The Art of Knowing

A man known simply as Rumi said some of the most profound things I’ve ever read. No, I’m not talking about Beyoncé’s baby: Rumi was a 13th century poet, and he managed more memorable one-liners than a Vince Vaughn flick. One of my favorite Rumi quotes is “The art of knowing is knowing what to ignore.” Rumi would have made one hell of a global macro maven because that 800-year-old quote succinctly sums up the key to successful investing.

One objective of this weekly commentary is to shift your focus away from the plethora of distractions the markets and media send your way and towards the most critical developments.

With that in mind, let’s take a quick tour of Washington, D.C., a road trip to Cleveland and then discuss what markets are signaling as we begin the final three-month push of 2017.

 

What to Ignore

One of the most common mistakes investors make is politicizing their investment decisions. I don’t care if you’re Republican, Democrat, Tea Party, or a member of the “tinfoil hat, conspiracy theory of the month club”; outside of a few days, nothing politically motivated impacts asset prices. And yes, that includes last week’s attempt to pull your portfolio into politics: Trump’s tax reform.

Trump’s tax reform should not be figured into your investing decisions because it simply doesn’t matter what he proposes. What matters is what he gets passed and how that legislation impacts the U.S. economy. We are months from any clarity on that topic.

Remember, the most important factors impacting asset prices are economic conditions and how central banks respond to those conditions, or what I call the Fundamental Gravity.

When markets overreact to political footballs, and move counter to their Fundamental Gravity, your job is use those opportunities to position yourself appropriately.

 

What Not to Ignore

While Trump was single-handedly attempting to break Twitter from the White House, in Cleveland Ohio, Janet Yellen was dropping real knowledge we can use to sidestep risks and possibly position ourselves for opportunity.

The core topic of Yellen’s talk was the surprisingly low level of inflation the U.S. has experienced most of this year. She flat out said, “the shortfall of inflation this year is more of a mystery.” How’s that for intellectual honesty?

The real juice came when Yellen said, “[There are] considerable odds that inflation won’t stabilize at 2% over the next few years” and “[it] would be imprudent to leave rates on hold until inflation reaches 2%.”

Allow me to translate “Fed speak.”

The Fed chairperson just told us they are raising rates in December and will begin shrinking the balance sheet as planned. She also revealed the Fed is no longer data dependent, but they have rather become market dependent. Specifically, the Fed is making decisions based on a healthy labor market that continues to create jobs and a healthy stock market that continues to create brand new all-time highs.

The bottom line is the Fed is moving forward with normalization, low inflation be damned.

A Fed chair whispering hawkish sentiment in our ears coupled with more rate hikes and a reduction in the Fed’s balance sheet is not what investors are positioned for right now, and it’s going to catch a lot of people wrong-footed.

 

Markets Say What?

As we enter Q4, U.S. economic growth continues to accelerate, but now we have something else occurring in markets that we haven’t seen in almost a year. In addition to U.S. growth being up, we also have the U.S. dollar up and U.S. yields up.

Around the office, we call that the three-headed U.S. hydra because, just like the mythical beast when it rises out of the Lake of Lerna, its impact is felt far and wide.

You’ll recall that in the Vague Destination from September 4, I wrote that the U.S. dollar was overdue for a bounce and that it would rally into year-end. Well, the U.S. dollar bottomed four trading days later and has since rallied 2% to close out the month of September.

The greenback isn’t the only U.S. market benefiting from strong U.S. economic data and hawkish Fed rhetoric; U.S. yields have found their footing again as well. After languishing for most of the year, two-year Treasury yields have spiked to the highest level since the crisis, and 10-year yields are now trading at three-month highs.

When these three factors move higher in lockstep, the playbook is straightforward. You want to be involved in the tech and financial sectors of the U.S. equity market, and you want to avoid gold, bonds and their equity cousins (utilities and REITs).

The last time we experienced the three-headed U.S. hydra was the second half of last year from June through December. During that time, long-dated Treasuries lost 13.8%, gold lost 13.3% and utilities lost 5.8%. On the flipside, U.S. tech stocks gained 12.5% and financials gained 26.5%. How’s that for some outperformance?!

But it’s not just performance that is impacted by the hydra. Risk for certain markets gets amped up as well. In fact, Treasuries, gold and utilities exhibited nearly three times as much downside volatility as U.S. tech and financial stocks during that stretch.

 

What’s in Your Wallet?

In the final three weeks of September, the three-headed U.S. hydra began its latest rise, and market reactions were in line with what we would expect. Long-dated Treasuries lost 3.3%, gold lost 5.0% and utilities declined 3.4%. Once again, tech and financial stocks were winners, gaining 2.2% and 7.7% respectively.

If you’re still holding those losers in your portfolio, you’re not alone.

Investors are positioned long in treasuries and gold, and during September they added an additional $258MM to the largest U.S. utility exchange-traded fund, the Utilities SPDR ETF (XLU).

They also have the least long Nasdaq exposure in the last year, and are outright betting against the Russell 2000 index, which is comprised of small caps. But why does that matter?

It matters because the Russell 2000 is heavily weighted towards financial stocks, which is why it gained 6.7% during September. This is not the environment in which to short financial stocks of any size!

 

The Bottom Line

Rumi also said, “Come, seek, for search is the foundation of fortune: every success depends upon focusing the heart.” In the investing game, every success depends upon focusing your attention on the critical economic and central bank developments and knowing what to ignore.

The Fed is crystal clear in their hawkish intentions, U.S. economic data is clear in its signal of accelerating growth, and the greenback and U.S. yields have clearly bottomed.

There is a right way and a wrong way to be positioned when the U.S. three-headed hydra arises. Unfortunately, most investors are positioned for losses as this monster awakens. How are you positioned?