The third quarter came in like a lamb and went out like a lion, as the return of volatility hit risk assets hard across the globe. As in previous quarters, emerging market stocks and commodities suffered double digit declines as markets continue to deal with the end of the commodity super-cycle and the mix of structural and cyclical problems reverberating throughout the emerging market complex. But the big news of the quarter was a catch-up in developed markets that had previously appeared impervious to the problems that were festering in the developing world.
In August, large developed markets that include the U.S. dropped quickly and in unison. The three day drawdown in August was one of the fastest on record, highlighted by a 1,000 point drop in the Dow Jones Industrial Average during the first 10 minutes of trading. The speed of the move caught investors off guard, and shook confidence around the globe. Safe haven instruments such as bonds, cash, and the U.S. dollar caught a bid off the turmoil in risk assets, though returns for the quarter were still somewhat muted given the amount of distress in risk assets across the globe. By the end of the quarter investors were left to assess whether they had witnessed just another correction in a bull market, or whether the volatility was the beginning of a cyclical downturn in stocks that might bring about a more meaningful move in risk assets.
Global Economic Cycle: Slowing
We believe the global economy, and particularly the issues in China and emerging markets, are at the epicenter of the world’s problems. By our estimates, between 30-50% of world GDP is directly or indirectly linked to China’s growth through various trade links. So while some believe that the U.S. economy is strong enough to simply brush off the effects of a major slowdown in China, we feel that decoupling is a dangerous possibility. Furthermore, while our base case has been that the U.S. will be able to maintain a low trajectory growth path, we believe the U.S. is currently slowing, as the drag in world trade is now showing up here.
There are some who believe that the U.S. is firing on all cylinders, arguing that our consumer-led economy is poised to benefit from the Chinese and emerging markets malaise (given that current low interest rates and low inflation are byproducts of the slowdown and busted commodity super-cycle). We agree that there are some positive side effects from a slowing China, and we’re hopeful that consumers will enjoy these inputs on a lag and support the economy. But we are also realists, and at this point it is hard to deny that U.S. data has started to develop some cracks in the armor.
For example, in the month of September all seven Federal Reserve district manufacturing surveys declined. In addition, signs of credit stress have materialized in the junk bond market, indicating growing concern that default rates may soon rise, led by energy-related companies struggling with much lower oil prices. Housing and employment have been solid areas within the economy, but even they have taken a few blows over the last month. While we aren’t calling for a recession yet, we do believe that the risks to the U.S. economy are growing.
Bottom Line: Overall the evidence is mixed, with global conditions looking mildly bearish, and the U.S. slowing.
Global Monetary Policy: Mixed Settings
We have come to the conclusion that watching central bankers has become such an important part of the investing landscape that it deserves its own category. Currently global policy settings are diverging, with international central banks mostly easing policy through various mechanisms, while the U.S. Federal Reserve is preparing to exit the zero interest rate policy that has dominated the landscape since the Great Recession. This leaves conditions mixed, but also creates uncertainty about how markets will respond to the prospect of a monetary tightening cycle in the U.S. for the first time in nearly a decade.
Bottom Line: The overall monetary policy setting is mixed with continuing liquidity abroad, and the U.S. Fed inching closer to policy normalization.
Technical Conditions: Broken
One area of the evidence that seems to be uniformly broken lies within the technical conditions of the market. Even before the latest selloff, a number of classic divergences were developing below the surface that signaled a market on increasingly shaky ground. These included such things as slowing momentum and an acute thinning in participation among many sectors of the market. When the market finally broke down in August from a long lateral phase, it did so decisively, causing an ominous surge in measures of underlying selling pressure. The best thing we can say about the market’s current technical setup is that it recently became extremely oversold, which means a bounce is likely to occur. But oversold conditions can be misleading, and what might appear to be another classic dip-buying opportunity in a bull market looks more like a classic bear trap to us (given our view that the primary trend has changed from bull to bear).
Bottom Line: Many technical measures have now broken, leaving us with a grade of “Solidly Bearish” for technical conditions.
Valuation: U.S. Still Overvalued; Emerging Markets Remain a Value Trap
One of the silver linings to any correction or bear market is that it tends to produce cheaper valuations, which can lead to a wider margin of safety that actually improves the long-term return profile for equities. Many bullish prognosticators believe the correction has already brought the broad market down to levels that are cheap, but we disagree. While it’s true that the market is a little less expensive than it was before the correction, the decline hasn’t been enough to really move the needle on the highly overvalued readings prior to the drop. Even after the correction, our valuation model suggests that over the next 5 years the S&P 500 is priced to produce less than 3% per annum. While we are not anticipating a devastating bear market that would send valuation to dirt cheap levels, we do believe the market will likely need to fall further before becoming fairly valued.
