Wespac Third Quarter Report

Volatility Returns to the Markets – Third Quarter in Perspective

Volatility returned to the US equity markets in third quarter, with the S&P 500 dropping -6.9% and bringing the index to a -6.7% loss year-to-date.    From the May 21, 2015 high to the August 25, 2015 low, the S&P 500 dropped -12.3%.

While this was a fairly normal correction from a historical perspective, the infrequency of corrections over the past 4 years and the mini flash crash of August 24, 2015 made this event seem more significant.   This is only the third 2-month consecutive loss for the S&P 500 since October 2011; December 2014-January 2015 lost -6.9% and April-May 2012 gave back -3.5%.   The S&P 500 has not really had a sustained correction since 2011 when the index dropped -18% over 5 consecutive months, losing -14.3% in third quarter of that year.

The mini flash crash on August 24, 2015 brought attention to how extended the market had become, and perhaps how brittle.    While the S&P 500 dropped -3.9% that day, there were many stocks and ETFs that dropped well over 25% at the open.    This kind of price action has made us more cautious.

The third quarter correction was driven by the Materials, Energy, Healthcare and Financial sectors.   Utilities was the only sector that made gains in third quarter, with Cyclicals and Staples around flat for the quarter.   Other than the pressure on the Healthcare sector in third quarter, these results were largely in line with what has been happening throughout 2015.

The Wespac Methodology

The Wespac investment methodology is different from most modern portfolio theory and fundamentally-based methodologies.   First, Wespac employs a methodology of evaluating the relative strength of market indices, sectors, and stocks in order to target investments.   This kind of approach leads to avoiding sectors like Materials and Energy in 2015 and to favor sectors like Cyclicals and Staples.  Further, when sectors like Healthcare fall out of favor, as it did in third quarter 2015, the Wespac methodology redirects investment to stronger sectors and stocks.   Second, Wespac employs a methodology of constantly evaluating risk in the markets to determine if it is appropriate to raise cash during times of market distress.   This element of the Wespac methodology can actually raise cash levels in portfolios to 100% in bear markets, helping clients avoid losses in tough markets.  As of the end of third quarter, most Wespac portfolios held 25-50% cash based on this risk management methodology.

When money flows shift quickly, as they have been doing since the beginning of June, it is necessary to increase the turnover in the portfolios to keep up with the index, sectors, and stocks that are showing relative strength.    When relative strengths relationships are fairly stable, as they were back in 2013, the portfolios have relatively low turnover rates.    In the 2015 environment, more turnover has required to stay aligned with where money flows and relative strengths are emerging – we expect continued high turnover rates at least through the end of the year.

Portfolio Highlights – Income and Growth

The Wespac Income and Growth Portfolio attempts to deliver yields in excess of the S&P 500 and modest growth.    The universe of stocks that Income and Growth evaluates includes dividend-paying common stocks, preferred stocks, business development corporations, master limited partnerships, REITs, and utilities.

Income and Growth, as of September 30, 2015 has generated net returns of 5.4% year-to-day, 10.7% annualized net returns over the past 3 years, 9.5% annualized net returns over the past 5 years, and 9.9% annualized net returns since inception, January 1, 2004.

Income and Growth currently holds 27% cash, 38% dividend-paying common stocks, 20% preferred stocks, 10% utilities, and 5% REITs.[1]

Looking Forward to Fourth Quarter

Fourth quarter has a strong history, generating positive returns a high percentage of the time.   Over the past 20 years, fourth quarter has had positive gains in the equity markets 80% of the time with an average gain of +4.96%.   Over the past 6 years, this has improved to gains 83% of the time with an average gain of +6.6%.   

Fourth quarter this year started out with a sharp rally from the September 29, 2015 lows, gaining +7.1% over just 9 trading days and 5% in fourth quarter.   Some of the best fourth quarter performances have come on the heels of a summer corrections; in 2002 a -32% Spring-Summer correction spawned an +8.3% rally in fourth quarter, while in 2011, a -18% Spring-Summer correction triggered a +11.1% rally in fourth quarter.   In this cycle, the S&P 500 lost -12% in the 2015 Spring-Summer correction and, as of this writing, has already retraced 5.5% of the loss.

We are cautiously bullish for fourth quarter – the Spring-Summer volatility appears to have been just a correction within an uptrend, with the recent rally pushing the S&P 500 back over its 50-day moving average and challenging its 200-day moving average.    It seems likely that we will follow a typical pattern of October volatility setting the stage for gains in November-January.

There are several primary risks that may affect our fourth quarter outlook, which we are actively monitoring.   The first risk is that third quarter earnings and outlooks will disappoint; despite aggressive expectations for third quarter earnings, we have yet to exceed third quarter 2014 earnings levels and analysts are forecasting that third quarter 2015 will be lower on a year-over-year basis.

The second risk is that the US Congress will fail to come to consensus to increase the debt ceiling, causing market volatility as the threat of government shutdown increases in probability.   The Spring-Summer 2011 correction was the last time this risk played out in the equity markets.

The third risk is that the Federal Reserve will surprise the equity markets with a termination of their ZIRP program at their December meeting.    This is a very tough risk to assess – not only is it impossible to predict what the Fed may or may not do, it is equally difficult to understand what the market reaction might be.

The final set of risks we see in fourth quarter are geopolitical events.   The equity markets have largely ignored geopolitical events over the last few years, but the number and seriousness of events around the world give us a growing feeling that we should elevate our attention to these risks.  

With the S&P 500 regaining its 50-day moving average and challenging its breakdown point in the 2040 range, we have reduced cash positions by about 15% in most portfolios, leaving about 35% cash at this time.    As the technical condition of the market improves, we will continue to reduce cash to participate in fourth quarter.   We expect money flows to favor 2015 themes, including late cycle defensive sectors and stocks – as always, we will continue to dynamically adjust portfolios as we update our risk assessment and analyze emerging relative strengths.