By Mitchell Anthony
The equity markets have continued the correction that began in October as fear of the unknown have motivated equity holders to move to cash and give up their equity positions for minimal returns in cash. The unknown involves all of the disconnect that seems rampant throughout America and the globe. Is the Federal Reserve disconnected from the fragility of our economy and is he recklessly raising rates? Is a highly divided Congress disconnected from the impact their actions may have on consumer confidence. Is the White House disconnected from how much change America can embrace without breaking consumer confidence? Are investors disconnected from the fundamentals that drive our economy and are they recklessly selling equities despite a strong forecast of steady continued growth from our Central Bank? Last and most importantly is Mitch disconnected from the fundamentals that are driving our markets and our economy?
It would seem that the traders and investors that are leaving our equity market are doing so in hopes of trading around this volatility with the intent to reinstate their equity positions when the fear has left the markets. While there is some who believe this cycle is over there is a tremendous majority who believe this economic cycle will continue, but cannot explain the volatility and simply want the comfort of cash at this point and blindly think they will be able to reestablish their positions without being whipsawed by continued volatility or leave most of the expected rebound on the table.
I have only reduced our equity positions modestly since October moving approximate 15% of our portfolios to cash. In hindsight this looks like a mistake. I have not reduced our equity position substantially because I do not believe there to be value in the other asset classes at this time. Bonds offer substantial risk as the Fed continues on his path of raising rates. Real estate is more overvalued than the equity markets, and commodities have little upside with inflation almost entirely bottled up. With cash returns still near zero this asset class is only interesting as a place to rest while I would attempt to trade around this volatility.
I have found it very difficult to trade around volatility in the past and have found myself whipsawed or under-invested when rebounds in markets occur. After the markets dropped 10% in 2014 I attempted to trade around the volatility and reduced equities by 25%. The storm clouds for the economy cleared a few months later and I moved back into the equity markets and left 7% or more on the table with this trade. This same event repeated itself in 2015. I under-performed the S&P 500 in 2014 and 15 because of these trades to cash. I did this because I was fearful I was disconnected from what was driving the markets lower and threw in the towel to some degree.
Given this I would only move to cash again for the same reasons (as a decision to throw in the towel on my understanding of what is occurring today in the markets). I’m not at this position and believe myself to be very connected to what is driving this selloff. Our portfolios have had tremendous returns for the last several years and most of my client’s portfolios have doubled in value throughout this great bull market for equities, real estate, and distressed debt. I believe substantial appreciation in equities lies ahead and believe the 15 to 20% decline from the highs that we have suffered will only be seen as a big bump when we look back at the end of 2019. I have had a handful of clients who have directed me to attempt to trade around this volatility and take big positions in cash. If you feel this is appropriate for you then please contact me. Historically these types of events have not played out well for most of my clients who direct me to do this type of trading. I will leave equities when I have conviction that the cycle for equities is over. This occurred in 1986, 1999, and 2006. I suspect it will occur again during the second term for Trump as I believe he will then push hard for substantial change and not worry about reelection and likely end the cycle if he is not successful. Trump is well aware of his reelection chances and how heavily they depend upon him not destroying consumer confidence and keeping this economy on a path of growth.
Let me elaborate on what I believe lies ahead for inflation, central bank policy, and economic growth, and as a result the equity market.
The Inflationary environment is quite benign and despite a robust economy and very accommodating central bank policy inflation has not emerged because of secular dis-inflationary trends that are in place, combined with rationality within our banking system. I have searched for signs of a credit problem in the banks or in our financial system and have found very little to build a forecast of a banking crisis on the horizon. The only interesting information was the discovery of about $1 trillion of shadow lending that has been provided by hedge funds and private equity who are making generous loans to small businesses. The size of the shadow lending is simply not large enough to be a problem at this point and the private equity managers who have created these products are more involved with the quality of their lending than banks were in our last credit cycle that was horrific.
The talk of Chairman Powell has shaken investors and traders over the last week and has added fuel to the fire that has pushed our equity markets lower. Powell made the mistake of looking disconnected from the weakness in the globe and in domestic housing. The chairman spoke far too much of his teams efforts in reviewing backward looking data. The actions of what Powell has done thus far with interest rates are not problematic and perceptively we conclude that he is in touch with what is on the horizon and will pause appropriately now with neutral interest rates. Speculators and traders have talked far too much about their worries that Powell may simply be disconnected and will recklessly keep raising rates and end this cycle prematurely. This is simply unlikely and traders, investors, and Trump are just far too nervous about this unlikely possibility. I conclude that the Fed will continue to be the friend of the equity market.
The outlook for economic growth is the most difficult of the forecasts. It is hard to forecast a recession when our economy is currently growing at above trend with unemployment still falling. The backbone of a strong cycle for growth is consumption which is driven by consumer confidence. Consumer confidence is close to all-time highs despite a highly divided America. America is probably the most divided it has been since the 1930’s, just prior to the war that united America and the election of Roosevelt.
Thus far this divide has not affected consumer confidence and liberals Democrats and Republicans have grown optimistic as this cycle has matured. Based upon historical data I would’ve never have predicted strong consumer confidence during a time of such division in America. However the division in America has come alongside a strong theme of self interest. The liberal Democrats routinely attack their president with intentions of destroying him and impeaching him, while at the same time spend record amounts of money on cars, food, entertainment, and durable goods. They don’t seem to care about the divide and only are interested in their own agenda. I believe this is the one million-dollar question that needs to be addressed when we assess whether this cycle is in jeopardy currently. Will this divide in America destroy consumer confidence and cause consumption to freeze and a horrible recession to unfold? Portfolio managers and market strategists have spent the last few days and weeks giving serious consideration to this question. Trump wants to deliver on his campaign promise of building a wall and has dug in his heels on this issue. Politicians have decided to shut down the government as they embrace this political fight. $8 billion for a wall is a very modest sum from a $15 trillion economy. However it seems to be the principal that is important here to both sides. Clearly this shutdown of the government will not put our economy in recession. Trump’s negotiations with the Chinese will not put our economy into recession. Trump’s lack of respect from the people who surround him and his associated anger will not put our economy in recession. The consumer will put our economy in recession if these events or any combination of them drive the consumer to halt spending and freeze. Americans seem to have grown accustomed to carrying on their lives despite political battles that are regularly waged in Washington. It seems unlikely that these heightened political battles will have any different impact on the consumer. However we will watch this situation carefully and vigilantly.
In any event we are very concerned about preserving the substantial growth that we have had on our client portfolios over the last five years and are weighing preserving that against giving up the opportunities for great returns in 2019 as the sky clears as we project.
Thus far I have taken about a 15% cash position during this correction. I plan to move another 10% to cash this week to enable these portfolios to endure what further volatility might lie ahead and at the same time recognize the likely untimeliness of this decision. There is nothing on the immediate horizon politically that would signal a turn back upward for the financial markets. The shutdown will likely continue for a bit but will undoubtedly clear before much damage has been done. It would seem like most capitulation has already occurred but I said that when the markets were 5% higher as well. Market corrections that are mostly fear driven generally end when the flow of bad news has run its course. Generally good news is not needed to turn markets around but just a decline in the flow of bad news. This is a reason to be optimistic.
We remain focused on the daily data affecting the economy and the valuations in the markets.
Merry Christmas and Happy Holidays!