I think you’ll be pleasantly surprised when you look at your quarterly performance reports, especially after a difficult 2018, and particularly challenging 4th quarter in which the markets dropped almost 20% from their highs. Before I go any further, I want to commend you, my clients for remaining invested and calm even when the headlines have made it excruciatingly difficult to do so. Not one of you called me to express concern or suggest we sell and hide in cash, succumbing to the negative headlines about trade tariffs with Mexico and China. I am sensitive to how hard you’ve all worked over your careers to accumulate the wealth you entrust me to manage, and each day when I go to the office, I am humbled to have the privilege to serve you as your fiduciary advisor.
With that, I’m happy to report that the first six months provided incredible market returns, with the major averages, the S&P 500, Dow Jones Industrial Average and Nasdaq Composite returning 18.54%, 15.4% and 20.66% respectively. But recession risk is indeed rising, and the overall data suggests a synchronized global deceleration in growth is already well underway.
As of July, the current economic expansion has entered its 120th month, now tied with the 1991-2001 period for the longest economic expansion in the post WWII modern era. While the saying goes, “bull markets don’t die of old age,” we still need to be cognizant of how much the markets have already run this year and in the 10 years prior.
Over the past 10 years, the S&P 500 has produced astounding annualized returns of 14.43% per year, a whopping 285% total return, while the historical average annualized total return for the S&P 500 index over the past 90 years is 10%. This difference of +4.5% annually over the past 10 years provides some context as to why many of the largest financial firms from Vanguard to Blackrock to JP Morgan are forecasting low to mid-single digit returns for US stocks over the next decade.
Given the low forward looking return expectations for stocks and bonds, you may be tempted to suggest that it’s come time to pull some chips off the table, perhaps move a portion of your investable assets to cash which is currently offering ~2%, (a real rate of 0% after factoring in inflation). Over the past 10 years, since the lows of 2009 we have had many occasions when one could rationalize selling stocks and raising cash—I can recall at least half a dozen times—but each time you would have been making a costly mistake as markets continued to soar and make new all-time highs.
With the IMF issuing a recent report cutting its outlook for Global Economic Growth from a level that was already the lowest since the financial crisis of 2008-09, and several of my recession checklist items flashing warning signals including: an inverted yield curve, IPO Market Boom, ISM index weakest reading in 3 years, defensive stocks/sectors outperforming, and extreme reading in bullish sentiment/investor optimism, now is the opportune time to adjust client portfolios for inclement weather ahead. Which is why I’ve prepared an investment playbook for the 2nd half of 2019 and beyond, that I’m excited to share with you below.
- Favor Large over Small Cap Stocks this late in the economic expansion
Weakness in the Russell 2000 (Small Cap Index) has taken it to the lowest level versus the S&P 500 since 2016, and sits precariously close to the lowest level since 2009. According to Ned Davis Research, weakness of small cap stocks has preceded broader market sell-offs in the past, and can be a recession warning.
From the chart below, you can see that small caps typically have their best relative performance early in an economic expansion. That is because smaller companies are generally more vulnerable to economic cycles, as they tend to hold more debt than their large-cap peers, making them especially sensitive to rising interest rates and wage inflation. 
2. Favor asset classes that historically provided positive annualized returns in a recession
The asset classes historically producing positive annualized returns during a recession are: Gold, US Dollar, Cash, Investment Grade Bonds, Government Bonds, Dividend Aristocrats, and Volatility.
Furthermore, our defensive positioning in stock market strategies hasn’t weighed on portfolio returns over the past few years. Our sizable position in the Vanguard Dividend Appreciation ETF Strategy (Figure 1) has outperformed the S&P 500 in 2016, 2017, 2018 and thus far in 2019 while carrying a lower Beta and Standard Deviation, two of the most common measures of investment risk.
Add to this our sizable position in the iShares Minimum Volatility ETF Strategy (Figure 2) which has outperformed the S&P 500 over a very strong 5-year period all while doing so with a substantially lower beta and standard deviation.
