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The Brave Report: Market Commentary for August 2017

Click here for PDF version of this report: The Brave Report-August 2017

Chaos as the norm. For a normally slow time of year in the news cycle, the past month has given us quite a few fireworks. As with past political surprises or issues that I have discussed in this commentary my discussion will try to focus on the business and market side of things and not on the moral abomination that we saw from the President over the past few weeks.

With that said, it seems the markets have resigned themselves to chaos as the norm in Washington. There is a general feeling that nothing is going to get done anytime soon. This is causing investors to not react to much of the news or rhetoric coming from Congress or the President and instead try to focus on company fundamentals. Any market reactions, however brief, seem to be based on how a comment or tweet will impact the ability of Congress and the president to work together on anything and not the comment itself.  With that said, we are entering a normally busy time in Washington and for the markets.  September and October are historically the two most volatile months for the markets. It will be interesting to see if this trend continues or if the markets just continue to shrug.

Market Overview

The markets have been a bit choppier than we have seen in previous months, especially over the past two weeks.  As of the close of trading on August 18th, the S&P was down 1.95% and the NASDAQ gave back around 2.64% over the previous 30-days. Almost all of this negative performance can be attributed to the last few trading days. The DOW Industrial Average was able to squeeze out a slight gain, increasing by 0.16%.  The interesting dispersion over the past month is between large and small-cap stocks.  While the large-cap indexes were flat or down a few percent, the small-cap Russell 2000 lost almost 6% over the last month. This index normally does experience more volatility but this shows a large bias toward larger, quality stocks.  It seems that investors aren’t ready to sell all their equity positions, but are much more comfortable moving to the more stable large cap names.

It is interesting to note, however, that we are starting to see some weakness in the large caps as well. Around 20% of S&P 500 stocks are currently in bear market territory, meaning they are down more than 20% from recent highs.  On top of this, around 40% are in correction territory, giving back more than 10%.  I am not pointing this out because I think we are entering a large-scale pullback.  I simply point it out because it is easy to just look at the performance of the large-cap indexes and think everything is powering forward. However, if you look below the surface there are definitely some cracks and some areas that are experiencing some natural consolidation.

Even with the uptick in volatility in the last few weeks, we didn’t see a huge dash into safety.  The fixed income space actually remained relatively stable.  The 10-year bond did drop to a yield of around 2.19% but this is only down slightly from the 2.26 we saw to start the month.  Investors may be looking for safety in other areas but the rush into treasures that we have seen during volatile times over the past few years has not happened.

Earnings: By almost all measures this has been a very good quarter.  With just over 90% of the S&P having already reported results, more than 75% have met or beaten their earnings estimates. This adds to our conclusion that the fundamentals of the economy are strong. Companies are performing well and we are seeing them grow both top and bottom-line results. Even without the benefit of new reforms coming out of Washington, the stage is set for continued growth for the remainder of the year. If Washington can actually follow through with some of their promises then we should continue to see robust earnings growth moving forward. My one concern is that valuations have become relatively stretched as we continue to test all-time highs. While earnings results should help temper some of these overbought fears I would not be surprised with a pullback as investors look to book some of these profits.

I spoke briefly last month about the Amazonization of the economy. This has continued to be a major topic in earnings calls and investor days over the past few months.  In the months of May, June and July Amazon was mentioned 635 times on earnings calls or other corporate events.  To put this in perspective, Trump was only mentioned 162 times.  In July alone Amazon was mentioned 165 times to 32 for Trump.[i] We have seen what Amazon has done to the retail space, which had one of its worst quarters in history, and is trying to do in the grocery space.  CEO’s in numerous industries are being forced to address this threat and it seems that Amazon’s impact is far more important than anything coming out of Washington. It will be interesting to see how this story continues to play out but what is certain is that Amazon is forcing companies to examine their businesses from a much different perspective.

Geopolitical Tensions: In previous reports, I have discussed my worry about tail risk events not being properly priced into the markets.  We got a taste of this over the last month. Tensions with North Korea intensified over the course of a few days.  Analysts confirmed some of the country’s missile and nuclear capabilities. This was followed by a public back and forth between Trump and Kim Jong Un.  While previous presidents have chosen not to engage with Un publicly, that is not Trump’s MO. The market reaction was a brief selloff and a spike in volatility.  While this spike was short-lived, it showed how quickly things can turn.

