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The Brave Report: Market Commentary for October 2021

Click here for .pdf version of this report: The Brave Report-October 2021

I thought the market only goes up…..  We finally got a pause in the market’s climb as all major indexes pulled back, registering their worst month since March 2020.  Rising rates, uncertainties over the Fed, a looming debt ceiling crisis and supply chain woes forced investors to de-risk and bank some of their YTD profits.  The fundamentals of the economy still remain strong but after a long run off the pandemic lows, it was finally time for some profit-taking and a reassessment of what is next.  While these uncertainties will continue to lead to some volatility in the markets, we are entering earnings season where we should get some color as to how any of these uncertainties are impacting corporate America.

I do think valuations have been stretched in some areas of the market, so a pause is very healthy. However, even with the overall indices performing well throughout the summer, there are some areas that have already seen some prolonged consolidation and a more substantial pullback. These are the names that should lead the markets higher once investors get more comfortable with the risks that are present.

Market Overview

The markets finally stopped to take a breath. After posting seven straight positive months, markets finally pulled back during the month of September.  All three major indices saw weakness throughout the month with the NASDAQ losing more than 5% with the DOW and the S&P 500 close behind, losing 4.2% and 4.7% respectively. This marked one of the worst months markets have seen since the pandemic. With that said, it basically gives up the gains we saw during the summer and brings us back to where we were in July.

On the fixed-income side, rates were stable for the first three weeks of the month but spiked sharply to close out the month.  The yield on the 10-year Treasury jumped from 1.30% to 1.50 over the course of 3 sessions.  The spike in rates added some fuel to the late month selling in the stock markets but rates still remain well below the high yields of the year that we experienced back in March.  With the Fed signaling a reduction in their asset purchases it is not surprising that we saw rates rise.  It will be important to watch how much of these Fed changes are already priced in or if we will see another spike in rates when they actually implement their rollback of buying.

While this weakness in the markets hasn’t been the norm this year and we have seen CNBC parade all the “the world is ending” crowd across the TV it is important to put this small pullback into perspective.  Even with the weakness over the past month, the S&P 500 still finished September up more than 16% on the year.  With that said, this provides us a chance to assess what caused this pullback and see if any of those risks may carry through for the rest of the year or if they are temporary.

With the run that the market has been on this year, it was inevitable that at some point some increased risk would present itself and we would see some profit-taking.  In this case, a few uncertainties have popped up and rather than see how they played out, a lot of investors just decided to de-risk their portfolios a bit and book some profits while we wait for the next catalyst.  This is normal and healthy for the markets and happens quite often during sustained bull markets.

Now, it is important to point out that I am not trying to downplay any of the risks that are currently present because all of them do have the potential to negatively impact valuations and economic performance.  The big question is to what extent will this impact be felt and how long will they last?

  • Debt Limit:  Unless Congress passes some new legislation, the government will hit its debt limit in the next two weeks. If this happens it could have ripple effects across the entire economy.  Besides its impact on government workers, this would also have a major impact on the creditworthiness of the US. Especially if the government is forced to default on any obligations. At this point, it looks like a temporary deal will be struck but this means the can has just been kicked down the road.  This risk will linger for a few more months until something of substance has hopefully passed.
  • Fed Policy: The Fed announced at their last meeting that they would begin to reduce their levels of asset purchases sometime in the next few months.  This reduction of liquidity in the system puts upward pressure on rates. This move is something that everyone knew would happen at some point so it is not a surprise. For the long-term health of the economy, I think it is a good thing because it shows that this increased intervention is no longer needed.  It signals that the economy is strong enough on its own to not need the Fed backstop anymore.  With that said, the Fed has not fully signaled if/when they will increase interest rates but this is the first step in that direction.
  • Rising Rates: Following the Fed’s announcement we saw a sharp jump in rates and the stock market reacted by selling off high multiple stocks (mostly in the tech space). I have covered the reasoning behind this in previous reports so I won’t do a deep dive into the justification behind this selling.  But, it is important to point out that even with the jump in rates we are still at historically low levels and not even back to the high rates for the year that we saw in the spring.  The selling pressure we see when rates rise seems more like a knee-jerk reaction or something that is more algo driven.  Until we see rates rise to a level that would have a negative impact on company fundamentals then I think this is a buying opportunity in those stocks that have solid balance sheets and trade at reasonable multiples.  I am looking mostly at the big tech names that often get sold off with the high momentum names whenever rates rise.
  • Supply chain issues: Coming through the pandemic we have also seen a lot of bottlenecks in the supply chain across the globe.  This has and will continue to have a negative impact on corporate results in the short term and will be something to monitor closely during upcoming earnings calls.  I think these supply chain issues will be transitory but the longer these bottlenecks exist the deeper the impact becomes and there could be some sectors that see a material impact to their earnings results.

While these risks could all have a negative impact on the markets, the underlying fundamentals of the economy are still quite strong. With the run the markets have been on over the past year-plus, we may need another catalyst before we can take the next leg higher.  As we enter earnings season, we will get some additional color as to how these risks are playing out in the corporate world.  The question will be, are earnings enough of a catalyst to trigger a rally into year-end or will this quarter’s earnings just be a justification of current valuations?  If some of these risks can abate, I think it could be a catalyst, especially with the weakness we have seen over the past month.  However, if any of these risks intensify, I would not be surprised to see continued choppiness, consolidation and profit-taking as investors try to bank what has already been a good year.

Strategy Commentary

I have continued to maintain my equity exposure slightly below full.  I continue to be bullish over the medium and long-term as overall fundamentals remain strong, both for the economy and on the company level.  I think the panic over rising rates is a little overdone at this point and until we see a more substantial rise in rates, I see no reason markets can’t resume their upward march. However, in the short run, I think we will see some continued consolidation and volatility while investors digest earnings over the next month and get a better picture of how aggressive the Fed will be at tightening.  I am comfortable being patient.  I will look to add to my equity positions on any considerable weakness but am in no rush as I think the short-term risk-reward profile looks muted.

Domestically, I have maintained my overweight to technology, and I think the rate induced selloff we have seen is a bit of an overreaction, especially for large tech whose multiples are not that bloated as some would have you think.  I have been hesitant to add to any other specific sectors until we get some more clarity about the Fed’s next move and some more certainty around the pending infrastructure bill.  The small equity additions I have made have been more size and style-based and not sector-specific.  The weakness we have seen has given me a chance to round out any holes in my allocations, but these additions have only been around the margins.

Internationally, I have made very few moves in recent months.  Weakness in China continues to drag on emerging markets and although there continues to be regulatory risk, there becomes a point when valuations become too low that you just have to plug your nose and add to some positions.  There will definitely be some continued volatility but for the long-term investor, these low valuations are difficult to ignore.  If I make any additions, it will only be to the high-quality large-cap names with solid balance sheets.

With rates rising, I have continued to maintain my extra cash allocations as a replacement for some of my fixed income positions.  The risk of continued upward rate pressure as the Fed reduces its asset purchases only adds conviction to this position.

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The Brave Report: Market Commentary for May 2021

Click here for .pdf version of this report: The Brave Report-May 2021

The Great Reopening…  With vaccine numbers continuing to rise and states throughout the country continuing to loosen COVID restrictions we are starting to see some semblance of a return to normalcy.  Economic data and earnings results from the first quarter also reaffirm that the economy is roaring back.  This economic growth is expected to continue as the government attempts to roll out a series of large spending bills and the spring and summer weather helps to add fuel to the reopening of states.  While it would be expected that this should add to continued upward momentum in the stock market (which I’m not saying can’t happen), it is important to remember that the markets are a forward-looking mechanism.  With the returns we saw last year and have seen to start the year there is a fear that much of this economic growth is already priced into stocks.

I do expect to see continued upward pressure in the markets in the mid to long term but would not be surprised to see some period of consolidation or weakness as the economic data continues to catch up with market prices.  With the potential of increased government spending, the markets will also need to hash out the potential impacts of inflation as we work toward a full reopening.

