Rising Tides, Changing News. Should I Change My Market Views?

Stock Market Up

Based on a steady, broad-based flow of positive reports from around the world, the tide of global economic growth is rising. And as a strategist, I take stands on the markets based on my interpretation of the facts. So, when the facts change, I need to decide whether or not to change my outlook. The facts have definitely changed with the recent news flow. While I anticipated slower growth rates in Europe, China and the United States this quarter, the exact opposite occurred. Growth has accelerated in almost all regions. The eurozone is seeing a rise in consumption and exports; US manufacturing and employment are improved; and China, Taiwan and South Korea are all posting better trade numbers. While GDP growth does not dictate earnings growth or return on equity, it does provide a favorable backdrop. Additionally, the margin and profit pressures we had been predicting did occur, but only briefly, and now we are seeing margins and profits rise again in the third quarter.

Contrary to my early 2017 view that wages would rise and squeeze company operating profits, wage costs have not risen quickly, even as unemployment has fallen. Therefore, many companies are experiencing better pricing power and better revenue growth. To add to the positive mix, long-term interest rates have been mostly range bound, corporate bond prices have held firm and the cost of borrowing remains little changed from last year.

Inflation, the long-dreaded curse for investors, has not yet been rekindled. As a result, investor confidence has soared, even if the roots of low inflation could have deleterious impacts over the long term. Aging demographics, heavy debt burdens and advances in automation and digitization are among the factors restraining prices — factors that investors will need to contend with for some years to come.

Volatility, too, has been unusually depressed. During 2017 we’ve barely experienced as much as a 3% pullback in the S&P 500 Index. October has historically been among the more volatile months — recall that the stock market crashes of 1929 and 1987 were October events — yet this year both the VIX (S&P 500 implied volatility) and MOVE (Merrill Lynch’s US Treasury-bond volatility index) are close to all-time lows as of mid-October. So the picture for risk takers is one of extraordinary calm and confidence. The markets seem to go up daily — even negative headlines do not disturb them.

From cautious to confident?

So, with unemployment low, volatility seemingly nonexistent and inflation muted, should I change my outlook from one of caution to one of confidence?

No, I’m not changing my view. I agree that the fundamentals have played out better than I’d predicted, but I’m not recommending that investors suddenly pursue risk again, as I had for seven years. I maintain that a capital preservation bias, while expensive in the short term (when you consider opportunity costs), is still the right way to invest. Here’s why:

  1. Valuation: Valuation does not determine short-term market returns. To be sure, markets were expensive a year ago and have only gone up. But for long-term investors, entry valuation matters a lot. We have lots of data that show that entering the market when the S&P 500 price/earnings multiple is above 20 — as of 19 October we are at 21 — means that annual returns 10 years down the road tend to lag the return on T-bills, and usually with many more headaches along the  way. Right now, most world equity markets are in the richest 10% of their historical valuation range, so it’s very hard to find cheap sectors or cheap markets.
  2. Cycle risk: The US business cycle has entered its ninth year, making it one of the longest cycles ever. The saying goes that business cycles don’t die of old age, but the longer this cycle goes, the higher the odds are of it ending.
  3. Challenges to global trade flows: Much of the profit accruing to the owners of capital in recent years has been the result of cost savings from global trade. But now, with contentious trade negotiations underway from China to Mexico to Great Britain, it appears clear to me that the world is moving toward less global trade, not more.
  4. Assets are expensive globally: Other asset categories are expensive too. Bonds in the US, Europe and Japan are all quite rich relative to history, some extremely so. With almost all investment vehicles historically expensive, some investors have gone so far as to speculate in things like cryptocurrencies, such as bitcoin, and the like. That seems unlikely to end well.
  5. China’s wild debt ride: No one is worried about the world’s second-biggest economy blowing itself up soon, but China’s use of debt, at the state, corporate and personal level, has gotten way above historical norms. At best, this pile of claims could slow growth. At worst, it could trigger a repayment storm. Someday, it could haunt investors.
  6. Relatively untested instruments: Lastly, I worry about the untested waters of new financial structures. Since the last recession and market downturn, there has been huge growth, measured in trillions of US dollars, in index-tracking vehicles, some of which are highly levered. These new structures have never been truly tested by an influx of sell orders, though the “flash crash” of August 2015 offers a cautionary reminder of what can happen when the herd stampedes for the exits. Spookily, market historians are reliving the events of 30 years ago this week, a market break known as the Great Crash of ’87, and one conclusion is clear: Stock market crashes are not caused by fundamentals; they’re caused by panics. Back in 1987, a combination of untested debt-financed risk arbitrage deals and new types of portfolio insurance fueled a collapse in prices that did not coincide with an economic event or recession. We don’t know with any great precision where the hidden fault lines are, but nine years of cheap money and excess cash reserves piling up around the world suggest that financial assets may be vulnerable. Not today and maybe not tomorrow, but someday the tide of money will go back out.

