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The Brave Report- Market Commentary for February 2017

View the PDF version of this report here: The Brave Report-February 2017

The melt-up continues. The market has continued to march higher since the inauguration.  With all of the geopolitical uncertainty that has been driving the market this type of move has been surprising. It seems the markets continue to shrug off any negative news coming out about the new administration.  The month has not been without scandals, whether real or perceived.  We have seen a number of controversial executive orders, the “firing” of the National Security Advisor and more news continues to emerge about Russia’s influence and yet the market doesn’t seem to be impacted at all.  Historically speaking, such news would usually cause the markets to take a pause or pullback as it digests any new geopolitical risks.  It seems that the markets have been desensitized to any of this new risk and continue to focus on the prospects of economic growth under the new administration.

Fundamentally, there have been a lot of positive signs about the economy.  Earnings season has been going well, jobs reports have been good and the Fed continues to speak positively about the economy, hinting at further rate hikes. All of this helps justify the move the market has been making. However, I fear that negative tail risk and other geopolitical risks are not being properly priced into the markets.  I am not saying that markets can’t continue to move higher, I just think the chances of a major market moving event are much higher than they have been in previous years and should be factored in.

Market Overview

Over the last month, the S&P 500 has added just over 4% and we have seen the three major US indices all reach new all-time highs.   This move hasn’t happened with a few sharp one day moves, but a gradual march higher.  Over the month we have only had three days with more than a 0.6% move and none higher than 0.8%.  There has also only been two negative days in the last fifteen trading sessions. This gradual move is not what I expected due to all of the geopolitical uncertainty still present in the markets and I still am cautious about a short-term pullback. With that said, it is refreshing to see the markets focusing on earnings and fundamentals for a change.  If some of the geopolitical uncertainty can be sorted out and some of the administration’s plans start to become clearer, the market should be able to continue this move higher and may even break out to the positive side.

The fixed income space has been relatively stable over the last month, with the 10-year treasury hovering between 2.35% and 2.52% over that time frame. There have not been any real catalysts to move rates in either direction.  Janet Yellen’s comments earlier this month didn’t shed any new light on rate increase expectations, and if anything just reiterated their current stance.

Earnings: Earnings season has been very positive by most measures. Over 70% of companies have beat on earnings and we have seen the largest number of companies expanding earnings estimates since 2011. These earnings seem to be pushing the markets on a daily basis and helping to justify what many feels has been an overvalued market based on forward price-earnings ratios.

Any Trump influence will not be seen in current earnings numbers but the adjustment of forecasts tell us that most companies are positive about the economic prospects under the new administration. The prospects of new trade policy, tax reform, and the overall global growth outlook are being viewed positively. Even without any concrete plans in either of these areas, companies seem to be optimistic about the direction of the economy.

Negative news, no problem: As positive as earnings season has been, there is still a major geopolitical overhang in the markets and the economy.  With each day, seems to come a new outrage or controversy with the new administration but the markets don’t seem to care.  It is good that the markets are not overreacting to every new story but I am surprised that more of this news isn’t being priced in.  There is still a significant amount of uncertainty surrounding the new administration and increased fear about Trump’s unpredictability. This kind of unpredictability would normally cause an increase in fear in the markets and yet the VIX (a gauge of volatility in the market and often seen as a measure of fear) is still very close to its 52 week low. As mentioned earlier, I am wary of the tail risks in the current market and I don’t think that the VIX is fully factoring that in.

Trump Policies: Outside of the initial barrage of executive orders, which focused primarily on immigration and the Affordable Care Act, we are still in a wait and see mode when it comes to the economic policies and priorities of the new administration.  Paul Ryan indicated earlier this month that they won’t begin to tackle the issue of tax reform and infrastructure spending, both key priorities of Trump’s campaign, until later in the spring.  At that point, we will hopefully start to get a better idea of what the administration will try to push through. Until then, everything is just speculation and it seems like any speculation is primarily viewed as positive.

Most of the news that is coming out about the administration has had more to do with immigration and foreign policy issues.  While these areas do not directly impact the economy in the short term, it will be interesting to see how these issues continue to be perceived by the markets.  So far they haven’t seemed to have any meaningful effect but at some point, I wouldn’t be surprised to see them become a drag on the markets, especially when it comes to currencies and trade.  Further, if a border tax is proposed and comes to fruition in some form, we could see a sharp move up in the dollar accompanied by a rise in inflation as companies raise prices to account for the tax.

