The Key Question Is…

“If you can’t explain it simply, you don’t understand it well enough.” Albert Einstein

Hello tax season survivors. In this commentary, I will do my best to explain the current state of capital markets as simply as it would please Einstein, and dive deeper as I move along.

To gain a big picture perspective, let’s look at the sentiment towards the end of last year:

• With their easy money policies, the central banks around the globe, especially the FED, have pushed all asset prices higher, punished savings account owners by turning “cash to trash”, gave investors no option but to take risk…and as a result major stock indexes in the US have seen all-time highs.
• These high prices resulted with stretched valuations and it had become harder and harder to find good value in stock investing.
• Earnings growth slowed down, corporate profits started to decline.
• Driven by Chinese slow down, global demand softened, which pushed energy and commodity prices, along with capital expenditures, down.
• FED was going to begin the tightening cycle and increase FED funds rate four times in 2016, adding up to a 1-1.5% increase. This was going put a tighter leash on both stock and bond markets.

So in short, along with high prices and weaker demand and earnings, the market was set for a correction…and that’s precisely what had happened.

Between November highs and February lows, the SP 500 index lost over 13%. If you date back to July highs, the loss is more like 15%. Other indexes have been struggling and waiving the red flag since the summer of 2014. For example between the beginning of July 2014 and Feb 11 2016, energy lost -69%, emerging markets -32%, Eurozone -24%, Japan -18%. In other words, a global correction has been under way since the summer of 2014 and the US stock markets had caught up with this trend by late 2015.

Since mid-February though, a rebound has been underway. Oil prices have bounced from 30 to 40 dollars range, major US indexes have recovered almost all of their losses, many US companies have been posting positive earnings surprises, market breadth has improved (the rate of total number of rising stocks to total number of falling stocks) and the fear of a global economic recession has been put to rest, at least for now.

Here comes the key question: is the recent bounce a dead cat bounce, a bull trap, or the beginnings of the next bull cycle?

Depending on one’s answer to this question, he/she should move to cash right now, or increase stock exposure.

Here is one big picture aspect of the markets, which I’ve talked about many times in the past. Markets, whether it’s currency, commodity, stock, bond or real estate market, tend to have a longer term trend, with shorter term counter trends within it. To define long and short term, this view determines roughly 5 to 20 years as long, and 1- 3 years as short.

No long term trend, also known as secular trend, is immune to shorter term, also known as cyclical counter trends. In other words, a 15 year bear market may have cyclical bull periods of a year or two within it. Naturally, these counter trends tend to leave a lesser of a mark than the longer term, or secular trend.

To revise our key question, if one believes that the longer term stock bull market that has started in March of 2009 is intact and the recent drawback is temporary, than the next cyclical bull market within a secular bull market may have started. If conversely, the longer term bull market is broken, and what we have seen since February is a bull trap, than we might be at the earlier stages of the next longer term bear cycle.

Clearly, we can call these dates and trends always after the fact …but managing investments require positioning assets based on probabilities and making changes as needed. Unfortunately we don’t have the luxury to wait until answers to these questions are abundantly clear. In the world of investments, there is no value in information known to all participants, except for their contribution to the historical perspective.

So if you go to cash, you might miss the next bull run. Conversely if you increase stock exposure now, you might lose some or all of your gains since 2009.

I think this much can be said with some confidence: the easy money has been made, and going forward one has to accept volatility as part of being in the game. If that’s not your cup of tea, this might be the time to consider a risk off strategy for your portfolios.

Moments like these remind me the scene from the musical Fiddler on the Roof, in which Tevye, the main character, talking about tradition, says “For instance, we always keep our heads covered and always wear a little prayer shawl. This shows our constant devotion to God. You may ask, how did this tradition get started? Let me tell you. I don’t know…”.

Well, I am paid to have an opinion and turn those opinions in to action. So unlike Tevye, I don’t have the luxury to say I don’t know…but I do recognize that both sides of the argument have valid reasons to stick to their guns.

I believe we have a few more years in this stock bull market. After that, I have concerns.

The main reason why I believe there is still room for price appreciation is that attractive valuations in different pockets of the market, and willing investors to exploit those opportunities are bountiful.

On the other hand, the reason why I am concerned is the lack of ammunition left in central bankers’ arsenal in case of an economic recession.

Speaking of which, let me share this with you: the longest period in the US economic history with no recession is during the 1991-2001 period. In every other case, on average, the US economy has experienced a recession every 5-7 years. Since we’ve been in an economic growth period for 8 years now, by the end of 2018, anticipating a recession wouldn’t be unreasonable.

In such incidents, governments have two resources available to them: monetary and fiscal policies. Monetary policies are driven by the central banks, mainly by managing the amount of liquidity through interest rates, reserve requirement etc. Fiscal policies are driven by the congress through tax policies, regulations, subsidies etc…

Currently, there is almost nothing left for central bankers to do in case of a recession. Rates are as low as they can get. The speed of a reaction is as important, if not more, as the reaction itself. That’s why the central banks, being able to make decisions faster than the congress, are critical in these circumstances.

Finalizing fiscal policies by congress may take months of negotiations and the damage may be done by then.

That’s why, I want to say that the long term/secular bull market is intact, have more legs in this rally and so one should increase stock exposure.

But I am being cautious because the underlying economic strength isn’t there and even though slow economic growth may be enough for the markets to move higher by further stretching valuations, any headwind could cause a fast reversal.

In terms of where to increase exposure to, look for better valuations in the emerging markets, Europe and recently beaten down sectors in the US. Previous winners may be too late to look for gains in the next 6 months or so.

Also bear in mind that we are in an election year and post elections, uncertainty may subside and leave room for another wave of tailwinds for the risk on trade. It also can rock the boat a bit till November.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.