SUNGARDEN’S INVESTMENT CLIMATE REPORT (As of 11/28/2018)

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 could be a period of wealth destruction.

 The stock market has spent the past two months trying to yell “can I have your attention!” and in November, more folks started to notice. A 10% decline from October 3 through November 23 (Thanksgiving week, no less!) reminded complacent investors that the major stock market indicators can go down as well as up…and they often go down MUCH faster than they go up. A month-end rally attributed to a change of heart by Fed Chairman Jerome Powell stopped (for now) what still appears to me to be a gradual roll-over by the S&P 500.

 We continue to sit on the edge of the defensive “Extreme Zone” of our portfolio positioning. Higher than normal short-term cash & equivalent investments and extreme selectivity in equity portfolios are “in” for us now. We allow for another modest leg higher in stocks, but not much more. A “Santa Claus Rally” is one thing, but a run to much higher all-time highs is quite another. Call me skeptical but ready for anything.

STOCK MARKET

Our proprietary Investment Climate Indicator turned to its most bearish of four levels (“Stormy”) back at the end of January. Over the past 12 months, the S&P 500 has not traded below 2500 or above 2950. That strikes us at best as a trading range, not a robust bull market. If we put on our “reading glasses” and look a bit closer, a range of roughly 2650-2800 (or about 6% from top to bottom) is where the market has travelled back and forth during a chaotic autumn.

The U.S. stock bull market (as depicted by the S&P 500, Dow and Nasdaq) is in its very, very late stages. One faint sign of hope for upside beyond a reactionary “bounce” is the perking up of non-U.S. stock markets, particularly Emerging Markets. But let’s not get carried away just yet. This is still a wounded bull, and the sharper the rallies, the more it reminds us of “classic” bear market behavior. But don’t take it from me: TheStreet.com co-founder Jim Cramer said as much on his November 26th edition of “Mad Money.” I see increasing similarities to the late year-2000 period, as the “market” turned from bull to bear in the year 2000 (Dot-Com Bubble). That sparked two years of major declines in momentum stocks, while higher-quality, non-tech Blue Chip stocks fared pretty well. Investors must moderate their return expectations from the stock indexes, or they will be very disappointed. 

BOND MARKET

During November, the bond market started to develop a split personality. Treasuries are shaping up to be fairly competitive investments in the late part of 2018, as short-term interest rates drift upward. But the more I look at the “credit” bond market (Corporates, High Yield) the more I see early signs of a debt crisis. When you consider the deluge of BBB-rated bonds that has flooded the market since the Financial Crisis a decade ago, you have to figure it will eventually catch up with investors in bond funds, and those who “reached for yield” via ownership of individual bonds. 

The big picture here is that U.S. bonds are likely into their 3rd year of a bear market, following a nearly 4-decade long bull market. But it is my observation that many “retail” investors have no idea that this is happening, as evidenced by a continued flood of assets into bond funds. As a result, “Balanced” portfolio returns are in their third year of lackluster returns. 

As for short-term rates, most investors know they are headed up. What is under-appreciated by the market may be the gradual impact that higher borrowing costs will have on the economy in the years ahead. This is, however, creating a nice additional tool for income-oriented investors during a period in which the stock market is threatening to tip over.

INVESTMENT REWARD / RISK TRADEOFF

Reward potential still exists (as it always does), but at a higher risk level than at any point in the past 10 years. 

BUT, risk-management should be a very high priority versus pursuit of reward. Increasingly, we see that profit opportunities are smaller and more fleeting (very short-term), which seems to match the late-in-bull-cycle conclusion we have drawn regarding the U.S. stock market.

POINTS OF INTEREST

What concerns us about today’s investment climate? High stock valuations, an overheating economy, geopolitical risk, trade spats, excessive leverage and most of all, the reversal of 9 years of “easy money” policies by the Federal Reserve. Historically high levels of investor speculation, consumer debt, and investor complacency only add caution to our outlook.  

Just last month, I wrote to you that “A recession may still be a ways off” yet we have come to “a ways” in just a month. The old-reliable signal of coming recessions is the spread in rates between 2-year and 10-year U.S. Treasury securities. As of late November, that spread was down to just 0.22% (22 basis points). As this month’s chart shows, since the mid-1970s, that has meant a recession is on the way, probably within a year or two. But we don’t need a recession to be formally declared to freak out markets. All it takes is a sufficient level of fear that one is coming. As they say, the markets are forward-looking. But they will not look forward to that, so to speak.

The good news? None of the above means that we abandon investing altogether. Sure, cash, short-term instruments and hedges play a bigger role than in less precarious times. But the stock market has many different segments, and opportunities appear all the time.  We see long-term opportunity in stocks and sectors that have been ignored late in the bull market. This requires patience, as some stocks are “re-discovered” by investors.  

