Sell in Fall for a Market Stall?
The “sell in May go away” thesis has been debunked in 2016, after being a profitable strategy for the last five years. Currently the S&P 500 is up 4.62% since the end of May. The Dow has gained 5.01% and the Nasdaq has surged ahead 6.23%. In late May, in a perspective titled “Pocket Aces: Play or Fold” Holbrook cited that market strength this Summer was a real possibility.
“Over the next six months, market pundits are going to continually question why this market keeps moving higher. They will try to pinpoint fundamental reasons why the equity market is undervalued, or that economic conditions are improving. These may be true. They may not be. But the reason we will move higher, is because of positioning. Bearishness prevails, and the street is underinvested.” –May 26th, 2016
In February, at the apex of market bearishness and recession fears, Holbrook analyzed market internals in a piece entitled, “S&P 500 – Correction or Bear Market Beginning.” We came to the conclusion that the market weakness was a buying opportunity and that market action, while volatile, did not resemble the beginning of a bear market:
“I am in the camp that the lows are in for 2016, and at some point this year we will be talking about new all-time highs on the S&P 500.” –February 17th, 2016
After a 20.6% rally off of the February lows for the S&P 500, it is prudent to re-evaluate current market positioning. As the Summer doldrums give way to increased volatility this Fall, the question all advisors are asking is, where are we heading on the major averages for the remainder of 2016. Much of the bull thesis is predicated on sentiment and a rebound in earnings. In this sense, not much has changed. Investors remain largely underinvested in the equity market. Mutual Funds are holding 5.8% cash, the highest since November 2001, says a Bank of America fund survey published last week. Meanwhile, the AAII sentiment survey last week had a Bullish reading of 31%, well below the thirty-year average of 38.6% and definitively below any level that might warn of an impending top. Meanwhile, with second quarter earnings mostly behind us, S&P 500 companies beat revenue estimates 56% of the time, and earnings beats have been registered at an impressive 78% clip. Earnings growth will have to pick up steam into the back half of the year since estimates are a bit more optimistic than the second quarter. Analyst estimates have S&P 500 companies growing revenues 1.6% and 4.6% year-over-year, in the third and fourth quarters respectively. Earnings are projected to fall 1.3% in the third quarter and then jump 7.8% in Q4. Have cost reductions produced the operating leverage necessary for such a rebound in earnings? Only time will tell. However, the street remains underinvested and pervasive bearishness should fuel an additional rally if companies meet expectations.
Technically, markets are following a well-tested script for a longer-term breakout. The cumulative advance-decline line continues to move to new highs and is illustrative of the strong market breadth that we have experienced over the last six months. This is a marked difference than 2014 and 2015, when the market highs were driven by a very small cohort of participants. Indeed, the cumulative advance-decline line broke out to new highs in early June, a full month before the major market indices. The fly in the market ointment is the continuing underperformance of the banking sector, which is likely the result of the Fed continuing to drag its feet with regard to raising short-term interest rates. And while a surprise rate hike would likely cause market volatility, it might also propel this lagging sector into a leadership role. As a result, any surprise hikes by the Fed should be treated as a buying opportunity for the overall market. 25 basis points of tightening will not derail the recovery, and is over-emphasized by short-term traders in terms of its economic implications. For short and intermediate-term traders the line in the sand is 2100-2130 on the S&P 500. This is the two- year resistance level where equity rallies consistently stalled. Now that we have a confirmed breakout, prior resistance should provide support on a shallow pull-back. A close below 2100 would drastically increase the possibility that this is a false breakout.
Long-term investors should take solace in the fact that equities remain quite attractive given the low interest rate environment. Earnings yields and dividend yields continue to be attractive relative to U.S. treasuries and merit tactical over-weights to equities. Currently, our relative value model has a 10% overweight to equities, so 50/50 portfolios should be 60/40 at this time. Moreover, there is a demographic shift underway that is getting no attention from the press. The Millennial generation is the largest cohort in the U.S., at 86 million people, 8 million more than the baby boomer generation. Moreover, they are well into their 20’s and 30’s, their most productive and consumptive years. The last time such a large cohort emerged onto the economic scene was 1982, the onset of the greatest bull market in American history. Demographics drive markets, and there are secular reasons for a long sustained period of growth and equity returns.
The case for a sell-off in treasuries this Fall is more substantive. And full disclosure, Holbrook’s projections for rates have not been as prescient as the equity call. In January, we included our interest rate projections for 2016 in a perspective entitled “Wage Growth, The Fed, and Market Hubris.” We concluded:
“Wage growth bottomed in 2012 and has recently broken out of its post-recession range. The Federal Reserve is reacting to this, as they always have, by raising rates to stave-off the potential inflation that could arise from accelerated wage growth. As long as wages continue to rise, the Federal Reserve will stick to its economic and rate projections. Meanwhile, the market is aggressively fighting the Fed, setting up a potential severe recalibration of interest rates to the upside. 2016 will be a year of yield curve flattening, as market participants readjust their shorter-term yield projections, but view Fed policy as a mistake. Future parallel and steepening yield curve shifts will only occur after economic data continues to improve and affirms Fed action.” –January 27th 2016
Again, we overestimated Fed resolve to raise rates in 2016. They continue to move the goalposts with regard to their policy, and it continues to undermine their credibility. Comments from Fed members paint an institution that is questioning their long-held mandates. Over the last month, James Bullard, president of the St. Louis Fed, has indicated that the Fed should give up their tradition of forecasting U.S. economic activity, and simply react to current conditions. John Williams, the San Francisco Fed president, has advocated raising the Fed’s 2% inflation target. Meanwhile, William Dudley, from New York, has indicated that the Federal Reserve could raise rates next month. If investors are aiming to get clarity from the Fed, it may be a long time coming. In a world where Fed credibility is hampered, investors should put more emphasis on market positioning and avoid joining a crowded trade, which at this point, is long a treasury market that offers very little yield or value. Consider this: markets are pricing in one fed rate hike by 2019. Ten-year term premiums are negative, and the lowest they have been since the early 1960’s. This means that market participants are not only disregarding Fed projections, but they are not demanding any time premium in the event that they are wrong. Meanwhile, core inflation continues to creep higher, and wage growth has rebounded this year. Much of the demand for U.S. treasuries has come from abroad, where rates are negative. However, hedging costs in foreign currencies now bring the foreign denominated yield on U.S. treasuries below zero. This should undermine the indirect bid coming from foreign investors and likely put upward pressure on longer-term rates. At 1.5% on the ten-year treasury, investors are paying 66x for next year’s income. Perhaps in a world where the sky is falling, this makes sense, but more likely it is indicative of the pervasive fear still inherent within the markets. The deep economic lacerations of the Great Recession have largely healed in the U.S., but the scars of market psychology are clearly visible. A wise investor is one who takes the other side.
The “Sell in Fall for a Market Stall” strategy pertains mostly to the treasury market, where valuations are stretched and the trade is incredibly one-sided. Treasuries have performed admirably in 2016, but tactically adjusting exposure downward is a prudent option. Spread products such as investment grade corporate bonds, high yield, floating-rate, and TIPS offer better risk reward scenarios in fixed income portfolios where durations are shorter and yields are high enough to buffer an unexpected rise in rates.
This article is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the author which are subject to change without notice. Forward looking statements, estimates, and other information contained herein are based upon proprietary and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.