2017 MEANS US SHARES OUTPERFORM EMERGING MARKETS, HIGHER BOND YIELDS, STRONG US DOLLAR, MORE VOLATILITY IN MARKETS. OR DOES IT?

It is funny how in early January we see so many articles in the media from pundits predicting how the various asset classes will perform over the next 12 months. For these couple of weeks in the year, suddenly it is critical that we form an exact 12 months view of various asset classes, with often precise end of year targets.

This year with the US election fresh in people’s memory, plenty was written about this result and how it tied in with various end of year targets. Mostly I seemed to encounter the following predictions.

– The US equity markets shall outperform, led by Trump cutting corporate taxes and a push to slash regulations. US equities remain preferable to Emerging Markets, where the latter faces potential risk of trade wars. The expected strong USD is also often a headwind for EM equites.

– Expect higher US bond yields, with more infrastructure spending under the Trump administration likely to produce higher inflation, and lead to a stronger USD.

– Obviously with the Donald Trump victory, expect volatility in markets to be much higher than the recent low levels over the last few years.

Looking at how some of the views have transpired, I once again think that a George Costanza LIC (do the opposite of what seemingly makes sense), could have some ability to perform and warrant some thought about listing.

Below are some various charts I found that make the popular views above at the start of January this year look a little awkward.

Forgive me if the charts maybe a little stale in some cases, but if I haven’t refreshed the information it just means I don’t think updating this will change the underlying points I am making. 

Firstly, EM equities have delivered stellar returns. Compare below to the S&P500 which only has gains of about 12% at the time of writing. This EM ETF was up over 28%.

EM ETF.jpg

 

This table below (up to end of August), also shows that other developed markets in the world outside of the US have performed better YTD.

other markets.jpg

The 10-year treasury yield has moved lower over 2017, particularly in the last month or so.

bond yields.jpg

Where is the increase in volatility this year? Below is a chart of the VIX over the last 5 years.

vix.jpg

And now the VIX since 1990, the lack of volatility of late is extraordinary.

vix2.jpg

 

I thought the USD was meant to rise in 2017 under Trump?

USD.jpg

Should we be surprised that US equities are under-performing of late given the backdrop of valuations?

cape.jpg

Source: Citi Research

Now I am not claiming to be better than the pundits who had these views. I have been surprised and dead wrong on the strength of equities markets, the recent rise of the AUD, and overall the lack of volatility in 2017.

I just thought I would explore how some of these trends may be impacting what I do with my portfolio in the near term. Here are some key points playing on my mind.

– The CAPE chart above leans me to expect that this current trend of US markets underperforming emerging markets and the rest of world is likely to be a long-term trend. Unfortunately, I don’t have much confidence in knowing how this plays out. i.e. does the bull market last further and EM show huge gains such as in 06/07? Or does the US market fall 30% and EM only fall 20%?

– Although I suspect this to be a long-term trend, is the decision to overweight other global markets over the US as compelling as it was at the start of the year given some of this theme has already played out? Does that mean it is prudent to trim positions in other global markets?

– The VIX continues to make many investors including myself look silly by remaining so low. Is it worth betting against this by perhaps not only buying protection, but also even buying call options in case of the market surging? After all, the final run up in a bull market is sometimes quite extreme. This perhaps wouldn’t shock with the backdrop of some sentiment measures indicating that there are still many bears out there.

– There haven’t been that many asset classes that you can describe as depressed in the last 2 or 3 years. However, Gold probably fits this description, and to a lesser extent some mining and mining services companies at times here and there. Now gold has come to life, and investors who have had exposure to many mining related companies may be a little happier compared with owning major banks of late, or some high P/E growth companies on the ASX. This recent article highlighted the outperformance of mining stocks in recent months.

http://www.afr.com/business/mining/mining-stocks-in-second-bull-market-this-year-but-be-cautious-20170911-gyese9

Do we use this strength to lighten up in the resources sector?

On June 9th I discussed the small cap sector as one to examine closer for bargains. Unfortunately, I didn’t get too involved around that time, because I have notice the small ordinaries index has bounced over 7% since, doing about 4% better than the ASX200. So, three areas of the market that I have recently felt offered pockets of value such as emerging markets, mining related companies & smaller companies don’t look quite as attractive.

– If we trim some exposures such as above, what is there left to buy?!

What should I do?

I have tried to gain global equities exposure outside of the US since I began blogging at the start of 2016. Some examples would be TGG.AX (large active bet on Europe over US), PAI.AX, EAI.AX, UOS.AX. I have also written about offshore listed investments like Vina Capital that I own and others, VNL.LN, 3918:HK, CEE:US, this latter group being more on the speculative side of the spectrum.

