The U.S. stock market is in a rut. Since the end of last year, little progress has been made. In the last three months, it has moved back and forth in a trading range 10 times. Volatility has increased, with larger daily moves than we have seen for some time. During the month of March, major indexes closed down about 1.5 percent.
Many markets around the world hit all-time highs during the first quarter, which, depending on your perspective, has its ups and downs. For momentum or trend traders, it’s positive, because they ride the trend as long as it lasts. On the other hand, for range traders it’s negative. We are currently hitting the upper end of the range, which may mean it’s time to sell.
Last October, we had a 10 percent pullback. It is too early to tell, but so far it seems the market leadership of large cap stocks and the S&P 500 may finally be changing. Since the October correction, the S&P 500 has lost relative strength.
Contrary to what doomsayers perpetually predict, the dollar has been incredibly strong for the past nine months. So while it may be a great time to go to Europe, it’s somewhat tricky for investors. In addition to determining where to invest internationally, it is important to make sure your dollar exposure is hedged properly.
After falling from $106 to $46 in six months, oil has recently found some stability. This is in the face of analysts calling for $30 oil. Opportunities to invest seem to be spreading out from the U.S. We are entering a transition period where the markets are offering new opportunities and risks.
The bond market continues to be somewhat of a conundrum. We have been at all-time lows with the 10-year Treasury bond yielding around 1.85 percent. That means if you bought that bond today, you would earn 1.8 percent for the next 10 years. By way of comparison, Germany’s 10-year bond is yielding an unbelievable 0.20 percent. In fact, in a number of European countries, you would have to pay the government if you bought shorter-term debt because they have a negative yield.
The bottom line? Rates are at all-time lows around the world. And because of that, we know rates will eventually rise. When those rates rise, many investors will be hurt. If rates were to move up quickly, bond investors could potentially see volatility and losses similar to what we see in the stock market.
Investors invest in bonds rather than stocks because of their historic level of safety. And that’s a problem considering today’s market. When interest rates move back up to their historical norms, that illusion of safety could easily evaporate.
Interest rates were supposed to move up two years ago. They didn’t. The FED determined the economy was too weak. Ever since then, investors have expected rates to move up. Most recently, rates were supposed to move up this coming June.
Simply put, it’s a guessing game. There are many variables at play and no one knows when rates will rise. The problem is that we have to protect Managed Income from those eventual rate increases. Protecting the portfolio has a cost, in that we give up some of the meager returns currently available. We will continue to do our best to protect the portfolio and pull out whatever returns are available without putting the portfolio at undue risk. When we move off these all-time lows in rates, we should have better opportunities to once again capture returns in the conservative space.
Active management strategies are coming back into favor. This usually happens later in a market cycle — after the easy money has been made. Early in a market recovery, almost any strategy will work because almost everything is moving up. This is when everyone appears to be a genius.
Later in a recovery, as many asset classes approach full value, it is more difficult to generate returns. Typically, that is when active managers outperform. This is also about the time many investors switch from active strategies to passive ones. Historically, because of the increased market risk, that is exactly the wrong time to make the switch.
We have seen this change in opportunity within Top Flight over the past quarter. Top Flight Portfolio returned 3.98 percent net of fees for the first quarter versus 0.96 percent for the S&P 500. From its inception in January 1998 through March 2015, Top Flight has returned 615 percent to investors versus 193 percent for the S&P 500. That works out to a compound rate of return over that period of 12.08 percent compounded for Top Flight versus 6.42 percent for the S&P 500. Please click here to see full track record and disclosures.
WHAT IS AHEAD?
It’s the question I get asked repeatedly. While no one really knows, there are factors we do know. We know we are likely in the latter third of this bull market. This bull market is the fourth longest in 85 years. From a low of 6469 on March 9, 2009, the Dow Industrials has gone up an additional 11,700 points.
Other issues include:
• How does the market usually react to a severe drop in oil?
• What does the market usually do in the seventh year of a president’s term?
• How does a rapidly rising dollar affect the market?
• Stocks are overvalued by most historic metrics but undervalued relative to interest rates.
The list is endless. We do our best to separate out those factors that matter and adjust our portfolios accordingly. We apply those factors to our investment strategy to give us a framework. More importantly, we process the actual market data through our models, then react to that data as market conditions change. For example, Top Flight is currently holding about 30 percent cash, which is its highest cash allocation in some time.
Investing is difficult. As I have said before, there are 10 ways to lose money for every one way to make it. Fortunately, Nate and I have a combined market trading experience of 50 years. As they say, “This is not our first rodeo.”
