Another Roaring 20’s Ahead?
Welcome to a new decade. The last ten years were amazing in many ways and certain things still look pretty impressive right now. The question on everyone’s mind is when will the party end and how will we know it’s time to leave before it’s too late? Last century’s “Roaring 20’s” started off exceptionally well as the Dow Jones Industrial Average Index grew over 220%, or approximately 13% each year on an annualized basis. Then, the music stopped playing and the 1929 crash devastated the country for years to come. After an elongated bull market run, the DJIA Index lost more than -87% between September of 1929 and June of 1932. Assuming you bought and held the DJIA Index starting in 1920, you would have experienced those initial tremendous gains, but eventually you would have lost -60% of your original investment by June of 1932, or approximately -7% each year on an annualized basis.
Don’t worry, I am not suggesting our Roaring 20’s are going to end as tragically as they did back then. And I certainly hope that we too will experience continued economic growth and widespread prosperity for as long as possible in this coming decade. Even though we have already had a substantially long bull market run, there are some fresh indications that suggest financial markets still have more upside potential. Last year, a recession appeared relatively imminent, but now it might be avoided for some time to come. On the other side, there still are some areas of concern that we are watching very closely.
Whenever the party does come to an end, it is extremely unlikely that we will experience an -87% loss in wealth like that which occurred last century. However, it is still wise to recall the more recent S&P 500 Index’s -49% loss that shocked investors between 2000 and 2002. Similarly, we need to remember that investors who bought passive index funds in late 2007 because they wanted to enjoy the final hours of the last bull market party suffered -56% losses over the next two years. Further, a $100 investment made in late 2007 caused a loss of wealth until six years later in 2013 when it was finally worth $100 again.
Looking ahead over the next six to twelve months, WBI Investments is currently focused on monitoring signs that the market is still healthy so we can help our investors continue to grow their wealth. However, we also remain focused on any signs the party might be coming to an end. Six years is a long time to wait to simply erase the damage of significant losses and break even, so, our goal is to capture as much upside as possible while working to avoid any catastrophic losses that may be on the horizon.
MARKETS IN REVIEW
Although the third quarter of 2019 was filled with volatility and concern, most market indices produced solid returns in the fourth quarter to round out the year. Looking only at the S&P 500 Index for a moment, the third quarter’s 1.19% return was followed by an 8.53% return in the fourth quarter. New market highs were achieved, and investors celebrated a 29% return for the year while easily forgetting the -20% decline in Q4 of 2018.
Similar results were achieved in large capitalization companies, represented by the Russell 1000, as well as small and mid-sized capitalization companies represented by the Russell 2000. Volatility seemed to disappear as the markets pushed higher. The S&P 500 didn’t have more than a 1% up or down daily move since mid-October. As a result of lower volatility and bullish equity markets, U.S. fixed income assets didn’t perform quite as well in Q4 as they did in Q3 with the Bloomberg Barclays U.S. Aggregate index returning just 0.18% in Q4 vs. its 2.27% return in Q3.
As we look forward, it is wise for us to first recall the way that 2018 ended. The Federal Reserve was raising rates, there was a government shutdown, and increasing tariffs on both Chinese and U.S. products were creating a great deal of uncertainty and investor pessimism. Once again, this resulted in significant volatility and close to a bear market as the S&P 500 sank almost 20% in the fourth quarter. In contrast, 2019 came to a close with a great deal of investor optimism demonstrated by a slow and steady grind upwards that was certainly due in large part to discussions surrounding an initial U.S. – China trade deal. The trade war is far from over and remains one of the core geo-political risks on the horizon. However, the “Phase One” trade deal that was officially signed on January 15 has helped quell investor fears for the moment.
For now, markets are calmed by the belief that a “Phase Two” deal is already in the works. Hopefully that is the case and we will continue to see progress which results in the removal of tariffs on both sides, increased intellectual property protections, and net growth in U.S. exports. However, any breakdown in talks that causes a re-escalation in U.S. – China trade tensions would materially impact the markets. We are cautiously optimistic but remain aware that there are still significant differences between what each side perceives as a successful resolution.
The current “cease-fire” should help the markets for now, but a dramatic turn of events is always possible. Furthermore, we recognize that politicians are utilizing social media even more frequently to announce or at least threaten the next battle move and these posts have the tendency to move markets violently and without any warning. That said, given we are in an election year now, there is a greater likelihood that political interest is focused more on keeping markets marching higher than throwing more Twitter “grenades”.
