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July 17, 2017

Thus far 2017 has been a good year for investors. In fact, it’s been the best start to an investment year since 2006, with a moderate 60/40 benchmark portfolio up a healthy 6.3%.

Performance like this is always welcome, but as we look to the second half of the year some concerns remain stubbornly in place.

On the positive side of the ledger:

1. US employment data has been stable.

2. Consumer and business sentiment remain at healthy levels.

3. Global economic data (especially Europe) has improved.

4. Leading US economic indicators are signaling growth, albeit sluggish.

5. And the risk of US recession in the near-term appears low.

On the negative side:

1. US equity valuations have reached the third highest in market history.

2. The US business cycle is now the 3rd longest in economic history.

3. US household debt has hit an all-time nominal high, but household debt to GDP is 67%, which is still below the 83% all-time high in 2007.

4. Corporate debt is at record highs.

5. Productivity and wage growth remain stubbornly low.

The two negatives receiving the most attention in investment circles are the markets high valuation and our aging business cycle. But as ominous as these two are there are several counter points for investors to consider.

First, with US markets rivaling some of the highest valuations in history many investors are rightfully concerned that the risk of a meaningful correction is higher than average. But the counter point to this concern is that valuation has historically not been a reliable short-term timing indicator.

Case in point – today’s valuations are the same as January 1998. But 1998 was actually a very good year for investors – the US market rose over 28%. And that was followed by a 21% gain in 1999.

The point for investors to keep in mind is that markets can and often do remain over or under valued for extended periods of time. Moreover, there’s no way to know if this market cycle will end with a difficult correction (as is often the case) or with an extended period of low returns.

Item number two is our aging business cycle – only the expansions from 1961 to 1969 and 1991 to 2001 were longer. But here’s the unique thing about our economic expansion… it’s been horrible! Indeed, it’s the weakest economic expansion in modern history. We’ve realized just a fraction under 2% annual growth – that’s half the historic average.

Moreover, given the length of our expansion, one would expect the economy to be running at or near full capacity, but that’s not the case today. One of the more telling stats in this area is employment, but contrary to media reports we’re not at full employment. In fact, an unusually high number of people are underemployed, working multiple part-time jobs, or out of the workforce entirely, as a result employment isn’t at full capacity for the vast majority of sectors in the economy.

Bottom line, our present business cycle is indeed 97 months long, but the length belies the fact that it’s been the weakest economic recovery in modern history. And when one considers the age and weakness in totality there’s a good case to be made that the cycle may not be as late-stage as it appears.

So what’s an investor to do? Do you Pollyannaishly ignore the significant red flags and sit in a buy and hold portfolio no matter what? Even if that “what” is a bear market with the potential for a 35% plus drawdown like that of the early 2000’s and 2008?

If you’re under 40 and investing a little every month, and you don’t have much money in your portfolio then “maybe” buy and hold doesn’t look so bad.

But what if you’re retiring in the next decade, or already retired, and/or have accumulated a significant portfolio that can’t afford a major loss? That investor needs to keep the “big loss” at bay.

Why is the “big loss” so important for high net worth and mature investors?

Just ask the average retiree from the early or late 2000’s, and you’re likely to find quite a few that lost about a third or more of their retirement nest egg. And with that loss came the stress of broken retirement dreams, a return to work for some, and major lifestyle adjustments for many.

So, how you invest is largely dependent on your circumstances and stage in life. And if you’re soon to retire or already retired, and looking at one of the highest valued markets in history, then it’s likely a very good idea to be keenly focused on downside active risk management.

Arguably, diversification and active risk management are at their pinnacle of importance in historically highly valued markets exhibiting classic signs of a late-stage market cycle.  Which in my opinion, is exactly what we have today.

Asset Allocation

From strictly an investment perspective, the equity trends in US and international markets remain positive. As such, we’re advising clients to maintain equity exposure at the moderate level of their personal risk tolerance.

As for bonds, tactical factors are mostly neutral; given this, we remain positioned in the 3 to 10-year range.

As for “strategy” weightings – in my opinion, this is a textbook environment to avoid buy and hold and overweight active / tactical portfolio management.

In closing, certainly there are some classic red flags in our present environment, but there’s also reason for investors to not be too negative in the near-term – especially with positive trending equity markets.

In the next commentary (October), I’ll discuss the factors I use to actively manage downside risk in index-based ETF portfolios, and illustrate historical returns with a buy and hold comparison.

 

*** 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. In most environments we prefer to have exposure to both buy & hold AND tactical strategies, but in high risk environments our strategy turns more tactical (active) with a greater focus on risk management. We’ve been primarily tactical since December 2015.

**For more information on how and why we blend buy and hold AND tactical strategies please read our Investment Strategy page.

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