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Late Cycle Investing Playbook


Late Cycle Investing Playbook


“You can’t predict, however you can prepare”

Howard Marks on The Tim Ferris Show


It’s now been 2,416 days (or 6.5 years) since the last 20% market correction.  In secular bull market cycles, the average is 1,105 days before a 20% correction occurs.  While we may not know what lies ahead, investors can enhance their likelihood of success if they base their actions on a sense for where the market stands in its cycle.

So where are we in the current market cycle?  The economic recovery in the US post 2008-09 has now entered its 10th year.  It’s worth noting that the longest U.S. recovery on record lasted just ten years.  While there certainly is no hard-and-fast rule that limits economic recoveries to 10 years, it seems reasonable to assume based on history that the odds are against a ten-year-old recovery continuing for much longer.

With it being the 10th year of the economic recovery, you may be wondering what one should do at the later stages of the economic cycle?  Move to cash and wait for the next market correction and opportunity to buy low?  ABSOLUTELY NOT!  If you fool yourself into believing you can time the market successfully, know that even the smartest of professional investors with the best technology and teams of research professionals can’t do this consistently.  However, if you’d like to apply a sensible investment strategy that has performed well on a relative basis in the 7th, 8th, and 9th (later) innings of the economic cycle, continue reading.

But first, an update on the US economy, and it’s mostly good news… 

  • We’re about to hit 9 consecutive quarters of accelerating US GDP growth (from 3Q 2016 to 3Q 2018), an unprecedented streak in US economic history.
  • Corporate profits have grown at a staggering 25% year over year, which is important because the US has never experienced a recession when corporate profits have been increasing.
  • There’s never been a recession in the US when the leading indicators have been rising as they are now.

While the S&P 500 was up nearly 9% this year (through September 30), the bulk of returns was driven by a few large tech stocks, not broad market participation.  On a recent conference call, Larry Fink, the CEO of Blackrock (one of the world’s largest asset managers) was quoted as saying, “If you strip out a handful of outperforming tech stocks, the lack of breadth in the equity markets is troubling.”  And the numbers are very much alarming.  Apple and Amazon were responsible for nearly 30% of the S&P 500’s nearly 9% gain so far this year, according to S&P Dow Jones Indices.

There are certainly risks to weigh…

I’m concerned that investors have largely ignored the glaring risks associated with major tech companies, such as potential punitive measures that could affect Apple’s manufacturing in China or cost increases that could hurt Amazon’s e-commerce sales, both risks to constituents that contributed 30% of the current returns to the S&P 500.  We’ll obviously need broader participation overall, and in particular from the financial sector to keep this bull market chugging along.

High levels of investor optimism, without a healthy level of skepticism also indicate we’re nearing a peak in the cycle, and that the easy money has been made.

A few more anecdotal pieces of evidence to support this extreme optimism:

  • At the beginning of 2018, 2,296 private equity funds were in fund-raising mode, seeking $744 Billion of equity capital. These are all-time highs. (Financial Times)
  • According to Crunchbase, there have been 268 venture capital mega-rounds ($100 million rounds), invested during the first seven months of this year, almost equal to a record of 273 mega-rounds for the entire year of 2017. And during the month of July alone, there were 50 financing deals totaling $15 billion, which is a new monthly high.” (The Robin Report)
  • Personal loans are surging. The amount outstanding reached $180 billion in the first quarter, up 18%.  “Fintech companies originated 36% of total personal loans in 2017 compared with less than 1% in 2010, Chicago based TransUnion said.” (Bloomberg)

Remember that every single economic cycle ends with wage growth accelerating; and every single US recession starts with wage growth accelerating (Hedgeye).  So while Amazon raising its hourly minimum wage to $15 seems positive for the economy, its likely a signal of where we stand in the market cycle.

While the US economy is doing quite well, it’s important to not overlook the market and economic structural concerns that remain.  Increasing federal debt will eventually cause interest rates to rise sharply and stifle housing and capital spending.  Higher tariffs imposed by the US are punishing already ailing Europe and the rest of the world where growth has been contracting.

In Europe, where the economy was growing at close to 2% last year, business activity has tapered off.  The UK is growing at only 1%, or one half of its growth rate prior to Brexit.  And in this globally interconnected economy, our markets, and specifically the S&P 500 generates more than 40% of their earnings from abroad.  So when the rest of the world catches an economic cold, we aren’t necessarily immune.

Now that you’ve had time to digest the good and the bad, let’s get to the main objective of this commentary—sharing with you, the strategies that are more effective at the later stages of the market cycle.  Stocks that have historically exhibited lower risk and higher quality characteristics, which will likely lag in a stronger market environment like the one we’re currently in, but over a full market cycle, could expect to earn a better risk-adjusted set of returns than the overall market.  Which is why, going into year-end, I’m beginning to trim my client’s exposure to cyclical growth sectors (Tech, Consumer) and re-allocating to sectors and stocks that demonstrate lower volatility and higher quality factors.

