DAY HAGAN STRATEGY UPDATE
DAY HAGAN TACTICAL ALLOCATION OF ETF MONTHLY UPDATE: JULY 2016
General commentary regarding the after effects of the Brexit vote, the global financial markets, and an update regarding the Day Hagan Tactical ETF Strategy.
Donald L. Hagan, CFA
July 8, 2016
PDF COPY OF ARTICLE
What Brexit vote?
On June 24, the first day of trading following the vote, we published a special update, writing, “The ‘Leave’ vote will cast a pall over the markets for the immediate future, but the reality is that it will take a long time for the process of ‘Leaving’ to flesh out. The more important ramifications (such as other countries indicating they too would like to leave) are likely to take shape over the next couple of weeks and we will have to assess them at that time. Currently, there may be some opportunities to increase exposure, and we are watching our models and indicators closely for signs that rewards become more probable than risks. At this point, we are being patient.”
The DJIA declined about 600 points (-3.4%) on Friday following the Thursday night (EDT) vote, and another 260 points (-1.5%) the subsequent Monday. And that was it. The ramifications of Brexit were, at that point, apparently priced in to U.S. stocks. Furthermore, according to Barron’s, the value of global equities declined by $3 trillion—so it was priced in everywhere. Then the markets reversed and closed higher for four consecutive days, with the DJIA finishing at 17,949—just 62 points below where it stood the day before the Brexit vote. The U.K.’s equity market, priced in Pound Sterling, actually was up for the week and is up for the year (versus Italy, which is down 23.9% year to date). It was as if Brexit didn’t happen and the EU was expected to continue along its merry path to globalization.
If Brexit caused the U.S. markets to decline by less than 5% (on a closing basis), what caused the markets to retrace the losses?
First, the markets rebounded as investors gravitated to our view that “Leaving” would take a while, and that it still isn’t certain that it will happen at all. The Brexit referendum was just that: a referendum. Non-binding. In fact, there are several avenues that can be taken procedurally to bring forth another referendum vote. In a research call I presented Monday, I opined that if the history of Greece’s woes have taught me one thing about the EU, it’s “Don’t underestimate the power and resolve of [un-elected] Bureaucrats to protect their jobs.” Confirming investors’ quick dismissal of the risks, the volatility that resulted from the Brexit fear decelerated quickly, i.e. the VIX index traded back to levels lower than prior to the vote.
Correspondingly, there was also a flight-to-safety trade that took place as investors bought bonds. In fact, the 10-year U.S. Treasury touched 1.39%, just below the 1.40% that we saw in 2012 during the heyday of the European debt crisis. When interest rates move lower, it is usually supportive for stocks. The 10-year Treasury closed the week at 1.44% while the 2-year Treasury closed at .60%, indicating that fed hikes are off the table for the foreseeable future. (Keep in mind, the 10-year Treasury was at 2.27% at the end of 2015.)
Between the recalibration of expectations for Brexit and lower interest rates, the U.S. equity markets are now, quite simply, back to where they were a little over a week and a half ago.
Now, we are back to thinking about whether or not anything has really changed in the past month:
Did the world’s economic growth prospects improve? No. Even though the U.K. only represents about 3% of global GDP growth (versus 30% for China and 20% for the U.S.), most firms are reducing their 2016 GDP estimates in an environment that is already under duress. Ned Davis Research, for example, now expects Global GDP to increase 2.8%-3.0% versus their previous estimate of 3.2%. While still positive, “markets react not to whether things are good or bad, but whether they are getting better or worse” (quote: Jeff Saut).
Did the U.S. economic growth prospects improve? No. NDR has reduced their U.S. GDP growth expectations from 2.3% to 1.8%-2.0%. Durable goods orders, the Services PMI, housing and automotive are all stalling. Consumer spending, after an April sprint, has declined in May. Interestingly, there have been some green shoots in the manufacturing sector and we are watching for signs that the trends will persist.
Are U.S. earnings revisions moving higher? No, but they have stopped moving lower. According to FactSet, second quarter year-over-year earnings are now expected to be -5.3%, which, if this occurs, would be the first time there were five straight quarters of earnings declines since Q3 2008 to Q3 2009. Will this mark the end of the “Earnings Recession?” It will if global growth accelerates, the U.S. dollar retreats and investors are willing to bid up valuation multiples as their perceptions of risk are mollified. At this point, we view the overall U.S. equity market as slightly overvalued.
Has China’s situation improved? China is still risky. Recent manufacturing-related reports have shown signs of continued weakness (PMIs). China has also been devaluing the Yuan as they struggle to maintain their global competitiveness. The PBOC is expected to unleash another round of stimulus along with accelerated infrastructure rebuilding. Our view is that China has substantial local debt issues and a shadow banking market that is far larger and fragile than most appreciate.
Has Japan’s situation improved? No. Retail sales, household spending and inflation have been lower for three consecutive months while the Yen has been in a strong rally. We have exited all of our Japanese exposure for the time being.
Has Europe’s situation improved? No. Keep your eye on Italy. If they begin rumbling about renegotiating their EU status, then all bets are off.
Is the carry trade still supporting U.S. assets? Yes. The U.S. is a flight to safety, and relative sovereign interest rate spreads still favor the U.S.
Has oil stabilized? Yes. We are expecting a trading range as there is a significant amount of offline production just waiting to come online with each increase in oil prices.
Can QE continue to save the day? Right now, it’s all about low interest rates, competitive currency devaluations and supporting the banking systems. Our view is that QE has become progressively less effective, to the point where new initiatives are met with a yawn. Interest rate levels, credit spreads and currency trends are key to understanding the risks inherent in the financial system. At this point, the Yen spike, the Yuan devaluation, the Pound Sterling crash and the dollar spike are all creating negative ramifications for each country’s earnings, capital flows and inflation expectations.
Has the race for President of the U.S. shifted? This is a wildcard and can’t be gamed at this point.
Bottom Line: We remain slightly overweight equities, slightly underweight fixed income and overweight cash. We are overweight U.S. versus International equity holdings and neutral on Value versus Growth attributes. Smaller capitalization equities are showing signs of relative strength near term, and we recently shifted our mid-cap growth exposure into small-cap value.
At the end of the day, our models’ message is that this isn’t the time to be overly bearish (negative), nor is it the time to be overly aggressive. A more neutral/mildly bullish stance is currently warranted. We will be looking for our models and the weight of the evidence to turn more positive before committing additional capital to equities.
If you have any questions or comments, please feel free to call anytime.
Donald L. Hagan, CFA
Arthur Huprich, CMT
Arthur S. Day
— Written 07-02-2016
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