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3D Asset Management: A Squirrely Market: November 2015 Market Commentary

Unless specified otherwise, all performance and market data are sourced from Bloomberg. For all indices, performance reflects total returns which is change in price plus reinvested dividends and/or interest, if any. MSCI index total returns are shown net of dividend withholding taxes.

12/04/2015

November 2015 Highlights

  • Global equities marginally underperformed global fixed income although U.S. equities outperformed all other major asset classes.
  • Market participation improved with small caps outperforming large caps and value outperforming growth.
  • U.S. dollar strength weighed on ex-U.S. asset class performance, particularly emerging market stocks and bonds.
  • Cyclical sectors, led by materials, technology, and industrials, outperformed defensive sectors despite the continued sell-off in commodities and energy.  Financials were the best performer for the month.
  • Within U.S. fixed income, credit sectors underperformed as spreads widened back out after having narrowed in October.  The energy markets continue to weigh on credit sentiment.
  • U.S. macroeconomic conditions continue to decline with weakening manufacturing and business sentiment, poor earnings releases from key retailers, and upwardly-revised 3Q GDP driven by a spike in inventories. 
  • The Fed is expected to raise rates in December although the focus will shift towards the pace of tightening throughout 2016.

Key Benchmarks: Performance and Characteristics as of 11/30/2015

Key Equity

Key Fixed

Squirrelly Market Behavior
A sell-side strategist relayed a conversation he had with a client who characterized the market as follows:

“…the market reminds me of a squirrel attempting to cross a busy street – unsure, wary, jumpy, skittish, and just as likely to a) make it to the other side, b) return to the original side, or c) get squashed by a car.”

Following an

8% rise in global stocks in October (narrowly led by U.S. large caps), it has become increasingly less clear whether bulls or bears are driving current market sentiment.  With both equities and fixed income moving sideways in November (Figure 1), the squirrel is sitting in the middle of the road trying to decide where to skirt to next. Investors, like the metaphorical squirrel, could end up getting squashed regardless of how they are positioned.    Investors running back to the original side (i.e. trend followers) are positioned for further market selling given how much technical damage was inflicted to longer-term trends during the 3rd quarter. Indeed, despite a brief early October rally, many international markets continue to suffer due to a strong U.S. dollar, declining commodity prices, and increased geopolitical turmoil (witness the Paris terrorist attacks and tensions between Russia and Turkey over the shooting down of a Russian plane); hence, the favored strategy for trend followers continues to be overweight the U.S. and underweight everything else (Figure 2).  Yet, global equity markets remain resilient in the face of expected Fed tightening amidst weakening global economic and credit conditions.  Running to ‘cash’ this quarter so far has not paid off.

Figure 1: Flat Performance for Global Assets

Figure1

Figure 2: U.S. Equities Outperform World Markets

Figure 2

For those investors attempting to cross the street (i.e. long-term bulls), the global macro backdrop and risk appetite remain at odds for further market advances.  U.S. markets and the dollar still serve as the world’s safe haven in a period of heightened uncertainty and risk aversion, yet investors are unwilling to exit U.S. equities with the S&P 500 trading near cycle-high valuations at 17.6x forward EPS estimates (Bloomberg) nor are investors willing to drive that multiple even higher.  The current landscape for U.S. equities is mixed at best.  U.S. 3Q GDP was revised up 2.1% from an initial 1.5% reading, but the revision was driven by a massive surge in inventories, which will likely serve as a drag on Q4 GDP as inventory is unwound.  Final consumption and sales were revised down from 3.2% and 3.0% to 3.0% and 2.7%, respectively. The inventory buildup and sales slowdown are now being reflected in various manufacturing surveys (Figure 3), which give the appearance that a slowdown, which started in China, along with a strong dollar are affecting U.S. industrial sentiment. 3Q2015 S&P earnings releases also point to caution.  Factset’s latest Earnings Insight reports that S&P blended earnings declined 1.3% (based on 98% reported companies), the first back-to-back quarters of earnings declines since 2009; revenue has declined 3.9%.  S&P operating margins have also declined to 12.3% from a peak of 13.4% early last year. Granted, much of this decline can be attributed to the energy and materials sector, but earnings releases from department stores and apparel retailers point to increasing headwinds for the consumer sectors.

