First quarter market performance was as whippy and volatile as the weather. Unusually cold temperatures in the U.S. not only froze much of the country’s population, but it also wreaked havoc on the quality of economic data, and kept markets on edge regarding how investors should be positioned. Geopolitical issues also rose from the ashes as various emerging markets had currency issues and Russia showed poor sportsmanship and invaded the Ukraine shortly after the conclusion of the Olympic Games.
By the end of the quarter, the markets showed mixed results, with U.S. stock and bond markets logging roughly equal returns, and international markets showing large variations depending on country and region. Commodities appeared to benefit the most from the weather and geopolitical environment, and they bounced to a very strong quarterly return.
A Spring Rebound Coming?
One of the hallmarks of the first quarter was consistently disappointing economic data in the U.S. Normally such an ebb might be expected to produce an abrupt drop in the equity markets, but stocks remained quite resilient and seemed to agree with analyst expectations that the drop in the data was a temporary phenomenon that was primarily driven by the weather. The positive spin from Wall Street was that the market was looking through the short-term valley, and the upside would come with a spring rebound that should unlock pent-up demand as a result of the harsh winter season.
While weather can be a convenient excuse that companies use to try to justify disappointing results, we have to admit that the past quarter was unusually harsh and likely wreaked havoc on the monthly data. We also wonder how much of the deceleration might be coming from a weakening in the Chinese economy. For the moment we agree with the consensus that the data will likely recover as the weather warms up. It is also worth noting that towards the end of the quarter we began to see a number of growth barometers begin to firm, implying that the winter soft patch may be coming to an end.
A Pause Approaching
Our view that the U.S. business cycle doesn’t appear to be taking a turn for the worse is important, because it creates a floor for the market since it implies that stocks will not have to be de-rated for earnings that come in lower than expected. But a good economy by itself does not eliminate the possibility of volatility in the stock market.
In January we postulated that 2014 may contain a pause in the uptrend that would serve as a healthy refresh from swollen valuations. We think we’re fast approaching the zone where the market will be at its most vulnerable for a significant retreat.
What’s the Catalyst?
Trying to guess what catalyst might tip the market towards a pullback phase is always dangerous. In 2002 former defense secretary Donald Rumsfeld articulated a line of thinking about the theatre of war that can also be applicable to thinking about markets. To paraphrase: There are things we know, things we know we don’t know, and things we don’t know we don’t know. Using this framework, we can try and pontificate as to why a market pullback might be in the offing over the next few months.
Things We Know
Here are some things we know that might factor into a pullback over the next quarter or two. It has now been over two years since the market had a 15% correction, and sentiment continues to linger in complacent territory on an intermediate timeframe. While longer-term trends still look solid, some divergences have begun to surface and former market leaders have been struggling recently. The Federal Reserve continues to taper (or slow) their bond purchases, and appears content to wind the program down by year end in the absence of a major economic or market shock. China is the world’s second largest economy, and its growth rate has unexpectedly slowed over the past few quarters.
Seasonally, we are fast approaching the more challenging May through October period, and to compound typical patterns, 2014 is a mid-term election year. Mid-term election years have typically been very hostile to markets starting sometime around mid-April. In addition, valuation has now entered expensive territory, providing less margin for error once a catalyst materializes.
Things We Know We Don’t Know
Credit strains have been rising in China, resulting in the first defaults in the brief history of China’s bond market in the first quarter. We don’t know how many additional defaults might be lurking beneath the surface, nor do we know the impact on the shadow banking system in China. We also don’t know how material the economic slowdown really is, how recent weakness might seep into the global economy, or at what point the Chinese authorities will feel they must start defending growth with vigorous policy initiatives.
We don’t know how the markets will continue to digest Fed tapering as the growth in their rate of asset purchases continues to slow. So far, markets have taken bond tapering in stride, and treasury yields have stayed contained, but will the cumulative effect of less juice eventually create a period of sagging asset prices?
Valuation is a poor timing indicator, and markets often revert past the mean. Today we find ourselves in overvalued territory, but just because markets are expensive doesn’t mean they can’t get more expensive before the reversion towards the average eventually takes hold. So while we are pretty certain that high valuations will dampen future long-term returns, we don’t know when they’ll ultimately matter from the standpoint of contributing to near-term volatility.
There is much more we could write about what we don’t know; for now we’ll leave it at that.
What We Don’t Know We Don’t Know
Perhaps the biggest risk to the market outlook comes from what we don’t know we don’t know. After all, the problems we are contemplating today should in theory be at least partially discounted in asset prices already. The world is a vast and dynamic place that is prone to change, and we’d be naïve not to admit that there are risks out there that are not yet baked into market prices. The late Barton Biggs once termed the risk of the “unknown unknowns” as a bolt from the blue, meaning that sometimes what hits the markets the hardest is the scenario that no one considered. The reality is that when conditions become unsustainable and a market is ready to tip, almost anything could become a catalyst.
Not Getting Overly Defensive
Though we think the markets are overdue a pause to refresh, we don’t think it’s time to fully close the blast doors and prepare for a deeper bear market. There are a number of reasons why the amount of defense that we implement will be kept under control. The first is that we think the U.S. economy has legs, and will get better in the second half of the year. Most major bear markets coincide with recession, so without a material slowdown in economic growth, it is hard to see the pullback getting much worse than something in the 10-15% range.
We also believe that the backdrop for markets is in a secular uptrend, which means even if a correction turns into a mild bear market, it is likely to be much less severe than the punishing cyclical bear markets that took place during 2000 and 2007.
Lastly, we admit that we could simply be wrong in our assessment that the market will correct this year. After all, the longer-term trends that have supported the move higher over the past 5 years are still in place. So, if the global economy resynchronizes faster than we are anticipating, and/or monetary policy settings become even more accommodative at the global level, there is certainly a chance that the market simply marches even higher on improving confidence and earnings. When dealing with macro forecasts, investors who are too certain of their view are effectively wearing blinders.
Portfolio Positioning
During the first quarter we made a number of trades to reduce the amount of equity in our model portfolios and to change the U.S. equity allocation from cyclically tilted to more of a balanced mix of sectors and industries. Given our view that a market pause has a high probability of occurring sometime in the next several months, we plan on methodically paring portfolio volatility to a mild underweight in the upcoming period. To get from point A to point B we will likely employ further rotational trades in equity, fixed income, and commodity positioning. The Holy Grail is to achieve a balance where there are enough shock absorbers in the portfolio to withstand a heavy bout of turbulence, but without overstepping our bounds in case the market has more left in the tank.
We truly believe that what is coming will be a pause to refresh an aging and tired bull market. From that perspective, volatility should be embraced, as it will ultimately translate into cheaper asset prices that can be taken advantage of. Corrections are always scary, but in the end we think a healthy downturn will set up a great buying opportunity later this year.
