2015: Spring market and economic review

At risk of sounding like a broken record, we don’t put much stock in forecasting the future, but we do spend a lot of time thinking about what might happen to our portfolios. There have been a lot of market gyrations year-to-date in 2015 in stock, bond, and commodities markets. As is always the case, we believe that portfolios that are diversified by both asset class and investment style, together with appropriately sized hedge positions, will be the best vehicle to ride out the markets.

For the first four months of the year, stock markets fell, rose, fell and then rose again. Bond markets followed a similar but reversed pattern. Through the first half of May, most markets continued what they did in April. Those markets that were down are still going down; those that were up are continuing to rise. This pattern is what we call a “whipsaw”, both because the path of the return quite literally looks like a saw blade’s profile, but also because navigating the markets can feel like a violent push-pull. Add the often confusing news flow to the soup and a volatile market cycle can feel quite difficult to navigate.

The main thing on investors’ minds seems to be the Federal Reserve and, more broadly, the action of central banks around the world. In the U.S. interest rates have been held low by the Federal Reserve for a while. We would argue though that once the Quantitative Easing (“QE”) programs ended, the economy has mostly determined the level of interest rates.  We don’t get as worked up as many do about the Fed’s role.

Just a few short weeks ago the investment world was abuzz about the prevalence of negative interest rates. The oddity of negative interest rates are always a fascinating occurrence. Around the world, the most creditworthy countries (Germany, Switzerland) were seeing negative interest rates in their government bonds. We wrote that this was the market’s bet that inflation and economic growth would be stunted for a prolonged period. Just in the last two weeks interest rates on these bonds, and in the U.S., have risen rapidly, and since bond prices fall when interest rates rise, this led to losses for bond investors. Rather than being worried about this, we welcome this development as an indication that the market is functioning normally and setting prices and interest rates on its own. This is what many have clamored for – noisily – for years! And yet, now it is met with hand wringing and consternation. We are not overly concerned. Interest rates rise in response to natural economic mechanisms.  Certainly the ‘adjustment’ of interest rates to their normal level will be a bit bumpy, but we do not believe catastrophic, and our portfolios are positioned for bumps along the way.

Many had expected the Federal Reserve to raise interest rates at its mid-June meeting. However the pace of economic growth slowed unexpectedly in the first quarter – registering just a 0.2% annual growth rate.  According to the recently released minutes of the Fed’s April meeting, the data and even sentiment now seems to indicate that we will not see an interest rate hike soon.

Stocks have had a very, very, long bull run from their 2009 bottom following the financial crisis. In fact, the current bull market in U.S. stocks has not had a meaningful correction since March of 2012. One might say a correction is “overdue”, since we have not had one in a while. The investment community doesn’t have good ways of knowing when corrections are coming.  In fact by definition they are random and unpredictable. Very few predicted a dramatic drop in oil prices last summer.  And very few will accurately forecast a drop in stock prices if and when a drop occurs. KilterHowling of course does not have a crystal ball, but we also cannot afford to sit on the sidelines and wait out a rising market when it is “overdue”.

The only solution we see is to design our portfolios to be adaptable and diversified by asset class (stocks, bonds, etc), geography (we are global) and investment style. Perhaps the most important thing we do is blend valuation-based processes with tactically nimble momentum strategies. That combination has demonstrated not only good downside protection in falling markets, but also the ability to participate in rising markets. If there is one constant tactic on our minds as we manage portfolios, it is this balance of return and risk. If we simply held short government bonds we’d have the risk side covered in spades but earn no return. If we simply chased the stock market upward, we would be guaranteed of earning its return (a simple index fund will do), yet we would have literally no risk controls on the portfolio at all. We believe a blend of these two ideas – risk must always be measured alongside return – is the only way to approach portfolio construction.

KH Portfolios – Global Growth and Capital Preservation – are each approaching their one-year track record. In Global Growth through March 2015 we did quite well from a risk and return perspective compared to the global stock index (ACWI). The whipsaw in the markets in April and into May caught both our managers and momentum strategy a bit flat, as we did not catch all of the upward move. However, our down market controls served us well, and as we continue to be “overdue”, we are happy with our positioning. Capital Preservation also witnessed bond market whipsaws but these brief corrections in bonds were well controlled. The trade-off was more modest participation when the market has risen, but as we primarily focus on beating what is now nearly nonexistent inflation along with limiting any losses, we are pleased with this portfolio as well.

We appreciate your continued trust and interest in our firm, and welcome your feedback and questions. We hope you find this update useful.