It haunts me that the later stages of market cycles are often marked by certain repeatable phenomena, such as a rise in day traders, a new “story” that replaces the old story, a fresh sense of confidence that the world of investing has been fixed and, of course, a sense that high market prices are justified.

All of these are happening today. Worse, investors are tempted back into risky assets by stories of their neighbors’ big gains, by the fear of missing out. Don’t feel left out. The easy money was the rise in the S&P 500 from 2009 to 2016. Then, fundamentals were good. The rising tide of recovery, pushed by easy money and cautious confidence, was supported by low or average price earnings valuations.

That’s not the case today. The hour is late, prices are high and hidden currents and rip tides lie beneath the seemingly placid surface of the incoming tide. This is not a call to sell all, but a call to be cautious, for investors to be wary and sober. Against this backdrop, a cautious mix of assets is best. The time for market heroics has passed.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

 

Past performance is no guarantee of future results.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affiliates and may be registered in certain countries.

Don’t Set It and Forget It—Monitor Your Portfolio

Doctors pockets with medical instruments.

I recently had a terrific experience at my doctor’s office. After my annual physical, the receptionist said, “There’s no charge for today’s visit. Your insurance covered 100% of the cost.” While my insurance is reasonably good, there are usually payments involved for most things. As I pondered why it would fully cover this bill—a preventive exam—I realized that the insurance company is happy to invest in monitoring my health, because ultimately it helps their bottom line.

The same goes for your financial health. It’s important to assess your goals—both the amount of return you need and the risk you can tolerate. But once that exercise is completed, investing should not be a “set it and forget it” exercise. Planning for life’s events can often have us looking far into the future, but markets can change quickly, so it’s important to regularly check in with your own plan. In other words, while it’s important to keep your eye on the horizon, it’s also critical to properly navigate the journey getting there.

Has anything changed?

This is the first question my doctor asks me at every annual physical. Being relatively healthy, I know he’s looking for early signs that my condition may be headed in the wrong direction. While I’m never happy when he points out that I’ve gained weight since last year, I know that this process is critical to my overall health. What I want to hear does not always align with what I need to hear.

Performing a similar exercise on your portfolio is also critical. Reviewing your portfolio when markets are up can be quite fun, while conducting that same review while markets are falling might be painful.

Here are a few questions to ask at least once a year about your portfolio:

  1. Have your objectives changed? Is there something new you are now planning for? Has your time horizon changed? If so, you’ll likely need to adjust your portfolio.
  2. How have your views of the market changed? Different investments come in and out of favor, and your portfolio should reflect that. However, this is not an invitation to bet everything on a hot investment, let a winner run for too long without trimming it, or go to cash if you’re scared. A proper asset allocation will give you the best chances for the success of your long-term plan, so unless your time horizon or required return have changed dramatically, you are best off tweaking around the edges, provided the portfolio was properly constructed.
  3. Is anything you own not working? Monitoring your holdings must always be done with perspective. Some investments should provide growth. Since not everything is meant to increase in price at the same time, some laggards may have justification. However, if none can be found, then it could be time to remove it. Conversely, some investments should help reduce risk. Our expectations for these holdings should be different, but no less important.

What if something happens?

Portfolios should evolve as circumstances change. Through disciplined monitoring and measuring of a portfolio against its benchmark, mismatches can be identified and remedied. In particular, regular portfolio stress-testing can help us learn a lot. Just like my doctor would ask me to run on a treadmill to test for any abnormal reaction in my heart rate, stress testing a portfolio can reveal scenarios that might elicit a dramatic response, helping us prepare for a variety of market events.

