Positioning For An Inflection Point In The Financial Cycle

by: Ben Comston


US equities and long-term bonds remain overvalued compared to historical averages.

Meanwhile, international equities probably offer the best future investment returns, while gold is still reasonably attractive after its recent run.

Even though no can ascertain when a shift in the financial cycle will happen, investors should prepare themselves now.

As the man looks back to the days of his childhood and his youth, and recalls to his mind the strange notions and false opinions that swayed his actions at the time, that he may wonder at them; so should society, for its edification, look back to the opinions which governed ages that fled. - Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

My first experience in investing happened early in the year 2000 when I was 15 years old. I had about $500 in a savings account that my father encouraged me to invest in the stock market. He had the right idea about investing young, his timing just wasn't so great. A mutual fund salesman advised me that since I was so young, I should be willing to take on more risk than many others and invested my money in a technology fund that lost about two-thirds of its value over the next couple of years.

I would hope that in the 16 years since that event, I have grown wiser in addition to growing older. It is important to always have both a macro view as well as a micro view. What I mean by this is that it is critical to understand an almost exhaustive amount of information on a company to invest in its stock, but it is equally critical to understand general market conditions. No one will ever be able to successfully time the market on a day by day basis, but it is very realistic to understand if an asset class is over or undervalued in general. Since many people are not selecting individual securities, understanding the macro picture is even more critical as they make choices for their IRA or 401(k).

I intend this to be a very practical discussion of how to go about surveying the macro investing environment as well as what that survey implies right now. Two books, in particular, are exceptional on framing this issue: Bull! A History of the Boom and Bust, 1982-2004 by Maggie Mahar and Irrational Exuberance by Robert Schiller.

The US Equity Market Cycle

The interesting situation we find ourselves in now is something of a contradiction. Statistically, US equities are historically very expensive, but the psychology of a market top does not seem to be present. The mood does not seem to be euphoric - far from it. If you were to survey a cross section of America, you would not likely find an excessively optimistic outlook as you may have in 2000 or 2007.

The best argument for a continued rise in equity prices is to justify the current high prices by pointing to the low interest rate environment that we have been in for many years now. But I think that argument holds the key to understanding the seeming disconnect between equity prices and sentiment. The prices of equities are not high because of enthusiasm about the prospects of business so much as they are, because so little of a return is available elsewhere.

I update the chart below from Mahar's book Bull! to illustrate long-term market trends:

Source: Bull! A History of the Boom by Maggie Mahar, updated with data from 2000-2008.

No one knows how returns will fare in the short term, so it is somewhat premature to label the 2009-2015 as a secular bull market, but the chart above illustrates very well the oscillations the market will go through and that there are some periods when the best choice you can make is to avoid it.

Some additional information on valuation and interest rates can help complete the picture.

Source: Derived by the author from Yale University data.

Robert Schiller has popularized the concept of taking a ten-year average of inflation adjusted earnings to compare market prices to, so that the business cycle's impact on current earnings can be smoothed out. It's since become the most popular way to value the overall stock market. Currently, the market trades at about 26 times these adjusted earnings, double the valuation of 13 times at the last market bottom in 2009. The 2007 market top was at a cyclically adjusted 27 times earnings and the 2000 market top was at 43 times.

There are a couple of counter arguments to the "market is expensive" thesis. For one, these ratios are far from hidden. A great many people purchasing equities today are doing so with the full understanding that they are doing so at historically expensive prices. As already mentioned, interest rates are incredibly low which reduces the opportunity cost of alternative investments such as equities. The real interest rate on a 10-year treasury bond today is essentially zero, unless you assume that inflation moves much lower over the next decade. At the time of the last cyclical market top in 2007, the nominal 10-year treasury yield was 5% and the real yield was about 2.7%. Bonds were a steal at the time of the 2000 market top with a nominal yield of nearly 7% and a real yield of more than 4%.

There is some danger in using this logic. I would not purchase long term treasuries today with a yield of less than 2%. Even 30-year treasuries are only yielding 2.5%. If I plainly consider the prices of government bonds to be expensive, why would I use them as a measuring stick for another asset class? Opportunity cost is a very real cost - at any given point in time we have to consider the options in front of us to determine the best opportunity - but nothing precludes you from deciding that both equities and bonds are expensive in a particular environment.

The other counter argument that one could make is that over time there seems to have been a trend towards an increasing earnings multiple in the stock market. While, the very long term average is a little than 17 times cyclically adjusted earnings, post-WWII the average is 18.6 and since 1990 the average is 25 - not far below the current valuation.

