In a recent article at WSJ.com, the author interviews Michael Hartnett, a primary investment guru at Merrill Lynch. The top strategist explains that commodities, emerging markets, high-yield bonds and small-cap U.S. stocks are the “four classic canaries” in the investment mines. Moreover, he warns, the archetypal canaries have stopped singing. Yet Hartnett simply views the absence of sound as a harbinger of increased volatility. I might find humor in the overtly bullish take were it not for the precarious environment for risk-taking. After all, when birds stop chirping in coal mines, they’re dead.
In truth, several of the four canaries have been sickly for months. On small-cap woes:
July 30. Tactical Asset Allocation And the Understanding of Longer-Term Trends
July 16. Why U.S. Small Cap ETFs Are Losing Their Way
On commodity depreciation:
August 20. Is the Depreciation in the Commodity ETF Space Surprising?
August 13. These 5 Charts Are Killing Risk-On Exhilaration
More recently, higher-yielding bonds have widened their spread against Treasuries. If you have been willing to take the risk associated with “high yield,” I recommend that you do so in the context of exchange-traded vehicles that actually mature like individual bonds. When you redeem shares of a popular fund like SPDR High Yield Bond (JNK), the sale may result in a capital gain or loss. The loss might even be rather severe. In contrast, holding an asset to maturity like Guggenheim BulletShares 2015 High Yield Corporate (BSJF) implies that you will collect the income payments as well as the return of principal of the diversified basket’s high yield corporates maturing in 2015.
It also makes sense to combine a riskier bond holding with long-term investment grade for safe harboring – a barbell decision that has benefited my clients throughout 2014. I frequently recommend ETFs such as Vanguard Long Term Bond (BLV) and Vanguard Extended Duration (EDV).
While the pullback in foreign equities has not been alarming – the euro-zone’s recessionary pressures have been well-documented – the September sell-off in emerging markets may be a troublesome blow for U.S. stocks. I remain committed to emergers, particularly in Asia, as long as they remain above my stop-limits as well as respective trendlines. On the other hand, Vanguard FTSE All-World (VEU) has been trading below a 200-day moving average. Investors may wish to consider the implication and pare back their allocations to VEU, as the all-world proxy is heavily weighted towards foreign developed markets.
Granted, U.S. stocks continue to hold up better than the competition. Nevertheless, with four of the “classic canaries” unable to make a peep, with foreign developed markets as well as mid-caps barely making an audible sound, how much longer will large-caps rally without a meaningful 10% correction?
Remember, IPO fanaticism and takeover talk had been rampant in 2000 and 2007; it resembles some of what is occurring here in 2014. What’s more, U.S. corporations are not just acquiring rivals, they’ve been buying back their own shares to boost prices and a perception of strong earnings. Meanwhile, bullishness recently hit extraordinary extremes. Valuation metrics for U.S. stocks are nearly unanimous in highlighting severe overvaluation. And technical analysts have identified signs of a “top” in the cumulative NYSE Advance/Decline Line as well as the NYSE High-Low Index. It would be wise to have a plan in place for protecting your portfolio.