I sometimes find the US CNBC “Fast Money” show a little extreme where the desk gets overly excited about the more recent trends. So, this article with Tim Seymour pumping up EM makes me think perhaps I should get defensive to some degree!

https://www.cnbc.com/2017/08/17/emerging-market-stocks-may-be-set-to-break-out-after-years-of-struggle.html

I still clearly have a bias that US equities will underperform the rest of world equities in the long term from this point, but wish to manage my risk with the size of the bet surrounding this view given the recent strength of emerging markets.

In doing this, I may increasingly place some trailing stop levels on positions where I am ok to sell now. I am certainly no chartist (not that there is anything wrong with that). I have just found over the years with certain types of stocks I am making profits on, selling them after they turn down a bit seems to often produce far better exit levels than me trying to predict when they have run up too far. Examples last year was when I had major urges to sell RMS at 25 cents, and SSM at 80 cents.

Of the above-mentioned stocks, I plan on trimming some Vina Capital exposure, and running a trailing stop on CEE:US. TGG I am still holding for the time being as I mentioned on the blog recently, but they have had a tailwind with the stronger European markets so may be tempted to lighten up this also.

In terms of the commodity space, a long while back I mentioned buying CEF:US. With the recent run up in Gold I don’t feel I need as much exposure, so will be running a trailing stop on this also.

Other mining related stocks that have worked ok of late are ILU & MAH. I plan on running a trailing stop on ILU. A primary catalyst I initially saw with ILU was more publicity surrounding BHP developing South Flank and the effects on valuing the ILU iron ore royalty. There have been more news coverage surrounding this in 2017 which has helped, but I’ve probably been fortunate more than anything with the strength in the Zircon price. This was again raised only in this week, so with the catalysts occurring I want to have some exit strategy in what can me a major trending stock.

In short, the minor selling and trailing stops (set around the 200 MDA) on CEF:US, ILU.AX & CEE:US will ensure I take some profits on themes that are not as compelling as they were earlier in the year due to the prices already moving in my favour. I mark these 3 holdings at values assuming the level of the trailing stop are hit, and am happy with the profits at these lower levels on each. In all 3 cases, they are examples of stocks that have shown historically to move in major trends up or down! I therefore see it as a small way to potentially retaining exposure to the possibility that market volatility increases amidst rising markets.

For very modest amounts I continue to occasionally look at mainly put options on the S&P500, but even call options to a lesser extent, unfortunately I doubt I will uncover attractive LIC options to buy though.

I had been previously looking at put options, but more recently became a bit more open minded to call options after reading this piece from Samuel Terry Asset Management, who have amongst the best after fees performance figures in the Australian market that I know of.

https://www.livewiremarkets.com/wires/6-catalysts-for-volatility-and-how-to-play-it

Holding a higher cash balance now because of the pockets of value in the market closing, yet retaining some exposure to a rising market this way started to appeal for the immediate term whilst I struggle to find buy ideas.

I think one of the points in the Fred Woollard article may be referring to this sort of example below, where heroes are being made of people assuming volatility will continue to be in a structural trend lower.

https://www.nytimes.com/2017/08/28/business/dealbook/vix-trading.html?smid=tw-share

The selling or trailing stops I mentioned earlier should result in my “cash equivalents” weighting climbing to 31% (I’m counting the trailing stop positions in this category), the largest I’ve had since around Brexit from memory. Since then it has often been around 25% or a tad lower at times.

This is a reflection that a year or so ago even though I felt US markets were expensive, opportunities globally, or in mining related, or the odd small companies could be sought out. Now I am not sure I can make the same comments. Looking back, I am not that far behind the performance of the S&P500 total return since the beginning of 2016, and better than the ASX200 Accumulation index so don’t mind risking lagging in the future in a bull market by adopting this stance. If I am fortunate, even if the market runs higher maybe some of the stocks I set trailing stops on can continue upwards, or the pace of the rally can pick up and call options may show some gains.

On the subject of underperforming the S&P500, many well-respected fund managers in the US are not keeping pace the last 7 years and I consider this quite a worrying sign. The chart I posted on a recent blog post about active funds being ready to outperform, shows that this has tended to occur historically when we are nearing a major bear market. The chart didn’t really show that in 2007, but was a reasonable indicator before major bear markets in 1973, 1987 & 2000.

Of course, if you have read my blog before you would have seen at times that increasing my cash levels and discussing the merits of buying put option protection has been costly. Perhaps my post here is another example of consensus thinking like the Trump trade views at the start of this year. If so maybe it is better to rush out and do the opposite to what I have discussed!

costanza pic.jpg

 

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