These are heady times for stock investors. Today's one-year election anniversary marks a robust 28.5% gain for the Dow Jones Industrial Average over that time. Even more remarkable, SMI's Sector Rotation is up a stunning 85.5% in that time!
When investors are enjoying these types of gains, it's tough for them to listen to the voice of reason. But the unfortunate reality of investing is that big gains don't reduce future risk...they increase it. If stocks were risky a year ago (and they were), they are that much more so after another year of growing toward the sky.
SMI readers have heard our many cautions regarding market risk in the current environment, so I'll keep this brief(er) by limiting myself to just two thoughts, neither of which I remember discussing at length before.
First, the U.S. has experienced at least one economic recession in every decade since 1850. Some decades had more than one, but every decade has had at least one. So far, the 2010-2019 decade is the lone exception. If we make it through the next two years without a recession, it will be unique in the past 170 years.
Keep in mind that the U.S. stock market typically peaks roughly one year before economic recessions begin. By definition, then, if we see a recession within the next two years, that would imply a stock market peak sometime in the next year.
That said, there are no particularly worrisome signs of recession on the horizon. Markets love political gridlock and expanding earnings, both of which are present right now — largely explaining the big gains of the past year. These gains could well continue. For that matter, there's nothing magical about the "recession every decade" idea other than the fact that it shows downturns happen with a certain regularity which we've been able to push off lately. The current economic expansion is the third longest on record; if it lasts through the end of 2019 it will become the longest. It could happen. But it might not be smart to expect it to.
Second, we've emphasized that the change in central bank policy from accommodation to tightening that began in earnest last month when the U.S. Fed started intentionally shrinking its balance sheet is a big deal. Not so much in its immediate impact, which is starting off quite modest (and is more than offset by the continuing stimulus from the European Central Bank and Bank of Japan). But as with QE on the expansion side, the Fed's move has signalled the other central banks to start discussing their own exit strategies from this decade of propping up the economy and financial markets with central bank largesse. If all goes as these central banks have currently outlined, roughly a year from now the world will be facing a net tightening of central bank capital for the first time since the financial crisis.
It's unfortunate that the numbers are so big that they're barely relatable, but the net impact of this shift is that the financial markets will go from half a trillion dollars worth of stimulus in 2016 to a trillion dollars of tightening in 2018. That's a $1.5 trillion dollar swing. That's roughly 2% of world GDP. Or put differently, that $1.5 trillion is roughly the size of Canada's GDP, which is the 10th largest in the world. Just as that money materialized out of nothing to buy bonds through QE, it's scheduled to evaporate, pulling that capital out of the world's system. It would be noticed if Canada just didn't show up economically all of a sudden. I expect this central bank policy shift will be noticed as well.
Along that same line, here's today's shocking note of the day, courtesy of Baird Advisors Mary Ellen Stanek: "Collectively, the Fed, European Central Bank and Bank of Japan own one-third of the global bond market." Astonishing.
Now that I've gone all Debby-Downer on you, what's the point of all this? Am I telling you to sell and run for the hills? Of course not.
However, an important fact of investing is that when prospective returns are high, that's when you want to be maximally aggressive. And when prospective returns are low, that's the time to get more conservative. We know when these times are (roughly) based on valuations, which have a fantastic track record of projecting long-term future returns. Valuation is a lousy short-term timing signal. But it's great at telling us what to expect over the next 7-12 years. And with current valuations ranging somewhere between "worst ever" and "only worse before the 1929 and 2000 market peaks," we know total returns over the next decade aren't going to be very good. Usually that means a significant bear market that knocks those valuations down to a more reasonable level.
The message here isn't to sell and run away. It's that prospective returns are low and risk is high, so keep risk front-of-mind as these fantastic returns continue to roll in. That's hard to do when Sector Rotation is up another 5.6% already in November, after skyrocketing 16.1% in October. But it's a necessary part of being a successful long-term investor.
At a minimum, applying this information means sticking to your long-term plan. Just this simple step will keep you ahead of most investors, who unthinkingly get more aggressive as risk increases late in a bull market. Those high returns entice them to allocate more and more to riskier stocks/strategies right up until the moment the market trap door swings open beneath them. At a minimum, keep yourself from following that path. Stick to your long-term plan and reallocate back to your baseline allocations at year-end. To be blunt, this is not the time to be increasing your long-term allocation to Sector Rotation!
If you want to be more proactive than that, the approach I've long advocated is to gradually shift money away from more aggressive strategies (such as Sector Rotation) as bull markets get over-extended, and re-allocate it to conservative strategies (like Dynamic Asset Allocation) that will hold up better in the next downturn. Full disclosure: this process stinks as you're doing it, because you're never going to get the timing perfect, which means kicking yourself month by month as the high returns continue — until the market rolls over. Then it's sweet relief. Naturally, there will come a point in the next bear market when the losses have deepened and accelerated to the point that you want to throw up — that's your cue to reverse the process and start gradually re-allocating more aggressively again. [To be clear, this entire preceding paragraph is optional — you don't have to do this to be successful.]
Always be aware of your surroundings
In closing, it's worth noting that we're working every day at SMI to figure out ways to protect your capital between now and the next market opportunity. DAA was a huge step in that direction. We continue to look for more breakthroughs along those lines. As we do, be mindful of where we are in this bull/bear market cycle. And make sure your current portfolio is such that if a major shift were to occur that you could handle it without it being devastating to your long-term financial progress.