Specifically, here are some investment strategies for further consideration:

  1. USMV. iShares Edge MSCI Minimum Volatility USA ETF

USMV is a strategy designed to track an index composed of U.S. equities that as a whole have lower volatility characteristics in relation to the broader U.S. equity market.  This strategy carries a beta of 0.67 in relation to the S&P 500.  Beta is a measure of the tendency of securities to move with the market as a whole.  A beta of 1 indicates that the security’s prices will move with the market.  A beta less than 1 indicates the security tends to be less volatile than the market, while a beta greater than 1 indicates the security is more volatile than the market.

Important to note, and taken directly from the fact sheet of this fund: Historically, USMV has declined less than the market during market downturns.

  1. VIG. Vanguard Dividend Appreciation ETF.

VIG is a strategy designed to track the performance of the NASDAQ US Dividend Achievers Select Index, an index of companies that have a record of growing their dividends year over year for a period of at least 10 consecutive years.  The strategy targets highly profitable U.S. dividend paying stocks, reducing the fund’s exposure to stocks with weak fundamentals.  The fund’s tilt toward more stable stocks has helped it shine during market downturns.

By no means should you entirely abandon the technology and consumer discretionary sectors, rather, if adding new cash to the markets at these levels, look to the above strategies providing exposure to companies with more stable cash flows and “boring businesses” that are less sensitive to the ebbs and flows of the economy.


Warm Regards,



Aaron L. Hattenbach, AIF®

Managing Member

Rapport Financial

[email protected]


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.

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Market Insights Second Quarter 2017

Strong Economic Data—However Brace for a Pullback in the Second Half of 2017

I’m beginning this economic commentary with the chart below from JP Morgan Private Bank’s Q2 insights presentation. The upper half of the chart identifies pullbacks during the current market cycle from 2010-present.


  • The last time we had a peak (top) to trough (bottom) correction in the S&P 500 greater than 10% was nearly 18 months ago driven by fears of a slowdown in China and weaker oil prices.
  • In every calendar year since the great recession of 2008-09 (2010-2016) there’s been a healthy pullback in the markets greater than 5%. 2017 is the lone exception.
  • 4 of 7 corrections were greater than 10%.

The markets have been remarkably resilient and immune to bad news. Each 1-2% correction has been met with opportunistic investors eager to “buy the dip” and put money to work at lower prices.


If you look a little deeper we see the following:

  • The U.S. has added jobs every month since October 2010, a record 81 month stretch that has resulted in roughly 16 million jobs and slowly repaired much of the damage inflicted from the 2008-09 recession.
  • Employers added 222k jobs in June and the unemployment rate ticked up to 4.4% with more people joining the labor force.
  • US Purchasing Managers Index (PMI) reading for June came in at 57.8, its highest level since August 2014. A number above 50 indicates an expansion in manufacturing activity.


While friends, family and clients would generally describe me as an optimist— the optimist in me is growing concerned with complacency forming in the markets. The current bull market that began in 2009 is now the second longest in history and 24 months away from being the longest ever! Valuations are high, balance sheets are levered, and the Federal Reserve is raising rates. I’d say given this mix of factors, you’d be wise to temper your expectations and not expect the double-digit annualized returns we’ve experienced since the financial crisis.

Central bank easy monetary policies have had arguably the greatest impact on this bull market in stocks globally. As you can see from the chart below courtesy of Bank of America Merrill Lynch, the S&P 500 has risen roughly in tandem with increases in central bank balance sheets during the past 9 years. With the Fed signaling it will begin to reduce its balance sheet, and the European Central Bank likely to end its quantitative easing program by the end of 2018, growth in central bank assets is likely to decelerate next year and turn negative in 2019. This could also weigh on future returns in developed market stocks.

There are several risks with the greatest potential to derail the 8 year bull market run:

1. Subprime Auto Loans-38% of new car loans have negative equity rolled into the loans. And lenders like Banco Santander aren’t verifying income or job histories. Sound eerily familiar? Auto financing is a $1.2 trillion market. I’d track down a list of the largest auto lenders and identify the lenders issuing the highest volume of subprime loans, that is, to borrowers with lower than average credit scores.

2. S&P 500 valuation getting extended. The Shiller P/E ratio is currently at 30.12, which puts the figure at its 2nd highest level in history! Stock market capitalizations as a percent of the US Gross Domestic Product (GDP) stands at 130%, close to peak levels.

3. Low volatility encouraging excessive risk taking through the use of leverage. Historically, during periods of extended low volatility, investors increase leverage by effectively borrowing to increase the size of their bets.

4. Exponential growth in popularity of passive market cap weighted index fund investment strategies. The proliferation of passive index investing has rewarded investors over this 8 year bull market expansion with double-digit annualized market returns and low fees. However, investors need to understand that these are bull market strategies that offer no downside protection.

THE #1 RISK TO INVESTORS: Formation of a Bubble in Passive Investing

Whether you invest through a registered investment advisor, robo advisor, company 401k plan, or happen to be a “do it yourself investor,” it is likely that you have a portion of your assets in what are called “passive investment strategies” designed to track an index like the S&P 500. These passive investment strategies, taking the form of a mutual fund or exchange traded fund (ETF) are now the most popular form of investing for both small and large investors.