I don’t think we ever were close to a real conflict but North Korea is very unpredictable.  Throw on top of this the unpredictability of our President and a simple conflict could easily escalate.  With market valuations already stretched I expect we will continue to see swift reactions to any potential geopolitical events.  This market seems to be resilient and bounce back quickly from these events but no one wants to be around if one of these such events escalates.

Trump:  The President reached new lows this week from a moral standpoint and we have rightfully seen many politicians and business leaders distance themselves.  The markets reacted with some brief volatility but I think the financial ramifications could be felt for the remainder of his presidency.  The issue at hand had nothing to do with financial or regulatory policy but the President is rapidly alienating members of his own party. This puts in jeopardy many of the policy initiatives on the president’s agenda. Following the election, it seemed that, with control of Congress, many of Trump’s campaign promises would quickly become law. Tax reform, infrastructure spending, regulatory reform all seemed all but guaranteed.  However, as more and more Republicans distance themselves from the president, the timeline for these reforms has become much more clouded.  No one, on either side of the aisle, wants to associate themselves with anything Trump. The end result is the slowing down of an already stagnant congress.

Further complicating the issue, following Trumps recent comments members of his economic and manufacturing councils began stepping down causing the councils to be disbanded.  While these councils have no real authority, they represented the business interests of the country.  They were the “smart” people in the room that Trump would turn to help shape some of his policy initiatives.  The scary part now is that the President is becoming even more of a lone wolf. The financial world was hoping that these councils would be a guiding voice to the president. However, now the president is left to his own devices to shape policy and that hasn’t seemed to work very well so far.

There is a positive side to all of this though.  It seems that the markets have resigned themselves to chaos in Washington being the norm.  There are few expectations of anything groundbreaking getting accomplished.  This has shifted the focus back to companies and their actual performance.  This has proved to be good for the markets.  It seems that the period of uncertainty about what the new administration was going to do following the election has given way to the certainty that nothing is going to get done. Company results and forecasts now become less clouded by what might happen in Washington. While I do think many of Trump’s proposed reforms could be positive for the economy, uncertainty around them was not.

Strategy Commentary

Over the past few weeks, I have reduced my overall equity exposure. Even with a positive earnings season, stretched valuations, rising geopolitical fears and disarray in Washington have added to the overall risks in the markets. Add to this the Feds plan to start reducing their balance sheet over the next few months and reducing exposure seems prudent.  I am not expecting a huge selloff but am happy with the recent performance so I am also comfortable taking some of my chips off the table. The market could very easily keep marching higher but I like to tell my clients: “you can’t lose money taking a profit.”  If the market does pull back or market risks are reduced then I will look to re-enter some of these equity positions.

While I have reduced the size of some of my equity positions, domestically I have maintained my equity allocation.  My shift away from small-caps a few months ago has paid off as large caps have outperformed small-caps by almost 4% over the last month. Technology continues to perform well and I am maintaining that overweight.

We are still maintaining our international exposure as well. Germany has underperformed recently and I will continue to monitor the position very closely moving forward. Emerging markets and other developed international markets still have a strong valuation story compared to the US markets so I continue to maintain those allocations as well.

I am still negative on the fixed-income space.  We have seen a little bit of a rush to safety as volatility has increased over the last week which has pushed rates down but I think on the long run rates will rise. I am maintaining my underweight to the space and again am more comfortable holding cash as a replacement.

[i] https://finance.yahoo.com/news/executives-more-worried-amazon-president-150716489.html

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Where has all the volatility gone?

A lot has been discussed in recent weeks about the period of low 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 phenomenon.

By almost any measure, volatility is at historic lows.  The VIX, which tracks the 30-day implied volatility of S&P 500 component stock options, and is widely accepted as the markets barometer for volatility has steadily marched lower since the financial crisis.  During the peak of the crisis in 2008, the VIX reached levels near 60 but in the last week, we have seen it hover at historically low levels near 10. So far this year we have also seen a number of record setting stretches including when the market went for almost 5 months without experiencing a 1% negative move on any day.

So the big questions that emerge are: what is causing this low volatility environment? Is this new low volatility the new norm or will we snap back to more “normal” levels? And most importantly, when will volatility return?

