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Expert Perspective

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Investment e.Perspective

Current Issue | April 27, 2017

Tornado Watch in Effect

By: James Mahoney, CFA, Senior Investment Strategist & Oxford Investment Fellow


Editor's Note: Please refer to Mark Green's article for an update on recent volatility.

Financial markets can currently be described as under a Tornado Watch. While tornadoes have not formed yet, justifying a Tornado Warning, there are various conditions and crosswinds in place that create instability and make tornados possible. Today these environmental factors include high valuations, diverging central bank monetary policy, a downshift in Asian economic growth, and declines in various commodity prices. These factors can be somewhat subtle or less obvious from watching mainstream markets or the broad domestic equity indexes, but they are there to the trained spotter.

Crosswinds Developing
Valuation is not a great short/intermediate term indicator and shouldn't trigger a Tornado Watch on its own unless extremes are reached. What is new is that with the Fed likely to increase rates in the coming months we now have global central banks beginning to diverge in their monetary policies. Now, with the Fed getting close to removing the punch bowl, the tailwind of rising P/E multiples may vanish.

Back in the US all appears relatively calm on the surface and volatility remains contained as measured by the CBOE Volatility Index (VIX), but anchored long-term bond yields and the recent decline in smaller capitalization stocks paint a more nuanced picture. Market technicals and internals continue to send weak, conflicting signals. Additionally, while China by itself does not pose a large risk to the US, a broader slowdown in emerging markets could have a material impact on the developed world when combined with other factors mentioned previously.

Déjà vu?
While no two market cycles are exactly the same, when one takes a step back, the environment today is similar to that of the late 1990s. A Fed on the verge of tightening policy, a strong US dollar, volatile commodity prices, trouble brewing in certain emerging markets, and rich stock valuations. The late '90s were a period defined by a wave of tornadoes across global financial markets – some broad and some more isolated. We all remember the dot.com bubble, the Asian Financial Crisis, and the Russian Ruble Crisis. The US equity market did not experience a major decline until years later, but volatility was certainly present. While we don’t expect history to repeat itself exactly, in the words of Mark Twain, "it rhymes."

So what should investors do?

  • Maintain a disciplined approach to risk assets. We are not calling a market top, but given lower long-term return expectations, now is not the time to take excessive broad stock market risk, but to decrease equity risk on the margin.
  • Focus equity exposure where there is a greater margin of safety. The medicine of ECB quantitative easing, a cheaper euro, and lower energy prices could be just what the doctor ordered for certain European stocks.
  • Retain a healthy allocation to fixed income. Bonds provide the most reliable storm shelter in unstable times.
  • Be exposed to managers and strategies that can benefit from growing dispersion and volatility. Within the equity universe, this includes active equity managers, sector specialists in beaten up corners of the market (such as energy), and long/short equity strategies that can separate winners from losers.
  • Seek out macro-oriented strategies that can profit from movements and volatility across multiple asset classes in a changing landscape. As an additional plus, these managers offer low correlation to traditional stocks and bonds.

Markets are not necessarily headed lower uniformly, but are transitioning to a phase of higher volatility and dispersion. Now is the time to prepare. We will be watching the financial skies closely, but as we've all learned, when a Tornado Warning gets issued we rarely know where or when and there's often little time to react.

The above article represents the opinions of the author as of 8.25.15 and is subject to change at any time due to market or economic conditions or other factors.