Investment Climate Forecast: Unsettled Markets

Investment markets can be confusing. To try to cut through the chatter and investment slang, we present this monthly view to you. We want you to give you a 50,000-foot view of market conditions updated as our view evolves. Currently, our Investment Climate Indicator remains at stormy. Stormy means that bear market rules apply, and we believe there could be a period of wealth destruction.

We continue to sit on the edge of the defensive “Extreme Zone” of our portfolio positioning. Higher-than-normal cash balances and selectivity are in for us now. We allow for another modest leg higher in stocks, but not much more. October’s market plunge seems more like the beginning of something than the end of a dip but it can take a while for major market changes (from bull to bear) to occur.

Stock Market

Our proprietary Investment Climate Indicator turned to its most bearish of four levels (Stormy) back at the end of January. Over the past 12 months, the S&P 500 has not traded below 2500 or above 2950. That strikes us at best as a trading range, not a robust bull market.

The U.S. stock bull market (as depicted by the S&P 500, Dow and Nasdaq) is in its very, very late stages. The lack of participation from many segments of the U.S. and international markets imply this. We see increasing similarities to the late year-2000 period, as the “market” turned from bull to bear in the year 2000, and we saw the dot-com bubble. That sparked two years of major declines in momentum stocks, while higher-quality, non-tech blue chip stocks fared pretty well. Investors must moderate their return expectations from the stock indexes, or they will be very disappointed.

Bond Market

U.S. bonds are likely into their third year of a bear market, following a nearly four-decade-long bull market. But it is our observation that many retail investors have no idea that this is happening, as evidenced by a continued flood of assets into bond funds. As a result, balanced portfolio returns are in their third year of lackluster returns.

As for short-term rates, most investors know they are headed up. What is underappreciated by the market may be the gradual impact that higher borrowing costs will have on the economy in the years ahead. This is, however, creating a nice additional tool for income-oriented investors during a period in which the stock market is threatening to tip over.

Investment Reward/Risk Tradeoff

Reward potential still exists (as it always does), but at a higher risk level than at any point in the past 10 years.

But risk-management should be a very high priority versus pursuit of reward. Increasingly, we see that profit opportunities are smaller and more fleeting (very short-term), which seems to match the late-in-bull-cycle conclusion we have drawn regarding the U.S. stock market.

Points of Interest

What concerns us about today’s investment climate? High stock valuations, an overheating economy, geopolitical risk, trade spats, excessive leverage and most of all, the reversal of nine years of easy money policies by the Federal Reserve. Historically high levels of investor speculation, consumer debt, and investor complacency only add caution to our outlook.

A recession may still be a ways off, but the U.S. economy is at the point where it doesn’t get better than this — which means we should watch for signs that it gets worse. We think that in such an environment, high-yield, corporate and mortgage bonds are particularly exposed to a deterioration in credit quality, investor sentiment or both.

The good news? None of the above means that we abandon investing altogether. Sure, cash and hedges play a bigger role than in less precarious times. But the stock market has many different segments, and opportunities appear all the time. We see long-term opportunity in stocks and sectors that have been ignored late in the bull market. This requires patience, as some stocks are rediscovered by investors.

The Plan

We diversify among owning long-term investments and renting tactical investments. This combination should produce more balanced results in the coming years, as opposed to traditional stock/bond mixes, or allocations to different asset classes. Hedging techniques are particularly valuable tools to have in one’s arsenal at this stage of the market cycle. Finally,┬ádo not assume that what has worked for the better part of the past 10 years will continue to work.

The Market Can Fall When the Economy Is Strong

I do get a little tired of hearing investment commentators rationalize that the stock market should hold up because the U.S. economy is strong. As the chart above shows, as of Sept. 30, 1987, U.S. GDP growth was strong (and about where it is now), inflation was up but controlled (as it appears to be now), and the unemployment rate was at a multi-year low (just like it is today).

What happened next? During the month of October that year, the S&P 500 Index fell by over 28% in 6 trading days, including over 22% in a single day. This is perhaps the most stark reminder that the economy and stock market are not the same, though history is littered with many more situations like that.

[“source=TimeOFIndia”]