May The No Fear Market

Transcription

1 May 2017 The No Fear Market The S&P 500 continued its triumphant run during April and has increased in value by over 300% from March of Unfortunately, no one can accurately predict where the market is going from here, but as market observers, we take notice when all 3 of our contrarian Fear Gauges are blinking at the same time! In our May commentary, we review the Current State of the Markets, our Fear Gauges, What to Do Now and What Really Matters. We also provide a preview of our mid-month May update that will examine two pieces of proposed Trump Tax legislation which could have a detrimental effect on every Family in the country that has an IRA or a taxable investment account. This proposed legislation could Shatter the Pillars of Financial Planning Theory! April 2017 Recap Monthly S&P 500 vs 2 Year Monthly Average 7.0% 5.0% 3.0% 1.0% (1.0%) Oct-16 Only Loser (3.0%) Mar-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Monthly Return Average Monthly The S&P 500 had a closing price of $2,384 at the end of April for a 1.19% total return. The rally continues! The S&P 500 has increased in value over 27% since March of 2016 for an average monthly return of 1.70%, an impressive string of 13 positive calendar return months out of the last 14!

2 For a historical comparison, over the last 20 years or 240 months, the average monthly return for the S&P 500 has been about 0.70%. To put the recent past into perspective, the average return over the most recent 14-month period has been 2.4 times higher than the average return over the most recent 240-month period, which happens to be one of the greatest investment periods in human history (i.e. this has been a really great 14-month run)! The technology heavy NASDAQ Composite index finished the month up 2.35% with an ending level of $6,047. Liberty Ventures, controlled by media magnate John Malone, was up significantly for the month (+20%) and Elon Musk s Tesla (+13%) performed well. The two innovative CEOs were accompanied by the familiar names Amazon (+4%), Facebook (+6%) and Microsoft (+4%) as strong performers in April. 12% 8% 4% 0% (4%) (8%) Sector Performance: April vs 1st Qtr % 8% 8% 5% 6% 6% 5% 3% 2% 2% 2% 2% 1% 1% 1% (1%) (7%) (3%) 1st Quarter Return April Return The sector performance continued a trend from the First Quarter 2017: Technology and Consumer Discretionary stocks performed well while Financials (on a relative basis) and Energy were the laggards. The Small Cap Russell 2000 Index rallied into the end of the month and closed at $1,400 for a monthly return of about 1.0%. Foreign Equity Markets fared even better than domestic ones as the Developed Nations index (EAFE) rose 2.4% and the Emerging Markets index (EEM) rose 1.7%. So once again in the equity markets, similar to our April 2017 commentary, Everything is Awesome!

3 The First Quarter Company Earnings Reports are estimated to be up 11.4% for the quarter, the best year-to-year increase since mid In a market priced for perfection, we have noted that a failure of a company to meet or exceed First Quarter earnings estimates, which has been provided by the various analysts on the street, has been met harshly by investors. In April two of the worst performing stocks in the S&P 500 index were W.W. Grainger (17%) and Acuity Brands (14%), the commonality was that both companies reported earnings that were below earnings estimates and the stocks were pummeled. The First Quarter Gross Domestic Product (GDP) report that measures the health of the economy caught economist by surprise with a weak reading of only a 0.7% growth rate and was a full 1.0% below expectations for the period. Economists may have been too optimistic based of the 2.5% reading in the Fourth Quarter of Although this sign of economic lethargy is something to watch, slower growth to start the year has been the norm since 2010 as First Quarter growth has only averaged about a 0.9% growth rate. What We Are Monitoring We try to gauge how much risk investors are taking on by analyzing three distinct measures. We have dubbed this process as our Fear Gauge and we have a provided a description of the metrics we regularly review: Margin Debt : Each month, NYSE member organizations are required to report their aggregate debits (amount borrowed by customers to purchase securities) in margin accounts. o Optimized Transitions s Observation: The more margin debt, the less fear investors have for investment loss as they are borrowing more money to buy more stocks. Volatility Index : The CBOE Volatility Index (VIX Index ) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX Index has been considered by many to be the world's premier barometer of investor sentiment and market volatility. - source CBOE o Optimized Transitions s Observation: If the VIX index is very low, investors have less fear for the potential of short-term volatility in the market.

