A Life Boat Drill May Save Your Portfolio

By LRG Wealth Advisors on August 22, 2019

 For anyone who has taken a cruise, you remember that the captain interrupts the excitement of the first day of frivolities with a life boat drill. Much like the fire drills performed several times a year in New York skyscrapers, the life boat drill allows the crew to familiarize the new guests with the emergency procedures on the ship as well as to share each passenger’s assigned life boat. These preparatory drills ensure that one may survive an unlikely calamity.

As 2019 unfolds, we, too, find ourselves communicating with our clients in the financial world’s version of a life boat drill. Preparing for a challenging market and having your plan of action in place may very well save your portfolio. As the year unfolds, we identify several dangers that possibly foretell trouble:

• a decelerating profits cycle
• an inverted fed funds to 10-year Treasury yield curve
• the incipient stages of market exuberance
• the ongoing trade war with China

Of course, many would add politics to this list; however, we believe that profits, liquidity, and sentiment, not politics, provide far better guidance to investors. In fact, while these basic tenets of investing are widely known, investors rarely follow them because “noise” (e.g. tweets, fads, new paradigms, etc.) distracts even professional investors. Instead of following a simple investment path, attention grabbing headlines lead most investors astray thus leading to imprudent investment decisions.

It is said that economic expansions do not die of old age, but instead, they are murdered. The typical culprits are either (1) a policy error (e.g. Fed interest rate policy, tariffs, etc.) (2) regulatory errors (e.g. compliance, mandates, enforcement, etc.) or (3) exogenous events (e.g. terror attacks, natural disasters, etc.). Yield curve inversions precede economic recessions and market corrections of 20% or greater with a high correlation. An even more impressive record belongs to the profits cycle. Profits recessions correlate with economic recessions and bear markets with an even greater preponderance. Interestingly, despite a long ten year bull cycle, investors only now have embraced the bull just as the profit cycle signals warnings. And there is the trade war.

The second quarter of 2019 provided yet another example of how a 24 hour news cycle can lead even the most levelheaded, long term investor to wonder whether he or she may trust their years of experience. The latest catalyst that investors seem to be trying to predict is a potential trade deal with China (not to mention the rest of the US’s trading partners). We think it is likely that the US and China will ultimately reach an agreement. But the risk that the US/China relationship deteriorates has risen since the beginning of the year. Why does this matter? In a word, profits. There’s no sugar-coating the fact that increased trade tensions and tariffs are likely to lead to slower GDP growth, a hit to business confidence, and, ultimately, weaker earnings. In our opinion, the most important consideration for investors could be 2019’s significant deceleration of US corporate profits. Policy is making headlines, but ultimately profits will steer the markets.

THE PROFIT CYCLE DECELERATES

Year-end 2018’s earnings growth was slightly over 20%, but that growth is likely to slow to 0 to 5% by year-end 2019. The below chart illustrates the profits cycles going back to December 1980. Notice that profits recessions lead major market corrections.

Data show that sector performance has started to reflect a late cycle, profits deceleration. Both technology and financials, two very cyclical sectors, now underperform. Rate cuts may lift earnings multiples, but rate cuts will not likely raise earnings.

The last few reporting periods illustrates how markets may ignore all sorts of weird, wacky activity or news when profits accelerate; however, during a late cycle profits deceleration, markets focus with laser-like precision on earnings reports.

THE YIELD CURVE INVERTS

Historically, inversions of the yield curve have preceded most U.S. recessions. Due to this high historical correlation, the yield curve is often seen as an accurate forecaster of the turning points of the business cycle. Be that as it may, the yield curve tells us that current central bank policy (short end) is getting too tight relative to the nominal growth outlook (long end). Also, because bank funding costs tend to be more tied to the short end of the curve while bank revenues and profit outlook tend to be tied to the middle to long end of the curve, a flatter or inverted curve is loosely tied to bank lending profitability. The less profitable, the less incentive banks have to extend credit, which can further weigh on future economic growth.

Reviewing yield curve data from the Federal Reserve Bank of St. Louis and interposing it with all bear markets where the S&P 500 dropped at least 20%, the data show that nearly every bear market in the last half century was preceded by at least one yield curve inversion within 18 months of the start of the market decline. The 1973 bear market, caused and compounded by an unexpected collapse of the Bretton Woods system and the outbreak of the 1973 oil crisis, provided the lone exception.

