By Joseph Calhoun of Alhambra
There hasn’t been a lot of change in our indicators since the last update and therefore, despite my discomfort with the altitude of this stock market, there are no changes to the Global Asset Allocation this month. For the moderate risk investor, the allocation between risk assets and bonds is unchanged at 50/50.
Bond markets moved around some during the last month but are today almost exactly where they finished at the last update. Other markets have moved to indicate a still ravenous appetite for risk but growth and inflation expectations are essentially unchanged. Stock and junk bond – I refuse to call them “high yield” with HYG yielding just a bit over 5% – investors seem quite a bit more sure of the outcome of the developing policy debate than the more sober Treasury participants. Commodities also moved a bit higher since the last update but the best performer was gold, not exactly a growth investment. It was very tempting to just move some out of stocks and into cash simply because valuations have gone completely off the reservation but our process requires something more than gut reaction to make a change. Momentum continues to favor stocks – US stocks mostly – and that has to be respected. Our allocation to stocks has already been reduced due to high valuations and absent more information I can’t justify moving the allocation even lower. I have decided though that I will consider making an intra-month move if I think it is necessary. That isn’t something I would normally do as I think one of the most common mistakes investors make is doing too much. But I think this market is so far beyond what is “normal” that one must make concessions to reality.
- Credit Spreads: Junk spreads continued to narrow, down another 7 basis points since the last update. They are still about 60 basis points from the lows of this cycle and nearly 150 from the lows of the last cycle. There is still plenty of room for improvement and there is no indication right now that spreads are about to reverse. The most likely culprit, if last year is a template, would be a fall in oil prices. While inventory would argue that might indeed be in the offing, momentum argues for the opposite. And as we’ve seen in the past, oil market moves owe a lot to the direction of the dollar which has recently found upside hard to come by.
One area we continue to monitor is TED spreads where the uptrend has barely wavered although at these levels the TED isn’t indicating any high degree of stress. It is moving in the wrong direction though and warrants our attention:
- Yield Curve The yield curve was unchanged since the last update, moving a mere 1 basis point. Not only that but the components barely budged either with the 2 year and 10 year essentially unchanged over the last month.
The steepening move after the election has petered out and I suspect that it will resume the prior flattening trend. Nevertheless, the curve remains in the middle of its historic range which gives us little reason for concern about recession. Will the curve get to flat before the next recession? That’s something we can’t answer but we do know that what we expect just prior to recession is a rapid steepening that comes as a result of a rapid drop in short rates. That isn’t even on the radar at present as the market is still discounting at least two rate hikes by the Fed this year. I have my doubts about that but I see no reason to try and anticipate something that can’t be anticipated.
- Valuations Earnings season is well under way and while it appears we may get our second consecutive quarter of growth, it isn’t very much and valuations haven’t improved as stocks have continued to rise. Earnings right now look to be up about 5% year over year while the S&P is up well into double digits so valuations have actually deteriorated over the last year. But of course, stocks – and all markets – are trying to discount the future. Unfortunately, 2017 earnings are expected to be up about 11% – a number I think will prove too high – so again, the market appears to be discounting something beyond even that. Foreign markets, on the other hand, look quite a bit more tempting. The best earnings growth is expected to come from EM, Europe and EAFE more generally. The US and Japan are both expected to be up about 11% but Japan trades at half the P/B ratio of the US. As I’ve said many times though, international markets are unlikely to outperform the US consistently until the dollar gets in a downtrend. While the dollar may – and I do stress may – be peaking, that call can’t be made yet. Nevertheless, our allocation continues to favor non-US stocks over US.
- Momentum Despite nominal new highs – and I know this sounds like a broken record – our long term momentum indicator for the S&P 500 remains on a sell signal. Shorter term momentum signals are obviously positive though and I will continue to hold our small allocation for now.
Long term momentum for the dollar index also appears to be peaking much as it did in 2001/2002:
And that has kept gold’s long term momentum positive as it moves off its recent lows. The correction appears to have ended in December:
Long term momentum continues to favor gold over the S&P 500:
EM stocks have outperformed US since the December bottom and long term momentum is still making and holding a bottom:
As I said in last month’s update, the momentum of intermediate Treasuries versus the S&P 500 has rolled over. On the other hand, short term it appears that longer term bonds are poised to rally so maybe the momentum of bonds versus stocks will reassert itself. Frankly, I don’t think either offers much in the way of value at this point.
This month, as most months, there are no changes to the portfolio allocations. The reason for that is simple – there weren’t sufficient changes in our indicators to warrant a change. I’m certainly not comfortable with US stocks at these levels but credit spreads and momentum indicate a continued appetite for risk in the market. Until that changes, risk investments seem likely to outperform. We’re already positioned more conservatively than usual – based on valuations – but until we get some indication of impending recession, doing more is just speculating about the future – something I’ve proven over several decades of personal market experience is about as accurate as a coin flip. Indeed, when one throws in some typical human behavioral bias, the odds are probably a bit less than 50/50. So, I’ll wait for some actual news before making any changes.
And that leads to a short note about the potential policy changes to come under the Trump administration. The stock market last week was trading pretty poorly until the President happened to mention that his administration would be releasing a “phenomenal” tax plan soon. Stocks immediately took off on optimism about this “plan”. The Trump administration may indeed offer a plan, phenomenal or not, but that is not the same thing as getting it through Congress. I do expect to see tax reform during the Trump administration and it will probably be structured in a way that is positive for growth. But I have my doubts as to whether that will happen in 2017; any impact from tax reform is probably quite a ways off. That isn’t what I call speculation but rather many years of experience observing Congress in action – or lack thereof as the case may be. There’s a reason we haven’t had a major tax reform since 1986 – it’s hard. Damn hard.
And frankly, I don’t think tax reform is the most important item on the agenda for this year and maybe not at all. For impact this year and probably for many to come, the institution to watch is the Fed. Trump will now have the opportunity to appoint at least 3 new Fed Governors and a chair before the end of the year. We at Alhambra have maintained for some time – years – that our problems are primarily monetary. If we are right about that, who Trump appoints to the Fed is much more important for our economy and markets than any tax reform that might emerge from Congress over the next couple of years. Again, it isn’t that tax and regulatory reform – especially the latter in my opinion – aren’t important; they are. But if the administration gets everything right on those issues and we don’t address global monetary reform, the impact will be muted and the markets are bound to be disappointed. I hope I’m wrong about that and if our indicators say I am then I’ll adjust but I’m quite concerned that I’m not.
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