Our objective is to make sure you are invested according to your risk comfort level. Each of our clients is invested differently depending on age, goals, total net worth and investment experience. In order to achieve investment success, you must be invested in a way that allows you to stay invested over the long term, through market ups and downs.
Please let us know if you would like to discuss your investments or make changes to them. We appreciate the confidence you have placed in us.
Written by Dave Young, President and Founder of Paragon Wealth Management
Disclaimer Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.
The era of QE has been a difficult environment for active managers. The last five years have been a heyday for the passive investor, aided directly and indirectly by the Fed’s Quantitative Easing (QE) programs, stocks and bonds have moved up in an indiscriminate manner. All one had to do was simply show up. Bonds have been directly aided by the trillions the Fed has purchased while equities have indirectly benefitted from the implied “put” or backstop inferred by these Fed actions. The Fed’s actions to keep rates artificially low have created market distortions that have interfered with many of our quantitative indicators.
When all equities or bonds generally get rewarded the same regardless of their quality or differences, it’s hard for the skilled manager to outperform. A rising tide of liquidity has lifted all boats making it easy for anyone to navigate in the harbor. But once the tide starts to recede, experience and skill are what matters. We have seen improvement with our models over the last year coinciding with the gradual reduction of QE. As markets return to “normal” we are better able to assess the risk and rewards of certain moves and strategies. We are seeing a number of opportunities develop that haven’t been available for years.
In the short run the market is looking tired. We have rejected the doom and gloom scenarios that have been so prevalent since the financial crisis and have caused many investors to miss out on the bull market. However, fewer stocks are hitting new highs and the breadth has been getting weaker. The uncertainty surrounding the end of QE and the timing of rate increases next year are factors contributing to the hesitancy. This is only natural and healthy in the long-run. As previously mentioned it also creates opportunities for us that have not been available for the last four years. Over the last few years we have held a cash position which has been a drag on performance. Going forward, this cash position is an advantage as it helps to cushion the downside and provide flexibility to take advantage of opportunities provided by any volatility and uncertainty.
Although the risks have risen, this doesn’t mean investors should get out completely. The market has been overdue for a correction for some time but it doesn’t mean that everything is ready to fall apart. Getting completely out now could cause you to miss crucial gains if stocks continue to rally as they have. The last four years have shown the futility of trying to time the market in an all in or out manner. It is still a bull market until proven otherwise.
The current economic data has been stronger indicating that the economic growth is picking up instead of getting weaker. Ultimately that is a good sign as it will support earnings growth that has been the key foundation for the current bull market. Any correction that comes will probably be more short-term and establish the next leg up for the market. Therefore, a correction would be viewed by us as an opportunity rather than a harbinger of doom. It is only natural after five years of market advances and ahead of interest rates starting to move up to get some market hesitancy or disruption. Our current exposures are to technology, energy, and materials which are late-cycle stocks and tend to do well in rising rate environments. We also continue to favor various segments of the healthcare sector such as medical device and healthcare providers. Several emerging market opportunities are also looking more promising than in the past and we have started to act in a few of these areas such as Mexico and Brazil.
It is no secret that we have been cautious on the bond market for some time. As the sun sets on QE the angst over when the Fed will begin to raise rates and by how much is growing. Markets always like to price actions in ahead of time and right now it seems the equity market is being affected to some degree by this interest rate uncertainty. However, the bond market has not moved much yet. Many thought that bonds would have a difficult year as they began to price in rate increases. So far, bonds have done the opposite and surprised many by having a good year. The inevitable is coming though and the window for bond gains is closing as we creep toward June of next year which is the most accepted time for rate increase to begin. Any equity market weakness will give bonds more time to put off the reckoning.
Although the potential for a bloodbath in the bond market is high, that doesn’t mean it will happen. It will probably be more like death by a thousand cuts. The Fed will be very slow and steady in raising rates as to minimize market disruption. After all, they do hold about $4.5 trillion of bonds! Even if interest rates rise in a slow and gradual manner (which is what I believe will happen) bonds will still produce negative or flat real returns at best.
For example, take a look at the interest rate sensitivity of a broad composite of investment grade bonds such as the Barclays US Aggregate Bond Index. If interest rates are a half to one percent higher a year from now, the index could be down 2.5 to over 5 percent respectively. The current yield of about two percent would still not offset the losses.
In preparation we have been making changes and getting ready for the coming environment. We have been early on this call which has caused us to underperform in Managed Income this year so far, but not by a lot and we are better positioned for what is to come. We believe this approach is the most effective from a risk/reward standpoint and will pay off in the environment to come. Now is the time to take a look at the risk in bond or fixed income holdings and make adjustments. The first one to two percent moves from the bottom will be the most painful.
Written by Nate White, Chief Investment Officer of Paragon Wealth Management
Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.