“With the global economy deteriorating by the day and the worst earnings season since 2016 having officially started, we are starting to see … no matter what one throws at the market, it just refuses to go down.” – Zero Hedge
In fact, the S&P 500 is already 70% of the way towards its best year ever, when considering the average returns of the S&P 500’s previous ten best years. Not only that, but commodities are on track for their strongest performance in 100 years. Zero Hedge points to recent charts from Bank of America to illustrate the point (see below).
Of particular interest is the out performance of commodities. “Commodities are cyclical in nature. As a general rule, commodities tend to do well during periods of late expansions and early recessions. The reason is that, as the economy slows, key interest rates are decreased to stimulate economic activity – this tends to help the performance of commodities.” – Commodities and the Business Cycle.
If you’ve been following energy prices, industrial metals such as copper, or the mass accumulation of gold by Central Banks around the world, you know something is going on. Despite media rhetoric and the mantra of “the strongest economy ever,” the numbers just don’t lie.
Something wicked this way comes
The question remains, where are we on the business cycle? Are we nearing the end of a bull market, or have we already entered recession? Or, as some maintain, perhaps we’ve entered a perpetual bull market?
“There are three principal phases of a bull market: the first is represented by reviving confidence in the future of business; the second is the response of stock prices to the known improvement in corporate earnings, and the third is the period when speculation is rampant – a period when stocks are advanced on hopes and expectations. There are three principal phases of a bear market: the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.” – Robert Rhea, The Dow Theory, 1932
- Investors [are] encouraged by the illusion that the Federal Reserve’s buying of Treasury bonds is capable of saving the world from any form of discomfort. That illusion is likely to prove costly.
- The recent bull market clocked in as the longest in history.
- Based on the valuation measures we find best-correlated with actual subsequent market returns across history, the current market extreme already matches or exceeds those of the 1929 and 2000 peaks.
- The primary effect of extraordinary monetary policy wasn’t to drive real economic gains, but instead to amplify speculation and contribute to wealth and income disparities.
- Wages and salaries as a share of GDP are clawing higher from the historic low set in 2011, but have only begun to erode the elevated profit margins on which Wall Street is basing its permanent hopes and expectations.
- In 2018, according to the Financial Times, 81% of U.S. companies that went public reported losses in the 12 months before their initial public offerings, matching the high-water mark set at the height of the dotcom bubble.
- A 65% decline in S&P 500 prices would be a run-of-the-mill cycle completion from current valuation extremes.
- The most reliable measures of valuation – those best correlated with actual subsequent market returns – have again approached or exceeded their levels of 1929 and 2000.
- It has taken one of the most extreme yield-seeking speculative bubbles in history to bring the 19-year total return of the S&P 500 to just 5.25% annually since the 2000 peak. Years of relentless yield-seeking speculation have created the potential for a financial collapse far more severe than the mortgage bubble, which was largely limited to a single class of securities.
- We’ve come to a point in this economic expansion where 1) structural real GDP growth is only running at about 1.6% annually, and; 2) there’s limited scope for further declines in the unemployment rate. The result of those two propositions is that real GDP growth is likely to average only about 1.6% in the coming years, and only then if the rate of unemployment is held constant.
“At current valuation extremes, it’s only the illusion of ‘paper wealth’ that temporarily anesthetizes investors and pension funds to the fact that their actual basis of wealth – the likely future stream of cash flows that will be delivered into their hands over time – is the smallest amount, relative to those ‘paper prices’ since the 1929 and 2000 extremes. That’s exactly what hypervaluation means.” – Hussman Funds
Recession & hypervaluation: “Be Prepared”
The prudent investor cannot ignore the evidence that recession is imminent. Neither can an investor take an overly bearish stance with stocks seeming to have more room to go before the bubble bursts. To be prepared for either economic condition, the only clear solution seems to be a neutral, well-diversified approach.
Proper risk management and portfolio diversification are not difficult to achieve. What is Investment Diversification? (pdf) introduces the concept of diversification, defines the importance of risk management, and identifies investable asset classes. This pdf is worth reading for investors unsure of what asset classes are and how prices of these assets classes correlate to one-another in various economic conditions.
Click on the image below for details on the complete book, which digs into each asset class in depth as well as specific investments to represent each theme. The complete book also includes detailed resources, glossary, and study cards for each chapter!