Weekly Market Update 01/12/2020Posted Jan 13, 2020
The S&P 500 gained 0.94% this week with Friday's close at 3,265.35. Friday's close is yet another new all-time high weekly close. The price action this week was rather wild, and the tensions with Iran took center stage.
The S&P 500 opened the week negatively on Monday, gapping down by -0.53%, with the narrative at the time being the risks associated with an escalation of the Iranian conflict. However, the S&P 500 would go on to finish Monday in positive territory, seemingly suggesting that participants aren't overly concerned with the risks associated with an escalation of the Iranian conflict. Then, after the market closed on Tuesday, it was reported that Iran launched missiles at U.S. forces in Iraq (click here). The futures market saw the S&P 500 plunge by roughly -1.5%. However, the S&P 500 would once again shrug it off, and recover everything it lost in a few short hours, and then finish the next two trading days higher by more than 1% in total. This tweet by President Trump (click here) was perfectly correlated to the S&P 500 taking a leg higher Tuesday evening.
Regarding the Iranian conflict, is the glass half full or half empty? In other words, is the resiliency the S&P 500 showed this week a good sign, a sign that future escalation with Iran is unlikely? Or, is the volatility the futures market showed in the after hours on Tuesday a sign of fragility, a sign that all it takes is one bad decision by Iran to bring about a volatility storm? We obviously have no idea, but we'd be lying if we said we're comfortable in having conviction in the idea that the Iranian conflict is over and behind us. There's a chance market participants, collectively, are underpricing the risk of further escalation.
The index has now increased 12 of the last 14 weeks, and hasn't had a weekly decline of -0.50% or worse at any point over the last 15 weeks. Both of these data points are very, very rare. Since 1990, there has only been one other instance where the S&P 500 increased 12 of 14 weeks and closed the week at an all-time high (12/15/2017). There has also only been one other instance where the S&P 500 went 15 consecutive weeks without recording a weekly decline of -0.50% or worse (12/22/2017). This, too, leaves us feeling a bit uneasy, since drawing parallels to late December 2017 reminds us of the S&P 500's price action from late January, early February, 2018.
Now, we don't mention this to be alarmist or to suggest that anything like late January or early February 2018 is in front of us, or that anyone should attempt to time, or navigate, the short-term gyrations of the S&P 500. We share it to illustrate that there's a "wall of worry", and generally speaking, a "wall of worry" is a good thing during "bull markets". Michael Batnick, CFA, put together a great chart illustrating the "wall of worry" the last decade. There have been a plethora of reasons to "sell" over the last decade, some of them prudent and justified and some of them not, and none of them have been profitable since the S&P 500 is at new all-time highs.
So, while we still believe there's a reason to expect turbulence in the not too distant future (even though we've been looking for turbulence for a few weeks now and there hasn't been any), the turbulence we envision is likely going to be temporary and only interrupt the S&P 500's advance - just like late January and early February 2018's correction. It's not likely going to be a reason to press "sell".
One quantitative study that supports this idea is the S&P 500's weekly RSI(14). Weekly RSI(14) closed at 75.55 this week, with the S&P 500 finishing the week at a new all-time high. A weekly RSI(14) close at or above 75, paired with an all-time high weekly close for the S&P 500, has happened 23 prior times since 1970. 21 of them then saw the S&P 500 close higher 12 weeks later. Average returns over the forward 12 weeks record at 2.91%. Many of them saw turbulence along the forward 12 weeks, but almost all of them closed higher 12 weeks later. We hope the next 12 weeks are no different.
S&P 500 Primary Trend - Up
We continue to label the S&P 500's primary trend as up or "bullish". During uptrends, long-term investors are generally best served with an equity overweight across their asset allocation, whether in absolute terms (i.e., allocating 51% or more toward stocks) or relative terms (i.e., allocating more to stocks than any other asset class). Passive, or strategic asset allocation methodologies, tend to outperform during primary uptrends for the S&P 500, too. Put more simply, patience pays during primary uptrends.
The importance in reminding you of the primary trend for the S&P 500 each and every week lies in the fact that it's the stock asset class that is the largest class held in most long-term investors' portfolios. Therefore, it's the week-to-week change in the S&P 500 that is most influential in the week-to-week change in the value of long-term investors' portfolios. Since stocks as an asset class tend to trend, then the primary trend of the present is the most likely primary trend into the future. Therefore, reiterating the primary trend is analogous to telling you the market climate, where primary uptrends are sunny skies, trendless climates are cloudy skies, and primary downtrends are storms. For now, the climate remains friendly, with sunny skies.
While we understand the investable universe is large, over the long term stocks have offered long-term investors the highest annualized returns relative to all other traditional broad asset classes. Therefore, it's only natural for long-term investors to look to stocks first when building their portfolio. That said, the returns stocks generate are mostly attributable to the equity market's risk premium (i.e., stock returns are long-term compensation for risking the loss of your money).
Everyone can still remember the 2007-2009 cycle, and some can even remember the 2000-2003 cycle, or even the 1970s. It's these time periods that fuel the S&P 500's average annual return being close to 10% over the last 70+ years. It's also these time periods that keep long-term investors from allocating 100% of their portfolio toward stocks, since stocks can produce negative total returns over a decade-long time span. But this begs the questions, "what percentage of my portfolio should I allocate toward stocks?", and "when should I make changes to my asset allocation?". This is where investors generally have two distinct options to choose from.
