Investment markets can be confusing. To try to cut through the chatter and investment slang, we present this monthly view to you. We want 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 we could be a period of wealth destruction.
In October, I wrote: “stocks will go up…until they don’t.” As the major stock indexes again hit new highs in the past 5 weeks, investors are likely trying to figure out where we are in the broader market cycle.
After all, in an era of instant communication and endless manipulation of markets by global central banks, isn’t anything possible? Shouldn’t we throw out all of the old rules? That may be the case.
However, human nature tends to be consistent over very long periods of time. Even if the mechanisms are different (algorithms instead of portfolio insurance, index funds instead of hedge funds, 401(k) plans instead of defined benefit pensions, etc.), greed and fear still have a home on Wall Street.
One of most persistent aspects of human nature I see in investing is over-confidence. It stems from a combination of being caught up in what others are doing, instead of what is truly in your own best interest. The modern term for this is FOMO: Fear of Missing Out.
FOMO is helped along by a big dose of complacency. This appears in many forms. Foremost is the willingness to trick ourselves with data. We choose only the data that makes us feel better, or makes our point. I am as susceptible to that as any market commentator. That is why I try to show you the “evidence” to back my opinions here each month. That way, you can decide for yourself what to do with it.
But, as is often the case these days, reality gets lost in excessive optimism, or within the mass of headlines that bombard our inboxes and phones. So, this seems like a good time to lay out the market view simply, so that you can do what I said earlier…decide for yourself what to do with it.
Here is the S&P 500 Index, from the start of 2019 through the end of November. Even with the market tipping over a bit to start December, this is still a heck of an 11-month run. Up over 27%. What you don’t see here is that large segments of the market have not kept up. See my notes in ETF tables below for more on that. It all helps to feed the notion that stock market leadership is narrowing. That’s OK until is is not. Just as in chess, if you take out the King (the market leader), the game is over. We are not there yet.
The other factor in play as we near year-end is what happened last year at this time. Trade relations were rattled, and a choppy October and November was followed by a vicious December. Short-term technical signals show potential for some flavor of that again this year.
Timing is everything, and nothing
Directly above is that same S&P 500 chart, but with one adjustment. I moved the start date back 4 weeks, from 12/31/18 to 12/3/18. Now, instead of 11 months, 27% return, we have 12 months, 10% return. That is still a very nice gain for the S&P 500.
However, I think this is where some of that FOMO comes from at this late stage of the market cycle. Few investors are walking around thinking that their 401(k) has had a good 12 months. They thrilled and spending money at the online mall, in part because they know their S&P 500 Index fund is “up 27% this year.”
When the “snow” hits the fan
It is a thought pattern among investors that is to their benefit for a while in each market cycle. It helps them to avoid being skittish or short-sighted in their investment efforts. However, it may leave them unprepared when the, shall we say, “snow” hits the fan.
The chart below is another one of those perspective items that I think get lost in a combination of holiday season, year-to-date performance tracking, and an economy that is clearly weakening. See this last of a trio of recent S&P 500 performance charts below. This one covers exactly a year. It started back on 10/3/18, when the fourth quarter of last year started a selloff that lasted until Christmas Eve (thanks for saving the S&P 500, Santa!).
A year after that October peak, as of 10/3/19, the S&P’s total return for the prior 12 months was 1.56%. That’s a total return including the S&P’s roughly 1.80% dividend yield. So, you made about the dividend, period.
Again, any 12-month period is just a snapshot in a movie longer than Netflix’ new “The Irishman” film. But my beef, if you will, is that too many investors near retirement or operate in retirement as if strong investment market returns from a “traditional” stock and bond portfolio are ever-present. They are not. Want proof? Look at how much bond returns have come down to earth over the past decade. Bonds used to supply a hefty, reliable 6-7% annual return to 60/40 portfolios. Other than occasional panics that force low bond yields toward zero, that’s now a pipe dream.
My conclusion: take a closer look
As we start heading into the season of making New Year’s resolutions we are not likely to keep, here is one to consider that CAN be kept with just a little effort: look beyond headlines, watch how markets move over multiple time frames, and be on the lookout for stress points that become breakdowns. Here is my updated list of those.
Key Market Stress Points
(ranked from most to least significant)
- Global Economic Growth: this tops the list for me. The Institute of Supply Management (ISM) Manufacturing Survey dropped to 48.1 in November. That figure, announced on December 2, was the fourth straight decline. Who cares about the ISM? The market does, eventually. It cares because at some point, if we slow down our production of goods, one of two things is happening. If demand is still there, but our own factories are slowing their production, we can import more (not as easy as before tariff wars). Or, it could be a sign that consumer demand is expected to slow and/or it is hard to find workers to keep production high. After all, there is such as thing as workers staying on the sidelines because they don’t feel compelled to work at the offered pay rate. Either way, this is troubling to an economic cycle long in the tooth. For what its worth, the last time this ISM figure fell to this level, it was September of 2008. Before that, it last occurred in December of 2000. In both cases, the S&P 500 soon began a decline of over 30%. One figure is not the whole economy, but leading indicators like this are worth watching, very closely.
- Geopolitical: China trade news is “good.” USMCA is “good.” Brexit is “delayed. Or, is this just an extended dance to an inevitable conclusion that changes nothing, except for the disruptions already caused to global business supply chains? The manufacturing economy is showing persistent weakness, while the services part is doing OK (debt is great enabler, eh?). That is similar to the stock market situation noted above. It doesn’t matter to investors until it does…and then, look out.