Reversal of Federal Reserve Policy and Likelihood of Recession
After raising rates nine times between 2015 through the end of 2018, the markets rejoiced when the Federal Reserve acknowledged last year that they might have gone too far. Chairman Powell noted that crosscurrents had emerged in the economic growth outlook and reaffirmed that the Fed was monitoring the implications of these developments and would act as appropriate to sustain the economic expansion.
The Fed proceeded to lower its primary target interest rate three times throughout 2019. However, during the last meeting, it seemed clear that no further loosening of monetary policy would occur in the foreseeable future unless something new showed signs of further deterioration.
Although Fed speeches and monetary policy changes were another key factor leading to positive market returns last year, there is still a question as to whether interest rates were lowered enough, and in time, to avoid a recession. We might not know the answer to that question for a while yet, but it does appear that a recession is not as imminent as was thought during certain periods of last year.
Historically, a yield curve inversion has been a good predictor for an economic recession. Such yield curve inversions have preceded almost every recession over the past eighty years, although the inversion itself does not mean the recession is imminent. An inverted yield curve occurs when the yields on short-term fixed income securities are higher than the yields on long-term fixed income securities. This is not the normal situation because typically, investors will demand more return for a ten-year investment, for example, than the return they will demand for a three-month investment. However, when investors perceive that risk in the near term is relatively greater, they will demand more return for the short-term investment and prefer to invest in long-term investments even though they will earn less return.
In the chart above, we have plotted the yield spread, or difference in returns, between the three-month U.S. Treasury Bill and the ten-year U.S. Treasury Note. Typically, the number is positive when 10-year yields are higher than 3-month yields. As you will see, the spread became negative (or inverted) in 2000, again in 2006/2007, and finally in 2019. The dark gray bars on the chart indicate the timing of the two recessions that followed in 2001 and 2008.
We highlight that the yield curve is no longer inverted as it was for a large part of 2019. This has alleviated some of the market concern that a recession is imminent. However, a common misconception is that it is the inversion itself that signals a recession is coming. Rather, it is typically the reversal of the yield curve inversion (which has now happened) that signals a recession is coming. However, the time between when the yield curve reverses its inversion and the beginning of a recession has historically been difficult to predict.
Furthermore, there is an argument to be made that the Fed’s actions in 2019 may have pushed the likelihood of a recession further off into the distance somewhat. It is possible that they successfully engineered an extension of the current economic expansion that could still last many months if not years and that this most recent yield curve inversion might even be an outlier when compared to the past 80 years of historical precedence. It is also possible that we may even need to experience another yield curve inversion before the next recession occurs this time. However, recession is still on the minds of many as “fear of an economic decline topped the list of [U.S. Chief Executive Officers’] concerns going into 2020, according to a survey from the Conference Board, a business research group.”That said, even if a recession does lie ahead, the good news for investors is that typically during the period between a yield curve inversion and the actual economic downturn, equity markets still perform quite well.
Similar to discussions about an economic recession, when reviewing corporate earnings and what we might see in 2020, we can find reasons to be both optimistic and pessimistic at the same time.
In the chart below, we plot the year-over-year change in corporate earnings for the S&P 500 as reported by FactSet. At the time of publication, actual earnings data for Q4 of 2019 is just starting to come in. The estimate for Q4 was -1.5% at the end of 2019. If that materializes, it would mark the first time the S&P 500 Index reported four straight quarters of year-over-year earnings declines since 2015-2016. This would extend the earnings recession, typically defined as two straight quarters of declines, that began last year. Please note that an earnings recession is not the same thing as a full-blown economic recession which is defined by two successive quarters of decline in the gross domestic product or GDP (the last one of those is highlighted in dark gray below).
Still, earnings recessions are certainly not indicators of stability and progressive economic growth, so, another negative quarter would be taken poorly by investors. However, markets also recognize that there is a common pattern of earnings estimates being overly conservative. Frequently, actual earnings will come in at least 1 to 2% higher than what was originally estimated. One analyst recently noted that “in the prior 31 quarters, actual results outpaced initial forecasts by an average of 3.8%”. For that reason, although investors might be slightly concerned with current estimates and certain data coming in at this point, there are those out there predicting this quarter will actually mark the end of the 2019 earnings recession. Historical precedence suggests this could be the case. We can also look back to the 2015 – 2016 earnings recession and note that although things looked pretty gloomy back then, it was just a pause in the expansion that eventually reversed itself sending the market higher after a temporary period of volatility and fear.