The first seeks to answer these questions by relying on individual investor attributes. Variables such as an investor's age and investing time horizon, total investable portfolio, future planned savings, and risk tolerance are the most important determinants in building an optimal asset allocation. This is the root of "strategic asset allocation" (often called "passive investing") and it relies heavily on the idea that the future will look like the past on a long enough time horizon (i.e., all asset classes performing in alignment with their historical risk:reward relationships). Portfolios are then generally rebalanced based on changes in individual investor attributes, best exemplified by the blanket recommendation for long-term investors to invest their age in bonds, i.e., invest less in stocks as they age. Importantly, "strategic asset allocation" gives virtually no consideration to the prevailing trends or opportunities available across asset classes, both at implementation and any rebalancing points. It pretends the primary trend for the S&P 500 in the present is irrelevant.
The second path is polar opposite. It seeks to establish investment policy based on the opportunities present across the investable universe. Variables such as trend, momentum, earnings, valuations, fiscal and monetary policy are massively important in building an optimal asset allocation. This is the root of "tactical asset allocation" (often called "active investing") and it, too, relies on the idea that the future will look like the past over the long term. Portfolios are rebalanced based on changes in the prevailing trends or opportunities available across asset classes, even if there are no changes in your individual investor attributes. Importantly, "tactical asset allocation" seeks to give little consideration to individual investor attributes, both at implementation and any rebalancing points. It believes labeling the primary trend for the S&P 500 in the present is beyond valuable.
Now, the debate between "strategic asset allocation" and "tactical asset allocation" is absolutely polarizing. Both camps believe their way is the right way, but as is often the case, both camps would be best served meeting in the middle.
In our view, both individual investor attributes and the trends and opportunities available across asset classes should play a role in building an optimal portfolio. It's imperative long-term investors understand their individual investor attributes when building an optimal portfolio, and it's also imperative long-term investors identify the primary trend for the S&P 500 (and all asset classes) when building an optimal portfolio. Just because someone is "young" is not sufficient evidence to passively invest 80-90-100% of their portfolio toward stocks at levels of nosebleed valuations, or during a primary downtrend. And just because someone is "old" is not sufficient evidence to passively invest 70-80-90% of their portfolio toward bonds at current levels of nearly all-time low interest rates, especially if the S&P 500 is in a primary uptrend. Furthermore, both stocks and bonds are remarkably "overvalued" based on historically reliable measures of valuations at the moment, but that's not a reason to completely exclude either asset class in an optimal portfolio.
The point is that you need a thorough understanding of both individual investor attributes and the trends and opportunities present across asset classes in order to build an optimal portfolio. There's a time to be passive, and a time to be active, and we think this is imperative for long-term investors to embrace as we enter the next decade, especially since we're all but certain there will be a primary downtrend for the S&P 500 at some point between 2020-2030.
Bond Market Update - Still Trendless
The bond market, as measured by the price of a 10-year United States Treasury bond (UST), remains trendless. UST declined -0.23% this week with Friday's close at 128.93, and Friday's close leaves the price of UST unchanged since late 2008, or nearly 12 years ago. We think there's a good chance that UST has reached a "permanently high plateau", in sarcastic honor of Irving Fisher (click here).
It's the price market participants, collectively, are willing to pay for UST that establishes the yield, or interest rate, on UST. We'll call the yield associated with UST by the acronym UST10y. With UST trendless for more than a decade, UST10y has also been trendless for nearly a decade. UST10y closed Friday at 1.83%, after first reaching 1.84% in 2011. In fact, UST10y has traded at 1.83% almost annually since 2011. UST10y hasn't been rising, it hasn't been falling, it's simply been stuck between ~1.5% and ~3% since the great financial crisis. It was 3.23% slightly more than one year ago, too.
If we decompose bonds, it's important for long-term investors to understand that the forward-looking total nominal return of UST is identified as the sum of UST10y at the time UST is purchased, plus any appreciation or depreciation UST experiences during the time an investor owned it. Therefore, if someone invests in UST on Monday, they can expect to earn 1.83% on their money for the next 10 years at worst (assuming the investment is held for a decade and the US Treasury has no credit risk), and they can maybe earn more than 1.83% over the 10-year period if market participants, collectively, want to pay them a premium for their bond (i.e., bond prices rise and interest rates actually go lower).
However, when you look at the charts above, UST has peaked three times between ~132-134 and UST10y has troughed three times between 1.3-1.5%. Given this, it's almost impossible to assume market participants, collectively, will ever be eager to pay more than ~132-134 for UST, which means if you're buying them in January of 2020, the most likely returns over time will actually be ~1.8%...
I don't think we're going out on a limb in saying that allocating any portion of your portfolio to earn 1.8% over a 10-year time span is not optimal. In real terms, this is likely going to lose you money, and in nominal terms, this isn't going to help most earn the returns they need in order to meet stated financial goals. So, with most long-term investors needing to "diversify" their portfolio, or collect a variety of forward-looking return streams in respect of uncertainty, how can bonds like UST play a meaningful role?
We believe the answer lies in long-term investors incorporating alternative investment strategies within their portfolio, both in terms of alternative investment strategies within the fixed income asset class, and alternative investment strategies that exhibit fixed income-like risk:reward profiles without investing in fixed income securities. In other words, an alternative investment strategy within fixed income, something along the lines of a long/short credit portfolio, may help derive added returns above and beyond 1.8% over 10 years for UST by hedging away interest rate risk while collecting quality yields on the shorter end of the curve. Further, we believe a merger arbitrage equity strategy can potentially behave fixed income-like, that is with similar annual volatility to that of UST, while having a far greater forward-looking return profile than that of UST.
As we head into a new decade, it's imperative long-term investors analyze and identify new ways to diversify their portfolios in order to generate the returns they need. The next 10 years for UST won't look anything like the last 10 years for UST. A trend will emerge, and if we had to guess, we believe it will be a primary downtrend (i.e., UST10y will be much higher in 2030 than here in 2020). It's in that scenario where taking an alternative approach to fixed income in the present can be expected to pay nice dividends into the future.
Steve, Rick, and the AlphaCore team
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