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MV Weekly Market Flash: Summer of Misery for Commodities

August 7, 2015

By Masood Vojdani & Katrina Lamb, CFA

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“Every unhappy family is unhappy in its own way.” The opening sentiment in Tolstoy’s great novel Anna Karenina works just as well for commodities markets in the summer of 2015 as it did for Russian aristocratic clans in the 19th century. Every major commodities “family” – from precious metals to energy and industrial metals – is unhappy. And the reasons are quite specific to each. Oil suffers from a supply glut. Copper and nickel feel the brunt of contracting production in China. Gold has lost its luster as a safe haven – nobody went piling into gold during the recent turmoil in Greece, for example.

Oh, sure, there are exceptions to the rule out there in the byways and back roads of the commodities world. Traders put a “squeeze” on robusta coffee futures last month and bid September contracts up to a ridiculous spread versus July delivery. But by and large, it has been a long and hard summer for the global economy’s major physical inputs. The chart below illustrates the shared pain. 

As dismal a picture as this chart paints, it does not even tell the full story. From its last six years’ high point in April 2011, Brent crude oil has tumbled 61 percent. Copper has fallen by nearly 50 percent over the same period, and gold’s retreat has topped 40 percent. Imagine what the conversation would be if major equity indexes had spent the past six years falling on an order of this magnitude. When the S&P 500 gives ground in the high double digits, retirement nest eggs look fragile and the prospect of recession looms large. When oil prices plummet – well, we just pay less at the pump. Good news, right? Not necessarily. Commodities price trends give us important information about the world economy. Right now the news is decidedly mixed.

Awash in Supply

Oil bulls got sideswiped by a steady drip-drip of supply news in July, with accelerating OPEC production dominating the headlines. Saudi Arabia remained firm to its commitment articulated last November to gain share rather than support prices through restricted output. Production in Iraq reached record levels. And the prospect of Iran – holder of the world’s fourth-largest proven reserves – reentering the market after years of sanctions added a further depressive element. Meanwhile, US shale producers still appear mostly determined to power through the downturn and find ways to further reduce their cost structures rather than let up on output.

The China Malaise

The unhappy story told by industrial metals is set in China, which is by far the world’s largest importer of copper, aluminum, nickel and other key metals. Forget about all the eye-popping gyrations on the Shanghai and Shenzhen stock bourses. The really important story in China is the slowdown in growth, punctuated by a sharper than expected manufacturing contraction in both June and July and coming on the heels of forty straight months of declines in the domestic producer price index. Whereas the oil story is mostly (not entirely) about supply, the plight of industrial metals has more to do with demand. And weaker demand from China has hit the export accounts of other emerging markets. It should come as little surprise that the MSCI Emerging Markets index is off by more than 12 percent from its June highs.

All That (Doesn’t) Glitter

Then there is gold. It would be fair to say that the gold bugs who went running for the hills in 2009, worried about the inflationary tinderbox the Fed was supposedly opening with its quantitative easing programs, have not been rewarded for their excessive caution. But at least gold was a part of the “risk off” trade back in 2011 when we had our last really big pullback in equities. Fast forward to July 2015, with Greece once again on the front pages and consensus forming around the idea that a breakup of the Eurozone is a matter of when, not if. Over the course of this month, with Greek banks shutting down and Chinese stocks plunging into bear territory, the price of gold actually fell by six percent. This is perhaps a useful reminder of something we have said from time to time on the pages of these weekly commentaries. There is nothing magical or mythical about gold. It is a commodity, with a price that goes up and down like any other commodity. Lately, the movement has been mostly down.

Trouble Ahead, Trouble Behind

Unfortunately for gold bugs, oil bulls and any other species looking for commodities gains to ring out the year, the road ahead does not look much more promising than the road behind. First of all, neither the oversupply of oil nor the slowing of growth in China look set to end any time soon. Those headwinds are likely to continue. Secondly, those headwinds are likely to compound further still if the Fed goes ahead with its rate program, as expected sometime between September and December. Higher interest rates impose a natural cost on holding commodities – after all, investors do not get any interest or dividend income from storing bars of gold or barrels of oil.  Now, if a rising Fed funds rate signals a faster tempo to global real economic growth, we would expect that growth to translate into higher commodities prices at some point. From where we stand now, though, that “some point” still seems to be some distance away.

