On the surface, the third quarter (Q3) of 2016 seemed to be a strong one for global equity markets. Global equities rose sharply, volatility was muted, and central banks were, as usual, supportive. Looking under the surface, however, a potentially different picture emerges.

The strong equity returns were largely an unwinding of the post-Brexit selloff that occurred at the end of the second quarter. Earnings and the economy were lackluster. Equity valuations, by some measures, reached their highest levels ever—indicating that one should expect low-single-digit annualized returns over the longer term. While U.S. interest rates rose slightly on speculation that the Federal Reserve might raise rates sooner rather than later, both the Fed and the European Central Bank (ECB) floated trial balloons in the media about the possibility of buying equities (a la the Bank of Japan) should either seek to expand its quantitative easing program (QE)—which is not exactly a rousing endorsement of the current state of the economic “recovery.”

ASSET CLASS RECAP

Equities: Non-U.S. equities were very strong in Q3, led by China and emerging markets (EEM). U.S. small caps (IWM) were also strong, as were large-cap technology stocks. Gold miners were weak on the back of lower gold prices, but have still led the way in 2016 with a 93% year-to-date return at the end of Q3. Despite the strong quarterly returns, equities have generally gone sideways since the end of 2014, with two large selloffs in between. Large-caps and mid-caps have appreciated at a 5% annualized rate, while small caps have risen at a 3.7% annualized rate, including dividends. Given the low-single-digit estimated returns over the next decade based on current valuations, sideways action and volatility is to be expected.

Bonds: U.S. interest rates rose slightly in Q3, seemingly on the expectation that the Federal Reserve would potentially raise interest rates in the near-term (although market-based probabilities have this as an unlikely event). Thus, perhaps part of the rate increase could also be attributed to mean-reversion after the significant fall in bond yields on account of the Brexit vote as the second quarter came to a close.

Commodities: Both oil and gold were down slightly in Q3 despite the dollar being weaker against major currencies (other than the British pound). After a hot start to the year, gold bumped up against the downtrend line from its 2011 peak and retreated.

Currencies: The dollar weakened slightly against the euro and yen in Q3. The British pound never recovered its post-Brexit loss and is down nearly 20%, as of this writing, from its pre-Brexit level (which subsequently may be boon for British exports).

CENTRAL BANK ACTIONS

In ancient Greek literature, the deus ex machina (literally “god from the machine”) was a plot device whereby the hero is saved from a hopeless situation through the intervention of a powerful and sometime magical third party that often literally swoops in to save the day. Contemporary examples include the magic sword delivered to Harry Potter by the Phoenix that saves him and the series from a certain and ignoble end, or the tyrannosaurus rex that charges in to kill the velociraptors that have the humans surrounded in Jurassic Park.

In recent years, global central banks have taken on the role of the deus ex machina, swooping in to save the day with actions or dovish jawboning anytime the markets appear to be faltering. Ben Hunt of Salient Partners calls this the Narrative of Central Bank Omnipotence, with everyone adhering to the Common Knowledge Game. Which is to say, everyone knows that everyone knows that central banks will support the market. Hence, despite significant overvaluation in U.S. equities or the lowest interest rates for centuries, central banks will have our backs. Thus, no need for worry, or so the thinking goes.

To that end, central banks maintained the illusion of control in Q3. The Federal Reserve did not raise interest rates at its September meeting, although some commentators had speculated that September would have been the ideal time for the Fed to raise rates. However, three members dissented from the decision, which may have been a foreshadowing of a rate increase at the December meeting.

We continue to think the Federal Reserve is stuck between a rock and hard place when it comes to interest rates. If it raise rates into a fragile economic recovery and a highly levered financial system, the likely result is market turmoil (see Q1 2016 after their December 2015 rate hike)—something the Fed desperately seek to avoid. If it does not raise rates, the Fed runs the risk of eventually bankrupting insurance companies and pension funds who will not be able to meet long-term obligations with the current expected return profiles of the equity and bond markets. The Fed also stands to lose credibility if it is unable to raise rates more than one time before the next recession arrives—leaving it with fewer easing options once the economy and markets begin to deteriorate again.

Across the pond, the ECB kept monetary policy unchanged in September after hinting in August at possibly expanding its QE because of the potential economic fallout from the Brexit vote. The Bank of Japan (BOJ), on the other hand, did expand its program to purchase equity ETFs that track the Topix at its September meeting, which led to a short-term pop in Japanese equities.

