March 19, 2018
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U.S. stocks had a wild ride so far in 2018.
The year began with a tremendous bull run, but then had a 10% correction (followed by a partial recovery) over concerns about how rising interest rates will affect equities and the economy.
After a couple years of record low volatility, normal (and healthy) volatility levels are back.
A big portion of this issue is devoted to giving readers an update on where we stand with recession indicators.
Expansions don’t die of old age- problems build up and then something triggers the fall. Just because an expansion has gone on for a while doesn’t mean it has to end soon, but the longer it goes, the more aware investors should be about how unusually long it has persisted.
The majority of investors tend to put more money into the market at market tops (due to greed and perceived safety and growth), and then pull money out of the market at market bottoms (due to fear and perceived risk). Smart investors do one of two things instead:
- Stay the course, keeping your asset allocation static throughout the market cycle. Buy, hold, re-balance.
- Become more conservative late in the business cycle and more aggressive after stock prices have fallen.
There are upsides and downsides to both of those strategies, but either way it’s much better than doing what most investors do.
The economic expansion we are currently enjoying is about to become the second-longest in U.S. history, but in terms of magnitude it has been fairly weak. I think JP Morgan has the best chart on the topic, showing how this expansion has compared to previous ones in the modern era in terms of both duration and magnitude (light blue):
Chart Source: JP Morgan Guide to the Markets, Q1 2018
There’s a case to be made that this expansion could end up being the longest in history, in part because it was so sluggish and so it has become a long-but-weak expansion.
But the bull market in stocks is already the second-longest in U.S. history, and unlike the economic expansion itself, is also the second largest in magnitude. Stocks have done exceptionally well while the economy itself has been mediocre, and so stock valuations have outpaced actual economic growth:
Here is a non-exhaustive list of some of the economic indicators worth knowing about, to see what the risk of a recession in 2018 is:
ISM Purchasing Manager’s Index (PMI)
The purchasing manager’s index measures the health of the manufacturing sector. Numbers above 50 indicate expansions in the sector, while numbers under 50 indicate contractions:
Chart Source: Trading Economics
With a PMI of over 60, the manufacturing sector is strong and rising, at levels not seen since 2004. The dip in 2015 was due to the decline in energy prices, which only affected certain industries.
The University of Michigan Consumer Sentiment surveys give an interesting look at the conditions and expectations of U.S. consumers.
Chart Source: Trading Economics
So far in 2018, consumer sentiment is at a 15-year high and still rising. It could, however, reach a peak and fall rapidly as things change.
Senior Loan Officer Surveys
Most banks are loosening their lending standards to companies once again, after having tightened them after the energy price decline. This is a somewhat bullish signal, because the opposite tends to occur prior to recessions (highlighted in grey):
Chart Source: Board of Governors of the Federal Reserve System
However, banks are beginning to tighten consumer credit card lending a bit, which is a bearish signal before recessions (grey):
Chart Source: Board of Governors of the Federal Reserve System
I wrote an article about the health of the banking sector a few months ago. Overall, the sector is in good shape with solid balance sheets, good returns, and benefiting from a rising interest rate environment. They appear to be managing risk well.
The Yield Curve
10-year U.S. treasuries usually give investors higher interest rates than 2-year treasuries, to compensate for additional risk of locking money up for longer.
But prior to a recession (highlighted in grey), the yield curve historically tends to flatten out and eventually invert, with 2-year treasuries yielding more:
This happens when investors expect interest rates to fall over the next few years, and therefore want to lock in higher rates for the long-term, which means there is more demand (and thus higher prices and lower yields) for longer-term treasuries.
The yield curve has inverted before all recent U.S. recessions. The current trend is heading downward, but still possibly a year or more from inverting, which could mean 2 years or so until the next recession.
On the other hand, due to the unusually low interest rate environment we’re in, the yield curve might not invert before this recession, and could instead just flatten out to low levels like it is now. An example of this is Japan- they’ve been in a low interest rate environment for so long that their yield curve no longer inverts before recessions; it just flattens out.
For all of these FRED charts, click on them if you want a bigger view.
Corporate Debt Levels
Companies de-leveraged after the previous recession. Then for the last several years, they have steadily taken advantage of the low interest rate environment to issue cheap debt and buy back their own shares, which has boosted EPS growth and dividend growth. Now, corporations are near their historical debt peak:
Chart Source: JP Morgan Guide to the Markets Q1, 2018
Thanks to tax reform and cash repatriation, companies will likely spend a record amount on share repurchases in 2018:
- Bloomberg: The Big and Possibly Dumb Buyback Boom
- Marketwatch: S&P 500 Expects $800 Billion on Buybacks
(I said this would happen back in my November 2017 newsletter.)
These buybacks should keep pushing S&P 500 earnings higher in 2018. But after that, with substantial debt on the balance sheet and higher interest rates for their bonds, share repurchases will have to chill out, which means earnings growth will likely slow over the next couple of years.
High stock valuations and slower earnings growth in 2019 and beyond is not a good combination for good stock market performance at that point.
The official unemployment rate is near its historical bottom range:
Source: Bureau of Labor Statistics
This implies that we are late in the business cycle. When unemployment gets this low, it tends to bottom out and start moving upward in a recession.
On the other hand, the official unemployment rate tells only half the story. It excludes people who have given up looking for work or have chosen not to work.
