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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.