Beyond the U.S., valuation metrics show a relatively cheaper profile (though to varying degrees). Some of the larger international developed markets are marginally cheaper than the U.S., and emerging markets definitely appear cheaper on some metrics. But given poor fundamentals that are likely to get worse before they get better, we continue to believe this part of the globe represents a value trap. Emerging markets may have gotten oversold enough this year to produce a powerful trading rally, but we do not think the underperformance vs. the developed world has bottomed yet from a longer-term perspective.
Bottom Line: Valuation in the U.S. is still in expensive territory despite the recent correction, and many of the cheapest markets continue to represent untouchable value traps.
We run our own quantitative models and supplement our work with a number of sources that have been building quant models for many years. We have watched our quantitative models vacillate between mildly bearish and neutral recently, but when balanced against the independent models we follow, the broad message is that we’re in a mildly bearish period.
Bottom Line: The message of the quantitative work is mildly bearish on balance.
At Pinnacle we augment our internal work with independent research from some of the industry’s leading sources. While these outside opinions are never in full agreement, they are currently offering wildly divergent views on what is taking place in markets, and how to position our portfolios to maximize returns and control risk. One clear divergence comes from a disagreement between macro strategists and market technicians: The strategists are still pretty constructive on balance, while the technicians are warning that the primary trend is now down.
Bottom Line: Add it all up and we believe the evidence is neutral, but with wide tails.
A Time for Caution
The evidence we just summarized has many nuances, and there are plenty of crosscurrents that cloud the picture. But sometimes the big picture is not really that complicated if we step back from the myriad of details that float around each trading day. We believe the combination of an aged bull market, poor valuation, and a technical backdrop that has finally broken down, has produced an environment that demands we manage risk at this time.
Of course, we will have to continue to challenge our conclusion as we move forward. If we are incorrect, it would likely mean that the global economy is actually bottoming right now and beginning to turn the corner. Should that prove to be the case, the weight of the evidence will eventually turn again, and we will reposition to at least neutral volatility weightings. In that scenario, we acknowledge in advance that there will be some opportunity cost in not fully participating to the upside (which we currently think is an acceptable tradeoff in light of the growing possibility that a bear market is beginning to unfold). At the moment the evidence suggests that it’s time to de-risk and play our hand somewhat conservatively here. Ultimately, our intention is to side step some of the pain during this cleansing process, and eventually look to reposition at better valuations to help our clients build long term wealth.
Note: The above discussion applies to the management of Pinnacle’s Dynamic Prime models. Below is a brief description> of changes during the quarter to Pinnacle’s new investment strategies that were introduced earlier this year. The Dynamic Market Series and the quantitative component of the Dynamic Quant are rules-based strategies and thus are not managed according to Pinnacle’s macro outlook.
Dynamic Market Series
The satellite of the Dynamic Market strategies, comprising 30% of the portfolios, remained on a defensive posture and was allocated to short-term T-bills (SHV) throughout the entire third quarter. This was the result of two separate components of the strategy: our valuation model for the S&P 500 index continuing to indicate that the market is overvalued, and the technical component of the model switching from a “buy” signal to a “sell” signal for the S&P 500. Either of these two conditions would be sufficient for the strategy to remain in a defensive posture, and both of them would have to reverse in order for the strategy to be allowed to move to either a neutral or aggressive posture. The choice of short-term T-bills over longer duration bonds was also driven by the technical component of the model, which was on a “sell” signal for the Barclays U.S. Aggregate Bond Index throughout the entire quarter. However, the component actually switched to a “buy” signal on October 5th as a result of a renewed up trend in the Barclays U.S. Aggregate index, and the satellite was traded accordingly on October 6th by selling our position in short-term T-bills (SHV) and initiating a position in bonds (SCHZ).
Dynamic Quant Series
During the first two months of the quarter, the quantitative satellite, comprising 37.5% of the Dynamic Quantitative strategy, remained invested in stocks according to the sector rotation component of the model, which continued to favor the Technology, Energy, Financials, and Consumer Staples sectors. However on September 3rd the technical component of the model for the MSCI USA index switched from a “buy” signal to a “sell” signal. This was primarily driven by deterioration in the market’s technical profile, which resulted from the August market correction. A “sell” signal from the technical component implies a defensive posture for the quantitative satellite of the strategy. As a result, all the equity sector holdings in the satellite were sold on September 4th, and the proceeds were held in short-term T-bills (SHV) for the remainder of the quarter. The choice of short-term T-bills over longer duration bonds was also driven by the technical component of the model, which was on a “sell” signal for the Barclays U.S. Aggregate Bond Index throughout the entire quarter. However, the component actually switched to a “buy” signal on October 5th as a result of a renewed uptrend in the Barclays U.S. Aggregate index, and the satellite was traded accordingly on October 6th by selling our position in short-term T-bills (SHV) and initiating a position in bonds (SCHZ).