Our Risk Odometer moved down one notch from +5, where it had been since March, to +4 for June. This small change in the overall score has caused us to also change our Outlook one notch lower, from “Positive” to “Cautiously Positive”. Our new outlook means we are still overall positive on the stock market, but with a small amount of caution.
The cause of the small change in our Risk Odometer and Current Outlook is due to deteriorating technical price action, uncertainty around the ongoing trade war with China and an inverted yield curve, a rare occurrence when longer-term interest rates are less than short-term interest rates.
The ongoing trade war between the US and China is likely the biggest culprit when it comes to the deteriorating price action of the stock market last month. Earlier in the year, it looked like there would be a quick resolution. Last month things changed when negotiations broke down, and now many are calling for a protracted period of tariffs. Both sides appear to be digging in their heels and playing the blame game. We did not get into the current situation overnight and we will likely not get out of it overnight.
The trade war uncertainty has not created a dramatic change in economic data yet. Economic activity was slowing going into the breakdown in negotiations last month, but we will not know the impact it will have for likely a few quarters as measurable data operates with a lag. Because of this, news headlines will be the primary near-term driver. Short-term volatility should remain elevated if the negotiations remain unsettled.
The other major area of concern we have is the recent inversion of the yield curve. This is a rare occurrence when long-term interest rates (10 US Treasury) is lower than short-term interest rates (3-month Treasury bills). An inverted yield curve in the US has happened five times since the 1970’s, with each time eventually leading to a recession between 10-24 months after the inversion (https://awealthofcommonsense.com/2018/07/arguing-with-the-yield-curve/). The stock market peaked anywhere from 2-23 months after the inversion and fell between 17% - 57% from its peak.
The challenge of using an inverted yield curve as a timing mechanism is the stock market can continue to rise after the inversion, which is what has historically happened. We also do not know if the signal will work this time (5 occurrences is not enough data to be considered statistically significant). We prefer to look for more timely warning signals and confirm them with additional warning signs. Nevertheless, the inverted yield curve is five-for-five in predicting an upcoming recession, and we believe this warrants a bit of caution in our opinion, hence the small downgrade in our Outlook. If additional warning signals confirm (especially earnings and economic indicators) it would raise more concern and likely cause a further downgrade in our Outlook.
Things can quickly change so it is important to stay abreast of changing developments. Information travels fast and the markets move at historically unprecedented speeds. We believe it is important for investors to monitor for changing conditions and we will continue to communicate these developments to our readers.
As always, we continue to believe our Risk Odometer provides guidance in making better investment decisions because it keeps us objective and disciplined. We use this methodology and advise our clients to do the same. Emotions are our enemies in investing.
It is important to understand that our Risk Odometer is not designed to anticipate small to medium corrections, typically those in the 5-15% range. Instead, it monitors for conditions which have typically preceded larger corrections. We believe trying to anticipate small to medium corrections sounds attractive but more often results in lost opportunity than savings.
The Equity Market Risk Odometer is our guide for judging risk in the equity market. It is used as a guide for investment decisions in The Core Equity Strategy. It is composed of various indicators based on leading economic indicators, earnings, technical price action, breadth, volatility, sentiment and reportable positions from the Commodities Futures Trading Commission. Its score can range from +7 to -7. Readings greater than 1 are positive and readings less than or equal to zero are negative.
Disclosures
This information does not have regard to the specific investment objectives, financial situation and the needs of any specific person who may view this information. Statements, opinions and forecasts made represent a particular observation and assessment of the market environment at a specific point in time and are not intended to be a forecast of future events or a guarantee of future results. Statements regarding future prospects may not be realized and may differ materially from actual events or results. Past performance is not indicative of future performance.
Each investment type has different investment risk characteristics. Risk is the variability of investment returns.
An investment in a money market fund is not insured or guaranteed and seeks to preserve the value of your investment at $1.00 per share. It is possible to lose money by investing in a money market fund.
U.S. Treasury bonds are guaranteed as to the timely payment of principal and interest.
TIPS offer a lower current return to compensate for the inflation protection. TIPS are tax inefficient and should belong in tax-deferred accounts.
Tax-exempt municipal bonds offer the opportunity to maximize your after-tax return consistent with the amount of risk you're willing to accept. Municipal bonds offer a higher net yield to investors in higher tax brackets. Municipal bonds may be subject to AMT.
Corporate bonds are considered higher risk than government bonds. Corporate bonds have higher interest rates than government bonds. The higher a company's perceived credit quality, the easier it becomes to issue debt. High yield bonds experience higher volatility and increased credit risk when compared to other fixed income investments.
Bonds have fixed principal value and yield if held to maturity. Prices of fixed-income securities may fluctuate due to interest rate changes. Investors may lose money if bonds are sold before maturity.
REITs do not necessarily increase and decrease in value along with the broader market. However, they pay yields in the form of dividends no matter how the shares perform based on different criteria than stocks.
Stocks can have fluctuating principal and returns based on changing market conditions. The prices of small company stocks generally are more volatile than those of large company stocks. Growth stocks are more volatile than value stocks.
International investing involves special risks not found in domestic investing, including increased political, social and economic instability. Investing in emerging markets can be riskier than investing in well-established foreign markets.
The price of physical materials is subject to supply and demand.
It is not possible to invest directly in any index. The performance of an unmanaged index is not indicative of the performance of any particular investment. The performance of an index assumes no transaction costs, taxes, management fees or other expenses. Past performance does not guarantee future results.
Sector investing that concentrate its investments in one region or industry may carry greater risk than more broadly diversified investments.
There is no assurance that by assuming more risk, you are guaranteed to achieve better results.
Historical performance relative to risk and return points to, but does not guarantee, the same relationship for future performance.
Diversification through an asset allocation plan is a useful technique that can reduce overall portfolio risk and volatility. Diversification neither ensures against a profit nor protects against a loss. Diversification offers returns which are not directly related over time and is intended for the structure of a whole portfolio to reduce the risk inherent in a particular security.
Data Source: YCharts
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Michael Fickell is an investment advisor representative of FC Wealth Solutions
Securities and investment advisory services offered through FC Wealth Solutions, a registered investment advisor.
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