Quote of the Week
“Whenever you find yourself on the side of the majority, it is time to pause and reflect.” – Mark Twain
Please read Larry’s Thoughts this week. It is important because I am explaining our process for managing your money.
U.S. stocks declined modestly last week, taking a breather after a sharp rally at year-end and a new record high on the first trading day of the year. Concerns over rising tensions between the U.S. and Iran emerged on Friday following the U.S. airstrike in Iraq that killed a prominent Iranian general. The heightened geopolitical risk in the Middle East led crude oil prices to rise 3% following the news which was good for our energy position.
Oil reflated another +2.2% last week and is +12.5% in the last month which is a confirmation that inflation is increasing which is good for our current positions. Remember our positions in Utilities, REITs, energy, TIPs, and gold should all benefit from inflation increasing.
Meanwhile, the economy is continuing to slow and wages are going up. This is the recipe for lower corporate earnings. If the economy is slowing that means lower top line revenue for corporations is declining. Combine that with rising wages, the corporate profit picture is continuing to deteriorate. If corporate profits continue to decline and wages continue to rise, eventually stock prices will start to decline. What can’t go on forever, won’t.
One interesting fact that I heard the other day is that the Wilshire 5000 which represents the entire stock market is close to setting a new all-time high in relation to earnings. The ratio of the total value of the Wilshire 5000 to the earnings of the index is at 15 to 1. That means for every dollar of earnings there is $15 of value. The top of the market at the beginning of 2000 was 17.5 to 1. We all know what happened in 2000 to 2002 when the stock market lost 50% of its value. The normal average is 9 to 1 which means the current market is 66% over valued as compared to normal using this yardstick. This is a simplistic illustration and many more factors go into stock market values, but it is concerning.
The Institute for Supply Management Manufacturing (ISM) just came in at a 127-month low of 47.2 and marking the fifth month of sub-50 misery. Any read above 50 means expansion and any read below 50 means contraction. Current production, new orders and employment all remain mired in contraction, falling sequentially while sitting at or near cycle lows. Meanwhile Industrial Production marked the third consecutive month of negative year-over-year growth confirming the capex-industrial recession domestically. We are still looking at a fourth quarter GDP of + 0.30% vs the third quarter GDP of +2.1%.
We are still maintaining our conservative positions.
Starting off 2020, I want to pull back the curtain and explain how we invest your portfolios.
First, a little history will be informative. We have been a data driven firm since 2005. Our computer-based process has used “trend following” as our primary tool. Trend following is just as it says. We used software to recognize investment trends and if the trend is up, we invest and if the trend is down, we avoided that asset.
This process worked very well until October of 2018 when the markets declined fast and deep. In my entire career I have never seen such a fast and steep drop. Because of the very nature of trend following, a period of time must elapse to recognize a change in the trend. Trend following didn’t work during that October because the time frame was too short to give us a signal to exit the stock market.
We were doing VERY well from the beginning of 2017 to the start of the month of October in 2018. Because trend following by its very nature was unable to recognize and act on the decline in October, we ended 2018 performing in line with the market returns for the year. Because I don’t know if we will get a repeat of October 2018 again, I started to look for an alternative. I believe I have found one.
We are now using a company called Hedgeye. If you are curious, I encourage you to visit their web site at Hedgeye.com. They have over 80 people employed with over 40 analysts.
The difference is that Hedgeye Is a Macro “meaning big picture” advisor which means they are tracking inflation and growth which determines what economic sectors we should be invested in. They divide the economy into four quadrants based on the direction of inflation and growth. Asset classes perform differently based on different economic environments. This sounds very simple; however, the analysis is quite complicated.
The following chart shows the four different quadrants as per inflation and growth.
Quadrant I and II are good for investing in the markets, Quadrant III is not as good for market investments as I and II, but with the right allocation decisions it is OK. Quadrant IV is the “death knell” for equities and where we go to safety and invest in high quality bonds.
The next chart shows which asset classes to own or not own in each of the four quadrants.
Hedgeye is forward looking vs trend following which is somewhat backward looking in order to see if a new trend is developing and thus can be late in giving us a signal. I don’t think we will experience an October of 2018 again. Of course, I can’t guarantee any future returns, but I feel we have a better source of investment analysis.