Posts Tagged investment adviser

2019…And the Plot Thickens

“Get your facts first, then you can distort them as you please.” Mark Twain

“There cannot be a crisis next week, my schedule is already full.” Henry Kissinger

According to the Chinese calendar, 2019 is going to be a Pig year and since it is a water animal, it can be as murky and confusing as a mud pile, or as clear as Lake Tahoe. Today, I will attempt to turn the murkiness of the current market conditions into a clearer picture. My goal is to share relevant facts without distorting them, and make useful and actionable forecasts…so, let’s start.

Quick Wrap Up of 2018

Last year presented a typical case of a late cycle, a nowhere to hide scenario for most investors. Major asset classes, like stocks, bonds, commodities and precious metals, either lost money, or at best stayed even. In hind sight, had you bought a 1-year CD in Jan 2018, you would have beaten most professional money managers.

The usual suspects are trade wars with China, FED tightening, the Brexit mess and fears around a maturing economic and market bull cycle.

While this is true for the US, which seemed to have decoupled from the rest of the world, the global picture is bleaker. Industrial countries like Germany, Austria and Japan have posted negative economic growth numbers towards the year end, Australia’s real estate bubble had burst, emerging market stocks lost over 30% from peak to trough, and political uncertainty had been elevated.

As a result, even though year-end numbers don’t look too dreadful, we saw two waterfall declines during the year, the latter pushing major indexes to a bear territory. This downtrend, as usual, hit the winners of the previous cycle’s big winners the most, and those who argued President Trump was good for stocks, remained quiet for the big part of 2018.

A Roadmap for 2019

For the reasons mentioned above, the risk aversion levels have been elevated, and as a result, yields dropped, helping fixed income valuations recover. A case in point can be the 1-year high valuation of a popular investment grade corporate bond Exchange Traded Fund, symbol LQD.

But if risk aversion levels are elevated, what is the cause of the recent rally in the stock market? Two potential reasons:

1 – Technical: It isn’t unusual for initial panic selling to follow a bounce back, but only to retest the initial lows after.

2 – Fundamental: FED chairman Jerome Powell’s words on a “patient” FED has triggered the oversold rally.

Is it sustainable? Highly unlikely. Why?

Because even with a patient FED, the monetary base is still in Quantitative Tightening mode, not only in the US, but in more than 50% of the central banks across the globe.

From a technical view, in similar cases of 2000 and 2015, a bear market rally followed the initial waterfall decline, then a retest of the initial lows, and the resumption of the next bull cycle after capitulation. If we are experiencing anything like the years mentioned above, it wouldn’t be surprising to see more volatility for the next 6 months, and a recovery to follow after.

The Economy and Market Implications

The most recent Economist issue (Jan 26th-Feb 1st) cover probably says it all: Slowbalisation. Currently, the US economy is doing just fine, but the future is pointing to a slower growth. Here, we need to be clear with our terminology. Slow growth doesn’t mean a recession, recession doesn’t mean a depression, and depression doesn’t mean a crisis (don’t want to upset Henry Kissinger). The US economy seems to be far from a recession, but Leading Economic Indicators (LEI) signal for a slower growth. The US Q4 Gross Domestic Product (GDP) growth rate will likely be announced around 2.7%, much lower than the 3.4% in Q3.

I have looked up past periods of extremely low unemployment, and in all cases (1953, 1957, 1970 and 2000) a recession had followed. When I look at current valuations and sentiment, I liken it to the conditions of 2000, which was followed by a recession in 2001.

According to the IMF and OECD, global economy is expected to grow at a rate of 3.5% in 2019, isn’t that great? Not really. Global economy almost never experiences a recession in its most technical sense, which is negative growth two quarters in a row. The only exception to this since World War II was in 2008. According to OECD definitions, global growth rates below 3% is considered recessionary. The IMF is much stricter and conservative in this matter. But when we include the World Bank estimates as well, we can conclude that a global economic recession is not likely in 2019. According to Ray Dalio, the manager of the largest hedge fund in the world, 2020 will be when the rubber will hit the road, and he may very well be proven right.

So, one might ask, if unemployment, sentiment, valuations and stock market action remind us of past periods which were followed by a recession, why is this time expected to be different? Maybe it won’t be, but one tailwind for the US economy is credit conditions. The US is a debt driven consumer economy and as long as there is room for more borrowing, and the cost of carrying loans hasn’t started hurting new purchases, one lesson I have learned from being a market participant for many years, is to never discount the US consumer’s appetite for consumption. The recent rise in oil prices have improved corporate loan quality (these are highly leveraged businesses and they make a huge impact on the web of corporate financing) and the spillover effect is the improved loan quality.

Due to rising risk aversion, a shift from stocks to bonds, and fears of an economic slow-down, 10 year treasury yield unexpectedly dropped form 3.2% to 2.7%. Lower yields relieve the FED from its highly anticipated rate increases this year, and allow it to be more patient as Jerome Powell puts it. Another data point that makes me question the probability of rate increases, is the low inflation rate of around 2%. After years of quantitative easing, low unemployment, rising wages and economic growth, one would surely expect higher inflation. So, why not this time? Because most likely, the name of this uncharted territory is called the Amazon Effect. Each time the price of a particular good goes up, someone somewhere steps up to the plate and provides it at a cheaper cost online. The jury is still out in this discussion but automation and globalization have been a huge weight on inflation and even after 10 years after the 2008 debacle, deflation is still more of a serious threat to economies than inflation.

It would be a sin to not talk about China when discussing the global economy. I have already mentioned the problems Germany and Japan are in, but the biggest contributor to global economic growth has lately been producing forward looking indicators (PMI) pointing to a contraction in growth as well.

One bright star in this gloomy sky, has surprisingly been the UK, but I believe it is due to production that is pulled forward as a preparation for the Brexit approaching fast (or not…who knows?).

As market volatility rises and global economy starts looking gloomier, safe heavens like gold, Japanese Yen and Swiss Franc may benefit and so by definition, dollar may fall, which also may make non-dollar denominated investments more attractive, i.e. international stocks and bonds.

Summary

If this downside correction will look anything like past similar cases, valuations and investor sentiment need to drop a lot more before setting the conditions for the next bull cycle, and it is fair to expect a retest of the lows within the first half of the year and a recovery in the second. So, it’s probably wise to start the year defensive, and to switch and switch gears in the second half. In US sectors, chose non-cyclical and defensive areas like consumer staples, utilities and health care during the first half and switch to more cyclical sectors like tech, consumer discretionary and financials in the second. All of the information above are educated guesses, and your personal goals and risk profiles have to be added to the mix. So, what ever you do, tread carefully and consult with a professional.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

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.

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…And Now, The End Is Near?

“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.

 Summary

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 bbakan@shieldwm.com for questions and comments.

Disclosure

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.

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