June 2019 Newsletter: Storm Clouds on the Horizon

June 10, 2019

Recently Published Articles: 

• Rockwell Automation is Getting Interesting
• How to Identify Great CEOs: 5 Point Checklist
• Put Discover Financial Services On Your Radar
• Thailand Market: A Blend of Growth and Value
• 2 Key Gold Charts I Follow Closely
• India’s Achilles’ Heel
• Why Interest Rates are Declining
• Bearish Signs are Growing, But Don’t Overreact
• Will International Stocks Ever Catch Up?
• The Guide to Closed-End Funds, and 5 Worth Buying

Slowing Economic Growth: Recession Watch

Economic indicators in the United States are starting to show early warning signs about a possible recession.

That doesn’t mean a recession is certainly going to happen shortly, but the risk that one is coming is elevated compared to a year or two ago.

More specifically, this decade-long expansion (which is now the longest in U.S. history) has had three smaller growth cycles within it. The first one ended in 2011/2012, the second one ended in 2015/2016, and the third one appears to be ending in 2019/2020. A recession was averted after the previous two cycles ended, and this third one is still playing out.

One of my colleagues at FA Trader, Eric Basmajian, focuses on charting the rate of change of various economic indicators.

Many investors just focus on the raw numbers, like whether an economic number is growing or shrinking. Eric stays a step or two ahead by focusing on the first and second derivatives of those numbers; their rates of change. This allows investors to see acceleration or deceleration in a number ahead of time.

Here’s an example. His raw four-factor economic indicator shows the growth that has occurred during this economic cycle. After declining during the previous recession, it has been in a solid decade-long uptrend:

Chart Source: Eric Basmajian, EPB Macro Research

However, when the year-over-year growth of that index is charted in recent years, we can see periods where this growth rate slowed down:

Chart Source: Eric Basmajian, EPB Macro Research

This year-over-year chart shows the acceleration or deceleration of growth, and gives an early warning signal for when the actual index is vulnerable to turning down.

Check out Eric on FA Trader if you want to see more of his work. You can scroll down on the home page, click on his name under his picture, and read several of his recent articles.

The period of 2015/2016 was the most recent slowdown. The first chart shows that growth nearly flattened out during that time. The second chart more clearly illustrates how much growth had decelerated.

There was a big crash of oil prices in the early part of that slowdown as Saudia Arabia tried to flood the world with cheap oil to hurt the U.S. shale industry and regain market share. The oil industry, industrial providers to oil firms, bank lenders to oil firms, and certain transportation companies were slammed pretty hard. The rate of overall economic growth in the United States declined substantially, but did not quite go negative, and thus a recession was averted.

I invested aggressively in the energy and transportation industries during this time, which resulted in strong returns as 2016 finished up.

China unleashed a massive stimulus in 2015, which considering the size of their economy and growing middle class and need for raw materials from the world, was an upward force on the global economy since everything is so interconnected. China has more leverage now than they did in 2015, and the trade dispute between the United States and China is adding further pressure to the mix, so we’re unlikely to see this same boost again.

You can see similar results to the rate of change model by looking at the United States Manufacturing Purchasing Manager’s Index:

Chart Source: Trading Economics

Whenever this is over 50, the manufacturing sector is expanding as viewed by supply chain managers. If it dips below 50, it is likely in contraction. As it rises and falls, we can see if it’s getting ready to contract or if it’s still accelerating.

In 2016, it dipped close to 50 but stayed over it; growth continued and eventually accelerated. Over the past year, it has fallen sharply, and is now just above 50 again. If it continues to fall, this indicator will be in a contraction. If it bounces back, and other indicators bounce back, maybe we’ll have another growth cycle. Right now, it’s giving us a yellow warning signal about a slowing economy, which might or might not turn into something worse.

Some of Europe’s PMIs are below 50 right now:

• The UK’s PMI recently dipped just under 50.
• Italy’s went under 50 about 7 months ago, hit a low of nearly 47, but is back up to nearly 50.
• France’s PMI and Spain’s PMI have both been hovering just above and below 50 for the past six months or so.
• Germany’s went under 50 at the start of this year and has been recently slammed all the way down to 44.