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MV Weekly Market Flash: And Now…The Dog Days of Summer

July 31, 2015

By Masood Vojdani & Katrina Lamb, CFA

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Yes, it is already that time of the year. August is upon us, otherwise known as the dog days of summer. This is the season of potato salad, beach volleyball and light-volume trading sessions on equities exchanges. Those light volumes have a habit of cutting short hard-earned vacations as random unexpected events pop into existence and cause exaggerated price swings. Are we due for another August of surprises, or will the relatively benign sideways market that has prevailed for the last seven months carry us gently into September?

Dog Days By the Numbers

The numbers tell us: volatile Augusts are not just another fanciful chestnut of Wall Street mythology. For the last quarter century, August has been the most negative month of the year on average (as measured by the price return from 7/31 to 8/31 each year from 1990 through 2014). The average August return for this period was -1.49 percent versus an average overall monthly return of 0.67 percent. August had two of the 10 worst monthly returns of any month during this period, and five of the top 25. By comparison October, that ghoulishly famous month of tricks and treats, made only one appearance (2008, of course) in the Worst 25 months over this quarter century span (which time period, of course, does not include the carnage of Octobers past in 1987 and 1929). So yes, August has earned its reputation as the month where the best laid plans of R&R go to die.

All Eyes on September

Two years ago, the event keeping investors off the beaches was the “taper tantrum” – the largely irrational spike in bond yields that followed from then-Fed Chairman Bernanke’s musing over a possible curtailing of QE3. Now the chatter is all about the real thing – an actual rate hike program for the first time since the sequence of 17 consecutive increases from 2004-06. The Fed has studiously avoided making specific time commitments even as the consensus forms around a likely increase before the end of the year. Coming into today’s 2Q GDP report, the question was whether the program would start in September or December.

According to the Bureau of Economic Analysis, real GDP grew 2.3 percent in the second quarter. That was slightly below consensus estimates, but at the same time the BEA revised first quarter GDP growth from the previous -0.2 percent estimate to a haler 0.6 percent.  Still, this year’s Q2 is a far cry from the 4.6 percent growth we saw a year ago, also coming off a seasonally challenged Q1. How does this information affect the likely timing of a September rate move? A scan of financial media headlines this morning reveals a healthy dose of “economy bounces back” narratives. We, however, believe that if the needle has moved at all today it has moved closer to a December start.

Time Is On Their Side

What the Fed has said time and again is that it will raise rates when it is good and ready, based on the data, and not before. Inflation remains below two percent, there is still slack in the labor market and capacity utilization hovers in the low 70s. In other words, there is no gun to the head. We believe a 2Q GDP number in excess of three percent would have been the needle-mover closer to a September event, but such was not the case.

Then there are all those other things that could spook the market and cause the dog days to live up (down?) to their reputation. Volatility has been relatively muted throughout the Greece and China dramas of the past several weeks. But if something comes out of left field in the next four weeks and sends the S&P 500 into a five percent-plus reversal, expect that to weigh further still against any moves by Yellen & Co. to move up the starting gate.

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MV Special Midyear Comment: The Current State of the Markets

July 24, 2015

By Masood Vojdani & Katrina Lamb, CFA

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To Our Clients:

We have heard from a number of you over the past several weeks with questions about what is happening in the markets – whether there is potentially cause for concern given some recent developments, and what else may be having an impact on your portfolio between now and the end of the year. In this letter we will share with you some observations that are contributing to our market view and decision framework.

