It’s pretty easy to hear the same investment theme these days “as many investors go to the same dinner”; hear the same story; and drink the same Kool-Aid. The huge world of investible assets is quickly shrunk down to just a few of the same companies owned by many. But years of tepid economic expansion and low returns cause many investors to be hesitant to broaden their holdings beyond the few stocks delivering eye-catching results. This includes index ETFs (passive strategies) that own outsize exposure to the same fast growing companies. Even today as global growth is slow there is caution to invest otherwise despite a record widening valuation gap between growth and value stocks. Additionally, money flows are more concentrated and could exasperate market volatility and drawdown for these heavily owned exposures. Did you know, the FAANG stocks provided 25% of the YTD2019 return for the S&P500? [FAANG stocks = Facebook, Apple, Amazon, Netflix and Alphabet’s Google] Together they are a large portion of the S&P500’s total market capitalization, and their growth sizzled in recent years. Yet caution is warranted as they are priced to “perfection” – requiring close awareness to their rich valuations and being widely owned.
During July, the financial markets anticipated the Fed lowering interest rates for the first time in over 10 years. The S&P500 generated 8 new daily trading highs, and advanced +1.4%. This advanced the YTD stock index return to over +20% by month-end. That means 6 of the first 7 months were positive market performance experiences; May was the exception when stocks slid -6.4% as Trump tweeted about considering tariffs against Mexico as a lever against immigration. As observed below, international stock investing in July was challenging because of tariffs and etc. which held back their advance. US and global bond yields dropped lower (prices rose) in anticipation of the Fed lowering interest rates at month-end. Low yields are again making bonds very expensive relative to history, and leaving stocks as the better valuation choice, or “TINA” (there is no alternative).
Client portfolios are advancing (shall we change it to read, were advancing, in July?) with the markets, albeit at a slightly slower pace. That’s because we tactically dialed back risk in both the stock and bond allocations as we continue to pursue the portfolio objective (stock/bond mix). In the bond portion of the portfolio, the tactical strategy calls for owning simple, straight-forward bond funds that are pure (not go anywhere, do-anything strategies); we are also reducing (not eliminating) exposure to the Convertible bond fund (a longtime enhancement). The tactical strategy for stock allocations emphasizes greater exposures to large and mid-sized high quality companies (under-weighting small), and giving greater weight to value over growth due to valuations mentioned above with Kool-Aid investing. The logic is similar for both asset classes – dial back risk because the current Bull market is 125 months old (duration is the oldest in US history); the US and global economies are slowing; valuations are full but not irrational; and policy risks exist (from tariffs and Fed). Portfolios can continue to benefit as long as the underlying economic fundamentals allow for the 10 year economic expansion to advance and Bull market to run. Risk is dialed back so portfolios are positioned for a future market drawdown whenever the Bull market ends. Two areas of stock investing will get hit hardest – most overvalued (FAANG and growth) and areas of very poor performance (bad situations).
Let’s share some additional points you may like to better understand, which can influence managing investment portfolios; much is happening since July 26:
- Economic growth and industrial production is slowing due to stalled or lingering tariff negotiations. The global economy is softer than the US because of tariff and other political issues (ie: Brexit, leadership changes, Iran and oil). Tariffs are a deflationary headwind to US and global economic growth, and a key reason why global central banks are pivoting back to accommodative monetary policies to stimulate sagging economic growth outlook.
- A survey of S&P500 companies reveals more citing government as their top risk – 52% in 2018 up from 43% in 2016. The largest increase in government risk was mentioned from communication services companies (tech regulation and personal data security) and energy (climate change). One might expect to see greater reference to government in healthcare/pharmaceuticals companies. Also, in 2019 there are increasing references to supply chain disruption from tariffs, costly to business revenue/profits.
