Our Risk Odometer ticked up one level from 0 to +1 for September, but our Current Outlook remained stable at “Use Caution”. While the economy has continued to improve it remains far from where it was prior to the pandemic shutdown. The growing divide between the economy and the markets continues to remain extremely wide. The markets relentless pursuit higher remains at odds with many other global markets and is being led by fewer and fewer companies, giving us reservations about the outlook for sustainable gains. We welcome the recovery but remain cautious over the short-term.
Recent market gains have now propelled the markets to near-record valuations, measured by Price-to-Earnings Ratio (PE Ratio, left chart) and Cyclically Adjusted Price-to-Earnings Ratio (CAPE Ratio, right chart). Current valuations have never been this elevated other than the 2000 stock market mania. Valuations are not great timing tools because they can remain extreme for a long time, but they do provide perspective on current conditions relative to history. For this reason, it gives us some level of caution. Absent this, our Outlook would be one level higher.
Another aspect that is giving us some caution is the concentration risk of the broad indices. The top 5 stocks in the S&P 500, which typically ranges from 11%-14% is now nearing 25%. This high level of concentration can create higher bouts of future volatility given the reduced diversity of the indices.
Not all is risky though. The economy continues to improve, and unemployment has now fallen below 10%. Our economic indicators signal went from negative to neutral this month. The spike in coronavirus cases in the summer is now declining and talks of a vaccine being ready by early 2021 is being discussed. All of this should continue to support the economy and we will continue to monitor its progress.
The failure to pass additional stimulus did not have a material impact on the markets but there does remain a possibility for Congress to pass something in the future. Fiscal stimulus, along with the upcoming presidential election, will be the near-term focus of the markets.
We hope the recent stock market gains are sustainable and the economy comes around to what the markets seem to be expecting. Hope is not an investment strategy, though, so we must set aside our hopes and remain objective. For now, poor fundamental data and extreme valuations keep us cautious. We would like to see a further recovery in either economic indicators or earnings, which would confirm the positive technical indicators, before changing our outlook.
Our caution has always been from a short-term perspective (3-12 months). From a long-term perspective (i.e. measured in years), we continue to believe our medical community will triumph and global stock markets will fully recover. We still believe the stock market is one of the best ways to grow your wealth over the long-term. Our concern remains in the speed of the economic recovery and stock market volatility over the short-term.
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.