As we enter the eleventh year of economic expansion, valuations in the US stock and bond markets have reached all-time highs. Real estate construction is booming. Cranes fill the skyline in every major city in the US and many around the world. Unemployment is low. Inflation is moderate. Optimism is high.
Meanwhile, consumer, corporate and government debt are extraordinarily high and rising, salaries are stagnant and tax revenues are falling. These are unusual and unexpected occurrences for an economy in the later stages of a strong, central-bank-driven, economic expansion.
Ten years after the “Great Recession”, we are witnessing the longest bull market in history, approaching ten years (or nearly 3,650 days).
As market risks rise, complacency is in the air
After eleven years of mostly rising US stock prices, “expected future returns” (based on today’s current lofty valuation levels) are falling. The demographics of an aging population and high levels of debt make it unlikely that future investment returns will be as strong as they have been in the past. This is not news to those of us who are serious students of the economy and the markets.
Each year four American institutions publish their long-term strategic economic views and market return expectations for the next 5 to 10 years. Their predictions rely on an understanding of economic cycles, market valuation metrics, and behavioral science. While forward looking projections into an uncertain future are rarely perfect, all four have accumulated a solid track record that adds to their credibility. My quarterly emails always include a copy of the “Ivy Portfolio Index”, which provides historical returns of the assets classes we invest in, alongside the future “expected returns” for each of these four institutions. This offers both a crystal clear “rear-view mirror view” of where we have been and a less clear but well-reasoned “front-windshield-view” of where we appear to be heading.
Past and future returns
Historically speaking, a well-diversified portfolio that equally weights most major asset classes has returned between 6% and 8% for the past ten years. However, all four institutions that publish their economic and market forecasts expect future returns to be significantly lower than that historical average:
· Northern Trust expects a 60/40 global stock/US bond portfolio to average 5.25% for the 5 years.
· PIMCO expects a multi-asset portfolio to average 4% over the next 10 years.
· JP Morgan Chase expects a well-balanced portfolio to average 5% over the next 10 years.
· AQR Capital Management (a research firm that provides data utilized by pension plans) expects that a balanced portfolio will average 4% over the next 10 years.
There is no escaping the fact that these institutions are quite sanguine about future forward looking returns. That reflects the current high starting prices. In their commentaries, each institution references similar realities that impact their forecasts. These include slowing economic growth based on aging world populations (especially in Japan, China and Europe), the end of economic stimulus and “extraordinary measures” by central banks, and (especially) the very high levels of debt around the world at a time of rising interest rates.
Lower expected future economic returns will not be linear
It is likely that the next 5 to 10 years will witness both bull and bear markets. There are likely to be some double-digit positive years as well as significant negative years. That is consistent with these institutional projections – which are long term averages.
One of my most important jobs as your financial advisor is to help reduce the negative impact of the next bear market or market crash, without exiting the markets entirely (an alternate solution that few of us can afford).
Risk management is now more important than ever
Diversification doesn’t pay off during bull markets. It keeps you from having all your eggs in a single high performing basket. However, diversification pays off big time when markets turn negative, as they inevitably and unexpectedly do from time to time.
Diversification helps to limit the size of the losses when these downturns occur. After a sizeable market loss, it can take nearly twice the percentage gain as the percentage loss incurred, just to get back to where you started. A smaller loss guarantees a much more rapid recovery on the other end. A smaller loss also allows you to sleep better at night when others are tossing and turning. And it reduces the likelihood that you’ll bail out altogether.
Minimization of losses is the most important factor in achieving strong long-term returns. At this point in the economic cycle, wise investors and their advisors are focused primarily on risk, and should not be stretching for higher hoped for returns.
Only one future will come to pass, but many are possible
Crashes most frequently occur after lengthy periods of economic success, when valuations are extended, optimism is high, and complacency is the norm. After many years of strong returns, markets have become priced for perfection. That’s nothing new. Bear markets typically occur every 8 to 12 years when prices get ahead of themselves and investors become complacent. Then, inevitably, something unexpected happens. The immediate triggers vary. Then paradigm shifts and the herd suddenly changes course.
