This year has been epic in its trials and tribulations and we would all like for it to be over. We empathize with you, as the longer this continues the more frustrated we become. This too shall pass and hopefully we learn things about ourselves that improves our lives. In the meantime, we hope that you and your loved ones remain healthy, safe and sane.
Within just five months we witnessed the fastest market decline in history, prompting the quickest recession and followed by the fastest recovery. Yet while baffling many investors, the S&P 500 Index® finished the first half of 2020 only 3% below where it started. We acknowledge that stock markets are “forward-looking” but given the headlines it’s hard to imagine that we’re close to full economic recovery – though we have seen the low point. We are also somewhat surprised at the resilience of the major averages given that recovery is going to take far longer than we envisioned when this began.Investors are placing their faith in a vaccine becoming available sometime early next year and economic activity resuming its pre-pandemic pace in short order. While we hope to see a vaccine this winter, pricing in a near-complete recovery is aggressive. We believe economic growth will continue improving but a full recovery will prove choppy, slow and extended.
With markets back to pre-crisis levels, there are concerning circumstances and trends emerging or becoming exacerbated.
We have written how growth stocks (technology, telecom, pharma) are outperforming value stocks (financials, energy, materials). The differential over the last decade was already wide and over the first half of 2020 it added another 24% – growth is up 12%; value is down 12%. If we look at technology vs. everything else, tech stocks are up 18% for the year; everything else is down 9%.We know that at some point this will correct and no one knows when. But we’ve all seen this movie before. It debuted in March of 2000 and robbed years of retirement from those who abandoned value to chase growth.
The market has become highly concentrated in just a few big names – Amazon, Microsoft, Facebook, Apple and Netflix primarily. There are sound reasons why these companies are attractive, yet at some point valuations will matter. The forward Price-to-Earnings ratio of the S&P 500 is now at 25x; the highest since 1998. While valuation is not a timing mechanism, we must remember that trees do not grow to the sky. These excesses are typically cured by the top coming down and not the bottom coming up, sowhile we continue to overweight the leaders, we are keeping our eyes wide open.
Only the technology, communications and consumer discretionary sectors have posted positive returns for the year. If the April/May period is repeated, we will see the value spectrum come back to life. This will only occur when new COVID cases are in retreat – which the S&P 500 has been foreshadowing lately. It has remarkably led new case counts by about three weeks and is forecasting now that case counts should begin retreating again. Only a vaccine will enable a full economic recovery, but the market has faith that one is near.The Treasury and Federal Reserve heaping stimulus packages upon the economy are the primary reason that markets continue to perform well. As we outlined in our Q1 commentary , the Fed has successfully so far levitated the economy while the pandemic plays out. That lifecycle is proving longer than anticipated and with enhanced unemployment benefits expiring next week, there is growing concern that consumer spending may retreat, rents and mortgages may not all get paid and the market will have overplayed its hand. Therefore, all eyes are on the continued supply of cash via further stimulus plans until an actual economic recovery can occur. This being an election year, expect further stimulus to sustain this rally.
We have longer-term concerns about all this new money entering the financial system. M2 money supply is 21% higher for the year – an increase of $4 trillion just in the US. Normally so much cash in the system would be quite inflationary. This time, because of slower spending, it’s the dollar retreating relative to foreign currencies. We anticipated this and used profits harvested during June to establish a position in gold. So far, this tactical move is paying off quite well and when a vaccine becomes available and economic growth accelerates, expect inflation and gold to accelerate, too. Another beneficiary is our foreign equity exposure which we expect to outperform the US markets over the coming decade.While this is a confusing time, one thing has been proven during the pandemic. Our paradigm of Goal Horizon Investing has allowed our clients to remain focused on living life (such as it is these days), as short-term income is insulated from market gyrations. We have also capitalized on opportunities presented by fear just a few short months ago.
We cannot be perfect with timing, with our investment choices or in our vision of how things will unfold. But we don’t have to be perfect when clients’ investment allocations to risk are dictated by their future withdrawal needs. It is a safety mechanism we purposefully engineered years ago and continues to prove its value.
We have a difficult task making long-term investment decisions with so many unknowns about the pandemic’s resolutionbut our paradigm ensures the longer timeframes needed for growth investments to succeed.
