Month: July 2016

General Market Commentary

This has been a very volatile year for the markets so far, and the uncertainty of potential Federal Reserve interest rate increases and presidential election issues remain to year’s end. The stock market had an impressive rally after the sell-off from Brexit fears, creating new highs for stock market indices. The S&P 500 Index has broken out to new highs, while the small cap Russell Index still lags. High yield bonds have also broken out to new highs, which is a favorable development, since their performance usually confirms the market direction. With earnings season approaching, improved earnings may provide the fuel for further gains ahead.

According to Sundial Capital Research, which projects probabilities for financial markets, the upside probabilities over the short term are less favorable, but are much better for later in the year (click chart to enlarge).

Leveraged High Yield Bond History

Managing high yield bonds has been Spectrum’s core investment strategy since offering investment management services in 1988. We have seen about every scenario possible—war, the great recession, over- and under-valuation, and have had experience in all of them.

We understand bonds, and consider them predictable, since we have observed them for over 10,000 days. There are times when it is good to own them, good to stand aside, and even times to consider borrowing money to own more for short periods of time when “the wind is at your back”.

If we can borrow money at 2% and purchase bonds that yield 7%, we can make a net gain of 5% in addition to the 7% bond yield. This is called “carry trade”. However, we need to have liquidity to exit these positions when they are no longer in an uptrend. Since all the funds we use have daily liquidity, we can use this strategy when appropriate without having to ride out a serious decline.


Chart above illustrates cumulative returns on a quarterly basis assuming a $100 initial investment from June 30, 1996 through June 30, 2016, net of fees. Performance calculations are based on actual client accounts having dividends reinvested, no purchases or withdrawals during the period, and may have been obtained from personal or related accounts. The Leveraged High Yield Bond Strategy fee is .63% from 12/31/10 to present, 0.625% through 12/31/2009 and 0.75% prior and is reflected in the calculated performance. The initial commission on funds is not taken into account but could reduce performance. Some performance may vary due to fund restrictions and/or limitations imposed by the mutual fund families. Past performance does not guarantee future results. Current performance may be lower or higher than data quoted. Investors should obtain the fund prospectus and read it carefully to evaluate the fund's investment objectives, risks, charges, and expenses before investing. The High Yield Blend Benchmark uses the Barclays US High Yield Very Liquid Index from present back to 12/31/2010, then Lipper High Current Yield (provided by Lipper) back to 12/31/1989.

The charts above and below illustrate Spectrum’s actual performance of this strategy for the past 20 years. If we had to use only one strategy, this would be it, since it has produced double digit returns in all kinds of markets with modest losses. The chart below shows a 12-month rolling average for every quarter, with substantial gain potential while minimizing losses. An investment of $100,000 in 1996 would have grown to almost $900,000 for an annualized return averaging 11.67% over the 20-year period. Some of these strategies are also used in Spectrum’s new Low Volatility Fund.

Presidential Election Year Market History

If the presidential election year returns for the past 60 years could be averaged, the gain for the S&P 500 would be 6.6% as illustrated on the chart below.

The graph reveals that the market tends to improve as the year progresses, but often experiences softness toward the end of summer, leading up to Election Day. Gains usually resume once the uncertainty of the election is over. However, 2016 has been anything but an “average” election year with abnormal major market volatility. According to the chart below several trends can be observed:

In most cases, Presidential Elections are positive for the market.
Presidential election years can be more volatile, but that has not determined the outcome.
When a bear market was not on the radar, a strong rally emerged as the year progressed.
Most market gains were concentrated in the second half of the year.

This blog contains excerpts taken from the July 2016 edition of The Full Spectrum newsletter. To continue reading please download the full copy here: The Full Spectrum: July 2016

Disclosure

Spectrum Financial, Inc. is a Registered Investment Advisor. The Full Spectrum is published quarterly for its investors and account executives. This publication is not intended to offer or solicit investment advice, nor should anyone act upon any suggestions made herein, without individual counseling from your account executive regarding risks involved. There is no guarantee that the recommendations of management will prove to be as profitable in the future, as they have in the past. The information presented in this issue has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. A copy of Spectrum’s current written disclosure statement discussing advisory services and fees is available upon request. All rights reserved, please notify when quoting.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Spectrum Financial, Inc. in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Spectrum Financial, Inc. expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. For full disclosure please see disclosures page here.

