Current investment conditions require an assessment about how to adjust for different levels of intervention, and an awareness of which assets it is influencing.
Primarily, markets across the world do still very largely reflect investment fundamentals, and over the long term they have to. While US equities seem to have detached themselves temporarily, government bond markets have not.
Globally bond markets are hitting all time low, and even negative, yields, very much in line with extreme weak global economic data. The chart below shows the that amount of negatively yielding bonds has just hit new all time highs, above 13 Trillion!
I believe that US economic policy has become increasingly dominated by dystopian interventions. While there can be a good case for rescuing anything when it is needed, this can become a problem if the rescues become seemingly daily efforts with policies that have failed over multi decade periods in other advanced economies like Europe and Japan.
Whether it is narrative, confidence, or the wealth effect, the level of the S&P 500 has become central to US policy, and the markets seem to have become dependent on this idea. Every time Powell or Draghi speak the market gets a boost.
The great problem comes when policy makers are confronted by an inconvenient truth. Despite constantly accelerating intervention, the economy appears to be responding less and less.
The chart below shows both the GDP and the “private sector” GDP, calculated by subtracting government spending from GDP. The “private sector” GDP is chronically weak. There was only a minor bump in 2017/18 despite the massive tax cuts, which has now been followed by 4 quarters of negative data.
The internals of the S&P 500 are also corroborating the private sector GDP data. Using Stan Druckenmiller’s economic predictor, the economic components of the market are also showing divergent weakness in key sectors of the S&P 500 relative to the S&P 500 itself. The link below includes a recent interview with the legendary Stan Druckenmiller, who is always worth listening to.
Sectors that are sensitive to economic downturns are significantly underperforming.
If intervention has distorted corporate bonds and the S&P 500 to extraordinary levels, at a time when even permanent interventions are having minimal impact on the private sector economy, then I believe it is not a big stretch to say that risk in the US markets has been accelerating.
This leaves markets increasingly dependent on everlasting higher frequency intervention. This makes it difficult to access what is a sustainably successful strategy.
Historical evidence from both Europe and Japan suggest that their policies have not managed to hold up equity prices over the long term in similar circumstances, nor have they improved the economy.
Buybacks may be an additional factor in the US but corporate balance sheets are already remarkably stretched, and are becoming a constraint.
What interventions will take place going forward is anyone’s guess. These interventions can overwhelm normal investor flows. So much so that they can price the “market” wherever they want to. When “market” prices become detached from economic fundamentals investors need to understand that risk and execution has become much more complex and dangerous.
Full Cycle Investing
In my opinion, we are in a bubble of enormous proportions and historically this has been a very significant challenge for investors. It is simply a matter of fact that pre tax profits in Q1 2019 were below where they were in Q1 2012. 7 years with no increase in profits, according to data taken from https://fred.stlouisfed.org/. At the same time the S&P 500 has risen by well over 50%!
Very few investors come out of the full cycle of a bubble successfully.
Investors need to make sure that they have a sufficiently robust strategy that will adjust to the different phases of a bubble. I believe Full cycle investing does this.Full cycle investing has both an economic and a market signal process. By measuring the cycle, and managing risk effectively, I believe investors can navigate every phase of the bubble with a greater probability of long term success.
Here are some of the steps.
Stay in the 2 low risk boxes of the chart below, especially when you are in a bubble.
In Full Cycle, Investing risk assessment is crucial, constant and dynamic.
It should include an AB test:
A. What is the strength and consistency of the rate of change of inflation and growth in the economic cycle?
B. What is the strength and consistency of current market price trends?
If these are in opposition or low conviction ( like equities in 2019) investors should take low risk.
If these are aligned and clear (like equities in 2017 or bonds at the end of 2018-2019) take more risk.
In the most efficient form of investing, lower risk and higher return can go together. I believe you will find that some of the most successful investors operate in this way.
In a bubble of this scale and complexity, I think this is the strategy with the greatest probability of success through the whole cycle.
Here is an in depth video about how to transition to full cycle investing by Keith McCullough, founder and CEO of Hedgeye: