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Fed Rate Hike Starts The Clock 12-18-15

Written by Lance Roberts | Dec, 19, 2015
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IMPORTANT NOTE:

  • There will be NO NEWSLETTER NEXT WEEK due to the Christmas Holiday.  Merry Christmas to you all.
  • I would appreciate it if you would send this newsletter to people who you think might enjoy it.
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Politically Incorrect

Before I get into this weekend’s commentary, I want to take a moment to be “Politically Incorrect.” 

In 2014, according to a Pew Research poll, 71% of American’s claimed to be Christian, with the Catholic, Baptist, Methodist, Latter-Day Saints and God In Christ comprising the top 5 denominations. Judaism, Mormons, Muslims, Buddhism, Rastafarianism, Hinduism, all other religious sects, and Atheists make up the difference.

From early colonial days, America has been profoundly influenced by religion. Several of the original Thirteen Colonies were established by settlers who wished to practice their own religion within a community of like-minded people: the Massachusetts Bay Colony was established by English Puritans (Congregationalists), Pennsylvania by British Quakers, Maryland by English Catholics, and Virginia by English Anglicans. All through history, in one form or another, religion has played an important role is shaping American culture, social life, and politics. 

According to a 2002 survey by the Pew forum, nearly 60% of Americans said that religion plays an important role in their lives, compared to 33% in Great Britain, 27% in Italy, 21% in Germany, 12% in Japan and 11% in France. The survey report stated that the results showed America having a greater similarity to developing nations (where higher percentages say that religion plays an important role) than to other wealthy nations, where religion plays a minor role.

Unfortunately, the U.S. is following in the path of a developed nation. In 1963, 90% of Americans claimed to be Christians while only 2% professed no religious identity. In 2014, the percentage of Christians was closer to 70% with close to 23% claiming no religious identity.

My point is simple. In recent years, the celebration of Christmas has been under attack by the liberal left and minority cultures in American. The fears of “offending” the 29% of the population that does not practice Christianity have escalated to where people are afraid to say those two simple words.

So, before you shy away from Christian beliefs in fears of offending someone else, let’s take a moment to remember that wishing someone a “Merry Christmas” is a gift of kindness. Regardless of your views, your religion, your personal intolerances, or position in life – a wish of happiness and joy at this time of year is nothing more than that.

While the celebration of Christmas is a wholly Christian holiday celebrating the birth of Christ, it is also a remembrance that we are all human. It is a time of year to set aside differences, put down the hate, and reach out to our fellow man. It is a time that we give love freely and expect nothing in return. For a brief moment, people all around the world are united in the spirit of Christ.

So, I want to take this opportunity to wish you all, regardless of your denomination, a “Merry Christmas.” I wish you and your family many blessings for a happy, healthy and prosperous New Year. It is my wish of good tidings, and a sincere hope that the “spirit of Christmas” fills your heart. I hope that you will take this wish and pass it on to everyone you meet.

After all, what do you really have to lose? Even the Grinch, who’s heart was two-times too small, was eventually overcome by the infectious joy and love that is Christmas.

MERRY CHRISTMAS!

christmas-quotes


TICK TOCK – THE FED STARTS THE CLOCK

This past week, Janet Yellen announced the first hike in the Fed Funds rate in eleven years from .25% to .50%. When asked about why the Fed decided to raise rates now, Ms. Yellen responded by suggesting that the “odds were good” the economy would have ended up overshooting the Fed’s employment, growth and inflation goals had rates remained at low levels. She then went on to state that it was a “myth” that economic growth cycles die of “old age.”

While such an optimistic outlook for economic growth was certainly welcomed by the markets, both of her statements expose the challenges that lie ahead for the Fed.

Ms. Yellen is correct in stating that economic growth cycles do not die of “old age.” It is historically the impact of an exogenous impact that ultimately slows economic growth rates into a recessionary cycle. What Ms. Yellen failed to explain is that historically it has been the “tightening” of monetary policies that have been the “exogenous impact” to the economic growth cycle. 

Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession. However, the timing between the first rate hike and the next recession is dependent on the level of economic growth at that time. As I stated earlier this week:

“When looking at historical time frames, one must not look at averages of all rate hikes but rather what happened when a rate hiking campaign began from similar economic growth levels. Looking back in history we can only identify TWO previous times when the Fed began tightening monetary policy when economic growth rates were at 2% or less.

(There is a vast difference in timing for the economy to slide into recession from 6%, 4%, and 2% annual growth rates.)”

Fed-Funds-GDP-5yr-Avg-Table-121715

“With economic growth currently running at THE LOWEST average growth rate in American history, the time frame between the first rate and next recession will not be long.”

Given the reality that increases in interest rates is a monetary policy action that by its nature slows economic growth and quells inflation by raising borrowing costs, the only real issue is the timing.

