RCM Managed Asset Portfolio
October 1, 2016
George Tkaczuk, MD
Christopher Chiu, CFA
Current Market Environment
The third quarter of 2016 marked the start of a new bull market. Many pundits and financial journalists have focused on the notion that the market has exhausted itself for the past 7 years. These pundits believe that the market just can’t keep up this trend due to the length of this run – we do not see it this way. This is how we break up the last few years, and what significance it carries for us.
The equity market bottomed in 2009 and had a nice run until May of 2010. At this point, the market corrected; then recovered until the summer of 2011. Soon after, it went into a bear market until late December 2011. The market then started a new run, with a few minor corrections during 2012, surviving all the doom peddlers. The S&P 500 made a new high in March of 2013, which marked the start of a new secular bull market (emerging from a secular bear market since March 2000). Peaking in the summer of 2015, equities went into a “stealth” bear market. We call this a “stealth bear market” since the S&P 500 corrected only 15%, however many of the underlying sectors in the S&P 500 corrected to a much greater degree (financials 30%, biotech 50% etc.) The last major shakeout of this bear market occurred with infamous Brexit event after which we saw a strong rebound. On July 8th 2016, the S&P 500 rose past a 2120 resistance point, signaling a new bull market. Now, the stock market never goes straight up and you always get a few gyrations along the way. We witnessed this turmoil during the September 9th panic sale when the equities successfully tested the 2120 resistance point, and bounced back up.. Please see the chart below.
As pointed out above, we believe the market has not had a straight run for 7 years, having experienced many significant pull backs scarring people out of the market, while creating enough fear and pessimism to keep the market in check.
We expect equities will remain volatile mainly driven by the media and headline fears. These fears will come in the form of the Fed raising rates, the Presidential election, China’s slowdown, a potential government shutdown, oil prices . At some point, the stock market will correct again, which could start the next recession – we do not feel that is going to happen in the near future.
We do not see any signs of a recession due to the fact that the Fed is very accommodative, swap spreads (indicators of systemic risk) are low and stable, Leading Economic Indicators point to continued moderate growth. At the same time entrepreneurs continue to innovate and these innovations of today become tomorrow’s baseline, where the world will build on this and improve.
Stocks may not be as cheap as they were a few years ago, but they are not overly expensive and are much more attractive than other alternatives, thus we expect equity prices to continue to grind upward over the coming year. Furthermore, it should be noted that the supply of stock is shrinking, due to low number of IPOs, stock buybacks, and cash merger and acquisitions. A net shrinking stock supply is bullish.
Whether or not you believe “our view” of the past 7 years, keep in mind economic recoveries do not die of old age, they die of excess, which is not anywhere to be seen at this time. To reiterate Sir John Templeton’s quote: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” A year or two ago, it looked like we were in an optimistic maturing stage, but now it seems we are back in the pessimism stage.
Recently there has been much interest in an investment strategy newly called smart beta. But what is a smart beta strategy and what does it entail?
To answer this question we should first explain what beta is. Beta is a measure of volatility compared to the market. The equity market has a beta of 1. If an investment has a beta above 1, we know that it is more volatile than the market, and that means it is thought to be riskier than the market. If an investment has a beta less than 1, then it is thought to be less volatile than the market. For example, if a young biotech company has a beta of 2, its price fluctuates twice as much as the market, while Coca Cola, being a consumer staple, has a beta of .54, which means its price wiggles around about half that of the market.
Managers of smart beta strategies allocate a majority of their investment strategy in the market. So a major portion of their portfolios has a beta of 1. But where these managers can (1) identify investment opportunities that have similar returns to the market with less volatility than the market or (2) opportunities that have the same volatility as the market but higher returns, then they accordingly devote the remainder of the portfolio to these opportunities.
But how do these managers identify these opportunities? The managers look for factors which will lead to this actual outperformance. What they do is observe how much an asset performs over a period of time when compared to a set of independent factors. For example, they may look at the performance of an asset like housing stocks and see how they do when interest rates and household formation change over the same time period. When a particular housing stock’s performance does better than the others, it becomes a stock to be included. This method of analysis allows managers to consider other factors of risk and return in a portfolio that would not have otherwise considered.
In this case they considered factors such as interest rates and household formation but it could have been other factors they considered important in determining the performance of housing stocks. It just depends on what they think are the factors correlated to the stocks’ performance And that is the key thing. It’s their opinion about what factors to consider which determines the success of many of these smart beta strategies. To identify such factors, managers and their analysts must resort to historical performance that has outperformed in the past or they must act on hunches about what will work in the future. The application of both of these is prone to error. History, which reflects past conditions, may not be applicable to the future, and hunches about the future are just that. Most of the time what is called smart beta strategies are just bets that the factors managers have identified will be the key factors driving performance going forward. And of course these may not hold.
Smart beta is not new. Smart beta is simply what is called factor-based investing, which was first formulated in the 1960s and elaborated upon in the 1970s. We at RCM Wealth do a variation of this in our own Managed Asset Program (MAP) where we screen mutual funds based on factors. In such cases we use history as well, but our choices of looking at the history tend to be factors that that are causal to the performance of the asset, not simply correlated and possibly incidental to the performance of the asset. For example, some of the factors that we look at in the bond arena are yield and credit quality, which have a direct relationship on bond performance. In the case of former, yield is the price you pay, and in the case of the later, credit quality is a measure of default of the cash streams and initial principal prior to maturity. Both of these directly impact performance over time.
