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Late Cycle Investing Playbook

10/11/18

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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February Market Insights

Topics Covered:

Market Update

There are a number of positives contributing to this robust bull market entering its 9th year. Consumer sentiment is at a 17 year high, while unemployment is at a 17 year low. Wage growth picked up to 2.9% in January, its strongest pace since the recession.  We also had the best January since 1997, with the S&P 500 finishing the month up 5.7%. The story–global synchronized growth.  US corporate and personal tax reform, the first we’ve had since 1986.

February Sell-Off

But February is off to a rocky start with a sizable sell off having wiped out all 2018 gains in the markets.  We’ve finally broken the streak of 81 straight weeks without a correction of more than 5%.  Commentators are reminiscing about Black Monday, August 24, 2015 when the Dow fell over 1,000 points only to recover some of its losses and finish the day down 588 points.  At the time, America hadn’t had a point drop of that magnitude since October 2008, when the financial crisis was in full effect and people were gravely concerned that more banks like Lehman Brothers would also collapse.  The following day, August 25, 2015 markets continued their downward plunge with the Dow dropping another 215 points.

It’s important to take note of what happened in the days ensuing.  August 26th and 27th of 2015 saw massive rallies of 609 points and 370 points respectively for the Dow, recovering all losses from the days prior!

We’re actually seeing the same pattern take place in February 2018. In just two days of trading in February (2nd and 5th) the Dow retreated -541 points (-2.07%) and -1,175 points (-4.6%), respectively, catching many investors off guard and left to wonder, is this the beginning of the next major financial crisis?  Only to rebound the very next day, February 6th when the Dow gained 567 points (+2.33%) erasing some of the losses from Monday’s rout.  This should remind investors that trying to time the market is a losing proposition.  If you cannot tolerate or afford these day-to-day whipsaws and market volatility, you probably shouldn’t be invested in the markets in the first place!

Drops of this severity are becoming commonplace as quantitative investment and growth of passive investing strategies continue to grow in popularity at the expense of fundamental stock selection.

According to a Wall Street Journal feature back in May 2017 called, “The Quants,” Quantitative investment strategies are now responsible for 27% of all U.S. stock trades by investors, up from 14% in 2013.  Furthermore, passive and quantitative investing account for about 60% of trading, more than double the share a decade ago.  Just 10% of daily trading volume can be attributed to stock pickers–individuals and professional fund managers.

But in the high frequency, computer driven trading world we live in, and with passive investment strategies continuing to garner the lions share of investor assets, such wild market swings have been, and will become more and more commonplace.

At this point, you may be asking yourself, what can I do to protect my portfolio should we go through a 10-20% correction? Well, for starters, don’t rely on a Robo Advisor strategy to protect your portfolio as they consistent entirely of passive investment strategies designed to track the markets.

Robo Advisors: Limited Downside Protection

In a blog post back in July of 2017 I warned readers that a bubble is forming in passive investing and may have serious consequences for investors.  I feel that this is an opportune time to remind you that a portfolio of passive exchange traded funds (ETFs) offered by the likes of Betterment and Wealthfront offer little to no downside protection from a major market downturn.  Such Robo Advisor strategies are not nimble, as they are designed precisely to attain market-like returns by using low-cost index funds.  Sure, they offer different mixes of passive investment strategies based on the answers provided from a cookie cutter questionnaire, but many were created after the great recession of 2008-09 and have yet to experience a major market downturn.

From personal experience, I can tell you how important it is to be selective with what you buy this late in the bull market and especially with valuations where they are.  Owning the markets since 2009 has worked out quite well for investors.  Get this–the S&P 500 hasn’t had a negative year since 2008, when Taylor Swift was only 19 years old.  Wow!

Past 5 Major Crises

For my clients, I’m going back to the drawing board, and using a proprietary portfolio analytics software (see image below) to stress test portfolios so we can better understand how they performed during the last 5 major crises:

      1. Asian Crisis of 1997
      2. Russia/Long Term Capital Management fiasco of 1998
      3. Tech Bubble of 2000-01
      4. World Trade Center Attack of 2001
      5. Subprime Crisis of 2008-09.

If you’d like to have your portfolio analyzed so you can better understand the risk you’re currently taking, schedule time on my calendar.

Bear Market Checklist/Recession Indicators

While we’re on the topic of risk, allow me to share a checklist I periodically review to make sure I’m not caught off guard by the next recession.

The two most accurate predictors of a recession being:

      1. Inverted Yield Curve. This occurs when the 10 year treasury and 2 year treasury note invert.  It’s more of a yellow flag, as historically it takes 18 months after an inverted yield curve to see a recession occur.  Historically after the yield curve inverts, there’s another 18 months with average returns of 40%.  So moving to cash would be a mistake.
      2. 10 Conference Board Leading Indicators begin to show signs of slowing down.

Other important indicators include:

      • Elevated Valuations
      • Extreme reading in consumer bullish sentiment/investor optimism
      • M&A/IPO Market Boom
      • Steep declines in: ISM Manufacturing, Service PMI dips below 50
      • Credit Spreads widening. Yield spread between high yield bonds and treasuries
      • Defensive Stocks/Sectors outperforming
      • Strong inflows into equity funds
      • Inverted Yield Curve. When short-term rates rise above long-term levels
      • Uptick in initial unemployment claims

So far, we can only check the boxes for Elevated Valuations and Strong Inflows into equity funds.  In my opinion, not enough to trigger a recession.

10 Stocks that Delivered Positive Returns in 2008

Finally, as promised, I’ve compiled a portfolio of 10 stocks that provided positive performance (and lower volatility) in 2008, while the markets proceeded to drop 37%.  And if you actually look over a 20 year period, this portfolio of 1o defensive stocks has provided annual returns of 14.89% while the S&P 500 has returned 6.96% annualized.

This is not meant to serve as a recommendation to buy the 10 companies listed, nor to suggest that these 10 particular stocks are entirely recession (fail) proof when we do indeed experience the next recession.  But these companies share a few commonalities that historically made them relatively stable holdings when seemingly everything collapsed.  They provide products (consumables) many would consider as necessities, preventing them from being dependent on a healthy economy.  Think of things you can eat, drink or smoke.

Remember, if you’re invested in the markets, it’s about the long game.  Ignore the short-term noise.  Don’t let this recent correction get in the way of sticking to a sensible investment plan.  And certainly don’t allow yourself to get whipsawed by these drastic day-to-day fluctuations!

Aaron L. Hattenbach, AIF®
Managing Member
Rapport Financial
2/6/18

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 Part 2a.