All of this deus ex machina-ness on the part of central banks is not free of externalities, however. In his October 3^rd missive, John Hussman, economist and manager of the Hussman family of value-oriented funds, had this to say about the Federal Reserve’s actions over the past seven years:

“The great victory of the Federal Reserve in the half-cycle since 2009 was not ending the global financial crisis; the crisis actually ended in March 2009 with the stroke of a pen that changed accounting rule FAS157 and eliminated mark-to-market accounting for banks (instantly removing the specter of widespread insolvencies by allowing “significant judgment” in valuing distressed assets). The victory was not economic recovery; the trajectory of the economy since 2009 has been no different than the trajectory that could have been projected using wholly non-monetary variables. No, the great Pyrrhic victory of the Fed has been to enable the third most extreme financial bubble in history, on the basis of capitalization-weighted indices, and the single most extreme bubble in history from the standpoint of individual stocks.”

Which is to say, central bank interventions have led to distortions in asset markets that have left markets increasingly susceptible to steep losses when investors suddenly become risk-averse. At which point, central banks again step in and alleviate the near-term crisis, but further propagate the markets’ fragility by not letting asset markets find natural clearing prices of their own accord. For this reason, a buy-and-hold strategy appears to be a sub-optimal strategy for preserving wealth at this point in the cycle, as it guarantees large losses, if and when the Narrative of Central Bank Omnipotence begins to weaken.

FUNDAMENTALS, MOMENTUM & SENTIMENT

According to data from Thomson Reuters I/B/E/S, S&P 500 earnings for Q2 (reported during Q3) fell by -2.2% year-over-year (excluding the energy sector, earnings rose by 2.2%), while revenues fell by -0.5% (excluding the energy sector, revenues rose by 2.5%). According to estimates from FactSet, S&P 500 earnings for Q3 are expected to fall by 2.1%. Negative earnings growth in Q3 would market the seventh straight quarter of falling year-over-year GAAP earnings for the S&P 500. Dating back to 1936, the last time the S&P had a seven straight quarters of negative earnings growth was during the financial crisis of 2007-2009.

While profits have fallen, the S&P 500 has generally stayed afloat, trading near all-time highs (albeit with two nontrivial selloffs in between—August/September 2015, and January/February 2016). Falling earnings and rising stock prices have led to higher valuations. In fact, by some measures, such as the price-to-revenue ratio, the median stock in the S&P 500 is more overvalued now than at any other time in history. Several valuation measures that historically have had high correlations with future equity returns are currently predicting low-single-digit annualized returns for the S&P 500 over the coming decade. Given that bond yields are near all-time lows as well, a 60/40 equities/bond portfolio is thus expected to have, at best, low-single-digit returns.

As for the U.S. economy, year-over-year growth for several indicators, such as real GDP, durable goods orders, and industrial production (among others), are at levels that have historically coincided with the onset of recessions. The Atlanta Fed’s estimate for Q3 real GDP has been inauspiciously trending downward from a high of 3.7% in early August to just over 2.0% at the beginning of October.

In contrast to fundamentals, global equity momentum at the end of Q3 was relatively strong across the board.  After lagging for quarters, non-U.S. equities finally joined the momentum party. This catch-up, so to speak, is not surprising given the better valuations in non-U.S. equities, which will likely lead to better long-term returns (over the coming decade) relative to U.S. equities.

While momentum was strong for global equities, sentiment in the form of how large investors were positioned—what we call the “smart money”—was not bullish for equities at the end of Q3, with three of our four smart-money indicators wanting to be out of equities. Since the year 2000, when three of our four smart-money indicators have been out of equities, equities have averaged a meager 0.70% annualized return (the blue line in the chart below). In contrast, when at least three of our four smart-money indicators have been long equities, the S&P 500 has advanced at a 19% annualized rate (the green line in the chart below). (The red line corresponds to the case when no more than one smart-money indicator wants to be long equities, that is, at least three, if not all four, of the indicators are out of equities.)

This prospective 0.70% annualized return given the current state of the “smart-money” positioning, while only forecasted to last as long as the “smart money” dislikes equities,  jibes with the low single-digit expected returns (projected to last at least a decade) noted above that can be estimated independently from earnings growth and valuation levels.

**Smart-Money Indicators do not represent the performance of AUA Capital or any of its advisory clients.

As it’s unlikely that the market will smoothly glide higher at such a low annualized rate, we expect the future to be marked by significant volatility—steep selloffs followed by strong rallies, with the market ultimately going approximately sideways once dividends are taken into account.

GLOBAL ALLOCATION

Global Allocation, our flagship tactical asset allocation strategy, continued its steady performance in Q3, rising 2.7% (net of fees), bringing its year-to-date total to 8% (net of fees). It has outpaced both the Morningstar Tactical Allocation Index (5.9%) and a 60/40 portfolio (6.1%)—consisting of ACWI, the MSCI All-Country World Index, and AGG, the iShares Barclays Aggregate U.S. Bond Fund—by approximately 200 bps each. The outperformance has largely been driven by the fact that Global Allocation avoided the severe equity market drawdown in the first quarter of this year, as the performance chart below (from January and February 2016) shows.

