Is the Reward Worth the Risk?

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In this month’s post, I am hoping to disturb you enough to stop ignoring the signals and take steps to prevent catastrophic losses. This is not the kind of language I generally use in my blog posts and podcasts but given where we are in the economic cycle among other signals, I believe that there are significant risks growing in the markets as well as our economy that could once again devastate investors. Only this time, many of the people who read my blog, won’t have the time to recover as they are in retirement or will be in the near future.

While I have been talking about the risks building in bond funds, especially those with lower grade corporate and municipal bonds, asset backed securities and leveraged loans, we haven’t looked at the stock market in a while.

In this column, I am usually addressing financial education, strategies and education related to a variety of financial and retirement topics. I have NEVER put out a blog like this one.

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The Signs are Going From Bad to Worse!

There are quite a few market metrics and indicators that I monitor on a regular basis. I cannot recall a period of time like the last couple of months, where we have seen such a sharp decline in these factors.

This has been so dramatic, a number of analysts and market participants I respect have come out with significant warnings. Now, I don’t like to get caught up in the Wall Street hype machine, but these folks tend to stay in the background, unless they see a significant change in direction or opportunity.

Here are a few examples of these warnings:

Morgan Stanley said that their proprietary Business Conditions Index (MBSI) fell 32 points last month, the largest one month drop in a single month in the index’s history. It is now at its lowest point since 2007-2008. A separate business condition index also fell by the most since 2008, likely due to uncertainty over trade and tariffs, which makes business planning and expansion difficult at best.

This is also reflected in a jobs report that showed 75,000 new jobs last month, instead of the 185,000 that was projected. Their conclusion; “these indicators point to business expansion coming to a halt near June”.

  • The Buffett Yardstick. This is the name given an indicator of future activity in the equity market by Jesse Felder of the Felder Report. It compares the actual market activity against the indicators predicted returns. It compares the total value of the stock market to the overall size of the economy. The divergence in this indicator is so extreme it is predicting a zero percent return on stocks for the next 10 years! At the same time, margin debt (money borrowed against a stock portfolio, usually to purchase more stock) in relation to the size of the economy indicator is at the highest greed level since early 1929. This alone could drop the market, the last two times we saw this kind of reading, the market suffered losses of 50%.
  • The CAPE ratio. This stands for “Cyclically-Adjusted Price Earnings ratio. This is an indicator developed by Robert Schiller, a finance professor at Yale and a Nobel prize winner. This indicator looks at stock prices vs. the real earnings per share averaged over 10 years. This smooths out the short term volatility that earnings can experience. It is designed to help investors decide if the market is over or under valued. Currently the reading is at 30.2 versus an average of 15.8 since 1871. This means valuations are extremely high as measured by this index.
  • Ted Bauman, who’s team predicted the crisis of 2008, the dot com crash in 2000, the recession in the early 1990’s and the 1987 crash. He has done significant research on current market conditions and thinks conditions are right for a huge drop in stock prices. I won’t depress you here with his entire predictions and analysis.
  • Jeffery Gundlach, who is the CEO of DoubleLine Capital feels there is a 40-50% chance of a recession within the coming 6 months and a 65% chance within a year.

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Big Rotation Away From Risk

Over the last year we have seen so called “defensive stocks” do very well. These are the big boring companies like utilities, like Consolidated Edison power company (up almost 16% so far this year) and consumer non-durables like Procter and Gamble (up 21% this year alone). These are the kind of returns we look to tech stocks for.

Meanwhile, highflyers like Tesla (dropped 35% this year) and Broadcom (down 8.39% in the past 3 months) are losing ground.

A lot of this is currently being blamed on political uncertainty. While there is a lot of that to go around with trade and tariff squabbles, Middle East tensions on the rise and a split congress. Looking deeper, business conditions are deteriorating.

Many measurements of profitability are dropping, hiring as I mentioned before, is dropping and the housing market as reflected by the sales numbers are slow, despite the lowest mortgage rates in 2 years.

Bonds are Telling a Tale

You also need to know that 10 year treasury yields are approaching 2%, while a year ago they were almost at 3%. This is a predictor of an economic slowing. Besides that, the yield curve is “inverting”. This is based on the fact that 6 month treasury bills are paying higher interest than the 5 And 10 Year Notes. Historically We Tend To See Recessions Following This Phenomenon By 12-18 Months. We Have Been Inverted For Many Months At This Writing.

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What to Do Now?

While I am normally an optimist by nature, I cannot ignore this stuff. Is the market guaranteed to go down from here? Nobody knows.

What I do know is that we are much closer to a top than a bottom.

Investors today are looking at a lot more risk in most stocks than the potential reward from them. I guess the question is would you give up the potential to make 5-10% if you could lose 40-60%? This is really what we are talking about.

If you have more than 10 years until you will use the money you have invested, and can handle the volatility, then stay invested, but move to more conservative holdings and reduce your exposure to banks, brokerages, tech and small cap stocks in general (there will always be individual exceptions) and move to more conservative holdings.

I would also recommend selling what you own that would not buy today at current prices. That cash will come in handy when stocks go on sale.

If you are less than 5 years from needing to use the investment (like for retirement), take steps to hedge your profits and reduce risk NOW. You will not have time to recover before your need to use this money. If you are willing to put off things like retiring, then don’t worry. But if not, be aware that you might find the quality of your retirement permanently reduced.

The other thing I would suggest is to do some “Tax Loss Harvesting”. Those losses, once booked, can become a valuable asset as this will allow you to take profits on other investments without being hurt so much by taxes.

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Are There Other Options?

If you can’t afford to put all your money into cash because you need it to grow or produce income for a pending retirement, there are many options out there that will keep you insulated from these types of losses.

Understanding where you are in life and what your options are will become more and more important as this plays out. If you would like to see some of the source material I mention in this article, or have questions about anything I wrote, contact the office, and I will be happy to answer them for you.

If you want to explore alternative options, you can also contact us. There are some strong alternatives that should do well in a downturn.

Remember, market volatility doesn’t mean you MUST lose money. In fact, it can produce some of the biggest gains when the markets drop dramatically. The key is being prepared.

Are you ready?

Bonus Content: Retire Happy Podcast Episode #15