4 Fixed Income Credit Spread : How much additional income or spread fixed income investors are earning by lending their money to Lower Quality (BBB rated) Companies for 10 years vs. lending money to the US Treasury. o Optimized Transitions s Observation: The lower the credit spread, the less fear investors have of lending their money to lower quality companies. Observations and Hypothesis: We believe there is NO Fear in the Market Right Now! Margin Debt: Investors are borrowing more money than ever to invest in a market that is up 27% in the last 2 years and 300% since o When do we get concerned? When the rate of Margin Debt increases at a rate greater than the rate of increase in the price of the market. We observed this phenomena of debt increasing at a rate faster than the market in March of 2000, July of 2007 and June of 2015, and the market, either by coincidence, causation or correlation, pulled back after all three observations. Margin Debt is up 80% from 5 years ago which is in-line with the 89% return of the S&P, so we are actually ok with the rate of the increase in Margin Debt currently. Margin Debt $600 Billions $500 $400 $300 $200 $100 March 2000 Margin Debt vs Price of S&P 500 July 2007 June 2015 S&P 500 Price $2,450 $2,150 $1,850 $1,550 $1,250 $950 $0 $650 Jan-97 Nov-99 Oct-02 Aug-05 Jul-08 May-11 Apr-14 Mar-17 Margin Debt S&P 500 Price

5 o Why then are we still concerned about Margin Debt? The sheer amount of Margin Debt outstanding at $536 billion is our concern. Although small in comparison to the $92 trillion of wealth estimated by the Fed in 2017, the amount of Margin Debt currently outstanding has never been in play during a prolonged market downturn and that scenario could make for an interesting market event. o Historical Note: Margin Debt during the Dot Com Bubble peeked in March of 2000 at $275 Billion (roughly 50% lower than today s Margin Debt level). Margin Debt gradually decreased and bottomed out at a level of $130 billion in September of 2002 during the period when the market collapsed. It is interesting to note that it took until 2007 for Margin Debt levels to once again reach $275 billion. VIX Index: Volatility is at near an all-time low and the price of the S&P 500 is close to an all-time high Volatility Index vs S&P Price VIX Index S&P Price 85 $2, June $2, March July $2, $1, $1, $1,450 $1, $1, $850 5 $650 Jan-97 Nov-99 Oct-02 Aug-05 Jul-08 May-11 Apr-14 Mar-17 Volatility Index S&P Price Volatility Index: Volatility prices are based on many things including the supply and demand for options. According to basic economic theory, the more demand for options, the higher the prices. Based on the current VIX levels, there seems to be no demand for (put) options that protect portfolio values. o When do we get concerned? Whenever we get to one extreme or another, analysis of market history tells us that usually investors do

6 the wrong thing at the wrong time and when no one is clamoring for protection, we take notice. o Observation: If you look back at history, the spread between the price of the S&P and the VIX index tends to peek right before a market sell off as the two have a strong inverse relationship (one goes up, the other tends to go down). We haven t found our crystal ball yet, but if asset prices are really high, the cost of protection is cheap, and spread is at historically high levels, then investors should at least review their hedging alternatives. Credit Spread: Investors are chasing yield and buying lower quality debt. o When do we get concerned? The lower the credit spread, means investors believe there is less perceived risk to lending their money to lower quality counter parties. Similar to the Volatility measure, whenever we get to one extreme or another, usually investors do the wrong thing at the wrong time. When lower quality borrowers only have to pay an additional 1.5% or less than the US Government to find lenders, it is time to take notice as there is not much fear of counterparty risk in the market (do you remember Lehman Brothers and Enron). S&P Price 8.0% $2, % June $2, $2, % $2, % March July $1, % $1, % $1, % $1,250 $1, % $ % $650 Jan-97 Nov-99 Oct-02 Aug-05 Jul-08 May-11 Apr-14 Mar-17 Credit Spread Credit Spread vs S&P 500 Credit Spread S&P 500

