Commentary Archive 2013

Commentary Archive 2013 background

Commentary Archive 2013


Performance results are based on estimates. Although the information contained in the commentary sections have been obtained from sources we believe to be reliable, the accuracy and completeness of such information and the opinions expressed herein cannot be guaranteed. Past performance is not necessarily indicative of future results. Different types of investments involve varying degrees of risk.

Fourth Quarter 2013

Fourth Quarter 2013

  • Hanseatic’s Large Cap product gained 8.25%, underperforming the Russell 1000 Growth benchmark by 2.19%.
  • The All Cap product gained 8.65%, underperforming the Russell 3000 benchmark by 1.45%.
  • The Growth & Income product gained 10.12%, underperforming the S&P 500 Total Return by 0.40%.

Year to date

  • Hanseatic’s Large Cap product gained 40.08%, outperforming the Russell 1000 Growth benchmark by 6.59%.
  • The All Cap product gained 46.10%, outperforming the Russell 3000 benchmark by 12.60%.
  • The Growth & Income product gained 33.48%, outperforming the S&P 500 Total Return by 1.07%.

2013 was not only an excellent year for market returns, but it was also one of the very best in market history when viewed in the context of persistence and low volatility that characterize the best price trends. Judged in terms of our quantitative model standards, 2013 was the best year since 1995; and before that since 1958 and 1954. The calendar year return that followed each of these periods averaged approximately 20%. In each case, however, the low volatility nature of the ’95, ’58 and ‘54 trends gave way in each following year to a more uneven environment and deeper corrections, though the corrections were still moderate in nature.

The strong Performance of the U.S. equity markets in 2013 was driven by three primary factors. First, investors’ fears at the beginning of 2013 weren’t realized. These perceived headwinds included a material rise in interest rates, a potential implosion of the Chinese economy and/or banking system, a U.S. debt default and/or fiscal cliff, and an on-going European debt crisis. While some of these headwinds remain for 2014, none of them developed in a materially adverse way during 2013. Second, as the crisis mentality gradually abated during 2013 and the realities of low fixed income returns set in, investors responded with renewed confidence by putting approximately $190 billion of new money into equity mutual funds through November 2013. The previous five years saw net outflows totaling $536 billion while bond funds attracted $1,372 billion over the same period. Perhaps the long awaited “Great Rotation” by retail investors from bonds into stocks has finally begun. Finally, corporate share buybacks continued to help stock prices as they have throughout this bull market and as they likely will continue to during 2014.

As we begin 2014, the consensus view of the investment climate appears to be dramatically different from a year ago. Employment is picking up, industrial production is on the rise, and there will likely be significantly less fiscal drag on the economy this year. The consensus forecast for GDP growth is approximately 3%, which is the highest consensus GDP forecast since 2007. Thomas Lee, equity strategist at JP Morgan Chase, noted that U.S. gross fixed investment has fallen to 13% of GDP, on par with Greece and significantly below the 16%-21% range that has been the norm for the U.S. from 1950 – 2007. The earnings growth consequences for a revival in investment spending could be very significant, and U.S. corporations certainly have the cash resources available to fund such investment.

So what are the risks to this seemingly rosy market scenario? First, one could question how much future earnings growth and/or PE multiple expansion has already been assumed by the market during the nearly five year bull market. Admittedly, we don’t have the answer – the question is cautionary. Those who have been steadfastly bearish about the market point to two primary risks. The first risk is that corporate profit margins are historically high and that they will necessarily revert to a much lower mean. The counter argument is that they have remained high for structural reasons such as lower interest expense and tax rates, and higher margins in foreign operations. In addition, technology companies have now become a greater weight in the S&P 500 and have higher margins than the Telecom and Utility companies they replaced.

The second risk relates to valuation, specifically long-term valuation measures such as Robert Shiller’s cyclically adjusted PE multiple (CAPE) that has long been regarded as a reliable indicator of long-term value. CAPE is now at a level where markets have peaked several times in the past. The same is true of other long term measures of value such as Tobin’s Q ratio. The counter arguments here relate primarily to accounting and changes in market structure. Our argument against CAPE is more basic; it’s been wrong for this entire bull market.

The biggest risk in our view is that for whatever confluence of reasons, interest rates go up too much and/or too fast. While many observers attribute low rates to quantitative easing by central banks, slow economic growth was also a key contributor. As economic growth rebounded in 2013, interest rates have also risen. Rate increases can be benign if economic growth translates into higher earnings growth. But if interest rates rise significantly faster than earnings growth, stock prices will decline.

