The first half of 2016 has come and gone, to the relief of some and excitement for others. As I have stated previously, the model used by my Absolute Return strategy is a formula that allows me to ignore the noise of the markets and focus solely on relative price behavior. To be clear, I do have a view on other markets and asset classes, which help me in advising on larger portfolios. The purpose of Absolute Return is to used as a core allocation and indicator for wider portfolio construction, helping in the timing of “Risk On” and “Risk Off”.
The first half of the year has been marked by a clear leadership in commodities, more specifically, precious metals. Silver, reflecting its more volatile nature, is up 43.67%, while Gold is up 26.82%. Platinum has always been recognized as a true hybrid metal, has joined the race upwards, with a gain of 19.16%.
In the equity and bond space, nothing beats the S&P HY Dividend Aristocrats and US 30-Year Treasury, up 14.13% and 13.24%, respectively. This performance can be simply described as a “search for yield”. The S&P High Yield Dividend Aristocrats is comprised of companies within the S&P Composite 1500 that have maintained a policy of increasing dividends every year for at least 20 years. The reported trailing P/E of this index is 21.85x, the P/Cash Flow is 26.04x, P/B is 2.51x, and P/Sales is 1.5x. The ratios seem high, but when you realize that the fact sheet states that this data is as of September 2015, it begs to question if the real ratios are more inflated today.
Ready for a surprise? The next two graphs are of the Price to Earnings ratios of the S&P 500 and the Nasdaq 100. Which has a cheaper valuation? The answer is quite clear, suggesting that investors are chasing possible future returns in the wrong index.
If the Leading Index of the US is any indication, activity in the US is not expanding, it is relatively flat since 2010 and trending downwards since 2014.
If the US is in a slow churn sideways, or slowing down, the rise in equity valuations, especially those generally accepted as “Value Stocks”, is concerning.
These concerns are reflected in other indicators. The TED Spread has been suffering from heightened volatility since mid-2015.
Not to be left out, the spread between the UST 30-year bond and UST 2-year bond continues its march downwards, signalling a flattening curve. We all know what that means. A flat, or inverse curve is a sure-fire indicator of recession and impending losses in equities.
Many macro signals are pointing to heightened risk awareness in the market and it makes no sense to chase yield in equities, especially when their valuations are looking stretched.
As if the world didn’t need additional themes to manage, the UK referendum held on June 23 resulted in a close vote, 52 to 48 in favor of leaving the EU. Since then, currency volatility has risen in GBP, EUR and JPY. Brexit has birthed a real EU existential risk, whether it be by future referendums or possible bank implosions. Deutsche Bank and Credit Suisse are giants, but are indicating huge dislocations in the EU banking sector. DB has a market cap of $19.22 billion, but has exposure to $46.53 trillion in derivatives.
To put this into perspective, as of the end of March, the total notional value of global OTC derivatives is futures and options reached a total of $492 trillion at the end of 2015. DB’s share is 9.5% of the global total, yet it has assets of only $1.9 billion, 11th largest in the world. According to the Office of the Comptroller of the Currency (OCC) of the US Dept. of the Treasury, at the end of the 1Q2016 the total notional value of derivatives in US banks was $192 trillion. At the end of the 3rd quarter of 2008, the notional amount of derivatives held by US commercial banks was $175.8 trillion. So, in spite of the forced downsizing of bank activities to reduce risk, the amount of exposure to derivatives has risen.
Now take a look at the total notional value of futures and options traded on global exchanges (in millions):
And now look at total notional value of global OTC derivatives (in millions):
After looking at these two graphs, it leads me to believe that exchange traded derivatives is becoming a commonly accepted asset class for everyday investors, a class that was once dominated by institutional players, who now see their exposure forcibly reduced due to more stringent regulations. Warren Buffett famously stated in the 2002 Berkshire Hathaway annual report, “In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” In a sense he was wrong, we assume that banks, with all their computing and risk management might, are able to use derivatives wisely. In another sense, Buffett was absolutely right: weapons in the wrong hands can truly become destructive.
Now seems like a great moment to recommend you read today’s Weekly Market Comment from John P. Hussman. In it he summarizes the difference between paper wealth and value. He states that the change in total market capitalization, such as the one we saw following the Brexit vote, is not what investors should be afraid of, nor should it be indicative of “value”. Instead, it is best to focus on the ratio of Total Financial Assets / Disposable Personal Income. He posits, quite successfully, that this ratio is near all time highs and reflects extreme valuations. Then he goes on to invert the historical graph of this ratio and superimposes it on the subsequent 12-year S&P 500 nominal annual total return.
Say what you will, but I believe this pretty much makes my point when I say that world financial markets are teetering on a precipice and it looks like it is a long way down.
Regarding my model, it would be nice if I could incorporate Gold and Silver into the strategy, but it is difficult since they reflect much more than “Risk On” or “Risk Off”. They both serve as a hedge against inflation and/or heightened risk awareness. It is important to remember that, ideally, inflation is a good indication of expansion and it could move inversely to US Treasury yields. Unfortunately, we are passing through a scenario where, in my view, inflation in some corners is transitory at best. I am more concerned about valuations and monetary policies that may very well upset the entire table. Among the risks to bond bears and equity bulls are Chinese Yuan devaluation, Japanese Yen destruction, Euro Zone slow implosion. All of this on top of the remnants of the commodity crush that we have seen in oil, copper and iron ore. The full effects of the slowdowns this has initiated around the world is taking a long time to show in credit. The time to pay the piper is near. Unless I am proven wrong, the Absolute Return strategy should continue to be an excellent indicator and core allocation for those who prefer to sleep well at night.