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More Concerns for Equity Investors

| June 26, 2018
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"Wall Street indices have predicted nine out of the last five recessions."

--Paul A. Samuelson in Newsweek, Science and Stocks, 19 Sep. 1966.

"Prediction is very difficult, especially if it's about the future."

--Nils Bohr, Nobel laureate in Physics

Despite the wisdom of the quotes above, I'd like to take a stab at addressing some concerns that investors are voicing about the current economic and market environment.  And I'll lead with my conclusion:  A recession is probably closer than it's been since the Great Recession of 2008-09.  Since bear markets usually (but not always) precede a recession by 6-9 months, some additional caution is in order.  

Trade is the ultimate two-way street

Back in March, I wrote that the "latest concern" for investors was trade.  We are now seeing that worry blossom into front-page news, with Harley-Davidson motorcycles targeted for 25% retaliatory tariffs from the EU (in response to the Trump Administration's tariffs on imported steel and aluminum.) 

Since companies operate with a global supply chain and far-flung production locations, it's not surprising to read that H-D may be moving some production offshore to avoid part of the impact of these tariffs. The unintended consequences of a trade war include targeted retaliation, like this. And lower profits for the likes of Harley-Davidson.

The impact of "trading" barbs

My concern here is not for Harley, of course, but that this tit-for-tat could get out of hand. Trade wars have long been associated with recessions because they slow down economic activity everywhere. 

Consumers pay more for both imported products and domestic products that USE imported products.  Meanwhile businesses are hit with confusion.  They need to know the rules of the game in order to plan and invest for the future.  Lack of clarity leads to slowing investment, which also depresses economic activity.  

It's also in the shape

There are other signals, too, in the bond market, that seem to confirm that the economic cycle may be closer to contracting than is widely believed.  One signal is called the "shape of the yield curve" (and to put it simply, it's the comparison of short term interest rates to longer term interest rates.)  When short rates are higher than long rates (a rare occurrence), the curve is called "inverted".  As the graph above shows, each recession in the past 35 years has followed an inverted yield curve.  (Highlighted by a red arrow.)

This is only one indicator, but it's a classically important one that many investors watch closely in their attempt to be ahead of the recession.

It's comfy now, but that sound you hear may be an approaching recession 

Yep, the economy is going great and nearing full employment.  Comfy, right?   But cycles come and go, and this expansion will give way to a contraction.  You might wonder:  Why worry about a recession? I mean, a recession is not the same thing as a bear market.  I agree wholeheartedly!  Measuring a recession is secondary. Stocks will decline before you even know that there was a recession.

Those who worry most about recessions are companies (whose sales decline), as well as workers (who could lose their jobs.)  But stock market participants are removed from economic fundamentals.  Economic data is revised repeatedly, so we don't know how the economy is really doing at any point in time.  Thus, the market usually is 6-9 months ahead of economic realities as investors react to leading indicators (like the shape of the yield curve), prompting stocks to decline well ahead of the recession.   

Conclusion

Nobel prize-winning economist Paul Samuelson famously stated that stock market indexes have predicted nine of the last five recessions. But, we're not using stocks to predict a recession...  We're doing just the opposite.  Our job is to be worried about the direction of stocks.  We're using indicators and policy changes to inform our view on the markets.

Worried about stocks?  Yes, we're always a little worried.  Just a bit more right now. 

You've likely received notes or calls from us suggesting that you move some money out of the market, and into "fill-in-the-blank" investment with a low correlation to the stock market.  Depending on the investor, the replacement idea could have been as diverse as farmland, principal protected funds or solar financing ...  The overarching idea among these investments is consistent:  To earn equity-like returns over time, but with less connection to the markets' ups and downs.

So, we humbly suggest that it might be time to take a second look at those communications and have another conversation.  

As always, we welcome your comments and questions.

Scott

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