As Sam Zell noted recently:

“I think this interest rate hike is too late, this economy is closer to falling over than it is to going up. I think there’s a high probability that we’re looking at a recession in the next twelve months.”

Looking at the historical data above, Zell’s timing appears to be just about right.


Fed Rate Hikes And Bull Markets

The other common meme this morning, following yesterday’s rate hike decision is that “stocks have nowhere to go but up.”

Again, this is a timing issue. If you have a very short-term view, history suggests that stocks do rise on average following an initial rate hike. However, as shown in the chart below, historically rate hikes have occurred when earnings growth was on the rise, not peaking and deteriorating.

Profit-Margins-Fed-Funds-121415

Furthermore, as explained by Jason Goepfert of Sentiment Trader yesterday:

“The S&P 500, gold and 10-year Treasury note yield are all up by more than 0.5% on the day. The knee-jerk assumption from that would be that traders are pricing in higher inflation.

This is occurring on a day the FOMC raised its Federal Funds target rate. If we go back to 1971 and look for every time all three rallied at least 0.5% on a day the Fed hiked rates, we get the following future performance.”

Sentiment-Trader-121615

However, if we step our time frame out to longer-term, since we are all supposed to be long-term investors, the outlook becomes rather grim.

Fed-Funds-Table-121715

In every single instance when the Fed has started a rate hiking campaign, that campaign ended in a market correction or worse. (The Fed then began lowering rates immediately to stop the ensuing carnage.)

With corporate profits deteriorating, economic growth weak and the dollar surging, the Fed is very late to the game. This puts the time frame between now and the next recession at the very short end of the scale.


Growth So Bright, Lower Outlook

One thing that is always interesting is comparing what the Fed “says” during their press conference and then looking at the history of their own forecasts.

During yesterday’s press conference, Ms. Yellen made several references, as noted above, about the strength of the economy and that despite the surging dollar and collapsing oil prices, everything should continue to improve. The problem is that is NOT what was reflected in their forecasts released along with their announcement.

The table/chart below shows the history of the Fed’s average range of their estimates going back to 2011 when they started releasing their forecasts as compared to what actually occurred.

FOMC-Forecasts-GDP-121715

Currently, economic growth forecasts for 2016 and 2017 are at their lowest rate since the Fed began predicting for those two years. Furthermore, it is worth noting that for 2015, the Fed had originally estimated growth to be 3.35% rather than the current run rate of 2.2%.

Furthermore, they lowered their long-term outlook to just 2.05% from 2.25% at the last release.

Yellen-GrowthForecasts-121615

Yes, please meet the “worst economic forecasters” ever. And while the mainstream media quickly laps up the optimistic outlook of the Fed, you might want to consider their own record of forecasts when making long-term investment bets.

Based on statistical history combined with the current underpinnings in the market, the outlook really isn’t as bright as Ms. Yellen suggests.

Something to think about.


THE MONDAY MORNING CALL

End Of Redemptions

Friday’s sell-off, combined with options expirations, pushed the markets back to short-term oversold conditions and at previous support.

SP500-Chart1-121815

For the year, the markets continue to post negative returns, which is a low probability event historically for 5th years of decades.

However, as I laid out at the beginning of November, with markets now oversold, option rolls and redemptions complete, this should clear the way for a rally into the end of the year. Such a rally will likely not be huge, but enough to re-balance portfolios heading into 2016.

SP500-Chart2-121815

I have reiterated over the last several weeks, that such a rally, driven primarily by window-dressing by mutual funds for year-end reporting, is in line with previous expectations.  However, as I have also noted, this is only a “set up” for more nimble and short-term focused traders.

As I discussed in detail recently, the underlying dynamics of the market are substantially weak and on a longer-term basis are more akin to market peaks than the beginning of new bull market advances.

Working With A Model Allocation

Let’s review the model.

NOTE: The following is for example purposes ONLY. It is in no way a suggestion, recommendation, or implication as to any portfolio allocation model currently in use. It is simply an illustration of how to overweight or underweight a model allocation structure.

Again, this is just for educational purposes, and I am not making any specific recommendations. This is simply a guide to assist you in thinking about your own personal position, how much risk you are willing to take and what your expectations are. From that starting point design a base allocation model and weight it accordingly. The closer you want to track the S&P 500 Index, the less fixed income, real estate and cash your portfolio should have. For a more conservative allocation reduce allocations to equities.

Got it? Okay.

S.A.R.M. Current

The Sector Allocation Rotation Model (SARM) is an example of a basic well-diversified portfolio. The purpose of the model is to look “beneath the hood” of a portfolio to see what parts of the engine are driving returns versus detracting from it. From this analysis, we can then determine where to overweight sectors which are leading performance, reduce in areas lagging, and eliminate those areas that are dragging.

