Market Bull takes a Pause
Stocks have mostly been caught in a state of reverse gravity this year (what goes up – keeps going up) and we’ve all become a little spoiled…until a few weeks ago.
Two factors have caused stocks and bonds to fade: Headlines about China and rising yields. We’ll discuss both. The bottom line, however, is that this week, we’ve shifted towards a defensive stance with our US stock allocations and taken partial defensive measures in High Yield Bond positions.
Bonds Yields Break to New Highs
After spending most of the year decently below 4%, the 10-year yield has broken decisively above 4% and reached a new high near 4.3% earlier this week. The outcome is that aggregate bonds are threatening to turn negative this year, and the long bond is already showing losses. This movement has also dampened enthusiasm for stock bulls, as the S&P 500 has faded about 5% from its high a few weeks back.
Our key insight is that even with a dovish (or neutral) FED, yields could continue to rise as the yield curve normalizes from highly inverted levels. An inverted yield curve is a predictor of recession, as investors anticipate FED easing to address a declining economy. If it appears that a recession can be avoided, the yield curve could revert to normal. This would result in additional losses in conventional bond portfolios and further potential losses in stocks. It could also re-accelerate losses for banks and other institutions that hold longer dated treasuries. The yield is currently at levels last witnessed just before the regional banking crisis emerged in March. Recall that that didn’t bode well for the markets.
Is China a Concern for US Investors?
Possibly. Creating a direct path from a weakening Chinese economy to substantial risks for the US is complex. A glaring issue is the deterioration of debt, particularly in the shadow banking sector, effectively another term for the banking sector. Effectively, some people in China have been using shadow banks to increase returns. If shadow banking trusts stop making payments to investors (some have), then people may lose their money just as if a bank became insolvent. This is effectively banks collapsing in terms of its impact on the economy. The key thing to watch here is what exposure other countries/investors have to China debt, and whether this debt spreads elsewhere, creating problems. In the past, we’ve observed how seemingly obscure sources of debt became significant issues for the global economy.
Ultimately, stocks are measures of optimism. We’re not buying current income or assets (based on how we price assets), we’re buying perceived earnings of growth. When anything happens to reduce optimism, or create pessimism, that causes markets to fall. The reason that’s so important to understand is that it’s not always concrete fundamentals driving the market so much as it is sentiment. If stocks bottom out this week or early next, a continuation of this year’s bull market could unfold. However, be vigilant for negative momentum building up, which could jeopardize this year’s gains. As always in overvalued markets, we recommend staying agile. Stop caring about markets and build stopgaps into portfolios.
Recent Trades and Current Positions:
Between August 16th and the 18th we moved into a fully defensive posture in our US Stock allocations, and to a 67% to 100% defensive position in our High Yield Bond allocations.
High Conviction Tactical Models1,2:
Developed International Stocks: 100% Invested
High Yield Bonds: 67% to 100% Defensive3
US Stocks: 100% Defensive
Investment Grade Bonds: 100% Cash Equivalents
Managed Risk: Approximately 8.7% out of the money at yesterday’s market close (LEAP on SPX Futures Put strike price)
Equity Portion of Defensive Alpha Models1:
100% Defensive Posture
These include the Toews Capital Preservation, Balanced, Balanced Income, Balanced Growth, Growth, and All Equity, High Income, Balanced Income, and Conservative Income portfolios. They do not reflect the allocations of these strategies that are not allocated to Toews Funds.
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(1)These include the Toews Capital Preservation, Balanced, Balanced Income, Balanced Growth, Growth, and All Equity, High Income, Balanced Income, and Conservative Income portfolios. They do not reflect the allocations of these strategies that are not allocated to Toews Funds.
(2)Exposure to vehicles invested in the listed asset classes.
(2)Hedged with HY Futures for defensive positioning.