Are We Sure This Isn't A Recession?

| About: Schwab U.S. (SCHD)

Summary

I came across a few interesting charts provided by Fidelity and decided to compare their estimate of the business cycle with the market returns.

Equity returns are more closely aligned with being late in the expansion phase or in the middle of a contraction.

I use SCHD as one of my default choices for domestic equity index funds because the defensive allocation more closely matches my outlook.

While recessions are a fairly precise technical term, investors never really know where we are in the business cycle until it is past us. We can certainly recognize the middle of a recession, but it is much more difficult to recognize the start. The reason the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) makes more sense than simply holding the S&P 500 is because of the risk of a recession being on the horizon. Corporate earnings are suffering fiercely with low oil prices and a strong dollar hammering away on the value of sales in foreign countries.

Domestic demand depends on consumers spending money on physical goods and services, not on stocks and bonds. This presents a real challenge to the American companies as strong returns to capital lead to more of the wealth concentrated in fewer hands. That makes it more difficult for companies that cater to the disappearing "middle class".

In a nutshell, the companies have performed so well at creating earnings and cash flows that their customer base doesn't have as much capital left for spending.

Not Quite a Recession

If we aren't headed into a recession, it still appears we are entering a period of fairly weak growth in real GDP. The result could be that stocks still follow the normal business cycle predictions for a recession. Fidelity believes we are still in the middle of the business cycle and I believe we are closer to the downturn.

This article is going to use quite a few charts, some are provided by Fidelity. My only relationship with Fidelity is that my wife's employer uses Fidelity for their retirement accounts, as a result I have an economic interest in accounts that are invested in Fidelity's mutual funds.

My view is a fairly rough estimate on the location, but the point is simply that I don't see this as the middle of an expansion phase any longer. Since I see very slow growth as a viable option, I don't want to be jumping out of the market entirely. Instead, I want to position my portfolio defensively.

Fidelity provides a great chart on the expected performance of different sectors during each business cycle:

If we are in the middle of the sector, as Fidelity's chart suggests, then materials and utilities are probably doing poorly while industrials and technology are doing great. On the other hand, if I'm right then the "late" or "recession" stocks should be doing well.

Again, I'm turning to a tool Fidelity produced for assessing sector performance:

The top sectors so far this year are telecommunications and utilities. Both were up over 16%. Both are identified as strong performers when the country is already entering a recession.

The material sector, which is predicted to underperform in the "mid" section and outperform in the "late" section is up 8.44%. Since the "mid" section only has four distinct trends, the precisely wrong prediction on materials and utilities should be a red flag. The only sectors identified for positive performance were technology and industrials, which were down 1.42% and up 4.47%. In other words, both substantially underperformed the two sectors that were expected to perform poorly.

The worst performer so far this year was financials, and the only time they had a clear negative pattern was in recessions.

The SCHD Portfolio

A chart from Morningstar demonstrates the portfolio split up by sector allocations:

Click to enlarge

This portfolio is heavy on the consumer staples. They aren't doing too badly this year, but consumer staples weren't expected to really shine until the recession got underway. The low allocation to the financial services sector has been a great way to avoid damage from interest rates going lower for longer. Understandably investors in banks may not be so thrilled with banks being stuck writing loans at low rates and not getting much in the way of interest on excess reserves.

The high allocation to technology has been a bit of a challenge and I have to admit that I would've been comfortable with SCHD's portfolio if the technology allocations were replaced with utility allocations. It may seem like my views are shaped by having seen the past few months, but I've been calling "lower for longer" on interest rates since around the end of the third quarter in 2016.

The downside for SCHD, if the index was restructured to overweight utilities and underweight technology, is that the ETF would fall pretty far behind during any bull market. As it stands the portfolio is already more defensive than the S&P 500 and should be expected to hold up better in a recession but underperform in a prolonged bull market.

Conclusion

The current situation looks like a weak scenario for growing revenues and earnings for corporate America unless the dollar weakens significantly to enhance international revenues. My perspective on the market is reflected in my portfolio. I see SCHD as a good candidate to lose less in a correction and to perform well (on a comparative basis) if the market simply trades sideways.

Disclosure: I am/we are long SCHD.

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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.