Balance and Temperament Are Key in This Recession-Worry Environment
“The investor’s chief problem — and his worst enemy — is likely himself. In the end, how your investments behave is much less important than how you behave.” – Benjamin Graham
The wild ride in 2019 continued in August. The volatility in price swings and investor psychology persist. On both fronts, it’s been quite a nine-month journey. During this period, headlines have swung from “Worst December Since 1931”1 at Christmastime 2018, to “Best Start to the Year Since 1987”2 through April 2019, followed by “Worst May Since the 1960s”3 and on to “Best June Since 1955.”4
After a solid July, August was testy. At its lowest, the S&P 500 has been down more than 4 percent during August.5 Daily volatility averaged more than 1 percent most weeks of the month,6 and we experienced three days in this 30-day period in which the S&P 500 dropped by 2.5 percent7 or more — the first time that has happened in more than eight years. And yet, the S&P 500 rallied 2.8 percent in the final week of August to pare the month’s price decline to only 1.8 percent, leaving the index a mere 3.3 percent off its all-time high in July.8 This is not even close to correction territory, despite the general feeling that we are experiencing one based on the headlines suggesting that recession is imminent. Further, stocks are up roughly 17 percent year-to-date,9 which isn’t too shabby, particularly when juxtaposed against investors’ negative mood. This is rather mind-numbing stuff. What’s next and what should we do?
Before answering the question as to what’s next in the very near-term, we would be remiss if we didn’t mention we are in the midst of a seasonally challenging period for stocks. The August-October period in the S&P 500 is feared, much like how the Masters Golf Tournament’s so-called “Amen Corner” is respected by some of professional golf’s greatest players. The water and sand hazards on the 11th, 12th, and 13th holes at Augusta can be treacherous in the midst of the unpredictable winds on this part of the course. Play on these holes is marked in history almost equally by valor, poise and steely success as it is by loss of concentration, trouble and defeat. The analogy is pretty straightforward.
September is known as the worst month in the stock market with average monthly returns of -1 percent from 1928-2019,10 yet the month has generated positive results, on average, during the last 15 years.11 October gets an unfair bad wrap given its average positive return; unfortunately, it is overwhelmingly known for the disastrous October crashes such as 1929 and 1987. The point is, this can be a seasonally rocky trek for the market, and we respect that. But it is certainly not destined to be so. As it relates to entering these historically shaky months in 2019, there are two countervailing views that are currently duking it out to win center stage in investors’ minds at this time. Concerns over moderation in growth and potential policy risks (associated with Federal Reserve rate policy and ongoing trade discussions with China) seem to inspire days of sizable sell-off in the market. However, the market shows a similar ability to rally handsomely on days in which news flow and data reports support the view that economic expansion continues and policy risks are exaggerated.
In such an environment, balance in portfolio positioning is key to ensure there is a proper blend of offense to benefit on the risk-on days and defense to serve as a buffer on the risk-off days. An objective temperament is also helpful so that, from a behavioral standpoint, one doesn’t heroically and blindly embrace either of the extreme market views above in regard to near-term outcomes and suffer from whiplash during these yin and yang price swings we are experiencing. In other words, we need to keep our cool…and our focus on the facts. Hence the quote from Ben Graham above about poised behavior. In taking a slightly longer 12-month view of conditions, we continue to find the fundamentals of the U.S. economy and the market remain healthy, and valuation, at these low levels in rates and inflation, to be attractive. Bottom line, we remain positive and would not want to pare back on our equity exposure, just be a bit more balanced within our equity exposure given the heightened near-term volatility and risks.
Our mission in this market is to keep our investors from suffering whiplash. Rapid swings in psychology have been causing rapid swings in stock prices for the last nine to 12 months or so. Through it all, the market is up sharply year-to-date and up modestly over the last 12 months. Taking dramatic action would not have helped. We have referred to this roller-coaster ride in trading and headlines in 2019, as the “wash-rinse-repeat cycle.” Investor anxieties lead to sell-offs (wash cycle), and when the ensuing positive economic and earnings data is released and appreciated by investors (rinse cycle), the market rallies sharply to take us back to where we should have been all along and eventually to higher highs. In December, for example, we noted the headlines were drawing parallels between the month’s correction to a potential ensuing 1931 level calamity and were forecasting economic recession in 2019. When GDP data and S&P 500 earnings were released in the first half of 2019, that illustrated continued strength and better-than-feared results on both measures.12 The market posted its best start to a new year in more than 30 years. This pattern of behavior of freak out based on speculation and fear, followed by rally based on the facts, has been repeated again and again during this 10-year bull advance…hence our wash-rinse-repeat cycle.
