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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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Third Quarter Commentary: US Tech and Consumer Lead the Way with Trade Wars Remaining a Serious Threat

Topics Covered:

    • US Growth Strengthens and Impending Trade Wars
    • Recap of Second Quarter: Strong Dollar, Global Growth Slow Down, Emerging Market Weakness
    • Portfolio Positioning for Latter Half of 2018
    • Firm Updates

US Growth Strengthens and Trade Wars:

By virtually all estimates the U.S. economy just completed an outstanding second quarter with robust growth. Bank of America Merrill Lynch officially revised its Q2 GDP forecast to 4.0%, and expects the US economy to grow by 3.0% in 2018. Looking ahead they expect some of the momentum and better productivity growth in the economy to carry over into 2019 in the form of better spending and investment, with expectations of next year’s annual growth number to 2.6%. 

American factory activity accelerated for the second straight month in June, signaling momentum in the U.S. manufacturing sector. We’re seeing the small business confidence index continue to hold at the highs (107.8 in May). And why does this matter? Conditions for small businesses can be taken as a quasi-proxy for emerging/prevailing “main street” conditions. Recall, small businesses represent over 99% of total U.S. Employer firms and >60% of net private sector hiring on a monthly basis. So, collective sentiment matters in handicapping the prospects for labor and wage trends.

Yet despite surging corporate profits, robust growth, record low unemployment and strong consumer spending, stocks have largely moved sideways this year on talks of trade tariffs and the growing risk of an outright trade war breaking out between the US and its trading counterparts. Ironically, US GDP growth is more vulnerable to trade tariffs than that of its trading partners.

Consider the following narrative below:

What matters to GDP growth is not the dollar amount of targeted products, but their share of GDP. When the US goes to “war” with many of its trading partners, they can collectively impose a much bigger percentage point shock on US GDP than the US can impose on ROW (rest of world) GDP. Recall that in 2016 ROW GDP was almost $57tn, or three times as much as US GDP (almost $19tn). Hence if the US puts tariffs on all of its imports it only impacts about 4% of ROW GDP. By contrast, if ROW puts tariffs on all US exports it impacts 8% of US GDP. Therefore a 25% tariff on all US exports and imports is equivalent to a 2% of GDP tax on Americans, but only a 1% of GDP tax on the rest of the world.

A full-blown trade war, on which the US puts 10-25% tariffs on most imports and trade partners put tariffs on most US exports, may very well lead to a significant reduction in growth, decline in confidence and supply chain disruptions which could amplify the trade shock, triggering a global recession. For now, the probability of a full-blown trade war is relatively muted, but the risks are certainly rising which has put the US equity market rally on hold, for now.

Highlights from Second Quarter:

Strong $US Dollar

The U.S. Dollar Index, +7% off its YTD lows, has already inflicted some major pain in consensus macro views that were positive on investments like commodities and emerging market financial assets heading into Q2.

40% of S&P 500 earnings are international and impacted by a strong dollar. As Keith McCullough the CEO of Hedgeye put it, “The S&P 500 has international baggage, emerging market baggage, china slowing baggage, and European and Polish Baggage.” For more pure US investment exposure, consider investing in indexes like the Russell 2000 which are less impacted by a strong dollar.

Global Growth Slowing Down

Growth and economic data in Europe has been weaker than expected over the last several months. Analysts have cut Euro area growth to 2.1% in 2018, and 1.7% in 2019 from 2.4% and 1.9% previously. The global wave, one of Bank of America Merrill Lynch’s most widely recognized proprietary indicators which combines seven key macro indicators, has peaked for only the 10th time in 25 years! Following previous peaks, the MSCI All Country World Index averaged -3.4% in the next 12 months, and the US tends to be a more defensive region on average.

In looking at world equity performance from the 2018 market peak on 1/29/18, we’re now down -10% from $87 trillion in total market capitalization to $78.6 trillion.

Emerging Market Weakness

Emerging markets are struggling with a sharp and abrupt reversal in the dollar, rising rates, and concerns about global growth and idiosyncratic issues surrounding particular markets such as Turkey and Brazil. Below are the 10 worst performing emerging market countries since the 1/29/18 market peak:

1. Venezuelan: -77%

2. Luxemburg: -54%

3. Argentina: -44%

4. Turkey: -32%

5. Brazil: -28%

6. Kazakhstan: -25%

7. Poland: -25%

8. Hungary: -24%

9. South Africa: -23%

10. China: -21%

Portfolio Positioning for Latter Half of 2018:

Positive on US Large Cap Energy

We remain bullish on energy because inflation has been heading higher.

Positive on Real Estate Investment Trusts (REITs)

Increases in interest rates often are driven by economic growth that may support the growth of REIT earnings and dividends in the future. Research shows that REITs have often outperformed during periods of rising rates.

Neutral on US Consumer Discretionary and Technology

We remain cautiously optimistic on the Consumer Discretionary and Tech sectors because these are the sectors most tethered to the U.S. consumer and an acceleration in the U.S. economy. We recognize that after eight consecutive quarters of growth acceleration, the prudent move is to book some gains in cyclically sensitive sectors.

Negative on Emerging Market Stocks

Strategists on Wall Street continue to advocate for buying emerging markets claiming they are “cheap.” Based on price-to-book ratios, the MSCI Emerging Index is indeed trading at a 30% discount to MSCI World Index of developed markets. But with the headwind of a stronger dollar, emerging markets can continue to get cheaper in the latter half of 2018, which makes us near/intermediate term bearish. We’d like to wait for a more attractive entry point in adding more exposure to emerging markets in client portfolios that may be the only area of the market where we’ll see positive real returns after adjusting for inflation.

Firm Updates:

As I reflect on 2018 thus far, there are a number of updates I’d like to share with you, my valued clients. You may recall back in January of 2017, that I took a leap of faith in leaving Merrill Lynch to start my independent wealth management practice, Rapport Financial. Since then, each and every morning I wake up with one primary goal in mind – to provide you with the best possible client experience. For this, I feel a great responsibility to continuously improve upon my practice by seeking out the best suite of solutions in the marketplace. A few of these recent additions are listed below:

      • Hedgeye. Independent Research Firm (responsible for the images you see in this commentary!)

There are other solutions being evaluated that I’m confident will improve upon the financial planning and risk management portion of my service offering and I cannot wait to implement these for you.

My job, as a client recently put it best, is to work with you to identify and implement the most appropriate strategies and solutions to meet your financial goals. To adjust your portfolios for the underlying conditions of growth and inflation that are directly impacting the value of your hard-earned assets. To provide advice that affords you a level of financial stability that promotes a healthy, wholesome personal and professional life free from financial stress.

This past month I was honored to be named an Investopedia Top 100 Financial Advisor. This list consists of advisors around the country who have contributed significantly to conversations about financial literacy, investing strategies, life-stage planning and wealth management.

Know that as your fiduciary advisor, I will (and am legally required to) always make suggestions that are in your best interest. But my commitment goes beyond that. Over the years I’ve continued my education in the field, from attaining securities licenses, to the life and health insurance license, and becoming an Accredited Investment Fiduciary where I took the fiduciary oath. I’m currently studying at the College for Financial Planning where I have taken classes on insurance, annuities, investments, taxes, and estate planning. The final step will be to sit for the rigorous CFP examination in November.

While the recommendations made in this commentary are backed by macro research and quantitative data, it’s important to remember that all investments are made within the framework of our long-held belief that diversification continues to be the foundation of each portfolio.

Warm Regards,

Aaron L. Hattenbach, AIF®
[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.