Market Overview

I feel like a broken record in recent months, but all three major indices continued to move higher, all reaching new all-time highs in the last week.  The NASDAQ and the S&P both advance more than 5% and the DOW gained around 2.7%. This brings YTD gains for the S&P and the DOW above 10%. The NASDAQ has lagged slightly but is still up around 8% so far this year. This represents one of the better starts to a year we have ever seen but it also gives me some pause. I, like most everyone, like to see the market go up but at some point, I think taking a breather would be healthy if we are to see these gains continue without a major correction. I would prefer to see a period of consolidation rather than a big pop followed by a big drop. There are some areas of the market and some specific names where this consolidation has already happened, but it needs to be broader.

On the fixed-income side, we saw rates stabilize after rising rapidly to start the year.  After peaking out around a yield of 1.75% at the end of last month, the 10-year spent most of the month trading around 1.6%.  The rate complex will be very interesting to watch in the coming months as the markets play ping pong with inflation concerns.  The strength and speed of the economic recovery will also play a large role in where rates go next.  Currently, there is a large spread of predictions for rates with some analysts predicting a full retracement back below 1%, with others expecting 2+% rates over the summer. If economic data continues at this pace and some of the government’s spending comes to fruition, I think a rise in rates is inevitable, it’s just a matter of when.

We have been getting new 1st quarter economic data almost every day over the last couple of weeks and it continues to reaffirm that the economic recovery is in full swing. Covid cases are down, and it seems each day a new state loosens their restrictions, adding more momentum to the economic recovery on Main St.  On Wall St., earnings data, so far, has also been positive showing that companies have been able to capitalize on the reopening.

With that said, much of this economic recovery was expected and the primary reason that the markets have been performing so strongly so far this year.  This begs the question, have the markets moved too far too fast?  We have seen this play out a bit during earnings season.  A number of names have put through extraordinary numbers, well above even the most optimistic expectation, but have not seen the expected stock price performance following their announcements.  Historically, this “buy the rumor, sell the news” mentality is a sign that much of the good news is already priced into the markets and can sometimes be a signal of a short-term top. Last year we saw a dynamic where there was a great dispersion between Main St. and Wall St. performance where economic data was terrible, but the markets were on fire. We could be entering an opposite scenario where Main St. economic data is stellar, but Wall St. performance lags because all the good data is already priced in.

Now it is important to point out that I am not calling for a large-scale correction in the markets but more a scenario where the stock market takes a bit of a breather while we continue to get economic data that validates the market’s current levels.  I think this would be healthy for the markets as we want to avoid entering a period of euphoria that then results in a much larger selloff.  I think this would allow a lot of names to create a base of support before the next move higher.

Another major variable we have seen enter the conversation is the fear of increased inflation as the economy roars back.  The kind of economic growth we have seen has historically led to increased inflation. Outside of the economic growth, the government has also proposed some major spending bills.  These are on top of the huge stimulus bills that were passed because of the pandemic.  We are still a long way from getting either of these new bills passed and I doubt they are passed in their proposed form but it is a clear sign from the administration that they intend to be aggressive in their spending agenda. This type of spending would also put quite a bit of upward pressure on inflation.

They have also been a bit unclear as to how they plan to pay for these massive spending bills.  A few proposals have been put forward to increase taxes on the very wealthy and increase capital gains rates but these are expected to be met with quite a bit of resistance from the other side of the aisle and I doubt would come close to footing the bill.  While the spending bills would increase economic growth and continue to help fuel the economy, until we know how they are going to be paid for it is difficult to handicap the impact on the markets.  If capital gains rates are used as a lever this could have a large impact on the markets since so many investors are sitting on so many gains. Until we know more about the plan though, we are just wasting our breath speculating about it.

No matter how they pay for it, this type of spending will have an impact on inflation.  The Fed does not seem overly concerned about rising inflation and in all their recent decisions have continued to stress that inflation is well within their long-term targets.  I think we are still in a wait-and-see time in terms of inflation.  Right now, much of the positive economic data is catch up from last year and this will continue for some time.  Until we are further beyond the recovery and returned to “normal” economic times it is difficult to understand what long-term impact the recovery has had on inflation.  In the meantime, I expect to see some volatility around the inflation debate since it would have a large impact on rates.

Strategy Commentary

My overall equity allocation has been consistent over the past month.  The economy continues to gain steam but throughout it, I have been hesitant to add to my equity allocation as I think we could be entering a period of consolidation.  With that said, I am also not reducing any of my exposure.  While we may see some weakness in the short term, I am comfortable holding the course.

I continue to maintain my overweight to technology.  There has been a bit of a rotation away from tech in the last few months but recent earnings reports, especially from the large tech names, have reaffirmed their strength.  I also think we have already seen some consolidation in the sector so they should be the names to lead us higher once the whole market has a chance to take a breath.  This overweight has definitely led to some underperformance in recent months, but I am still comfortable with my positioning. Within tech I am much more biased toward the larger, profitable names, rather than the speculative profitless ones. Domestically, I did trim some of my small-cap growth exposure and rotated it into mid-cap value as some of these names could benefit more from the recovery.

Internationally, I trimmed some of my broad emerging markets exposure.  With COVID raging in a few of the developing nations, I think being much more selective in my exposure is warranted.  I am still optimistic on China. It has pulled back over the past few months and I think this provides some selective entry points.  I am not rushing out but if we start to see some upward momentum I will be quick to add since I think the valuation picture looks quite strong there.

On the fixed income side we are kind of in no man’s land.  I continue to hold extra cash as a proxy for some of my fixed income exposure and until we get some directionality on inflation and rates I will maintain this positioning.  There isn’t enough yield right now to justify the risk of rising rates.

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The Brave Report: Market Commentary for November 2020

Click here for .pdf version of this report: https://www.braveboatcapital.com/wp-content/uploads/2020/11/The-Brave-Report-November-2020.pdf

I delayed writing this report this month as I wanted to get a more clear picture of the outcome of the election.  With the election being called in Biden’s favor over the weekend we can now start to digest what this means for the country, the economy and the markets.  We saw a lot of volatility coming into the election as many unknowns hung over the economy.  We now have some of those answers, but I would still stress the need for patience. What campaign promises will become actual policy initiatives, and which were just campaign rhetoric?  Until we get a full understanding of the new administration’s priorities and which of those are actually realistic with a presumptive split congress it is still difficult to project the short-term impact of a Biden presidency.

Market Overview

During the month of October, all three major indices continued to lose ground.  The S&P 500 lost 2.8%, the DOW Industrials lost 3.9% and the NASDAQ was down just shy of 2%.  While these losses represented a continuation of the weakness we saw in September, these performance numbers do not tell the whole story. Earlier in the month, both the S&P and the NASDAQ were up over 5%, only to lose ground rapidly the last week of the month to finish negative. We often see this kind of volatility heading into an election and with the current division in the country this year was no different.  Throw on top of this a rapid spike in Coronavirus cases and we had the perfect recipe to push investors to the sidelines.

We saw similar volatility on the fixed income side with the yield on the 10-year bouncing between the high 0.60s and mid 0.80s. I expect to see continued volatility as the market digests Biden’s policy agenda and we try to project out the economic impacts of a continued surge in Coronavirus cases across the country.  I expect any spikes in rates to be bought, capping their upward momentum. Once the dust settles from the election I wouldn’t be surprised to see rates settle back near 0.7%, where it has been trading from the last few months.

Over the past few months, we have seen a lot of prognostication about what the various election outcomes would mean for the economy and the markets. We have seen arguments on both sides for almost all scenarios. While some legal challenges from the Trump side still need to play, Joe Biden will be the new president.  Some questions still remain as to the final balance in the senate.  Most expect the Republicans to maintain control but the potential for two runoff votes for the final two senate seats in Georgia could still hand control back to Democrats. While this is unlikely, it is still a possibility.

