If ever I have seen a VUCA (volatile, uncertain, complex, and ambiguous) market, it is this one. We not only have extreme market volatility day to day, we have it within each day too.
This past week's performance was a prime example of volatility and uncertainty: up 150, down 150 and so on and so forth only to end virtually flat for the week. Who knew what to believe? You needed those core beliefs to guide you and act as your North Star.
When asked by Bloomberg News two years ago why I decided to return to managing money, I responded "to prove investing was the only way to create wealth, not trading." Their follow up question was "what is wrong with the market today"," and I responded, "there is too much news." To this day I fully support that view.
I do not see evidence of core beliefs-a compass informed by values and belief systems with conviction. Seems everyone is trading.
Let's face it, extreme volatility influences all of us even if you are a seasoned investor with a proven decades long track record who hold to core beliefs about this market today.
Personally I try to take advantage of excessive market volatility by trading around my core positions at the edges. For example, if a normal position is 100 shares, I may sell 10% if there is a rapid, sharp move to the upside and parenthetically I may buy an additional 10% if there is an extreme move to the downside. In the end, this strategy may not add much to performance but it gives me a better feel for the market and specific stock dynamics. I always maintain my capital allocation and risk management while utilizing this investment tool.
The Fed note of its prior meeting became public on Wednesday and was the key event of the week. I wrote a blog immediately afterwards titled "Fed Should Not Raise Rates Now" in which I discussed that the U.S and global economic landscape remains on a slippery slope and it is better for the Fed to hold off longer before raising rates as risks remain to the downside. Notwithstanding, the key message from the Fed notes was that a rate increase was on the table for June, naturally data dependent, and the markets reacted quickly with the dollar rising, commodity prices falling, the yield curve flattening and the stock market falling as risk was taken off the table. Was the Fed attempting to get ahead of the market and gain some credibility even though recognizing that it may be a bad decision as was the one made in December? Does the Fed really want to see a flat or even inverted yield curve? I surely hope not.
Let me state for the record. The Fed fund rate needs to be normalized over time however now is not the time to raise rates as the global economic environment including the U.S. is just too fragile and the ripple effect across all markets and regions could be very disruptive if the Fed prematurely moves again. Does the Fed want to slow the one economy that is right now the engine of the world? Let's hope they do not.
That brings me to the G-7 meeting held Friday and Saturday. While nothing tangible came out of the meeting; no surprise there, finance chiefs reiterated concerns about a lack of growth, their desire for more government stimulus, risks of terrorism, cross border tax policy, the negative impact of Brexit and finally reaffirmed their prior pledge not to deliberately weaken their currencies. Finance Ministers Taro Aso of Japan and Secretary Lew of the United States seemed to disagree on whether the rise in the yen was orderly or not. If the Fed hiked rates that boosted the dollar, would that be considered an overt move of the U.S to manipulate its currency and would that comply with the G-7 understanding not to make any overt moves to influence currencies? Interesting!
Let's quickly review key data points around the world:
As anticipated the U.S economy is bouncing back from a weak first quarter and we anticipate growth of around 2.5% in the second quarter led by the consumer. Data points reported last week included: industrial production rose by 0.7% in April, the biggest one month gain in 17 months; factory output grew by 0.3%; housing starts rose 6.6% from a month earlier; average weekly earnings adjusted for inflation rose 0.2% in April; and the CPI jumped 0.4% including food and energy and 0.2% excluding them after rising just 0.1% in March. Energy prices jumped 3.4% in the month including an 8.1% increase in gasoline prices. We expect energy prices to continue to increase with the price of oil, which should be capped at $55/barrel at which point shut in shale production becomes economic, once again and will quickly come on stream limiting any further price increase.
We maintain our view that the U.S. economy will expand at the lower end of our long standing band of 2-2.5% for 2016 unless the Fed does something foolish which will scare business executives and consumer as occurred in January after the December hike.
There was no major economic news out of China and the Eurozone this past week. Japan reported a surprisingly strong first quarter, up 1.7% on an annualized basis, due in good part to Leap year, which added one-day to the calendar. Dollar weakness has made it easy for the Chinese central bank to stabilize the Yuan as it is tied to a basket of currencies, which all had strengthened. But, this could change if the dollar rally continues. China, Japan and the Eurozone count on exports to boost their economies, as it is a greater percentage of their GNP than here so if global consumption is weak, so will exports which will suppress their economies. Did you know that China has increased its share of global trade over the last 6 months? Think about that for a moment! China has slowed in good part due to weakness overseas. The leaders of the world need to focus on policies to increase demand, employment and wages. We need financial, regulatory and tax policy changes and we need them now!
Dollar strength is good for our global competitors as it boosts their growth while hurting us while and the reverse is also true. Remember too that most commodities are dollar denominated so a weaker dollar boosts commodity prices and vice versa. So watch the Fed, as it will clearly influence the dollar, which impacts interest rates, currencies, regional growth and commodity prices. A successful manager must understand the inter-relationship between all these variables and how it impacts all markets.
Oil prices have been boosted by supply disruptions and output cuts offsetting a large increase in Iran's production. I still believe that we remain in an oversupply position, which will come into balance by the end of this year, or early 2017 as global demand continue to rise. Prices should be capped at $55/barrel at which price shut in shale production becomes economic and will begin coming back on stream. U.S production has declined by over 1 million barrels per day over the last year, which is easily reversible without much incremental cost.
Let's wrap this up by saying that there has been very few changes in our core beliefs, the stock market is statistically undervalued, monetary supply continues to increase more than demand, interest rates will stay surprising low, the industry disruptors are impacting many industries, current inflation and future inflationary expectations, M & A remains strong across all borders, new issues and private equity continues to cool down, investor pessimism continues to increase, and markets normally rise on a wall of worry.
We maintain a portfolio of 40 stocks that are all best in class, have superior management, are generating significant free cash flow, have dividend yields over 3% which will increase this year and are going through positive change to enhance their future global competitive position and returns which will lead to a revaluation in multiple over time. Our portfolio also is full of internal hedges to limit risk and is incredibly liquid. Needless to say, we continue to outperform all averages.
Finally, the upcoming Presidential election will have even more of an impact on the financial markets as we draw closer to November. I now believe that Donald Trump has a better than 50/50 chance to beat Hillary as the disenfranchised, disenchanted Bernie Sander's Democrats may cross over and vote for him. I have personally known Donald Trump for over 20 years and feel that he will do what it takes to get things done through negotiation reminiscent of Ronald Reagan. Don't dismiss Trump nor believe that he expects to win all or even on some of his more extreme positions. It's his beginning bargaining point. Change in DC is needed!
Remember to review the facts, step back to reflect before acting, consider first asset allocation and risk control, then do in-depth research on each investment and...
Invest Accordingly!
William A. Ehrman is managing partner at Paix et Prosperite LLC.