Investment Climate Forecast: Unsettled Markets

By Rob Isbitts

Investment markets can be confusing. To try to cut through the chatter and investment slang, we present this monthly view to you. We want you 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 there could be a period of wealth destruction.

We continue to sit on the edge of the defensive "Extreme Zone" of our portfolio positioning. Higher-than-normal cash balances and selectivity are in for us now. We allow for another modest leg higher in stocks, but not much more. October's market plunge seems more like the beginning of something than the end of a dip but it can take a while for major market changes (from bull to bear) to occur.

Stock Market

Our proprietary Investment Climate Indicator turned to its most bearish of four levels (Stormy) back at the end of January. Over the past 12 months, the S&P 500 has not traded below 2500 or above 2950. That strikes us at best as a trading range, not a robust bull market.

The U.S. stock bull market (as depicted by the S&P 500, Dow and Nasdaq) is in its very, very late stages. The lack of participation from many segments of the U.S. and international markets imply this. We see increasing similarities to the late year-2000 period, as the "market" turned from bull to bear in the year 2000, and we saw the dot-com bubble. That sparked two years of major declines in momentum stocks, while higher-quality, non-tech blue chip stocks fared pretty well. Investors must moderate their return expectations from the stock indexes, or they will be very disappointed.

Bond Market

U.S. bonds are likely into their third year of a bear market, following a nearly four-decade-long bull market. But it is our observation that many retail investors have no idea that this is happening, as evidenced by a continued flood of assets into bond funds. As a result, balanced portfolio returns are in their third year of lackluster returns.

As for short-term rates, most investors know they are headed up. What is underappreciated by the market may be the gradual impact that higher borrowing costs will have on the economy in the years ahead. This is, however, creating a nice additional tool for income-oriented investors during a period in which the stock market is threatening to tip over.

Investment Reward/Risk Tradeoff

Reward potential still exists (as it always does), but at a higher risk level than at any point in the past 10 years.

But risk-management should be a very high priority versus pursuit of reward. Increasingly, we see that profit opportunities are smaller and more fleeting (very short-term), which seems to match the late-in-bull-cycle conclusion we have drawn regarding the U.S. stock market.

Points of Interest

What concerns us about today's investment climate? High stock valuations, an overheating economy, geopolitical risk, trade spats, excessive leverage and most of all, the reversal of nine years of easy money policies by the Federal Reserve. Historically high levels of investor speculation, consumer debt, and investor complacency only add caution to our outlook.

A recession may still be a ways off, but the U.S. economy is at the point where it doesn't get better than this -- which means we should watch for signs that it gets worse. We think that in such an environment, high-yield, corporate and mortgage bonds are particularly exposed to a deterioration in credit quality, investor sentiment or both.

The good news? None of the above means that we abandon investing altogether. Sure, cash and hedges play a bigger role than in less precarious times. But the stock market has many different segments, and opportunities appear all the time. We see long-term opportunity in stocks and sectors that have been ignored late in the bull market. This requires patience, as some stocks are rediscovered by investors.

The Plan

We diversify among owning long-term investments and renting tactical investments. This combination should produce more balanced results in the coming years, as opposed to traditional stock/bond mixes, or allocations to different asset classes. Hedging techniques are particularly valuable tools to have in one's arsenal at this stage of the market cycle. Finally, do not assume that what has worked for the better part of the past 10 years will continue to work.

The Market Can Fall When the Economy Is Strong

I do get a little tired of hearing investment commentators rationalize that the stock market should hold up because the U.S. economy is strong. As the chart above shows, as of Sept. 30, 1987, U.S. GDP growth was strong (and about where it is now), inflation was up but controlled (as it appears to be now), and the unemployment rate was at a multi-year low (just like it is today).

What happened next? During the month of October that year, the S&P 500 Index fell by over 28% in 6 trading days, including over 22% in a single day. This is perhaps the most stark reminder that the economy and stock market are not the same, though history is littered with many more situations like that.

Global Market Performance Summary

While this group of 100 ETFs is certainly a wide-ranging group, when you average their returns you get a sense of general global market conditions for investors over the time periods shown. As indicated, the first 10 months of 2018 have been no picnic. The past three years have been OK, but with the S&P 500 returning nearly 11% during that time (see below), I fear that there is quite a bit of FOMO (fear of missing out) amid the investor population. That is dangerous to one's wealth, as history has repeatedly shown us.