Figure 3: Declining U.S. Industrial Sentiment: ISM Manufacturing Diffusion Index and Philadelphia Federal Reserve Business Outlook (Available Releases through 10/31/2015)

Figure3

Those investors not wanting to sell U.S. equities but who are parked in lower volatility, higher quality segments of the market also run the risk of getting run over with S&P defensive sectors (utilities, telecom, staples, and healthcare) underperforming the broader market (Figure 4) this month.  Despite the continued poor performance of commodities and energy and impending Fed rate hike in December (Fed Funds Futures pricing in 70% probability), cyclical sectors are outperforming defensive sectors this quarter, led by materials, technology, energy, and industrials.

Figure 4: U.S. Cyclical Sectors Outperforming Defensive Sectors

Figure4

The U.S. Dollar as the Latest Acorn
Markets are acting squirrely because the acorn they’re drawn to is constantly shifting.  In August, it was China devaluation.  In September, it was uncertainty surrounding Fed policymaking (which reversed in October).  This month, it was U.S. dollar strength (Exhibit 5) responding to strong U.S. employment releases, uptick in inflation indicators, and heightened expectations for quantitative easing by the European Central Bank at the December meeting. Interestingly, U.S. dollar strength did not directly impact cyclical sectors sensitive to the dollar such as energy and materials which outperformed in November.   Some strategists now expect the euro to reach parity with the U.S. dollar as central bank policies diverge.

Figure 5: U.S. Dollar Index Spot (DXY) and EUR/USD through 11/30/2015

Figure5

Dollar strength heavily influenced U.S. vs non-U.S. regional performance with emerging markets continuing to underperform the developed markets in both equities and fixed income (Figure 6 and 7). Commodities and precious metals also felt the brunt of U.S. dollar strength (Figure 8).  Commodity weakness spilled over into the credit markets with high yield reversing its October gains (Figure 7).

Figure 6: U.S. Equities Outperform All Other Regions

Figure6

Figure 7: U.S. Fixed Income Outperform All Other Regions

Figure7

Figure 8: Commodities Continue to Suffer

Figure8

Where Does This Leave Us as We Head into Year-End?
So taking stock of current market and macroeconomic indicators, bullish investors can point to the following:

  • Broadening out of market participation with smaller caps outperforming larger caps and value outperforming growth (Figures 9 and 10).
  • Cyclical stocks (particularly industrials) and financials are now outperforming defensive stocks.
  • Consensus forecasts indicate strong earnings recovery over the next two years, starting in 1Q2016. All the poor data is now behind us.
  • Expected Fed tightening in December reflects increased confidence in U.S. economic activity, reaffirming the positive releases in employment and housing.
  • European macro backdrop (Figure 11) continues to improve despite the Paris attacks, Syrian conflict, and Volkswagen emissions scandal.  In addition, Global PMI-Services Indices remain strong.
  • Emerging market industrial sentiment appears to be bottoming (Figure 12).
  • Despite continued oversupply, global energy demand continues to grow narrowing the supply/demand gap (Figure 13) while speculative net short positions in energy futures are at record levels (Figure 14).

Figure 9: Small Caps Outperform Large Caps

Figure9

Figure 10: Value Outperforms Growth

Figure10

Figure 11: Markit Eurozone PMI and IFO Pan Germany Business Climate: Eurozone Business Sentiment Remains Positive (Available Releases through 10/31/2015)

Figure11

Figure 12: HSBC China PMI and Citigroup Economic Surprise Index (EM): Despite Strong USD, Emerging Market Sentiment Appears to Be Bottoming (Available Releases through 10/31/2015)

Figure12

Figure 13: Global Oil Supply/Demand Gap Remains Wide but Demand Continues to Grow

Figure13

Figure 14: NYMEX Speculative Positioning in Energy Contracts: Record Net Speculative Short Positioning Suggests a Crowded Trade in Oil Bearishness