Yield Curve Inversion

There is a lot of attention in the financial media about the partially-inverted yield curve. This is another bearish indicator.

Normally, longer-duration bonds pay a higher interest rate than shorter-duration bonds, all else being equal. This makes sense, because investors take on more risk for inflation or default when buying 10-year bonds or 30-year bonds as opposed to 3-month bonds or 2-year bonds. This can be represented in the yield curve, which shows longer-duration bonds paying higher interest rates.

The Federal Reserve tends to raise short-term interest rates over the course of an economic cycle to prevent excessive inflation, and cuts interest rates when economic weakness starts to occur to stimulate borrowing and growth. Additionally, the bond market moves ahead of the Fed, anticipating Fed raises and cuts.

As a result, the yield curve tends to invert in the later period of an economic cycle, shortly before recessions. In other words, as an economic cycle gets closer to ending, longer-duration bonds tend to pay lower interest rates than shorter-duration bonds.

MarketWatch has a nice graph of the current yield curve (partially inverted) compared to how it was a year ago (totally normal). The horizontal axis is the duration of the Treasury bond, and the vertical axis is the interest rate that the bond pays:

Chart Source: MarketWatch

And this chart shows that when the interest rate of the 10-year Treasury bond inverts under the interest rate of the 3-month bond (the difference crosses under zero), it tends to occur near the end of an economic expansion (recessions shaded in gray):

Chart Source: St. Louis Fed

This next chart shows that same yield curve (blue line) alongside the interest rate set by the Federal Reserve (red line):

Chart Source: St. Louis Fed

The Fed typically raises rates throughout the cycle (white period), and then cuts it when the economy starts to weaken (right before a gray period). This cut historically un-inverts the yield curve.

The bond market is currently pricing in a high probability that the Federal Reserve will cut interest rates by the end of 2019 due to economic weakness. The Chairman of the Fed has stated that they will do what they can to prolong the expansion, which implies easier monetary policy including interest rate cuts and an end to quantitative tightening.

It is also worth noting the downward trend. During each economic cycle, the Federal Reserve had a lower-low and a lower-high in their short-term interest rates (red line above). During this last cycle, the United States and the rest of the developed world hit rock bottom at 0% interest rates, and some countries went mildly negative.

A concern that many investors have is that the Federal Reserve does not have enough room to cut interest rates during the next recession, whenever it comes. It historically takes about a 5% cut to help stimulate the economy out of a recession, but interest rates are currently less than 2.5%. Therefore, many analysts expect a combination of zero/negative interest rates, quantitative easing, or other unusual monetary policies during the next recession.

Now, this chart shows the yield curve (blue line) overlaid on the the Wilshire total U.S. stock market price index (red line):

Chart Source: St. Louis Fed

It’s not surprising to see that the stock market tends to peak in the months prior to a recession, which also happens to be around the same time as the yield curve is inverting, the Fed cuts rates in response to early signs of economic weakness, and the yield curve un-inverts.

In the mid-1990’s, the yield curve nearly inverted, but then widened, and the economic cycle went on for longer than it historically does. Some analysts believe this might happen this time, further extending the already-long economic cycle that we’re in and delaying a recession for a few more years. We’ve already had three mini-cycles of accelerating and decelerating growth during this ten-year expansion; could we have a fourth after this slowdown ends?

It’s hard to say either way, but as markets are near all-time highs and there are various early indicators of economic weakness, it’s a risk to be aware of. I’ll be watching various employment metrics in the coming months.

Right now, the official unemployment rate (blue line below) is near all-time lows. The rate of change of that unemployment rate (red line) shows that it’s flattening out:

Chart Source: St. Louis Fed

The skilled labor market is already pretty tapped out. Contrary to what is intuitive, a low unemployment rate is historically a bearish sign for the forward returns of the stock market and tends to occur near a market top in the months prior to a recession. Low unemployment is a late-cycle indicator and implies things are already nearly as good as they can get, with little room to keep going up and more room to start going down.