As I discussed last month, the prospect of one party controlling the Executive branch and one controlling at least one house of Congress can create the best opportunities for positive stock market performance in the short-run as the more radical policies of either party cannot become a reality.  The sides are forced to work together to get anything done, thus eliminating the possibility of a tail-end policy.  In this case, if the Republicans can maintain control of the senate then some of the more radical far-left proposals would be dead on arrival. Increases in capital gains rates, rollbacks of Trump’s corporate tax cuts and aggressive spending on climate change and healthcare would be muted.  Now, I am not making the argument that some of these changes would be wrong, I am just saying that the markets prefer incremental change and when any major policy shifts are muted the markets react more positively.

Alternatively, this scenario could also hinder a large scale COVID stimulus bill from getting passed which will have a negative short-term impact on the economy, especially with the potential for more pandemic restrictions being imposed. While I expect a bill to get passed, had there been a blue wave then the bill would have been much larger.

Looking out a little longer term, it is difficult to assess what the real economic impact will be from a Biden presidency.  Throughout his campaign, he was not very specific about his economic plan, so it gives us very little to work with in terms of long-term projections. In his acceptance speech over the weekend he spoke of cooperation and working together with republicans. This is a similar sentiment as to what most other president elects have spoken about but when actual governing begins the levels of cooperation tend to fall short.  It is clear that a lot needs to be done once he takes office, ranging from controlling the pandemic and implementing stimulus to widescale infrastructure improvements. Until we get a full understanding of his agenda priorities, I will withhold making any major projections about his longer-term impact on the economy.

Outside of the election, the COVID situation is still front and center.  Cases continue to rise across the country and we have started to see more restrictions that could hinder the economic recovery. However, there has also been some bright news.  We have started to get results from some of the late-stage vaccine trials and so far, the results have been positive.  It now looks like one or more vaccines will be ready for emergency use approval within the next few weeks.  While this is amazing news for the country and will help dispel some of the long-term fear around the pandemic and give most people hope for the future, I would again stress patience.  The vaccine will take months, if not years to fully roll out and it will do nothing to alleviate the current spike in cases that we are seeing.  I expect that many places will have to increase restrictions over the next few weeks or months which could negatively impact the markets and force the need for a stimulus package sooner rather than later. However, the progress on the health front should create a light at the end of the tunnel that we will eventually get this pandemic under control.  The big question that remains is what economic damage will be done before the vaccine can be rolled out to enough vulnerable people to allow us to return to normal life?

Strategy Commentary

I continued to maintain my overall equity allocation throughout the month.  There is often a spike in volatility heading into an election and with everything going on with this election that volatility was exaggerated.  However, I was comfortable with the overall equity allocation and decided not to make any changes.  Once the dust settles from the election, I will probably do some rebalancing as there are definitely some sectors that will be worth adding to under the new administration

Domestically, I continue to maintain my overweight to technology.  With the prospect for increased capital gains rates being muted and the assumption that the Republicans maintain control of the senate I think we could see continued strength in technology.  We may see a slight rotation away from some of the more stay-at-home tech names if we continue to see progress on the virus front but the quality tech names will be able to continue to capitalize in the shifts in consumer behavior. Once we get a more clear picture of Biden’s policy priorities I will reassess adding to some other sectors that could benefit from his agenda.

Internationally, I continue to be staying away from Europe as their Covid cases have surged and their ability to form a unified policy response remains low.  With the prospects of a vaccine soon, this could change but even with a vaccine we are far from seeing society return to normal.  Alternatively, I will continue to look to add to my China exposure.  Their Covid response combined with the alleviation of some of the Trump era trade war rhetoric could create a great opportunity for outperformance.

I continue to prefer larger a cash position to a full fixed income allocation.  Rates are near the high end of their trading zone since the start of the pandemic but I expect to see rates to stay relatively low until the economy is back to normal.

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The Brave Report: Market Commentary for May 2019

Click here for pdf version of this report: The Brave Report-May 2019

All good things must come to an end…. The euphoric start to the year finally hit a speedbump.  Over the first four months of the year we were cruising in a Goldilocks environment.  Uncertainty around the Fed was muted, earnings were better than expected and all signs were pointing toward great progress on the trade front.  This all changed at the beginning of May as Trump surprisingly imposed new tariffs and China responded with increased blame and finger-pointing. With both sides blaming the other for the deal falling through, the leaders seem to be digging their heels in and trying to rally their own domestic support. This has increased fears of a long drawn out trade fight and stoked the worries about overall slowing global growth. While expectations for a recession have increased in recent weeks, I don’t think a recession is imminent and there will be a number of policy opportunities to avoid any recession.

Even with this sharp monthly selloff, it is important to remember that we are still only around 6% off all-time highs and the S&P 500 is still up more than 9% so far this year.

Market Overview

All major indices finally took a step back this month.  The DOW and the S&P 500 both lost around 6% while the NASDAQ pulled back around 7.5%.  After such a hot start to the year, which saw most indices testing their all-time highs, we saw some rapid selling throughout the month.  The DOW has now been negative for 6 straight weeks, the longest such streak since 2011. While most of the selling can be attributed to the increased trade tensions and new tariffs, the selling was exaggerated due to the runup we saw in the first 4 months of the year.  Traders were very quick to trim their positions and capture some of their profits which put some extra downward pressure on a lot of names, especially the more tech-heavy momentum names.

While the stock market tends to get the majority of the headlines, the real movement over the last month has been in the fixed income complex.   The 10-year treasury rallied substantially over the last month. After trading at a yield of 2.57% early in the month the yield has dropped all the way to 2.14% as of the close of markets on May 31st.  This has been the sharpest drop in yields that we have seen since 2008.  Trade war fears and global growth concerns have increased the likelihood that the Fed will cut rates this year to try to mute the economic impact of this weakened growth.  The yield curve also continues to flatten (or even invert in some areas) which is a sign that long term growth expectations are becoming more pessimistic.

Trade war: All the perceived progress that was made on the trade front over the past six months seems to have been thrown out the window. It now seems that we are back to the drawing board with China as both sides continue to point fingers at the other for torpedoing the potential deal.  For much of the last year, I have viewed Trump’s hardline stance as a negotiation tactic, and I still think it could be, but it seems that China is finally fed up with it and the mixed message they are getting from the President and his representatives. China now looks less willing to make concessions, even if it means playing the long game and waiting out the president.

While the trade war with China is getting all the front-page coverage.  The most concerning development we have seen recently is Trump’s threat to impose tariffs on Mexico if Mexico doesn’t tighten their border. We are just completing our renegotiation of a North American trading agreement with Canada and Mexico in which both countries made concessions in order to get the deal done, but now the President is threatening tariffs for other ends. While I doubt the tariffs ever come to fruition, this is concerning for a few reasons. First, this sends the message to other trading partners, especially the ones we are currently negotiating with, that even if you make concessions to the US in the trade negotiations the President could still try to punish you with tariffs. It weakens the US negotiating stance because it reduces US trustworthiness.  If the President is just going to impose tariffs outside of the framework of a trade negotiation, then why should any trading partner make any trade agreements with us in the first place

Second, it is very rare for a country to use tariffs to try to achieve a non-economic goal, in this case, immigration reform. This tactic becomes a slippery slope because it adds additional risk and uncertainty that at any point the President may use tariffs to accomplish any goal and this does not put markets at ease.  The fact that US companies would be the real losers if there are increased tariffs on Mexico raises concerns that the President doesn’t fully understand the economic dynamics of trade.

I am still a believer that we will still get a trade deal with China sometime this year as there are rarely any winners when it comes to a long, drawn-out trade war. So far, most economists have concluded that US companies and consumers are bearing most of the costs from any new tariffs. Chinese companies will eventually have to adjust their pricing and will bear some of the economic impacts but on the short run, most of the tariffs are just passed along to consumers by American importers. While pro-American/ anti-China tweets play well with Trump’s base, the actual economic impact will eventually start hurting his supporters.  As we approach a campaign year it becomes more important for the President to get something done. He does not want trade uncertainty hanging over our markets, especially since Trump has linked his success to market success.

