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.
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.