Why has the ratio moved higher, particularly since 1990? Various arguments have been put forward such as demographics or better technology allowing for greater stock market participation. Of course, the simplest answer is that it could be that the stock market has tended to be more expensive recently than it has historically.

The current price of the stock market does not necessarily imply any kind of crash is forthcoming, but it does imply that investors should expect a lower total return in the future than would have been expected in the past.

Generally, expensive markets by themselves are not enough to change the tide - it is often a combination of valuations and some other factor that causes a market shift. That may be an event, such as an unexpected "Brexit" vote, or it could simply be a weakening of economic conditions.

The Business Cycle

The business cycle lasts longer now than it used to - a welcome change. The last three expansions have averaged eight years. Earlier in the last century recessions were far more frequent, occurring every four years or so. Like predicting short-term movements in stock prices, no one can accurately predict when a recession will come. Further, we never know a recession is beginning as it happens. These calls are made after the fact. But it is still an unavoidable fact of life that they will come and go.

Sources: Bureau of Economic Analysis; Yale University.

A recession itself does not mean that equities are a poor investment. During the summer of 1981, a recession was beginning and it was one of the best times in recent history to have invested in the US stock market. But the combination of a high earnings multiple with a recession is not a place investors would like to find themselves. With the last three expansions lasting 6, 10, and 8 years and the current expansion 7 years old, it's a high probability event that in the next couple of years we will see a recession.

The next recession could also well be one of greater than average severity. The reason for my pessimism is that it is more uncertain than normal how politicians and central bankers would respond to the next recession. There is little central bankers could do with short-term interest rates still near zero and negative in some parts of the world. Quantitative easing would be the only lever that could be pulled and with long-term rates so low, it is doubtful that that lever would have much impact either. That leaves the politicians in whom no thinking person would want their fate to rest.

The next recession, like the last one, would be an ideal situation in which to achieve large returns from fiscal stimulus with the confluence of low interest rates, a genuine need for infrastructure investment, and weak aggregate demand. Of course, most recessions cure themselves without any need for monetary or fiscal stimulus, but we are used to experiencing recessions in conjunction with counter-cyclical forces pulling the other direction. The next recession may be deeper and longer than a typical business cycle recession (although not as bad as the last one).

Source: Chart derived from data from the Federal Reserve Bank of St. Louis.

Looking at the four coincident indicators (the economic indicators that tend to move in tandem with GDP) since the start of the last recession in December 2007 shows that industrial production is the only one that has rolled over, the victim of a stronger dollar and weak international demand. Personal income, employment, and retail sales though have continued moving higher through May. There are signs that they have started to weaken, though.

Source: Chart derived from data from the Federal Reserve Bank of St. Louis.

Real retail sales have declined month over month in five months over the last year and all four indicators have softened this year despite the fact that all of them save industrial production show an economy that is still expanding.

During 2014 and 2015, the average growth in the four coincident economic indicators was 2.6% and 2.2% respectively, while real GDP growth was 2.4% in both years. So far in 2016, the average growth among those same indicators has been 1.4%.

Leading economic indicators may show a somewhat more positive future as they do not seem to have rolled over. These indicators include new housing permits, initial unemployment claims, delivery times from the ISM survey, and the yield curve. Typically, we would see substantial weakness in these indicators at least six months prior to the start of a recession.

Source: Federal Reserve Bank of Philadelphia.

Of course, stock markets themselves discount the future, so if you are looking to wait until more visible cracks appear in the foundation you are likely going to be too late.

The combination of a historically high valuation with a strong chance of a recession-induced earnings decline in the next couple of years should make you skeptical of having a large exposure to US equities. Of course, long-term bonds could well be an even worse investment than US stocks since they have a real yield of basically zero.

What options does this leave?

The Commodity Cycle

One market that has already declined precipitously from highs, despite a rebound this year, is the commodity market. Following a sharp drop in 2008, most commodities rallied during the recovery before peaking in 2011. There is certainly some evidence to suggest that commodities are cheap compared to their recent history.

Sources: Federal Reserve Bank of St. Louis; NYMEX.

A longer term view of commodity cycles also supports the positive view of commodities. The chart below shows the real return for a basket of commodities for past secular moves in prices.

Source: Originally shown by Mahar, updated with the CRB index.

I think some skepticism should enter the conversation here as well though. Commodities are not very good long-term investments and for many commodities, we should expect the real price to decline over very long periods. Coupled with a poor long-term track record is incredibly high short-term volatility. Precious metals have a better long-term record and are seen as ideal assets during market turmoil.