However, it’s hard to say how much more this cycle can squeeze out of the labor market. Maybe we’ll get a bit lower, or stay under 4% official unemployment for several more quarters. We’re pretty clearly in the later period of the cycle, but getting more precise and saying whether we are very close to the end or still have a bit to go, is the harder part. That’s where watching the rate of change of various metrics certainly helps.

• Read more: Guide to Interest Rates and the Yield Curve

International Stock Peaks

Changing topics, Ye Xie from Bloomberg posted this chart last week, which in my opinion shows the importance of international diversification and avoiding bubbles. It charts the performance of the primary four equity groups in the world over the past thirty years:

• The Japanese stock market peaked in the late 1980’s with crazy overvaluation and hasn’t recovered even three decades later.

• European blue chips peaked in the late 1990’s, and still aren’t close to recovering 20 years later, although the broader European market has fared a bit better (still not great). The U.S. market also took a long time to fully recover from those high valuations.

• Emerging markets peaked in 2007, again with extreme overvaluation, and it has been flat and choppy since then, and is still lower on an inflation-adjusted basis.

Xie is implying here that the U.S. stock market may be in a similar situation, as it has crushed virtually all other markets this decade and could be peaking.

I don’t have a strong opinion if that is true or not, but the U.S. stock market is indeed one of the most highly-valued markets in the world based on most metrics (price-to-earnings, price-to-book, CAPE, low dividend yield, etc.) When adjusted for sector concentration (because the U.S. has a large percentage of tech stocks, which generally carry higher valuations), the valuation divide between the United States and the rest of the world is somewhat diminished but not eliminated.

In my 2019 International Opportunities Report, the United States market had a moderately low ranking, based on a combination of growth, valuation, debt, stability, and currency fundamentals. There are a number of markets that I like better than the U.S. over the next 5-10 years based on a combination of those factors for risk-adjusted returns.

Basically, there is a lot of capital put to work in the S&P 500, driving up valuations, because investors view it as safer. Unfortunately, history shows that when a market is priced to perfection, it tends not to do very well compared to some of its cheaper peers. Time will tell in this case.

Although it’s hard to predict future performance of an index relative to any other index, the key takeaway from this chart in my opinion is that international diversification helps investors avoid some of these multi-decade periods of poor returns that can and do occur to various markets. Investors that were globally diversified and owned a set of all four indices through this period have minimized these very long and drawn-out bear markets.

Another good chart that captures this is from Star Capital:

Star Capital always does great charts and tables and is a core source for international investing. This one zooms in on the current decade of performance compared to the previous decade.

There is a nearly perfect inverse correlation; the worst-performing markets of the previous decade tended to be the best-performing markets of this decade. Similarly, the best-performing markets of the previous decade tended to be the worst-performing during this decade. The last shall be first and the first shall be last, in this case.

When times are good and a market is doing well, investors tend to get excited, pour money into it, and price it up to perfection. Such a market tends to perform poorly from that overvalued peak. Similarly, investors tend to pull money out of troubled spots of the world, which drives valuations very low. Even a modest recovery can then drive huge stock gains in undervalued markets.

I am globally diversified, but my favorite equity grouping over the next decade is probably emerging markets. However, because China has such a huge weighting in emerging markets, I prefer to use a more broadly diversified grouping closer to equal-weighting among many emerging markets countries. I particularly like India for the long-term.

• Read More: Guide to International Investing
• Read More: Guide to Emerging Markets

Portfolio Updates

I have four investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue.

These include a primary passive/indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and the new account specifically for this newsletter at M1 Finance.

I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.

M1 Finance Newsletter Portfolio

I started this account about nine months ago with $10k of new capital, and I put an additional $1k into it before each newsletter issue, totaling $16k so far.

It’s by far my smallest account, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market.