Figure14

However bearish investors can point to the following factors:

  • Negative year-over-year S&P revenue and sales have preceded the last two recessions. Operating margins are also coming off peak levels reflecting a combination of lower volumes, diminished pricing power, and higher input costs (wages).
  • Industrial sentiment is starting to turn south in the U.S.  Companies are increasingly reluctant to engage in meaningful capital expenditure programs.
  • Time is running out for emerging market companies as declining commodity prices continue to pressure exporters.  Emerging market corporate defaults are also on the rise as a strengthening dollar increases the debt burden of dollar-denominated debt.
  • After recovering in October, U.S. credit spreads (Figures 15 and 16) are widening suggesting lenders are less confident in the ‘going concerns’ of many of their borrowers.
  • The Fed is about to make a policy mistake as it seeks to hike rates given weakening U.S. economic activity and wide credit spreads.  With inflation expectations picking up and the 2-10 year term structure flattening (Figure 17), this suggests the Fed is behind the curve in raising rates.
  • Despite underperforming since 2011, emerging markets are not that cheap when you strip out the state-owned enterprises (SOEs).  According to WisdomTree, emerging markets ex-SOE trade at a 15.0x P/E multiple versus 12.6x for MSCI Emerging Markets and 16.2x MSCI EAFE (as of 9/30/2015).

Figure 15: Investment-Grade Credit Spreads

Figure15

Figures 16: High Yield Credit Spreads

Figure16

Figure 17: 5-Year/5-Year Forward Breakeven Spreads (Inflation Expectations) and 2-10 Year Treasury Term Structure: Rising Inflation Expectations and Flattening Yield Curve Point to Stagflation

Figure17

This year has proven to be difficult for many time-tested investment strategies from strategic/alternative beta to signal-driven tactical timing to macro-driven business cycle regime positioning.  December tends to provide a seasonal tailwind for risk assets, but investors heading into 2016 face an uncertain environment marked by the pace of Fed tightening, the recovery in S&P earnings, and the resolution of geopolitical events going into a presidential election year.  3D Asset Management continues to believe in a disciplined and dynamic investment approach as we seek to navigate this uncertain environment.

 

Additional Disclosure Statement
Unless specified otherwise, all performance and market data are sourced from Bloomberg.  For all indices, performance reflects total returns which is change in price plus reinvested dividends and/or interest, if any. MSCI index total returns are shown net of dividend withholding taxes.

More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing sales@3dadvisor.com or visiting 3D’s website at www.3dadvisor.com. The above commentary is for general information purposes only and is not investment advice. The information provided above is obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. The above is neither an offer to sell nor a solicitation to buy and fund or exchange traded product. 3D Asset Management, Inc. is a fee-based investment adviser and is not affiliated with a broker dealer and does not sell or promote funds or ETFs. 3D is also not affiliated with any ETF or fund manager and is free to select any funds or ETFs for use in it managed portfolios or other products.

None of the investment vehicles discussed in this publication are guaranteed in any way and past performance may not be indicative of any future performance. There are risks associated with investing including possible loss of principal. Fund’s focusing its investments on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Indexes are unmanaged and do not incur fees. It is not possible to invest directly in an index. Indexes cited in this commentary are constructed and published by companies not affiliated with 3D Asset Management, Inc.

Below is a listing of index providers and restrictions imposed by those providers. • Barclays Global Indices are a proprietary product of Barclays. Barclays shall maintain exclusive ownership of and rights to the Barclays Indices. • Standard & Poors Indices, S&P/Citigroup Indices. Standard & Poors is a division of the Mcgraw-Hill Companies, Inc. All rights reserved. • All MSCI indices are the exclusive property of MSCI and may not be used in any way without express written permission of MSCI. • Morningstar indexes are a product and property of Morningstar, Inc. • GSCI indices are published and owned by Standard & Poors, a division of the McGraw-Hill Companies and licensed for use by Goldman, Sachs & Co. • All Dow Jones indices are published and owned by Standard & Poors, a division of the McGraw-Hill Companies.

 

 

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