WESPAC Advisors, LLC - Portfolio Update - August 2016Submitted by Wespac Advisors, LLC on September 16th, 2016
Once again, we find the Federal Reserve front and center in market dynamics with their next meeting scheduled for September 20-21. In the run up to every meeting, markets expect the Fed to be resuming its tightening cycle - the US dollar, rates and financials creep higher, while high yield, utilities, REITS and commodities creep lower. Then, the Fed punts, and the trade reverses. The NFP jobs report on Friday was a slight miss from expectations, so the odds of a hike in September are dropping. After climbing from a low point on July 6th of 1.33%, ten-year treasury rates climbed steadily to a 1.63% point on August 26th. Confirming expectations, rates dropped 3.3% today to 1.54%.
We are likely not alone in wishing the Fed would simply get on with normalizing interest rates at the short-end; a simple predictable schedule to get short rates up to 1.0-1.5% would surely not upset the economy for long, let alone the equity and bond markets, and such a move would go a long way towards curbing the various bubbles certainly in progress due to ZIRP. But, alas, we doubt the Fed will do this before the election, and perhaps not for a long time; they seem to prefer data dependent dithering, apparently wringing their hands over the significance of any suspect economic statistic. The simple fact is that the Fed will probably not raise rates so long as the rest of the world has much looser monetary policies; the US dollar index would rally, further jeopardizing US exports. This Fed meeting feels like déjà vu.
The US equity market broke out at the end of June following the Brexit decision; while a very odd catalyst, the breakout seemed to be an important resolution of the sideways market action that we have seen since the beginning of 2014. Unfortunately, this breakout quickly stalled into a remarkable 56 day range that is only 1.5% wide. It is as if the equity market is being held in suspended animation, unable to move in either direction.
As we mentioned in our last post, the current optimism with respect to GDP and earnings reversals may also turn out to be déjà vu; it has been several years now where analysts have forecast GDP and earnings breakouts. The forecasts have been consistently missed, and we find ourselves simply muddling along on a fundamental basis. And, to repeat ourselves, GDP and earnings need to breakout, or the equity markets will be left in an increasingly obvious overvalued state.
While we do not trade to seasonal statistics, we do track them. There will be reports surfacing about how September is the most dangerous month of the year; that is definitely true, on average, since 1950. However, over the past 10 years, the worst months, on average, have been June, January, and August. In fact, since 2009, the September-October period has had an average monthly gain of +2.29%. While there was a -7.1% drawdown in September 2011, it was followed by a +10.8% gain in October 2011. Last year, September lost -2.6% after losing -6.2% in August; both losses were essentially reversed with an +8.3% gain in October.
Our assessment is that the equity markets will likely drift higher into the end of the year, barring any unusual catalyst. While we think there is a possibility of an equity market challenge over the next several months, we think it will be probably be short-lived. Unfortunately, as we are seeing now, market action around Fed meetings will continue to exhibit flip-flops in sector strengths and stock performance that will be difficult to follow.
With respect to the fixed income markets, we think that even if the Fed raises short rates several times over the next six months, it will most likely have a nominal effect on the long end and will probably end up with a flattening of the yield curve. We do not expect any material spike in interest rates through the end of the year.
We continue to be cautiously optimistic; having said that, we are vigilant in our assessment of market conditions and will quickly adjust if necessary.
We had expected some market weakness in August and September, but the tight sideways range in the markets continued through August. Energy and Financials led in August, but, in the case of Energy, it was simply a snap back from the selloff in July. Energy has been dead money, trading sideways since mid-April. Financials are following their now-typical pattern, rallying into the Fed meetings, only to be sold off after the Fed punts. Having said that, Financials have broken out to 2016 highs are now testing November-December 2015 highs.
Technology and Industrials were the next best performers in August, with Technology continuing its relative strength since May 2016. Over the past several weeks, we have started to see the return of relative out performance from REITs, particularly specialty REITs.
It would be difficult to predict an end to such a long sideways chop in the equity markets, but they always do end. Before then, we expect this incredibly narrow 1.5% trading range to widen both to the upside and downside before it resolves. It would not be unusual at all to go back to retest the S&P 500's breakout point in the 2120-2130 range, or even a bit farther back to intermediate term support in the 2040-2065 range. Either way, we expect such a move to be short-lived. If economic and earnings forecasts are achieved, we would not be surprised to see a pattern of new highs emerge.
We are approaching fully valued equity markets, as discussed above, so paying attention to PEG ratios will be important. The S&P 500, excluding the troubled energy sector, is trading at a 1.93 PEG ratio (PE ratio versus 3 year projected earnings growth, forecast by Standard and Poors). This is not a low number. Telecom (3.37x), Utilities (3.33x), Materials (2.46x) and Staples (2.46x) are the most richly valued sectors relative to their projected earnings growth. Consumer Discretionary (.96x), Information Technology (1.52x, and Healthcare (1.52x) are the sectors with the lowest ratios relative to their projected earnings growth. We will pay particular attention to these points as we move into third quarter earnings season in October.