Brexit and Active Management

By Christopher P. Hendrix, CMT

On July 1, 2016

In Market Research

Stock markets around the globe reacted by moving sharply lower on Friday, 6/24/16, and again on Monday, 6/27/16. Chart-based or technical analysis-based investors point out that chart patterns and indicators often give warnings ahead of declines. In some cases, however, declines can be swift and without warning. In most cases, these are initiated by news events in which there are very low probabilities of foreknowledge by even a small number of individuals.

Low probability news events can be labeled as “UFOs” or “Unforeseen Fundamental Occurrences”

Terrorist events and natural disasters are the most common “UFOs”. Interest rate changes and currency devaluations can be surprises but in many instances, some clues may be present in price action ahead of the actual event. In many cases, dates of certain news events are known ahead of time but the outcome may be a shock to market participants. Examples of this would be scheduled economic releases, including Federal Reserve policy announcements, as well as earnings releases from major companies. Most recently, the vote for Britain’s possible exit of the European Union was known, but the actual result of the vote obviously was a surprise to market participants.

So how should investors respond to UFOs? Some readers may see it as a blatant omission of valid strategies if not mentioned, but one response is the use of option strategies of varying degrees of sophistication. In this article, however, we are going to focus on a broader, more practical concept.

News events happen on a daily basis which means we need to define UFO shocks versus other times of weakness. For now, we will limit the discussion to downside shocks but the concepts will generally transfer over to upside surprises. Chartists or technical analysis-based investors, can define UFO type of shocks in many different ways. The underlying concept behind technical analysis is that price action, and various market related data, conveys the net stance of market participants – bullish or bearish and the degree of their convictions through buying and selling intensity. Logically, shocks mostly run counter the prevailing trend. With trend following being so popular for charting reasons or fundamental reasons, a large number of investors can be caught off-guard. This results in a herd mentality stampede.

A popular technical choice is the use of Bollinger Bands. These display a moving average with upper and lower lines or bands that respond to the volatility of the underlying investment. Movements outside the bands by the underlying investment, the S&P 500 Total Return Index for example, define rare events relative to the prevailing trend and volatility. The chart below displays a number of these periods in which the selling intensity was robust enough to get the S&P below the lower band. These periods invariably have news events behind them. Notice this method separates the more intense movements, the shocks, versus the more common periods of trending and volatility. Chartists tend to not get overly concerned with the details of the story behind the news, rather, the market’s reaction. Simply put, price movements outside of the bands can define a reaction to an Unforeseen Fundamental Occurrences.

Another popular method is to gauge the CBOE Volatility Index (VIX). The VIX is often referred to as the “Fear Gauge” as it tends to spike during times of negative market shocks. – (See chart below) Even though only two charting methods have been shown, there are numerous ways to define shocks.

The primary reason to have a mechanical or disciplined method of defining these events is because in the moment, emotions from the UFO event tends to cloud judgement. Being able to identify these periods as being out of the ordinary can bring an investor back to the reality of the next step.

“Failing to plan is planning to fail” – Benjamin Franklin

That pithy saying is full of wisdom, especially for the chart-based investor. Once again, how does an investor respond to “Brexit”, a terrorist event, a sharp decline in oil, China lowering growth expectations, or an expected sour economic release? When UFO’s occur, don’t try and overanalyze the content of the news but simply stay focused on your trading plan. Yes, that assumes a trading plan is in place. It is similar to the advice from a doctor or a trainer, “if you want to lose weight, you need to exercise”. Thanks Captain Obvious! This advice may be easier said than done but the goal is to develop a resistance to the emotional knee-jerk reactions that can pull an investor away from a trading plan. A whipsaw may be the result, selling then rebuying soon after, but risk controls must be a priority.

Even if a trading plan is not an unemotional black box, rules based method, a logical, qualitative strategic approach can be applied. For example, setting investment exposure at levels in which the market response in either direction would be acceptable. That way, an investor should not find themselves too far behind benchmarks if a reduction in exposure after a UFO is followed by a surprise rebound. At the same time, if the market continues lower, at least some steps would have already been taken to reduce risk.

Articles related to the “Brexit’s” potential impact to the world’s economy are a dime a dozen right now. Such articles may add color to one’s understanding of the event but the most useful advice may be to simply prioritize the disciplines adherence to an established trading plan.

Disclosures

S&P 500 TR Index: is a capitalization weighted index of 500 stocks representing all major domestic industry groups and assumes the reinvestment of dividends and capital gains. It is not possible to directly invest in any index.