February 2016 Portfolio Update

As we close out February, equities appear to be carving out a bottom. The worst may be behind us. The rebound has largely been led by defensive sectors. This means our growth oriented portfolios are lagging slightly behind where I’d like them to be. Obviously, I always want returns to be as high as possible. Once growth sectors join the rally, returns should improve significantly. I anticipate this will happen in the months to come.

When the portfolios are compared to similarly allocated portfolios, our returns are in-line with expectations. If we include returns from last year, we are still on par with similarly allocated portfolios. The one exception is that I believe our allocations have a much greater potential for upside return should the market rally.

Much of our present underperformance was my failure to anticipate the correction and rapid drop in interest rates following the initial Fed rate hike. As you may recall, we finished 2015 with strong returns that were both above benchmarks and above similarly allocated portfolios. I did not know Wall Street was heavily betting on a recession by shorting equities and taking a long position on bonds. While it is purely subjective at this point, I could have made adjustments to the portfolios to mitigate those risks if I had possessed that information.

Going forward, I will build that information into the research I use to manage all of the portfolios. Rest assured I am now updating and reviewing data from the Commitments of Traders report on a regular weekly basis. This data shows the number and changes in short positions over several key indices. I expect this additional data will help me to make more fully informed decisions.

It’s all about the Economy

As I reported last month, Wall Street is betting heavily that our economy will fall into a recession similar to 2008. I find this baffling. In 2008, a severe liquidity crisis caused the market to drop. Today, there is no risk of a liquidity crisis. The one risk I do see is that we are in the midst of a corporate profits recession. I believe much of this is due to a strong and rising U.S. dollar.

Over the past couple of weeks, U.S. economic data show our economy is moving at a reasonable pace with no signs of a recession. In fact, last week the Gross Domestic Product, personal income, consumer spending and core inflation all rose. All of these are signs of a growing economy, rather than an economy teetering on the edge of a recession.

Equity Allocation

Looking at the recent data from the Commitments of Traders report, the number of short positions on the S&P 500, S&P 400 (MidCap index) and the Nasdaq 100 have started to back off slightly. This is good news for equities. As short positions recede, the market should rally.

Volatility, as measured by symbol VIX, is also falling. This is one of the biggest trends investors should really monitor. Falling volatility is usually very bullish for equities. In my opinion, equities would be higher right now except for the large volume of short positions, mainly because volatility has dropped considerably from its earlier high.

If current conditions begin to mirror 2011, the market could be back to its former high in a few months once the short positions back off.

When coming out of a correction there is an occasional delay before growth sectors join in. Once they do, growth sectors frequently generate above average returns. This should allow us to quickly recover. Please be patient. It may take a couple months before those sectors kick into high gear. When they do, I expect to see returns normalize by reverting back to my long-term expectations for each portfolio.

Bond Allocation

Interest rates remain very low. This is a sign of concern in a global recession. What I find interesting is that the 10-year Treasury yield is approximately 1.75%. This means investors are trading their money to earn 1.75% a year for 10 years. The 30-year Treasury yields are approximately 2.6%. Meanwhile, an investor could buy a dividend paying stock with a higher yield and potential for significant upside return over the next 10 years.

It is interesting, because it doesn’t make much sense. These yields make it appear Wall Street has already priced in a recession. After all, buying a 10-year Treasury at 1.75% means the investor believes both stocks and interest rates will fall over the next 10 years.

What does make sense is there are still a large number of short positions on 10-year and 30-year Treasury bonds. This appears to be artificially holding interest rates down. Should those short positions back off, it is likely interest rates would quickly rise over the next few months.

Based on my research, and if those short positions were to back off, I believe the 10-year Treasury yield could rise to somewhere between 2.3% to 2.4%. I believe the 30-year Treasury could quickly see its yield rise to somewhere between 3.1% to 3.2%. If this happens, the portfolios are well positioned to take advantage of rising rates. As I look back at periods when the shorts did recede, rates rose rapidly over the months that followed.

For this reason, the bond allocation remains hedged on long-term interest rates. The duration has been further reduced on all other bond funds to the lowest levels possible. As the global stock markets bottom, I anticipate investors will be quick to sell off safe haven assets such as U.S. Treasuries in order to take advantage of a rising equity market. As bonds are sold, interest rates generally rise.

The Big Picture

Looking at equities, I believe the upside potential far outweighs the downside risks. Some experts say equities could drop another 10% or more. However, as long as the economic data shows the U.S. economy is growing, it is increasingly unlikely the market will see another large sell-off.

In terms of bonds, I believe the upside potential for interest rates is much greater than chances that interest rates will fall further from their current levels. At this time, the portfolios remain allocated for a market rebound and for interest rates to rise. Should the data change and indicate signs of a recession, further changes will be made to the portfolios based on the new information.

Thank you for the opportunity and trust you place in me to manage your money. I appreciate having you as my client and all of the referrals! If you have any questions, please feel free to call or e-mail my office.