5 Things You Need to Know for 2016

PART 1–


The days are long and the years are short.


That’s what floats through my little head when I think about how it’s “that time of year” again. You know what I’m talking about. When you realize it’s time to move all that crapola in the way of your holiday decorations.


As I dust off the boxes and pull out the ghouls and goblins, I’m reminded that this year is coming to a close with another quick on its heels to get started. For us at Quiver, this is also the time for us to dust off our thinking caps and swing by the repair shop to pick up our crystal ball in order to formulate some possible outcomes for what we call the “5 Pillars”.

The 5 Pillars are the asset categories that most likely have the greatest influence on how your investment portfolio performs.

Currencies – The U.S. Dollar
Commodities – Oil and Gold
Equities – U.S. and International
Interest Rates – Treasury Bonds and Corp Bonds
Real Estate – Traded and Non-Traded REIT’s

In our opinion, if we can formulate a plan that covers both sides of the coin in each of these asset categories we have gone a long way to managing risks while keeping our eyes open for opportunities.

It’s a lot to cover and in an effort to not lose your attention we have broken this missive into a few digestible pieces. So let’s get started with discussing what we feel could be the corner stone for markets in 2016, The U.S. Dollar.


The U.S. Dollar


It may matter more than you know


When thinking about the future of asset categories it’s helpful to think about which part of the tail is wagging the dog. Or is that, which part of the dog is wagging the tail? Regardless, the point being is that correlation in markets matter. And not too many things effect correlation as much as liquidity. To take this one step further, at the heart of liquidity is the currency world and The U.S. Dollar.

Most currencies have very long cycles so there can be many months when changes in currency values have little effect to other markets. Then there are times when we find ourselves at inflection points that can result in dramatic changes in liquidity across the globe. This change in liquidity can create some interesting reactions in other assets and markets. 

It appears to us that we are entering one of those inflection points when it comes to The U.S. Dollar and the outcomes will have an influence in how commodities and equities act through 2016. For this reason, we felt The Dollar deserved our attention first.

Since a picture can say a thousand words let’s take a look at The U.S. Dollar through the lens of UUP, an exchange traded fund that tracks the dollar compared to six other major currencies.


From a technical view this picture says it all. Remember I mentioned currency cycles tend to be long? As you can see by the chart The U.S. Dollar has oscillated above the dotted green support shelf for over 30 weeks. That’s pretty much all year long! The longer The Dollar stays above that shelf the greater the chances that The Dollar is headed towards the green X and possibly beyond. If this is to be seen then the earlier comment about being at an inflection point will have merit and the chances of seeing reactions in other assets increases significantly.

From a fundamental point there seems to be a greater amount of fundamental evidence supporting dollar strength as opposed to dollar weakness. At the hub of this is the recent announcements from Europe (The ECB) and Bank of Japan (BOJ) that due to their poor performing economies they are willing to turn on their printing presses again. A significant amount of the strength in The Dollar during 2014 was the result of The ECB and BOJ announcing printing press measures.

Dollar strength is not a friend to your investment portfolio during the period of time directly after an inflection point. In these times, Dollar strength tends to create down drafts or head winds for commodities and U.S. based equities. And since most of your portfolios are probably highly dependent on commodities and equities these times can be very challenging to a traditionally diversified portfolio.

To be fair, we should note that there is another side to the coin and The U.S. Dollar could fail and move lower setting up a different scenario. While possible, as of this moment with the information we have it doesn’t seem probable. Watching that support shelf is our “tell”. A threat to break below that shelf would cause Plan B to be discussed. If and until then we are moving forward under the impression that the end of 2015 and start of 2016 will be accompanied with strength in The U.S. Dollar and this will most likely create both challenges and opportunities.


Commodities


They may have more influence on your portfolio than you know.


Commodities tend to have a tough time during periods of Dollar strength. That’s the bad news. The worse news is that your portfolio may be influenced by commodity prices more than you know. Case in point, if you have any funds in your portfolio that contain in their description the words – High Yield/Income, Strategic Income, Corp Bond and Mid Cap – there is a good chance that your exposure is not obvious.

While there are exceptions, in many cases funds with those descriptions tend to have a greater weighting of investments that are related to energy and basic material sectors. As an example just take a look at how “High Yield” funds have declined along with Oil and Nat Gas prices over the last year.

Many investors of “high yield” funds were not aware that the high yield was being provided by energy related bonds and MLP’s that are very sensitive to the price changes in the underlying commodity.

