Thoughts on the Market

August 14, 2019

Since the S&P 500 Index peaked on July 26 at $3025, it has fallen 6% to today’s closing price of $2840, highlighted by extreme down moves on August 5 (-3.0%) and today (-2.9%). Note that the S&P 500 is still doing well year-to-date up almost 15%. Market sentiment the past few years has shifted multiple times from one extreme to the other. Either everything is great and concerns are minimal or brushed aside (see January 2018, September 2018 and July 2019 for recent examples), or everything is bad and there is tons to worry about (see February 2018, December 2018 and today for recent examples).

Likewise, the same worries have been recycled over and over in different forms. Here are the current iterations:

Global Growth Slowdown: Recent global economic data has come in weaker than expected and points to slowing growth in China and the US and minimal growth elsewhere. Germany may even be in a technical recession right now (albeit a very mild one). According to FactSet data, almost 40% of revenue for S&P 500 companies comes from outside of the US, so there is no hiding from global economic issues even if the US is still doing fairly well. This is the market’s biggest focus and the other concerns listed below are all related to this.

US Treasury Yield Curve: Normally, investors are compensated with higher yields for the increased interest rate risk and uncertainty that comes with owning long-maturity bonds versus short-maturity bonds. Currently, this is not the case in the US Treasury market. Short-term yields are higher than long-term yields, a situation known as an inverted yield curve. While the 3-month/10-year yields first inverted in March, today was the first time the 2-year/10-year yields inverted, so we are seeing a slew of fresh headlines on the subject. Historically, an inverted Treasury yield curve has been a fairly reliable prediction signal for a recession occurring within a few years. It is also possible that an inverted yield curve can help cause a recession by disrupting the traditional banking strategy of borrowing with cheap short-term funds and lending long term. The weak recent economic data and numerous other uncertainties discussed below are the primary driver for the inverted yield curve, but the large interventions of global central banks to hold down long-term bond yields is likely also playing a role. We have examined trading strategies based on yield curve inversions, and like all the other market timing strategies we have tested, they fail to beat a buy and hold strategy when examined over a long time period. There is simply too much uncertainty and no consistently reliable signal about when a major downturn will occur and when is the right moment to reinvest.

Global Trade War: Regardless of your politics or the long-term strategic justification for tariffs/trade wars, there is little doubt that reducing global trade has direct negative short-term economic implications. In addition and perhaps even more importantly, the uncertainty created by global trade wars holds back business decision making and investment. Most firms in the S&P 500 are global companies, and large-scale decisions about where to deploy capital are more difficult to make when the international rules are constantly shifting. While the US vs. China is the largest ongoing trade war, other countries’ disputes such as Japan vs. South Korea are also impacting global growth. Also note that from the market’s perspective, the most important outcome of the recent protests in Hong Kong will be their impact on the US/China trade war if China feels the need to forcefully intervene.

Europe: The odds of a “Hard Brexit” (Britain leaving the EU with no deal in place) have been rising since Boris Johnson became Prime Minister in July, and the current decision date for Brexit is 10/31/19. Elsewhere, the Italian government may need to hold elections once again following recent political turmoil. Like the trade wars, both of these issues are causing massive business uncertainty in Europe and hampering its already weak economic growth.
Bottom Line:

A recession will occur at some point. With high current debt levels and governments/central banks not having as much firepower to combat a slowdown as in past recessions, it could be significant. On the other hand, many positive steps have been taken to shore up the banking/financial system following 2008, so a repeat of that crisis is very unlikely. We do not have a crystal ball on when a recession will occur. We could be seeing its beginnings now or it could start five years from now. We had a very similar situation in late 2015/early 2016 when multiple signs pointed to a near-term global recession, but it did not occur and the S&P 500 Total Return Index is up over 65% since. As mentioned above, there are several sources of uncertainty that, if cleared up favorably, could spark a rebound in global economic activity. We do not know how these situations will unfold.

What we do know is that long-term investors have historically been rewarded for the risk of investing in equities more than any other asset class. We believe that the best strategy is to invest for the long term at the correct target risk profile using a properly diversified portfolio of well-researched investments. The October-December 2018 selloff provided a scenario to evaluate your risk tolerance. Were you able to maintain your target risk level and stay invested? If so, you were rewarded. At some point, we will see another selloff of that magnitude or higher. Despite knowing this, we still believe that equities will provide the best relative return of any major asset class over the next 20 years. If you try to time the market by getting out and back in, our internal studies and those by numerous academics show that you have to get lucky to be successful. Future events are uncertain and while we acknowledge known market risks and specifically limit client exposures accordingly, we are not in the business of guessing how macro events will play out.

We do not panic when we see high volatility. This is the time to stay the course and focus on executing our clients’ long-term investment strategies.

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