This is part of who we are as a species. We move along the continuum between greed and fear at least once a decade or so. It’s been a consistent story since time immemorial. We’re taught this as children through stories like “The Emperor has No Clothes!” when a young boy clearly sees obvious facts that the herd chooses to ignore. It’s illustrated in the childhood game of musical chairs when more and more players join the game only to lose their seat when the music suddenly stops. An awareness of these all-to-human frailties is the first step in ensuring that you are prepared when old perceptions and new realities suddenly and violently come into conflict.
Taking a few chips off the table
Of course, it would be foolish to think that I (or any investment manager) will be able to exit the markets the day before the next crash. What I do aim to do however, is prepare and protect your portfolios as the probabilities of negative surprises rise. It’s time for many investors (and especially those who have accumulated the majority of their total lifetime wealth) to take a few chips off the table.
After a market crash, journalists are fond of asking “What are you doing now?” A better question might be “What did you do ahead of time to prepare?” What a portfolio manager does ahead of a market changing event will have a much greater impact than their reaction after the fact. The ability to successfully react and take profitable action after the event is limited (like grabbing a chair when the music stops).
Despite our efforts, the economic cycle has not been repealed. Nor has the ongoing battle between greed and fear. Crashes will inevitably occur from time to time…
Crashes exist precisely because human beings are wired to become greater risk takers and increasingly complacent after long periods of strong market performance. When logic suggests that we should take a few chips off the table, greed and complacency set in and many investors instead choose instead to double down. This can cause the music to keep playing longer than expected. Frankly, it may continue for some time. As valuations become increasingly stretched and expectations rise to unsustainable levels, markets become increasingly vulnerable to unexpected negative events. And then it ends. How much sand can you add before the last grain of sand collapses the entire pile?
Are we there now? Perhaps not, but we’re definitely closer than yesterday. At the crux of this debate is the fact that every bear market is different. Soul searching, regulation and legislation is imposed after each episode, never before the crash occurs. Post-crash models are developed to perfectly spot (with hindsight) the last crash, but often the focus point is no longer correct for the next crisis.
The global system is complex and dynamic. I’m confident that the next crash will result from a separate set of vulnerabilities than the last. That said, the lessons of history are not to be dismissed out of hand. I’m convinced that it’s important to study and understand market valuation tools and the history of economic cycles to help us prepare.
How will we know when a bear market is just around the corner?
Economists cite four main indicators that can signal changing probabilities. Right now, all four are flashing red or yellow.
The four main indicators:
· Corporate behavior – Mergers and acquisitions, initial public offerings and corporate stock buy-backs are always good to keep an eye on. There is strong evidence that most of the gains in the US stock market in recent years have been a direct result of financial engineering via stock buybacks. Generally, markets do a pretty good job of determining prices. That assumes there is a fairly diverse group of buyers and sellers and that each act in its own economic self-interest. In real life, however, this is not always the case. In recent years there has been a mind-boggling increase in corporate buy backs. Corporations tend to buy back stock regardless of economic value, thereby distorting stock prices. Buybacks offer a quick way to boost executive bonuses, regardless of the risks and rewards passed on to shareholders. They can push up prices beyond their market determined true economic value.
Between 2012 and 2015, US companies acquired $1.7 trillion of their own stock, with many companies going deeply into debt to purchase their shares on the open market. More recently buybacks have been funded by corporate tax cuts and repatriated foreign cash. This rocket fuel was in plentiful supply after the recent tax cut, but may now be largely spent. With interest rates rising, the price of this rocket fuel is also going higher. With leverage ratios high, and interest costs rising, stock buybacks are likely to be fewer and less frequent in the future than we’ve seen in the recent past. If you want to understand why US stock prices are rising much faster than they are around the world, the first thing to look at is this “elephant in the room”. http://www.areteam.com/blog/the-elephant-in-the-room-share-repurchases
· Profitability metrics – Corporate profit margins are at all-time highs. Theoretically at least, outsized profits eventually lead to greater competition as new entrants join the market to share in the riches. Eventually these new competitors and employees themselves demand a greater share of the pie, thereby bringing margins back down to earth. Those are factors that have, until recently, kept profit margins relatively consistent over long periods of time, always eventually reverting back to the mean. If history is a guide, future profit margins will decline from these currently lofty levels. The price-to-earnings ratio is a key valuation tool. If earnings fall or are expected to fall, stock prices will likely follow.