This is why it’s important to evaluate your portfolio for correlation risks a couple of times a year.

The bottom line is if The U.S. Dollar experiences additional strength the probabilities will lean in favor of continued weakness in commodity prices as we end 2015 and enter 2016.  That is where the opportunity may be found for those that like to buy when there is “blood in the streets”.  Another leg lower in price, if it were to happen, would most likely create a point of capitulation setting up a potential buying opportunity in some commodity related names for those that have the risk tolerance and time frame.

I have a sneaky suspicion that this inflection point will be resolved over the next few weeks so make sure to attend our 5 Things You Need to Know for 2016 events in November and December so we can update you in real time or feel free to contact us at 800-992-5592 if you would like to stress test your portfolio for correlation risks and opportunities.

 

PART2–


Last week we started this “5 Things You Need to Know” series discussing currencies and commodities.

Our premise in the previous missive was that the strength of The U.S. Dollar may matter more than you know. In this second part of the series, we will discuss equities and interest rates which both seem to be in some particularly tricky territory for anyone attempting to postulate on their future potentials. Let’s get started with what has most likely been the biggest topic of the year for financial news watchers ... The direction of interest rates.

 

Interest Rates


More of the same?


For most of this conversation I will be using the rate of the 10 year Treasury as my reference point. So if I say rates are rising or rates are falling, it is the rate of the 10 year Treasury that I will be referring to.

All year there has been an insatiable level of attention on interest rates and what The Fed may or may not do at their upcoming meetings. Will they raise rates or won’t they?

We have been saying all year that the chance of a rate hike from The Fed was low. We still have the same belief as December is the last opportunity for The Fed to make a move in 2015 and unless the economic reports for October and November are extremely hot the chances of a rate rise are slim to none.

For 2016, we feel it will be more of the same. The Fed will be data dependent and if the data isn’t giving them what they need The Feds only choice will be to jaw bone the market by sending mixed messages that will be slanted in creating the perception that The Fed may hike.

The reality is, The Fed is data dependent and the data up until now has not supported a rate hike. Also, it is important to remember that strength in the currency, in this case The U.S. Dollar, is in essence a rate rise. I wouldn’t be surprised if The Fed’s game is to keep the currency strong through its rhetoric while suppressing interest rates as much as they can through other measures. That type of approach would put some headwinds on equity markets and other asset classes that may be looking a little frothy without breaking the back of the economic expansion that is underway and maturing.

Predicting the future of longer term interest rates has become a tricky chore. On one hand it makes logical sense that rates should be rising. After all, how long can they stay this low and how much lower could they go? If Europe and Japan are any example the answers could be, yes, they can stay low for a long time and yes, they could go quite a bit lower.

On a relative basis rates in The U.S. are significantly higher than other developed parts of the world like England, Germany and Japan. As a global investor you are rewarded more by buying a 10yr Treasury that pays roughly 2.15% compared to a German Bund that pays roughly 0.55%.

It wouldn’t be shocking to see capital flow from Europe to The U.S. causing the potential for downward pressure on U.S. rates over the next year or so. There is a lot of speculation in that statement but it does not make sense to this observer that an investor would be happier with a 0.55% yield compared to 2.15% considering the U.S. economy seems to be in better hands than the Euro space.

From a technical point of view the picture is just as wishy washy.

Above is a chart of IEF, which is an exchange traded fund that tracks the price of 10 Year Treasuries. The price has an inverse relationship with rates. As the price rises it indicates that rates are declining.

As you can see by this chart we have been stuck in a “Triangle” pattern for just about 5 years with a lid on prices indicated by the red dashed line and a rising support shelf represented by the solid green line. Eventually one of these lines will give way and when it does that will give us our indication of what to do next. The text book says that “Triangle” patterns have a tendency to resolve themselves in the direction the asset was heading prior to the triangle. In this case that would mean a resolution higher in price and lower in interest rates.

I should warn you that just because the text book says this, doesn’t mean it will happen. I like to remind people that if something has a 75% chance of happening, that still leaves a 25% chance for chaos and confusion. For this reason it is usually best to wait for one of those lines to break before positioning for the next trend whether that is for lower or higher rates. The good news is that a break of one of those lines should happen within the next month or two which will give us a much stronger clue as to whether Government Bonds or any other rate sensitive investment will be a help or hindrance to your portfolio. We will continue to update you as this unfolds as it could be one of the more important events for 2016 in determining how your asset allocation should be designed.


