This article was written on a Florida beach. The ocean, sound of waves and the sunshine are soothing and relaxing, especially considering the blizzard that occurred over the weekend back in the northeast. However, it is hard not to think about the market given the volatilities we had so far this year.
As of last Friday, 1/22/16, the S&P 500 Index was down almost 7%, with the worst performing sectors being financials (-10.7%), materials (-11.2%) and industrials (-8.3%). The best performing sectors year-to-date in the S&P 500 Index are utilities (1.2%), telecommunications (2.4%) and consumer staples (-2.5%).
For investment grade credit, the Barclays Credit Index widened 22 basis points (bps), almost the same as the total spread widening in all of 2015. Financials was a big outperformer in 2015, but not anymore, as it widened 21 bps year-to-date (ytd). Energy has been the worst performing sector so far this year.
For high yield, the index widened 110 bps ytd, compared with 170 bps of widening in 2015.
Looking around globe, German Dax was down 7%, Japan Nikkei was down 10%, and the Shanghai stock exchange index was down 17%. These are extreme moves in a very short time frame. What is market trying to tell us? And how should we navigate this market?
The selloff of Chinese stocks and the yuan is a sign that decades of fixed-assets-investment-led growth is slowly coming to an end. I am tremendously proud of what my native land has achieved in last twenty years. However, I also see how too much of a good thing is not necessarily great. The over-investment has created a lot of over-capacity in the economy. Now, this process is reversing. One major economic policy in China now is "supply-side economy." There is still debate what it really is, but I believe the key is what it is not. It is no longer the traditional "demand-side economy", which is an economy where fiscal spending will be applied to stimulate whenever economy weakens. The government has clearly seen its limit: It increases over-capacity, it increase leverage in economy and it worsens the environment, which is starting to be the top concern of many Chinese.
How this will play out?
I am concerned, just like the market is. The correlation between U.S. markets and Shanghai Index is at all time high now. It is never easy to change a growth model. Throughout history, the first sign of trouble is capital flight. Last year, China had a $300 billion trade surplus, but foreign exchange (forex) reserves came down by about $500 billion. This means $800 billion flowing out of China. This is a big number … even for China. (Current forex reserve is $3.3 trillion)
Looking at the U.S. market, the market stress has broadened this year. Bank stocks and credit performed well last year, but they have underperformed so far this year. Auto stocks are down between 10-20% ytd even when the U.S. is reporting record annual auto sales. Homebuilders are down around 10-15% ytd when many economists are talking bullishly on house formations. My experience is that when market and economists diverge, usually market tends to be right. I am watching to see if this time it’s different.
I have recommended caution and defensive positions since last May. However, at this moment, the divergence in market pricing makes constructing a defensive portfolio complicated.
In history, a defensive position means high quality names (higher rating, large market cap) in non-cyclical sectors (staples, utilities, health care). However, in the last year, we’ve seen a dramatic price divergence between high-quality and low-quality names. Currently, a lot of high-quality names are trading at such rich levels that makes me wonder if the pricing is justified. And a lot of low-quality names are trading at such distressed level that I wonder how much worse it can be. (This phenomenon exists for both equity and credit, but more so in equities.) Basically, do you prefer potentially over-priced high-quality names or potentially under-priced low-quality names? Only time will tell.
There is a research piece out of JP Morgan about a bubble in macro-momentum names. These are all high quality and large cap names. It’s worth a read.
We had a powerful reversal last Wednesday and a nice rally on Thursday and Friday. We have seen this short-covering rally a few times. I don't think this one will change the trend. Oil might stabilize a little, but the worry about China, earnings, and the spillover effect of commodity meltdown are not resolved yet.
Key Takeaway: The market is sending out warning signals … should we stay defensive? How to stay defensive becomes a little more complicated when market pricing between high-quality and low-quality names have diverged dramatically. Cash is not a bad position in this environment.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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