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The Brave Report: Market Commentary for May 2017

View the PDF version of this report hereThe Brave Report-May 2017

Complacent markets with some political overhang. If I had sat down to write this commentary a few days ago the whole thing may have been a bit different.  The main theme over the past month in the markets has been complacency.  Volatility was hovering around all-time lows.  We weren’t seeing any big swings and earnings was continuing to push the markets higher.  Most of the controversy and questions coming out of the white house didn’t seem to be any different than we have seen over the past few months and the markets were continuing to shrug it off.  Following the election in France, geopolitical risk was beginning to subside as well. Some tail risks in the market still worried me but fundamentals looked strong.

Fast forward to today and we have seen a quick jolt to the system.  The S&P 500 was down around 1.8% on Wednesday. This was a major departure from what we saw all month.  Up until Wednesday, the market had gone 15 straight sessions without moving more than 0.5% on a single trading day. This was the longest such streak since 1995. This was also the biggest one-day drop since September.

The catalyst for this jolt was a leaked memo about a meeting between then Director of the FBI, James Comey, with the President in which it is alleged that the president asked Comey to stop his investigation into Michael Flynn’s relationship with Russia during the election.  While on the surface this would seem like just another Trump controversy that the Teflon Don would easily slip past. This one may have staying power as it represents a clear obstruction of justice and something that, if true, could lead to impeachment proceedings for the President and put some of his policy initiatives at risk.

The market may have been shaken out of complacency this week. However, the questions still remain. Will volatility return for good? And, is this complacency good for the market or does it blind us from bigger potential risks?

Market Overview

Even with the widespread pullback on Wednesday, the markets still had a decent month, led by the tech-heavy NASDAQ.  The NASDAQ was up by around 2.5% in the last 30 days even after giving back more than 2% on Wednesday alone.  The S&P500 and Dow industrial average both gained around a half of a percent over the same time period.

As the market rallied throughout the month we saw the yield on the 10-year bond jump from 2.18% to a high of 2.41% last week before pulling all the way back to 2.21% on Wednesday as there was a rush to safety in the markets.  We saw a similar pattern in other safe assets, with Gold dropping almost 6% before recovering more than 3% during this recent rush to safety. These safe assets will be important to watch as some of this political turmoil plays out. They could be very telling about the risks investors are seeing in the stock market.

Complacency: This was going to be the main theme of this week’s commentary until the events of this week.  However, even with Wednesday’s selloff, I think it is very important to discuss the complacency that has existed in the markets in recent weeks and months. This low volatility is blinding us from some of the real tail risks that are still present in the markets. Prior to Wednesday, the CBOE Volatility Index (VIX) was close to its lowest level on record.  This would normally tell us that investors are the least nervous they have ever been about volatility in the markets in history. It is difficult to believe this is true.

Investors have been hearing for the last few years that the bull run is near its end but the markets keep grinding higher. This has provided investors with the feeling that they can just stay invested and the markets will continue to churn higher. This passive approach has led to lower levels of volatility and a false sense of security.  This same mentality has held true since the election.

Even further, professional money managers who traditionally make money on large market swings have been continually burned by making tail risk bets over the past 8 years that never materialized.  So, they are now making fewer of them.  This forces the VIX down even further. This can all be a very dangerous recipe for the retail US investor as I feel the current tail risk environment is not being fully factored into the VIX. Complacency can then become a major risk factor because these investors are not in a position to protect themselves as volatility increases and/or a tail risk event occurs.  A complacent investor becomes reactionary rather than proactive and by the time they react it could be too late. If we look at the chart of the VIX over the last 30 years (below), it doesn’t normally increase gradually but increases in large, rapid swings. Professional money managers are often able to get out ahead of such events and protect themselves but the retail investor ends up suffering the most.

Now I am not saying that I think we should all move to cash (as you will see in my strategy commentary).  I am simply saying that I don’t think the VIX is currently factoring in some of the risks in the market.  As an investor, it is important to not get lulled to sleep by the lack of price movement.  This is a time to revisit your asset allocation and make sure this recent run-up in the markets hasn’t made your portfolio out of balance.

Trump:  Many of these tail risks I mention above could directly or indirectly stem from the actions of President Trump.  This week’s selloff does not count as one of them.  While the allegations are quite troubling for the white house, the markets are not going to implode if we end up in impeachment proceedings.  Bill Clinton faced impeachment eighteen years ago and the market just marched higher.  The real risk within this situation is it puts in doubt many of the policy initiatives that Trump and his Republican colleagues have touted since his campaign and that have already been priced into the markets to some extent.  Will this distraction delay bills on infrastructure spending, overhauling financial regulation and, most importantly for the markets, corporate tax reform? Some of the biggest losers on Wednesdays were companies that hold a lot of their cash overseas and thus would gain the most from any tax reform or breaks on repatriation. Apple, for example, had its biggest selloff in more than a year.

A lot still needs to play out in this saga. As we have done since the election we will continue to try to make sense of what political hiccups the markets will just shrug off and which will have real staying power. In the meantime I expect this increased uncertainty about the outcome of Trump’s policy initiatives to create a bit of an overhang on the markets and may overshadow the many positives that we have seen this earnings season.

Earnings:  By almost every measure this earnings season has gone very well. Of the companies that have reported so far, approximately 64% have beat analyst estimates.  In terms of earnings growth, we are on pace to see profit expansion of around 14%. This is the best growth rate since Q3 of 2011.  This earnings success helped to propel almost all of the major averages to record high levels right before Wednesday’s selloff.  If some of the political headwinds can be removed, I expect this earnings-driven move in the markets to continue.

Strategy Commentary

I continue to maintain my equity exposure and have actually added to my exposure over the last month as earnings and other fundamentals have been strong. The political overhang of the last few days may have pressed pause on the rally and forced me to rotate some of my exposure but I look at a pullback as a buying opportunity for most sectors.  If we can get past some of this political uncertainty I think the fundamentals are there to push the markets to new highs.

After reducing my financial exposure last month I also cut exposure to industrials and small cap value this month.  Both areas were great winners for me at the end of last year but have since lost momentum so taking profits seemed reasonable. With uncertainty around the President’s agenda, it is better to stay away from these sectors until we get a little more clarity on the progress of any legislation.  I have also increased my allocations to utilities and consumer discretionary while still maintaining an overweight to technology.

I have increased my international exposure over the last two months. I added to emerging markets last month. Although it has been on quite a run so far this year I think it still has some room to run. With political uncertainty subsiding in Europe following the French election, I have also increased my exposure to developed international markets. The valuation picture in Europe has been very attractive for a while but political uncertainty in the region made the risk too great.  There is still some political risk in the region, with details about Brexit still to be ironed out, so my overweight includes other developed international countries to help diversify any remaining risk.

I am still negative on the fixed income space. If there is a continued rush to safety I could miss out on some opportunities but I don’t think the risk/reward profile is worth it right now. I am maintaining my underweight and am still happy to hold more cash as a replacement.  The increased cash allocation will also be helpful if there is any pullback and any buying opportunities present themselves.

 

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  1. […] volatility we are currently experiencing in the markets.  I touched upon this briefly in one of my recent market commentaries but I felt like a deeper dive was needed into the […]

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