“The sun is gone, but I have a light.” – Kurt Cobain
For years now, market participants have been arguing on whether or not “the” market top has been seen. So far, those who had suggested “a” market top yes, but not “the” market top have won the argument and prevailed. That being said, “this time”, both economically and market wise, it appears likely that we are in the later stages of a growth and bull cycle.
This conclusion may be easier to reach compared to the timing of a correction that could follow it. I am watching multiple “big money” sources, and all I see is a wide spread agreement on a tiring up trend, but hugely different projected time lines of a reversal.
Well then, what do we do now?
The Sun is Gone
Since 2008 global financial crisis, central bank balance sheets have grown from 3-5 trillion dollars to 15-20 trillion, China included. This 12-15 trillion created out of thin air did pull the global economy out of a deep hole and some but, has also created a dependency on easy money.
In short, FED driven expansion days are over. We all need to tattoo this on our chests backwards so we can read it in the mirror as a reminder every morning…and drop our habits developed in the last 9 years relying on it. Party bowl is gone and it’s time to sober up.
The direct effect of easy money policies has been stretched valuations in most asset classes. You can see this in your stock portfolios, real estate and speculative investments.
The good news is, that the global economy is still growing, valuations came down a bit from highs due to the drop in Feb-March of this year and forward earnings are closer to historical averages. Plus, just because the monetary easing has stopped and tightening has been resumed, it doesn’t mean liquidity has dried up. There is still plenty of cash hovering around globally.
You might ask: How much longer can the economies grow, and what if forward earnings disappoint?
The answers are: Probably not for much longer, and a correction would only be natural.
But I Have a Light
Yes, the FED sun is gone, but there is still plenty of light. The global growth is in tact and a recession isn’t an evident threat in the short term. Pro-growth policies are gaining traction, interest rates are still low, consumer and business confidence are high. On the cons side, populist rhetoric and policies, trade wars and anti-immigrant sentiment raise political risks, which can override the positives rapidly.
Just when the volatility has risen, inflation is looming, currency fluctuations are hurting trade, oil price is up and FED is in a tightening mode, the last thing markets need is irresponsible and short sighted political outbursts.
Had I just focused on newspaper headlines, I would say liquidate all your holdings and start planting tomatoes cause a third world war is looming. Luckily, there are plenty of reliable indicators suggesting that things are not that bad.
Here is a critical question in that regard: which single data point has the highest probability of predicting a recession in the US? Like any other question in finance, you’ll get many different answers to this but I agree with Ray Dalio, the manager of the largest hedge fun in the world, Bridgewater. He argues that the debt service ratio is the most important single data point as we live in a debt driven consumer economy. The end of a growth cycle usually comes with a debt service ratio high enough to hurt consumption. In other words, once the interest payment on the loan starts hurting new purchases, that’s when the party ends. Business cycles and equity markets are driven by this phenomenon. Without further ado, let me share with you that current debt service ratio in the US is at all-time lows, consumer balance sheets are healthy and household net-worth is at all-time highs.
What’s the Game Plan?
It’s a military rule, that strategic mistakes can not be remedied by tactical moves. Meaning, if you have your longer-term objectives, plans and action items lined up ineffectively, short term shifts can not bring ultimate success. So, first lesson from this is to make sure that you, or your financial advisor, wealth manager, financial planner etc…understand your long-term goals and your portfolios are adjusted accordingly.
The key thing here is to focus on asset classes more carefully then securities within in it, because 70% of a portfolio’s returns come from asset allocation decisions.
Once your asset allocation (stock, bonds, cash, alternatives) fits your long term strategic goals, then in the next 12-18 months, each time you see a high in the stock market, consider using that as an opportunity to lower your risk exposure from stocks to bonds, from international to domestic equity, from cyclicals to non-cyclicals.
Most likely, before the bear market hits, selling your long-time winners, triggering capital gains taxes and investing in potentially low performing investments won’t “feel right”, but once the bear market losses start creeping in on your statements, that feeling speedily reverses.
As far as the timing goes, it is close to impossible to know when the bear will attack, but it’s probably fair to say that sometime within the next year or 2020. We may see a seasonal summer weakness ahead, higher volatility approaching the mid term elections, and a recovery during the seasonal Santa Claus rally.
But looking at the correction in 2015, let’s remember that the recovery at year end was reversed during the following January in 2016. This time around, that reversal to the downside has the potential to has a longer duration. To be fair though, the worst year in a 4-year presidential cycle is the current second year and the best year is the third, which will be next year in 2019, so there is still some things to be hopeful about.
The Key Factor
I was working at a bank during the Nasdaq bubble and at a money management firm during the Global Financial Crisis in 2008. In both cases what I have observed is, that from trough to peak, a buy and hold equity portfolio recovered its losses 5 and 4 years respectively (based on S&P 500 returns). For a risk adjusted, diversified and rebalanced portfolio, that time span was halved.
More importantly, those who got out at the wrong time, missed the fast run up following the drop. So, in other words, your stocks, bonds, cash and alternatives asset allocation, shouldn’t force you to sell at the worst possible time.
In fact, those are the times, in hindsight, appear to be the best times to start buying. The key is to be able to stay invested for the long term.
A peak in the economy and equity markets might be near. Timing the reversal of the uptrend is extremely difficult, if not impossible. So in the next year or so, you might want to consider lowering your risk levels during up swings to a level that will not force you to sell during the correction
Thanks for reading my commentary and as always, you can reach me at firstname.lastname@example.org for questions and comments.
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.