We leave with a chart that shows the Dow Industrial average’s 10 year rolling returns back to 1910. It depicts a market in January 2014 that is potentially still in the early stages of a secular bull market.

Third Quarter 2013

Third Quarter 2013

  • Hanseatic’s Large Cap product gained 11.98%, outperforming the Russell 1000 Growth benchmark by 3.86%.
  • The All Cap product gained 14.26%, outperforming the Russell 3000 benchmark by 7.91%.
  • The Growth & Income product gained 6.34%, outperforming the S&P 500 Total Return by 1.09%.

Outperformance in the Large Cap during the quarter was derived primarily from Consumer Discretionary, Healthcare and Consumer Staples. Seven out of ten sectors contributed positively to Performance. OutPerformance in the All Cap during the quarter was primarily attributable to Consumer Discretionary and Healthcare. All ten sectors contributed positively to the outPerformance, with Telecom and Utilities having no exposure in the portfolio. The Growth and Income product benefited from exposure to Consumer Discretionary and Industrials primarily. Six of ten sectors contributed to the relative outPerformance.

The U.S. equity markets navigated the Third Quarter quite well considering all the cautionary advice to investors which included the annual “go away in May” warning, multiple versions of what impact QE will have on the markets and the Mideast turmoil. To say nothing of the political and fiscal circus in our nation’s capital. The market corrected over the entire month of August, but the 5.7% pullback in the S&P 500 was considerably more modest than many analysts had forecast. The correction was even milder for the small and mid-cap indices. July and September were, contrary to expectations, quite robust.

By Hanseatic’s count, there have been eleven ≥ 5% corrections in the S&P 500 since the bull market began in March, 2009. The current calendar year is the first, thus far, to have had only one > 5% correction, and also the first year not to have endured a > 7% correction, much less the 16% and 19% selloffs that occurred in 2010 and 2011 respectively. Thus, when Hanseatic combines directional and volatility measures, the conclusion is that the past nine months have been the “healthiest” run for the market indices over the course of the 54 month bull market, one of the longest in history.

Despite the relatively tranquil upward path the domestic equity market indices have traced this year, the behavior of the underlying sectors and industry groups have been rather chaotic, especially relative to market benchmarks. Only two of the ten market sectors, Consumer Discretionary and Healthcare, have produced consistent leadership in 2013. But within most sectors, including Consumer Discretionary, there have been significant leadership rotations among the component industry groups. The groups that were the Performance leaders within Consumer Discretionary early in the year, such as housing, retail and restaurant stocks, are now the laggards, replaced by a rather motley group of names which seemingly have no particular theme. Perhaps the most striking example of the subsurface industry group rotation is the real estate component of the Financial sector. REITs were among the strongest market performers through May, but have corrected sharply since and are now the weakest single industry group.

Looking ahead, Hanseatic believes there are several reasons for investors to be modestly optimistic. The first is housing, the health of which is important for the economy and employment. The correction in housing stocks over the past few months coincided with the rise in interest rates in general and mortgage yields in particular. Our models indicate good probabilities that the correction in both housing stocks and bond prices is likely over.

The second reason for modest optimism lies in the outlook of the global economic recovery. In recent years, international economic growth has been anemic, at best, with some major economies in outright recession; however, the Eurozone emerged from recession in the second quarter and leading economic indicators point to continued recovery. Most European stock markets have been mired in a trading range for the past several months. That has changed in a positive way in recent weeks with Spain, Italy and France making new 18-month highs, and by Hanseatic measures, stronger than both Germany and the S&P 500. There are also signs of improvement in the emerging world economic recovery. China and the emerging market ETFs have also rallied sharply in recent weeks. A synchronized global recovery would provide a significant boost in confidence and spur more durable economic growth.

Lastly, another positive for modest investor optimism, and for the U.S. economy, is energy. U.S. oil production has risen dramatically over the past few years while net imports of crude oil have persistently declined for the first time since 1980. While it will take some time, there now seems to be a viable path towards energy independence.

Second Quarter 2013

Second Quarter 2013

  • Hanseatic’s Large Cap product gained 0.35%, underperforming the Russell 1000 Growth benchmark by 1.71%.
  • The All Cap product gained 1.97%, underperforming the Russell 3000 benchmark by 0.71%.
  • The Growth & Income product lost 2.37%, underperforming the S&P 500 Total Return by 5.29%.

The U.S. stock market is now early into the fourth year of a cyclical bull market. The market indices rose in general about 2% during the second quarter and registered the best Performance for the first half of the year since 1999. The market peaked in mid-May and incurred an approximately 6% correction, assuming the correction ended in late-June, as Hanseatic thinks is probable. This was the first second quarter interval since 2010 that the market did not correct at least 10%.