So how should these new trade developments inform investment decisions?  In the short-term, I think we will continue to see volatility and uncertainty in the markets as trade war fears weaken economic growth projections. In the longer term, I expect this volatility to present some great buying opportunities as a number of great companies are already trading at a major discount. As was the case in December, we have seen a lot of companies dragged down by trade concerns even though they have very little trade war exposure.  This creates some great opportunities. I think a trade deal will eventually get done and when it does, we will look back at this summer as a great opportunity to add to positions. I am not rushing to get in yet, but I will be looking to start building or adding to some long-term positions if we start to see some stability in the markets or on the trade front.

Rates:  Along with increased trade tensions, the entire rate complex took a dive this past month. This represented one of the sharpest drops in treasury rates that we have seen since 2008. This rapid drop can be attributed to a couple of things. Increased trade tensions caused a rush to safer assets as traders took profits. This drove up demand for treasuries.  Also, fears that a prolonged trade fight will slow global growth also raised the expectations for a rate cut later this year. After a few years of upward pressure on yields from the Fed, many expect them to reverse course in an effort to keep our economic expansion going. The Treasury market reacted accordingly, driving the rate on the 10 years to its lowest point since 2017.

Strategy Commentary

I cut some equity exposure early in the month as renewed trade war fears increased risk in the market.  As I mentioned last month, the market had already run-up substantially year to date so trimming a little while some trade war uncertainties dissipate seemed prudent. I do think we are in or near a longer-term buying opportunity, but I do not see a need to rush back into additional equity positions at this time. Once some of the volatility subsides, we will have an opportunity to add back to some positions.

Domestically, I trimmed my exposure to industrials and trimmed a little of my technology exposure.  I am still overweight technology and consumer discretionary but took some profits on the tech side. Utilities have been the big outperformer in recent months, and it seems I missed the boat on this trade. If volatility continues, utilities should still do well but I am not adding yet as I don’t see the need to chase the trade and buy it at the top.

On the international side, I reduced my overweight to emerging markets as the trade war has intensified.  I still like the opportunity in emerging markets, and I expect it to be a great outperformer in the near future, but I plan to wait till some of the trade war uncertainties subside to add back to my position.

Fixed income has been on a tear over the past two months and I missed an opportunity to increase my allocation. As I mentioned last month, I am no longer underweight fixed income and have moved more to a neutral allocation.  With the yield curve flattening, I am looking primarily on the short end of the yield curve.  My cash allocations are also up a bit as I am looking to have some dry powder ready for when the market bounces back.

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The Brave Report: Market Commentary for April 2019

Click here for PDF version of this report: The Brave Report-April 2019

(A quick caveat to add into this report.  It was written last week (5/3/19) but with the developments in the Chinese trade negotiations over the weekend I decided to add in a small section to comment on it before sending this out.)

When is this recession happening again? While stock market performance is not a direct indicator of economic growth, it seems that investors continue to shrug off any fears of an impending recession that many pundits were preaching about only a few months ago.  Market uncertainties seem to be muted at the moment allowing strong earnings to be the focus for investors.  The reduction of earnings expectations going into the quarter and the fears about a potential rapid slowdown in earnings growth seem to have been both overdone. This has led to a continuation of the historically strong YTD market returns and near historic highs for the major indices.

Again, the fear continues to be whether the market has run too far too fast? It is inevitable that we will see some profit taking and consolidation at some point.  Will this lead to a sharp pullback or will we just see market returns slow for a few months?

Market Overview

The markets continued to add to their already historic first quarter with gains across the board.  As has been the norm, the NASDAQ was the big winner, adding around 3.6%.  The S&P500 and DOW each saw consistent gains as well, adding 2.9% and 1.7% respectively.  We have now seen four straight months of above-average gains to start the year.  While these outside gains have only brought us back around the September highs from last year, they are a far cry from where we saw ourselves around Christmas. Strong economic data and above consensus earnings data have continued to push the markets higher.  Uncertainty around a China trade deal still exists and will be back in focus as the negotiations seem to be in the home stretch. Failure to reach a deal would cause markets to pause or pullback, while a deal will again shift the focus back to corporate results and could add another leg to the rally.

After the sharp drop in rates across most of the fixed income complex last month, rates stabilized in April.  After hitting a low yield of 2.35% near the end of March, the yield on the 10-year bounced back to spend most of April trading in the 2.5-2.6% range. Like the equity side, strong economic data and corporate results seem to have muted some of the recession fear brought on by the inverted yield curve last month.

Earnings: As has been the case over the past few quarters, corporate results have been above expectations.  This quarter has been closely watched as we saw a number of revisions in earnings guidance during last quarter’s reports. The major concern was that we would see some sort of earnings recession as the stimulus provided by tax cuts last year roll off.  While overall earnings growth has been slightly negative so far this quarter, the majority of the drop can be directly tied to the one-time bump in earnings that we saw due to these tax cuts.  The first quarter last year was a bit of an anomaly as earnings were inflated substantially.

With around half of the S&P500 companies having reported earnings so far, 77% have exceeded analyst’s estimates on the earnings side. This is above the historic average but also a sign that some of the guidance revisions last quarter were warranted.

Economic Data: With the worries about an impending recession and all the uncertainty around what the Fed was going to do, economic data continues to point to a very strong economy and has added fuel to this rally.  Employment data continues to be strong with unemployment near all-time lows and labor demand strong. Even with this strong labor market, inflation has been kept in check and right around the Fed’s long-term target. While these two factors have helped to support the current market rally, the strong consumer still seems to be the major driving force behind the market returns. Consumer attitude and confidence slumped near the end of last year due to the market selloff and the government shutdown, but corporate results continue to point toward a very strong consumer and show that some of those worries were unfounded or fleeting.

While economic data has been strong it hasn’t been too strong that it forced the Fed’s hand.  Throughout 2018 the Fed raised interest rates as they tried to keep the economy from overheating.  It looks like they went a little too far near the end of the year and we are now in a somewhat goldilocks environment where economic data is strong but not too strong that the Fed has to step in and do something.  This can always change but based on the recent Fed statements, they are comfortable with the current rate environment for the foreseeable future.

Chinese Trade: (As I mentioned above, I felt the need to add this section even though the new developments took place in May.) For the past few months, all signs have pointed toward a trade deal with China being reached.  Even as recently as the end of last week, administrative officials echoed hopefulness that a deal would be reached by this Friday. This all changed over the weekend as the President tweeted out a threat to impose higher tariffs on China starting on Friday.  This was followed by the Chinese delegation threatening to pull out of this week’s high-level trade meetings.

As could be expected, markets sold off rapidly on the news.  Again, the debate is back to whether these are just last-minute negotiation tactics or something that could torpedo a deal.  I tend to think this was again just negotiations as discussions draw to a close.  Trump wants to show his strength going into the week’s trade talks.  It doesn’t seem like something that needed to be made public but as we have seen for the last few years, the President is not afraid to air his frustrations across the Twittersphere.  The hope is that these tweets don’t backfire as China might come back over the top and cancel the meeting.   I think a deal will eventually get done but I do think the risk in the short term has increased dramatically and we may see administrators walk back their hope of a deal this week.  I do expect this to just be a short-term market pullback as this type of widespread selling often reverses as the stocks that were sold but wouldn’t be impacted by any tariffs rebound.

Strategy Commentary

I added back to some of my equity positions early in the month as fear from yield curve inversion seems to have been overdone.  This maintains my equity exposure as slightly overweight.  I do think equities have run a little too far too fast and I would not fault anyone for taking some profits at any point now.  I think we end the year higher than we are now, but I don’t think the pace we are on can or will continue.  I also don’t think the move higher will happen in a straight line. There will be an opportunity at some point this year to take some profit and buy back in at a lower price.

