Price
Source: dshort blog, Monthly Moving Averages: November Month End Update
All three S&P 500 moving averages signal "invested" at the end of November. Three of five Ivy Portfolio ETFs —Vanguard Total Stock Market ETF (VTI), Vanguard REIT Index (VNQ), and iShares Barclays 7-10 Year Treasury (IEF)— are signaling "invested" with two ETFs —PowerShares DB Commodity Index (DBC) and Vanguard FTSE All World ETF (VEU)— signaling "cash." The last five days of trading in November pushed VTI into an "invested" signal from "cash." Price action can whipsaw investors from time to time and this is one of those times. Last month's update Choppy Waters acknowledged that we could see whipsaw action in one or more of the Ivy Portfolio asset classes. If the economic background looked better, I'd feel more comfortable investing with the end of November signal of "invested" for VTI, however the U.S. economy is decelerating in Q4 and VTI month-end price barely rose above the monthly moving average indicator, therefore I remain skeptical of this price action and currently do not want to enter this possible investor trap disguised as a "Santa Claus Rally."
Sentiment
Source: CNN Business Fear & Greed Index
The Fear & Greed Index shifted up from 7 at the end of October to 23 at the end of November. Sentiment measures "Extreme Fear" for the second month in a row. The beginning of December is also the second month in a row that none of the seven components of this index read "Greed" or "Extreme Greed." One indicator, Market Volatility, remains in "Neutral" with the remaining six indicators all reading "Fear" or "Extreme Fear." Before we move on to discuss valuation I'd like to highlight the Goldman Sachs Bull/Bear Risk Indicator, which we first showed in the October update:
Source: Goldman Sachs via MarketWatch
Notice on this chart that once the risk indicator is this elevated historically a period of lower market returns should be anticipated.
Valuation
I'll tip my hat to Jesse Felder who recently highlighted this passage from the Fed on his blog The Felder Report in a post titled, The Fed Warns the 'Drop in Asset Prices Might be Particularly Large':
An escalation in trade tensions, geopolitical uncertainty, or other adverse shocks could lead to a decline in investor appetite for risks in general. The resulting drop in asset prices might be particularly large, given that valuations appear elevated relative to historical levels. In addition to generating losses for asset holders, a significant fall in asset prices would make it more costly for nonfinancial businesses to obtain funding, putting pressure on a sector where leverage is already high. Markets and institutions that may have become accustomed to the very low interest rate environment of the post-crisis period will also need to continue to adjust to monetary policy normalization by the Federal Reserve and other central banks. Even if central bank policies are fully anticipated by the public, some adjustments could occur abruptly, contributing to volatility in domestic and international financial markets and strains in institutions.Let's discuss the main valuation metric that shows the S&P 500 remains undervalued, the Fed Model. The Fed Model compares the earnings yield of stocks to the 10-year Treasury yield. When the earnings yield exceeds the yield on 10-year Treasury bonds, stocks are cheap. When the 10-year Treasury yield surpasses that of the S&P 500 earnings yield, stocks are expensive. Currently the earnings yield is 4.44% and the 10-year Treasury yield is 3.01% (as of 11/30/18) indicating stocks are still cheap relative to bonds. If operating margin compression occurs between Q4 2018 through Q1 2019 the earnings number will decrease more than expectations. As the earnings yield changes, bonds could look more attractive than they do currently using this model.
Overview
Price action surged to end November showing investors using The Ivy Portfolio system should be "invested" in VTI, VNQ, and IEF. As noted earlier, I'm not taking the bait of the VTI "invested" signal for this month. Sentiment improved modestly from 7 to 23, still reading "Extreme Fear." Valuation for U.S. stocks continues to look appealing when compared to bonds using the Fed Model; outside of this metric, the majority of valuation metrics I examine tell me stocks are overvalued.
Additionally, readers need to watch for signs of margin pressure in corporate America. I still believe profits will slow in 2019 as operating margins compress due to higher costs, particular the cost of capital with higher rates and increased labor costs. There is no doubt in my mind the business cycle is slowing after a near record economic cycle advance since June 2009. During the end of a business cycle, investors --primarily retail investors-- who missed the bull run use market weakness, like October's decline, to add money to the market. At best, this can last for a few months.
Given the high levels of corporate debt, I expect a major theme for 2019 to 2020 to be a rerating of debt. This will result in investors who think they hold investment grade paper dealing with some version of junk in their portfolios. According to S&P Global Market Intelligence total leveraged debt outstanding (high yield bonds and leveraged loans) is now $2.5 trillion, exactly double the amount in 2007. Leveraged loans have risen from $500 billion in 2008 to $1.1 trillion today. Moreover, according to the IMF, BBB-rated bonds -the lowest investment grade category- now stand at $1.4 trillion in the U.S. and constitute the largest component of the investment grade universe (roughly 47% in both the U.S. and Europe, up from 35% and 19% respectively, ten years ago).
December begins with the news of a China-U.S. tariff delay. This deal leads many to believe stocks and other risk assets will have a positive first week of December, however the theme of rebalancing into high quality bonds ahead of the next down cycle in the economy will continue. The Fed will raise rates at the December meeting with one to three more rate hikes expected for 2019, which means yield curve inversion remains likely between now and the end of next year. The halt to trade hostilities and no more tariffs for a while is, at best, good enough for a relief rally in both the U.S. and China’s markets. The breather in trade hostilities is not enough to change the current outlook for next year and stop the global economy from slowing down. Whether we are dealing with the potential partial U.S. government shutdown on December 7, 2018 or the trade issues with China, current U.S. policy can be summed up in a few words, "Let's kick the can down the road." Political risk may also increase in 2019 as the Mueller investigation continues, while the Democrats in the House of Representatives start using their powers in our "checks and balances" democracy to investigate the Executive branch. Let's end with a couple quotes:
"Your time is limited, so don’t waste it living someone else’s life." - Steve Jobs
"Make sure you have finished speaking before your audience has finished listening."
-Dorothy Sarnoff
As always, wise investing my friends.
Please consult a qualified financial advisor before making any investment decisions. This blog is for educational purposes only and does NOT constitute individual investment advice.--------------------------------------------------------
Here's what I've been reading and watching recently:
- Boomers Find Reasons to Retire Later (Squared Away Blog)
- The Periodic Table of Investments (Visual Capitalist)
- U.S. Relations with China 1949-2018 (Council on Foreign Relations)
- World GDP by Country:1960-2017 (YouTube)
- Future Top 10 Country Projected GDP Ranking: 2018-2100 (YouTube)
- Financial Stability Report (The Federal Reserve)
- Hard Choices (HBS by Seth Klarman)
- The ‘true state’ of Americans’ financial lives: only 3 in 10 are ‘financially healthy’ (MarketWatch)
- The Biggest Myth in Retirement Savings (A Wealth of Common Sense)
- Webcast | Quad 4: The Worst is Yet to Come (Hedgeye)
- U.S. investment-grade corporate bonds now riskier than before each recession since 1981: Moody’s (MarketWatch)
