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Market Update and Model Portfolio Reviews 1/31/2018

For the month of January, investment grade domestic bonds were down -1.15%.  On January 26, large cap domestic equities were up as much as 7.55% for the month, before giving back some of those gains to end the month up overall at 5.73%.  Of the 11 sectors in the S&P 500, Consumer Discretionary led the way up 9.34%, while Utilities had the worst performance of the 11 sectors—off by -3.07% for the month of January.

 

Bonds had an incredibly difficult month, as fears over inflation rising faster than expected sent yields higher and traditional bond prices lower.  This continued increase in rates appeared to put pressure on equities after the record closing of the S&P 500 Index on January 26.  Equities trended lower from the recent record high on January 26 through month-end.  This recent selloff appears to be a product of the velocity of rates rising in January as well as animal spirits pushing equities in near term overbought territory. 

 

We are seeing indicators that are consistent with late business cycle behavior, which we believe indicates that we may be approaching a market correction.  We look at indicators that have historically coincided with full business cycles.  All of our model portfolios performed positively for the month of January, though we experienced our toughest month-over-month relative performance to the benchmark.  We are confident that in the one to three year time period we will report back better relative performance, given our fundamental views across asset classes and given our view of the current economic cycle.  Nevertheless, we still want to highlight relative under performance to each model (with the exception of our Ultra Conservative model).  To perform well in the long run, you have to be able to appear wrong in the short run. See our charts below or on the following pages for some of the more commonly understood indicators related to business cycles. 

Our large detractor was our “safe haven” allocation to long duration, which was off approximately -4.27%, while our best performing allocation was in regional banks, which was up approximately 8.09%.  The respective performances of these allocations can be attributed to rising rates.  In order for an allocation to be included in our respective models, the exposure, in our view, needs to do two things.  First, we seek conviction that over a 1 to 3 year time horizon the allocation will have positive results, or relative positive results, compared to similar exposures.  Second, the allocation needs to deliver a diversification benefit to the entire portfolio.  A good example of this is the pairing of the two exposures within long duration and regional banks.  Elsewhere in the portfolio, our relative non dollar asset allocations, such as UK Equities, emerging market local currency sovereign debt, and long the Japanese Yen to Dollar, faired well—up approximately 3.74% for both UK and sovereign debt exposures, while the Yen exposure was up 3.22%. 

References to business cycle data for defining recessions can be found here. See “Model Disclosure” page for important disclosures and information – Period Measured 12/30/2016 – 1/31/2018. Model Performance presented net of highest advisory fee and trading costs.

Late Stage Business Cycle Indicators

 

Output gap eliminated and economy at risk of overheating?

Qualitatively, Yes.

 

Central Bank limits the growth of the money supply?

Yes.

 

Rising stock prices, but increased risk and volatility?

Yes.

 

Confidence and employment are high?

Yes.

Rising short-term interest rates?

Yes.

 

Rising Bond Yields?

Yes.

Inflation Increasing?

Modestly.

Period measured over 1/1/1928 to 2/1/2018 for the S&P 500 price return index.  Historical S&P 500 Index price series compiled from multiple sources by Alternative Capitalis, LLC

Complacency Measured In Volatility

We continue to stress the risk of complacency and the signs of complacency when volatility trends lower.  This chart may seem confusing, but take a look at the red line (the one that looks like a bad polygraph test).  This is commonly referred to as a “fear measure”.  Now, take a look at the black line.  The black line is the price return of the S&P 500 Index.  Before the last recession (note the low of the black line/price return in 2009), we saw a downward trend in volatility (red line/fear measure) before a subsequent peak.  This preceded the largest drop in the S&P 500 Index since the Great Depression.  On Friday, February 2, 2018, the S&P 500 Index experienced the first 2% or greater drop in 511 days.  Comparing historical measures to recent trends, we believe we are in for a more bumpy ride in 2018—if interest rates continue to rise as quickly they have over the past month. 