Strategy Commentary

With the markets’ continued rise we have patiently maintained our allocations and not made any major changes outside of regular rebalances. The run-up of the last month has seemed to have lifted most sectors so we are still cautious about making any widespread changes to our allocation.

I continue to maintain a bias toward the US. I am still watching some international positions but have only dipped my toe in a little, adding some German exposure for a short time, which I have since exited. Germany still intrigues me from a valuation standpoint but does not seem to be outperforming yet. I have been watching emerging markets and some developed Asia closely, as they have outperformed so far this year but have not increased either of these allocations.

I am maintaining my overweights to financials, industrials, technology and small cap.  Earnings releases in these areas continue to justify these sectors and I think they all have room to run.  The only major shift I am thinking about adding is to buy some protection for any potential negative tail risk events.  I think the market can continue to climb but I want to be insulated should something major happen to the negative side.  I haven’t added this protection yet but will be looking for an attractive entry point over the next few weeks. With volatility at such low levels, this protection is currently cheap.

I am still negative on fixed income and will continue to maintain more cash as a replacement for these fixed income allocations.

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Investing in a World of Uncertainty

It seems that a day (or sometimes hour) doesn’t go by without some new piece of potentially market-moving information or news coming out.  This is partially a reflection of the speed in which the news cycle operates these days with everyone now being a potential news source.  But even more, as the world and financial markets get more interconnected the impact of an event, speech, news report, data point, etc somewhere in the world has far-reaching implications and can impact markets throughout the globe.

The recent news is all about the impact of the Trump presidency. Tax policy changes, immigration reform, protectionism, tariffs, social unrest and cabinet appointments have all dominated the news cycle over the past month and should be potentially market moving variables. However, these are not the only uncertainties in the world. Even before the election, there were already questions about Brexit, OPEC, rate changes, terrorism, the Eurozone, refugees and China, just to name a few.

In the past any one of these variables could have moved the markets in one direction or the other but what we saw last summer and again this past month is this uncertainty leading to stagnation in the markets.  I touched upon this in my January market commentary (The Brave Report) as the market traded in one of the tightest ranges in history.  With all of these uncertainties in the market, no one wants to be on the wrong side of the next market move. The result is……nothing.  Unlike some other times in market history when any one of these variables would have caused a major pullback or pushed the market forward, we are seeing all the uncertainty cancel itself out and make it very difficult for investors and traders alike to find any directionality. My fear and the fear many investors are feeling is that the market is just storing up its energy so when a move in one direction does happen, it will be sharp and quick.  We saw an example of this following the election. Uncertainty had been building up throughout the summer and into the fall causing markets to trade in a tight range. Once we had certainty about the election, we saw a sharp move higher and could just as easily see a similar move in the other direction.

So with such a range bound markets and uncertainty in every direction we look, how should you invest?

Unfortunately, the answer isn’t sexy but during these times of such uncertainty, the best investment is a well-diversified portfolio. I know this sounds simple but when markets are range bound and lack directionality the prudent investor should be rebalancing to their optimal balanced asset allocation.  Attempting to time a market in this environment is a dangerous game to play because it is very difficult to predict what the final catalyst will be to move the markets in either direction.

Numerous studies have been done about the benefits of being fully invested for the best trading days or being out of the markets for the worst days.  Michael Batnick points out that since 1970 the market has gained an average of 6.7% annually. If you missed out on the best 25 days your annualized return would drop to just 3.4%. However, if you missed the 25 worst days your annual return would have been 11%.

This is quite a performance disparity in both cases but to be able to accurately predict these best and worst days is impossible. With that said if we do expect uncertainty to continue to rule the markets, you want to make sure your portfolio is positioned in a way to capture at least a portion of the upside if the market does break out higher.  You also want to make sure you limit your downside if the market pulls back significantly. The best way to do this is through a balanced asset allocation in line with your risk tolerance.

You can’t always predict the next market move but you can put yourself in a position to limit your risk during such uncertain times.  Waiting until markets are trading more on fundamentals and certainty before taking a real stance on the market’s direction is not a bad thing. Your outcome will not be quite as fruitful as if you were able to time the markets perfectly but if you have the ability to do that then you probably don’t need to be reading this article anyway.