We are also faced with generating relatively safe income when interest rates are at yet another all-time low. While Treasury securities yield less than 1% the only way to produce a livable income is to take additional risk. This means accepting price volatility to obtain desired incomes. Our Income Strategyis our current laggard, as two debt positions experienced just such price volatility while continuing to produce attractive income. Prices will recover in a more durable economy, but it’s a prime example of how difficult it is to generate a comfortable income these days. We did use the dislocated pricing during March and April to build customized Structured Notes producing very significant income. Be sure to read about our Structured Note holdings, generating outsized income while interest rates remain near zero. Please stay safe and follow medical guidelines. We will come out the other side of this in better shape than we all thought possible in March.
Financial markets entered the 4th quarter with heightened concerns that a recession was near. Three primary concerns stood to determine whether markets would rebound or safety should be the preferred path. During the summer we installed hedges in our longest Time Horizon Strategies as our concerns were high as well.
Thankfully, we received a raft of good news over the past three months, taking markets to record highs:
The Federal Reserve signaled it would not raise interest rates, perhaps for all of 2020.
The Trump administration achieved a “Phase One” deal with China.
Brexit uncertainty was decided with the landslide re-election of British PM Boris Johnson.
The US dollar peaked and has begun falling, which benefits trade with our major partners.
These all buoyed investor sentiment, turning markets from recession watch and to rally mode. Summer headwinds became tailwinds in the Fall. This news is cited most often as fueling the market’s resurgence but the real catalyst pushing markets is the renewal of Quantitative Easing (QE) by the Federal Reserve.
The S&P 500 rose 8.5% in the final quarter, capping an astounding 31% for the year. International markets rose 7.3% for the quarter and 22% for the year. Emerging markets broke out, gaining 11% during the quarter and 17% for the year. Bond markets were relatively flat this Fall but were up 8% on the year as the Fed lowered interest rates three times earlier in the year. Accordingly, we sold most of our hedges and again returned to a fully invested profile with confirmation that the headwinds of Q3 were indeed in the rear-view mirror.
The Real Catalyst
You won’t hear it called Quantitative Easing by the Fed itself, given the unpopularity of the term. But make no mistake, QE it is. During the quarter the Fed purchased about $300 billion of debt securities to build reserves for an arcane part of the financial plumbing that allows financial markets to function – the REPO market.
This reason for further balance sheet expansion is frankly less important its effect on financial markets. Every time the Fed’s balance sheet expands the markets rise. Every time it is reduced, markets fall. Should the Fed again pare its balance sheet, markets will surely fall again. QE does the same thing as lowering interest rates, printing money or expanding the monetary supply – allowing the dollar to fall and asset valuations to rise. Since it has consistently worked and there is little room to further reduce rates, we can assume this is the playbook of the future for central banks. Until it creates meaningful inflation or unforeseen problems with market functions it will continue. While it continues financial markets have a tailwind.
When inflation or undervalued commodities begin a long-expected surge a fierce headwind for financial markets will return. In the meantime, we will gladly participate in the growth and give credit to the Fed for sustaining the stock market rally.
What’s in store for 2020?
During 2020, equity markets will face many risks: constricted trade impact, tepid domestic growth, rising payroll costs, corporate margin pressures, modest earnings, and the 2020 election. Given the markets’ recent rise, full to high valuations move to the top of this list. We have written about all of these and they will drive markets. Because of emotions, it will be the electoral process that will get the headlines.
Capitalism has become the foil for the more “progressive” Democratic candidates. As their poll numbers move, equity markets will correspondingly move in the opposite direction. As we approach the Democratic convention this will become more exaggerated and pronounced should one of them be nominated. We continue evaluating market risks and opportunities but do expect volatility to rise as we get closer.
On a fundamental level, it is earnings and valuations that determine market direction. Prices have exploded higher as investors recently piled into all types of risk assets. One year ago, the S&P 500 was priced at 14 times earnings. Today it is near 20 times. Historically, when markets reach into the 20’s on a price/earnings basis, trouble usually isn’t far behind. But timing markets based on valuations is one of the worst methods to manage market risk. With low-interest rates and QE remaining in place, it’s possible that the increasing valuation trend could continue for a while.
Earnings estimates came down over the past several months as the economy slowed and corporate leaders became less optimistic. Given this reversal of headwinds, we could see an improvement in earnings to start the year. While a positive development, the possibility of a correction should not be dismissed. However, a reset of stock valuations will not likely end the bull market.