The following chart demonstrates that not only are most bear markets preceded by a yield curve inversion, but also that the yield curve inverting is a good, but not perfect, predictor of a future bear market to come especially when it comes to timing. At a minimum, we view a yield curve inversion as an important indicator for liquidity, and as a clear sign that the economic cycle is long in the tooth and the risks to growth are increasing. One thing is relatively clear – investors probably shouldn’t get more bullish after the yield curve inverts and should begin to reduce exposure to risk assets on rallies.

“NOISE” CHALLENGES INVESTORS

We cannot emphasize enough the distraction that “noise” causes investors of all ilks. Disciplined focus on profits, liquidity and sentiment may protect an investor from making performance destroying decisions from which recovery may be difficult. The data, though, prove the challenge.

The two charts below illustrate how poorly investors manage their own investments. When left to their own devices, the vast majority of individual investors significantly underperform most asset classes for both a 10-year and 20-year period. Investors chase performance and react to headlines rather than following well known, tried and true investment tenets. Can there be any doubt that “noise” plays a significant role here?

Asset Class Returns Past 10 Years (annualized 12/31/2008 – 12/31/2018)

Asset Class Returns Past 20 Years (Annualized 12/31/1998 – 12/31/2018)

SENTIMENT SIGNALS CAUTION

There are times when investors should be more aggressive and times to be more conservative. History clearly shows that most investors mistime their exposure to risk assets. They are scared to invest when the opportunities are greatest and eager to invest as the opportunities dwindle. As Warren Buffett says: “Be fearful when others are greedy and greedy when others are fearful.”

The bull market is now more than 10 years old, yet investors have been overly cautious during most of the bull market and worried more about preserving capital than searching for opportunities. Individuals invested for “safe” fixed-income instead of equities, and institutions underweighted public equity for exotic, alternative investments. As the profit cycle decelerates and liquidity indicators flash warning signs, investors are coming out of their defensive shells. Their typical metamorphosis from bears to bulls seems ill-timed yet again.

Sentiment data show that investors are slowly but surely getting more bullish about equities. The chart below shows Wall Street’s consensus recommended asset allocation to stocks within a multi-asset portfolio. Note that Wall Street recommended underweighting equities during the current bull market as it did during the bull markets of the 1980s and 1990s. The only time the Street recommended overweighting equities was during and immediately after the technology bubble. US equities performed miserably during the following decade. The “Smart Money’s” recommendation to underweight equities mirrors investors’ anxiety during the past decade’s bull market. Wall Street is still recommending an underweight today, but a more bullish consensus is clearly forming.

Wall Street Sentiment Indicator (August 1985 – March 2019)

POSSIBLE BUBBLES ON THE HORIZON?

Finally, we offer two cautionary data points that may cut through the noise. The average bond “p/e,” calculated as 100/10-year Treasury yield, is at record levels and more than twice any previous decade since 1960. The current bond p/e is 50 times. That compares to 23.8 times for the period 2000 through 2010. The second data point is the average house “p/e” by decade, as measured by U.S. median home price/median rent. Current p/e of 21.4 is nearing the all time high of 21.8, hit by the previous decade (2000 through 2010), which included the property market bubble.

CONCLUSION

Investing in any period presents challenges. The “noise” level in our 24-hour news cycle deafens. We strive to simplify the investing process by focusing on three important factors informing the allocation of capital throughout the economic cycle:

• the profits cycle
• liquidity
• sentiment

As the profit cycle decelerates, the yield curves sits inverted, and individual and professional investors grow more aggressive, we urge caution. Furthermore, bubbles grow during every economic cycle. Might bonds, and, by extension, the credit sensitive housing market pose risks?

We intend this review as your life boat drill. We find equity markets near all-time highs; bond yields near all-time lows; and sentiment improving steadily. Please allow us to review your allocation positioning prior to the next market conflagration.

We continue to work on your behalf to cut through the “noise.” We never forget that it is not the money, but what the money does for you, your family, or your organization. Thank you for your confidence in our practice. Call with any questions, thoughts, or concerns.