The Wall Street Journal recently posted an article that captured two of the opposing forces that I expect will cause the markets to have a bumpier ride in 2018. It was titled “Don’t Trust Dow 25000. The Economic Cycle Is Broken: Markets and economic indicators offer differing signals on where the U.S. economy is poised.”
When it comes to assessing how to navigate through this Everything-Is-Awesome stock market, here are five major factors to watch for, some of which conflict with each other:
1. Economic output is looking very strong, the kind of strength that you usually see at the beginning of an economic cycle. This is providing support for the narrative that the stock market has room to rise given the expectation that earnings will grow.
2. On the other hand, recessionary indicators like the difference in Treasury yields for the 10 year bond vs the 2 year bond have been pointing lower, signaling a greater likelihood that we will tip into recession as planned interest rate increases occur in 2018. This is the canary in a coal mine, and once it becomes a negative value known as a “yield curve inversion,” the probability of a recession rises significantly. The last seven times this value has gone below zero, the economy tipped into a recession, making this a formidably accurate gauge to pay attention to:
3. As stocks have risen for 14 straight months (which has never before happened in history), stock market bears are throwing in the towel (Jeremy Grantham, a long-time bear, says stocks could move dramatically higher). Investors have also become convinced that protecting against the downside is no longer worth it (as stocks reach new highs, investors abandon hedges). Guess where we are in the stock market cycle of fear and greed?
4. Speaking of Fear and Greed – another reason for caution is that if you look at the market through a tool called technical analysis, you can see that we are in one of the most overbought markets ever, with the recent rate of appreciation greater than that of the 2000 and 2007 markets. Said another way, relative to equilibrium levels, there is as much greed in the markets today as there was fear at the bottom of the market in 2009.
5. Currently, the stock market has a future expected return of (brace yourself) an annual loss of about 4% per year for the next 10 years (source). How can we make such an assertion? If we track the relationship of stocks to its historical valuation relative to GDP, we find a close relationship between valuations and future returns. This relationship between valuations and future performance has been able to explain 82% of the returns (source):
If we plot the the historical expected returns with actual returns, we again see a close relationship below (the black line is the actual return, the blue is the expected return based on valuation):
It doesn’t mean that we should necessarily expect a loss this coming year and that we should sell all our stocks right now. It means that there is a good probability of an eventual large draw-down that causes the annualized return over the next 10-years to converge to negative values. The catalyst for the change has historically been the economy, so I am closely monitoring this. The economy is doing well and creating plenty of jobs, and my research shows that as long as jobs growth remains positive, there will likely be a continuation of the upward trend for the markets, regardless of valuations. Here’s a graph of the US jobs growth:
Once that changes and it turns negative, our approach is to change with the market and shift our asset allocation to more heavily favor investment grade bonds, which held up well the last time markets fell during the recession.
To conclude, markets are showing a level of exuberance not seen since the turn of the century. While it may be tempting to sell, experience has shown that some of the biggest gains tend to happen at the highs. While we aim to protect against the downside, we also need to balance that with protecting against missing upside opportunities. The recent corporate tax cut and economic growth accelerating across all the major economies in the world may be enough to keep the trend moving in a positive direction, and as long as the trend is our friend and continues to be the path of least resistance, we will maintain exposure to the market, though with a more balanced approach that includes bonds and covered calls to create and provide a margin of safety where very little exists.
Rainier Trinidad, CFA
Parabolic Asset Management
Investment Risk Disclaimers: (i) Investments involve risk and are not guaranteed to appreciate, and (ii) Past performance is no guarantee of future results. (iii) My articles may contain statements and projections that are forward-looking in nature, and therefore are subject to numerous risks, uncertainties and assumptions. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.