Author's note: Investment markets can be confusing. To try to cut through the chatter and investment slang, we present this monthly view to you. We want to give you a 50,000-foot view of market conditions updated as our view evolves. Currently, our Investment Climate Indicator remains at Stormy. Stormy means that bear market rules apply, and we believe we could be a period of wealth destruction.
So much for the summer vacation. The financial markets sailed through July, only to close the month with a thud. That sinking feeling continues into August. The culprits: a rate cut/trade war double-header. The two current investor obsessions competed for attention as the stock market entered the time of year that often brings the weakest returns. Yet, with the buy-the-dip mentality still dominant in financial markets, the nine lives of the 10-year bull market could continue. Let's take a closer look.
Ray Dalio, founder of the world's largest hedge fund, Bridgewater Associates, recently wrote in a LinkedIn post that "investors have been pushed into stocks and other assets that have equity-like returns. As a result, too many people are holding these types of securities and likely to face diminishing returns."
Why would he think that? Because after one of the longest economic expansions ever, there is still a big part of Wall Street that wants more. It reminds me of one of my daughters when she was very young. You see, it wasn't enough to have cake batter-flavored ice cream. No, the dessert was not complete without gummy bears and sprinkles on top. We were all taught as kids that the place where camels roam is the desert with one "s". And, what you eat after dinner is dessert, with two "s"s. In my daughter's case, perhaps the word should have been "desssert."
That's what the market seems to want. More dessert. After all, as I have noted here in recent months, dropping interest rates can only go on for so long. The Fed Funds rate is at 2.25%. Past rate-cut cycles have typically resulted in cumulative reductions in rates of 2-3 times that. So, the Fed will run out of room to maneuver quickly -- kind of like how most of us would not maneuver too well after eating the dessert I described above.
Meanwhile, my "Eye of the Hurricane" scenario looks more likely all the time. As you may recall, that is my analogy for the current stock market. It was pretty angry late last year and then enjoyed some very nice weather this year. But a hurricane does damage in two phases, with a period of calm in the middle.
However, given the laundry list of hurdles to continued high returns, the eye could be running out of time, right on schedule for what is often the worst stretch of the year (August/September/October). And, an intensification of the U.S.-China trade war doesn't help.
And then, there's bitcoin. I see what many others do in the evolution toward blockchain technology. What I don't see is a lasting frenzy over the stock prices of one application of blockchain, namely cryptocurrencies. To me, it's very simple: any asset whose value fluctuates as wildly as bitcoin does should be considered less of an investment, and more of a speculation. I leave it to others to play that game.
"Aggressive capital preservation" is still the name of the game. Knowing your risk limits is key. That starts with being realistic about how you will act amid future market turmoil. At this late stage of the market cycle, it is a priority for retirees and those within at least 10 years of retirement.
U.S. Stock Market
The S&P 500 did not spend one second of July in the red. It rose 1.51% for the month, and finished July up over 20% for the year so far. Unfortunately, this is starting to develop like past periods of market turmoil. Specifically, the S&P 500 has outperformed even aggressive portfolio mixes by a wide margin recently. In other words, good old-fashioned diversification techniques are being left in the dust. This creates excitement and herding into index funds that track the S&P 500. When so much money is chasing yesterday's winners, that's a red flag to me.
Bonds may stink for yield these days. However, for price-appreciation, they are racking up impressive, even historic gains. The 10-year U.S. Treasury yield spent most of July in the 2.00-2.10% area, and then dove below 2.00% as August began.
I see bond volatility continuing, since so much of what concerns investors today has a direct relationship to interest rates. The trade war impacts rates because currencies and global growth fluctuate. The Fed rate cut, though it pertains to very short-term interest rates, impacts longer-term bonds as well. And the stock market's gyrations can create a situation where Treasury bonds are seen as a safe haven investment one week, only to sell off the next when the momentary fear subsides.
Most importantly, if history is any guide (Hint: it is), the Fed rate cut on July 31 is more likely to mark a point where investing became more dangerous. This is especially important if you are investing based on some type of very long-term strategy that blows off the threat of major market turbulence. It's been a nice 10-year run, and it may well continue for a bit. But don't wait until the bear is in your face to think about how you will confront it.
This chart summarizes today's U.S. economy as it pertains to work and wages. The unemployment rate is about as low as it can get. But wages have been stagnant for decades. I think this has a lot to do with how the nature of work is changing, and how the employment figures are calculated (no matter who the president is).