I chose M1 Finance because their platform is commission-free and allows for a great combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)

After adding $1,000 in fresh capital in June, here’s the portfolio today:

Changes since previous issue:

• I added a starter position in Rockwell Automation to the dividend stock section. It didn’t quite hit my fair value target but due to the quality of the company I considered it close enough to nibble on and start dollar-cost averaging into. I wrote about Rockwell recently here. I plan to hold this one for a very long time, and would potentially add it to one of my other accounts as a larger position during a major sell-off.
• I reduced my allocation to a few other dividend holdings to make some room for Rockwell and further diversify. None of these were actually sold or trimmed; I reduced their position simply by allocating new capital to other positions and reducing their allocation in the dividend stock pie from 4% to 3%.

Here’s the more detailed breakdown of the holdings:

Primary Retirement Portfolio

This portfolio is my largest and least active. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.

Here’s the allocation today:

From 2010 to 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.

Starting in 2017 in order to preserve capital I dialed my equity allocation down to 60% (40% domestic, 20% foreign). This was due to higher stock valuations and being later in the market cycle more generally. If and when the U.S. economy encounters a recession and significant bear market, I would likely increase equity allocations to upwards of 90% once again.

Related Guide: Tactical Asset Allocation

One reason this is so conservative is that my active portfolios below are more concentrated and aggressive, so I consider them together when determining how to allocate assets.

This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years based on market conditions. This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts.

Active Portfolios

My accounts at Fidelity and Schwab are mainly for individual stock selection, single-country ETFs, and selling options:

Changes since previous issue:

• I sold September 2019 covered calls on my SunPower position at a strike price of $8.

Final Thoughts

For the U.S. economy and much of the world economy, storm clouds are on the horizon.

This doesn’t mean we’ll necessarily get hit with rain and lightning, but it means the chances are higher for that to happen than they were a year ago, and it’s something we need to watch. The storm clouds might keep coming and hit us, or they might abate.

Specifically, as we head deeper into 2019 and eventually into 2020, we’re in a period where the rate of growth is slowing. Will this bounce back up like it did in 2016 for another mini-cycle of growth, or will this sink lower into negative territory and result in an actual recession? It’s hard to say for sure, but with the market still near record highs, it’s a good time for investors to check their asset allocation and risk tolerance.

Many investors tend to overreact in my opinion, and shift their assets around too much. I prefer a more gradual, lower-turnover, tax-efficient asset allocation strategy. So, I continue to have substantial equity exposure, but have some defensive elements in my portfolio, and am very satisfied with my current allocation mix if we were to head into a significant down trend. Investors that are closer to retirement would likely want a somewhat more conservative mix.

Additionally, the types of stocks matter. Unprofitable new IPOs with sky-high valuations are particularly vulnerable during an economic slowdown or recession. Additionally, seemingly cheap stocks that have high debt loads and are being disrupted by new technologies are also vulnerable. High-quality stocks with good balance sheets that generate strong and growing cash flows and that are not at very high valuations will likely hold up better.

Trying to predict precisely what will happen is not very effective. Instead, it’s more accurate to view the future as a range of probabilities that shift over time.

Earlier in this economic cycle, U.S. stock valuations were low and there was a lot more potential for growth than there was potential for downside risk, so I was very heavy into U.S. stocks. As we moved into 2017, 2018, and 2019, stock valuations became higher and late-cycle indicators started to build, so I shifted my asset mix to be a bit more defensive for my age. I also started allocating more to certain out-of-favor emerging markets which in my opinion are offering better fundamentals and lower valuations for investors with a very long-term approach that can put up with the extra volatility.

Just as importantly, investors should make sure their personal finance situation is in order, rather than just their portfolio. Just like squirrels gather acorns in the warmer months to feed themselves through the colder months, this warm period in the markets when autumn or winter might be coming is a perfect time to make sure you have enough liquidity and defensive elements in your financial plan to do well in the coming years, whatever they may bring.

Have you paid off high interest debt, built up a cash reserve for liquidity, kept expenses considerably lower than income, and diversified your sources of income? If not, this is a good time to do so.

The next newsletter issue is planned for late July.

Best regards,