 OUTLOOK

We are cautious with respect to our outlook for global asset markets. Economic data are lackluster. U.S. equities are by some measures the most expensive they have ever been (meaning any burst higher in U.S. equities likely will not be sustainable). Long-term expected returns are by all accounts in the low-single digits, suggesting that volatility will be a fixture of asset markets for years to come. One wonders whether the deus ex machina in the form of global central banks can continue to save the day. Areas that may hold up on a relative basis include the energy, materials, and financial sectors given their long-term underperformance relative to the broad market, as well as non-U.S. equities, which are more reasonably valued.

As always, when making allocation decisions, we will continue to be guided by our suite of broad market indicators and our dynamic risk-management approach that underlie our Global Allocation strategy.

–AUA Capital Management 

AUA Capital Management is registered as an investment adviser with the SEC. The firm only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.

All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed. Content should not be viewed as an offer to buy or sell any of the securities mentioned or as personalized investment advice.

Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. Asset allocation and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses.

Historical performance returns for investment indexes and/or categories, usually do not deduct transaction and/or custodial charges or an advisory fee, which would decrease historical performance results. There are no assurances that a portfolio will match or exceed any particular benchmark.

The second quarter of 2016 was a notable one in many respects for financial markets. The rally in U.S. equities continued, as did the rally in U.S. bonds, leaving stocks on the pinnacle of all-time highs and U.S. long-term interest rates on the precipice of all-time lows. Over $10 trillion in worldwide debt now has negative yields. Central banks stepped up their asset purchases in the second quarter to a level not seen since 2013. But perhaps most notably, the U.K. voted to leave the European Union (“Brexit”), an event that ushered in a short-term bout of market panic that quickly reversed itself on the back of central bank liquidity. Let’s review.

ASSET CLASS RECAP

Equities: Global equities in dollar terms were mixed in Q2. While large-, mid-, and small-cap stocks in the U.S., were up 2.5%, 4.0%, and 4.0%, respectively, developed-market equities (EFA) were down 2.3% (in dollar terms) and emerging-market equities were flat. Despite the positive performance in the U.S., it wasn’t a particularly smooth ride, especially after the Brexit vote in the U.K. (the aftermath of which hinted at the potential ferocity of any future selloff should risk-aversion return). Moreover, low volatility stocks continued to outperform high beta stocks during the quarter, suggesting some caution on the part of investors.

Defensive sectors (Staples, Healthcare, and Utilities) and Energy were the leading sectors in the S&P 500 for the quarter, while Consumer Discretionary, Tech, and Biotech (high beta) lagged. As in Q1, gold mining stocks continued their torrid pace for the year, up 39% in Q2 and up over 100% year-to-date (YTD).

Bonds: Interest rates continued to fall worldwide in Q2. The amount of global debt with negative yield surpassed $10 trillion in May. The 10-year U.S. Treasury bond yield reached a record low level, below the previous record set during the Great Depression (not something one would expect with stocks at all-time highs). Meanwhile, the U.S. yield curve continued to flatten, an indication in years past of slowing growth. U.S. corporate bonds and high-yield bonds had strong quarters, as well, up 4% and 6%, respectively. But the best performing fixed income instrument was the U.S. long bond, which returned nearly 7%. Whether the performance of the long bond was due to a general lack of supply of positive-yield debt or an indication that economic growth continues to slow, remains an open question.

 Commodities: While the plunge in oil and its effect on equities was the big story in Q1, oil headlines were not as prominent in Q2. Crude oil, however, was up 20% during the quarter, which helped alleviate fears of Energy sector bankruptcies and high yield bond defaults. Precious metals also saw positive returns in Q2, with gold up 7.5% and silver up 22%.

 Currencies: The U.S. dollar strengthened modestly, up 1.7% on a trade-weighted basis. The Japanese yen was up nearly 9% against the dollar (which, coupled with Ben Bernanke’s visit to Japan in early July, has prompted speculation that the Bank of Japan will embark on so-called “helicopter money”—the permanent monetization of government deficits—in order to weaken the yen). The euro weakened 2.7% against the dollar. Notably, the British pound fell 10% against the dollar after the U.K. voted to leave the E.U. which, contrary to pre-vote fear-mongering, propelled the FTSE 100 to fresh new highs for U.K. investors.

CENTRAL BANK ACTIONS & COMMUNICATIONS

 The Federal Open Market Committee met twice during the second quarter and did not raise rates either time, using lackluster global growth, low inflation, and a slowing jobs market as reasons to forestall further rate hikes. In doing so, they emphasized their continued vigilance in monitoring the incoming economic data and then listed a broad array of indicators that they will take into account when deciding monetary policy—effectively giving themselves enormous wiggle room not to raise rates for the foreseeable future.

