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Investment Strategy Conference - October 27, 2018

How Much Runway Is Left?


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How Much Runway Is


Left in U.S. Economy?
• Where are we in the business cycle?

• Potential landmines and opportunities in


Richard Sylla

the next recession

• The road ahead: Why Pythagoras is


wrong
Why the Business Cycle Matters
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Past performance is no guarantee of future results. Source: Bloomberg, Financial Sense Wealth Management
Why the Business Cycle Matters
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Of the Last 10 Bear Markets:


•8 were associated with recessions

•4 saw commodity spikes

•4 witnessed an aggressive Fed

•5 were associated with extreme


valuations
Source: JP Morgan Guide to the Markets, Financial Sense Wealth Management
WHEN You Buy Is Just as Important as WHAT You Buy
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Future investment
returns diminish later
in the business cycle.

This dynamic is
mitigated by shifting
away from riskier
assets like stocks and
into safer investments
like cash and bonds.

Source: Fidelity Capital Markets, Quarterly Market Update (Q3, 2018)


Investors Have Had an Emotional Ride Over the Last 20 Years
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Source: Bloomberg, Financial Sense Wealth Management, Hat tip David Rosenberg
Current Expansion Likely to Set Records
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Source: NBER, Financial Sense Wealth Management


Cycle Received a New Lease on Life Post-2016 Election
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Source: NBER, Financial Sense Wealth Management


Extended Cycle
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Source: NBER, Financial Sense Wealth Management


No Near-Term Risk of Recession
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Source: NBER, Financial Sense Wealth Management


The Extended Bull Market in Stocks
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Source: Fidelity Sector and ETF Outlook


A Look at Early Cycle Indicators
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Several key areas of the economy typically peak well before the onset of recession.
Corporate Profits Typically Peak Halfway Through the Cycle
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Source: Bloomberg, Financial Sense Wealth Management


Auto Production Typically Peaks 2/3 Through the Cycle
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Source: Bloomberg, Financial Sense Wealth Management


A Look at Early Cycle Indicators - Housing
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Source: Bloomberg, Financial Sense Wealth Management


Home Sales Appear to Have Peaked
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Source: Bloomberg, Financial Sense Wealth Management


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Rising Mortgage Rates Likely to Continue Weighing on Home Sales

Source: Bloomberg, Financial Sense Wealth Management


Housing Affordability Becoming an Issue Again
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Source: Bloomberg, Financial Sense Wealth Management


Housing Affordability Becoming an Issue Again
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Source: Bloomberg, Financial Sense Wealth Management


Another Hallmark of Late Cycles – Elevated Sentiment
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Source: YouTube.com
Another Hallmark of Late Cycles – Elevated Sentiment 22

Source: Ispot.Tv
The Two Most Powerful Investor Emotions
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FEAR

GREED
Source: Source: Kevin Kallaugher, www.kaltoons.com (used with permission)
Another Hallmark of Late Cycles – Elevated Sentiment
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The Two Most Powerful Investor Emotions – Fear & Greed


Conference Board’s Consumer Confidence Index
S&P 500 Price-to-Sales Ratio

Past performance is no guarantee of future results. Source: Bloomberg, Financial Sense Wealth Management
Another Hallmark of Late Cycles – Elevated Sentiment
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Source: Bloomberg, Financial Sense Wealth Management, Hat tip David Rosenberg
While Recession Risk Remains Low, It’s Rising
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Source: Bloomberg, Financial Sense Wealth Management


Billionaire Ray Dalio Sees a Potential Recession
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Dalio warns that investors should be


"more defensive" in the stock market
and "as time progresses" he sees
risks increasing.

The "upside looks limited" because


a lot of cash on the sidelines has
been put to work and the benefits of
the corporate tax cuts are "behind
us.”

Source: CNBC
Landmines & Opportunity in the Next Recession
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“The optimist sees opportunity in every danger, the pessimist sees danger in
every opportunity.” - Winston Churchill

“When written in Chinese, the word ‘crisis’ is composed of two characters.


One represents danger and the other represents opportunity.” - John F.
Kennedy

“Good luck is when opportunity meets preparation, while bad luck is when
lack of preparation meets reality.” - Eliyahu Goldratt
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Never Was So Much Owed by So Many to So Few

Only 2% of the entire S&P


500 holdings are
responsible for 66% of its
bull market return!

Source: Bloomberg, Financial Sense Wealth Management


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What Happens When the ETF Movie Plays in Reverse?

When you sell $100 of an S&P 500


ETF, $22.9 goes toward selling 10
companies while the remaining
$77.10 goes to sell the other 490.

Of your $100 sale, nearly 23% goes


into only 2% of the total S&P 500
holdings.

Source: Bloomberg, Financial Sense Wealth Management


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Blue Chip Dividend Stock Opportunities in the Next Bear Market

Some of the largest


U.S. companies may
get hit the hardest as
ETF providers face
liquidations.

Dividend yields spike


during bear markets,
creating opportunity
for income-focused
investors.

Source: Bloomberg, Financial Sense Wealth Management


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Another Potential Landmine Ahead: U.S. Corporate Debt

Source: Bloomberg, Financial Sense Wealth Management


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The Corporate Bond Market Is Walking a Tight Rope

Source: Bloomberg, Financial Sense Wealth Management

Source: David Rosenberg, “Charts with Dave” (09/19/2018), Used with Permission
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The ETF Bubble Is Not Isolated Only to Stocks

iShares Investment Grade U.S. Corp. Bond ETF (LQD) ~ $34B in assets

Source: Bloomberg, Financial Sense Wealth Management (Data as of 09.11.18) Source: Bloomberg, Financial Sense Wealth Management (Data as of 09.11.18)
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Lack of Depth in the Corporate Bond Market Is Concerning

More active holders like


mutual funds and
foreign sources account
for close to 50%
ownership.

