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Quarterly Investment Outlook: Growth Slowing/Inflation Accelerating

 4/9/19  

*6 minute read 

 Update on Current Bull Market: 

The Economic Expansion Cycle is now 118 months old. The record is 120 months. The average since 1950 is 40. 

 Quarterly Performance Figures as of March 31, 2019: 

The S&P 500 finished the quarter up 13.07%, the Nasdaq up 16.49%, and the Dow up 11.15%. 

 Here’s a video from Hedgeye summarizing the points made in the below commentary if you prefer to digest your content this way: https://youtu.be/O9LYDpkJSYM 

 With the first quarter of 2019 in the books, the performance figures paint a rosy picture! In fact this was the best start to a year for the S&P 500 since 1998. That’s welcome news for investors after a poor year-end showing in which stocks and bonds underperformed cash in 2018. 

Needless to say, this market performance is quite strange in light of the soft data, weak income and spending, contracting manufacturing numbers, lower than expected GDP growth, and corporate earnings expected to slow in the latter half of the year. 

Over the past few weeks I have poured through commentary after commentary from economists and investment strategists trying to make sense of the double digit returns we have seen in such a short period. If markets are truly driven by corporate earnings, but earnings are slowing, why are markets then shrugging off this information and prices reflecting a rosier environment? Why are stocks rallying but bond yields are reflecting much lower growth? Why is the data suggesting the economy is slowing down, when logically, with cheap oil, low interest rates, tight spreads and a stable US Dollar, the global economy should be booming? So many questions to address, so let’s dive into why. 

As I suggested in my previous commentary in March, the main driver supporting this market rally is The Federal Reserve’s decision to back away from raising interest rates and its commitment to remaining patient with future increases. But we have to wonder, is this dovish Fed policy actually enough to keep the market on steady footing and will it support the current rally through year-end? Or will a recession sneak up on us in short order? 

What we do know is the bond market just gave us our first signal of a coming recession with an inverted yield curve, the first time this has happened since 2007. And this has many concerned. If it’s inevitable that a recession will occur at some point, like a broken clock is right twice a day, it’s no longer a matter of if, rather, when we get the next recession. History suggests 12-18 months after the inversion of the yield curve, so this gives us some time to prepare. 

This also brings about the question, how reliable is an inverted yield curve in predicting a coming recession? The results are compelling: 85% of the time recessions follow an inverted yield curve. Recall that last time we had an inverted curve in 2007, what followed a year later was the global financial crisis of 2008-09. Major equity (stock) markets dropped over 50%, peak to trough (top to bottom). Panic ensued, and emotions ran wild. Sensible investment strategies and carefully constructed portfolios gave way to panic selling and a rush to safe haven investments such as treasuries and cash. 

This is a time when your financial advisor should have talked you out of making emotional decisions. They should have set you up with the proper asset allocation from day 1, a mix of stock/bonds/alternatives/cash matching your risk tolerance and long-term investment goals, and kept you committed to this plan even when every part of you was ready to hit the sell button. 

Given we’re 10 years into the current bull market expansion, you must be wondering what steps you can take to protect yourself from future steep declines? 

I’ll simplify this into two common strategies that are employed. The first strategy is taken by a majority of investors and can have devastating consequences to long term returns. It involves selling all your stocks, sticking the proceeds in cash, and waiting until “things look better,” more commonly referred to as market timing. With market timing, you have to get two things right, when to buy AND when to sell. Market timing is not a repeatable process, so even if you somehow managed to sell at the top of the market in 2007, and re-entered in March of 2009 at the market lows, consider yourself lucky and don’t fool yourself into believing this is at all attributed to skill. But this is not to suggest we have to sit on our hands either. 

The second and more preferred strategy, the one I use in managing client portfolios is what we financial professionals like to refer to as “rebalancing.” Rebalancing is an opportunity to 1) bring the asset allocation back to its original mix and 2) adjust portfolios to reflect the current growth and inflationary environment. 

Let’s first address 1) bringing the asset allocation back to its original mix by providing an example of a $100,000 portfolio invested on Jan 1, 2019: 

Original Portfolio Value and Stock/Bond mix as of Jan 1, 2019 

$70,000 (70%) of S&P 500 ETF, Ticker: SPY 

$30,000 (30%) of Barclays Aggregate Bond ETF, Ticker: AGG 

Year to Date through April 5, the S&P 500 ETF is up 15.97%, while the Barclays Aggregate Bond ETF is up 2.54%. The portfolio now has a current value of $111,941. 

Current Portfolio Value and Stock/Bond mix as of April 5, 2019 

81,179 (73%) of S&P 500 ETF, Ticker: SPY 

30,762 (27%) of Barclays Aggregate Bond ETF, Ticker: AGG 

When the stock market rises sharply like it has year to date, the portion of stocks in your portfolio grows to a larger amount (percentage) of the overall portfolio, which may expose you to more risk than you’re comfortable taking should the markets drop substantially. In this example, what started as a 70% Stock/30% Bond portfolio is now a 73% Stock/27% Bond portfolio only 4 months later. You can imagine that over a 3 or 5-year period of solid stock market returns, and average bond market returns, the portfolio doesn’t come close to resembling its original mix! 

After the asset allocation has been addressed, I look to implement item 2) adjusting portfolios to reflect the current growth and inflationary environment as another risk management strategy. 

This is where I turn to the research team at Hedgeye for their quality, independent, data driven research to help me implement decisions through a repeatable rules-based process, not guesswork. 

Recently the research team over at Hedgeye suggested we are in a slowing growth and accelerating inflationary environment, which they call #Quad3. 

They suggest “overweight(s),” to asset classes you should consider increasing exposure to, and “underweight(s)” to asset classes you should consider decreasing exposure to. 

Here is a list of the overweight’s and underweights they recommend for Quad 3: 

Asset Class Overweight(s): 

  • Fixed Income

Equity Sector Overweight(s): 

  • Utilities, Tech, Energy, and REITs

Equity Style Factor Overweight(s): 

  • Low Beta/Minimum Vol., Growth, and Quality 

Fixed Income Overweight(s): 

  • Long Duration Treasuries, Taxable Munis, and TIPS

Asset Class Underweight(s): 

  • Equities and Credit

Equity Sector Underweight(s): 

  • Financials, Materials, Communication Services, and Consumer Staples

Equity Style Factor Underweight(s): 

  • High Dividend Yield, Value, and Small Caps

Fixed Income Underweight(s): 

  • Convertibles, Leveraged Loans, and High Yield Credit

As long as the data continues to reflect this combination of slowing growth/inflation accelerating, we will boost our investments in asset classes above labeled “overweight.” These are some of the modifications that we can implement to help improve the overall risk adjusted returns of your portfolios. 

Aaron L. Hattenbach, AIF®

[email protected]

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February Market Insights

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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.