The Sector Allocation Rotation Model continues to deteriorate suggesting that markets are significantly weaker than they appear. As suggested all through this missive, a reflexive bounce in the market can be traded but not bought.

SARM-Model

I had suggested last week, that the current set-up provided an opportunity for a tradeable rally in the improving and leading sectors of the market. (Stay with “winners” as they tend to be safer for short-term trading opportunities.)  I suggested:

  • Adding To: Energy, Industrials, Materials, and Technology this week as shown in the model allocation below.
  • Watching: Healthcare, Staples, Discretionary and International for some improvement before further increasing exposure in those areas.
  • Selling/Profit Taking: Bonds, Utilities, REITS

The addition to the Energy trade is not working out as hoped. However, as shown below, energy has not violated important support as of yet, so we will give it another week to see if stability can be found. A violation of support, and the position will need to be reduced for now.

XLE

BONDS/REITS/UTILITIES –  I previously recommended that profits should be taken in fixed-income related investments as rates had reached their target levels. The recent run-up in rates on expectations of a Fed rate hike, have pushed bonds back towards a favorable position. HOLD allocations for now. 

Interest-Rates

Small and Mid-capitalization stocks continue to struggle and should be avoided for now. Volatility risk is substantially higher in these areas and are better used during a firm growth cycle versus a weak one.

The same advice for bonds applies to UTILITIES and REITS. Hold current positions for now as rates stabilize and adjust for the Fed rate hike. (Don’t worry, rates are going lower, not higher, in the long-term.)

The recommendations for “pruning and trimming” exposure over the past couple of months has already done much of the risk mitigation needed to navigate the current markets. Therefore, there should be only relatively minor changes needed currently.

S.A.R.M. Model Allocation

I have adjusted the SARM Model to reflect the changes discussed above and previously.

  • Hold Materials
  • Hold Industrials
  • Hold Discretionary
  • Hold Energy
  • Hold Technology
  • Hold Utilities
  • Hold Staples
  • Hold Healthcare
  • Hold Financials
  • Hold REITs
  • Hold Bonds

These actions would rebalance the example portfolio to the following:

SARM-Allocation-121815

With the pullback this week, the markets are oversold enough once again to elicit a short-term rally through the end of the year. As you will notice, the model below is currently carrying 30% cash in the portfolio. So, despite the conversation of a short-term opportunity through the end of the year, I am not optimistic about markets currently, hence the overweight cash holding.

If you a longer-term investor it is advisable to wait for a clearer bull-market confirmation to be made before increasing equity risk substantially.

It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance.

As you can see, there are not DRASTIC movements being made. Just incremental changes to reducing overall portfolio volatility risks. However, if the expected bounce fails at resistance, then further reductions will be required in accordance with the risk reduction modeling.

Remember, as investors, our job is not to try and capture every single relative point gain of the market as it rises. While we certainly want to participate in the rise, our JOB is to protect our capital against substantial losses in the future. A methodology that regularly harvests gains, reduces risk and keeps the portfolio focused on longer-term goals will lead to a more successful outcome.


The Real 401K Plan Manager

401k-Plan-Manager-121815

Market Struggling – Caution Advised

As discussed above, the recent pullback to support, and reaching oversold conditions, sets the markets up for a seasonal rally into the end of the year. However, as shown in the chart above, the technical deterioration is significant.

As I have repeatedly cautioned, any year-end “Santa Rally” could well be short-lived. I continue to advise caution.

The 401k Model is NOT being tactically adjusted at this time because the suggestion of a tradeable rally is far different that an increase in risk for long-term investors. The current market environment is NOT conducive for a long-term allocation adjustment.

Portfolio management rules still apply for now. If the recent market volatility has made your nervous as of late, you are probably carrying too much risk in your portfolio.

As always, your portfolio, much like a garden, must be tended too in much the same way. By doing so, it will ensure that it prospers and grows over time and yields a fruitful bounty.

  1. HARVEST: Reduce “winners” back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole vine out of the ground.
  2. WEED: Sell losers and laggards and remove them garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing “nutrients” that could be used for more productive plants. The first rule of thumb in investing “sell losers short.” So, why are you still hanging onto the weeds?
  3. FERTILIZE AND WATER: Add savings on a regular basis. A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NOT EVER LOSE money investing in the markets…then STOP investing immediately.
  4. WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or a drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn’t occur. Likewise, a portfolio protected against “risk” in the short-term, never harmed investors in the long-term.”

As I have discussed many times in the past, the trend of the market is still positive and there is no reason to become extremely defensive as of yet. However, this does not mean to become complacent in your portfolio management practices either.

If you need help after reading the alert; don’t hesitate to contact me.

Current 401-k Allocation Model

401k-Allocation-121115

401k Choice Matching List

401k-Selection-List

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Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter and Linked-In

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