Lesser-Known Risk
The Fed stated in December that it would allow inflation to overshoot its 2% target before it considers raising interest rates. One of the goals of the previous decade’s massive QE programs paired with historically low rates was to ignite dormant inflation. While there is little evidence that inflation is poised to hurdle the 2% threshold, the stage is set for it. Tight labor markets, significant wage growth, constrained inventories and supply chain disruptions have all created dry powder for inflation to rise. But it needs a catalyst to set off the chain reaction.
We don’t know which catalyst it might be (a known unknown). Yet should inflation take off, the Fed will be forced to act and put the brakes on the economy. This will surely lead to a significant market decline, perhaps ending the great bull market. While it’s inevitable, we will stay fully invested and vigilant for signs.
Going Forward
With the dollar weakening, a potentially strengthening global economy and the significant valuation discounts of foreign stocks, we are at the precipice where foreign stocks could outperform U.S. stocks. While this condition has previously been undermined by trade tensions, there is an opportunity in foreign markets. Emerging markets hold greater promise as their performance gap to US markets has widened over the past decade. Therefore we increased foreign and emerging market exposure over the past quarter. Should our dollar continue to fall, clients will enjoy an additional tailwind here.
Our Cash Flow Timeline Allocation Process dictates client exposure to market risks, based on how long progressive amounts of money can remain invested. We make sure each client has adequate resources in less volatile strategies to leave long-term money invested to outlast risks facing market assets. We have also been busy recently performing due diligence on a range of alternative Real Assets to complement market risks while seeking attractive returns. We will explore increasing exposure in this area – on a case-by-case process.
As we enter 2020 we do so with less than 20-20 vision. We remain mindful of the risks we know and ever vigilant for signs of those we don’t. For now, the sun is shining on financial markets, but we believe the upside is limited given the longevity of the economic cycle and risks inherent to high valuations. While we remain fully invested we seek opportunities to reduce risk while sustaining attractive returns. Readers should expect episodic volatility as news events the interest rate landscape unfolds. Our clients can rest assured that their assets are in line with their income timelines and that Integras Partners works diligently to moderate market risks when uncertainty is high.
Many investors have forgotten that volatile markets exact an emotional toll. For several years during the current economic expansion, the biggest dips were in the 6% range. December 2018 saw a 10% decline in about three weeks. Market corrections (~10%) can be considered a healthy stabilizer. It’s when they’re frequent or more severe that investor and consumer behaviors can swing.
Markets were increasingly volatile during the 3rd quarter. As recession fears mount and trade negotiations have yet to produce results, confidence fell and economic indicators weakened. Markets generally gained ground due to the Federal Reserve providing a boost by lowering interest rates. “Risk-off” assets outperformed again, most notably US Treasury bonds (the ultimate risk-off asset) gained an astonishing 8% during the quarter. The 30-year Treasury Bond yield fell to all-time low of 1.95%.
For the record, the S&P 500 Index® rose 1.7%, foreign stocks (MSCI EAFE index) fell 5% and emerging markets fell 2.1%. Bonds (Barclays US Aggregate Bond Index) gained 2%, largely benefiting from long maturities. Bonds and bond proxies; i.e. consumer staples, real estate & utilities, received a strong interest-rate generated tailwind.
Global rates have never been more supportive of inflation and economic growth, yet neither are responding to them. Inflation is steady at an anemic sub-2%; while global economic growth continues to decline. Central bank efforts around the world continue to lower interest rates which have not produced the desired effect. Global manufacturing is contracting, services activity is slowing, and several recession indicators are flashing red. More accommodative monetary policy is not the answer, though it may extend the expansion. While we continue to wait for direction, domestic stocks have become more volatile but effectively gone nowhere for 18 months, and clouds darkening the investment horizon get closer.
We have discussed in previous issues that the immediate challenge is trade and tariffs. The U.S. and China have agreed in principle to a détente of future tariff escalations and a timeline to reach agreement on many major sticking points. Yet nothing material is at hand and markets have discounted any meaningful improvement soon. Currently, markets are fully priced based on next year’s projected earnings (which continue to be revised lower) and very susceptible to bouts of Twitter-related volatility.
Until and unless business sentiment and business capital spending improve, there is little support for a meaningful move in economic growth or stock markets outside of still lower interest rates. Corporate expansion plans have been put on hold until there is clarity in the path of trade and its impact on supply chains, cost structures, and overall sentiment. For now, the US consumer holds the lever to determine whether we maintain growth or fall into recession.
