For the first time since February, our Current Outlook moved into the top half our four-level grading scale. Moving from “Use Caution” where it had been for the previous three months, our Outlook moved one level higher to “Cautiously Positive”. Although our fundamental indicators and technical indicators are still sending mixed messages and the Risk Odometer remained at +1 for the fourth consecutive month, positive developments in other areas is giving us more confidence in the markets.
The reasons for our improved outlook despite an increase in Risk Odometer score is reduced uncertainty on the political front, a (likely) divided Congress and positive news on a Covid vaccine. For several months prior, political uncertainties and unknown stage 3 vaccine results were risks weighing on the markets. The passing of these events, although not a certainty yet, are now high probability known outcomes. This reduced uncertainty along with favorable seasonal months of December and January moved our outlook one level higher.
We are also witnessing our Volatility Indicator near an inflection point. It remains neutral where it has been since March but is close to turning positive. Continued positive price action in the markets, which often occurs in December and January, would likely switch the Volatility indicator from neutral to positive and move our net Risk Odometer further into positive territory.
The big positive development in November was the passing of the US presidential election. This was a major concern we had for several months. Most concerning was not the outcome but the potential for a contested election which would have created an extended period of uncertainty. Markets hate uncertainty. Although the election results are still being contested in the courts, the probability of changing the unofficial results is very low. Those unofficial results most likely will see a Democratic president, Democratic House and Republican Senate, thereby creating a divided political outcome. Divided political outcomes have historically been most favorable to markets because it makes change more difficult. This should be favorable for the markets because it makes recent tax law changes more likely to remain. These tax law changes, in our opinion, was the biggest reason for the large gains prior to the pandemic.
The other major recent development which made us more constructive was the positive news on the vaccine. Better than expected stage 3 results from Pfizer and Moderna created a sense of euphoria in the markets. It makes a widely available vaccine feel tangible and around the corner. Although current Covid infections, hospitalizations and deaths are rapidly increasing, the markets forward looking nature is seeing light at the end of the tunnel, especially with multiple vaccines from multiple companies coming soon.
Although our outlook is more positive, we do still have concerns in the current environment. Elevated valuations are top of the list. Price to earnings ratios, the most common valuation metric, is more elevated than almost any time in history. The economy will need to meet high expectations of a continued strong recovery to justify current valuations. The pace of economic growth continues to decelerate and rapidly increasing Covid cases should continue the current deceleration. A fast and effective distribution of the vaccine will be a necessity to meet economic growth expectations. Any serious disruption to the vaccine distribution or economic acceleration that does not meet high expectations would cause higher levels of volatility in markets given current lofty valuations.
Risks in the markets always exist. The pandemic is still creating economic uncertainties, but recent positive developments are now tilting us to be more positive than cautious. More economic clarity that would align our fundamental indicators with positive technical indicators would increase our confidence even further. Until then, we remain “Cautiously Positive” and will continue to monitor incoming data and communicate our opinions.
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.
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.