Is It Time To Yield for A Grexit?

Equity markets faced substantial obstacles during the second quarter (Q2). The optimism that pervaded during Q1 – with international (non-US) markets finally “catching up” to US markets – dissipated during Q2, likely due to ongoing concerns over a Greek default and potential exit from the European Union (“The Grexit”), concerns that Puerto Rico will default on its debt, as well as significant gyrations in Chinese equities. Despite the barrage of bad news on the international front, the S&P 500 Index managed to eke out a 0.2% gain for the first half of the year, with the biggest dip occurring during from 12/29/14 – 1/15/15, down -4.7%. The S&P 500 Index has now gone 914 days without a 10% correction, it’s third longest on record.* Against this backdrop, where do we go from here? Before we look forward, let’s look at how a few of the major asset classes have fared:

  •  US Equity Markets Pre-election years are historically bullish for stock markets. However, given international stressors, it’s not surprising that the S&P 500 Index posted its worst start to a  pre-election year since 1947.  As our clients know, we tend to go by the “weight of the evidence” when making investment decisions – that is, using quantitative models to determine what to buy and when to add to or reduce positions. We do the same when assessing the overall stock market’s health.  One of the charts that we watch closely is a momentum indicator, which looks solely at the price action (“the tape”) of a broad universe of US stocks. As you can see (chart below), the indicator is still at a healthy 68%, meaning that over two-thirds of US stocks across various sub-industries are still trending higher.  One can never apply just one indicator when striving to make “a call” on the market; however, this particular price momentum indicator supports a continuation of the long-term uptrend.

 Big Mo

  • US Bonds The Barclays Aggregate Bond Index, a benchmark used widely to assess the overall US bond market, slipped -1.7% in Q2 and -4.7% for the first half of the year. Long-term Treasury Bonds, which tend to be more volatile than shorter maturity bonds, tumbled even more – down -8.3% in Q2, their worst quarter since Q3 1981.  Yield and associated price action of Long-term Treasury Bonds tend to reflect the bond market’s inflation fears; as such, the sell-off Long-term Treasuries is likely telling us that the bond market is foreshadowing concerns about future inflation.
  • International Developed Markets After the MSCI Europe Asia Far East (EAFE) Index posted its best Q1 since 1998, it prices faltered in Q2 likely due to “Grexit” fears. Despite this, however, the EAFE was the top performing asset class year-to-date with the EAFE Exchange Traded Fund up $2.65 or +4.4%.
  • Emerging Markets Likewise, the MSCI Emerging Market Index was up sharply in April, but gave back most of these gains in May and June.

So, is the weak start to the year a dangerous omen once seasonals kick in – that is, once we move into September and October, when volatility historically tends to pick up? Or is the price action a sign of the market’s resiliency? We believe that, for the moment, caution is likely warranted. From our perspective, not much has changed over the last quarter to make us more bullish. If anything, there has been a deterioration in the outlook, particularly as it relates to international markets:

  1. Uncertainty about Greece Will Greece default on its debt? Will it leave the European Union? While no one yet has the answers, if it turns out to be “yes,” we have no roadmap or history to point to that helps us better understand the potential impact on US and international markets.
  2. Uncertainty about Puerto Rico Will Puerto Rico default on its debt? According to an article on Market Watch titled 3 Things to Know About Puerto Rico’s Debt Crisis, about 60% of Puerto Rico’s bonds are held by traditional municipal bond investors, and the rest is in the hands of hedge funds and other crossover investors.” As the article points out, hedge fund managers may be inclined to sell their positions, rather than taking a “wait and see” approach. This has the potential to increase market volatility if managers decide to sell their positions “en masse.”
  3. China Suddenly In A Bear Market After a meteoric rise, the Shanghai Index (China’s main equity index) peaked on June 12th and by the end of the quarter, had lost over 24% of its value. In just over 2 weeks, the index officially entered a bear market, which is typically marked by a 20% loss.
  4. US Equity Market Valuations The S&P 500 Index continues to be in overvalued territory. The Value Line Price-to-Earnings (P/E) Ratio that we typically reference is still hovering above 19, near historic highs. This indicates that many stocks continue to be expensive.
  5. Uncertainty About US Interest Rates The Federal Reserve continues to take a “data dependent” approach regarding the timing of raising interest rates. Pundits continue to make calls on this, but the fact is, no one knowns. If history is a guide, then the first couple of rate hikes should not be too destabilizing to the equity markets. But as with everything in the markets, there are no guarantees that history will repeat itself – or even rhyme.

Bull markets typically don’t die of old age, and typically “don’t go out with a whimper, but rather a roar.” If some the international concerns right themselves, the market could move higher. Even so, we will still find ourselves with lofty US P/E ratios and the specter of higher interest rates. So, until some of the uncertainty outlined above is resolved, we think it is likely worth yielding for the moment. Our portfolios reflect only a moderately bullish stance. Depending on the portfolio’s risk versus reward objective, each is holding some cash and/or very short-term (low price volatility) bond ETFs.

As always, we will continue to primarily follow the discipline of our models to help us decide when to buy – and when to reduce exposure to the stock markets in our portfolios.

Feel free to join the conversation!

Be well,

Roberta

 

*Source: Ned Davis Research

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