- TARIFFs will shake the market; prospects are rising that they could really hurt the economy. Trump tweeted last week that a 10% tariff on products not already subject to levies would start because China appears to be pursuing “stall” tactics. China is hoping the US economy will slow a lot and Trump will not be re-elected in 2020; China might then negotiate better trade arrangements than it believes currently possible. China retaliated by devaluing its Yuan to the lowest in years; in effect manipulating its currency to make its export products cheaper in world markets (to boost its economy) while the rising US dollar makes US-made products more expensive. Economists call this devaluing of currency a “race to the bottom” or “beggar thy neighbor” to boost their own trade and economy. Much of Europe and the world are pursuing this currency strategy over the last couple of years to stimulate their slowing economies. In essence, both the US & China need to feel more economic pain before they complete a deal; economic pressure is quickly rising in China, as foreign capital is leaving (fleeing), and supply chains are migrating. Tariffs seem here to stay.
- “But the Fed can kill the economy”. With US interest rates high relative to the rest of the world, the US dollar is “kept” strong/high and US-made products are expensive to sell overseas. The Fed needs to be involved via interest rate policy (lowering rates) while the trade/tariff issue continues so the US dollar does not remain high and thereby cause US economic growth to crater.
- Q: If given the choice to own a negative interest rate Japanese or German government bond, or a US bond yielding 1.75%, which would you own? The US Treasury of course. Why own a bond that pays no interest or would result in receiving less money back at maturity than originally invested? Investors will follow the yield, and buy the highest available. US interest rates are the highest of any developed country in the world. As foreign investors convert their currency into the US dollar, that demand raises the value of the dollar relative to other foreign currencies. High relative US interest rates and a high US dollar promote an uncompetitive environment for US export trade. Thus, as many countries follow negative interest rate and low currency strategies to boost their economies at the sake of the US, currency manipulation can pose economic growth problems
The whole process is linked – trade issues and the Fed must be coordinated, otherwise a policy mistake is in the making. Further, business leaders are impaired to make plans for the near future (invest in new plant or equipment, or hire new workers) when they are uncertain about supply chain issues related to tariffs – this is creating the first industrial slowdown since 2009. The outlook base case—low inflation; additional Fed cuts; no trade deal this year; no recession in the next 18 months. Monitoring the economy is very important in a fluid environment as it alerts to slowing conditions that would cause the current Bull market to expire.
All is not dire as the many points addressed above might otherwise suggest. The old market saying “don’t fight the Fed” means that where we are today, following the first Fed interest rate cut, the average annualized return for the S&P between the first rate cut and the next hike was +20% since 1982; the median increase was +13%. It probably remains critical to be a “time in the market” investor to capture upmarket action, albeit that some volatility must be endured. Our tactical strategy is following dialed back risk because the duration of the current Bull is long and economic/political issues are so prevalent. Don’t forget, politicians are poised to spend……
- The US government can’t stop spending – last week marks the 5th time that Congress ignored annual spending caps stipulated in the Budget Control Act of 2011. The spending bill passed will provide funding until 7/31/2021 with no statutory limit on the nation’s borrowing for the next 2 years; it raises the debt ceiling again (extending or suspending it 87 times since 1960). Why? There’s another election of Congress & President in 2020. Spending should provide economic growth support during tariff negotiations.
- Do you remember? August 5 is the 8-year anniversary since the USA was downgraded by S&P from its top credit rating (reason: too much accumulating debt relative to GDP). Since 8/5/2011, the yield on the US 10-year Treasury fell from 2.57% to 1.85% and the S&P500 gained +189% (total return), equal to +14.2% per year. The initial shock of the credit downgrade dropped the S&P index –6.6% during the first trading day. For bonds, when a downgrade happens, yields rise (prices fall); yet note that over the years, the yield is falling due to slow global economic growth; the US rate being higher than the world with investors seeking to own the higher yields (creating currency and trade issues discussed above).
It’s always challenging to invest as a Bull market ages. That’s because not everything is working as it did in early days of a Bull market. It then becomes easy to seek confirmation to an investment process by listening too much to “table talk” or drinking the “Kool Aid” being served. Yet, It is more important to remain above the noisy news “weeds” to monitor key factors that would allow one to remain invested for long term success.