- Sentiment: last December was very telling to me. A whipsaw 20% drop in the S&P 500 in a few months, and I suspect many investors didn’t even realize it. Strong, built-up positive sentiment will do that to a market. So, while another baby bear market like that one is always within reach, I will feel that the “top is in” on the bull market when we get something more confidence-shaking. I think that is more likely in 2020 than at any time in 2019.
- Index mania: S&P 500 index funds have essentially become the “1-decision-investment” of our generation. That is, conventional wisdom says you buy one, and never have to sell it. Call me suspicious for thinking that investing for retirement is still challenging, and requires more careful planning than that.
- Credit: the credit bubble is as big a concern as ever. A big part of that is the likely congressional inaction we can expect for at least the next year.
- Bond market risks: with approximately 50% of bonds in investment grade bond funds are rated BBB, the lowest of the 4 possible rating categories, falling prices/higher rates could be a generational tipping point for bonds. This may also spark more chatter about a long-awaited return of inflation.
- Impeachment: from an investment standpoint, I see this going one of two ways. It could end up as a nothing burger that fades from the public’s attention by the 2020 U.S. election. Or, it could continue to track on its current, loosely-correlated path to the Nixon impeachment episode. Not to sound like a broken record, but that could produce a downside risk of about 30% from current levels.
- Valuation: the Shiller CAPE (a longer-term version of the S&P 500’s price-earnings ratio I track closely) is re-accelerating toward its 2018 high. That’s a market risk for 2 reasons. First, it has more to do with stagnant corporate earnings than anything else. That is, the “E” is flat or down, but the “P” edges higher, so the “P/E” does too. The other concern is that this is exactly what tends to happen before market tops. It is as if the S&P 500 says, “oh, but just one more ice cream” before the after-effects of the sugar-high set in.
- Fed rate decisions: the Fed might well fade into the background into 2020. But that does not mean that interest rates will stay stagnant. Remember, the Fed only directly controls very short-term rates. Rates on longer-term Treasury securities and other high-quality bonds look to be gradually reversing some of their declines from earlier this year. That would be bad news for asset allocated portfolios that are heavily-invested in bonds.
Bottom-line: don’t get complacent. Look forward. The investment climate is changing. While none of these issues individually will wreck a retirement plan immediately, it does tell you that this “all time highs” thing must be taken in stride, not pointed to as a signal that greed is good. After all, we know where that approach took Gordon Gekko.
I am neither bull nor a bear. I am a realist and a devout risk-manager. Be careful, understand what you own, and respect the laws of gravity.
2019 has been a year in which “mainstream” investment segments have been strong performers. The laggards have been the more mundane market areas (as will happen during an up market) and some of the traditionally volatile areas. See below for more.
Small Cap Stocks have been big losers versus Large Caps the past few years. Symbol IWM closed November about 5% below its August, 2018 high, while the S&P 500 has gained about 10% since that time. If history is any guide, this will not persist.
It wouldn’t be a stock bubble without a surge in the Technology sectors toward the end. If 2020 turns out to be the year that starts the next major bear market, we will look back at this chart, and see a year-to-date return of 43% in symbol XLK, and say that’s when we knew. Or, it can continue unabated. Either way, tech’s market “leadership” is a factor to watch.
Biotech and other healthcare stocks continued their surge in November. That these 2019 laggards are catching up a bit helps to counter the argument that the market is getting narrower.
Other than the obvious strong performance of the tech and telecom giants (symbol FDN) the past few years, so-called “wide moat” stocks have been out-performers. These are businesses that are thought to have a sustainable competitive advantage. That should help them in a market downturn, too.
If you are looking for international diversification, and also want above-average dividend yield, there is reason to believe you have potential there. The strength of the U.S. Dollar and U.S. economy on a relative basis to the rest of the world could eventually lead to an opportunity to get your diversification cake and dividends too.
Marijuana stocks fell by over 11% in November. That’s 1% for every U.S. state that has passed a law legalizing weed in some form. This is more about the viability and vulnerability of the small companies that make up symbol MJ. Longer-term, it seems more a matter of whether some big healthcare and/or consumer companies become players in the space. As with other areas of investing, it is not always easy to be the upstart in a world of big businesses.
Emerging markets continue to lag the U.S. This has been going on for so long, it begs the question: should long-term asset allocation portfolios be adding more to EM? That’s for them to decide. However, just as with U.S. Small Cap stocks, these historically-wide gaps in return don’t last forever.
It is not often you see a 25% return on TLT (the 20-30 year U.S. Treasury Bond ETF) in a 12-month period. In fact, by my count, it has occurred less than 7% of the time since TLT was first brought to market back in 2003. That is geeky fact, but it corroborates with what I see in the charts. Namely, that long-term Treasury Bond prices are in danger of declining. In other words, long-term interest rates appear poised to climb.
It has been a very nice 2019 for this investment category. Thank a drop in rates and a market that is not concerned about credit conditions for that. However, if your retirement investment plan rides heavily on “reaching for yield,” don’t count on most years being like this one.
Natural gas prices have cratered. The ETF that tracks that commodity is off more than 50% in 12 months. Unless you think you have a true edge in the oil and gas investment markets, it is best to tread very carefully here. Picking bottoms is a tricky business.
Source for all ETF data: Ycharts.com
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