This Week’s Message: Carefully Rising To The Challenge

I gotta hand it to the bulls, the equity market (on the surface* [see supplemental charts below]) remains the definition of resilient! Of course, as we’ve been stating from the moment we became guarded, it would/will be positive trade news that keeps the market afloat.

Over the weekend, China announced that it’s tightening its laws against intellectual property theft; clearly a goodwill attempt at getting a phase-one deal done, which largely explained Monday’s rally in stocks.

Trump’s hesitation to sign the hugely bi-partisan Hong Kong Democracy bill, over concern it’ll hamper trade negotiations, says to me that — at a minimum — the cancelling of the scheduled 12/15 tariff hike is a no-brainer. In fact, politically-speaking, the latter is far less-risky for him. Beyond that, China is steadfast that a phase-one deal will have to include a notable rolling back of existing tariffs. While the Administration has been stubborn in this regard, I strongly suspect that that’s exactly what we’ll see; a phase-one deal that takes the tariff regime back a step or two. A Reuters article over the weekend reported that a phase-two deal, however, is not remotely in the cards until after next-year’s election; according to sources on both sides of the negotiating table. We’ll see…

Considering decent seasonality, the latest warm-and-fuzziness over a phase-one trade deal, and the high probability that the Brexit news will be positive going forward, I can see why for the moment short-term traders refuse to bail; even while most sentiment indicators, futures traders’ positioning, lack of short interest, etc., paint a dangerous real-time setup.

Note; to this point I’ve touched on conditions that, while instructive for the short-run, have virtually no bearing — given the current on-balance trajectory of the macro data — on our longer-term strategy from here.

While it does indeed feel a bit odd limiting (somewhat) our upside potential while the market melts higher, given the fundamental backdrop and the debt picture below the surface (the lowest credits, for example, are getting blown out as I type, while the world remains sanguine), it would be wholly irresponsible of us not to play defense for the time being.

In formulating next year’s strategy for client portfolios — given the very challenging setup — we’ll be notably more tactical than we’ve had to be throughout this bull market. I.e., we’ll be looking to complement our sector weightings by taking modest positions in some more-idiosyncratic plays, like possibly going long the British pound, via FXB (as a soft Brexit is a high-probability event) and possibly shorting junk bonds via SJB (as an ultimate meltdown in high-yield bonds is also a high-probability event), while scaling a bit into GLD (gold). By including positions such as these we can, at least at the margin, enhance our upside potential while potentially reducing risk by diversifying further into non-correlated asset classes. We’ll look to limit each new position’s downside through the use of stop orders, or put options when/where we deem appropriate. 

As for our foreign equity exposure, there are clear divergences in terms of the macro setup when we look at the world country-by-country. Again, given the challenges we — as asset managers — presently face, we’ll not only need to be more tactical in terms of asset classes, but we’ll be looking to add alpha (excess relative return), and reduce beta (relative volatility), by taking advantage of the positives (that we can locate) brewing in certain countries and by avoiding the negatives in others; i.e., we’ll likely add individual country ETFs, when/where they make sense, to satisfy our target foreign equity exposure going forward.

Bottom line: Given our present assessment of general conditions, preservation of principal has become paramount for the time being. Thus, while, per the above, we expect to be generating alpha for our clients through a more tactical, more diversified, approach, each position we take will be thoroughly screened through our now-defensive lens, and individually hedged when/where appropriate. 

Suffice to say that (and in this I am 100% certain!) investors face a far more challenging and uncertain future than they have during the past 11 years — whether they realize it yet or not. On behalf of the folks who place their portfolios in our care, we are 100% committed to carefully rising to the challenge!

Happy Thanksgiving to you and yours!

Supplemental Charts:

PWA Macro Index (current score -10.47):  click each insert below to enlarge…

Avid watchers of our video commentaries will appreciate the bullish technical setups displayed by the daily charts for the two new positions we’re considering; FXB (in particular) and SJB:  

FXB (breaking out of a multi-month descending wedge, with positive macd and rsi divergences):

SJB (potentially bottoming from a multi-year downtrend):

*Here’s some food for thought that supports my “on the surface” comment in paragraph one:

While the major averages race higher, some of the most economically-sensitive sectors can’t seem to match the performance (a classic bearish signal), at least not for now:



Consumer discretionary:


And speaking of junk bonds, the fact that they’re presently diverging from stocks is a potentially-ominous sign; a phenomenon that preceded every double-digit correction during the current bull market:

And, lastly, also on the junk bond topic, per my comment above about the lowest credits presently blowing out, here’s a look at the average yield on Caa-rated bonds vs those rated B-Ba:

That — the Caa’s diverging (to the latest extent) from the pack of higher-rated, yet still-poor-quality bonds — is an historic first. And, frankly, it portends tough times to come (red areas highlight the past two recessions).


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