According to Citi, close


to 80% of net buying in
2017 came from foreign
sources and mutual
funds.
Will U.S. Corporations Face What Homeowners Faced in the Last Cycle?
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Financial Sense – “Credit Erosion: The


Worst Is Yet to Come” (08/29/2007)
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Market Events + Low Liquidity ≠ Stability

Source: Bloomberg, Financial Sense Wealth Management


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Market Events + Low Liquidity ≠ Stability

Source: Bloomberg, Financial Sense Wealth Management


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“There’s always a
bull market
somewhere”
~Jim Cramer
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Crisis = Danger + Opportunity

Source: Bloomberg, Financial Sense Wealth Management


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“Good Luck Is When Opportunity Meets Preparation…”

Source: Bloomberg, Financial Sense Wealth Management


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“Good Luck is When Opportunity Meets Preparation…”

Source: Bloomberg, Financial Sense Wealth Management


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The Road Ahead


Why Pythagoras Is Wrong
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Fiscal & Monetary Authorities' Diminished Capacity

Image Source: Shutterstock


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Fiscal & Monetary Authorities' Diminished Capacity

Source: Bloomberg, Financial Sense Wealth Management Source: Bloomberg, Financial Sense Wealth Management

In response to the last three recessions, While the Federal budget deficit expands
we’ve seen the Fed slash interest rates just over 6% of GDP.
nearly 6%...
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A Return to Zero Interest Rates in Our Future?

%
The median Fed forecast for the terminal rate this cycle is 3.375%
as of the 09/26/2018 FOMC meeting.

This is a problem given the average Fed rate cut response to


recessions for the last three cycles has been 5.8%!

3.375% - 5.8 = -2.425%


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Implied Rates Went Negative With Money Printing

Source: Bloomberg, Financial Sense Wealth Management


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The Fed Is Already Talking About a Return to Zero Interest Rates


“The staff’s analysis indicated that under various
policy rules, including those prescribing aggressive
reductions in the federal funds rate in response to
adverse economic shocks, there was a meaningful risk
that the Effective Lower Bound (ELB) could bind
sometime during the next decade.

…Participants saw monetary policy as having less


scope than in the past to reduce the federal funds rate
in response to negative shocks. Accordingly, in their
view, spells at the ELB could become more frequent
and protracted than in the past, consistent with the
staff’s analysis.”
Source: Minutes of the FOMC (July 31 – August 1, 2018), hat tip David Rosenberg
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What About The Fiscal Response?

Source: Fidelity Capital Markets, Quarterly Market Update (Q3, 2018)


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DDD = Double Digit Deficits

%
The average budget deficit-to-GDP ratio prior to the last six
recessions was -0.60%. We are likely to enter the next recession
with a -5% budget deficit!

We’ve seen the budget deficit widen by 6.1% percentage points,


implying triple digit budget deficits may be in our future.

-5% - 6.1% = -11.1%


Forewarned Is Forearmed
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How many people who retired in


’99-’00 had to go back to work
because of the dotcom bust?

How many families wished their


advisor told them NOT to buy a
second home in ’05-’06?

How many people would have


appreciated their advisor telling
them to invest in real estate in
2010-2012?

How many of today’s retirees


wish they could have locked in
double-digit bond yields as in
the early 1980s?

What should today’s advisors be


Source: Bloomberg, Financial Sense Wealth Management
telling their clients?
Forewarned Is Forearmed
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Rarely, over the last


century, have we seen both
bond and stock valuations
near extremes at the same
time.

Source: Bloomberg, Financial Sense Wealth Management


Forewarned Is Forearmed
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Find me a baby boomer who can afford to


lose two decades of return

Source: Doug Short, Advisors Perspective


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“Policymakers have front-loaded returns, leading to weak forward returns” – Barry Bannister

This forecast may not develop as expected


Source: Barry Bannister, Stifel Nicolaus – Macro & Portfolio Strategy (09.05.2018)
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“History doesn’t repeat itself but if often rhymes.” – Mark Twain

Source: Barry Bannister, Stifel Nicolaus – Macro & Portfolio Strategy (09.05.2018)
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How to Not Only Survive but Thrive in the Next Decade

Focus on Income

Seek Value Opportunities

Focus on Future Growth Themes

Row, Not Sail

Source: Barry Bannister, Stifel Nicolaus – Macro & Portfolio Strategy (09.05.2018)
Focus on Income
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Allocate to high-
dividend paying stocks
in the next downturn.

Source: Bloomberg, Financial Sense Wealth Management

Acquire investment grade


and high yield corporate
bonds after yields spike. Source: Bloomberg, Financial Sense Wealth Management
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Seek Value Where & When It Can Be Found

Percentiles

Source: Research Affiliates Source: Research Affiliates


This forecast may not develop as predicted or expected.
Focus on Future Growth Themes
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Emerging markets will


be the driving force of
global growth over
the coming decades.

Future investor
capital will likely be
deployed in these
growing regions in
the decade ahead.

Source: Fidelity Capital Markets, Quarterly Market Update (Q3, 2018)


This forecast may not develop as expected.
Focus on Future Growth Themes
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Source: Kleiner Perkins, “Internet Trends 2018”


Source: Rick Rieder, BlackRock (01.14.16)
Focus on Future Growth Themes
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Source: Kleiner Perkins, “Internet Trends 2018” Source: Kleiner Perkins, “Internet Trends 2018” Source: Kleiner Perkins, “Internet Trends 2018”
Focus on Future Growth Themes
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Summary and Conclusion

1. Where are we in the business cycle?

2. Potential landmines and opportunities in


the next recession

3. The road ahead: Why Pythagoras is


wrong
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Lunch