In this environment, we think it’s just as likely the market melts-up in the near-term, because we see further weakness. To ignore the risks of policy error would be like sticking one’s head in the tiger’s mouth. Or, to ignore the solid fundamentals and the possibility policy may make a better-than-feared landing could cost one significant gains. This is what is driving our call for balance and a blend of exposure to cyclical or economically sensitive equities, coupled with more defensive, consistent earnings growers that are less tied to economic swings…as opposed to a major tilt in either direction.
Yield Curve Inversion
Our thoughts in technical terms — it’s overcooked. Don’t get us wrong, this is a signal to watch. But the current chorus about inversion is misguided in our view. Forget the fact that the two-year to ten-year has come in and out of inversion and by only a small amount. In the past when we’ve seen sustained inversions as a real signal of recession, they were accompanied by credit market stress and dislocations that are absent today and occurred when the level of rates were far higher and restrictive in nature.
Levels at which they choke off credit growth and cause economic activity to slow, current policy is accommodative. This is a “bull market flattening,” meaning long rates are dropping faster than short rates (a la 1998) with low international rates being a significant driver of demand for U.S. intermediate-term and long-dated bonds, in our view. This stands in contrast to a “bear market flattening,” when short rates are rising faster than long rates. The latter generally inspires recession as the Fed is becoming more and more hawkish to slow things down — that is not the case today. So, we’re not saying it’s different this time…and that’s the point. Inversion is not accompanied by severe widening in credit spreads this time, like it normally is. If anything is different this time, it’s that the algorithms are pushing the market around more on false announcements of sustained yield curve inversion. We will keep a sharp eye on how this evolves.
Risks of Recession Risen but Not Our Base Case
The chorus has continued to rise. “The recession is coming, the recession is coming.” Of course, it will happen sometime, but we just don’t see signals that one should occur in the near-term. Interestingly, we’ve seen expectations of recession spike intermittently throughout this entire 10-year bull run…in 2010, 2011, 2012, 2015, etc. Look at the calls for recession in the chart below around the mid-term elections in 2010, the riots in Europe and U.S. debt downgrade in 2011, fiscal cliff in 2012, oil prices plunging in 2015, etc.13
Recession is always seemingly one year away. As the late economist Paul Samuelson’s quote goes, “The stock market has predicted nine of the past five recessions.” One of these days the recession chorus will get it right. For us to make such a call, the data must support it. Yes it is moderating and policy risks have increased the odds of recession, but key indicators that have signaled recession prior to previous slowdowns are not flashing red as yet and there tends to be a healthy lag between the signals and recession’s occurrence. Near-term recession is not our base case view at present. To become base case, we must see it in the data.
Valuation is more Appealing than Advertised
Can we stop saying in robotic fashion that this equity market is expensive…it is not! Valuation is not one metric…P/E level. It is a mosaic of a number of metrics and it can’t be judged in a vacuum. Even if one focuses just on the current absolute P/E level of roughly 17 times, this is actually quite reasonable for these low levels of inflation and rates. On this point, if you look at other valuation metrics such as dividend yield to 10-year Treasury yield (more than 60 percent of S&P 500 constituents have a dividend yield above the 10-year Treasury yield),14the market is cheap. This is certainly the case on the earnings yield to bond yield ratio as well. Earnings yield of almost 6 percent versus a treasury of 1.55 percent is extremely attractive15. P/E’s would need to surge to more than 21 times for this metric to fall to historical averages. This is the flip side to the negativity surrounding low rates. Valuation is not expensive in our view, and low rates are part of the valuation appeal of stocks. At the individual stock level, we find plenty of attractively priced stocks.
The latest round of tariff’s applied on September 1, warrant a couple of comments. First, I must admit that we are disappointed this worrisome item has remained unresolved for this long and that visibility on progress is limited. Because both parties are highly incented to do so, we believe we will not see worst-case closure on trade discussions. However, the extended tensions and escalation in tariffs have contributed to recession risks to that one-in-three level, in our opinion. The direct economic costs are not that large, but the derivative effects of lower CEO confidence and potential spillover into declining capital expenditures and employment is problematic. Employment data and U.S. consumer spending remain robust at present, but this is why we continue to look at the data. It is also why we remain balanced in positioning and want both offense and defense in our equity exposure.
Balance and temperament are key as we head into this fall, seasonal chapter in the market. We remain cautiously optimistic and focused on trends in the data.
3The Wall Street Journal
4July1, 2019. Barron’s
6Aug. 26, 2019. The Wall Street Journal/Factset
7Aug. 31, 2019. The Wall Street Journal/Factset
8Sept. 2, 2019. Barron’s
10Yardeni Research Inc.
12Factset; GDP Q1 3.2%, Q2, 2.0%; EPS Q1 +2%, Q2 +2%
13“S&P 500 vs. # of Times Recession is Mentioned in News Stories” chart. Strategas
14Bank of America Report
15Source Yardeni Research Inc/I/B/E/S data by Refinitiv and Federal Reserve Board
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