Monthly Update December 2014
CONCLUSION—A Classic Topping Process
Since our last email update on Halloween six weeks ago, there has been a considerable amount of both up and down volatility in world stock markets. From the October 15 low for most markets to December 5, the top for most markets, various indexes rallied anywhere from +5% (EEM—Emerging Markts Index) to +13.4% (Russell 2000 Index of small companies). This past week, the worst in 3 years, shows a variety of indexes off their highs ranging from -3.19% (Russell 2000) to -9.66% (EEM), yet the Vanguard Total Stock Index is still up 9% for the year. This may lead many investors to conclude that all should be well with their portfolios, especially considering that the Vanguard Total Bond Index is up 6% ytd, thanks to a drop in the yield of the 10-year Treasury Note from 3% to 2.10%.
What we’re actually experiencing though, is a bifurcated market (a split, in English). See the dispersion below of various market segments, which include reinvested dividends:
Vanguard Total Stock Index +9.0%
S&P 400 Midcap Index +5.5%
Russell 2000 (small caps) +0.34%
Vanguard Total International Index -5.6%
Emerging Markets Index (EEM) -7.54%
As a result, diversified portfolios are struggling in comparison to the cap-weighted S&P 500 Index, which is comprised of large companies. Throw in that actively managed funds are significantly lagging index-based benchmarks and you construct a very different picture. What this all appears to mean is that the stock market appears to be in a multi-month transition from a bull market which is in its sixth year, to the inevitable bear market which follows. According to Lowry’s Research, 43% of small caps in their Operating Only Companies database have already dropped by 20% or more. This past week, on a weekly basis 522 stocks made new 52-week lows on the NYSE, while 387 made new highs. On a daily basis, Friday saw 371 new lows and only 57 make new highs. In other words, a large number of stocks are already in their own bear market.
On the positive side, advance/decline lines for the large cap and mid-cap segments of the market have made recent new highs, suggesting several months of further price highs, though likely with increased volatility and selectivity. Large companies are usually the last to fall, and by the time the Dow Industrials and S&P 500 really break down, the majority of other stocks will have already entered a bear market. The growing divergence between the performance of large cap U.S. stocks and those of global equities are a warning, as is the breakdown of high yield bond prices, which have already taken out their October 15 low. Near term risk seems to be elevated, though stocks are decently oversold, and the final half of December is normally positive. The longer term models we employ for the stock market with a trend-following bent are not yet suggesting heavily defensive positions, but the probabilities are likely that changes sometime in 2015, most likely sometime after April/May.
Crude Oil—Be Careful What You Wish For
Since June, the price of crude oil has dropped over 40%, to under $60 per barrel, which has translated to the pump, with a gallon of premium gasoline near or under $3, depending on the region of the country. For a good visual, see the chart below courtesy of www.stockcharts.com. It was not that long ago that a gallon of premium was around $4.80.
Certainly realizing that every household’s driving habits are different, along with the size of their cars/trucks and how many gallons are in a tank, I concocted the following scenario. A husband and wife each drive and fill up twice a month, with a 20-gallon tank. Assuming we are now saving $1 per gallon, that would amount to $20 each visit, so with four visits a month, the savings are $80. Multiply this by 12 months and you see the savings if maintained over the course of one year would be nearly $1000 for the family. No doubt this is significant for the bottom 50% of American households. But, for the upper 50%, I’d argue this is a non-event, and likely even a negative. Anyone with even as little as $50,000 in an balanced investment portfolio has likely lost at least 2% in the past few months. That’s a $1000 loss, and is of course much greater on larger sums. Throw in the psychological component, and I’d suggest the vast majority of these households are actually worse off. Add to that the fact that a large number of major and minor energy companies are having to cancel or scale back exploration projects, suggesting spending will be reduced by 10-30%, and you have a recipe for layoffs and other unintended consequences. Major players in the rest of the world are highly dependent on oil production (Russia, Saudi Arabia, etc). All in all, the lower the oil price goes, I believe the worse things will get, and the U.S. financial markets will not be immune. I have no idea how low oil can go, but the technical breakdown below the $75 level is similar to what took place in gold over a multi-year period. That’s deflationary, and I don’t think that’s good.
Stock Market Allocations—Going Global—Not Necessarily
A lot of theories abound on Wall Street on how much global equity exposure should be in one’s portfolio (compared to U.S. domestic stocks). Some people think 25%, 33%, some even argue 50% since the U.S. is only about half the world capitalization, and others suggest zero. Our particular stance for passive portfolios is 25%, but for tactical allocations, we prefer to be guided by relative strength calculations, which can guide investors to over-weight segments that are actually performing the best. The changes, therefore, are dynamic, and change as markets change. An example is below, comparing the Vanguard Total Stock Index Fund to the Vanguard Total International Stock Index Fund. The method and analysis process are courtesy of our research friends at Dorsey Wright & Associates.
I won’t go into the nuances of point and figure work, but a SELL was given in favor of International in July 2002 which then switched to a BUY in favor of Total Stock in September 2011 (see red circles on chart). When the International Fund was favored, it gained 88% vs 67% for Total Stock. While Total Stock has been favored since September 2011, it has gained 77% vs 27% for International. No method is perfect, but if followed with discipline over time, this can help a portfolio’s returns by putting more money into funds which are performing the best, and systematically selling them when they begin to underperform. This is the same process we use in analyzing 401 (k) portfolios for clients along with the selection method we use for our tactical equity funds.
Portfolio Allocations
At present, the majority of our stock market risk models are positive, indicating 70% tactical equity exposure. This is in contrast to our high yield bond models, which remain 90% invested in short term bond funds (since August 1). The position in Loomis Sayles Bond is now back down to 30%, reflecting weakness in corporate bond prices, yet our GNMA model remains 100% invested, and our real estate model remains strongly positive. As noted above, the stock market is historically strong in December, closing with gains nearly 80% of the time. Maybe this month will be one of those 20% events, but what is not typically known is that stocks tend to be weak in the first half of the month and stronger the second half. We’ll see if that plays out, given the market is quite oversold right now.
Material of a Less Serious Nature
Here’s some year-end holiday humor—hopefully it makes you chuckle, since that is the intent!
The teacher gave her fifth grade class an assignment: Get their parents to tell them a story with a moral at the end of it.
The next day, the kids came back and, one by one, began to tell their stories. There were all the regular types of stuff: Spilled milk and pennies saved. But then the teacher realized, much to her dismay, that only Janie was left. “Janie, do you have a story to share?”
“Yes, ma’am. My daddy told me a story about my Mommy. She was a Marine pilot in Deset Storm, and her plane got hit. She had to bail out over enemy territory, and all she had was a flask of whiskey, a pistol, and a survival knife. She drank the whiskey on the way down so the bottle wouldn’t break, and then she parachuted right into the middle of 20 Iraqi troops. She shot 15 of them with the pistol, until she ran out of bullets, killed four more with the knife, till the blade broke, and then she killed the last Iraqi with her bare hands.”
“Good heavens,” said the horrified teacher. “What did your Daddy tell you was the moral to this horrible story?”
Janie answered, “Don’t mess with Mommy when she’s been drinking!”
As we close out another year, I’d be remiss in not expressing how much we appreciate your friendship, trust and confidence in all of us at TABR. May you, your friends and loved ones enjoy a Happy Hanukah, Merry Christmas and a Happy New Year.
Sincerely,
Bob Kargenian, CMT
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