Following the pullback at the end of 2018 and subsequent recovery, most analysts agree that we are likely near the end of the bull market. The 10 year – 2 year yield curve nearly inverted in December, and the 10 year – 3 month yield curve inverted in March. Other leading indicators have been mixed, as well.
Over the last several years, the best performing asset, by a lot, has been US large cap stocks. For those investing with a home bias, this has been a winning strategy. For those investing with global diversification, it’s been a long hard road.
Looking at valuations, it appears that emerging markets have the best opportunity for higher forward-looking returns, followed by international developed, with US equities coming in last (see https://mebfaber.com/2019/01/25/the-biggest-valuation-spread-in-40-years/). P/B, CAPE, and cyclically-adjusted CAPE values all suggest that the S&P 500 is due for a rough 10 years ahead. However, this has been true for at least the last 3 years. John Hussman has been predicting low returns for far longer. If you examine his analyses (at http://www.hussmanfunds.com), they are clearly well researched and make sense. But they haven’t worked.
One unaccounted-for variable has been central bank interventions. This includes not only our Federal Reserve, but actions of the central banks of Europe and Japan as well. You can find a monthly update showing the close correlation of the S&P 500 to the total of these balance sheets at yardeni.com. Since October 2017, the Fed has been reducing its balance sheet. Will this cause the US markets to decline? It appears that instead, the other central banks will increase their holdings to make up for at least part of it. The correction in December 2018 has been variously credited oil prices, revisions to 2019 earnings estimates and/or Fed balance sheet reduction. Of those three options, we have many years experience with two of them, and zero experience with the third.
One way to determine a sensible action plan is to think through possible outcomes and consider their likelihoods. Start with some assumptions: Economic conditions are likely to either stay stable for the foreseeable future or weaken. Although it is possible for conditions to further improve, it seems unlikely based on most forecasts. Central bank interventions will likely be contingent on economic conditions, which may include market conditions.
What are the possible outcomes of stable conditions vs. weakening conditions? We know that economic recessions are nearly always accompanied by market corrections. We also know that the US market is more richly valued than other markets, which may result in a larger over-correction in the next bear market. OR NOT! In Meb Faber’s article referenced above, notice that the US has been over-valued now for about 7 years. How long can this continue? Is it related to the Fed or to something else?
Many market observers, myself included, believed that this massive Fed balance sheet would cause sustained inflation above the Fed’s target 2%. We have been wrong. Before responding with, “CPI is measuring inflation wrong,” take a look at this article from Cullen Roche: https://seekingalpha.com/article/4255137-hard-truths-inflation-truthers. His arguments debunking the idea are compelling. We have not experienced excessive inflation so far, but that doesn’t mean we can’t. Moderate inflation is possible, although hyperinflation in the global reserve currency remains unlikely. How to protect clients from inflation? The traditional answer has been real assets and commodities, with a newer option being TIPS.
Will the US dollar remain the primary global reserve currency through the next recession? Despite the ongoing buzz about how China and the yuan are taking over the world, the answer is almost certainly yes. This article explains why: https://www.thebalance.com/world-currency-3305931. What does that mean for our analysis? It means the dollar, and US Treasuries, are special compared to any other currency and any other security.
Conclusions for asset allocation:
- If you hold US government securities for diversification and stability, there appears to be a strong argument that they will continue to function well in this role.
- If you hold most of your equity allocation in US securities, this might be a good time to consider some diversification to a more global allocation, international developed and/or emerging markets. Please note, this involves home-bias risk, because clients will certainly see the underperformance of their portfolios if the current outperformance of the US market continues.
- If you have concern about possible inflation, consider a position in one of the traditional hedges, keeping in mind that while these positions have provided effective diversification over the past 10 years, this mainly means that they have been performing poorly compared to US equities and other investments.