It is possible that lower interest rates and reduced concern about trade wars and other geo-political risks may lead to a rebound in corporate earnings and help the U.S. continue to enjoy its longest post-war expansion for some time to come. However, there are still some cracks in the foundation. Morgan Stanley found that earnings are contracting for a growing share of S&P 500 companies. Specifically, they determined that “more than a third of the S&P 500 companies have posted a year-over-year decline in earnings in 2019 [and] the last time the share of companies posting contracting earnings was that high [was in] 2009, 2008 and 2002, all periods when the broader economy, plus the stock market, were in decline”.
Manufacturing, Services, and the Consumer
Some signs of slowing domestic demand continued through the rest of 2019. The Institute for Supply Management (ISM) reported that its manufacturing index came in much weaker than expected, falling to 47.2 in December which is the lowest reading in a decade. Note that any reading below 50 is considered a sign of contraction while any reading above 50 is considered a sign of expansion or business growth. This index is based on a survey of purchasing managers from more than 300 manufacturing firms and helps indicate the amount of demand and economic activity in U.S. factories. However, this reading, along with other signs of manufacturing weakness, is believed to be largely the result of the U.S. – China trade uncertainty. In other words, assuming terms of the Phase One deal are met over time and further positive negotiations take place, we could see a rebound in manufacturing activity as purchasing managers regain confidence.
Even so, activity in the U.S. services sector is already telling a different story. The ISM Non-Manufacturing index, which tracks the services sector, signaled a better-than-expected expansion as it climbed back up to 55 from its 2019 low of 52.6. This gave the markets continued confidence that the economic expansion is not over yet and should likely see a further boost assuming there is a continued alleviation of trade concerns.
Another indicator of economic strength is coming from the consumer. According to the Conference Board’s latest Consumer Confidence Report, U.S. consumer confidence “neared a historic high at 122 points on a scale of 54 to 138 points” in the fourth quarter of 2019. The report continued to note that “a strong labor market with low unemployment and rising wages have kept Americans spending through 2019.” Although the report was positive, it did highlight that looking forward, slowing employment growth, slowing wage growth, and potential layoffs in the manufacturing sector could result in the consumer spending less in the coming year.
So, even though my wife is already shopping for her own “flapper dress”, the 2020’s probably won’t “roar” as much as the 1920’s did. At least not to the same degree where there were nine straight years of significant economic growth and widespread prosperity before the party came to a brutal end. But that doesn’t mean we won’t see several more months or even years of expansion before another recession comes to bear.
Our base case scenario suggests that new positive economic data, easier monetary policy and less geo-political uncertainty will likely help keep the markets grinding higher for at least the first half of the year. The persistent trade tensions, slowing global growth, damage from negative interest rates and fears of imminent recession that plagued much of 2019 seem to be alleviated for the moment. U.S. consumers still have confidence, inflation is on target, the economy is still expanding, stocks continue to hit all-time highs, and unemployment is the lowest it’s been in 50 years.
However, even if the market does continue to climb, downside risk potential is probably higher now than it was in 2019. There is a clear possibility that China fails to deliver on the terms of the Phase One trade deal. Alternatively, negotiations could break down with regards to any Phase Two deal and a re-escalation of tensions could easily occur. China might leverage perceived political weakness due to the impeachment trial or upcoming elections and decide to change the rules of engagement at any time. Or, President Trump might be the source of new geo-political tensions with China or other countries as he looks to solidify his position ahead of the election.
If we assume that history will continue to repeat itself, then the fact that the 2019 yield curve inversion has reversed suggests that a recession is definitely on the horizon although it could still be more than a year off. And it is possible that the monetary policy adjustments by the Fed last year might have been enough to push it out even further.
Corporate earnings might rebound this quarter in contrast to original forecasts and the manufacturing sector might start to grow again assuming trade tensions do not resurface. But many believe that the market is currently “priced for perfection”. In other words, the market bulls are still enjoying the party, but any signs of weakness or new uncertainty might cause a violent reaction to the downside.
Here at WBI, we focus on using a portfolio management approach that works to capture as much upside as possible but is simultaneously prepared to protect investor capital when the market begins to show signs of deterioration. Our quantitative models and disciplined investment processes have helped us manage risk to capital for institutions and private investors for over 30 years. We target competitive long-term returns with substantially less risk to capital as we work to avoid catastrophic losses, because few investors can afford to wait over six years to simply break even.
We appreciate your continued faith in our approach and wish you all the best in the New Year.
-Steven Van Solkema
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