Stress testing can also help keep you from making inappropriate moves as market volatility changes. When markets are volatile, investors tend to grow more risk averse. The opposite is also true—when markets are calm, investors tend to take on more risk. In other words, if managing against a large drawdown is the key to keeping you invested at stressful moments, building the portfolio with an intentional awareness of how it would behave should we have a recession (as an example) may be the key to keeping the portfolio invested, and your investment plan on track.

Constant evaluation

More than just a step, monitoring permeates the entire portfolio construction process. It gives you the ability to evaluate results during the journey, ask questions about the portfolio’s recent behavior within context of the markets’ recent returns, and ensure the portfolio’s alignment with the return target you established at the outset.

The process of constructing a portfolio is more complex than ever. Investors need the right tools, technology, resources, products and, most importantly, insights to achieve their investment goals. The portfolio construction process can be time consuming and confusing. In the same way I look to my doctor to help keep me healthy, working with a financial professional can also bring objectivity and expertise to the process, which our research shows can help investors feel more confident and better prepared for their financial future.

While it’s natural to focus on the horizon—your long-term goals—it’s always important to remember that the journey is never a straight line. Regularly monitoring your financial health is essential to your success.

Patrick Nolan is the Portfolio Strategist within BlackRock’s Portfolio Solutions group. He is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of October 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

October 2017 Investment Newsletter

Glen Eagle Logo

As of Oct 19th, the Dow Jones hit its 66th high since the Nov 2016 election.  The market has been in a mode of complacent growth with historically low volatility.  The number one question I get asked is how high can the market rise?  Obviously, no one has a crystal ball that predicts the future.  At Glen Eagle our Investment Committee does meet regularly to review the trends based on both qualitative and quantitative data to help steer our efforts to best position our clients’ portfolios for what we believe are the most likely possibilities.  Interestingly, in general the data, ranging from unemployment rates to yield spreads, does not imply that the market is overvalued.  Most importantly, corporations are generally seeing increasing earnings.  There is also no indication of an imminent economic recession.

While the data is not signaling concerns, we do feel that it is prudent for investors to begin to become more conservative by both focusing on downside protection and increasing their exposure to fixed income, preferred stock and convertible instruments.  Unfortunately, market turns are often only seen after they happen and while it is likely that in the late stages of a bull market one gives up some return for becoming more conservative, we think it is worth protecting some of your assets from a potential significant stock market correction.

At this point in the market we are closely watching three areas: Tax Reform, the Federal Reserve and International Markets.

Tax Reform

The United States currently has the highest corporate tax rate among advanced economic countries. Both the President and many in Congress are actively pursuing tax reform including significant changes to the corporate tax rates.  This is an issue that business owners care about, as 52% of small and medium size businesses believe that tax changes will impact their operations more than any other issue.  The likelihood of a corporate tax cut is one issue that has been driving the market.  Failure to pass a tax cut could be the catalyst for a correction.  On the other hand, if there are real cuts to the corporate tax rates it is likely to drive the market higher as this will result in a direct benefit to most corporations’ bottom lines. ‌

One area that both parties in Congress seem to support is the idea of creating a tax incentive for corporations holding cash overseas to bring that cash back into the U.S.  If this idea becomes reality the largest technology and health-care companies should benefit.  Even without tax reform, we believe that the technology and healthcare sectors will continue to grow as a result of continued automation and an aging demographic, respectively.

Federal Reserve

The Federal Reserve has indicated that it plans to continue raising interest rates going forward.  It is likely that these increases will be relatively slow because the Fed does not want to repeat the mistake it made in the past when it raised rates too quickly and pushed the economy into a recession. Additionally, the recent string of natural disasters in the form of Hurricanes Harvey and Irma may lead the Fed to further slow the hikes as the economies and populaces of Florida, Texas, and Puerto Rico recover.  Further complicating the outlook is the fact that President Trump needs to decide whether he will keep or replace the current Federal Reserve Chairwoman, Janet Yellen, at the end of her term in four months.

As we have mentioned in previous commentaries, the rise in interest rates most directly benefits financial institutions, such as banks, that are able to earn more fees from the spread between what they pay for money (deposits) and what they earn on loans.As a side note, we also see some interesting opportunities in materials and construction, companies that will be at the forefront of the hurricane disaster-relief and rebuilding efforts.