In light of the build-up of leverage in the financial system since the Financial Crisis, the capital flight from emerging markets when the dollar strengthens, the $2 trillion in deficit spending proposed by Congress for this fiscal year, and the continued need to roll over maturing debt, it is unlikely the Federal Reserve will ever be able to raise interest rates even moderately without sparking a major negative reaction in global markets. (Ben Bernanke, soon after he left the Fed, was quoted at a private meeting of hedge fund managers saying that rates will never “normalize” in his lifetime.) Indeed, by the end of Q2, the Fed Funds futures markets were not pricing in any additional rate hikes until October 2018.

One very notable development regarding central bank actions is that central bank liquidity (asset purchases) rose to its highest level in over three years during the second quarter, which may explain the exuberance in both equities and bonds. (Chart and analysis courtesy of Citi.)

FUNDAMENTALS, TECHNICALS, SENTIMENT & GROWTH

 On the surface, the fundamental situation for U.S. equities at the end of Q2 was relatively unfavorable when judged by the light of history. GAAP earnings ($98.61) continued their recession in Q1 (reported in Q2), and are now down 14% from their peak in September 2014 ($114.50). That puts the S&P 500 trading at over 21x GAAP earnings (the S&P 500 peaked back in 2007 in the range of 17x-18x GAAP earnings). Further, Q2 GAAP earnings (to be reported in Q3) are estimated to have declined 5% year-over-year. As mentioned previously, the median stock in the S&P 500 was the most expensive it has ever been on a price-to-sales basis, while Shiller’s cyclically-adjusted price-to-earnings (CAPE) ratio is at the 94^th percentile of its 130-year data history.

In light of these valuations, many prominent asset managers are forecasting 10-year forward annualized returns for the S&P 500 in the low single digits, if not negative. These forecasts are based on the relatively constant level of historical earnings growth and a presumed reversion to the mean for valuation multiples. Our own proprietary measures are suggesting 10-year annualized (nominal) returns in the 4%-5% range—certainly below historical levels, but not as dire as some forecasts.

Whether stocks return 0% annualized or 5% annualized over the next 10 years, however, neither result precludes the market from experiencing a significant drawdown at any point in time should a serious and sustained bout of risk-aversion arise (as Q1 demonstrated).

From a technical perspective, momentum at the end of Q2 was mixed, while some markets were at or near all-time high, others were still down significantly from their peaks in 2015, though most short-term momentum indicators were relatively positive. As for sentiment, the “smart-money” institutional traders were relatively neutral with respect to their positioning in the S&P 500.

On the growth front, the Atlanta Fed GDPNow Tracker is forecasting Q2 GDP to come in between 2% – 2.5%, after Q1’s growth of 0.4%. Despite that respectable growth forecast, Deutsche Bank recently reported that they are forecasting a 60% chance of a U.S. recession within 12 months based on the continued flattening of the yield curve. Critics were quick to argue, however, that the reduced supply of government bonds because of central bank buying has reduced the effectiveness of the yield curve as a leading indicator of growth. We should have an answer one way or the other by the end of the year.

GLOBAL ALLOCATION & CORE EQUITY

AUA’s proprietary strategies, Global Allocation and Core Equity, had mixed performances in Q2. Global Allocation, a systematic, tactical asset allocation strategy that aggregates market information across multiple factors and frequencies, returned 1.45% (net of fees), bringing its return for the year to 5% (with no substantive drawdown, having been out of equities during the Q1 swoon). Its 60/40 ACWI/AGG benchmark returned 1.75% for the quarter and is up 4.5% for the year, while the Morningstar Tactical Allocation Index was up 2.28% for the quarter and is up 3.23% for the year.

In contrast, Core Equity, a tax-efficient, concentrated single-stock portfolio of liquid large-, mid-, and small-cap stocks that are selected based on their aggregate attractiveness across factors that have historically provided excess returns (momentum, valuation, low volatility, profitability, mean-reversion), finished the quarter down 6% (net of fees), underperforming both the Russell 3000 (+2.6%) and the Russell 1000 (+2.5%). This contrasts to Core Equity’s positive outperformance in the first quarter of 1.4% and 1.1%, respectively.

As of mid-year, Core Equity is down 4%, while the Russell 3000 is up 3.6% and the Russell 1000 is up 3.7%. The underperformance of Core Equity was largely driven by poor earnings performances of the stocks held by the strategy. While this underperformance has already begun to abate in early Q3, its manifestation in Q2 demonstrates that the rise in the equity markets was not universally shared by all stocks. Indeed, this mixed breadth, coupled with the underperformance of high beta stocks, may be a tell-tale indication that the current market rally is relatively narrow and perhaps limited. Over the medium-term, we expect some type of reversion between the stocks in the Core Equity portfolio and the Russell 1000 and 3000.