Domestically, the only adjustment I made was adding back to my industrial exposure. I am maintaining my overweights to technology and consumer discretionary as a strong domestic consumer continue to drive both sectors.

I am still staying away from most European equities. Returns in the region have been strong this year but the upside potential and risk exposure don’t make it a favorable place to put money to work.  I am maintaining my slight overweight to Emerging Markets.  I am watching the trade negotiations closely as any Chinese exposure well be driven almost exclusively by a trade deal getting reached.

While I am not fully underweight fixed income anymore, I have still been very cautious putting much money to work in the space.  With the yield curve being relatively flat I am looking primarily at the short end of the curve for any exposure.

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The Brave Report: Market Commentary for March 2019

Click here for the pdf version of this report: The Brave Report-March 2019

What inversion?… Some market uncertainties seem to be clarifying themselves as progress on the trade front continues and the Fed has basically said they don’t plan to raise rates this year.  However, something very unique and potentially worrisome has raised some flags with investors. The yield curve inverted as the rates on shorter duration Treasuries rose above rates on longer-dated ones.  This does not happen often and is seen by many as a sign that a recession is on the horizon.  Even with this new fear the markets continued to accelerate higher and capped off one of the best first quarters we have seen in years.

The questions still remain’ will history repeat itself and is this inversion really a leading indicator? Or are we in a much different environment this time around and we can continue to grow the economy even through the fear of a potential recession?

Market Overview

The markets finished off the first quarter on another high note, extending their gains from the previous two months.  The NASDAQ continued to outperform, gaining around 3% during the month, with the S&P 500 and the DOW trailing. The S&P 500 was up a little more than 1% and the DOW finished almost flat for March.  This continues to mark one of the best starts to a year we have seen in a long time and that normally bodes well for the remainder of the year. Investors continued their optimism around fed policy adjustments and the potential for a trade agreement with China.  The inversion of the yield curve, however, still worries some that fear a recession in the coming year.

The real movement over the last month was in the fixed income complex. We saw rates drop sharply throughout the month as almost all fixed income rallied.  The rate on the 10-year treasury dropped from a high of 2.75% on March 1st all the way to 2.35% in the last week of the month.   Not only did we see rates drop across the board we also saw some the yield curve invert as the gap between the 3-month treasury and 10-year went negative.  This is the first time we have seen this closely watched spread invert since just before the financial crisis in 2007. Historically, this type of inversion is seen as an indicator of an impending recession and will be very closely watched over the next few months.

Yield Curve Inversion: Back in November I discussed the prospects of an inverted yield curve and what that means for the markets.  I’m not going to rehash all of the points I made back then (feel free to look back at all of these reports are archived). In November we were starting to see some slight inversion on the short end of the yield curve.  This past month we saw the most watched, and worried about, spread invert as the yield on the 3-month treasury rose above the rate on the 10-year treasury. This was the first time this has happened since 2007 and we all remember what happened after that. For many, this is a leading indicator that a recession is on the horizon and historically that has been the case. However, this does not mean that a recession is a foregone conclusion or needs to become self-fulfilling.

So why might history not repeat itself this time:

  • The economy is still growing: While global growth has slowed and is expected to slow during 2019 that does not mean it will turn negative anytime soon. If growth picks up throughout the year, fears of recession will dissipate. Throw on top of this the potential for a trade deal with China and some of the factors weighing on growth will be eliminated.
  • The Fed can cut rates: It seems that the Fed may have overshot with their rate hikes or with the verbiage of their outlook. They have already softened their stance and some are now predicting the potential for rate cuts. Fed policy can have a major impact on the slope of the yield curve and can also help to stimulate growth that would avoid a recession.
  • Stimulus: I am not saying stimulus in the way we say after the financial crisis but any agreement on government spending such as an infrastructure deal would add to GDP growth and stimulate the economy away from recession.
  • Times have changed: While all recessions since 1970 have been proceeded by an inversion that was not the case prior to 1970. We are also in a much different rate environment than we have been during any other inversion.  Rates remain near historic lows across the yield curve so comparing the landscape today with that of 1981 when rates on the 1-year were around 17% is not an apples to apples comparison and makes it difficult to conclude that a recession is coming.

I am not trying to argue that there is no chance for a recession in the next few years but I am not predicting one any time soon. The characteristics of the markets are very different now than they have been in the past.  I think a lot of policy mistakes would need to be made to send us into a recession and even if that does happen it does not necessarily mean the stock market goes. Many people often confuse a recession with market declines. This is not always the case.  A recession refers to economic decline and not market decline.  One sometimes leads to the other but a market pullback does not mean recession.

Strategy Commentary

I slightly cut equity exposure this month as I rotated out of a few positions. I am still overweight equities but the fast start to the year has moved markets pretty quickly and taking a few profits seemed prudent.  It seems uncertainty around future rate hikes has been alleviated but questions still remain around trade with China and the inversion of the yield curve so I am comfortable just maintaining my current allocations.

Domestically I trimmed my exposure to healthcare.  I was a little late getting into it this fall and it has underperformed as the rest of the markets rallied during the first quarter.  I also reduced some exposure to industrials. I am still maintaining my exposure to consumer discretionary and technology as these higher momentum sectors continue to outperform as the markets rally.

I am still underweight European equities. They have performed great so far this year and I have missed out on some of those returns. However, the growth prospects still seem weak there and if there is a global slowdown, the risks there are higher then in other developed economies. I continue to be slightly overweight emerging markets and I think there is still some room to run if trade tensions can be eased. Although I am still bullish on China I am also starting to look to other emerging markets for some value.

My shift away from underweight in fixed income is looking like a good decision as rates have dropped over the past month.  With a little more certainty around fed policy for the rest of the year, I am still maintaining my neutral rating on the whole fixed income complex. With my exposure, I still have a bias toward the short end of the curve as the curve flattens or even inverts some more.

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The Brave Report: Market Commentary for February 2019

For PDF version of this report click here: The Brave Report-February 2019

And the train keeps rolling on….  The Dow and the S&P 500 just capped off their best start to the year since 1987 and logged their best two month run since 2010.  What is up for debate now is whether this rebound has come too far too fast?  History tells us that this kind of start to a year bodes well for the remaining 10 months.  Of the last 27 times the S&P 500 has been up for each of the first 2 months of the year, 25 of those times the remaining 10 months of the year have also been positive.  The average return in the circumstances is 12.1% versus a normal last 10-month average of 7.6%.  This is pretty substantial outperformance and something that should give investors some optimism moving forward. I would also argue that most investors would be happy with just the average return over the next 10 months.

However, with this optimism should also come some caution, especially in the short-term. We rarely see continued follow through on these types of rallies without at least a little consolidation or pullback. Profit taking in these situations is normal and healthy and is often needed if the markets are going to make another leap higher.

Market Overview

The markets continued on their tear higher adding to the spectacular gains we saw in January.  All three major indices gained more than three percent, with the NASDAQ gaining the most at around 3.8%.  This puts all three indices up between 11% and 14% for the first two months of the year.  This represents one of the best two month stretches we have seen in years and the best start to a year in decades. With some more clarity emerging around Fed policy and the potential of a trade deal with China there could be some catalysts to see some further follow-on to this rally. However, I would stress caution as well.  When the markets move up this quickly we often see a reversal or some consolidation before another move higher.

With the stock markets continuing to march higher the fixed income complex has been relatively stable. After dropping sharply in November and December, rates have stabilized to start the year.  We saw the 10-year treasury trade in a range between 2.63 and 2.72%. This was one of the tightest monthly ranges we have seen in quite some time.  This can partly be attributed to some additional clarity coming from the Fed as it looks like rate decisions will be very data dependent and the pace of rate hikes seems to be slowing. If fears of a global slowdown do materialize over the next few year or two, I would not be surprised to see rates stay flat or even drop as global policymakers attempt to prevent a recession.

