BY PWM June 8, 2016
Bottom Line Up Front:Given recent market volatility and the present level of uncertainty among investors, we believe it is prudent to maintain a somewhat larger position than normal in cash or short-duration bonds. Cash continues to be attractive for three reasons. First, with yields on the usual fixed-income options near historic lows, the opportunity cost of holding cash is lower today than before the Great Recession. Second, markets are exhibiting unusual patterns of volatility driven primarily by sentiment: market moves are highly susceptible to each news headline. Given high valuations and profit headwinds in certain sectors, we believe the market is likely to go down 5% before it goes up 10%. Thus, it seems sensible to us to have extra dry powder to dampen volatility and to try to buy on dips. Third, even in a challenging environment, companies can still potentially gain market share, grow their earnings, and increase dividends over time. Identifying and buying them at potential bargain prices is an important tactical advantage.
The Way We See It:The US economy is still expanding at a slow-but-steady pace of around 2%, and the labor market continues to strengthen. The recent recovery in commodities has pushed inflation closer to the Fed’s target rate of 2%. Continuing growth and reduced concerns over too-low inflation may give the Fed room to raise rates for the second time fairly soon, if not before the election, then soon after.
We remain concerned the Federal Reserve’s second and further moves may trigger another run-up in the dollar like the one we saw in the second half of 2014.That said, we remain concerned the Federal Reserve’s second and further moves may trigger another run-up in the dollar like the one we saw in the second half of 2014. That episode caused pain for emerging markets in particular, but it also meant stronger headwinds for earnings at US companies with large non-US operations. What’s going on with oil? Prices nearly doubled from the low of $26 to $50 in three months. US crude production has stopped growing and is expected to decline by 1.6 million barrels per day, roughly 10%, by the third quarter of 2017 from its peak in April 2015 according to the US Energy Information Administration . Short-term supply disruptions in Nigeria, Canada, Libya, and Venezuela pushed global oil production below consumption this month for the first time in at least two years. Despite these developments, we believe oil prices will stay below the $60 level for at least several years for three reasons. First, excess global supply will continue beyond 2017. Second, the new economics of US shale production will limit future prices. US shale producers don’t need $80-to-$100 oil to operate profitably any longer. New drilling and fracking techniques unleashed drastic improvements in efficiencies: today, the cost structure for new shale production is significantly lower as the required capital expenditure per barrel of production has fallen. Third, major OPEC members and Russia will continue competing on price to maintain their share of global markets.
Investing In The Current Environment:We are cautious yet tactical in this environment when identifying opportunities and exercising our buy-sell discipline. Since the end of 2014, the market has been nearly flat [See Chart]. But it doesn’t feel that way. It’s because we’ve witnessed a pattern of volatility with two major check-downs each over 10%. And over the same period, moves in the major stock indices between each day’s high and low exceeded 1% over 30% of the time. We expect these unusual, sentiment-driven market conditions will stay with us for a while because of what’s ahead:
- Brexit, Britain’s June 23 referendum to decide whether to stay in the European Union or not
- The US presidential election in November
- The uncertain path of Fed rate hikes and its potential consequences on the dollar, earnings, and the global economy
Dryden Pence III, CPM®, AIF® Chief Investment Officer | Pence Wealth Management LPL Registered Principal
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For our clients with Strategic Asset Management (SAM) accounts where we manage with full discretion, depending on your individual situation, objectives and type of accounts, we expect to hold slightly higher cash positions. We will deploy excess cash positions opportunistically as we evaluate both volatility and value. In short, we will remain tactical in a market we expect to be volatile. For our clients who hold brokerage accounts, if you are interested in a similar fee-based strategy, please contact your advisor. If you are not yet a client and are interested in learning more about our services, please contact Susan Herman, our receptionist, at 949.660.8777, extension 100, or firstname.lastname@example.org to schedule an appointment. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All investing involves risk including potential loss of principal. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies. The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.