 OUTLOOK

While many of the issues we highlighted in Q1 remain extant at the end of Q2—namely, deteriorating earnings and profit margins, historically high equity valuations, lingering negative momentum in some global equity markets, muted economic growth—and some newer developments have arisen (Brexit, low-volatility stocks continuing to outperform high-beta stocks, ongoing  flattening of the yield curve, etc.), our signals have us neutrally-weighted in global equities and overweight long-term U.S. government bonds going into Q3.

As Q3 progresses, we should get more information regarding the nature of the yield-curve flattening (is it primarily because of slowing growth or central bank purchases?), the sustainability of the equity rally (is it poised to move sustainably higher or is it narrowing and on its last legs?), and the expectations for Q3 earnings and economic growth.

Whatever transpires, however, we will continue to be guided, in a disciplined fashion, by our data-driven and time-tested market indicators; indicators that have, heretofore, helped us to avoid large drawdowns, while also enabling us to take tactical risk exposure when prudent.

AUA Capital Management is registered as an investment adviser with the SEC. The firm only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.

All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed. Content should not be viewed as an offer to buy or sell any of the securities mentioned or as personalized investment advice.

Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. Asset allocation and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses.

Historical performance returns for investment indexes and/or categories, usually do not deduct transaction and/or custodial charges or an advisory fee, which would decrease historical performance results. There are no assurances that a portfolio will match or exceed any particular benchmark.

The first quarter of 2016 turned out to be a capricious and turbulent one for financial markets. The quarter was punctuated by significant equity market drawdowns and rallies, oil prices in the mid-20s and low-40s, central bank actions and about-faces, and the resurgence of precious metals and miners, to name but a few developments. Just as March is said to come in like a lion and out like a lamb, the same could be said of Q1 2016—although the prevailing calm at quarter’s end, may yet again prove to be merely temporary.

Asset Class Recap

Equities: Fortunes looked bleak for global equity markets by the second week of February, getting off to their worst start for a year in the modern era. Maximum equity market drawdowns ranged from -10% to -20% globally. Then, as quickly as they fell, equities rebounded, finishing the quarter roughly flat as measured by the MSCI All Country World Index (ACWI +0.4%). The S&P 500 was marginally positive (SPY +1.3%), while the Russell 2000, which by mid-quarter had entered bear market territory from its 2015 peak, finished marginally negative (IWM -1.4%). Emerging markets had a strong quarter (EEM +6.4%) despite China finishing down (FXI -4.3%). Gold mining stocks were the big winners, however, finishing the quarter up 45%.

Bonds: U.S. government bonds, particularly at the long end, were the beneficiaries of the equity market volatility, providing a safe haven for investors, despite a relatively hawkish policy stance from the Federal Reserve coming into the quarter. However, some might say “because of a relatively hawkish policy stance,” as the prospect of the Federal Reserve tightening into a slowdown in global growth had investors fearing a recession. Yields on the 10-year and 30-year U.S. government bonds fell significantly during the quarter as investors recalibrated their views on global economic growth. Investment grade bonds also performed solidly (LQD +4.8%). High yield bonds (JNK +2.0%) finished the quarter moderately positive despite reaching an interim bottom mid-quarter some 25% below their July 2014 peak level. The increase in high yield bond spreads was partly driven by the fear of energy companies defaulting. This fear was lessened as oil prices rebounded sharply from their mid-February low.

Commodities: Oil prices were a prime driver of broad market movements and sentiment in Q1. Oil prices and equity markets bottomed in tandem on February 11^th. Oil prices subsequently rebounded nearly 50% over the balance of the quarter after pronouncements by OPEC and non-OPEC countries of a potential production freeze. The other notable development in the commodity space was the resurgence of gold and silver, both of which had been in multi-year bear markets (having peaked in 2011). Gold finished the quarter up 15%, while silver finished the quarter up 11%.

Currencies: Despite a hawkish policy stance from the Federal Reserve coming into the quarter, and stronger relative growth in the U.S. than abroad, the U.S. dollar fell during the quarter, as markets anticipated that the Federal Reserve would have to change its hawkish policy stance. Several rate hikes for 2016 had been priced into the Fed funds futures in December 2015, but by mid-quarter, the next rate hike was not expected until the end of 2017. Commensurately, the euro and Japanese yen both had strong quarters, up 4.5% and 6.6%, respectively.