Trade Deal: Most signs coming out of Washington seem to point toward some real progress being made in the trade negotiations with China.  Most notably, Trump again delayed the implementation of new tariffs on Chinese goods.  This can only be a sign that the two sides are much closer to a framework for a deal than they have been for months.  It benefits both countries greatly to come to some sort of positive agreement.  The prospects of and speculation around a trade war have cast a cloud over the entire global economy for almost a year now and helped to catalyze the major selloff we saw over the last few months of the year.

We have also started to see the impact of a potential trade war on the prospects for global growth as it has muted the earnings guidance for a number of companies.  Without an agreement, it has seemed like most global companies have lowered their growth outlooks in an effort to hedge the potential risk of increased tariffs.  Rather than speculate on the outcome most companies have been comfortable projecting more conservative results.  If a deal gets done they can always raise guidance later but this prevents them from having to adjust down in the future. As we have seen from market performance for the last two months, most stocks have not been overly punished for these guidance adjustments.

I do still maintain a worry about the trade deal.  As I discussed last month, I worry that the market has moved so far so fast that if/when a deal gets announced it will turn into a sell the news event in the short-run.  The markets have run up on expectations that a deal will get done so unless the deal is viewed as perfect then we could see some profit taking.  Now, I’m not saying the trade deal won’t be a positive catalyst in the long-run but I would not be surprised to see some selling on the news.

Earnings: With earnings season drawing to a close, we finally have a clear picture of how companies actually performed in the 4th quarter and whether the doom and gloom feared near the end of the year was warranted.  For the S&P 500, 69% of companies beat on earnings and 61% beat on revenue. This is slightly below the 5-year average beat rate for earnings but slightly above the average for revenue.  Where these numbers did disappoint is in the magnitude of the positive surprises in both earnings and revenue, which both fell below the 1- and 5-year averages.

In terms of earnings growth, which is one of the metrics that many pundits were worried about, we saw a 13.1% growth rate.  This is higher than the 12.1% estimated at the end of the year.  This also marks the 5th straight quarter of double-digit earnings growth.

While this all seems like decent news, and most of it is, we did see 73 companies issue negative guidance for upcoming quarters and we saw analysts reduce their forward earnings estimates by 6.5%. This was the largest decrease since the 1st quarter of 2016.  The big question moving forward will be whether this decrease in earnings estimates is due to an actual slowing in the global economy or if it can be attributed to the risk of a trade war.  We should get a better picture of this if a trade agreement can be reached and analysts adjust their estimates accordingly.

Strategy Commentary

I have continued to add to equity positions but plan to take a pause on this approach as the markets seem a bit overheated in the short term.  I am currently slightly overweight equities and am comfortable here even if there is some short term consolidation. With that said, I will also not hesitate to take some profits if the market pulls back in the short -term.

Domestically I have maintained my overweight to consumer discretionary, industrials, technology and healthcare.  I am watching the healthcare sector closely as it outperformed in the 2nd half of last year but has been struggling to find footing as of late.  This could be due to some profit taking or just a rotation into higher momentum stocks as the market has accelerated. If this continues I will be looking to reduce exposure.

I am still underweight European equities as growth prospects in the region seem to be muted.  The risk of a recession is much higher there and there continues to be a long list of uncertainties that will hang over the region. I am maintaining my overweight to Emerging Markets.  The recover there, especially in China has been pretty sharp.  As I mentioned above, I am worried that a trade deal with China could turn into a sell the news event in the short-run as investors capitalize on the run we have seen so far this year but I still like the risk/reward profile for the remainder of the year.

On the fixed income side, I am removing my underweight.  I am not looking to rush in and start buying bonds with both hands but it seems that the upward pressure on rates is starting to be relieved.  I will start to selectively add some positions, especially on the short end of the curve as long as rates seem to be range bound or trending lower.  I am not moving to overweight at all but will look to bring the weighting up to a more neutral position as the data dictates over the next few months.

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The Brave Report: Market Commentary for December 2018

Click here for PDF version of this report:

Yelling fire in a crowded theater… The markets decided to end the year on a bit of a sour note, registering one of their worst months since the financial crisis and logging the first negative year since 2008.  It seems that some people started yelling fire and investors and traders couldn’t get to the exits fast enough.  The selling was widespread, and few sectors were spared.  However, with all the carnage it is important to put everything into perspective.  While most in the media would have you believe the world is ending, the S&P Total Return (the S&P 500 including dividends) only lost just more than 4 percent for the year.  Not really that bad of a year following nine years of healthy positive returns.

Even with all these people yelling fire, I think the rush to the exits has been a bit overdone. While there are currently several risks to the markets and the underlying economy, the theater is not on fire yet.  If anything, there are a few candles burning on stage. Some may be getting bigger and tipping a little more than they were a few months ago but even if they do tip over (which very well might not happen), it doesn’t mean the theater will burn down. I think these risks warrant a reassessment of equity valuations and a normal, healthy correction or consolidation while the uncertainties become clearer but nothing like we saw over the past month. This view may change as we get 4th quarter data and start to get some earnings reports later in the month. I expect to see some softening in the data but not enough to warrant the type of moves we have been seeing.

Market Overview

The markets had their worst month in years, with all three major indices dropping around 10%.  More notable than the severity of the selloff was the lack of dispersion between the various indices and sectors.  It was an equal opportunity sell off meaning that fundamentals were being thrown out the window and the markets were being driven by technical factors, algorithmic trading and ETF selling.  Even more was the intraday movement of stocks.  We often see overnight gaps up or down during big selloffs or rallies but over the past month most of the movement took place throughout the trading day.  We saw a number of days where the markets sold off, recovered or rallied multiple percentage points throughout the trading day. This is not normal trading activity and not natural price discovery. By that, I mean there have been other factors other than the real valuation of companies and the economy driving stock prices.

Unsurprisingly, we saw a rush to safety as equity markets sold off. After starting the month with a yield above 3%, the 10-year treasury rallied to close the year with a yield of just under 2.7%.  We saw similar action across the fixed income complex. This rally in fixed income was not just due to a rush to safety but the fed announcement was also much more dovish than it has been over the past year. The indicated a slower and much more data dependent projection of future hikes.  While the equity markets didn’t fully see the statement this way, the interest rate complex rallied on the news.

Last month I discussed the various risks and uncertainties in the markets going into year end.  What we have seen is a continuation of some of these risks and a realization that unless news around these uncertainties is perfect the default stance in the current environment is to sell. This selling has not just happened because of real news or changes in actual economic data but on the prospect of future bad news and the breakdown of technical support levels. I continue to think these risks are a bit overdone and if there is any resolution around these uncertainties or the actual results are not as bad as the fear mongers would have you believe they could be then I think the companies with strong fundamentals could eventually divert from the rest of the market and rise.  At some point, valuations become to attractive for real money investors to pass up.

I am not saying we are necessarily at a bottom for equities yet and I still expect to see some downside pressure and increased volatility, but the disciplined long-term investor should be able to identify some real long-term opportunities in this environment. Once good news becomes good news again these investors should be rewarded.

To revisit my analogy from earlier, while the theater is not on fire yet there are some candles burning on stage that could tip over and cause some short-term damage. They won’t burn the theater down like we saw in 2008 but these risks should be factored into valuations.

Global Growth Fears: The candle that has moved to the forefront seems to be fear of global growth slowing.  The cheap money environment we have been in for the past decade is starting to be phased out. There is concern around the trade war with China and Brexit concerns in Europe.  Domestically we also saw a boost to the economy from the tax cuts that went into place earlier this year. With all these factors considered, a number of economists are projecting a slowdown in global growth. While I would agree we will probably see growth slow it is important to remember that it is slowing from a very high rate in historical terms. Since 2011 we have only seen four quarters with a higher growth rate than we saw the last two quarters so even if growth drops from the 3.5% we saw in Q3 of 2018 the expectation is still for it to be in well in line with long term average growth.

