Investing from the end of the diving board

When I wrote a “Return to Volatility” last February, there was no way of knowing when the tipping point would occur to bring back volatility normally associated with risk assets, or how much volatility would occur when the dam broke. Obviously, the end of 2018 will be remembered as the return of volatility.

Our argument posited in February 2018 was simple:

1. The S&P was holding a high P/E ratio which was sustainable in a low interest rate environment with robust earnings growth.

2. Since the Fed was forecasting raising rates, to argue the P/E ratio would return to its average seems more like common sense than a complex argument.

3. By the end of 2018 the S&P was much closer to its average.

In our view, the market volatility experienced at year-end of 2018 will likely continue into 2019. The underlying tenet for continued volatility in 2019 might be the market is forecasting a recession.

In our view the “red flags” indicating a potential recession on the horizon include:

1. QT, or quantitative tightening (unwinding the Fed balance sheet), slowing earnings growth, P/E ratios, Fed rate hikes, and the 5-year treasury yield verses the Fed target rate (see chart on last page).

2. Low interest rates have allowed for a higher than normal P/E ratio on the S&P 500 or the market. As the Fed has been on an interest rate hike cycle, it’s likely the P/E ratio would compress. The hope of course, is that the compression would be smooth.

3. In 2018 the Fed continued with their rate hikes along the dot plot graph as expected. With the start of 2018 having a strong gross-domestic-product (GDP), tightening labor market, ISM well above 50, and oil over $70 a barrel and possibly going higher, normalizing rates made sense.

4. However, at the end of 2018 things changed: oil prices collapsed to under $50, the stock market volatility spiked, and treasury yields compressed. It takes imagination to look around the corner to see what these are forecasting; probably more of an art than a science.

Just like in life, one is always in a tension between freedom and necessity, so too economic policy, which is in a tension between too much liquidity and not enough. As too much liquidity can lead to asset bubbles, so too not enough liquidity can lead to a recession. The ramifications of Quantitative Easing and extremely low interest rates will be debated for years to come. Some argue the QE, which became known as money printing used to survive an economic catastrophe, is a Faustian deal. Once you make a deal the horned devil, then good luck getting away. Some might call this the enhanced Fed Put: rate cuts with QE.

The new Fed Chair, Jerome Powell, has the impossible task of knowing just when and how to unwind QE called Quantitative Tightening while normalizing rates. As I mentioned, it is possible there is no getting out of the deal; this implies a return of quantitative easing (QE 4) and rate cuts in the future! The unintended consequences get kicked down the road a little further, hopefully.

In short, it seems the Fed makes their decisions based on economic data which has taken place already.

Where does this leave us as investors? A compression of P/E ratios certainly has begun and will likely continue. Earlier I argued the market would return to its average P/E from its unusually high P/E ratio. Given all the headwinds, it’s easy to imagine a market that finds a P/E ratio in a range of 15.5 to 12.5. Let me explain:

The Tipping Points we vigilantly watch:

1. Credit down grades

2. Slower earnings growth

3. Higher cost of capital

4. Negative investor sentiment

5. Higher interest rates

6. Unresolved tariff rhetoric

7. Slowing gross-domestic-product both domestic and global

8. Government shut down

9. National debt reaching new highs

10. Central bank deleveraging: Quantitative Tightening

All these headwinds may leave us with a bifurcated market where an index might disappoint, but owning the right stock prove to be the most rewarding. In short, I believe it is a stock pickers market. Further, if you are a bull and want to buy and hold stocks or exchange-traded-funds (ETF’s), then you may be disappointed by the short-term results. Likewise, if you are a bond bull and expect a deep recession to find price appreciation due to falling interest rates, again you might be disappointed. We at Fulcrum Wealth Advisors expect we might all experience secular stagflation rather than massive deflation as we saw in 08-09.

On the one hand, academics raise rates based on historical data or current economic c​onditions. On the other hand, to have the imagination to see how things will look in the future is much less scientific and more difficult to be taken seriously; as a hard core academic-give me the facts!

Lastly, a disconcerting chart of the 5-year treasury yield verses the Fed target rate is shown below. Going back to the 60s shows that if the Fed Target rate goes above the 5-year treasury yield and stays there, one year later a recession seems to follow. I am not saying a recession is a foregone conclusion; I am arguing the probability of a recession increases with each new Fed rate hike.

It looks prudent to de-risk portfolios slowly in case a storm does come later this year or early in 2020.

In summary:

Find companies with strong balance sheets, increase quality and duration of your bonds, and increase cash. It looks like passive investing is passé for the foreseeable future. If I am right, there might be some great buys in 18 months in the risk asset arena; so, let’s make our shopping list and be patient.

Chart below: Upper red line is the 5 year treasury rate. The bottom grey line is the Fed target rate. The red columns show past recessions.

Source: Bloomberg