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February 2, 2018

Even though the year has just begun, we’ve already set several impressive records in the markets. In fact, with the S&P 500’s positive performance in January, we realized our fifteenth month of consecutive gains – the longest winning streak in S&P history.

With 2017 notching a 19% plus gain, and 2018 off to a good start, the bull market appears comfortably intact. And not surprisingly, as investors see the gains, confidence has grown; with investor sentiment readings matching highs not seen since the late-1990’s.

Contrarian minded investors are rightfully suspicious of the market’s record-setting stats, but historically, rallies similar to ours most commonly end with a gradual erosion of the trend (marked by brief periods of consolidation) not an overnight bear market.

In the interest of gaining a better big-picture perspective let’s take a look at the pros and cons of our present environment.

Tailwinds:

1.  The U.S. Economy has now posted the best three consecutive quarters of GDP growth since 2005, and thus far the start to 2018 looks good.

2.  Near-term recession indicators are rising with higher interest rates but still look likely to remain below red flag levels for at least the next 60-days.

3.  U.S. consumer and business confidence are both at highs not seen since the 1990’s.

4.  Lower tax rates are expected to provide economic stimulus and boost 2018 corporate earnings.

5.  U.S. employment data has been stable.

6.  Global growth appears to be improving – the numbers for the fourth quarter of 2017 were the best in a decade.

Headwinds:

1.  The U.S. bond market in recent weeks has seen significant selling pressure – driving interest rates up.

2.  The U.S. Federal Reserve is presently targeting two or three interest rate increases in 2018.

3.  International Central Banks are signaling intent to slow down unprecedented monetary stimulus.

4.  Over the past year, U.S. consumer debt has surged, and savings rates have fallen to the worst since 2007.

5.  U.S. businesses are at record highs in debt exposure.

6.  By most every metric the U.S. markets are trading at the second highest stock valuation in history – exceeded only by the historic run of the late-1990’s.

7.  In two months, we will be in the second oldest business cycle in market history – exceeded only by the decade-long expansion of the 1990’s.

Big Picture

The two big picture developments of the past month were economic stimulus (tax bill) and rising interest rates. As I discussed in 2017, these two opposing factors are likely to dominate the markets until the end of our present investment cycle.

January provided us with an excellent example of how these factors can dictate market activity. Through most of January the dominant topic was pro-growth stimulus, but at the close of the month, the focus quickly turned to higher interest rates as bonds saw one of the most dramatic price drops (rate increases) of the past decade.

Today’s healthy employment number adds fire to the interest rate dilemma since it confirmed that wages are surging. Why is that a problem? Because wage growth is inflationary – and with wages suddenly rising at the fastest pace in ten-years many investors are evaluating the possibility that the rapid jump in interest rates could offset the stimulus.

The counterintuitive issue for investors is that what’s good for Main Street is sometimes bad for the markets. Indeed, based on the data through January, economic growth in the first quarter is now projected at better than 5%. Certainly, it’s just a forecast, but we’ve not seen non-partisan projections at that level in over 20-years, and if close to accurate interest rates could move significantly higher.

There are many in the financial media making bold calls as to how these factors will play out, but the reality is that they produce opposing cross-currents that create an unpredictable toss-up environment. And the wild card in it all is the Fed and their post-2008 boldness to influence the markets at nearly any time.

Moving Forward  

The business cycle is soon to be the second longest in history, we also have the second longest bull market and the second highest market valuations. Combine that with the Fed trying to raise rates, and numerous other headwinds and our present market cycle is textbook late-stage.

That may sound ominous, but being in a clearly defined late-stage market cycle (like 1999) can be a significant positive for investors that recognize it for what it is. With that said, it’s very important for investors to keep in mind that textbook late-stage doesn’t mean this cycle will come to a quick end. In 1999, for example, the market had a fantastic year – gaining over 21%.

Our present cycle could indeed extend to a record length and / or valuation for any number of reasons – private sector stimulus, Central Bank activity, healthy earnings, etc.. And the demise of the cycle may not be a bear market (as is usually the case) it could instead be an extended period of low returns.

So what’s an investor to do? I think the best advice is to try to temper strong opinions as to what could happen in the near-term and invest in ways that provide an opportunity for upside with a very clear strategic emphasis on active downside risk management.

For most investors, this isn’t likely a good time to be a buy and hold investor or to extend risk beyond the middle of their risk tolerance range. The big mistake that many people make in this type of environment is concentrating their portfolio to the hottest areas of the past couple years. Thereby (knowingly or not) increasing their downside risk far beyond what they can ultimately tolerate.

Asset Allocation

In the past 6-weeks bonds moved strongly to a negative trend. With bonds trending neutral to negative over the past year we fortunately encouraged investors to overweight U.S. Government notes with no exposure to maturities over 10-years, and no exposure to international or high yield bonds. We are now encouraging clients to hold that allocation.

Equities remain in a positive uptrend, given this, we continue to encourage investors to maintain equity exposure in a diversified global allocation at the moderate level of their personal risk tolerance.

 

** For those not familiar with the firm, it’s important to note that we are not short-term market timers. We employ both buy and hold AND tactical / active strategies in well-diversified portfolios using transparent, inexpensive, and tax-efficient index-based ETF’s.

* Historical returns do not guarantee future results. Investing always involves the risk of principal loss.