There have been some, especially in the media, that are calling for a recession in the next one to two years. So far, most economic data does not support this hypothesis. Some data does support a slowdown in growth but in the absence of a major policy mistake, a full recession is unlikely this year. The outcome of trade discussions along with Fed policy decisions could change this but I see that as a low probability tail risk. With that said, the things that could cause a recession is the fear of a recession itself.  Recessions can sometimes become self-fulfilling as fears of a recession cause companies to reduce spending and handicap growth. Again, I don’t see this happening any time soon, but I could be a concern is some of these uncertainties are not resolved in a responsible manner.

It is also important to point out that a recession doesn’t mean that the stock market drops.  It often drops leading into a recession but since World War 2 the market has been positive during 6 of the 11 recessions with a median return of 5.4%. So, while I am not expecting a recession to happen, especially if a trade agreement can be reached, I am also not overly concerned if one does occur.

Trade War:  I have touched on the trade war at length in previous reports, so I won’t linger on it. All signs seem to show that some progress is being made and that a trade deal will eventually get down. However, with the environment we are in right now, until an actual deal is announced any market reaction from progress will be muted.  As I said earlier, the only positive news investors are reacting to is perfect positive news.

Fed Policy: The other big candle that is burning on stage is interest rate policy.  The Fed again raised rates in December, much to the dismay of investors.  I think Powell is in a very difficult situation.  Most economic data are showing the economy is strong which would justify continued rate hikes. But the stock market is showing something different.  Powell’s job is not to react to stock market but to make decisions based on what the overall economy is doing, and the stock market does not always represent the underlying economy. Now, I am not saying Powell was right in raising rates in December, but I think the reaction to the hike and his statement has been overdone. Over the next few weeks we will start to get some real data about the 4th quarter and this will be very telling as to what the Fed’s next move is.

Many investors, and especially media pundits read Powell’s statement as he is going to do two hikes next year and this sent the markets into a tailspin.  I read his statement very differently. While he did project two hikes for next year he said that was based on the current economic data. He said if that data changes then he will adjust those projections. This is the most data dependent he has sounded in any of his statements since taking over leadership of the Fed. It is also important to note that since the Fed started to raise rates a few years ago they have never raised in line with their previous projections.  I think that in a different market environment this announcement would have caused a positive reaction in the markets but in the current environment it wasn’t good enough.

Strategy Commentary

I continued to maintain my equity allocation throughout the month. As I discussed last month.  Making widespread changes during these types of markets can be a dangerous game of timing that can often backfire.  The only adjustments I made were in the name of some tax loss harvesting and had nothing to do with a change in sentiment.  After years of gains there was finally an opportunity to realize some gains and losses in some equity positions and save some money on taxes

Domestically I maintained my allocation.  If we start to see a bottoming in the market I will selectively look to move into some high-quality names, especially in the technology space.

I am maintaining my underweight to most international markets. I will continue to add selectively to emerging markets names as news on trade negotiations materializes.  I think those markets have been showing more of a bottoming and could be huge winners if a trade deal is reached.

I have still maintained my underweight to most of the fixed income space. This was a major missed opportunity over the past month with the rush to safety but if equity markets stabilize I expect rates to bounce back a bit.  If the fed continues to sound more dovish I may start to add back some of my fixed income exposure, especially in my longer-term portfolios.

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The Brave Report: Market Commentary for October 2018

Click here for the PDF version of this report: The Brave Report-October 2018

Well, that escalated quickly. For anyone waiting for a pullback, October finally delivered.  In what has historically been a very volatile month we saw some of the sharpest fluctuations we have seen in years with some of the major averages giving back almost all of their year to date gains and the NASDAQ having one of its worst months since the financial crisis.  The reasons behind the sharp selloff are still being dissected and as is often the case it wasn’t one single thing that caused the selling. However, as we have seen in some other brief selloffs this year, the selling happens quickly and is often exaggerated as traders rush to lock in profits and algorithms precipitate the movement in both directions.

While some pundits have been shouting that this is the beginning of the end of the bull market, others are rushing to call the bottom.  In these times, as an investor (and not a trader), it is important to block out the noise and put the focus back on fundamentals. This doesn’t mean the bottom is in yet, but if you were optimistic over the last few months and looking to put some new long-term capital to work, then black Friday sales have come early.

Market Overview

There was no real winner over the last month, just areas that lost less.  The Dow Industrials held up the best losing only 4.8%. This was followed by the S&P 500 at -6.3% and the NASDAQ lost the most at around -9.8%.  This represented one of the worst months the tech-heavy NASDAQ has had since the financial crisis.  It is not surprising that it would the biggest laggard as it has been the biggest outperformer over the past few years so when panic selling occurs it is normally the normally the high flying momentum names that get hit the most. These are normally the names that have seen their valuations get stretched and investors rush to try to lock in gains. The selloff, however, was market wide with very few places to hide.

On the fixed income side, we saw rates jump rapidly at the beginning of the month, only to settle back down a bit as the month went on. While the initial jump in rates may have contributed to the selloff, we did not see a rush to safety as equities started selling.  I see this as a sign that there is still upward pressure on rates and that investors may not be as fearful of this equity selloff as they have been in the past.

Market Selloff:  This recent market selloff was one of the swiftest we have seen in recent years, but, historically speaking, is pretty standard as market selloffs go.  The averages only briefly touched correction territory of down 10% from their highs and have seemed to find some stabilization over the last week.  I’m not saying the averages can’t go lower but the underlying fundamentals in the economy and corporate America are too strong to be ignored and should provide some level of support to at least mute too much further deterioration.

Since the selloff started, almost all financial news coverage has been insufferable with every pundit coming out of the woodwork with their opinion as to what happened and where we are going from here.  Depending on their background or investment stance they try to pin it on one thing or another. As with most market movement, it was not just one variable that led to this correction, but a series of uncertainties that told traders it was time to take a step back and reevaluate valuations until some of these uncertainties subside. Once the selling started, however, the current trading landscape takes over and we saw algorithmic sell programs and ETF selling accelerate the downward pressure. This new market dynamic speeds up and amplifies market movements. Because of this, selloffs and bounce-backs now happen much quicker and are often exaggerated. This trading dynamic is here to stay but what caused the initial selling in the first place?

  • Rates: At the beginning of the month we saw a rapid jump in rates as fears that the Fed would continue to aggressively raise rates were amplified by some comments by Fed Chairman, Jerome Powell. I think this was a major factor in some traders moving to the sidelines, however, it shouldn’t be a surprise to anyone that rates are moving up to more normal levels.  The pace of these moves is what investors should be watching now. While this may have been the initial spark to the selloff, if other market uncertainties were not present this spark would never have lit a fire as it did.
  • China Trade: This has been the elephant in the room for months now and the uncertainty around it is casting a large shadow over the markets.  Throughout the current earnings season, trade tensions have been mentioned over and over again. However, we have seen very little negative impact on actual corporate results.  The problem lies in future guidance.  With such an uncertain outcome it is difficult for companies to project how any tariffs will impact future results. This uncertainty often leads companies to announce more conservative guidance. With all the other uncertainties in the markets, it seems that traders are jumping on any bad news in these earnings reports and dragging stocks lower, adding fuel to the selling.
  • Midterm Elections: The administration has pinned most of the selling on uncertainty around the midterm elections, trying to pin any negative market news on the prospect of Democrats taking control of one or both houses of Congress. I do not put much credence in this assertion.  I do agree that there is a lot of uncertainty about the elections but historically a split congress is often a boon to the markets as there is some certainty that nothing will get done. I do think a blue wave taking both houses could have some potential negative impacts on the markets but with a Republican in the presidency, it would be very difficult for a democratic congress to accomplish anything for the next two years.
  • Earnings:  By most measures, earnings season was again very strong.  The concern that some traders and investors are jumping on is that we are at peak earnings meaning earnings growth will stall or decline over the next few years.  I agree the earnings growth we have seen this year, which was fueled in part by the tax cuts, will be tough to sustain but that doesn’t mean that corporate results can’t still be strong in historical terms.