7 Summary of Observations There is no doubt this market could continue to run, but as portfolio managers, we get nervous when all 3 of our Fear Gauges are blinking! The last three times all three of the Fear Gauges were in what we would describe as the No Fear Zone was March of 2000, July 2007 and June The time it took for the eventual market pullback to occur, the severity of the pull back and the duration of the pullback varied greatly. The only thing we know for certain is that a pullback will occur at some point in the future. What Do We Do Now? What do we do as portfolio managers in these situations? We avoid making predictions and, worse yet, making investment decisions based on short-term guesses. No one has any idea where this market is going in the short-term. Our goal with every client is for our advisors and for our clients to avoid making dumb choices when things get hairy by allowing emotions to cloud our judgement. What should every client or investor do today to prepare for an eventual pullback in the market? Hope for the Best but Prepare for / Expect Pain (think Mr. T from Rocky): A market pullback is inevitable at some point in the future. The loss of value of your portfolio securities is going to hurt and will stir emotions. Market downturns are healthy and are actually great for long-term investors to buy fantastic companies at lower prices (don t you wish you could go back to 2009 and take on a margin debt to buy equites?). Reevaluate Investment Policy Statement: The field of study of Behavioral Finance has documented that market volatility can trigger emotional responses that can lead to less than optimal decision-making. One of the critical functions of an investment policy statement is to provide policies and procedures that serve as a strategic guide for clients to rely on during periods of market volatility. When the market is falling apart, investors feels like they should do something when history tells us the best thing to do is do nothing! Reevaluate Goals and Risk Tolerance: Over the last 15 years, have you personally made enough money in the market to meet your long-term goals? Pigs get slaughtered, maybe this is a time to bring in your risk tolerance and reassess your entire investment strategy. Stop caring about beating a

8 benchmark. Anyone can beat a benchmark in an upmarket by taking on more risk. Invest for your goals, not for what you have been programmed to care about. Rebalance Portfolio: Investors should take the counter-intuitive step of selling off their winners and adding to the losers, otherwise known as rebalancing a portfolio (this period s winners are in many cases the next period s losers). o One additional thought: the cost of protecting a portfolio by buying put options is at an all-time low vs. an all-time high for market prices. Read up on the concept or call our firm. Don t close the barn door after the horse has already left the building! What Matters What does all of this current market noise mean? Really nothing if you have a longterm time horizon. If an investor has a short-time horizon, they probably shouldn t be investing in a manner that short-term market fluctuations could have a material effect on their goals anyway. We always advise our clients to stop believing in the fallacy that short-term investment predictions are possible or important. The key to financial success is a tax-aware long-term financial planning strategy that includes investment management, which will allow them to reach their goals and to focus on what matters! What matters today? There are currently two pieces of proposed Trump Tax legislation that could have a detrimental effect on every Family in the country that has an IRA or a taxable investment account. The proposed Tax legislation could shatter the pillars of Financial Planning Theory which is the foundation for any Financial Plan based on Tax Optimization of Retirement Income and Wealth Transfer! We are in the process of drafting an analysis on the proposed legislation and will have further detail available soon, stay tuned! Michael Lynch, CFA, CFP Optimized Transitions Please feel free to contact an Optimized Transitions Advisor to learn more about Financial Planning Process and Investment Management by calling at (800) or visit us at

9 Disclosure The information provided in this document is for educational and/or general information and is not intended to provide specific legal, accounting, tax, estate planning or other professional advice. For specific advice on aspects of these topics, a client should consult with their professional advisors. The information provided is not an offer to buy or sell any security, option or strategy. This communication cannot be used by a tax payer to avoid US Tax penalties. Additionally, it is important to note that information in this report is based upon financial information input on the date above; results provided may vary over time and with subsequent uses and the opinions of the author may change at any time. The described strategies contained are not specific recommendations. The strategies described are not suitable for every investor, and require analysis by qualified professionals Source for Information Morningstar, Y-Charts. Market statistical information for S&P performance charts provided by Y-Charts. All indices are unmanaged, cannot be invested in directly and do not include any fees or expenses. Any and all back up information is available upon request including detailed disclaimers provided by the issuer of the indices included. The information provided is believes to be accurate but Optimized Transitions has not independently verified the source information utilized by each index provider. OPTION DISCLOSURE: Options involve risk and are not suitable for all investors. All clients engaging in an options transaction must receive an options disclosure document provided by Optimized Transitions or at www. otwealth.com.