We will continue to favor these dividend appreciation, quality and low volatility strategies which historically fare better during recessions. Ironically, they also perform well during strong bull markets—go figure! In this vane we also want to favor buying defensive stocks over cyclical stocks. Cyclical stocks that typically are tied to economic growth have failed to regain the ground lost in May, whereas defensive groups like consumer staples and utilities have confirmed the S&P 500′s new highs. In fact, the S&P 500 consumer discretionary sector has consistently lagged the S&P 500 consumer staples sector ever since October 2018.
3. Focus on investments in Quads 3 and 4 (Figure 3)
4. Keep Bond Duration (length) Short/Intermediate
In all my client portfolios from the most conservative to the most aggressive, we maintain a position in bonds for a number of reasons. Bonds, especially Treasuries historically have been negatively correlated to the performance and directionality of stocks. When major stock indexes drop 10, 20, 30%, and panic ensues, you can count on your US Treasuries to preserve principal and provide a modest income stream which given where rates are now, should meet inflation and allow you to maintain your purchasing power. Admittedly, not exciting stuff, but absolutely necessary if you’re nearing retirement and need to preserve the wealth you’ve built to get you through your retirement years.
With long term bonds currently offering lower rates than short term bonds, a trend that’s lasted for over 3 months (or one quarter), one of the clearest signals of a coming recession in the next 9 to 18 months has been triggered, the inverted yield curve. According to Campbell Harvey, a Duke University finance professor whose research in the 1980s first linked yield curve inversions to recessions, an inverted yield curve has been associated with predicting a recession for the last seven recessions.” “From the 1960s, this indicator has been reliable in terms of foretelling a recession, and also importantly, it has not given any false signals yet.”
5. Don’t follow the herd—BE DIFFERENT (My Clients Certainly Are)!
The famed Chief Investment Officer of the Yale Endowment David Swenson is quoted saying, “in order to outperform other people you have to do something different.” While I’m sure this statement doesn’t come as a surprise to you, most investors do not take the steps necessary to increase their odds of outperforming others, especially those that fully automate their investment management or implement a 100% passive strategy.
In my experience over the last decade, I’ve found it takes hard work, a calculated and tested process, solid understanding of the economy and capital markets, and last but not least, humility, to build a sustainable investment management strategy. I strongly believe Robo Advisors are not an effective investment management strategy for all market environments. For example, at the beginning of an economic expansion, you’d want to increase exposure to Small Cap Companies to enhance overall portfolio returns. While in the later stages of a bull market, you’d want to emphasize dividend appreciation, quality, and defensive sectors, factors that historically perform better than owning a passive S&P 500 index fund. This is where Robo Advisors fall short. They are not tactical or flexible when they should be. They don’t take into consideration where we are in the economic cycle. Which is why many of the investors I speak to and eventually work with are skeptical of relying entirely on such products to manage their hard-earned money.
As always, please let me know if you have any questions, and I look forward to scheduling our quarterly review meeting.
Warmest Regards,
Aaron L Hattenbach, AIF®
Managing Member
Rapport Financial
2 Embarcadero Center 8th Floor
San Francisco, CA 94111
(310)383-6204
The opinions expressed herein are those of Rapport Financial, LLC (RF) and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Consider the investment objectives, risks and expenses before investing. You should not consider the information in this letter as a recommendation to buy or sell any particular security and should not be considered as investment advice of any kind. You should not assume that any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in this newsletter. These securities may not be in an account’s portfolio by the time this report is received, or may have been repurchased for an account’s portfolio. These securities do not represent an entire account’s portfolio and may represent only a small percentage of the account’s portfolio. partners, employees or their family members may have a position in securities mentioned herein. Rapport Financial was established in 2017 and is registered under the Investment Advisors Act of 1940. Additional information about RF can be found in our Form ADV.