We also know that high stock market valuations do have a negative impact on future stock market returns. Expensive valuations should still be considered as a warning sign. Today, Schiller’s cyclically adjusted price-to-earnings ratio (CAPE) remains the highest it’s been in all of US history at 32.70 (i.e. US companies are currently valued at 32.7 times their ten year average earnings; a record high). This indicates the U.S. equity market is quite rich by historical standards. That begs the question—are we near the end of this bull market or will it go higher still? Markets do have a way of defying logic from time to time, and attempts at timing rarely work out.
While CAPE is not a short-term timing tool (according to Professor Schiller’s own admission), it does help us to shape our expectations for the future. It narrows the funnel of doubt. Professor Schiller is on record as stating that today’s market reminds him of the Roaring 20’s and the Tech Boom of late 1990’s, both all of which ended with significant economic pain. https://www.cnbc.com/2018/10/01/bull-run-has-echoes-of-1920s-nobel-prize-winning-economist-shiller.html
· Balance sheet and credit metrics – High debt levels are rarely a good thing! It depresses investment and places a future drag on economic activity. Consumer debt, corporate debt and government debt in the US are all setting new records. If growth slows, that couldn’t come at a worse time. Central banks around the world are reducing or reversing their extraordinary accommodative policies and interest rates are beginning to rise around the globe. They have few tools left should economies falter.
The US federal government could soon pay more in interest on its debt than it spends on the military, Medicaid or social programs. The massive run-up in debt of the past decade combined with newly rising interest rates creates a one-two punch.
A growing budget deficit, made worse by the recent tax cuts, in combination with steadily rising interest rates, will put a crimp on future growth and asset prices. With less money coming in and more going toward interest, political leaders will find it harder to address pressing needs like fixing crumbling roads and bridges or to make emergency moves like pulling the economy out of future recessions. Within a decade, more than $900 billion in interest payments will be due annually, easily outpacing spending on myriad other programs. Already the fastest-growing major government expense, the cost of interest is on track to hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office. I thought that fact deserved both bolding and underlining!https://www.nytimes.com/2018/09/25/business/economy/us-government-debt-interest.html
· Positioning – Knowing where you are in the crowd is a very useful thing. I always attend at least a few webinars each week and listen how other managers are positioned to ascertain what the herd is saying. Right now, the herd is mostly “all in” and somewhat euphoric. Even well-informed and anxious advisors are afraid to pare back their equity valuations, for fear of missing out. The final stage of a bull market can be quite lucrative to investors. It’s also quite dangerous to advisors who can be punished in the short term by their clients if their exit (in retrospect) turns out to have been premature. In the game of musical chairs, nobody enjoys sitting alone in a chair while the music continues to play.
The four main indicators are all flashing red or yellow. What now?
The four indicators provide both kindling and fuel for a bear market. But, the list isn’t exhaustive. Something is missing, i.e., the spark to ignite the fire is needed. The spark in 2000 was the collapse of a handful of massively overvalued start-up Dot Com companies with no earnings (i.e. “the emperor had no clothes”). The spark in 2008 was one too many no-down-payment mortgages (the “last grain of sand”) and the last renter on earth suddenly became a homeowner and there was no one left to buy at the new record high prices (i.e. “too few chairs when the music suddenly stopped”). Could this be where we are with the US stock market today as the baby boomers continue to liquidate holdings to finance their retirement?
How bad can it get?
None of us can say for sure what the next catalyst will be or when it will occur, but the massive and growing size of consumer, corporate and government debt in the face of rising interest rates will likely make it more severe than most people currently expect. History offers a sobering assessment:
· On July 8, 1933, the Dow was down to 41.22, a 90% loss from its record-high close of 381.2 on September 3, 1929.
· The NASDAQ Composite fell 78% over the three weeks from it’s all time high on March 10, 2000.
· Recall that a 50% drop requires a 100% gain to get back to even.
How many people do you know that are mostly invested in highly priced US stocks? Have they been bragging lately about how much better they are doing than you in the markets, with your globally diversified, lower risk (and currently lower return) portfolio? Do they understand the risk they are taking for an extra few percentage points?
My final confession today: There is no perfect answer.