At the beginning of 2011, I wrote about gold prices and provided a convenient model for determining a rough fair value for the price of gold. The price of gold has historically been bounded by the price that would be expected if it was viewed primarily as a commodity (adjusting the price for inflation) and what would be expected if it was viewed as a monetary asset (adjusting the price for the growth of money versus the growth of gold stocks).

If two currencies were compared using a theory such as purchasing power parity, factors including the reference economies performance would have to be taken into account - in other words if, say, you were to determine a hypothetical exchange rate between the US and Canadian dollar in the future you would need to know the amount of goods and services produced over time in addition to monetary aggregates and the velocity of money.

If you were to use gold as a monetary asset, however, you can ignore fluctuations between the hypothetical reference economies. While saying that gold prices should be bounded by these two values is by no means an iron-clad law of economics, I still think it's a very good indicator of the attractiveness of gold.

At the time I wrote in 2011, gold prices were $1,341 a troy ounce while an inflation-adjusted view would price gold at about $400 per troy ounce and a monetary view would have priced it at about $1,800 per troy ounce. I thought that while gold prices may continue drifting higher until it reached the price implied by money creation, there was no longer a margin of safety in owning gold and recommended that it be avoided. My exact words were:

Today's environment provides few extremely attractive opportunities. The stock market is not deeply discounted, interest rates are still low (particularly short-term interest rates), real estate has corrected but not beneath its long-term trend, and after a decade it has become hard to argue that commodities are cheap. With gold, as with these other asset classes, patience is important. For now, the best course seems to be to selectively invest in equities that are cheap relative to the market and position yourself to be able to exploit future opportunities whether they be in gold or elsewhere.

It seems that I was way early in my pessimism on the stock market and, much to my surprise, interest rates have not risen since that time. My argument on gold prices, though, has been a good one.

Here is the updated chart:

The inflation adjusted price at the end of 2016 should be about $455 and the money adjusted price about $2,400. While gold prices are not as cheap as they were at the beginning of the century, they are a much more intelligent speculation today than in 2011 at a recent price less than $1,300 per troy ounce.

For the time being, it could make a great deal of sense to devote 5%-10% of a retirement account to gold in the form of SPDR Gold Shares (NYSEARCA:GLD). With silver and platinum prices punished much more than gold prices over the last several years, owning a precious metals basket such as GLTR makes even more sense.

International Equities

Most global stock markets are cheaper than the US right now. Many European countries, in particular, are still extremely cheap compared to the United States. Parts of Europe are justified in having low valuations, particularly when the dysfunction of individual countries is amplified by the dysfunction of the collective Eurozone, but it's hard to justify why Spain and Italy should trade at 1/3rd the valuation of the United States. Brexit aside, the UK stock market looks particularly cheap considering it does not have some of the negative side effects of belonging to the Eurozone since it continues to use its own currency. I also think that the South Korean market is particularly cheap right now, but the Korean market seems to be perpetually cheap.

Source: Research Affiliates.

The best course of action is to have some overweighting of broad-based international funds in your portfolio and if you purchase individual stocks then taking your cues from the relative attractiveness of the markets is not a bad idea.

Make a List

As markets become more attractive the simplest thing to do is hold more cash. It is true that you will get virtually nothing for it, but if markets decline in the future you will have a multitude of good options. Successful investing is only partly about knowing when to make a smart choice, it's also about having the resources to do it.

Holding a short-term bond fund in a 401(k) or an IRA is pretty intelligent at the moment. If you hold a substantial amount of cash now, then make a list of investments you would like to be able to buy in high quality companies as well as the price level that you think would make them attractive and then just wait.

My list would include companies such as Middleby (NASDAQ:MIDD), The Walt Disney Company (NYSE:DIS), Markel Corporation (NYSE:MKL), UPS (NYSE:UPS), Morningstar (NASDAQ:MORN), Amazon (NASDAQ:AMZN), Starbucks (NASDAQ:SBUX), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and Costco (NASDAQ:COST) among others.

The Future

No one can say with accuracy how markets will behave over short periods of time. We can say with more confidence the returns we can expect given certain valuations. My own perspective is that given current valuations long-term bonds should be avoided, US equity exposure should be reduced, and international markets should be overweighted. Some exposure to gold or other precious metals could also be considered.

To quote Maggie Maher, "a knowledge of history is an investor's best defense against error". Learn from history and be cautious now, with the short term perceived gains you're giving up coming with the compensation of greater gains in the future.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.