Act I: The Year to Date

For an opening act, let us shine a bright light on what has been a rather unusual several months. In late April, benchmark German interest rates experienced a sudden and unexpected surge of more than 700%. June and the advent of summer brought with it a default by Greece on a loan payment to the IMF, raising the probability of a Greek exit from the Eurozone with unknown consequences. Finally, China’s high-flying domestic stock market got a little too close to the sun and collapsed, giving up more than 40% over the latter half of June before stabilizing as a result of massive government intervention.Yet for all that action, the one remarkable characteristic of US equities during this time has been a distinct lack of conviction. Consider the chart below, which shows the performance of the S&P 500 stock index in the year to date. 

The S&P ended 2014 around a price level of 2080 (indicated by the dark gray dotted horizontal line). Following a very volatile January and then a strong breakout rally in February, the benchmark index has mostly traded in a range in more or less equal distances above and below the year-to-date break-even level. For the last five months, nothing has been able to catalyze a sustained upside or downside directional movement. What is causing this stubborn lack of conviction?

We believe the upside resistance tracks back to a main theme raised in our Annual Outlook back in January: namely, that after a three year run in which stock price gains far outpaced growth in corporate earnings, those earnings were likely to act as a limit on price growth.  The May 21 high water mark for the S&P 500 this year represents about a 4.3% total year to date return, which is not too far away from consensus projections for fiscal year 2015 earnings per share growth for the companies which make up the index. The upside directional headwinds, then, may be mostly about earnings.

On the downside we see a similar phenomenon: there has not been a single pullback this year of a peak-to-trough magnitude of 5% or more, and for the most part the reversals have found support at key technical indicators like the 100 and 200 day moving averages. Now, part of the downside resilience is arguably event-driven – neither China’s stock collapse nor the Greek debt crisis resulted in a worst-case outcome. More broadly, though, we do not see a compelling bear case for US equities. The low likelihood of a near-term recession, along with a sense that the key prevailing risk threats are outside the US, help make the case for downside support.

Act II: The Year Ahead

Keeping to the theme of events impacting market performance, perhaps the most significant development that has yet to play out in the second half of the year is the Fed’s decision on interest rates. This event is of particular interest to diversified portfolios with significant yield exposures – for example to high dividend stocks, convertible bonds and REITs. Generally speaking, exposure to these asset classes makes sense in a world of near-zero interest rates. They have been, and continue to remain, an important part of our asset allocation strategy. Recently, though, there has been a very close inverse correlation between short-term movements in interest rates and the price performance of enhanced-yield assets. The chart below provides one such illustration, showing the year-to-date performance of high dividend stocks compared to the yield on the 10-year Treasury note. 

We believe the Fed is likely to make its initial move on interest rates sometime between September and December, with the timing depending mainly on the growth, inflation and employment data points that come in between now and then. So, it would be reasonable to ask what we are planning to with our enhanced-yield exposures in a rising rate environment.

To answer the question we need to consider the larger picture. Short-term traders are focused entirely on the first rate hike – as illustrated by the above chart – but that is not the right focus for the long term portfolios under our management. What kind of economic environment do we expect to prevail over the intermediate term – in the next two to three years? The base case scenario driving our investment decisions is an environment of low growth in the US and other developed markets, and a continuation of below-trend growth in emerging markets. This scenario envisions a very gradual pace of interest rate increases, with the Fed ever ready to suspend a rate increase program if low positive growth turns flat or negative. We believe that enhanced-yield assets will continue to play an important role in this environment, as yields on high dividend stocks, REITs, Master Limited Partnerships and other similar assets are likely in these circumstances to remain attractive relative to high quality fixed income issues. We also believe that the underperformance of enhanced-yield assets in 2015 is partially a case of “sell the rumor, buy the news”. Once the first rate hike takes place and the world does not come to an end as a result, we expect phenomena like the “dividend-rate trade” to subside.

There are of course many other variables at play that we continue to monitor closely. We will continue to share our thoughts with you as and when our views adapt to evolving market realities.

