Thursday, October 2, 2014

Equity Market Rout In Context...& Portfolio Implications

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Best, Ed
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On the heels of yesterday’s equity market rout, it’s worth considering the move in context, namely, relative to where the market has been in recent months, and relative to where it’s been over the past couple of years.  The charts below reflect both.
The first chart, showing recent months, is particularly troubling, especially the ‘thumbnail’ on the side that highlights the activity in recent days in which the DJIA broke down aggressively below its recent trading range (note:  the shaded blue area shows and +/- 2 std. dev. range around the previous 20-day simple moving average of prices).

The second chart shows the past two years’ price history.  It’s a healthy reminder of just how far the market has come, and depending on your fundamental outlook, could raise concerns about a major market pullback that would make yesterday seem like a rounding error!!   Conversely, what looked like an awful setback yesterday, might really have been only a small move in the larger context, and along those lines (pun intended), one could also note that several times over the past two years, the market ‘corrected’ (not literally, which would be a 10% move, but more figuratively in the form of a major selloff that broke the uptrend at that time), and each time, the 200 dma (white line) was the support from which the market resumed its uptrend.

Which will it be this time????

We’ll see.

But away from the day-to-day gyrations, the underlying global macro view that I shared in recent missives still stands.  I think a continued pullback in equities is likely, though I don’t anticipate an ‘Armageddon’!  I think the Fed will begin to raise rates in H1 ’15, but only moderately and in slow, measured, well advertised steps.  With all kinds of commodity prices having fallen in recent months, most notably in the energy and agricultural space (see charts below of commodity indexes), and with plenty of excess capacity still in manufacturing and labor, there’s no evidence of prices pressures that should force the hand of the Fed to move more aggressively.

 I think that when bond markets overreact to anticipated Fed moves and, in turn, the bond market sells off hard, it makes sense to consider adding fixed income for a relatively small portion of the portfolio (as we’ve done last week).  On equities, though I am concerned about upcoming earnings meeting expectations and justifying current valuations, I don’t see grotesquely high PEs in general that would cause concern about a broad market ‘correction’ (literally this time, meaning 10%).  I don’t see that.  With the S&P currently at roughly 18x PE, and with companies generally in ‘lean & mean’ conditions on an operating leverage basis and on a balance sheet debt/equity basis, it’s hard to find too many signs of a bubble, except perhaps in small-cap land, which btw, would explain the recent 10%+ selloff from July highs.  

I continue to use cash to selectively buy what appear to be undervalued names in the various themes that drive our strategies, with particular focus on the ‘emerging middle class’ theme keeping our exposure in consumer discretionary and technology quite high.  I’m also looking at EM countries where currencies have fallen in value vs the USD on its recent run-up, and where local currency debt and equities have slipped.  At some point, when the USD tops, those EM local currency bonds and equities could be compelling.

Will keep you posted.


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(Please note: This article is solely meant to be thought provoking and is not in any way meant to be personal investment advice. Each investor is obligated to opine and decide for themselves as to the appropriateness of anything said in this article to their unique financial profile, risk tolerances and portfolio goals).
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