High confidence and low unemployment can also indicate a late stage in an economic cycle.  As the economy reaches full employment, GDP growth starts to reach full capacity. With employment running at full capacity, there is less slack in the labor force and therefore the economy starts to reach its full capacity.  With full capacity tends to come confidence and renewed spirits of prosperity and wealth. Workforce competition increases and employers generally tend to increase wages as individuals search for higher paying jobs.  The average investor also tends to become the most bullish on the stock market in these later stages.

As the economy starts to reach full capacity and full employment, fears of an overheating economy and higher inflation pushes the central bank to limit the supply of money by selling treasuries and other assets from their balance sheet.  This simultaneously causes rates to rise as the selling (or the markets anticipation of selling) lowers bond prices and increases yields (rates).  Higher rates leads to higher cost of capital for business and consumers alike. Loans and mortgages become more expensive.   

Consumer Price Index for All Urban Consumers. Time Period Measured 1/31/1960 to 12/31/2017

Higher inflation pushes the central bank to limit the supply of money by selling treasuries and other assets from their balance sheet.  This simultaneously causes rates to rise as the selling (or the markets anticipation of selling) lowers bond prices and increases yields (rates).  Higher rates leads to higher cost of capital for business and consumers alike. Loans and mortgages become more expensive. Historically, the components of household debt can drive to different reasons that have caused over leveraging and reduced spending capabilities of consumers (the driving force of the economy).  As example, 2007 was over leveraged in the mortgage space.

In reviewing other analyst commentary, the general theme is that the average household is in good shape.  One of the common issues with averages is that they can be skewed upwards to very financial healthy and wealthy households while overlooking the median of the household conditions.

Although consumer credit as a percentage of households total liabilities is relatively high, it has still been higher as a total component of liabilities.  The issue we see in the consumer credit space is how high the actual percentage of debt is relative to household disposable income.  Since data has begun tracking this, we have reached an all time high for consumer credit debt as a percentage of their disposable income. 

Balance Sheet of Households and Nonprofit Organizations, 1952 - 2017 . Time Period Measured 3/31/1952 to 9/30/2017. Note: Home mortgages also include loans made under home equity lines of credit and home equity loans secured by junior liens. Consumer credit includes credit cards, auto loans, student loans, and other consumer loans. Other liabilities include other bank loans and the liabilities of nonprofit organizations.

Generally speaking, consumer credit is more expensive than mortgage loans. The continued upward trend in consumer credit debt coupled with the highest amount of corporate debt outstanding in history, in our opinion, is a screaming red flag for the business cycle if interest rates continue to move higher. Corporate debt and household consumer credit debt is our 800 lb. gorilla in the room, because slowing growth and rising rates will ultimately hurt consumers and business alike at these elevated levels.


Balance Sheet of Households and Nonprofit Organizations, 1952 - 2017
. Time Period Measured 3/31/1952 to 9/30/2017. Note: Consumer credit includes credit cards, auto loans, student loans, and other consumer loans. Views and opinions are of Alternative Capitalis, LLC and are not intended as investment advice.

Disclosure WARRANTIES & DISCLAIMERS There are no warranties implied. Alternative Capitalis, LLC (“RIA Firm”) is a registered investment adviser located in Chelsea, Massachusetts. Alternative Capitalis, LLC may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. Alternative Capitalis, LLC’s presentation is limited to the dissemination of general information pertaining to its advisory services, together with access to additional investment-related information, publications, and links. Accordingly, the publication of Alternative Capitalis, LLC’s presentation should not be construed by any consumer and/or prospective client as Alternative Capitalis, LLC’s solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation, over the presentation. Any subsequent, direct communication by Alternative Capitalis, LLC with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Alternative Capitalis, LLC, please contact the state securities regulators for those states in which Alternative Capitalis, LLC maintains a registration filing. A copy of Alternative Capitalis, LLC’s current written disclosure statement discussing Alternative Capitalis, LLC’s business operations, services, and fees is available at the SEC’s investment adviser public information website – www.adviserinfo.sec.gov or from Alternative Capitalis, LLC upon written request. Alternative Capitalis, LLC does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Alternative Capitalis, LLC’s presentation or incorporated herein, and takes no responsibility therefor. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. This presentation and information are provided for guidance and information purposes only. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy. This presentation and information are not intended to provide investment, tax, or legal advice.