US consumers are responsible for roughly 70% of U.S. economic activity and perhaps as much as 20% of global activity. As such, it’s imperative that consumers maintain their ability and willingness to spend. Current ability is not in doubt as consumers in aggregate have rarely been in such good financial shape. So, consumer confidence becomes the primary concern. While personal incomes are growing the fastest of this expansion and current optimism is high, future expectation surveys indicate consumers are concerned about financial security lasting much longer. Any pullback in either consumer spending or an increase in layoffs and the strongest leg of the stool will be broken.
We repeat our assertion that we see a binary outcome scenario. Either we get meaningful trade resolution or we fall into recession. It’s as simple as that. This fork in the road is coming but we don’t know how soon.
Expectations range from 12-18 months before profit margins contract, business confidence is broken, companies lay off workers, consumer confidence evaporates along with spending and recession ensues. Should we reach an honest, comprehensive trade agreement that eases tariffs and opens end markets, markets would likely explode upward with a huge rotation away from safety into cyclical growth stocks.
Consequently, we see this as a 50/50 proposition and have positioned our Participate but Defend strategies to capture meaningful upside potential with protection from downside volatility.
This does not rule out equity markets moving up prior to the fork in the road. In fact, we believe there may well be another leg higher for U.S. stocks as an abundance of investment capital looks for a productive home and stock dividends are higher than bond yields. While corporate profits remain positive there should be adequate demand for blue-chip stocks – especially with the skepticism meeting new IPO’s coming to market. Should interest rates fall further, as expected, future earnings would be worth more today, further driving equity prices. These outcomes will ultimately cause pain as the farther the market rallies in the meantime the farther it will fall once a recession begins.
Longer-term there are reasons for both optimism and concern. We assume that the U.S. will eventually reach some agreement China, providing a clearer path for business investment and renewed economic activity. In and of itself it would be a major boost to the world economy. We must also recognize that only so much economic growth is possible over the next two decades because of demographics. The global population is aging, which reduces spending on goods and certain services. With escalating retirement, there are fewer workers producing products and fewer wage earners buying products. The prospects for long-term investment becomes rather sober. Lower revenue growth, tighter margins, lower profits, and lower dividend growth lead to historically lower share price appreciation. Some predict that over the next 10 years we will likely see only 4%-6% average stock market returns as a result. Bond returns will be closer to zero.
Therefore, it is incumbent a sound financial plan be in place and mated with investment strategies that can perform in such a low-return environment. Those accumulating assets for future retirement will simply have to save and invest more. Those entering retirement will have to become comfortable with taking more risks in order to outpace inflation and greater longevity trends. Most importantly, assets must be matched to the intended timelines for consumption.
Integras Partners recognized many years ago that markets are volatile and less predictable over shorter timeframes (the environment of the future) and designed our investment paradigms to guide clients and manage assets with reasonable expectations and measured risk. Our detailed cash flow planning and timeline investment strategies allow clients to rest assured that both long-term growth assets and near-term income streams are structurally protected from random, short-term market movements.
2019 Second Quarter markets were narrowly focused on trade talks, interest rate speculation and concerns that economic expansion may be very close to stalling; yet stocks prices kept climbing.
Economic and market outlooks now hinge on three big questions: Will diplomatic negotiations end tariffs and foster trade? Can central banks keep economic growth rolling while we wait? Is global growth sustainable even with these actions? The unknowns have investors walking a tightrope, balancing the fear of missing out on stock gains with the darkening clouds of economic weakness on the horizon.
Integras Partners clients can take comfort that we recently installed some protections while participating in market gains. Our retirees can more freely enjoy spending monthly income because it’s insulated from cyclical downturns while allowing the future growth needed to outpace rising expenses. We detail these benefits at the conclusion under Benefits of Time-Horizon Investing.
Market Recap
After an almost miraculous first-quarter rebound from December’s 10% decline, US stocks sustained the uptrend, though a peek under the hood reveals a lack of conviction. As economic data continues to weaken, the Federal Reserve is expected to lower interest rates to counteract the mounting impact of trade tariffs. Markets love lower interest rates, so the prospect of them buoyed both stocks and bonds, ultimately sending the S&P 500 Index to new highs into July. Hardly a broad-based, healthy advance as defensive sectors (Utilities, Staples, Real Estate) and the largest technology names led the way, but we’ll take it.
