Kotok recently sat down with ETF.com to give his take on the end of QE and the latest market sell-off. He discusses his favorite defensive sector and where he currently sees opportunities. Finally, he tells us what he expects out of the eurozone and the ECB.
ETF.com: We've seen a steep correction in the past month in broad U.S. equities. Do you see this sell-off stabilizing, or do you see more pain for equities for the remainder of the year?
David Kotok: We started the pain in July. For the first time we had a situation in which QE, by the Federal Reserve, worked its way down so that at an annualized run rate, the Fed was not absorbing the additional federal debt created by the deficit. Prior to that, the Fed essentially was financing the federal government. That has come to a stop. This is the month of a full stop.
So we started to cross over the erosion of the support that QE gave to fiscal policy in the U.S. In the middle of the summer, if you use annualized rates, we are now down to a deficit which has gone to neutral. We've now gone to a neutral monetary policy from a run rate of $85 billion a month net new purchases of federally backed securities. So QE went down to zero. That's where it will be at the end of October. The federal deficit went from 9 percent of GDP to under 3 percent of GDP right now.
What does that mean? It means there's a shift of leveraging and a burden that has now transferred off the central bank. Now that had to happen; they had to do it. I wish they had done it a year ago.
The second policy is that the mechanics of the Federal Reserve are evolving and being tested now. The markets are saying there's going to be an increase in interest rates coming. So it's making an adjustment. At the same time, the Europeans are going the other way. They'll become more expansive. They have an economy in a dead stop. Japan probably will have another round of QE, as it's the only tool it has left. The U.K. may even start to tighten policy a little within the next year.
What used to be was the G4 central banks, which are 85 percent of the capital markets of the world, maintaining a zero interest rate policy and a future forward zero interest rate policy for five years, which have suppressed volatility. That started to change in July or in the summer. It is changing now. Volatility is much higher. It will continue to be higher.
What that does is scare market agents because they're not used to it. They've spent five years in this sort of linear rising market with corrections of 3 and 4 percent. Finally we're having a real one. You take a look at the S&P, you can get down 8 or down 9 percent, depending on where you use it in terms of a peak. You get to the Russell, you can have more; you get to the energy sector, a lot more. We're going through a change in volatility. So it's serious.
ETF.com: What could put a floor on this most recent sell-off?
Kotok: I think recognition occurs. The recognition occurs when, No. 1, the panic selling has to run its course. The forced liquidation out of funds and other institutions have to run their course. The sellers have to get exhausted. The people who were scared have to have exited the market. That's underway now. You see violent moves of selling. We saw them today [Oct. 15, 2014].
The second thing is a realization must hit the investing class. How long will interest rates be very low, even if they're higher than zero? My view is the realization will hit that they're going to be very low for a long time. A long time is measurable in several years. So even if the Fed hikes in the second half of next year, which I expect it will, it will be a small hike, and the recovery continues at a slow pace and the inflation rate stays very low. The combination of that is enough to argue in favor of stocks. So I don't think we're going to have a recession. That would justify a bigger drop in stocks.
I think we go through a correction. We alter the sentiment, we remove the complacency. That puts in place in a platform for another round of rising stock prices in a gradually improving U.S. economy. That's our forecast.
ETF.com: This past July, you mentioned raising cash because the markets weren't ready for a tightening Fed, and you saw an inflection point on the horizon. Are you now putting that cash to work, or are you sitting on the sidelines waiting for better opportunities?
Kotok: I have a cash reserve, and I have had a partially invested position. My largest position the entire year has been the Utilities Select SPDR ((NYSE:XLU). I’ve used the utility sector for a variety of reasons, and that’s been a very positive thing to do. It’s a sector which is 3 percent or so of the weight of the S&P. For us, we are way overweight, and it’s had a terrific result. I think it’s up about 13 percent total return year-to-date. So it’s helped the portfolio performance in addition to the cash reserve because I viewed a defensive position as an alternative to cash.
We deployed some cash today when the market was down 300 and 400 points. In this wild day, we rebalanced the position we have in transports. They have gone through a big correction, so they're cheap. Our view is simple: There's only so many railroads in the United States. There won't be any new ones. There's only so many trucks and trucking companies. They are capital-intensive businesses. The shortage in the trucking area is in skilled drivers. That's a very slow change, so there's pricing power in trucking.
Air freight we know. Airlines were knocked off and knocked down by the Ebola scare. Transportations got hurt. You can buy them, and they are capital-intensive companies which are able to finance themselves at a very low interest rates and they are domestic. By and large, the transport sector is an American thing; it doesn't depend on how things are in Europe. The railroads in Europe are not part of this business model.
So we use the weakness in this sell-off, which became extreme, to round out and rebalance the transport position. The ETFs I used were the iShares Transportation Average (ARCA:IYT) and the SPDR S&P Transportation (NYSE:XTN). They’re different, the composition is different, so you need a little bit of each if you want to cover the whole landscape in transports. That’s a perfect example of something you can do with an ETF. You don’t have to worry about a single company. You can get it with great efficiency in a market like this, because you can clear and execute very well, because you’re the only buyer. There aren’t a lot of buyers who can do a block trade.
