A Fast Paced and Risky Second Half
July 10, 2018
Shashi Mehrotra is the Chief Operating Officer and Chief Investment Officer of Legend Advisory and a pioneer in the application of artificial intelligence to the field of investment management.
He is the chief designer of Legend's Asset Allocation Neural Network (AANN). AANN is a sophisticated computer model that uses mathematical algorithms to forecast the relative strengths of different asset classes. Mr. Mehrotra spent over a decade on the research, development, testing and implementation of AANN's state-of-the-art artificial intelligence system.
2nd Quarter 2018 Market Commentary
A Fast-Paced and Risky Second Half of 2018
Our outlook for the global economy is bullish, particularly for growth in emerging markets. Global growth could easily exceed 3.5% for 2018. Japan has been a bit of a surprise this year with the strategies employed by Japanese prime minister Shinzo Abe (Abenomics) working to prompt some growth. Over the short to intermediate term, our models continue to favor U.S., Japan, and emerging markets, but are averse to Europe. This doesn’t mean this is time to abandon European equities because they should do well over the longer term. One caveat is the potential “Italeave” – that Italy might leave the European Union (EU). The probability of that happening is very low but, if it does happen, it can be troubling. Europeans could react by crowding the German banks and fearing that other countries would leave the EU as well. A common currency is similar to an arranged marriage – it’s an agreement that is easy and exciting to get into, but excruciatingly painful to get out. Italy would need a referendum in order to leave. But, Brexit happened in spite of the difficulties they faced. It is an area we will continue to keep an eye on.
On the U.S. front, we think the economy is going to continue to grow, but at a slower pace. It would be pleasing if growth could reach 3%. Our concerns for the U.S stock market in the second half of 2018 include:
- Decreased Earnings Growth: Earnings are a catalyst for markets to go up, but it’s a double-edged sword. The market can tend to expect earnings to continue growing the way they have over the last five years and set themselves up for disappointment. The U.S. market is the most expensive market because it’s highly valued for its performance over the last five years. However, we don’t think the EPS (earnings per share) momentum that we’ve seen in the past, can continue to grow at the same pace.
- Inflation Increase: We think interest rates also present a risk. The Federal Reserve could have a misstep in their decisions. Or, long-term rates could start to jump in response to inflation fears.
- General Lack of Pessimism: While you don’t want people to be afraid of the market, it is good to have a healthy dose of caution. One of the things we’ve noticed is households have 23.5 trillion of equity holdings, which is about 40% of their total household financial assets. This is higher than the long-term average since 1968, and it’s even higher than what it was in 2007 right before the peak of the market. If you exclude real estate holdings and anything other than financial assets, the percentage is more alarming. Looking at only stocks, bonds and cash allocations by households, equities make up 55.2% of their assets. This is significantly above the average of 45% we have seen since 1952. When investors are fully invested in stocks, the returns looking out 10 years are generally not that healthy.
- Market Stages: In any market, there are varying stages. Even in a market that’s been surging higher and higher slowly, when it has a panic selling moment, then it goes through four different phases. We experienced the first one where panic selling was seen in the steep sell-off in February. Then we saw multiple failed retests when the market tried to start to bounce back but could not go through the resistance and go higher. That’s just part of the process. This will continue until a long-term market trend is established and backed by fundamental or technical indicators.
- Breadth Thrust: When the market started falling, the volume of stocks going down was much higher than the volumes of stock going up. We want to see the opposite which is called a breadth thrust. It is a very big concern over the short term that we haven’t seen that happen. The markets can still go up without a breadth thrust, but the bull’s days could be numbered if we don’t have one. We could experience this in the second half of 2018, but it is more likely we will see more volatility.
A Volatile and Hyper-Reactive Market
2017 was a very anomalous year due to the lack of volatility. At the beginning of 2018, we indicated we expect to see more volatility and we have. We think in the second half of the year, there’s going to be even more. I’m not bearish by any means. I think it’s still time to continue to give the bull the benefit of the doubt because our financial models remain bullish.
The high percentage of algorithmic trading makes this a much trickier trading environment. In algorithmic trading, pre-programmed formulas are used to automatically sell or buy depending on the programmed response to market conditions. I am concerned about the impact of this trading as it increases the speed of market reactions. Algorithmic trading volume has gone from 25% in 2004 to just shy of 70% in 2017. This means if there’s a catalyst for a market decline, it can go down faster and deeper.
In summary we still believe that the bull market is alive and well, but we think it’s probably in a mature phase with the upside being limited. As always, we are closely monitoring changes so we can do the right thing with our client’s money.
Sources: NDR, Trend Macro & Wellington Shields Inc.
Shashi Mehrotra, Chartered Financial Analyst, is the Chief Operating Officer and Chief Investment Officer of Legend Advisory. The opinions and predictions expressed herein are those of Shashi Mehrotra solely and not necessarily the opinions or expectations of Legend Advisory or any of its affiliates. Such opinions and predictions are as of June 21, 2018, and are subject to change at any time based on market and other conditions. No predictions or forecasts can be guaranteed.
Current market and economic data is as-of June 21, 2018. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Important Disclosures and Definitions
Investing involves risk including the potential loss of principal. The opinions and material presented are provided for informational purposes only. No person or system can predict the market. Neither asset allocation nor diversification guarantee a profit or protect against or eliminate the risk of experiencing investment losses. All investments are subject to risk, including the risk of principal loss. There is no assurance that the investment goals and process described herein will consistently lead to successful investing.
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There are some risks associated with investing in the stock markets: 1) Systematic risk - also known as market risk, this is the potential for the entire market to decline; 2) Unsystematic risk - the risk that any one stock may go down in value, independent of the stock market as a whole. This also incorporates business risk and event risk; and 3) Opportunity risk and liquidity risk.
Emerging markets are sought by investors for the prospect of high returns, as they often experience faster economic growth as measured by GDP. Investments in emerging markets come with much greater risk due to political instability, domestic infrastructure problems, currency volatility and limited equity opportunities (many large companies may still be "state-run" or private). Also, local stock exchanges may not offer liquid markets for outside investors.
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Foreign Equity - Issues floated by foreign companies in the domestic equity market. Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. Hyperinflation, with prices rising at 100% a year or more, causes people to lose confidence in the currency and put their assets in hard assets like real estate or gold, which usually retain their value in inflationary times.
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