Market volatility is spiking. Volatility, measured by the VIX, is approaching levels similar to last January, when the market was navigating the GameStop news. The increase in volatility is a reflection of investor sentiment expressed through an increase in buying of put options, a method of portfolio protection. With equity valuations near record high levels, and the Federal Reserve narrating the withdrawal of its monetary stimulus, any number of factors could trigger a sell-off. While the downward move over the past week has been credited to the spread of the Omicron variant, we suspect that compounding issues are more prominently weighing on the capital markets, including the expectation for a challenging corporate earnings next year and ongoing global geo-political issues.
Geo-political risks are increasing. China’s growing military initiatives have been in progress for many years. This past year, we have witnessed the test firing of a hypersonic missile, the continued buildup of islands in the South China Sea to support their Navy, and the continued breach of Taiwan airspace by the Chinese Air Force. China’s ambition to be a global superpower cannot be hidden. This week, the Wall Street Journal reported that classified American intelligence revealed China is looking to establish its first military base in the Atlantic Ocean in the country of Equatorial Guinea. We expect China will persist to maintain a global military presence in order to defend its growing global trade initiative.
Market volatility has spiked over the past 2 weeks. The CBOE Volatility Index, VIX, has increased above 30. Normal market volatility would be 15-18%, and readings above 25% are considered high. The VIX is a measure of the current market environment, called the spot market. The more alarming factor is not the VIX level, but that longer-term volatility futures have spiked just as much as the spot VIX. Volatility normally hits markets in clusters, but then reverts. Generally, acute market dislocations will increase the spot VIX much higher than 1-year volatility. In the most recent move, the 1-year VIX has increased just as much, to 32%, meaning that investors believe this round of volatility could persist for a longer period.
As we contemplate the risks and opportunities in the capital markets, we are assessing the increased use of leverage in the market. This is showing up in several ways. First, margin debt, measured by FINRA, has increased over 40% over the past year and is approaching record high levels at $936 billion. Margin debt is the amount of money investors have borrowed to buy securities, using their securities portfolio as collateral,
While the increase in margin debt is a concern, the percentage of the stock market’s value relative to margin debt outstanding is alarming. Margin debt is currently roughly 2.4% of the S&P 500 ‘s aggregate market value of $38 trillion. Prior to the onset of the pandemic, this ratio was closer to 2%.
The market has not yet focused on the increased use of leverage to enhance investment returns. Last month, Calpers released its 2022 target asset allocation with a sharp reduction in global equities from 50% to 42%, and marginal increases in fixed income, private equity, and real assets. However, the asset allocation included the use of 5% leverage on the fixed income portion of the portfolio.
Markets continued to pull back last week, with the S&P falling -1.22%, and the Nasdaq dropping -2.62%. The S&P is now 5% lower than its all-time highs, and the Nasdaq is 7.5% off of its high mark. As we head into the final weeks of the year, we review changes in our sector weights, which guides our investment process.
Sector Allocation Shifts
As the markets continue to navigate heightened volatility and digest company earnings news and economic data, we are making tactical shifts in our Core Sector Portfolio Models as well as our Large Cap Blend and Dividend Growth SMA’s and Portfolio Models in order take advantage of the relative value opportunities across sectors.
First, we are shifting industrials from neutral to underweight. Industrials have made a quick recovery as the economy has reopened. However, we think it has run much too far. The sector is up over 20% year-to-date, and we believe there is still a lot of uncertainty around defense spending, as well as headwinds in airline demand with the new Covid variant.
Next, we are shifting Consumer Staples from neutral to overweight. The sector performs well in periods of uncertainty, and the stability of this sector makes it a great defensive play. In addition, Staples is the worst performing sector so far this year and has an attractive valuation. In cases where growth of the economy has peaked, this sector will outperform.
Additionally, in the Consumer Discretionary sector, we are remaining neutral, but we are taking steps to manage risk given the large exposure to Tesla and Amazon within this sector. The two stocks combined make up over 40% of the weight. Therefore, we are implementing a sleeve of an equal weight consumer discretionary ETF, ticker RCD. The ETF diversifies large concentration risk for two stocks that have run quite far over the last few years.
In Financials, we are removing our sleeve of KBE, the banking sector ETF. Overall, we are underweight the Financials sector. The sector has run very high this year, and has been the second-best performer. Although we continue to see some value in big banks, KBE does not provide the best exposure to opportunity as the ETF is made up of only small and mid-cap regional banks, which we do not find any near-term catalyst for.
Finally, we are moving overweight the Healthcare sector, XLV. This sector has lagged the S&P. However, there are many positives for future growth. Many companies in Healthcare have strong balance sheets with plenty of cash for M&A. Biotech and pharmaceuticals have strong pipelines, and valuations are very attractive relative to historical averages. COVID will continue to linger and mutate, giving vaccine players such as Pfizer large bumps in revenue.
Heading into the New Year, we are overweight Technology, Consumer Discretionary, and Healthcare. We are underweight Energy, Financials, Industrials, and Utilities sectors. And, we are neutral with the Consumer Discretionary, Consumer Staples, Materials, and Real Estate sectors.
Interest rates across the globe fell considerably due to growth concerns from supply chain disruptions and the new variant of Covid outbreak. The rate on the 10-year U.S. Treasury fell to 1.35%. Global bonds followed suit, with the entire German Bund curve turning negative once again, and negative yielding global debt is back to $14 trillion.
The decline in rates, and overall market volatility led to the first spread widening across credit since December of 2020. Investment grade spreads have widened 15bps, and high yield spreads have widened 40bps over the past week. Large portfolio trades left Wall Street investment banks long credit going into this dislocation, which only worsened the spread widening as overall liquidity was low coming off a holiday weekend. Short term, we believe liquidity will remain low through the remainder of the year, which will put pressure on spreads. Ultimately, we believe the need for yield and overall solid credit conditions will lead to a resumption of spread tightening.
This report is published solely for informational purposes and is not to be construed as specific tax, legal or investment advice. Views should not be considered a recommendation to buy or sell nor should they be relied upon as investment advice. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. Information contained in this report is current as of the date of publication and has been obtained from third party sources believed to be reliable. WCM does not warrant or make any representation regarding the use or results of the information contained herein in terms of its correctness, accuracy, timeliness, reliability, or otherwise, and does not accept any responsibility for any loss or damage that results from its use. You should assume that Winthrop Capital Management has a financial interest in one or more of the positions discussed. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Winthrop Capital Management has no obligation to provide recipients hereof with updates or changes to such data.
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