The raw labor participation rate (the % of people who work) is at 62.5%, below its peak of over 67%:
Source: Bureau of Labor Statistics
The rise in the early decades was primarily due to women joining the workforce in larger numbers. But the total numbers peaked in the 1990’s and have fallen since then.
One may reasonably assume that this declining rate is due to an aging population, that a larger percentage of the population is retired. But as this table shows, the exact opposite is true. It’s young people (aged 16-24) who are working at far lower rates, while older people are working later in life than they used to.
Overall, the employment characteristics imply that we are late in the business cycle, that unemployment rates may bottom out and start rising. However, the labor participation rate remains below its historical peak, and shows that the economy is not quite at the capacity that it could theoretically reach.
Recession Indicators Summary
Based on most of these metrics, the coast seems fairly clear for avoiding a recession in 2018 but doesn’t look good for 2019. We seem to be late in the business cycle, but not necessarily at its imminent demise.
However, nobody can predict a recession for sure. Things can change suddenly, and destabilizing events could happen without notice. And things can last longer than expected; some people have been saying we’re in the ninth inning of the cycle for the past several years, which means they called it way too early.
My personal approach is that I’m gradually making my portfolio more conservative as we get into the later part of this cycle, but still benefiting should the market continue to rise.
International markets are reasonably well-positioned for growth. The unemployment rate in the Eurozone is at 7.3% and on a steady decline. Brazil and Russia are slowly recovering from recessions related to the fall of energy and commodity prices a few years ago. I continue to have an out-sized allocation towards emerging markets.
U.S. stocks are highly-valued at the current time after the 9-year bull market we’ve enjoyed so far.
Japanese and European stocks look more attractively valued on the surface, but their slow growth offsets a lot of the impact of their lower valuation multiples. Emerging markets in my opinion offer the best long-term value at current prices, with a solid combination of high growth and reasonable valuations, as long as you can put up with their higher volatility.
That being said, even in the U.S. there are some attractive opportunities. Energy stocks and MLPs continue to be in a bear market due to low energy prices, and REITs have been selling off over concerns about rising interest rates.
Both the Vanguard Real Estate ETF (VNQ) and the Alerian MLP ETF (AMLP) have had poor 1-year performance while the S&P 500 has reached record heights:
Last week, master limited partnerships had a massive one-day sell-off due to a change in tax policy by the Federal Energy Regulatory Commission. But many MLPs, like Enterprise Products Partners and Magellan Midstream Partners, announced they would have no material effects from the change.
This seems to be a case of investors selling industry ETFs like AMLP, which dumps the stock prices of both affected and non-affected MLPs alike, since they are all in the index. MLP stock prices partially recovered on Friday but remain very cheap, and I personally consider this a buying opportunity for the sector, particularly the highest-quality names.
While I think buying the VNQ ETF is a good choice, I wouldn’t buy the MLP industry as a whole via AMLP. Instead, I would only buy the highest-quality names in the MLP space, with above-average balance sheet strength and good distribution coverage. Those are the ones that can continue to deliver growing distributions even in an environment with low energy prices.
I recently put together a virtual high-yield dividend portfolio, which shows some of the MLPs and companies I think are particularly attractively valued from a risk-adjusted return perspective going forward:
My Personal Portfolio Updates
My primary retirement account is purely indexed, and currently consists of about 40% U.S. stocks, 20% developed international stocks, and 40% short-term bonds and cash.
From 2009 through 2016 it was more aggressively positioned in equities that enjoyed a long bull market, but in 2017 I began dialing back my equity exposure due to high valuations. I’ll significantly increase my equity exposure if/when valuations decrease substantially.
In addition, I have two other accounts that I make more active investments in, including individual stocks, ETFs, and options. Here is their combined summary:
I manage all of my accounts and monitor my net worth by using the free tool from Personal Capital, which makes everything easy.
Changes since the previous issue:
-My cash-secured put options on SunPower expired without being assigned, so this was an 8% gain in 2 months even though the stock price itself declined. I wrote about SunPower in the previous newsletter issue. This week I plan to initiate a new cash-secured put position on the company.
-During the market sell-off, I sold June put options on Synchrony Financial (SYF) at a $35 strike price. If the options are assigned, my cost basis will be $32.66. If the options expire, I’ll make about 7% returns over a 4-month period. High market volatility means high option premiums, and that’s a good thing for option sellers.
-I sold $155 January 2019 covered calls on Traveler’s Companies, a long-term holding of mine. This helps generate more income on the position (which I consider to be fairly-valued), with the combo of dividends and option premiums.
Virtual ETF Portfolio Updates
Each newsletter for fun, I update a virtual ETF portfolio.
It takes about 5 minutes per newsletter to manage, and helps show where I think value is in the market without focusing on individual securities.
You can see the previous version from the January issue here.
The S&P 500 is at 2,752.01 and the S&P 500 TR is at 5388.74.
Changes since previous issue:
-The put options on GLD expired profitably without being assigned.
-I’m selling a covered call on EWZ at a strike of $50 for 1/18/19 at today’s option prices of $3/share.
-I’m selling 200 shares of IDV at $33.57 and buying 200 shares of RSX at $22.81.
In the next issue (around late April or early May), I plan to write about historical performance of various market sectors during the different phases of the market cycle.
I’m also working on a big investment report for global equities, comparing various countries based on valuation, growth, debt metrics, and other factors.
Have a wonderful spring,