Once again, our Outlook and Risk Odometer reading remained unchanged for August at “Cautiously Positive” and +4. While on the surface nothing has changed, under the hood it has. The overall score remains unchanged, but many indicators are deteriorating, meaning things could change quickly.
Under the hood, many of our indicators are positive but deteriorating, which means they could quickly change. We expressed a similar “positive but deteriorating” warning in our December 2018 Risk Odometer Blog (http://www.fcwealthsolutions.com/resources/risk-odometer-blog/item/2018-december-risk-odometer.html). That month we had a “Cautiously Positive” Outlook but warned of many indicators sitting near inflection points and could quickly change. The S&P 500 dropped almost 10% that month. We are not predicting the same, but we are particularly sensitive in the current environment.
The global slowdown and China trade war is taking its toll on the economy. The Economic Indicators signal remains positive but has deteriorated and could turn negative if economic conditions continue to deteriorate. Earnings are also still on a positive signal but dramatically slowing. This theme of our Risk Odometer displaying positive but deteriorating indicators is similar to our overall assessment of the economy.
The major market development over the past month has been the inversion of the yield curve. We have written about this on several previous Risk Odometer blogs. It is the rare occurrence when long-term yields on government bonds is lower than yields on short-term bonds. This does not happen often and has predated every recession in the US in the past 60 years. Historically it occurs around 12-18 months before a recession occurs (https://awealthofcommonsense.com/2018/07/arguing-with-the-yield-curve/).
The Federal Reserve lowered interest rates for the first time in 10 years in July and they are widely expected to cut them another 0.25% in mid-September when they meet again. The cut was in response to slowing global growth and the uncertainty the US/China trade wars are having. They do not see a recession on the horizon and are viewing their rate cuts as “insurance”. We also do not view a recession as an imminent threat.
Given the recent yield curve inversion, the financial press has latched onto the idea of a recession. Investors need to be careful of listening to too much media coverage of the markets. It’s important to understand the media is in the business of selling stories and advertisements. Feel good stories do not sell as well as “doom and gloom” stories, so take caution with reading too many news headlines whose underlying intent is conflicted with selling stories by tapping into unavoidable human emotions. Therefore, we prefer to divorce ourselves from our emotions when making investment decisions and follow an objective and disciplined approach.
The New York Federal Reserve and St. Louis Federal Reserve both produce recession probability models. Those models place probabilities on the chances of experiencing a recession in the next 12 months. The NY Fed’s model is placing a 33% chance while the St. Louis’ model assigns a 1% chance (see links below for details of those models). Our opinion would place the chances somewhat between the two. Who is right is not important. What is important is that investors realize a recession is inevitable and plan for dealing with it. We are currently experiencing the longest economic expansion without a recession in the nation’s history, so time is not on our side.
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.
For more detailed information regarding the New York and St. Louis Fed recession probability models, use the following links:
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.
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.