Having an awareness of the lessons of history can help us prepare for the next bear market. It gives us an idea of what we need to monitor. As markets rise beyond expectations, we can lean away from expensive assets while being mindful of the danger. We can regularly rebalance out of the asset classes that are rising the fastest and into those that are falling or rising less quickly. Those actions can significantly mitigate the losses when they arrive unexpectedly. I’m currently leaning away from expensive US growth stocks in favor of less expensive value stocks that offer greater downside protection. We also have lower exposure to US stocks than do most US investors.
It’s likely that none of us will be able to spot the exact turning point. This is a fact that should be accepted. But, I believe that a good process should have investors leaning out of risk assets as valuations rise and future expected returns decline, before the exuberant market psychology changes, and before the volume of debt and corporate stock buybacks collapse under their own weight.
The best solution: Diversify, diversify and diversify some more. And pay off as much debt as you can.
Yes, that’s something we’re already doing. We invest in a very wide variety of asset classes with a history of little correlation (or better yet, negative correlation) to the others. It does little good to diversify among asset classes if they all go up and down together at the same time. The underperformance of the laggards is the price we pay to avoid the really big double-digit declines that occur from time to time. Diversification provides greater stability and predictability in long term returns with considerably less volatility.
True diversification also requires that we include a healthy dose of “real assets” that should do well when inflation returns. Inflation is especially harmful to stock and bond prices. It is a risk that is often ignored.
Real estate, infrastructure, commodities, precious metals and inflation-protected bonds offer protection from this monster. If you’re looking to finance your retirement over 30 or more years, inflation is the wild card that can derail even the best financial plan.
And lastly, which is heresy for an investment manager to say: Your best “risk adjusted return” may simply be to pay off debt. Talk about shooting oneself in the foot! Isn’t that a little like Macys telling shoppers to go to Gimbels (or Amazon to bring that analogy up to date?). Perhaps. But I’d rather sleep at night knowing that I’ve offered you the best possible advice even if it results in less assets under management for my firm.
Paying off a 5% mortgage or a 7% car loan is the same as a guaranteed 5% or 7% investment return. When the best minds on Wall Street are projecting 5 to 10 year expected returns at 4% to 5% (and with the possibility of short-term loss), doesn’t paying off higher rate debt sound reasonable?
I’ll be making modest changes in your portfolio in the 4th quarter.
· Adding more inflation-protection. I’ll be rebalancing fixed income portfolios away from nominal bonds and toward inflation-protected securities, particularly those with shorter durations carrying less market risk.
· Lowering portfolio costs. I’ll be adding new ultra-low cost, no-transaction fee funds from State Street and others. Under new arrangements with TD Ameritrade, many of the newest and lowest cost ETFs in the world are now available with no transaction fees. I’ll work to lower your portfolio costs by replacing existing funds with these new funds, especially in tax-deferred retirement accounts where capital gains taxes are not a consideration.
· Tax loss harvesting. The recent downturn in international stocks and bonds relative to US assets offers an opportunity to harvest losses in these asset classes even as we keep allocations unchanged. I’ll be selling investments in asset classes that have losses and replacing them with similar investments with identical performance characteristics, generating tax loss carryforwards. That’s the equivalent of a “free lunch”. It may not be as tasty as a free lunch made by Chef Jae, but it puts free money in your pocket thanks to the extra efforts of Chef Bill.
· Increased use of alternative assets. Your current investment policy includes an allocation for “Soft commodities and Other Alternatives”. Other alternatives include long/short funds, market neutral funds, S&P 500 put/write strategy funds and “thematic investments”. Many of these funds are designed to produce positive returns regardless of the direction of stock prices. Thematic investments include investments in companies that are likely to outperform most others during a market downturn. These include innovative companies that offer new disruptive technologies, health care and biotech companies that benefit from an aging population, and those who are focused on high growth areas such as robotics, artificial intelligence and cyber security. I’ll be increasingly adding new ETFs that specialize in “Other Alternatives” later this year.
· Reviewing your asset allocation. After years of cheap money and strong investment returns, it may now be time to take some chips off the table. We can do this by making incremental changes to your allocation model. That involves reducing exposure to highly priced equities and increasing exposure to fixed income and real assets that typically offer more stable and/or inflation-protected returns. I’ll contact you before year-end if I believe that changes are in order given my knowledge of your financial resources, risk tolerance and long-term goals.
All my best,