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MV Technical Market Comment: Greece, Europe and Global Asset Markets

July 6, 2015

By Masood Vojdani & Katrina Lamb, CFA

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Yesterday, Greece’s citizens resoundingly rejected the most recent proposal by the country’s creditors to implement new austerity measures in exchange for continued financial assistance. The size of the “no” vote was a surprise to observers of the situation and leaves Greece’s economic future, and its continued participation in the single currency union, very much in doubt. We continue to follow the unfolding events closely, and are using this Technical Market Comment to share our views and outlook with you.

The Situation As It Now Stands

The most pressing question in the next several days will be whether the European Central Bank (ECB) will continue to provide emergency financing to Greece’s beleaguered banking system. Greek banks closed last week after the ECB’s Governing Council put a cap of €89 billion on its emergency credit line. The ECB is expected to announce sometime after it meets today whether it will increase the amount of emergency funding it provides to Greece. Yesterday’s vote is expected to move sentiment among Governing Council members closer to the hard line position of Germany. The bottom line, though, is that without some form of continued support the Greek banking system could very well be insolvent by the end of this week. This would further extend the pain of the worst economic collapse not related to war that any country in Europe has suffered in the last 125 years.

The ECB will also be a key player in what many EU policymakers see as a more important concern than Greece’s economic future; namely, how to prevent the situation from being a Continent-wide contagion that poses a deeper threat to global asset markets. To help calm nerves the central bank could accelerate the pace of the bond-buying program announced earlier this year. One fact that may temper panic among investors is the relatively low level of exposure to Greece held by other European financial institutions. In a briefing note last Friday, Barclays Bank estimated that the total exposure of all Eurozone countries to Greece amounts to less than 3.5% of the region’s total GDP, and that only a fraction of that amount is held directly by its financial institutions.

Finally, while Greeks voted “no” in the referendum, it remains unclear what exactly they voted for. The majority of polls continue to indicate most Greeks want to remain in the Eurozone. And their support for Prime Minster Tsipras and the ruling Syriza party, whose credibility was enhanced by the referendum, would not be likely to last if the country faces bankruptcy. Early indications are that Tsipras and his team are returning to the negotiating table with renewed seriousness – a position underscored by the resignation this morning of controversial finance minister Yanis Varoufakis. Greece is expected to propose new bailout terms at an EU summit meeting on Tuesday.

Our View and Outlook

We expect short-term asset movements will be largely event-driven and influenced by how alternative scenarios play out. One can never rule out a worst-case scenario, but we do not see such a scenario – involving a viral collapse of peripheral Eurozone debt markets and an ensuing sharp reversal in global equities – as the most likely outcome. The market response in the immediate aftermath of Sunday’s vote has been relatively muted, with most European bourses down by less than 1%, the S&P 500 trading more or less flat, and peripheral Eurozone bond yields up a bit but nowhere near danger-zone levels. Most observers, ourselves included, expect to see negotiations muddle along even as the probability increases of an eventual Greek exit from the single currency.

We do see elevated risks, but we also believe the risks are more prevalent outside the US – not only in Europe, but also in China where monetary authorities are trying to stabilize a sharp pullback on domestic stock exchanges. International sentiment could certainly spill over into US equities, but we would expect any such pullback to be relatively brief and within the 5-10 percent range of a technical correction as opposed to a more sustained structural reversal. Economic data continue to reflect growth, with good consumer activity indicators, a decent (if not barnstorming) June jobs report and expectations for 2Q real GDP growth above 3 percent.

We believe the Fed remains on track to begin gradually raising interest rates as early as September. However, the Fed will not be forced into a rate hike if developments between now and September suggest otherwise. The economy is not overheating, inflation remains somewhat below the 2 percent long term target, and this gives the FOMC plenty of leeway to defer action on rates if need be, while adhering to its dual mandate of stable prices and full employment.

If we do experience a pullback in US equities sometime in the coming weeks, we would be inclined to view it more as an attractive buying opportunity than a signal to take on a more defensive strategic position. In any event, our current action plan is simply to stay disciplined and closely attentive to the situation as it continues to unfold.

