The U.S. Dollar remains a very powerful force.
If you had to point your finger to one instrument driving the bus for all the others, then the U.S. Dollar has to be it. Its strength comes from the weakness of other economies and markets, and the fact that the U.S. is the next major central bank to start raising rates. With no strong headwind in sight, the strengthening dollar should continue to benefit U.S. equities while pressuring the commodity complexes. The good news is that you will be able to fund your foreign vacations cheaper. So check out those travel websites and guides you’ve been saving for that next big trip.
With Q4 and 2015 drawing to a close, let’s look at the major influences:
- A continued strong U.S.dollar leads to…
- Further Commodity pain which…
- Hurts Emerging Markets & resource-based economies
- Credit spreads continue to widen as Energy, Mining, EM credits get pummeled
- Bet on a future Fed hike helping Banks, hurting bonds
- Small Caps started to outperform in November (just reversion or getting strong U.S.$ help?)
- One by one, the giant investment funds are quietly switching out of government bonds, the most overpriced assets on the planet.
- Nobody wants to be caught flat-footed if the latest surge in the global money supply finally catches fire and ignites reflation, closing the chapter on our strange Lost Decade of secular stagnation.
The markets bounced as the world joined together to move against ISIS. If you need any evidence that global equities liked the united front, look no further than Russian equities rising 10% in one week when Oil and Metal prices were down. But while equities rose, foreign currencies, commodities and credit fell in price reflecting further slowing thoughts for the global economy. A strong US dollar should lead to falling commodity prices and, given the large weighting of energy and metals/mining in the credit markets, it should be no surprise that credit spreads continue to widen. The big question is how unlinked can Equity and Credit prices become? It is one thing if 20% of Energy and Mining firms go bankrupt. It is another thing if these industries pressure the other sectors of the economy, especially the banking industry.
Now a bit on the Large Cap Growth Conundrum:
If you go back to 2000, Jim Cramer went on CNBC and declared that funds beating the S&P500 were unimpressive. They had to beat the Nasdaq 100 (tech stocks) to impress him. Of course, that would have led to aggressive allocations and just at the wrong time, as the Nasdaq 100 was cut by 84% in 2001 tech bubble bursting. So trying to chase the hot-dot is not wise. Even a seasoned hedge fund manager looked like a fool.
Morningstar has a portfolio of funds they call the Morningstar Rotation Strategy. They use funds in different asset classes such as large cap growth and small cap value, etc. They also include funds in sectors such as biotech, energy, and health care. They attempt to rotate to hold the “hot” sectors and not hold the out of favor sectors. That portfolio, managed by Morningstar with all their resources and knowledge, has underperformed a portfolio if you had simply put equal dollars into the various asset classes like value and growth and not held any sectors such as energy and health care. The point is this, even a shop with a lot of expertise and resources can’t call the right sectors at the right time.
Investors tend to change funds too often because a particular sector is hot or a particular style is not working. Our observation is that these outflows are often times a function of unrealistic expectations. Investors routinely mistake underperformance as a sign of a bad investment. A portfolio is a collection of assets assembled to achieve a certain goal that is almost certainly not measured over days or weeks. As Yale’s David Swensen has said, “Casual commitments invite casual reversals.” The purpose of a robust due diligence process must be to avoid making such an error. The due diligence process has to ensure that investors know what they are buying, what the return drivers are, and what embedded risk factors exist. Investors must acknowledge that the dips in the growth of a dollar chart may be painful in that moment, but are to be expected. If the initial reaction is to sell when a strategy prints a negative return, we’d suggest re-thinking the diligence process itself, rather than the strategy selected. When looking at a portfolio on a daily basis during times of stress, investors are almost guaranteed to be disappointed.
Any given day, week or month, strategies or assets that are uncorrelated over longer periods can behave similarly to overall market movements, and if risk has increased, the moves will be larger. Ideally, investors will have thought through this possibility ahead of time, which will allow for more level-headed thinking during market turmoil. One’s emotional response to daily moves should be considered when constructing a portfolio. The key is to know that you will have an emotional response in the face of losses, but rather than react, trust that you have constructed a portfolio to be resilient in timeframes longer than a day, week or month. If, as an investor, you find yourself ready to jettison assets after a week, quarter, or even a year of disappointing performance, then you are probably better off holding Treasury bills, as you are almost guaranteed to be selling for the wrong reasons.
My Sports analogy: stick to basic fundamentals. Do a lot of diligence on the basic asset classes, pick the funds with managers that are good at what they do, and let them do it over a period of 7 – 10 years. Change funds when something changes within the fund that you don’t like. Like what? A fund manager change is akin to a coaching change. An analyst change is akin to a quarterback change. As fund managers get older they tend to delegate more decisions to the junior managers so they can spend more time on a yacht, sometimes funds tend to drift out of their wheel house and start to pick “hot” stocks rather than sticking to their core competency. If you monitor those types of things and make wise decisions on the fund managers you choose and change only when the fund changes materially, you will most likely beat 75% of the folks in the market.
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