U.S. Equity -- Broad Market

Is the bloom finally off the S&P 500 rose? It is starting to look like it. A volatile October left the S&P 500, Dow Industrials and Nasdaq 100 slightly positive for the year, but the rest of the broad market indexes we track are down. Historically, that scenario has often been a sign that a bear market in global stocks has already begun, and that the headline indexes are merely the last to fall. This bears watching very closely in the weeks and months ahead, pun intended.

U.S. Equity -- S&P Sector

Increasingly, the U.S. stock market is characterized by the dreaded "sector rotation," whereby investor money flows massively in and out of different stock sectors, often at a moment's notice. This can create a trendless feeling, and that's what October and 2018 in general have felt like. As a result, about half the sectors of the S&P 500 are down year to date.

U.S. Equity -- Industry

When we look a bit deeper into industry groups, we can see the impact of FANG on the internet stocks as a whole, as they have appreciated during the past 12 months, even after a real pounding the past few months. On the downside, home construction stocks are in the gutter, so to speak. After a strong run, perhaps the market is sensing a turn in the housing cycle. Economic reports during October imply that the top is in for U.S. housing, after a revival post-financial crisis last decade.

U.S. Equity -- Thematic

High beta stocks (those with high historical price volatility) have lived up to their name recently. They are a poster child for 2018's market, one which has yet to sustain a trend in either direction for more than a few months.

Non-U.S. Equity

This table shows a world of hurt. Declines in India, China and Europe speak to both mediocre stock performance in local currency, and a deduction in returns from a strong U.S. dollar. Note that since these are U.S.-based ETFs, their returns are impacted by movements between the home currencies and the U.S. dollar.

Equity: Dividend-Focused

This is a group of dividend ETFs that track different definitions of what a dividend stock is. Until October, the higher-yielding segments of the dividend universe tended to lag behind those with lower yields but higher earnings growth potential. This is essentially another form of growth stock investing outperforming value stock investing. October changed that a bit, and it is another theme to continue tracking -- and we will. After all, high-yield stocks tend to underperform the most before major declines in the S&P 500 (1999, 2007).

Asset Allocation

We look at that 1-year column and think "nice grouping." But it is not so nice for so-called balanced investment portfolios, which these four ETFs attempt to replicate. In reality, the past three years have been about the Nasdaq and the S&P 500, with everything else taking a back seat. If, as alluded to earlier, the bloom is coming off of that rose, asset allocation portfolios are vulnerable in the years ahead.

Commodity/Currency

Volatility in the commodities market? Next, you will tell us there is gambling in casinos. Gold has been on the performance sidelines for a while, thanks in part to a strong U.S. dollar. Oil is up nicely over the past 12 months, but if you drive a lot, perhaps "nicely" is not the word.

U.S. Treasury Bond

This is not your parents' bond market. Nowhere is that more apparent these days than in the low to negative performance of U.S. Treasury securities. Across the yield curve there are losses or slight gains, except for the suddenly ascending short-term end of the curve. This is the reality. What is also reality is how much investors are underestimating how this will change how they view investing. This does not mean that bonds have no redeeming qualities. As long as they still hold their ground during equity market selloffs, they can at least be considered for tactical opportunities.

U.S. Credit Bond and Non-U.S. Bond

It should come as no surprise that credit bonds -- that is, non-U.S. Treasuries, which are often priced based on their perceived risk as compared to Treasuries -- are producing low positive or negative returns over the past year and beyond. The exception to this point is convertible bonds, which are more stock-like (since they are essentially bonds that can be converted into stocks), and as stock prices rise, their likelihood of converting increases. In a credit crisis, much of this credit bond group would go from weak to bad to worse. This is worth watching as investors figure out how governments around the world will pay for all of the heavy spending of the past decade, coming out of the Great Recession.

Disclosure: Comments provided are informational only, not individual investment advice or recommendations. Sungarden provides Advisory Services through Dynamic Wealth Advisors. Source for all data and charts from YCharts.com.

About the author: Rob Isbitts is the the chief investment officer of Sungarden Fund Management, the subadvisor to a long-short mutual fund (DNDHX) and the founder of Sungarden Investment Research, an investment management and equity research firm. Over the past three decades, he has managed daily liquid portfolios through diverse market conditions. He has created several investment strategies, including the Sungarden Hedged Dividend portfolio, an alternative approach to the pursuit of income, preservation and long-term growth. He also is the auhtor of two books and hundreds of articles on investing. Follow him on Twitter @robisbitts, and see his website at Sungarden Investment Research.