Figure 1: Q1 2016 returns for select asset class ETFs

Figure 2: Q1 2016 maximum peak-to-trough drawdowns for select asset class ETFs

Central Bank Actions & Communications

The large rebound in global equities and commodities from their lows in mid-February can largely be attributed to monetary policy machinations by central banks. On January 29th, as risk assets tumbled, the Bank of Japan surprised markets by instituting a negative interest rate policy (NIRP). The initial reaction was one of euphoria, with the yen weakening and global equity markets rallying. But that effect was reversed in short-order as stocks once again turned down in early February and the yen began a strong march higher (finishing the quarter up 7.5% from the close on the day that NIRP was announced). Next up was the European Central Bank (ECB). On March 10^th, the ECB cut rates to 0 and boosted quantitative easing. While European stocks benefited slightly from that move, the euro (as with the yen after NIRP) became much stronger (contrary to the ECB’s intentions). Finally, stepping to the plate on March 16^th, the Federal Reserve lowered its forecasts for the trajectory of interest rates, taking a more dovish stance. This change in stance was likely spurred by the substantial selloff in global equity markets in the early part of the quarter. The currency markets had anticipated this policy change as the dollar weakened and the euro and yen strengthened throughout the quarter.

Fundamentals, Technicals, Sentiment, & Growth

From a fundamental perspective, global earnings for Q1 are expected to continue the global earnings recession. According to Factset, S&P 500 earnings are forecast to decline 9.1% year-over-year. If that is indeed the case, it will be the first time since Q4 2008 through Q3 2009 that the S&P has experienced four straight quarters of year-over-year earnings declines. S&P 500 earnings have declined over 15% from their peak in Q3 2014, yet the market, as of this writing, is only a few percent below its all-time highs, putting the cyclically-adjusted price-to-earnings ratio (CAPE) at the 93^rd percentile historically. Continued buoyancy in stocks may be difficult to sustain should earnings continue to decline.

On the momentum front, despite the strong rally from the lows, medium-term global equity momentum is still fairly negative across the board, with many developed and emerging markets still deep in bear market territory. Further, the S&P 500 has gone more than 11 months without a new 52-week high. Historically, this lack of a new 52-week high has been indicative of the presence of a nascent cyclical bear market during “secular bear markets” (i.e., 15-20 year periods where the market is flat relative to inflation, such as the period we have experienced since the peak of the dotcom bubble in 2000 and which we may still be mired in). During secular bull markets, a lack of a new 52-week high was not an impediment to further equity gains.

As for sentiment, starting in late January, the commercial traders (i.e., the so-called “smart money”) as designated by the Commitment of Traders report had significant net long positioning in equities (relative to their historical average positioning) and the non-reportable traders (i.e., the so-called “dumb money”) had significant net short positioning in equities (relative to their historical average).  Notably, the same was true at the interim bottom in September 2015. During the subsequent rally from mid-February to the end of Q1, the smart-money began to sell into the rally up to the point that now the situation has been reversed: the “smart money” has a net short positioning in equities relative to their historical average position, while the “dumb money” is net long. Such positioning may present a headwind to further substantive equity gains.

With respect to U.S. economic growth, in early February, Q1 GDP was originally forecast by the Atlanta Fed’s GDPNow tracker to be 2.7%. But as of the end of Q1 that forecast had been revised down to 0.4%, which jibes with the generally lackluster economic and trade data emanating from the rest of the world.

Global Allocation & Core Equity

AUA’s proprietary strategies, Global Allocation and Core Equity, both performed solidly in Q1. Global Allocation, a systematic, tactical asset allocation strategy that aggregates market information across multiple factors and frequencies, returned 3.25% while completely avoiding the significant drawdown experienced by the equity markets, as Global Allocation was mainly allocated to long duration U.S. bonds and had virtually no allocation to global equities. Heading into Q2, the equity allocation has increased to approximately 20% of the portfolio, but it still remains significantly underweight equities due to the continued presence of substantial negative equity momentum across global equity markets.

Core Equity, a tax-efficient, concentrated single-stock portfolio of liquid large-, mid-, and small-cap stocks that are selected based on their aggregate attractiveness across factors that have historically provided excess returns (momentum, valuation, low volatility, profitability, mean-reversion), finished the quarter up 2.05%, outperforming the Russell 3000 by 1.15% and the Russell 1000 by .85%.

In light of the confluence of deteriorating global earnings and profit margins, high equity valuations, continued negative momentum across global equity markets, stagnant economic growth, and smart-money selling into the late-quarter rally, we believe it’s prudent to be underweight equities and overweight long-duration U.S. government bonds, which have benefited and will likely continue to benefit from renewed equity market volatility.

 AUA Capital Management is registered as an investment adviser with the SEC. The firm only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.