There are a number of factors that could explain why volatility is so low. Here are few of the more interesting ones:

  • Changes in information flow: This is an interesting one that I don’t normally hear discussed. However, I think it is an important one to consider. Over the last 20 years we have seen access to and the flow of information increase dramatically.  The internet, social media, the 24-hour news cycle and Twitter have put almost any information we could possibly need right at our finger tips. With so much access to information, there are fewer surprises. Everyone from the Warren Buffett to the trader at home knows everything that is going on in the world at all times. All of this data overload has reduced the number of shocks to the markets. Based on advanced modeling, leading indicators and the speed of information flow the market has the ability to react by the millisecond. If there are no surprises and all information is always available than one would assume that the markets would become more efficient and volatility has to come down as a response
  • ETF and Index trading: In a recent podcast Steve Bregman discusses this topic and I think it is an important one to consider because if he is right then it is setting the stage for a potential rapid increase in volatility if this trend reverses. In summary, the rise in popularity of ETF investing over the past few years, and the massive inflows away from active management and into passive are causing a wide range of stocks to be propped up artificially.  When a large ETF, like SPY, sees inflows, management has to go out and buy a majority of the stocks in the underlying index in order to mirror performance. This buying is not selective and has little to do with the fundamentals of the underlying companies. Since they are forced to buy, this dynamic is creating bids to buy all of these stocks, even the low-quality  These “artificial” bids prevent these stocks from selling off to the extent they really should if they were trading on their underlying fundamentals. This reduces overall volatility and mutes any potential market pullbacks. As long as flows continue into these passive vehicles there will always be someone out there buying the stocks.  The scary part about this is that if this trend reverses and flows stop going into these stocks then the pullback could be dramatic.  The artificially propped up stocks will not only give back these artificial gains but then pull back to where their fundamentals say they should be trading. Further, there will be forced selling of the quality stocks too, exacerbating the problem. The argument against this has been made that a lot of stocks have seen big pullbacks over the last few years so all ships are not being lifted with the ETFs.  My contention, however, would be, would these companies have pulled back even more if there weren’t ETFs being forced to buy them?
  • Post crisis tail risk fear: Following the financial crisis market confidence was at all-time lows and the fear of another tail risk event was on everyone’s mind. This fear caused many investors to pay crazy amounts for options to hedge any exposure they had. With investors willing to pay so much for protection, implied volatility stayed high. Even further, hedge funds who had missed out on making money on the financial crisis began to make more and more bets on tail risk events, hoping for another shock to the system. In the 9 years since the financial crisis, few of these tail risk bets have paid off so managers are now more reluctant to make them causing the VIX to drop. As the crisis moved further into the past, investor’s confidence also returned and their desire to buy option protection decreased. As options become less expensive, implied volatility also comes down dragging the VIX with it.  The interesting thing we have seen, however, is that numerous pundits are now screaming about an impending pullback but volatility still remains low.
  • Calm, stable period: The simplest answer to the low volatility question may be the most probable. Maybe we are just in a very calm, stable period for the financial markets.  The economy is currently at full employment, inflation is low and although GDP growth has been below its long term averages it has been very stable and predictable over the past few years. Additionally, even though we hear a lot of talk coming out of Washington, not a lot has happened to shock the system. Further, there are a lot of geopolitical tensions in the world but it has been years since we saw a major geopolitical threat come to fruition. A stable economy, minimal shocks to the system and no tail risk events coming to fruition may have just lulled the markets into this complacent state. This isn’t the sexiest explanation and even in this environment valuations may be getting stretched but until there is a major catalyst to shake things up the markets are comfortable with their slow steady march forward.

These are obviously only a few of the possible variables that may be driving this low volatility environment and it is most probable that a combination of factors has led us to where we are. As an investor, the questions still remains, what will change this current pattern?

Every day we read more and more about how a major pullback is coming. Whether this pullback is simply a natural market consolidation driven by overstretched valuations or a more severe geopolitically driven sell-off, it is important to not get lulled to sleep by current conditions.  As I’ve written about in the past market pullbacks are normal. The risk lies in whether there have been changes in market dynamics that could lead to a more severe pullback than normal.  If multiple factors are contributing to this low volatility environment and a few of them reverse or break down than the pullback could be exaggerated.

I, for one, think the fundamentals in the market are strong and without any major geopolitical disruption or major policy shift in Washington expect the market to continue to march higher.  We may see some profit taking here and there and some short term pullbacks but the foundation is set for the bull market to keep marching.

My fear, however, still lies in a tail risk event that causes panic selling. While we are years removed from the financial crisis, most investors still remember it vividly and they don’t want to be there if it happens again.  And while ETF flows may have propped up stocks on the way up, they could have the reverse impact on the way down, as forced selling drags down the quality stocks too. As low as the probability of such an event may be, all of this paints a dire picture if a real shock hits the markets.