“Through the first five months of this year, investors put $338 billion into passive mutual funds and ETFs—that’s on top of last year’s record inflows of $506 billion, according to Morningstar. If this pace keeps up, passive funds could take in more than $800 billion in 2017, a 60% jump from 2016’s record and nearly double the assets from 2015!”

Record inflows into passive investment strategies are also happening as investors abandon actively managed strategies that have failed to outperform their indexes and come with higher fees. In fact, new data confirms passive investment strategies are actually beating 82% of all active funds after fees.

As a result, once industry powerhouses known for their actively managed mutual funds, T. Rowe Price and Franklin Templeton have been replaced by the new 800lb gorillas in asset management and early adopters of passive ETF investing: Blackrock and Vanguard, the two largest asset managers in the world according to the Top 400 Asset Managers of 2017.  See the chart below which shows this trend taking place over the past decade.

I am admittedly a strong proponent of the low-cost and market exposure offered by passively managed index tracking strategies. The ability to hold an investment that gives you exposure to 500 of the largest companies in the United States for a fee as low as 0.04%–that’s right, 40 cents on every $1,000 invested is absolutely brilliant and arguably the greatest invention in modern finance. But in an aging bull market, it is important you recognize that these funds are designed precisely to match the return of the index and therefore offer no downside protection. Furthermore, when you buy a market cap weighted index fund like the Vanguard S&P 500 Index Mutual Fund, you’re effectively buying all the stocks in the index—whether they’re cheap or expensive. So, as more money pours into a passive fund like the one above designed to track the S&P 500 index, it must buy stocks in the same proportion as the index it tracks—with no regard for stock price or fundamentals. The effect is that the largest companies become larger, riskier, and more important in determining the overall direction and performance of the index.

Which brings me to the issue at hand: elevated valuations on the largest companies. If you rely exclusively on passive market cap weighted index investment strategies you could be paying prices for stocks that are at or near peak levels. And paying prices that are too high is the single greatest risk to an investor according to one of the greatest investors of all time, Howard Marks of Oaktree Capital.

The best illustration of this elevated price risk can be seen by looking at the 5 largest companies by market capitalization (still publicly traded) in the Nasdaq 100 index during the tech boom and subsequent bust of the late 1990s-early 2000s. 4 of the 5 companies listed below are still recovering losses in market capitalization from their peak in 2000. And if you had the great misfortune of purchasing the Nasdaq 100 index fund at the peak of the market in 2000, you had to wait until September 30, 2016 to get back to even! That’s an astounding 16+ years of no returns!

Source: Yahoo Finance

Again, I’m increasingly becoming concerned about the enormous amount of money flowing into passive market cap index funds which is making large companies even larger and no longer reasonable on a fundamental basis. Technology stocks now make up over 58.32% of the Nasdaq 100, not far from their high of 64.9% in 2000. By many measures technology stocks have gotten expensive. Apple, Microsoft, Amazon, Facebook and Alphabet (Google) make up over 42.28% of the Nasdaq 100 index. These same 5 companies now constitute 12.36% of the S&P 500 index, and were responsible for 58% of the index’s 2017 advance through late May! When volatility and fear re-emerge from a long slumber, investors will, like they have time and again during previous downturns, sell what they own in their investment accounts, which for many investors includes these passive market cap index ETFs and mutual funds. Top heavy indexes like the S&P 500 and Nasdaq 100 will get absolutely clobbered and companies with the largest weights will suffer sharp declines.

While I’m likely calling this bubble in passive market cap index investing a bit too early, I’d rather forgo a few percentage points of upside to be protected when markets inevitably do correct. The alternative isn’t necessarily using an expensive active manager, that often (but not always) statistically provides lackluster performance. Instead, there are strategies designed with factors not limiting them to the restrictions imposed by strict index funds. If you’d like to learn about some of these alternative investment strategies or are interested in scheduling a complimentary portfolio review, feel free to book time on my calendar:

I’ll conclude this commentary with a reminder to review your asset allocation—being the mix of stocks, bonds and cash held in your investment portfolio. Start by comparing your initial asset allocation from when you first put together your portfolio to how the allocation looks today. For my current clients, this is an exercise we conduct quarterly to ensure the portfolio is aligned with their risk tolerance, time horizon, and investment goals. It’s likely after this long bull market run that the percentage mix of assets in your portfolio is now different, and you may be taking on more risk than you can stomach when the next major correction hits.

I’ll sign off with my favorite quote and let you determine where you think we are in this market cycle:

“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on Euphoria.”    –Sir John Templeton

My gut tells me we’re in the “mature on optimism” phase.


Aaron L. Hattenbach, AIF®
Managing Member
Rapport Financial
[email protected]

PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. This market commentary is a matter of opinion and is for informational purposes only. It is not intended as investment advice and does not address or account for individual investor circumstances. Investment decisions should always be made based on the client’s specific financial needs and objectives, goals, time horizon and risk tolerance. The statements contained herein are based solely upon the opinions of Rapport Financial. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Information was obtained from third-party sources, which we believe to be reliable, but not guaranteed.