Some initial observations:

 

·         A headline sums up the market’s action: it’s a “sell first, ask questions later” market as investors experience flashbacks to the 2007/2008 markets

·         investors/markets don’t like uncertainty and they’re getting political, economic and sovereign uncertainty in abundance

·         with the austerity discussions that are dominating US and Europe, there are increasing concerns about a double-dip recession even though positive economic signs are out there – earnings, revenues, and a slightly better than expected jobs report

 

Some initial thoughts:

 

·         In the most recent prior market downturns of 2000 – 2002 and 2008, we fared well relative to the market because we maintained our long-term focus, maintained our confidence in our adaptive investment process, and resisted making knee-jerk moves in response to day-to-day market movements.

·         Volatility is the market boogeyman that challenges all managers – traditional and quant alike. Our process explicitly considers past markets of higher and lower market volatility when we strategically select the factors to our models. Volatility happens and will happen some more in the future, that’s why we incorporate stock selection criteria that have proven to be successful in higher volatility markets as well as indicators that have worked in lower volatility markets. Our adaptive process will systematically gravitate towards the factors that are most effective in the prevailing level of market volatility.

·         In our largecap strategy, we have seen the models increasingly favor stocks with lower risk, lower beta, and more of a growth bias. Stocks such as Amazon (AMZN) – a stock that is organically growing with a low market beta; Smuckers (SJM) – a low beta, PB&J stock that is well suited for families that are dialing back their budgets; AutoZone (AZO) – a low beta, strong margin growth stock well suited for people looking to make their cars last longer; and Verisk Analytics (VRSK) – another low beta growth stock that provides loss prediction and risk pricing to an increasingly risk-aware property & casualty insurance industry.

·         We have always been a firm believer in consistently measuring and managing the total active risk within our portfolios as well as the sources of active risk. This investment guide has served us well and provides our clients with a truly transparent view of the drivers of risk and return within their portfolios.

 

We produce a weekly report to examine the traits of the buy and sell lists generated by our MaxCap, Large, and SMidCap models.  Throughout the first four months of the year, we saw a significant bias towards higher volatility stocks, which was manifested in a number of traits.  On a net basis, we saw preferences toward smaller market capitalization, high beta, higher price and earnings variability, stocks with higher earnings estimate controversy, and higher idiosyncratic risk. 

 

We’ve seen a significant de-risking within our models over the past 8 weeks.  The LargeCap model was the first to reflect this de-risking, followed by the SMidCap models within a few weeks.  With the end of the expansion of the Fed’s balance sheet, one could have expected at least a degree of this rotation.

 

The US stock market was then forced to confront not only the end of QE2 and what the removal of that stimulus would mean for the economy, but also the rapidly approaching deadline to raise the debt ceiling.  The world witnessed the severe dysfunction of Washington, DC in all its glory, and “kick the can” became a household phrase.  The gridlock over the debt ceiling and whether and how to make the necessary changes to restore the US fiscal condition to a viable long-run trajectory then resulted in a downgrade to US debt by Standard and Poor’s (who had warned of the possibility).  Naturally, the politicians quickly lashed out at S&P, rather than working to repair the true underlying problems of  1) poor economic growth resulting in lower revenue, and  2)the looming explosion of baby-boomers beginning to draw on Social Security, MediCare, and Medicaid.  No sooner was the US downgraded than speculation began about which Euro-area countries would soon undergo a similar fate.  Contagion.

 

The tremendous uncertainty, combined with earlier signs of an economic slowdown, has investors discounting the chances of a double-dip recession (although the National Bureau of Economic Research will view this as an entirely new recession), akin to the recessions of the early 1980’s (which was in many ways the economic environment most similar to this – albeit it with much higher interest rates):

 

The Recession Case:  Stocks are down, the ISM Index has declined sharply, and GDP growth has already slowed to less than 2%. Consumer confidence is at very low levels.  The housing market remains seized.

 

Skirt-the-Recession Camp: Exports are robust on the back of a weak dollar.  Consumers can maintain spending levels given the balance sheet repair which has already occurred.  Commodity prices have eased, interest rates are very stimulative, and money supply is growing quickly.

 

Both are compelling cases.  The fact of the matter is that the US has moved from the only major economy with a stimulative fiscal & monetary policy to an economy with less stimulus.  We believe it’s likely that if we enter a second recession, it will be far milder than the first.  Companies have substantial cash on hand (and have been aggressively buying back stock).  The housing market has taken major steps forward, with construction levels having sat at all-time lows for four years.  Valuations at the market level appear fair, and many individual companies are very attractively priced.  All of this should serve to put a much higher floor on the market.

 

One of our colleagues recollects the Mike Tyson line, “Everyone has a plan, until they get punched in the face.”  Well, we’ve all just been punched in the face (again), and our systematic approach will allow us to stick with our plan.  Right now, that means shifting towards stocks of larger, more stable companies.  For our tax-managed clients, the volatility gives us an opportunity to harvest losses more aggressively, producing after-tax value-added.  It’s also an opportunity to remind our clients that we offer a MaxCap strategy, which selects from the largest 100 stocks in the US.  This market segment offers attractive valuations and less volatility in this schizophrenic environment.  We also urge our clients to examine their fixed-income/equity allocation, and rebalance to plan given the massive run-up in Treasuries this past week.

 

Above all, we will remain disciplined, and allow our adaptive process to navigate these choppy waters.

 

What are we looking into:

 

·         We have done some innovative work in assessing the merits of incorporating ESG data into the risk management of our portfolios – beyond our dedicated Sustainable Responsible strategies. This looks to be a promising additional dimension of portfolio risk that is not being widely measured/managed.

·         We are looking at complementing our dynamic, adaptive, mostly bottom-up stock selection models with insights to be derived from macroeconomic and macro-market indicators. Members of our research team have experience designing value-added models that provide insights into style and sector returns using macro indicators. This is an active project that looks to capitalize on the increasing importance of macro dynamics within the market.

 

This market is like other similar markets (2000 – 2002 and 2008) where it’s a daily battle against emotions. In the past, this is when our disciplined process that inherently adapts to prevailing market dynamics has paid off for our clients. After the 2007/2008 market, many of our quant peers scrambled to make their processes dynamic, which ours has always been and has a proven, successful track record.

 

We won’t get every quarter right, but we have proven to be effective in adding value to our client’s portfolios during prior market downturns.

 

 

 

(c) Advanced Investment Partners

www.aipllc.com