Late Innings

TV commentators have been buzzing recently about what possible “inning” of the economic cycle the US is in.  The baseball analogy is an understandable way to frame the discussion and slightly more tangible than the question, “how long until things are bad again?”  The economy and the stock market go through cycles.  Good times don’t last forever, nor do bad times.

An important distinction needs to be made right up front.  The economy and the stock market are not the same thing.  Economic headlines remain encouraging: low unemployment, strong economic activity, and relatively strong consumer spending.  However, those numbers each measure the past.  Investors are forward-looking.  What are next year’s earnings projected to be?  How much more will the Fed raise interest rates?  What will consumer spending be next year?  Will housing starts slow more than expected?

For this reason, stock markets tend to go south much earlier than the actual economic data would suggest, and likewise, tend to go up well before the economy when coming out of a recession.  While I continue to believe that the next recession is 12-18 months away, the next bear market may be much closer.  Rather than lay out the litany of reasons why we feel that we are in the late innings (which I’ll be glad to address individually), I’d like to highlight some steps to take in case I’m correct in my hypothesis.

October’s performance offered a concerning reminder of how quickly markets can change.  After ending September with a nice gain, the S&P500 fell 6.84% in October, essentially giving back nearly all its gains on the year.  But let’s keep things in perspective.  Since 2009, the S&P 500 has rallied from 666 in March of 2009 to 2940 in September of 2018.  A rise of more than 340%.  A pullback of nearly 7% is hardly much to be concerned with, yet. 

In hindsight, the most beneficial asset allocation over the last decade was pretty straightforward: 100% US stocks.  Diversification into international stocks, bonds, precious metals, and other commodities offered no tangible improvement in total performance, and in most cases offered a substantial drag.  It’s easy to abandon the idea of diversification when one asset class has done so much better than the others, but I suspect the next decade will look considerably different than the last.  Keep in mind, from March 1999 to March 2009, an asset allocation of 100% S&P500 would have produced a total return of a whopping -26%.  (Source: Thomson One) 

Even this year, it’s hard to get excited about other asset classes.  In fact, this year may be the first since 1971 (when gold prices floated freely) that stocks, bonds, and gold have all fallen in value in a calendar year.  While many issues abound for international stocks, and interest rate hikes temper our excitement over bonds and gold, we maintain that the best investment strategy over the coming years will be an allocation that encompasses each.  Despite the unique circumstances this year, bonds and gold still offer uncorrelated returns.  One of the key ingredients to managing risk is uncorrelated assets that provide diversification in bad times.