Conclusion and Opportunities: There are obviously a number of other factors that probably helped contribute to the selloff but more than anything I think it was a perfect recipe for a quick correction. Valuations were getting a bit stretched, especially in some of the high flying momentum names.  A number of uncertainties were weighing on investors so all it took was one spark for investors to decide to take a little breather and reevaluate their risk exposure. They took some profits in names that had made them a lot of money and will now look to redeploy it when some of these uncertainties are lifted.

As a long-term investor, I look at this selloff as a great opportunity to invest in some quality names at a discounted price. As I mentioned earlier, very few areas were spared from this selloff, meaning traders were throwing the baby out with the bathwater. This caused a lot of very strong companies to be sold off, not based on their own results or growth prospects, but because everything was being sold. The opportunity now lies in identifying these names or sectors you have wanted to get into.  They are now at much more attractive valuations.  If you were bullish on them a few months ago then you should really like them now.

Strategy Commentary

Over the past month, I selectively cut some of my equity exposure as the market began to sell off.  In hindsight, I probably should have cut a little more in some places but the worst thing you can do during a sharp selloff is panic sell.  In the end, patience will pay off. I reduced our exposure to small caps as they tend to get punished more when the markets sell off.  I also reduced our exposure to consumer discretionary as this is another area that has been on fire for the last few years so will be one of the fastest to selloff as momentum changes. I will look to redeploy this cash as soon as we feel any panic is gone.  The goal is not to call the bottom but to find a lower entry point once things stabilize.

Domestically I am still maintaining my overweight to technology.  I probably should have cut some exposure early in the month but I do not think the fundamentals have changed much, if at all in the sector and it should be one of the winners if the market bounces back. Of all sectors, it has provided and should continue to provide some of the best opportunities for continued earnings and revenue growth. I am also still maintaining my overweight to healthcare.  The sector has performed relatively well in recent months and if we do not see a quick bounce back money should continue to find its way into this defensive sector.

I am still underweight almost all international markets.  That being said, we could see some amazing opportunities in some of the emerging markets that have sold off over the past 6 months. In particular, China is very intriguing. The trade war cloud is still hanging over everything china related but many high-quality names are down 20-50% from their highs earlier this year.  Should any progress be made on the trade front I expect many of these names to rebound quickly.  I am not advocating putting all your money to work here but there could be some amazing opportunities to start building back some international exposure.

I continue to be underweight almost all of the fixed income space.  With rates on the rise, we have seen pretty broad-based negative performance throughout the space.  I am maintaining higher cash allocations as a replacement for my fixed income allocations.

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The Brave Report: Market Commentary for September 2018

Click here for the pdf version of this report: The Brave Report-September 2018

Will fundamentals win the day? Strong economic numbers continue to drive the markets higher but trade concerns and political posturing have left a cloud over the markets and muted what could have been even greater gains.  With the start of earnings season coinciding with the run-up to midterm elections, there will be a tug of war in the markets as to what will drive investor decisions for the rest of the year. With the possibility of flipping the majority in Congress, I would not be surprised to see some major political posturing from both sides over the next month.  The big question is will this impact the markets or will economic fundamentals and corporate results remain the key focus?

Market Overview

The markets saw mixed results over the last month as trade tensions and political discourse again moved to the forefront. The Dow was the big winner, gaining just shy of 2%. The S&P 500 also moved higher, adding 0.6%. While the NASDAQ, for a change, was the underperformer, losing around a half a percent. Investors continue to be torn between the tailwinds provided by strong fundamentals and corporate results and the headwinds of a potential trade war with China and rising rates. This battle has been playing out for almost the entire year. With earnings season kicking into gear and the run-up to midterm elections over the next month it will be interesting to see how October plays out.

On the fixed income side, we finally saw a meaningful move higher.  After being relatively range bound since the beginning of February, the 10-year treasury seems to have made a sustained move above 3%, reaching a high yield of just above 3.1%. This upward movement is not unexpected as the Fed again raised rates at their September meeting, but it finally looks like the rate increases are putting some real upward pressure on rates.  The questions that remain now, is how fast and how high will rates move now and how will these rising rates impact the equity markets?

Fixed Income Lags: The rise in rates finally seems to be taking its toll on the fixed income universe. Market pundits have been calling for the end in the bond bull run for a few years now but it finally seems that it is materializing. The Fed has not hidden its intention to raise rates over the past few years but that seemed to have little impact on real returns. That story seems to be shifting this year. The chart below illustrates the real return of the major global asset classes since 2008 or the return adjusted for inflation.

Source: Morgan Stanley

As you can see, we are poised to see negative returns across almost all major fixed income classes. As of the end of September, US High Yield bonds is the only place that investors have not lost money year to date and it is only up around 0.2%.  Some investors will argue that fixed income has been on a great run and is due for a little consolidation or even a pullback.  I don’t think these investors are wrong, however, the concerning aspect for me is how this impacts the everyday retail investor, especially those in retirement. Most retail investors flock to fixed income for its perceived safety and steady income.  They look at their fixed income allocation as their safe haven, and in general, it has been for many years.  This year will be very shocking to many when they realize these “safe” investments have actually lost money. These investors should not panic but use this as a learning moment.  There are risks with any investment and it is important to understand the risks associated with what you are investing in. It also should show the importance of diversification.  Looking at the above chart again we see that the very few global assets have performed well either but if you had exposure to US equity you would have helped to balance out the negative performance elsewhere.

Earnings and Mid-term Elections: I touched upon this briefly above but a few factors have been driving the markets so far this year. Basic economic fundamentals and strong corporate results have been pushing markets higher.  These gains, however, are in spite of the political and trade uncertainty that hangs over the markets.  It seems that during times that earnings are in focus the market easily shrugs off these uncertainties.  But when earnings move out of focus, the uncertainties around our current trade and political climate take control and the market stagnates or pulls back slightly.

Over the next month, these factors could have quite a battle as they will all be difficult to ignore. Earnings season is set to kick off but with midterm elections on the horizon, we should see quite a bit of political wrangling as the GOP looks to hold on to their majority.  It would not surprise me to see an attempt by the administration to try to notch a few victories to help solidify the base and motivate voters. Add to this the issues the GOP is having with their Supreme Court confirmation and I think they will need some other big wins in order to protect their majorities. What this wins will look like is the big question mark.

The questions then remain, will this ongoing political discourse distract investors from what is expected to be another stellar earnings season? Or will investors be able to put aside the political uncertainties and focus on what really should matter; fundamentals?

Strategy Commentary

Over the last month, I have added back to some of my equity positions. While the trade conflict with China still has a ways to go until a real deal is reached, there has been some positive progress on other fronts. We are also entering what is expected to be another strong earnings season and this should shift some of the daily focus away from trade negotiations and again allow traders and investors to focus on company fundamentals.  I did not return to a full overweight of equity but brought it back to a more neutral allocation. If we continue to see more resolution on the trade front there could be some great buying opportunities in some areas that were beaten up by trade war fears.

I am still maintaining my overweights to both technology and consumer discretionary.  As expected, I also increased my weighting to healthcare.  Healthcare has outperformed over the last six months and I expect this outperformance to continue especially if trade tensions with China still hang over our economy.

I continue to be underweight on almost all international markets. There are too many headwinds in Europe with Brexit still being resolved and uncertainty in Italy. As I have mentioned in the past, with emerging markets being severely beaten up for the last few quarters I think there could be some country-specific buying opportunities if China and the US can work out a deal. The severity of the pullback, especially in China, does not match up with the economics of the tariffs that have been implemented or proposed. With the trade risk removed, I think there could be a pretty swift recovery.

I continue to be underweight almost all of the fixed income space.  With rates on the rise, we have seen pretty broad-based negative performance throughout the space.  I am maintaining higher cash allocations as a replacement for my fixed income allocations.