 All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed. Content should not be viewed as an offer to buy or sell any of the securities mentioned or as personalized investment advice. References to ETFs are intended to show the returns of an index and should not be construed as the performance of AUA Capital Management. Historical performance returns for investment indexes and/or categories, usually do not deduct transaction and/or custodial charges or an advisory fee, which would decrease historical performance results. There are no assurances that a portfolio will match or exceed any particular benchmark.

 Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. Asset allocation and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses.

Global equity markets got off to a rocky start in 2016, while yields on long duration U.S. government bonds fell sharply, as markets began pricing in a possible U.S. recession and a deeper slowdown in global growth. Our Global Allocation strategy was well-positioned for this turbulence, having been significantly underweight equities and overweight bonds since the beginning of August 2015.

The S&P 500 started the year off with a 9% drawdown before rallying in the last few trading days of the month to finish January down only 5% after Japan’s central bank instituted a negative interest rate policy (NIRP). Developed markets (EFA) finished the month down 6% (after having been down 11%), while emerging markets (EEM) finished the month down 5.5% (after having been down 13%).

The bounce in the equity markets coincided with a bounce in the price of crude oil, which rebounded from a 13-year low of $26 to finish the month near $33 a barrel. Small-cap stocks suffered even deeper losses as IWM was down as much as 13% before finishing the month down 9%. China, perhaps the epicenter of the slowdown in global growth as its credit bubble bursts, finished down 13% after having been down 17% mid-month.

Notably, the mega-cap FANG stocks (Facebook +7% in January, but -10% prior to its earnings announcement; Amazon, -15% in January; Netflix,-20%; and Google, -3%), which had held the S&P 500 afloat in 2015, masking broad-based weakness throughout the market, finally showed signs of vulnerability.

Long-duration U.S. bonds (TLT) rose 5.4% in January as the 30-year yield fell from 3% to 2.75%. 10-year yields fell from 2.26% to 1.93%. Emerging market bonds finished flat on the month after being down 2% prior to NIRP.

Gold and mining stocks while up only modestly in January, at 5% and 3%, respectively, have started off February at a torrid pace. Gold was up 10% through February 5th, while mining stocks were up 22%, in what may be the first signs of investors beginning to question the credibility and “omnipotence” of central bankers. Significantly, the NIRP equity bounce has all but evaporated as of this writing. In December, the raising of interest rates by the Federal Reserve along with the S&P 500 just shy of its all-time high was widely acclaimed by the financial press as evidence of a U.S. recovery and that the Fed could justifiably say “mission accomplished.” Now the consensus has shifted to viewing the rate hike as a policy error, with the market now not pricing in another rate hike until November 2017 at the earliest (when multiple rate hikes for 2016 had been priced in just a month ago).

With 63% of the companies in the S&P 500 having reported earnings as of February 5th, the year-over-year earnings decline for the index is 3.8%. Q4 2015 marks the first time since Q1-Q3 2009 that the S&P 500 has seen three consecutive quarters of year-over-year earnings declines.

The profits recession coupled with the ongoing manufacturing recession, equity market selloff, ongoing hard landing in China, and flattening of the U.S. yield curve has brought to the forefront the possibility that the U.S. may be headed for, if not already in, a recession. Various studies have been trotted out on both sides of the argument to bolster or refute the notion. Q4 2015 GDP appears to be tracking in the 0.0% to 0.4% range, while Q1 2016 GDP is currently forecasted at 2.4%

Other macro developments include a continued loss in foreign reserves for China as it sells dollars to defend the yuan from speculators who envision China having to devalue its currency to help stabilize the fallout from the bursting of its credit bubble. And in both the U.S. and Europe, financial stocks are suffering deep losses as poor earnings combine with fears of a global growth slowdown and the effects of NIRP to scare away investors.

In light of the turmoil across the global financial landscape, we are suggesting that clients use the inevitable short-term rallies in equities to continue to reduce overall global equity exposure and increase long-duration U.S. government bond exposure. With earnings decreasing, U.S. equities are still significantly overvalued relative to history despite the recent selloff. Further, the slowdown in global growth and the exceedingly low (or negative) bond yields across developed markets should bolster the attractiveness of long-duration U.S. government bonds.

Our positioning in our Global Allocation strategy remains significantly defensive. We continue to have a substantial underweight to global equities and a substantial overweight to long-duration U.S. bonds. This positioning has only intensified (less equities, more bonds/cash) in recent months as equity market momentum turned negative and we anticipate it will remain that way until equity market momentum stabilizes or turns positive.

This commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed. Content should not be viewed as personalized investment advice. Information presented is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities discussed. References to specific investments should not be construed as being past specific recommendations of the AUA Capital Management, LLC. The returns discussed in this commentary do not represent the performance of the firm or any of its advisory clients.