Equities


The election probably creates confusion and prevents big commitments.


Equity markets have given everyone a pretty wild ride over the last 3 months, dropping fast and furious in August and September to snap back in October. Back in August, we poised the question “Will August mark the end of the bull run” and as of now that question still remains. Net-net of the stock market measured by the S&P 500 has essentially gone nowhere since the last time we were eating turkey dinner in 2014. Although the Dow and S&P 500 have snapped back after the August swoon, the higher risk indexes like small caps and high yield debt are trading well below their July levels and have not seen the same recovery. Sometimes this type of negative divergence where the higher risk areas of the market are not rising as strong as the bigger indexes is a sign that caution should be warranted. Usually strong bull markets have more cohesion with the higher risk assets leading the way, not following. None the less there definitely seems to be some liquidity shenanigans being provided to markets by central banks and if this continues equity markets could run higher from here. The following chart should explain.

I always like to start with a very long term view when I am looking at markets. This helps put in perspective where we are in the larger cycles of markets. The above chart shows the SPX (S&P 500) over the last 20 or so years. This should help give you some visual as to how extended markets may be on a historic basis. While there is nothing scientific to the notation of 7-8 years I reference it as markets tend to appreciate symmetry so it will be interesting to see if the market holds this 7-8 year cycle. Regardless, when I see a chart like this I then have to break down the analysis in a couple ways.


1. If I already own the asset, I would hold as long as the trend was my friend and I would be willing to sell into strength or place stop losses just below important trend lines. This would help protect my investment if the trend should change from up to down.


2. If I had cash and wanted to buy this asset, I would proceed cautiously knowing that I am probably closer to a top than a bottom. In which case, I would prefer to dollar cost average my purchases over a longer period of time to manage the risk.


In the shorter time frame and for 2016, I think equities will continue to give investors a wilder ride for a couple reasons. First is, that this election year is up for grabs. I can’t imagine that there are many CEO’s and CFO’s that are willing to commit large sources of capital to mergers or growth initiatives until they get a clearer picture on whether the white house will have another democrat or republican. I would imagine that industries like financials, health care and defense, which is affected more by regulatory and budget decisions than other industries, will probably be sitting on their hands for much of 2016. The second headwind I see for equities is the stronger dollar. Continued strength in the dollar will place additional burdens on the earnings of many U.S. based companies. This doesn’t mean that equity markets couldn’t push higher. After all, the central banks across the globe seem determined to keep these markets afloat and as the old adage goes “Don’t fight The Fed”. However, my gut tells me that even if equity markets are able to push higher I would be more inclined to look for signs of exhaustion as opposed to signs of continuation. Below is a shorter term view of the SP500 with some notations of what we are watching for.

As you can see we are at an interesting juncture when it comes to the shorter term time frames for equities. The bounce in October seems to have everyone expecting the equity markets (measured by SP500) to make new all-time highs. However, how the market reacts over the next week or two by either hurdling back over the green line or peeling away from it will be the “tell” that can help you decide what to do next with your equity allocations. Next week, we will wrap up this series of “5 Things You Need to Know” with a discussion on Real Estate and a special note on the potential future of economic growth.

 

PART 3–


Behind the idea of “5 Things You Need to Know” is the belief that much can be gained or saved through the practice of pausing to gain a clearer view of the terrain before you. By doing so it gives you time to focus on finding the smoothest path between where you are and where you may want to arrive. It’s a practice I learned attempting to stay sane while raising a family and running a business.

Each year as the seasons change, this practice gets put to good use as we pause to hypothesize the potential future terrain for the “5 Pillars” of the market. The “Pillars” being the asset classes which most likely influence your investment portfolio the greatest.

Now, in an effort to wrap up this year’s “5 Things You Need to Know for 2016” we will Discuss the final Pillar. And, as a bonus if time and space allow, we will have a little discussion around the overall economy for 2016.


Real Estate


Will 2016 be the tale of 2 markets?


When discussing real estate I think it is important to differentiate the discussion between traded and non-traded types of investments. The reason for this is the different factors which influence each type of investment as well as how each affects the volatility within a portfolio.