Many people are working multiple part-time jobs because they can't find a satisfying full-time job. That creates more Uber drivers and the like, but it doesn't help people earn and save more. Combine this with the fact that there is a serious skills gap -- many high-skilled jobs that go unfilled, and this appears to be a problem. More jobs are being automated as we speak, and that will only intensify the problem.
This has been masked by headlines about a strong economy, but with global economic growth starting to slow, the risk is not that this issue will get worse. It likely will. The risk is that investors will be shocked when it becomes more obvious and react harshly.
Key Market Stress Points
- Fed rate decisions: Well, rate-cut fans got their July gift. Now, they want more. Watch closely.
- Geopolitical: This seems to be getting worse and not better. And, while we in the U.S. are hyper focused on sound bites and scoring points, China tends to think in decades. This could be the biggest risk to global markets: that nothing happens to repair the relationship, and global supply chains, in place for decades, start to get disrupted.
- Valuation: The Shiller CAPE version of the price/earnings ratio is up near its 1929 level. Think about that.
- Index mania: S&P 500 index funds are very popular. That type of herd mentality will likely contribute to the next bear market panic.
- Credit: Consumer credit growth is unsustainable, and many corporations are highly indebted. That's a nagging issue, as it was a decade ago.
- Bond market risks: Approximately 50% of bonds in investment grade bond funds are rated BBB, the lowest of the 4 possible rating categories. Many of those bonds are likely to be downgraded at some point, and there is a nasty potential ripple effect.
- Sentiment: TV coverage of the stock market is dominated by companies that don't make a profit. Speculation is as interesting to investors as it has been since the dot-com bubble.
Perhaps this old bull market has one more run higher in it. We always need to account for that. The churn of the spring has given way to a precarious late summer. So, what's the action plan?
My portfolios have been positioned with above-average caution for much of this year, while still allowing a portion to ride the bull, so to speak. The events of late July into August are a time to examine that balance even more closely, with a willingness to throw the hammer down to protect portfolios as needed. Every move today (whether to add or reduce risk in exchange for more or less potential return) should be part of a multi-move sequence. The next moves will be based on how the reward/risk tradeoff changes next.
I am neither bull nor a bear. I am a realist and a devout risk-manager. Be careful, understand what you own, and respect the laws of gravity.
This is a group of 100 ETFs I track to get a general sense of global market conditions for investors, over the time period shown. Year-to-date has been strong, but the 1-Year figure shows how much of that simply served to even out a rough end to 2018.
Nowhere are the gyrations of the past 12 months more evident than in the wide gap between small-cap and large-cap stocks. Theories abound that small caps will be helped by the trade war, since they tend to be more domestic-focused businesses. As I see it, in a bear market, all stock categories are vulnerable.
Energy stocks have lagged enough that that they are now the highest-yielding sector of the S&P 500.
Stocks of gold mining companies have surged since the start of May, but still lag nearly other industry over the past three years. The current disruptions in the global economy have a lot to do with the recent strength.
In a sign that stability still counts for something, "wide moat" companies have been leading the market. These are businesses judged to have a sustainable competitive advantage that insulates them from major threats.
International market weakness was visible in the dividend segment in July, while tech stocks with dividends did quite well.
The mobile payments sector is up over 40% year-to-date.
Stocks outside the U.S. are taking a step back. It remains to be seen if they are the leaders the U.S. will follow down.
Yields across the Treasury curve are pretty flat. You don't get paid much to own longer-term bonds right now.
If the concerns of late July into August continue, this category will be in for a rough patch.
The U.S. dollar just keeps on keepin' on. However, as our rates drop, moving more in line with the rest of the world, pressure on the dollar could pick up.
Source for all ETF data: Ycharts.com
About the author: Rob Isbitts is an investment strategist and portfolio manager for high-net-worth families with over 30 years of industry experience. Over the past three decades, he has managed daily liquid portfolios through diverse market conditions. A thought-leader and founder of a boutique investment advisory firm in South Florida focusing on breaking investment myths and bringing common sense analysis to his audience, he has authored two books: "Wall Street's Bull and How to Bear It" (2006) and "The Flexible Investing Playbook" (2010), plus over 300 articles on investing. Connect with him on LinkedIn and follow him on Twitter @robisbitts. Rob's website is SungardenInvestments.com.
Disclosure: This material contains the current opinions of the author, Rob Isbitts, but not necessarily those of Dynamic Wealth Advisors and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Past performance is not a guarantee or a reliable indicator of future results. Investing in the markets is subject to certain risks including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Rob Isbitts offers advisory services through Dynamic Wealth Advisors.