Past performance may not be indicative of future results. All investment strategies have the potential for profit or loss. Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. Asset allocation and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses. Historical performance returns for investment indexes and/or categories, usually do not deduct transaction and/or custodial charges or an advisory fee, which would decrease historical performance results. There are no guarantees that a portfolio will match or outperform a specific benchmark.

AUA Capital Management, LLC, is registered as an investment adviser with the SEC. The firm only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.

At end of the third quarter, the S&P 500 had its first negative total return quarter since the third quarter of 2012. In addition to having its first negative quarter in three years, S&P 500 returns have now turned negative when measured from the end of QE3 (“quantitative easing” round 3), which concluded in October 2014—giving credence to the argument that in order for equity returns to remain positive the Federal Reserve must perpetually expand its balance sheet (recall that equity returns faltered after QE1, which led to QE2, and after QE2, which led to QE3…)

While the Fed itself continues to communicate its intention to raise rates in 2015, the recent pullback in equities has led to murmurs from some market participants that the Fed should do more quantitative easing. Indeed, Fed funds futures rates indicate that investors are not expecting a rate increase until March 2016 (whereas they had seen two rate increases in 2015 earlier this year). Those economists who see recession on the horizon claim the Fed may have already missed its window to tighten, making this the first economic cycle where the Fed did not tighten even once between recessions.

So where do things stand? On the macroeconomic front there are several interdependent developments to take note of, all driven primarily by what’s happening in China. As China’s growth has slowed and fears of a hard landing have surfaced, estimates for global growth have come down. Commodity prices have commensurately tumbled, leaving many commodity-exporting emerging market countries in dire straits financially, which has precipitated capital outflows from those economies, weakening their currencies. In order to shore up their currencies, those countries have had to engage in “quantitative tightening,” i.e., selling their dollar-denominated assets (for example, U.S. government bonds) to purchase (and strengthen) their own currencies. This suggests that even without the Fed raising rates, financial conditions have been getting tighter—which likely has played a role in the recent selloff in global equities.

From a technical perspective, global equity markets have triggered several negative momentum indicators—falling below various moving averages and exhibiting negative returns over different intermediate-term time periods. Small cap stocks have underperformed large caps in recent months, implying that the current market environment is one of general risk-aversion. In fact, the continued outperformance of the S&P 500 (relative to small caps and global equity markets) belies the recent performance of a majority of the stocks in the market. The former has been held up by a narrower and narrower subset of large cap technology stocks such as Facebook, Google, and Amazon, while many sectors, particularly energy, materials, biotechs, and industrials, have experienced large drawdowns. The number of stocks below their 50-day moving averages is near an extreme. While such extremes tend to lead to higher prices in the short-to-medium term, the negative technical landscape coupled with worsening fundamentals (both macroeconomic and corporate) may not bode well should the Federal Reserve not engage in further balance sheet expansion (yet were the Fed to engage in additional QE without having tightened first, that could seriously call into question the Fed’s credibility).

Turning to equity fundamentals, earnings estimates for the S&P 500 have systematically been coming down for the past two years. At the beginning of 2014, expectations for 2015 S&P 500 operating earnings per share stood at nearly $150. Today, with 2015 almost in the books, those expectations stand at roughly $110. Expected forward earnings growth hovers near 0. In light of the fact that much of the equity market appreciation over the past several years was predicated on a high level of earnings and earnings growth, and expectations for both of these have now been tempered, it would not be unreasonable for markets to reprice commensurately lower.

Further, based on many metrics—whether one is looking at Cyclically-Adjusted Price-to-Earnings (CAPE) or Market-Cap-to-GDP or Price-to-Sales equity markets are anywhere from substantially overvalued to extremely overvalued and thus poised to deliver subnormal nominal returns (ranging from small negative to small positive, i.e., -3% to +5% annualized) over the next 7 to 10 years.
According to the research of John Hussman, the combination of negative momentum, poor market internals, and overvaluation is precisely the type of environment that has led to sharp and substantial equity drawdowns in the past, irrespective of whether the Federal Reserve was tightening or easing.

What does all of this mean for asset allocation? Our suite of equity and bond indicators (which aggregates momentum, valuation, sentiment, breadth, economic, and investor’s positioning signals) is currently suggesting a lower allocation to equities and larger allocation to bonds. While we expect equities to have modest positive returns in the future, the current environment strongly suggests caution in the near term.

This commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed. Content should not be viewed as personalized investment advice. Information presented is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities discussed. References to specific investments should not be construed as being past specific recommendations of the AUA Capital Management, LLC. The returns discussed in this commentary do not represent the performance of the firm or any of its advisory clients.

AUA Capital Management, LLC, is registered as an investment adviser with the SEC. The firm only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.