Thoughts on recent market volatility

For the past three years the market has had an annualized return of 15%, but sales/EPS have grown at a rate less than 5%. Basically, the market has gotten ahead of real activity. My take-away from Q2 earnings season was that sales were lacking. We have gone through the cost cutting cycle and now moved onto buybacks and dividend increases funded with cheap money in order to “manufacture” earnings. Money is getting more expensive so you need organic growth to increase EPS, which is hard to find in a 2% GDP environment.

For all of 2015 we haven’t been able to get a real rally going and find ourselves in the tightest trading range in years. The charts on the major indices like S&P 500, S&P 400 Midcap, and S&P 600 SmallCap are all basically where they were last Nov '14. The slowdown in China , falling oil prices, and worries about Fed policy are just the catalyst to a sell-off based on weaker economic fundamentals. The stronger dollar is not helpful either.

Just as a comparison, we had a similar market sell off last September after which the market recovered fairly quickly and began making new highs again. There has been very similar market action over the past few weeks. The difference is that the catalyst for last year’s decline was the rise of ISIS, the Ebola breakout, and the takeover of Crimea. While significant, these events were overblown on a macro level and played into existing fears of an overvalued market. Now you have China slowing and the worry of slower global growth in general which is a much more real and significant development.

My opinion is this sell-off is healthy and the market is in need of a breather. I don’t think this is the start of a 20% plus downturn, but the weakness is real and could continue for months. Market Sentiment is no where near frothy, and I’m guessing another 7-10% down from here before things turns. A pull-back of this nature could set up a nice rally for Q4, but it may be a while before we recover and begin to make new highs again. There is the possibility that this is just an intermediate bottom and we could experience a retest of the lows. My main view is this is a BUYING opportunity for U.S. equities, but don't bet the farm just yet. You may get the chance to buy this cheap for a while.

My first thought in regards to sector allocation would be to avoid commodity related areas like ENERGY and MATERIALS. In anticipation of the start of a FED rate hiking cycle I would cutback on bond equivalent sectors such as UTILITIES and CONSUMER STAPLES. I would look more toward CONSMER DISCRETIONARY and TECH areas and maybe take a look at FINANCIAL stocks, in particular BANKS. The HEALTH CARE sector has had a good run for the past few years but the valuation is quite high and it is maybe getting a little long in the tooth.

I am getting nervous about Treasuries in general and would recommend sticking with shorter duration assets. The High Yield market has seen rates move up so again I would urge caution.

Globally I would avoid much of EM given the direction of commodities and the slowdown in China. Of the BRICS countries only India seems compelling. Maybe look to Europe where QE is moving forward. Some of the core European companies have been struggling and it may be worthwhile looking at some of the smaller countries that have seen their share of problems but have been doing better lately. Also, the FINANCIAL sector in Europe may benefit from Central Bank policies.

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Who Am I?

For two decades, I was the Senior Investment Manager at the pioneering asset management firm, Zweig-DiMenna, working directly with legendary Wall Street investor, Dr. Martin Zweig.

 

An established Strategist and Portfolio Manager, I possess deep expertise in equity markets, with particular emphasis on asset allocation.

 

My in-depth research background has fostered unique investment ideas derived from analyzing large amounts of empirical data.

 

I have an established track record for generating alpha and controlling risk in times of volatility.

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