The summary return numbers for the equity markets belie the fact that market volatility returned with a vengeance over the last few weeks, especially in the fixed income and commodity markets. All of this in response to Chairman Ben Bernanke’s comments and the market’s chaotic attempts to understand when the Fed will begin to taper its QE3 activities and what impact it will have on interest rates and economic growth. The fixed income markets reacted rather violently to the downside as investors realized that capital losses can quickly overwhelm yield returns.

It seems to Hanseatic that the Chairman has been consistent in stating that the open market bond purchases will continue until there is solid evidence of either:

  • “An improvement in economic activity to the point of the economy being able to grow sustainably under its own power (as measured by the unemployment rate).”
  • “An upward shift in inflation (somewhere around 2.5% inflationary expectations).

There is wide-spread concern that a shift away from QE3 would signal the end of the cyclical bull market. A move away from QE-type remedial treatment likely will engender uncertainty simply because of change itself. The more important point is that there is no doubt that monetary policy will continue to be accommodative. The unemployment rate is too high and economic growth too slow for the Fed to consider tightening. But the markets and economy are no longer in crisis; normalizing monetary policy recognizes that the economy is close to normal. Hanseatic believes that this is at least part of what the U.S. equity market has been discounting.

The recent rise in long-term interest rates are reflecting more normal conditions of risk and reward; a structure of interest rates that is reverting to normal from crisis conditions. Hanseatic does not believe a moderate rise in the yield structure poses undue risks for stocks as long as inflation is held in check.

First Quarter 2013

  • Hanseatic’s Large Cap product gained 15.16%, outperforming the Russell 1000 Growth benchmark by 5.62%.
  • The All Cap product gained 15.42%, outperforming the Russell 3000 benchmark by 4.34%.
  • The Growth and Income product gained 16.87%, outperforming the S&P 500 Total Return by 6.26%.

OutPerformance in the Large Cap was paced by positive contributions from stocks in the Industrial, Energy, Technology and Healthcare. Portfolio holdings from the Consumer Discretionary, Financial and Consumer Staples also contributed positively.

As we begin the second quarter of 2013, the cyclical bull is entering its fifth year. This cyclical bull market is within the broader framework of a presumably ongoing secular bear market that began in 2000. Also of note is that in 2010, 2011, and 2012, the stock market peaked in April and began corrections ranging from 10% to 19% over a two to five month time span.

There are bearish arguments to be made on several fronts. RBC Capital Markets has a composite sentiment indicator which shows market optimism at a level higher than at any time in several years. Likewise, Citibank’s panic/euphoria model shows investor sentiment nearing euphoric levels. The near historic lows in the volatility index is also indicative of a complacent market.

There is also a complacency of a different sort that is of concern; the notion that the Fed will maintain its easy-money policy for the next few years has seemingly become widely accepted. Ergo, the central bank will continue to support at least modest economic growth, and by extension, the stock market itself. If this is the consensus view, what happens when the Fed begins to normalize monetary policy? No one can answer that question, but we do know the markets will begin to discount the policy change well in advance of its reality.

While Hanseatic recognizes the above concerns as legitimate warning flags, our intermediate term market outlook remains sanguine. The reality is that the economy has proven to be very resilient in its ability to weather a whole spectrum of uncertainties ranging from double-dip domestic recession concerns, China growing either too fast or too slow, and the grim reality of a Europe, most all of which is in recession. All the while, economic activity in the U.S. continues to grind higher, and is much less fragile than the consensus view.

Based on Hanseatic’s internal work, we do not observe any of the excesses or imbalances that are characteristic of high risk conditions in either the overall market or any of its component sectors. After a four year bull run in equities, one would reasonably expect some measure of confidence expressed in fund flows. Instead, the data portray a lack of enthusiasm. While individuals added almost $20 billion to U.S. stock funds this year, this amount is just 3.5% of the withdrawals since 2007 according to the Investment Company Institute. The $20 billion inflow to equities compares with $44 billion placed with fixed-income managers in 2013.

Pension funds stock allocations similarly reflect a lack of confidence in forward stock returns. As of the most recent survey of the asset allocation of U.S. corporate pension plans by Pension and Investments, the allocation of just 44% of plan assets to stocks is now the lowest in the survey’s history. In contrast, allocations to both fixed income and alternative investments reached the highest level in the survey’s history.

Market and sector structure is healthier than it was at the April peaks in the past three years based on our internal work. We also have yet to observe any significant warning signs from our internal risk models.