By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management

The markets have provided the opportunity to realize what would be considered an excellent full year return in just six months. The first half rally makes sense given the price declines that we saw late last year with a backdrop of solid economic fundamentals. In short, the markets priced-in a recession that did not come late last year.

At the start of 2019, we considered U.S. equities attractively valued for the first time since 2016. In light of this year’s rally and the rate of economic growth that we expect ahead, we now think that U.S. equities are fairly valued, and the pace of market appreciation is likely to slow. While our base-case scenario is still constructive, we think that downside risks have increased.

We are concerned that the markets may have become too complacent. Though the U.S. stock market is near all-time highs, some of our favored economic indicators have weakened. For example, the 6-month average for the Leading Economic Indicators (LEIs) for all the countries participating in the Organisation for Economic Co-operation and Development and the six largest emerging countries (OECD+6) has deteriorated significantly. While the rate of growth for the U.S. LEIs has slowed, we think it is the slowing growth rate of the global economy, not just the U.S., that is holding long-term interest rates down.

US Yields and Leading Indicators

Overall, this weakening suggests sluggish economic growth ahead and any economic deterioration will likely make equity markets more vulnerable. As a result, we have moved to further increase the defensive nature of our Strategies.

We agree with the consensus that the U.S. Federal Reserve (the Fed) will soon begin to reduce short-term interest rates in response to weaker economic growth. However, we are concerned that the Fed will not act quickly enough or forcefully enough to avert further economic deterioration. We think that the Fed should more aggressively follow the natural interest rates down or run the risk of stifling U.S. economic activity through a liquidity crunch. The yield curve, as represented by the 10-year Treasury bond and the 3-Month Treasury bill, has been consistently inverted for weeks. An inverted yield curve has historically been an economic warning signal. However, the yield curve is among the longest lead-time indicators, sometimes leading economic contraction by up to 2 years. Other indicators, such as narrow money growth (inflation-adjusted M1), and the year-over-year decline in weekly jobless claims are suggesting slower growth, but not a recession. That would be consistent with our previous chart on leading economic indicators.

Typically, year-over-year inflation-adjusted M1 growth goes negative prior to recession (exhibit 2). In addition, weekly jobless claims tend to increase 15-20% from prior year levels (exhibit 3). Neither of these situations is occurring today. While the yield curve and some other long lead-time indicators are suggesting the end of the business cycle at some point in the next couple of years, other important signals are suggesting slow growth, but not recession.

In short, we think that the Fed has time to adjust policy in order to prolong the current business cycle if they act quickly, forcefully, and persistently. A significant reduction in short-term interest rates and an early end to the Fed’s balance sheet reduction may cause the yield curve to steepen and money growth to accelerate in a positive fashion.

Aside from these important economic fundamentals, which are still generally positive over the near-term, we think many headline risks could create volatility but are not a fundamental risk to the U.S. economy. From geopolitical headlines to domestic politics, when markets have been this complacent, there are any number of non-fundamental headline risks that can create turbulence. In this environment with equity markets at or near all-time highs and markets very complacent, we think risk management becomes even more important.

THREE LEVELS OF RISK MANAGEMENT

We manage risk at three levels within each of our Strategies. First, we manage risk within our strategic, long-term allocations based on diversification across low-correlated assets and a focus on areas where we find more attractive relative values. Secondly, we manage risk tactically over the short-term by investing across a broad array of themes and asset classes including cash. Lastly, our proprietary Cash Indicator methodology acts as a plan in case of an emergency. This approach is analogous to the multiple safety systems in a modern automobile, which includes an airbag. Each of these systems work together to potentially help smooth the ride for our investors.

Within our strategic allocations, we have increased our exposure to domestic equities that tend to exhibit lower volatility and more consistency yet are generally not as sensitive to interest rate changes. In addition, we have increased our allocations to diversified alternative investments as we expect that they will be an important source for non-correlated and consistent returns while our high-quality core fixed income will act as an important ballast to potential equity market volatility.

Tactically, we favor low volatility equities, the medical devices industry, global infrastructure investments, and some emerging market exposure in our more equity-oriented Strategies. Additionally, we like merger-arbitrage (long-short equity exposure), high-quality fixed income and diversified alternative income.

In 2019 and into 2020, we think that it will be critical for investors to be prepared for market volatility and increased economic risks. We think it will be important to continue to put risk first while also being ready to act tactically to benefit from continued equity market upside.

We are watching our indicators closely and will make adjustments quickly if we sense problems or other opportunities ahead. That flexibility is one of the benefits of including a tactical allocation where we can manage risk in real time.

THE CASH INDICATOR

The Cash Indicator (CI) continues to hover near historic lows, which suggests to us that the markets may be too complacent, especially with the backdrop of sluggish economic growth and the potential for headline risks. While the CI suggests that we are far from a crisis, we should expect an uptick in volatility. In our experience, it is only a matter of time before the markets find some reason to panic. Still, the increased volatility that we expect is likely not a sign of a crisis. However, our innovative process allows us to be nimble and make changes should we see additional opportunity or see a need to become more defensive.

This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.

DISCLOSURES

Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.

The securities and strategies identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.

Data is provided by various sources and prepared by Stringer Asset Management LLC and has not been verified or audited by an independent accountant.

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