Model Portfolio Update
Currency swings are getting more violent, a clear sign of stress in financial markets, as central banks step up their efforts to intervene, all in the name of price stability. Of course, increased currency volatility has been a direct result of central bank intervention. With the Euro -25% in 12 months, systemic risks are rising and a market dislocation cannot be ruled out. Despite the escalating risks, equities continue to trade in bullish mode. In this month's Investor Letter we examine some potential chinks in the armor of the stock market.
The Active Asset Allocator is currently defensively positioned 20% equities / 30% bonds* / 30% gold / 20% cash. (Bonds now include euro government, corporate, inflation linked and absolute return bonds). We increased the allocation to gold in December 2014 from 20% to 30% and gold rallied +20% the following month in euro terms.
Stock Market Update
While stock markets were surging higher back in 2007, three technical indicators were diverging and signalling potential trouble ahead. The Relative Strength Indicator (RSI) and Moving Average Convergence Divergence (MACD) Indicator shown at the top and bottom of the following chart were both losing momentum, making lower highs and lower lows for much of 2007 despite rallying stock prices, suggesting that the underlying trend of the market was weakening. (The third indicator of course is our own Technical Trend Indicator, which forms the basis of the decisions we take in our Active Asset Allocator investment strategy). Both indicators of course proved prescient as stock prices tumbled in 2008.
Roll forward to today and we may have a similar set up. Global stock markets, measured by the FTSE All World Index above, peaked at 286.09 in September 2014, declined in October 2014 and then made a slightly higher high in February 2015 at 286.34. Today, FTSE All World Index trades at 282. Note however, that the technical indicators, the RSI and MACD, are diverging again. Both have been unable to confirm the recent highs in the stock market. If this internal market weakness persists for much longer, we could experience an acceleration in selling in the stock market. Our own technical trend indicator is also only a couple of days away from delivering another "All Market Sell Signal". We therefore remain defensively positioned in the Active Asset Allocator, holding 20% equities, 30% bonds, 30% precious metals and 20% cash.
On a regional basis, stock market performance has varied widely, depending on which currency is used as the denominator. Currency swings are getting more violent, a clear sign of stress in financial markets, as central banks step up their efforts to intervene, all in the name of price stability. Of course, increased currency volatility has been a direct result of central bank intervention. With the Euro -25% in 12 months, systemic risks are rising and a market dislocation cannot be ruled out. Despite the escalating risks, equities continue to trade in bullish mode.
Since January 2014, the clear stock market winner has been the United States, where the S&P 500 (below left) has rallied +15% while the USD has also gained +26%, providing a double win for non-US investors. The S&P 500 chart in euros now looks parabolic in its rise (below right). Currency volatility is distorting the investor decision-making process and leading to mis-allocations of capital. This will not end well.
In addition to the overvalued and overbought nature of the US stock market, long USD is now also a very crowded trade. At some point soon, US equities and the USD will both turn lower and non-US investors will suffer a double hit. We continue to advise caution for now.
Closer to home, the Euro has lost a full -25% of its value in a little over a year, a staggering move (Thank you Mr. Draghi). EU stocks have so far been able to offset those currency losses, albeit to differing degrees. Since January 2014, the Eurostoxx Index has returned +24%, Germany +26%, France +20%, Italy +12% and Spain +12%. If you are a non-Euro investor however, and you have not hedged your currency exposure, your net return from investing in the EU stock market has been, at best, zero.
The rally in the USD (and plunge in the EUR) has been relentless without any kind of correction in over twelve months. I am expecting a "sell the news" event that puts at least a short-term top in the USD (and bottom in the EUR) as Fed Chair Janet Yellen steps up to the microphone and once again announces she will think about raising rates from zero to 0.25%. When stock, bond and currency markets catch on to the fact that the Federal Reserve is trapped there will be hell to pay, but that is tomorrow's news. Today, investors appear unconcerned.
It is interesting to note that, while US and EU stock markets have been ripping higher, emerging market equities have not participated in the cyclical bull market in stocks over the past five years. Emerging markets have been consolidating in a relatively tight range over that time. A break higher would be a bullish development and likely cause us to add an allocation to EM in our Active Asset Allocator investment strategy. For now, we watch and wait.
For more information on our analysis, please get in touch. You can reach Brian Delaney at firstname.lastname@example.org or 086 821 5911.
Bond Market Update
We continue to operate in an environment of low inflation and modest economic growth in the Eurozone, which supports our continued positive outlook for Eurozone government bonds. The ECB is also helping our cause, printing €60BN / month and buying bonds of EU member states in an effort to fulfill their price stability mandate.
Yields on AAA and AA EU government bonds have reached record low levels and have moved below zero for 2 and 5 year bonds in Germany, Netherlands and Austria. We believe there is still scope for peripheral EU bond yields to fall and prices to rise. The performance and asset distribution of the iShares Euro Government Bond Fund ETF in our Active Asset Allocator strategy is summarised below.
Our smaller allocation to EU corporates and inflation linked bonds offer some additional protection in the form of a higher yield for corporates and inflation protection in the index-linked fund. However, these holdings are more short-term tactical positions rather than long-term holdings, as we continue to wait for a lower-risk entry to the stock market.
For more information on our bond market analysis, please contact Brian Delaney at 086 821 5911 or email@example.com.
Gold Market Update
The USD surge (and EUR plunge) has been one of the most violent on record since the Euro started trading on world financial markets on 1st January 1999 (at €1.00 / $1.1743). The Euro is now approaching oversold levels on a technical basis (MACD and RSI) and we should expect a rally in the EUR from here.
Commodities have borne the brunt of the USD rally over the past 18 months but are now trading at long-term support. The CRB (Commodities Research Bureau) Index for example is priced at a -20% discount today to the price it reached all the way back in 1996. Despite the US central bank printing trillions of USD in the intervening period, investors continue to focus on deflation as their main concern.
We are getting close to the inflection point when inflation rather than deflation becomes the key focus for investors. This is why we own gold in the Active Asset Allocator. Despite the correction in 2013, gold (priced in euros) continues to be the stand out performer relative to equities and bonds since 2007. Gold also provides an excellent hedge during difficult, volatile markets.
We increased our allocation to gold in the Active Asset Allocator in December 2014 and caught the +20% surge in Euro gold in December and January. Now that the USD has potentially topped, we are looking for gold to make its move. If we don't get what we are looking for, we cut back our allocation to precious metals accordingly, but for now, we are happy with our positioning and remain patient for gold to show its hand.
For more information on our gold market analysis, please contact Brian Delaney at 086 821 5911 or firstname.lastname@example.org.