INSIGHTS

On August 01, 2016

AAM Viewpoints - Skepticism Reigns Over Optimism

At the beginning of this year prospects for the financial markets looked pretty bleak. “Recession” was the word on everyone’s mind as equity markets failed to register any significant gains in 2015. For many asset classes 2015 was quite simply a bear market. Our own prognostication noted that we were likely at the end of a bear market in materials and energy that had raged on for over four years. We noted that the road ahead for business globally was getting much easier. Central banks globally were flooding the markets with reserves at the expense of bloating their own balance sheets. We surmised that the dreaded recession would not come and that energy and materials were actually showing signs of bottoming. We suggested that with a global environment friendly to business growth, plenty of liquidity and a steep yield curve that we would expect higher asset prices both here and abroad in 2016.

Fast forward to July when the S&P 500 continues to notch new highs. There has been no recession; however, the fear of one is still being spoken about constantly on the business networks. In fact, this bull market continues to be the most hated in history. Cash on the sidelines in equity mutual funds is reported to be the highest since 2001. So, we are seeing new highs as Wall Street analysts continue to warn of an oncoming rout. Consensus is bearish, yet the markets continue to be bullish.

During the first half of this year we have seen a rather odd list of winners. We have seen a nice bounce in oil, materials, precious and industrial metals. The countries responsible for production of these commodities have also put in a nice performance. Along with energy and materials we have also witnessed a huge run-up in consumer staples and utilities. Generally, we think of higher prices in real assets to precede an increase in demand; a precursor to growth. On the other hand, we think of rising prices for soap, soft drinks and utility companies as being defensive. Those are places where money hides as those industries tend to survive economic downturns better than others. So, what is the story here? Are markets topping out or are we just entering the next leg of a very long bull market?

Our take here is the latter and not the former. A broad bottoming for energy, metals and materials suggests that the long four-year bear market is finally coming to an end. Remember, low input prices are very stimulative to economic growth. Also, future supplies of depleting resources have not been funded and replenished given that current low prices makes digging for more supply unprofitable. That is what we have seen in the oil patch, in copper mining, iron ore, coal and the list goes on. As we have seen prices turn globally for these items, we believe it signals future growth is on the horizon. Many argue that on a price-earnings basis, energy and materials are very expensive. We would argue that they are incredibly cheap. Looking at a chart of most any of these companies reveals they are selling at a mere fraction of their historic prices. Stock prices tend to move well ahead of future revenues. We think this is a normal start to a new economic growth cycle which will benefit energy and materials along with the emerging markets that produce them.

Looking at the other side of the ledger, consumer staples and utilities are at or close to record prices and valuations. Bond valuations are at all-time highs. Recently, Bloomberg reported that over $13 trillion of global bonds are now owned at negative yields. Yes, that is guaranteed loss of principal. When asset classes enjoy record demand when the future expected returns are at record lows, we normally refer to this as a bubble. Yet, there are many who urge people to crowd into these reward-less assets at a time when these markets guarantee you will lose money. If you are in the recession camp then these are areas that might be friendly to you. History might suggest you take a different route. Global central banks are busy daily printing new currency and buying assets. They are intent on creating inflation. They have unlimited tools but a limited attention span. History shows that sooner or later this behavior will produce inflation. Inflation is a bondholder’s worst enemy. Ignoring obvious risks in any investment is highly likely to lead to trouble. Is it obvious today? We think so but the waves of buying continue. We think this could end badly.

The arguments against this expected next leg in a long bull market can be compelling but not necessarily logical. Many argue that this current bull market is already longer than the average length of prior bull markets. Well, that is true; however, markets don’t die of old age. Markets turn down when earnings shrink. We have seen a bit of earnings slowing, however, none of the signs that would normally be evident at the end of a bull market. Sir John Templeton is often quoted as saying, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Where are we now? I would argue that with the abundant warnings, flight to buy bonds at the lowest yields on record and highest level of cash in mutual funds since the beginning of the bull market in 2001 that we are still firmly in the growth part of this cycle. There are no signs of euphoria. There are little signs of optimism. There are, however, abundant signs of fear and skepticism.

Are we in for a correction? The answer is always “yes.” Healthy bull markets are always marked by intermittent pullbacks. Are we due for one? The answer is “yes.” When will it happen? That we just don’t know. Pullbacks tend to remove the weak-handed investors and actually provide the skepticism for prices to move higher. “Brexit” (Britain’s departure from the European Union) days really do help. Those events are uncomfortable but they provide the dip in prices that will cause weak hands to sell.

So, what does that mean for asset allocation models? We fashion ourselves as “value investors” and believe that there is still significant value in these markets. We have spoken about energy and materials which we really like and would suggest they will continue to normalize. We think that the precious metal rally will continue as it provides the best defense against central bank fiat currency binge. We like Europe and Asia as we think they are about two years behind the United States in their recovery. Their asset prices present a significant value. We believe that for those who don’t mind a bit more volatility that emerging markets are well levered to the rising demand for real assets. We don’t see them at the beginning of a bear market, but rather at the end of one.

What don’t we like? We don’t like assets that are priced historically expensive. So, consumer staples, utilities, and long duration bonds would be on the list to which we would under allocate. We are not suggesting that investors drop these asset classes, just underweight them. The most important lesson we can point to here is that investors should never try to time the market. We believe time in the markets is more important than timing the markets.

We think that the remainder of 2016 will be friendly to equities. We believe that the global environment is very friendly to economic growth. Unanimous global central bank support for growth and inflation should lead to prices that should end the year much higher than they began the year. We believe that we are in the later stages of a secular bull market. But as with most bull markets, the most prolific returns are at the end of those cycles. When skepticism gives way to optimism and optimism gives way to euphoria then you might want to revisit your equity allocation. Until then, we believe that you should remain calm and remain fully invested.

CRN: 2016-0705-5448 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.