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®