline. As a result, a decisive breakout above the 20-day moving average in gold and silver is essential at this point in seeking to begin to confirm that a sustained uptrend in the metals is finally underway. In the meantime, stepping out of the way of any further price declines and moving to cash is prudent until we begin to see such confirmation signals.
More generally from a portfolio strategy perspective, we have arrived at arguably the most difficult juncture in the post crisis period for global policy makers, which is the transition from policy dependent markets back to fundamentally driven markets. This is a transition that is likely to take time and be fraught with considerable challenges, investor confusion and policy backtracking along the way. As a result, volatility is likely to remain elevated across all asset classes as policy maker carry out this transition over the next few years. And as evidenced by the events of the current quarter, this will likely be true even those categories that are traditionally regarded as the safest across the investment universe.
The expectation for increased volatility across asset classes over the short- to medium-term requires adjustments to portfolio strategy.
First, in order to continue working to achieve the portfolio objectives of absolute returns and risk parity, a blend of the traditional asset classes listed above can no longer be fully relied upon to achieve this goal given the risk that all may go down simultaneously for an extended period. As a result, other investment allocations may play a greater role at times in portfolios when warranted including volatility and inverse positions as part of pair traded allocations. More importantly, it is also likely to result in far greater allocations to cash than what might otherwise be desirable in more normal market environments (needless to say, we are currently in a highly abnormal market environment right now). The appeal of cash during periods of heightened market volatility is that it is the one asset class, barring the unlikely collapse of the FDIC Insurance structure that backs portfolio cash balances, where protection agains the risk of loss can be fully guaranteed. Thus, a significant allocation to cash may be actively serving a role as a broader portfolio hedge at any given point in time. In addition, portfolios may find themselves completely in cash during short-term periods when volatility has increased or when waiting for tactical entry points to establish new positions. Such is the reason why portfolios were recently reallocated to cash over the past few weeks amid increasing volatility as the second quarter drew to a close.
Another adjustment to portfolio strategies necessitated by the current environment is the time horizon in which positions are held. With increased volatility across asset classes expected going forward, investments are likely to be held for shorter-term periods of time in certain instances. As alluded to in the outlook by major asset class above, this will include clearly defined tactical entry and exit prices that will be subject to adjustment as time progresses and the position evolves, but has the potential to result in holding periods that may range from many months to as little as a few days depending on the price movement once a position has been established. Added sensitivity to short-term price movements is being emphasized in order to provide added downside protection against sudden sharp downside price movements in more volatile markets expected in the months ahead. As much as possible, I am planning to detail the specific strategy behind such positions as they are undertaken in portfolios on this website.
It promises to be an interesting second half of the year for investment markets filled with both challenges and opportunities. The changes that we are likely to watch unfold are potentially very positive for capital markets long-term, as they are likely to bring us to the beginning of the next great phase of economic growth and capital market health. But it will remain as important as ever to manage against the considerable short-term risks that are likely to present themselves along the way as this transition from excessive policy dependency back to more fundamentally driven markets is carried out.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.