UNSAFE AT CURRENT SPEEDS
The quantitative model supporting the Post-MPT strategies has made major changes in the third quarter. At the end of June, the iSectors® Post-MPT Growth Allocation was leveraged, with major overweights in the finance, health and technology sectors with a small long-term bond holding. Currently, the model is slightly leveraged, the health position has been sold for the most part and one-third of the portfolio is in fixed income. In fact, the long-term bond position is the largest holding in both Post-MPT Growth and Moderate.
The model turned more negative throughout the quarter for a number of reasons:
- On a macroeconomic basis, the prospect for 3%+ real growth has been downgraded. After the model was run, the September employment numbers confirmed this finding. The leading economic factors serving as inputs into the model was already picking up on this fact as early as the second quarter when the model started decreasing leverage in the Post-MPT Growth Allocation and adding bond positions to both portfolios.
- Market volatility has picked up and been sustained at above-average levels. As the CBOE Volatility Index (VIX) chart indicates below, there was an initial burst of volatility above the 16 level in June. Then the VIX went to extremely high levels in August. Although lower than in August, volatility continues to run at higher levels than in the second quarter. This is important to our model since it strives for the highest prospective returns with the lowest probability of losses. When volatility increase, the chance for negative returns also increases. Thus, the model results will become more conservative as volatility rises and moderates at higher levels.
- There has been a rotation from growth to value stocks. As the chart below indicates, from January to July, growth outperformed value by 10%. This helped the performance of sectors such as health care and technology. From July to the September, value outperformed by 3.5%. Sectors such as consumer durables and financials have benefitted from value’s relatively strong showing. This change may be a near-term phenomenon or the beginning of a new trend. This has increased the potential for downside moves in each of the equity sectors and caused the model to emphasize fixed income.
Source: Federal Reserve Bank of St. Louis
- The Federal Reserve has added to second half volatility. The chart below indicates that the market expectation for December Fed Fund rates in the second quarter, ranged from 0.60% (100.00-99.40) to 0.85% (100.00-99.15). Thus during that timeframe, the market was expecting two or three 25 basis points increases in the Fed Fund rates before year-end. Currently, the market believes that the chance of a Fed Fund rate increase in 2015 is less than 50%. The Fed has done a terrible job managing expectations for a rate increase, which has added to the uncertainty in the market. Again, the model has become more conservative to reflect this increase volatility.
Source: CME Group
- As the probability of near-term Fed Fund rate increases have diminished, Treasury bond yields have declined, increasing returns for bond funds. Currently, the Fed Funds contract is pricing in two 25 basis points increase by the end of next year. Given the global economic growth slowdown, the ongoing energy sector crisis, and US employment growth declines, we expect only one Fed Funds increase by year-end 2016, at the most. Although we are convinced that we are in the middle of an elongated economic recovery, there will be soft spots in the domestic and international economies that can lead the Fed to hold off raising rates through 2016. The last thing the Fed wants to do is to start raising rates and then have to reverse course such as was the case in Canada, Euroland, and Australia.
Source: Federal Reserve Bank of St. Louis
Ultimately, when the Fed’s course of action becomes clear and earnings growth turn positive on a year-over-year basis, the US equity bull market will resume. Therefore, it is dangerous to go to cash equivalents (earning zero, currently). Not only do you have to correctly predict that the market will continue downward from these levels. You must also know when to get back into stocks. Long-term investors should emphasize equities in sectors with strong earnings visibility (such as technology) and significant bond allocations to profit from declining interest rates as expectations for Fed Fund increases dissipate.