WESPAC Advisors, LLC - Portfolio Update July 2016Submitted by Wespac Advisors, LLC on August 18th, 2016
July was to be an important month - it was broadly expected that there would be both a turnaround in GDP and a turnaround in earnings that would support the market, reduce multiples, and allow the market push to new highs. Both GDP and earnings were a disappointment, but the momentum from the Brexit lows helped push the market to new highs anyway. We are now experiencing very low actual volatility, with the markets stuck in what some have described as the least volatile environment we have experienced in the last 45 years.
Analysts were optimistic about second quarter GDP, at one point expecting a +2.9% growth rate; just before the report, the forecast had dropped slightly to +2.6%. Actual 2Q16 GDP was just 1.2%, a number that surprised nearly every analyst. To make this worse, 1Q16 was dropped from an already anemic +1.1% to just +0.8%.
Earnings were a similar story. There has been continuing optimism for a reversal of a 7 quarter slide in earnings and a return to record earnings. As with the seven quarters before, 2Q16 earnings forecasts at the beginning of the year called for a new record - with 91% reported, 2Q16 operating earnings were a disappointment again, down -1% YoY and down -12.5% below the 3Q14 peak.
There is optimism that the second half of 2016 will see a turnaround in fundamentals. GDPNow is calling for +3.6% GDP growth and Standard and Poor's is, once again, calling for an earnings reversal, record earnings next quarter, and continued earnings growth into 2017. Given the inaccuracies of these forecasts over the last several years, we are skeptical. It is important whether or not these forecasts are achieved - if they are, the equity markets are trading at somewhat reasonable 16.4x and 17.9x multiples of 2017 operating and as reported earnings forecasts. If they are wrong, as they have been for some time, valuations are much more extended. Trailing 12-month multiples are a rich 22x and 25x operating and as reported earnings.
The US has certainly traded at higher multiples in history, and it is entirely possible that the state of the global economy and the actions of global central bank could generate more multiple expansion. While the US is in a quiet period with respect to quantitative easing, the rest of the world is adding liquidity at a record pace. With the US continuing to have a relatively strong economy and relatively high interest rates, it is entirely possible that money flows into the US will propel multiple expansion, higher equity market levels, lower long-term interest rates, and a flatter yield curve all at the same time. An odd scenario, but certainly possible given the current dynamics in the market.
There have been some epic moves in important markets since Brexit that deserve mention because they highlight the low volatility of the US equity markets. After the Fed statement and then Brexit, 10-year treasury rates plunged from their 1.7%-1.9% range to a print under 1.4%, even lower than the previous low print in June 2012. Rates have since rebounded to the 1.5% level, but continue in a multi-decade downtrend despite the actions of our Federal Reserve. We doubt that we have seen the end of downward pressure in long duration interest rates; if there is a rate hike at the short end, we expect the yield curve to continue to flatten.
Commodity markets have also been volatile. Crude oil had staged a sharp rally from the February lows in the $26/barrel area. From early May through Brexit, crude had been trading in the $50/barrel range. Brexit sparked a sharp sell-off, with oil dropping briefly below $40 once again. Supply and demand fundamentals seem to suggest that we may revisit the 2016 lows. Equity markets and crude oil markets were tied for many months - crude oil dropped over -20% in a relatively short period and equity markets went in the opposite direction. Crude has since rebounded to the $45 range, but its relationship to the equity markets appears, at least in the short term, to be waning.
The US dollar index has been very volatile as well. The US dollar index has been rallying since the end of QE in the US, rising 25% from mid-2014 through the end of 2015, and trading sideways over the past 20 months. After the Fed meeting and Brexit, the US dollar index has bounced from the bottom of its range in the 92 area and is now in the 96 area. So long as the US has a relatively tighter monetary policy and a superior economy to the rest of the world, we think there will continue to be upward pressure on the US dollar index. We would not be surprised at all to see the US dollar index back at its highs in the 100 range.
We are now entering a seasonally weak period in the markets. While we don't invest based on seasonal statistics, we suspect that there might be an episode of weakness in the equity markets and a strength in the bond markets over the coming weeks. Given that it is an election year and there is such a high correlation between markets and the success of incumbent nominees and parties, we expect whatever can be done will be done to encourage higher markets into the election and into the typically strong fourth quarter. If there was a challenge in the equity markets, we think it will more likely be short-lived and, if anything, a buying opportunity. If the incumbent nominee and party appears substantially behind in the polls, we may have to change this outlook. For now, we are cautiously optimistic.
While we had expected equity market strength in July, we did not expect such a strong reaction post-Brexit in the equity, bond, and commodity markets. Sector leadership changed substantially in a short period of time from a defensive posture (Staples and Utilities) to more offensive posture (Technology and Financials). Keeping up with market rallies has required exposure to the volatile Energy sector - investments in that area also tend to cause higher losses in down markets, setting up quite a challenge.
We continue to move Core Equity towards higher quality companies, focusing on the largest S&P 500 companies with the best fundamentals. The transition to this approach is nearly complete, but there will be more trades over the coming weeks to better align the portfolio with the current market environment.
The other portfolios have been fairly stable with only a few transactions in July and early August. Most of the changes lately have been either individual stock issues or opportunities, or adjustments to reflect changing sector relative strength.
While we are concerned about a consolidation in the markets in the coming weeks, we do not think it will be substantial. As such, our cash levels are currently modest. If we see more negative action than we expect, we will adjust very quickly. We do not think the Fed will raise rates in September, but will be watchful, as always, around that event. We continue to think that more significant risks will be in October and January as the market processes whether or not the second half recovery has materialized. If it does not, we will become more concerned with market valuation.