For the quarter, the S&P 500 Index finished up 4.25%. Bond markets rallied with the broad Barclays Aggregate Bond Index finishing up 2.3%. Established foreign markets lagged the US again, up 3.5% while Emerging Markets finished up less than 1%. So, stocks are relatively expensive, as prices average 18 times forward earnings and nearly 20 times current earnings. We’ve returned to the TINA scenario, where there is no Alterative bonds and cash yields continue to decline.
Economic Outlook
Equity markets are rising as if a trade deal is near and it would fuel the earnings growth necessary to justify current stock prices. This may prove correct. Bond investors, however, believe that economic growth is slowing, a trade deal is far off, and the stock market has it wrong. Only one will be right!
Stocks and bonds have diverged to their widest point of this expansion. At some point, this divergence will be rectified. There is some justification for higher equity values if the Fed lowers rates as expected next week. Ultimately earnings MUST justify the prices being paid and trade certainty is the key to unlocking that potential.
Investors on the tightrope are balancing slowing economic data (below) and hopes for meaningful improvement with a trade deal. While negotiating a deal is vitally important to both the US and China, the Chinese have the freedom to play the “long game” by waiting for a more amenable administration to take office. President Trump essentially has a year or less to close a deal going into the election.
Should the Fed lower interest rates (a 1/4 % to 1/2 % cut is already priced in), it will provide the short-term stimulus the stock markets desire but will come at a long-term cost. Low-interest rates allowed companies to borrow at a record pace, issuing bonds that financed increase dividends, stock buybacks and execute mergers and acquisitions. All of which have greatly fueled the run-up in equity prices in recent years. As a result, companies hold record amounts of debt, which can continue with low-interest rates. What happens when (not if) earnings deteriorate and cash flows needed to service this debt decline? Will investors cheaply lend more money to sustain this debt? Of course not. And the Fed’s effectiveness will wane again having already lower interest rates. These are all hallmarks of the late-cycle. The late-cycle is when excesses and stresses begin to accumulate, ultimately triggering a recession.
Though likely a year away, the probability of a recession is rising. We reiterate the point that we are very late in the economic cycle (as of May 31, this chart is at 29.6). Equities are reaching new highs primarily on hope while bonds tell us differently. Incoming economic data continues to weaken, so markets are primed for volatility. It is vitally important to be cognizant of risk today.
Markets are Primed for Higher Volatility
History shows that it’s common for stocks to exhibit outsized gains during the final stages of a market cycle. So, let’s not abandon them just yet. There are many reasons, including trade and rate accommodation to believe this party will continue, providing further gains. Yet many of the economic indicators we track indicate current and coming weaknesses. (See below). While we may miss some of these final gains, we plan to leave the party early, striving to protect asset values before the music stops. We do so knowing that our clients are likely to emerge from a recession in stronger shape than average investors. Without a crystal ball, we think it’s prudent to reduce risk as we get closer to the cycle’s end.
Benefits of Time-Horizon Investing
All Integas Partners clients have a unique blend of proprietary strategies we manage for graduating timeframes. We have been taking most of these increasingly defensive over the past year or two and recently installed protection mechanisms in even our most aggressive strategies. Having captured significant growth over this expansion we aim not to ride the market down when the tide ultimately turns. While our clients are structurally protected with time appropriate investment risk with their customized allocations to them, we have added further protection to the strategies themselves.
Near-term withdrawals come from our Liquid Assets strategy designed for capital preservation. We reserve the next tier of withdrawals in our Income Strategy, targeting attractive income with minimal volatility for four to seven years. Then additional layers increase opportunities for capital appreciation all the way out to money they won’t need for 15+ years, allowing risk assets to weather virtually any storm. Who wants to make lifestyle adjustments due to protracted bear markets? Our process and implementation allow you to sleep at night knowing that you can weather the next storm and emerge with your lifestyle and your dreams intact. We vow to uphold this commitment to the best of our ability.
We are passionate about investing wisely and seek to balance our communications for the layperson. Please reach out if you would like to discuss any of this in more detail. For prospective clients, we provide a complimentary analysis of your investments with our recommendations. From today on, investing gets tougher and the risks get higher. The music hasn’t stopped yet and may not for many months down the road. But when it does, we need to be already sitting safely in a chair.
