Past Performance

May 1, 2018

What a difference a few months can make. In January we were enjoying the longest period without a pullback of more than 3% in market history, and now here we are in one of the most volatile 3-month periods of the past decade.

Times like this can be exhilarating or frustrating, depending on perspective, but periods like this one are not at all uncommon. In fact, in the 21st century, the average S&P 500 pullback per year is just over 10%.

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

Pros

1.  The US economy has now posted the best four quarters of growth since 2005.

2.  Leading US economic indicators are positive and near-term US recession risk appears low.

3.  US small business confidence is at its highest level in over 20-years.

4.  US consumer confidence is at a 14-year high.

5.  First quarter corporate earnings are up 26% - the highest rate since 2010.

6.  US labor markets remain stable.

7.  US Business investment has surged to its best showing in over 7-years.

Cons

1.  The Federal Reserve is presently targeting at least two additional interest rate increases in 2018.

2.  Debt costs are up - the 10-year Treasury has moved from 2% to 3% in just 8-months

3.  US total business debt as a share of GDP is now above the previous record highs of the financial crisis.

4.  US consumer household debt as a share of GDP is just below the record highs of the financial crisis.

5.  Europe’s economic data has softened, and the synchronized global growth story of 2017 has sputtered.

6.  US equity valuations remain elevated.

7.  Our business cycle is now tied for second oldest in history.

Bulls and Bears

As is often the case, the list of today’s pros and cons present a mixed picture. Clearly we have some good news on the earnings and economic front, but what’s moved to center stage in 2018 is the volatility inducing battle between higher interest rates and pro-growth stimulus.

With the uptick in volatility many in the media are now making bold calls as to how these competing factors will play out, and even though entertaining forecasts should always be looked upon as folly we consider them to be especially unworthy of attention today. That’s because the tug-of-war between higher interest rates and fiscal stimulus is thoroughly unpredictable.

So what’s an investor to do? There’s a lot of noise in today’s market, but the bottom line for us is to remain keenly focused on the high likelihood that the market and economy are in a textbook late-stage economic cycle.

Given this, there are several time-tested investment points to consider: First, late-stage is typically not a good time to push risk exposure beyond the mid-range of your risk tolerance. Second, late-stage markets often favor quality – so overweighting large and stable may be a strong consideration. Third, late-stage has historically been an optimal time to overweight tactical strategies emphasizing downside risk management and underweight buy and hold.

Perspective

Over the past few months, we’ve seen the market exhibit some clear signs of rolling over, but what we’ve not seen yet is a negative trend or strong indication for investors to reduce equity risk exposure.

For perspective, let’s take a look at a classic example of a market with “strong” risk reduction signals. In late-2007, after the market hit an all-time high it churned slightly lower for several months until gradually slipping to a negative trend. Very importantly, what also happened in late-‘07 was that the yield curve inverted and recession red flags spiked across the board.

The good news today is that the U.S. is not seeing a scenario like that – not yet anyway. Recession red flags are virtually nonexistent, and even though the market has experienced volatility in recent months, it hasn’t moved into a negative trend.

Recent Activity

In the past six-weeks, we rebalanced portfolios by significantly reducing our 2017 overweight in international developed markets. In the process, we realized substantial capital gains that we’ll strive to offset with any tax efficient ETF swaps that may arise, but clients with taxable accounts should expect capital gains in 2018.

Allocations

Volatility notwithstanding, we are advising patience on the “equity” side, and are presently significantly overweight US large-cap and significantly underweight Europe and international developed markets.

As for bonds, it’s been almost twenty years since bonds have been routed this badly, and investors with traditional exposure (not us) have seen substantial losses.

Given the negative trend that developed in bonds last year – we remain positioned in short maturities in investment grade floating rates, US treasuries, municipals, and money markets.

In closing – we are implementing our investment process with a late-stage market tilt, which means we are overweighting tactical with an emphasis on risk management - favoring large and stable - and underweighting / avoiding areas in negative trend.

 

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

* Historical returns do not guarantee future results. Investing always involves the risk of principal loss. No mention of a particular security, index, or strategy in this blog constitutes a recommendation to buy, sell, or hold. Nor does it constitute an opinion on the suitability of any security, index, or strategy.