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MV Weekly Market Flash: Not Dead Yet: Dividend Stocks in a Rising Rate World

July 2, 2015

By Masood Vojdani & Katrina Lamb, CFA

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It seems like the easiest trade in the world: interest rates go up and the price of high dividend stocks go down. Yield-intensive shares have taken a beating this year, none more so than the beleaguered utilities sector. While the S&P 500 is struggling to stay above break-even for the year to date, investors who took on exposure to high dividends are firmly in negative territory: DVY (the iShares ETF) is down by almost 5% as of yesterday’s close. XLU, the SPDR ETF which seems to have become a proxy for a pure play on the dividends-rates trade, is down by almost 12% for the same period.

As investors contemplate a likely secular environment of rising rates, it would seem sensible to reduce the enhanced dividend slice of a diversified portfolio, no? That approach could be a smart tactical play heading into the fall, with possible rate action on the calendar for the September and December meetings of the FOMC. But with below-trend growth likely to keep interest rates below historical norms for some time to come, we would caution against reading last rites on high yielding stocks.

Opposites Day

In the chart below we use XLU, the SPDR Select Utilities Sector ETF, to illustrate the uncannily tight negative correlation to bond yields that has characterized high dividend shares’ performance so far this year. This chart plots XLU’s price performance against movement in the 10-year Treasury yield.

The 10-year yield rose from 2.17% at the beginning of January to 2.42% as of the July 1 close. The average dividend yield for the S&P 500 utilities sector is 3.9%. Clearly, the negative correlation between rates and dividend shares has little to do with rational expressions of income preference. Traders make use of ready proxies like XLU simply to trade the day’s news on rates. Many algorithms in this trade key off events like FOMC meetings and the monthly release of jobs numbers. For example, the jobs report released back on February 6 contained a number of upside surprises, indicating a healthier than expected economy. On that day the 10-year yield spiked up 7.7 percent, from 1.82 percent to 1.96 percent, while XLU shares tanked by 4.1 percent. Irrational? Sure, but that’s the way of things in short-term trading. This rate-dividend pattern continued to be reliable as interest rates resumed their upward trend in late April, this time with US benchmarks following the unexpected reversal in Eurozone bond prices.

Give, Give, Give

Dividends, of course, are only part of the widely-followed metric of Total Shareholder Returns (TSR), the other and often larger component of that metric being share buybacks. The two often go hand in hand: as companies move off the steep stage of their growth cycle (the famous S-curve), they tend to give increasing portions of their earnings back to shareholders through buybacks as well as increases in the dividend rate. Over the course of the current six year bull market, top-line revenue growth has waned for a growing number of companies across all industry sectors. During the same time the pace of shareholder returns has quickened; companies are set to return over $1 trillion in buybacks for 2015, a record level representing more than 90% of total S&P 500 operating profits.

Critics will note that buybacks are easy in an environment where borrowing costs are ridiculously low. Rising rates could bring the buyback bonanza to an end, which would seem to be one more reason to be wary of overexposure to stocks and sectors with higher than average TSR yields. While we see logic in that argument we believe it oversimplifies the situation.

Quality, Not Quantity

We believe TSR will continue to be an important metric in evaluating the relative attractiveness of shares, but that the quality of TSR programs will become increasingly important. Companies that can meet their TSR goals largely with free cash flow (FCF) rather than tapping the debt markets will, all else being equal, be preferable to those with growing amounts of net debt on their balance sheets. Investors should also be able to see that buyback programs are being used for more than just insider stock and option awards. A good way to track this is by monitoring the number of fully diluted shares outstanding from quarter to quarter. Large buyback programs without a commensurate reduction in shares outstanding are likely going right into the pockets of options-holding insiders, and doing little to benefit outside shareholders.

Bond yields may be headed north from the historically low floor of the past six years. But “lower for longer” is still in our opinion the most likely scenario for the intermediate term. Lower for longer means that investors should continue to place a premium on shareholder returns. Once the short-term frenzy over the first rate hikes settles down, we expect that premium will come back into clearer view.

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