Traded investments are securities which trade on a stock exchange and therefore fall into the “Traded” category. Examples can range from funds with a diversified mix of Real Estate Trusts (REIT’s) wrapped in one fund such as IShares Real Estate (IYR) or Vanguard REIT Index (VNQ) to individual REIT’s such as Global Net Lease (GNL) or Health Care REIT of America (HCA). *

Traded products provide greater liquidity as investors can buy and sell in the same way they can a stock. Click a button to buy one minute, click a button to sell the next. As a result, many of the traded REIT’s get traded in sympathy with investors’ opinions as to where they think the future of interest rates is headed. If market participants expect rising rates, they can easily reduce their exposure by selling some of their traded REIT’s. If market participants feel rates will decline, with a push of a button they can increase their exposure to REIT’s. In this way traded REIT’s will have affection to being “rate sensitive” investments. As a result, there can be times when the price performance of a traded REIT could be influenced more by interest rate fluctuations as opposed to the underlying fundamental value of the REIT. These short term fluctuations can cause a greater amount of volatility within a portfolio.

Non-Traded Real Estate can range from an investment such as your home or a rental property to a more complex investment trust such as a Non-Traded REIT which may hold a variety of real estate properties that are not traded on an exchange. As a result of investors not being able to buy and sell their shares at a push of a button, the underlying price of Non- Traded REIT’s tend to be less influenced by the whims of investor sentiment as to where interest rates may or may not be headed in shorter time frames. There are many other risks for Non-Traded investments but short term thinking of traders is rarely one of them.

While interest rate fluctuations will most likely have the greatest influence on the performance of traded investments in 2016, Non-Traded items will be more sensitive to the overall growth rate of the economy. History has shown that jobs and real estate are directly tied.
In regards to interest rates, I’ll take you back to what we discussed in the previous portion of “5 Things” by reposting the following chart and commentary.

As you can see by this chart we have been stuck in a “Triangle” pattern for just about 5 years with a lid on prices indicated by the red dashed line and a rising support shelf represented by the solid green line. Eventually one of these lines will give way and when it does that will give us our indication of what to do next.

Since those comments, rates have pushed higher threatening to break out of this triangle and it appears the next week or two will be influential in determining the direction of rates
as we enter 2016. At times like these, it makes sense to strategize around 2 scenarios - 1 being “what if rates break out decidedly higher?” and 2 being “what if rates break down decidedly lower?”


In scenario 1 - where rates break out decidedly higher, it seems fairly obvious that you will want to consider reducing your exposure to traded vehicles or find a way to hedge the risk and if you were contemplating on buying traded real estate investments you may want to watch what happens with interest rates before making too big of a commitment.

As for scenario 2 - where rates break down and head lower, it would be assumed that if your risk tolerance and time horizons are appropriate then adding traded investments to a portfolio may help increase the yield and potential growth as rates trend lower.

The best advice I can give you is to stay tuned as we will be updating this as the next few weeks unfold.

As for Non-Traded items in 2016, it’s important to remember that an investment into a non- traded product has to be included as part of your longer term investment plan. Since non- traded items will most likely lack liquidity you want to examine your risk tolerance and time horizon prior to making an investment. As a result of this lack of liquidity, you want to consider the larger cycles of the economy when deciding whether to make any commitments to this space.


The typical fundamentals that support real estate seem to be intact. Interest rates are low and jobs are being created. As of this moment, there has not been any evidence in the economic reports to indicate this is changing. It should be noted that the recent pace of growth in the economy has slowed over this year. This seems to be the result of a stronger dollar as well as a slower global economy. It is our view that the economy for 2016 will most likely have similar or slightly less growth to what we have seen this year. Which, if this is to be the case, it would seem that investors can still consider including non-traded real estate within their portfolio as long as their risk tolerance and time horizons are appropriate. It should also be noted that not all real estate is created equal and there are different categories of real estate that will perform better than others as the economy evolves. That will be a topic for a future writing. For now, I have ran out of time and want to encourage you to attend our upcoming “5Things You Need to Know for 2016” on December 3rd where we will give you an update on the 5 Pillars and how they may act through 2016.


Warm regards, Colby McFadden


*The mention of specific securities is for example purposes only and in no way constitutes a recommendation or solicitation of these securities.

 

The opinions expressed are those of Colby McFadden and Quiver Financial as of November 18, 2015 and are subject to change due to market or other conditions. This is not a solicitation or recommendation of any investment; always consult a Financial Advisor before investing into any investment. Securities offered through Newport Coast Securities, Inc. - Member FINRA / SIPC - Advisory Services Offered through Newport Coast Securities, Inc. 18872 MacArthur, 1st Floor, Irvine, CA 92612 - 800.992.5592