International Markets

The economic expansion has officially taken hold internationally as 98% of the world’s economies are now participating in the growth.  Asia and Europe, in particular, look to have some positive momentum.  We expect this trend in the larger East Asian economies to continue as corporate earnings rise further and the uncertainty of China’s 19th National Congress, which is planned for the end of October, passes.  Similarly, Europe has benefited from the election of pro-European Union (EU) leaders, such as President Emmanuel Macron in France and Chancellor Angela Merkel in Germany.  Although there seems to always be another unanticipated cause of fear in the European Union, such as Catalonia’s current independence effort in Spain, we believe that the European economic zone is poised well to continue to grow.

Due to the United States’ stronger economic growth trajectory after the 2008 recession, many portfolios have become heavily weighted toward U.S. investments.  While we generally advocated an overweight position in the US market, we think that some allocation toward international markets is beneficial.  In particular, materials and semiconductor companies stand to benefit as China’s economy continues to grow.  This is because China consumes over 50% of some of the world’s raw materials such as aluminum and concrete, while at the same time having the largest demand for semiconductors as it continues relying on a manufacturing-based economy.

When people are complacent it is always prudent to stay vigilant.  If you have any concerns or would like to review your portfolio in detail, please do not hesitate to reach out to us.

I hope you have a great fall season with family and friends,

Susan McGlory Michel

CEO & Founder

 

Disclosure: This commentary is furnished for the use of Glen Eagle Advisors, LLC, Glen Eagle Wealth, LLC and their clients. It does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific objectives, financial situation or particular needs of any specific person. Investors reading this commentary should consult with their Glen Eagle representative regarding the appropriateness of investing in any securities or adapting any investment strategies discussed or recommended in this commentary.

A Song of Ice and Fire: Portfolio Hedging Edition

Mountains 2

With the S&P 500 at another new high and volatility beaten into a state of permanent submission, it seems churlish to discuss preparing for a downturn using hedges and downside protection. That said, while the market rally can continue, it is worth pausing to contemplate how surreal things are getting.

For example, the Sharpe ratio, which measures units of excess return per unity of volatility, is used by professional investors to calculate risk-adjusted returns. Currently, the one-year Sharpe Ratio on the S&P 500 is comfortably above 2, a remarkably high number. Not only is the market producing stellar returns, those returns are coming with virtually no volatility.

With that in mind, and with respect to those who prefer to do their holiday shopping in midsummer, maybe it isn’t too early to start thinking about positioning for the next downturn. The challenge for asset allocators is that when insulating a portfolio, the source of the downturn is as important as the magnitude.

Growth or interest rate shocks

While it is impossible to quantify all the ways things can go wrong, broadly speaking, most corrections fall into one of two broad categories: growth or interest rate shocks. The former describes any event that calls into question economic growth. The latter encompasses periods when investors are facing an unexpected rise in interest rates, either due to an unexpected pickup in inflation or a change in central bank behavior.

Whether an equity market downturn is caused by a growth or rate shock is a crucial distinction. To illustrate, consider a long-term portfolio targeting a 9% risk level. Now assume a shock that causes stocks to underperform bonds by 10%. Consider this the growth shock, as we assume no change in long-term bond returns.

Analysis of this scenario suggests a few conclusions. The obvious changes: Own less stocks, and of the stocks you do own, opt for lower volatility names. You could also theoretically sell credit and raise a bit of cash. The funds from lower equity, credit and cash would be reallocated to long duration bonds, the preferred post-crisis hedge against equity risk.

Now change the scenario. Using the same methodology consider what happens if stocks are selling off because bonds are underperforming, something that has rarely happened in the post crisis environment.

Under this scenario the portfolio rebalance looks very different. To start, you would want to consider lowering your equity allocation even further than in the first example. The reason is that when rates rise, low volatility stocks are often the worst place to hide. Another difference would be raising the allocation to high yield bonds, which are less rate-sensitive than traditional bonds.

The cash factor

However, the big change in the allocation involves cash. In the first instance bonds are the hedge. You even reduce cash to buy more bonds. In the second scenario bonds work against you, so you want to sell both stocks and bonds, using the proceeds to dramatically raise your cash position.

Allocation Scenarios

Both growth and rate shocks can produce stock market corrections; what changes is the prescription. The typical post-crisis correction has been driven by a growth scare. But that is not always the case. If the next correction comes from twitchy central banks, running to bonds is counterproductive.

The bottom line is that nervous investors, assuming there are any left, are faced with two decisions: When will the bull market hit a speed bump and, equally important, why?

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of October 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.