2017 was a banner year for markets. Rarely in history have the markets displayed such consistent increases. We first noted the calm in the market in our 2017 Q1 commentary, and that theme continued through the year. Looking specifically at the S&P 500 through 2017, we can see:
At no point did the market close at less than 3% of its previously achieved high.
December 31st marked the 13th consecutive month the S&P posted a gain (the last time this happened was in 1959).
The highest daily increase in 2017 was 1.38%, one of the lowest on record.
In prior commentaries, we have explored at length the various factors creating the calm in the market, and honestly, not a lot has changed. Congress did pass a tax reform bill, but that was already being figured into market expectations. So, we enter 2018 at the same pace and with the same calm that dominated markets in 2017.
What will 2018 bring us? In the past we’ve written about our trepidations with market forecasts and predictions (something about expert forecasting being as accurate as dart throwing chimpanzees). It is uncertain what will transpire over the coming year and the useful benefits of prediction are limited. What we do find useful, especially in times where the market calm tempts us to complacency, is to consider where we are. Markets and economies go through cycles. Markets move from a state of absolute fear (everyone is selling) to a state of absolute greed (everyone is buying) and then back to fear. Economies go through cycles of expansion and recession and, while separate, these two cycles are closely related. When the economy is growing, or shows the prospect of growth, markets tend to perform well. When economic data points to a recession and a decrease in corporate profits, markets tend to perform poorly.
Framing our thinking within the paradigm of these cycles is a reminder that things change. It is especially critical to remember this right now as the length of the current economic expansion and the calm, steady upward climb of the market pushes us into complacency. It helps us resist resting on our laurels because we remember that things will change. Thinking in terms of cycles also helps us frame some of our portfolio decision making. There are certain opportunities and risks commonly associated with the various parts of these cycles. Having a general idea of where we are helps inform us of how our portfolios should be positioned and what we should be prepared for in the future. So, let’s get out our road maps and see where we are at.
Where are we?
We are going to start with the easier of the two cycles: the economic cycle (oftentimes also called the business cycle). The chart to the right outlining the business cycle is one that you can find in any Macroeconomics textbook (page 11 of mine). It is important to remember that economics is not a hard science…economists are basically philosophers with calculators and spreadsheets. That’s not an insult (or at least isn’t meant as one). There are far too many variables, and so much of what happens in an economy is up to human behavior. However, some general trends, like the business cycle, are consistent. A well-functioning economy will expand, reach a peak, then enter a recession, before it eventually troughs and then goes into expansion.
We’ve taken the liberty, in the style of a mall map, to indicate roughly where we are in the cycle. Please don’t read too much into the sizes of peaks and troughs and don’t focus too closely on where the little star is, because I don’t know exactly where we are in the cycle and neither does anyone else. However, certain characteristics tend to exist in certain parts of the business cycle. Looking at the data across the board suggests our current business cycle is nearing a peak: unemployment, credit expansion, default rates, businesses growth, and other economic activities are at or nearing places typical of a business cycle that is getting close to a peak.
This isn’t a call for a recession in 2018. The recently passed tax reform bill will provide stimulus to the economy. Companies are already announcing wage increases, special bonuses, increased capital expenditures, and job creation measures that will likely lengthen the cycle. Even with that being the case, we may see some signs of a slowdown or even deterioration in economic data sometime in the next 12-18 months.
Determining where we are in the market cycle is less data driven and more inference driven. Market cycles do not tend to follow the same gradual changes of economic cycles. Much of that has to do with what is driving market cycles: it is less about reality and more about peoples’ perception of reality. Knowing exactly where we are is difficult but there are indicators you can look to: measurements of business and investor sentiment that can provide a loose picture of where we are at in the scale of Fear to Greed.
To the right is a chart I keep and update on a continual basis (it didn’t upload very well into wordpress). This is not something we came up with. This is a guide investor Howard Marks uses and outlines in his book, The Most Important Thing. He calls it the “Poor Man’s Guide to Market Assessment” because it does not require a $25,000/year Bloomberg Terminal (has 2-6 computer screens and you can get about any economic/market data set imaginable) to complete. We like it because of its simplicity and, because it’s generally true.
Here’s how it works: the two right columns are opposing market characteristics. You simply work your way down the list and bold which best describes today’s environment (I highlight but the spreadsheet didn’t transfer over well to wordpress). Is today’s economy vibrant or sluggish? Is the outlook positive or negative? Are lenders eager or reticent? The more bold characteristics on the left, the farther in the market cycle we likely are.
As you can see, most of the descriptors we chose when applying it to the US Stock Market are in the left column: lenders are eager, capital markets are loose, debt terms are easy, interest rates are low, spreads are narrow, markets are crowded, there are few sellers, recent performance has been strong, and asset prices are arguably high, to name a few. These characteristics are indicative of late market cycles. Admittedly, there is a lot of subjectivity involved in this chart. It is not perfect, and neither are we in its application. Another person may take the opposing viewpoint on some of our selections. But when looking at market characteristics it appears we may be nearing the end of a market cycle.
Knowing where we are doesn’t tell us exactly where we are going and when we will get there. We don’t know what the year will bring. Our guess is that there will be more volatility in the markets this year. It is hard to imagine such a calm, steady year being followed up by yet another calm, steady year. However, just because it is more volatile does not mean it will be worse or better. But, predictions aside, the most important thing to take from all of this is not to buy into the calm. It will not last. The economy appears to be nearing a peak and domestic equity markets are exemplifying the characteristics of an over-priced, over-extended market. We need to vigilantly work to hold assets that are reasonably priced, limit credit exposure, and be ready for mispricing opportunities that can arise if the market does turn. We will continue to look for opportunities to invest capital at an acceptable level of risk.
Past performance is not a guarantee of future earnings. Asset allocation does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.