Many of these smart beta managers are not doing this. In order to find extra returns, they are looking at new and nontraditional factors, which may only be coincidentally correlated for a short time with outperformance but are not causally related. Some of these factors may even be novel. But that does not mean they lead to causation. Investors of smart beta products often pay higher fees for strategies that are thought to be new and innovative, but these may just take them to a misapplication of old methods in attempt to seek out riskier areas of outperformance.
Current Market Environment
Markets go up and down, most often not in a meaningful way. And people attribute market moves to some causal reason which may not be significant but often sways market opinions. But just so we are consistent about our commentary, we just present to you what market participants said was important at the start of the year.
In the first quarter of this year, people were worrying about a deceleration in growth from China. It decelerated, the yuan weakened, and the market went down. The deceleration showed no significant signs of abating and yet the market went back up. Was the market pricing in a calamity? Was there a calamity in the making or was there just the opinion of a coming calamity which changed as soon as another set of data was issued?
Oil prices continue to wiggle around the $40 – 50 range after falling steadily throughout 2015 and early parts of 2016. In the short term a decline in oil prices undoubtedly hurt the overall earnings of the S&P 500 companies, which was alleged to be a partial cause to the decline of stock prices in January and February. But taken in an aggregate, we continue to believe that lower oil is a net positive since it is an input cost and whatever overcapacity exists will be washed out of the oil industry. It seems that this is occurring gradually as we have reached some supply demand equilibrium point and some projects, operating below breakeven costs, are departing the market.
Gov’t, High Credit Corporates
We remain in an extremely slow rate-rising environment. While the Fed has signaled recently the possibility of an autumn raise, we do not anticipate rates to rise dramatically over the near term, as inflation levels both domestically and abroad do not warrant such action from the central banks of the developed economies. On the international front, the ECB has signaled a possible revision of the negative rate effects resulting from their monetary policies. Japanese government rates still remain negative as the JCB looks to continue with their program. Nevertheless, it will take some time for policy to change globally, as one central bank policy is a consideration for another in a global economy. In our opinion, even as the U.S continues to grow steadily, Fed policy is unlikely to diverge significantly from the central banks of other developed economies.
High yield, which is currently on the downside of the credit cycle, as credit condition deteriorated in Q4, experienced a recent rebound through the second quarter for 2016. However, the high yield market’s exposure to the oil patch warrants some caution. High yield prices historically have bottomed when default have finally exceed 8% percent.
We are nowhere near those levels currently–with defaults currently well below 4%.
Investments in the high yield market represent riskier investments among the risk spectrum. As we enter the end of this credit cycle, we expect this sector to be among the most vulnerable to any increased risk and volatility. It will also be among the fastest to recover in any recovery of credit markets.
Recent developments in Large Caps and Strategic Knight
For the most part, there were gains in the equity markets, through much of the third quarter, after concerns of fallen oil prices, fears in slowing China growth, and the results of the Brexit vote abated.
The effect of low oil prices has had a negative effect on S&P earnings. we anticipate that lower oil prices will have a positive effect on stocks.
As there is some expectation that the Fed will raise rates .25% at some point later this year, one could also say that it is anxious to do so, mainly because they need the ability to lower them as a remedy for the next recession.
in the second quarter, we bought a regional bank headquartered out of the Washington DC area. Banks should generally perform well in this rising rate environment. Eagle Bancorp should benefit from this increasing tailwind as this interest rate cycle plays out over the next several years.
But the specific reason we purchased Eagle Bancorp, in addition to excellent operating performance, is that it also benefits from the economics of the region. Fairfax and surrounding counties where Eagle Bancorp makes many of their commercial loans is a growing region and among the most affluent in the country. Additionally, there will be increased development as the Washington Metro builds an extension of the Silver Line from the DC center to Dulles and beyond.
Small and Mid Caps
We continue to maintain an equal weight exposure to small and mid-caps. Unlike large caps, which have a large portion of their sales to international markets, small and Mid-caps sell almost exclusively to domestic markets. Despite the strengthening of the dollar in 2015, the dollar has weakened in the second quarter of 2016. Nevertheless we view that in the long term, as rates begin to rise, there is ample cause for the dollar to strengthen. Drawbacks to investments in the small and mids include the higher levels of debt to capital when compared to historical norms. This implies higher levels of risk that need to be weaned down over time.
Strategic Knight: Favored Sectors
We continue to be optimistic about healthcare and technology as these have proven to have the highest returns on capital. The healthcare sector has performed poorly recently, partly because drug pricing has become part of the news cycle. Regardless of the heated rhetoric that comes out of the presidential campaign regarding drug pricing, we find it would be very difficult to change the current medical payer regime, which is the byproduct of decades of negotiating between drug companies and payers. We therefore have not greatly changed our modeling on the valuations of these companies. Such drastic controls limiting drug pricing would require bipartisan Congressional agreement on what would be a very partisan topic. One might ask why we own so much healthcare? Simply put, the returns on investment in the pharmaceutical industry remain the highest in the equity markets.
On the other hand, we remain underweight energy. Our thesis is rising rates result in a stronger dollar; a stronger dollar, as the opportunity cost for owning commodities, results in weaker commodities, including oil. We are at the start of a long cycle where energy becomes un-investable unless you have an eye and an ability to invest in distressed assets. Investing in operating assets of the energy industry is like swimming against the tide.