THE PLAN:

We diversify among “owning” long-term investments and “renting” tactical investments. This combination should produce more balanced results in the coming years, as opposed to traditional stock/bond mixes, or allocations to different “asset classes.” Hedging techniques are particularly valuable tools to have in one’s arsenal at this stage of the market cycle. Finally, DO NOT assume that what has worked for the better part of the past 10 years will continue to work.

RECESS TIME!! OH WAIT, HE SAID RECESSION TIME ☹

Recession talk is creeping into the public discussion. And to me, there is no better track record of recession risk than the spread between the 10-year and 2-year U.S. Treasury securities, pictured above. Since 1976, every time the 10-2 spread dropped as low as it is now, 2 things happened: it went negative (in that 2-year bonds yielded more than 10-year bonds), and then a recession followed. Expect the media be all over this history if the 10-2 spread goes negative. In the meantime, consider this one of many overhangs on the U.S. stock bull market.

While this group of 100 ETFs is certainly a wide-ranging group, when you average their returns you get a sense of general global market conditions for investors over the time periods shown. As indicated, the September to November period was a downer, and not just by a hair. And with a month to go, 2018 has been a negative return year.  

Nothing says “risk-off” like a 15% decline in Microcap stocks in just 3 months. Emerging Markets continued their awful year, but hinted at getting a “bid” toward month-end. The EAFE Index (Europe, Japan and Australia, primarily) is now yielding over 3.3%, its highest level since mid-2015. Meanwhile, the S&P 500’s 3-year return is still over 10%, but after 2018, it is clear that return figure is becoming “front-end loaded.”

The past 3 months have brought “corrections” in some sectors, but Consumer Staples, REITs and Utilities are actually up. Those 3 sectors also produced strong relative returns in the first 2 years of the Dot-Com Bubble burst (2000 and 2001). The current period looks more like that one with each passing month. But let’s not get ahead of ourselves.

Housing stocks are either very undervalued or a “canary in a coal mine” that corroborates weakening home sales data that continued in November. Meanwhile, Biotech, Internet stocks, Metals and Mining, and Energy all connote a “risk-off” period since September. In addition, over the past 3 years, a mere 5 out of the 21 industries shown here have produced annualized returns greater than the S&P 500’s 10.78% over the past 3 years. Can you say, “top-heavy market?!”

The only 2 from this group that have produced double-digit returns over the past year are the two most narrow segments of the very eclectic batch of ETFs. Translation: a sanguine stock market does not necessarily eliminate return potential for investors.

Non-U.S. Equity

Europe has been a rough place for equity investors this year, though with the yield on Europe and Pacific indexes moving higher, you wonder when they will go from “dividend dogs” to helpful diversification tools.

Dividend stocks have been relative safe-havens in the autumn stock market carnage. But excuse me for being a bit hesitant to declare them the “hot” place to invest. There have been too many rallies that turned into false alarms in this segment of the market since late 2016. Still, if interest rates were to peak for a while, this corner of the market could look very interesting very quickly.

Stock/bond diversification is striking out this year, and at least for that relatively short time period, it did not really matter how much risk you took. After all, Conservative and Aggressive portfolio allocations are just 1.28% apart during that time.

No, that is not a misprint. That is a 45% return in the Natural Gas ETF in 3 months. That long-depressed market segment rallied while oil prices went the other way. The U.S. Dollar has appreciated strongly in 2018, but if the Fed is truly on the way to ceasing rate increases next year (I am not convinced of that yet), the Dollar could give a lot of that surge back.

I think this is the most interesting segment of the global markets right now. Why? Because investors are trying to figure out whether to sell long-term Treasuries for fear or rising rates, or to buy long-term Treasuries for fear of everything else! 2019 will be a very interesting environment for this giant part of the global financial markets. In the meantime, its nice to see the Yield column above zero for the first time a long time.

Want to take a peak at what a debt crisis redux might look like? See the 5% drop in Preferred Stocks in just 3 months, and the more than 6% drop in Convertible Bonds over the same time frame. Those securities start to look a lot like the stock market when things get rough, and that could be a major surprise to unsuspecting investors in 2019 and beyond. Yield-reachers…beware!

Disclosure:

Comments provided are informational only, not individual investment advice or recommendations. Sungarden provides Advisory Services through Dynamic Wealth Advisors. Source for all data and charts from YCharts.com

Author Bio:

Rob Isbitts

I am the Chief Investment Officer of Sungarden Fund Management, the subadvisor to a long-short mutual fund (DNDHX) and the founder of Sungarden Investment Research, an investment management and equity research firm. Over the past three decades, I have managed daily liquid portfolios through diverse market conditions. I created several investment strategies, including the Sungarden Hedged Dividend portfolio, an alternative approach to the pursuit of income, preservation and long-term growth. I have authored two books and hundreds of articles on investing. I can be followed on Twitter @robisbitts, and my website is www.sungardeninvestment.com.