By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
Overall, our base-case scenario is constructive and built on solid U.S. economic fundamentals that are now combined with compelling equity valuations resulting from the recent market declines. The forward price-to-earnings (P/E) ratio of the S&P 500 Index fell 5.1 between December 2017 and 2018. History suggests that when the price to expected 12-month earnings for the S&P 500 Index has fallen by a similar degree as it did during 2018, the returns over the next 12-month can be significant (exhibit 1).
However, we recognize that there are significant risks to the global economy and the markets. We estimate that about half of the recent equity market declines were associated with what we view as non-fundamental risks to the U.S. economy, such as trade wars and other geopolitical threats. Furthermore, we expect global economic growth to slow, which should result in slower corporate revenue and earnings growth.
We continue to think that the primary risk to the U.S. economy and the continuation of the current business cycle is U.S. Federal Reserve (Fed) policy. Given the flattening yield curve, slowing money growth, declining market-based inflation expectations, such as TIPS spreads, and the slowing pace of economic growth, we think that the Fed should stop raising interest rates and declare victory (exhibit 2).
Since the recovery from the global financial crisis began, we think the Fed has done a good job with actual monetary policy, but not with their communication. Our economy is experiencing low unemployment and low inflation at the same time that the it continues to grow. That is a great outcome and much of the credit should go to the Fed (exhibit 3).
All things being equal, if the Fed were to make an announcement that they were done for now, we believe that this business cycle would continue, corporate revenues and earnings would grow, and stock prices would move higher.
Conversely, if the Fed were to continue to raise short-term interest rates, we would respond quickly by paring back on equities while increasing our allocations to high-quality bonds and cash.
Unless the global economy picks up pace, driving long-term interest rates higher, we think the Fed should stop their rate hikes. Long-term interest rates are driven by global economic factors because the market for U.S. Treasury bonds is a global market. Central banks, large corporations, and other institutional investors dominate the U.S. Treasury market. We think that the Fed should be concerned with economic developments in Europe, Japan, and other major economies. Global leading economic indicators suggest that the U.S. is on solid footing, but the rest of the world looks relatively sluggish overall (exhibit 4).
INVESTMENT IMPLICATIONS
In 2019, we think that it will be critical for investors to be ready for a binary set of potential outcomes. It will likely be important to continue putting risk first while also being ready to act tactically to potentially benefit from an equity market recovery. Equally crucial, we think that investors should be ready to take defensive tactical positions in the new year, along with the willingness and ability to raise cash up to 50% of a portfolio, as can be done via our Cash Indicator methodology.
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) has increased in recent weeks but may have topped out. At this point, the CI reflects heightened risk relative to the calm we saw last summer and in 2017, but not an impending crisis. The CI has certainly been active recently and we will continue to monitor it and our other tools for signals dictating increased caution or optimism. At this point, our base-case scenario suggests the latter.
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 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.
Index Definitions:
Bloomberg Barclays U.S. Corporate High Yield Index – This Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
Bloomberg Barclays U.S. Corporate Index – This Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.