Model Disclosure

 

Alternative Capitalis, LLC is a registered investment adviser. Information presented herein is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Model Performance Disclosure: The performance shown represents only the results of Alternative Capitalis, LLC’s model portfolios for the relevant time period and do not represent the results of actual trading of investor assets.  Model portfolio performance is the result of the application of the Alternative Capitalis, LLC’s proprietary investment process.  Model performance has inherent limitations. The results are theoretical and do not reflect any investor’s actual experience with owning, trading or managing an actual investment account. Thus, the performance shown does not reflect the impact that material economic and market factors had or might have had on decision making if actual investor money had been managed. Model portfolio performance is shown net of the model advisory fee of 1%, the highest fee charged by Alternative Capitalis, LLC and sample trading costs based on our Custodian’s, TD Ameritrade Institutional, trading costs. Performance does not reflect the deduction of other fees or expenses, including but not limited to brokerage fees, custodial fees and fees and expenses charged by mutual funds and other investment companies. Performance results shown include the reinvestment of dividends and interest on cash balances where applicable. The data used to calculate the model performance was obtained from sources deemed reliable and then organized and presented by Alternative Capitalis, LLC.   The performance calculations have not been audited by any third party. Actual performance of client portfolios may differ materially due to the timing related to additional client deposits or withdrawals and the actual deployment and investment of a client portfolio, the reinvestment of dividends, the length of time various positions are held, the client’s objectives and restrictions, and fees and expenses incurred by any specific individual portfolio. The performance calculations are based on a hypothetical investment of $100,000 for both the model and benchmarks presented.  Benchmarks: The Ultra Aggressive Risk Off performance results shown are compared to the performance of the performance of a blended ETF (exchange-traded-fund) portfolio comprised of the following two ETF’s symbols, SPY & AGG, are described below.  The ETF symbol SPY (SPDR® S&P 500® ETF Trust) which seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index (the "Index").  Visit https://us.spdrs.com/en/etf/spdr-sp-500-etf-SPY for more information about the ETF. The S&P 500® Index results do not reflect fees and expenses and you typically cannot invest in an index.  The ETF symbol AGG (iShares Core U.S. Aggregate Bond ETF). The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market. (the "Index"). Visit https://www.ishares.com/us/products/239458/ishares-core-total-us-bond-market-etf for more information about the ETF. The index composed of the total U.S. investment-grade bond market results do not reflect fees and expenses and you typically cannot invest in an index.  The benchmark is blended representing a weighting of ninety (90%) percent to SPY and ten (10%) to AGG.  Unless otherwise indicated, the benchmarks are not rebalanced to maintain their original weighting.  Instead, they are comprised of the starting allocation and will shift given the prevailing market environment over the period measured.  Return Comparison: Explanation of why benchmark was chosen.  To benchmark the results, the ETF (exchange-traded-fund) symbol SPY (SPDR® S&P 500® ETF Trust) which seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index (the "Index").  The S&P 500 was chosen as it is generally well recognized as an indicator or representation of the stock market in general and includes a cross section of equity holdings. In addition, the ETF symbol AGG was chosen as a benchmark. The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market.  The total U.S. investment-grade bond market was chosen as it is generally well recognized as an indicator or representation of the bond market in general and includes a cross section of debt holdings. For each respective model benchmark the performance measurement weightings are as follows to SPY & AGG: 20/80, 30/70, 40/60, 50/50, 60/40, 70/30, 80/20, 90/10 respectively for Ultra Conservative, Conservative, Moderate, Balanced, Growth & Income, Growth, Aggressive, Ultra Aggressive.

 
The results do not represent actual trading and actual results may significantly differ from the theoretical results presented.