ETF.com: You mentioned utilities earlier. Do you still favor that sector?
Kotok: I own it. I rebalanced it in the beginning of this year. The rationale behind SPDR Select Sector - Utilities (NYSE:XLU) is still the same. What we said in January is that the running yield is 1 percent a quarter, 4 percent for the year, if the prices don't move. Our forecast is low interest rates. Well, it's still low interest rates, and now we have the stock price up.
If you look at the total return for the year, you've got about 3 points so far out of the yield, and you've got 10 percent in the price. What do you do today? The yield is about 3.5 percent because the prices are up. What's the outlook? It hasn't changed. The interest structure is actually lower. So I have not rebalanced it. I looked at it this morning, but to me it looked like it could trade a little weaker. So I held back. I could do it tomorrow morning.
ETF.com: Your call to sell out of energy with XLE when we last spoke in July was spot on. Since then, energy has gotten crushed. What's your take on the recent rout in oil prices? Do you think it's too soon to get back in energy?
Kotok: I think it is too soon. The energy sector is going through a clear bear market. So, there, it’s not a correction. You can look at a highly volatile ETF like the Market Vectors Oil Services (ARCA:OIH), which has lost 25 or 30 percent from the peak. I don’t know where the price is today, but I saw it about $42. I remember it at $55. I owned it and sold it there. So OIH is a good example because it’s a higher-beta basket. It’s got Halliburton and Schlumberger.
But you can take energy pieces, and you can say OK, even the big ones, the ones that have Exxon and Chevron as components, are in bear market range. If they haven't truly lost 20 percent of their value, they're in double digits. That has to run its course. I believe that you start to position up the weight in energy. You do it in a step function; you don't do it all at once.
You start it once the price breaks below marginal course of production. Now in the U.S., that is variously estimated at somewhere between $70 and $80 a barrel on WTI. I don't know the exact number. But if I see oil in the $60s, that's going to start to tease me in. If I see it held there, I know somewhere, some place, somebody is not going to drill a well. That's the beginning of making a bottom in the energy patch.
ETF.com: I'm going to go back to Europe here, because I think some of the fear is coming from the eurozone. Do you see the ECB coming to the rescue in Europe quickly enough to stop the carnage over there?
Kotok: I wrote a piece the other day, and after Draghi's last commentary, I suggested that the revelation is the emperor has no clothes—Emperor Draghi has no clothes. There is division here. The division is between Germany, which is its largest weight, and the fourth-largest economy in the OECD. France is No. 5. So you have division, No. 1.
Secondly, you have very large debt issues even after the crisis. They're stabilizing. But austerity means that you don't get growth. In Europe, you have no room for fiscal policies now. So you don't have any fiscal policy expansion, and the monetary policy that might have offset it has been way too slow in coming.
So now you have a situation in which the policy interest rate in the European Central Bank is a negative number. They can't take it any lower. It's already at minus 20 basis points.
ETF.com: Could they change the rules to start a large-scale sovereign bond purchase program?
Kotok: They need the Germans to agree. Germany says, "Wait a minute; I don't want to pledge the strength of my economy for you, central bankers, to go buy Cypriot bonds or Greek bonds. That's not what I bargained for," which is a different story than if the ECB says to the Bank of Cyprus, "We will let you through your commercial banks take a pledge of small business loans in Cyprus that you've screened with a haircut."
That alone is bad enough. Christian Noyer, the governor of Banque de France, said, "No, I don't want to do that." He knows what it means to open a Pandora's box of weaker and weaker credit as a tool.
There's a great piece on central banking history. Walter Bagehot wrote about the purpose of a central bank. What he said is, "In a crisis the Central Bank should lend liberally, but take collateral of good quality." That was the teaching of central banking for many years. Whenever a central bank violated that teaching, there was trouble in the land. The eurozone started with that as a policy. Then when credit ratings of sovereigns started to fall, they waved the rules. That got them Greece, and then Cyprus and then a mess. Now they have no growth, no inflation, huge unemployment and no prospects to turn it around, no fiscal policy to save them.
There's only QE, and there you have political division in making a decision. If Draghi could get it, he would expand the central bank's balance sheet by a trillion euro rapidly. Whether it would turn it or just take the growth rate to 1 percent instead of zero, we don't know. My suspicion is that's what it would do. You would have a little growth, which is better than none. You have no inflation characteristics in Europe. Europe is a mess. It's a mess that took years to create, so it's not going to be fixed so fast.
Disclaimer: David Kotok is the chairman and chief investment officer of Cumberland Advisors, a registered investment advisory firm based in Sarasota, Florida. Cumberland offers several fixed-income, equity and balanced portfolios, with its equity portfolios constructed using solely ETFs. He is a frequent guest on various financial television networks, and is quoted regularly in the financial press. Kotok has authored two books, including the recently released second edition of "From Bear to Bull with ETFs."
Kotok recently sat down with ETF.com to give his take on the end of QE and the latest market sell-off. He discusses his favorite defensive sector and where he currently sees opportunities. Finally, he tells us what he expects out of the eurozone and the ECB.