Wisdom of the Ancients

CWM model exposures ended the year (conservative) much differently than they started (aggressive). Despite recent positive market action, your CWM team remains concerned about the future market potential based on current data and its similarity to calamitous events in history.
Bird in Hand

“A bird in the hand is worth two in the bush” is one of the oldest proverbs in the English language, with sourcing back into at least the 1400s.1 It is a piece of ancient wisdom that serves to caution against taking unnecessary risks; the suggestion being that it is better to keep what you have (a single bird) than to risk it in order to maybe get more (the two birds currently out of reach).

The above point is completely in line with one of your CWM team’s core investment philosophies that “downside protection is more important than upside participation.” Put simply, it is more important to keep the asset value you have than risk it to obtain more; a piece of advice that apparently has withstood the test of time and a point that can also be proven mathematically.

Take three scenarios, one where all upside potential (+50%) is realized along with all downside (-30%), the buy and hold option, versus two versions of less upside and half of the downside participation. In both latter cases, the result is better than the full upside scenario despite missing a significant portion of the upside. This outcome would be the same if the loss happened first, followed by the gain, and is a clear demonstration of why downside protection is more important than upside participation.

Source: CWM Data Analytics

In today’s investment environment, downside protection continues to be the focus of your CWM team based on the current economic data. While recent positive market performance may seem to suggest otherwise, the negatives are beginning to stack up and it is likely just a matter of time before some level of stock market calamity ensues.

A Quick Look at the Recent China Trade Deal

It’s more than a year after the above tweet from President Trump, but some kind of deal (the details are still relatively unknown) has occurred that has at least for now lessened both tariffs and tensions. Schwab’s chief economist, Liz Ann Sonders, summed up what is known about the deal as follows:

“It falls quite short of the initial U.S. goals of forcing China to morph its state-driven economy to a more open/fair economy. It does, for now, defer the tariffs that were set to go in effect on December 15, 2019. That’s good news as they targeted a mass of consumer-oriented goods. In addition, there was a partial roll-back of prior tariffs—with those having been imposed last September getting cut from 15% to 7.5%.
However, the ’original’ 25% tariffs on $250 billion of Chinese goods remain in place. China also agreed to increase its purchases of agricultural products to $40 billion, up from its current annual run rate of less than $10 billion (and the all-time peak of $29 billion). However, the product lists will not be publicly disclosed; meaning monitoring capabilities will be limited. Finally, China has promised to revise some laws and regulations on foreign investment and intellectual property (IP); but it doesn’t prevent China from continuing to ‘import’ (aka, steal) U.S. IP through its powerful technology ecosystem.
The ‘deal’ also doesn’t mean the Trump administration won’t continue to use tariffs and other trade barriers as a tool to coerce various concessions from, or to punish, other countries. This ongoing uncertainty is likely to keep a lid on corporate confidence—and in turn capital spending.”2

The recent deal is a start, but it would be disingenuous to describe it as substantial progress towards normal relations with China. Your CWM team continues to believe the U.S. and Chinese markets are stuck in the below trade war cycle that has existed over the last two years.

Source: CWM Data Analytics

Focusing on the Bird in Hand as Negative Market Data Piles Up

As it is the end of the year, and decade, there is a wide variety of interesting and relevant data points to discuss when looking at what next year and the 2020s may hold in store. This section will highlight several of these different items of interest, accompanied by the usual wonderful squiggly-line charts and data tables and brief commentary on each in a lightning-round style of presentation.

As the 2010s close out, it’s worth noting that this is the only decade on record, going back as far as the 1850s, that did not experience even a single short economic recession (assuming one is not already present and just not formally recognized). History would seem to suggest that the U.S. economy is well overdue for a recession within the normal timing bands, though it should be noted that age/time itself is not a causal reason for recession to occur.

Source: Carlson, B. (December 6, 2019). The First Decade in Modern Economic History. @wealthofcs, Twitter.

Long regarded as one of the world’s most successful investors, Warren Buffett, through his firm Berkshire Hathaway, has been steadily growing his cash pile for some time. It is worth noting that this growth has occurred through a time period of sharp stock market valuation growth; valuations that have continued to rise to nosebleed levels. When trying to be successful at any endeavor, it is wise to take note of the moves of the experts in that field.

Source: Stevens, P. (November 4, 2019). Warren Buffett Has $128 Billion In Cash to Burn. CNBC

Warren Buffett does not appear to be alone amongst the cautious “smart money” class. So-called smart money and “dumb money” investors (please note these are not CWM-coined terms) are separated and measured by a variety of indices that track the trading activity of large institutions, financial professionals, and smaller individual investors. The measures of smart money investors have become ever more pessimistic as market valuations have risen, while dumb money has become nearly giddy with optimism. Large differences, like those that exist now between the two groups, have corresponded with at least short-term market tops in the past.

Source: Sonders, L. (December 16, 2019). 2020 U.S. Market Outlook: Ramble On? Charles Schwab.

CEOs are arguably part of the above mentioned smart money group while the average consumer is part of the dumb money. CEO sentiment minus consumer expectations has shown some predictive power for forecasting economic recession in the past, with low readings preceding the last few recessions. The measure is currently at its lowest reading on record. Logically, if CEOs are feeling negative about the future, and they are the ones who control hiring and business investment decisions, it stands to reason that those negative future expectations will result in less business investment and hiring activities— with less business investment and hiring being a significant negative for the economy, of course.

Source: Sonders, L. (December 16, 2019). 2020 U.S. Market Outlook: Ramble On? Charles Schwab.

Based on the above data, it’s not too shocking that 2019 saw more CEO departures than during the height of the great recession in 2008, and that is still with one more month to go (December data not yet included for 2019). Notable recent departures were the Google cofounders. The question remains whether this is meaningful information or just noise in a small data sample, but suffice it to say that it does not inspire confidence to have high levels of people-in-the-know quitting.

Source: Fitzgerald, M. (December 11, 2019). Nearly 150 CEOs Departed in November, Putting 2019 on Track to Be Record Year for Executive Exits. CNBC.

It might surprise some to know that the S&P 500 stock index is not equally weighted among all of the included companies; it is weighted based on market capitalization (i.e. bigger companies get a larger weight). The five largest stocks in the S&P 500 now make up the largest percentage of the allocation since 1999, which means the index’s outcome has become more dependent on the performance of fewer companies. Those that have been investing and working with a financial planner for an extended period of time know that investment outcomes typically improve by having a fully diversified, not concentrated, investment portfolio.

Source: Edwards, T. (December 9, 2019). 20 Charts for the 2010s. @drtimedwards, Twitter.

The CBOE Volatility index (the VIX) is often referred as a measure of fear and greed, as it measures the ratio of open put-to-call options in market. Low readings of the VIX represent a low level of investor interest in buying downside protection via put options, while high readings show a high demand for protection. Typically, the VIX reading is lowest near market tops and highest near market bottoms, as investors react emotionally and irrationally to recent market price movement.

Over the last decade, this index itself has become a popular speculative tool with investors able to bet whether the measure itself will go lower (short) or higher (long). Despite being already near historic low levels of the index, record levels of VIX shorts are currently in place (i.e. bets the index will fall further). Like kindling for a fire, the unwinding of these short positions could result in or correspond with a significant negative market move, as the last two times a sharp unwinding of VIX short positions occurred.

Source: Ingles, D. (November 25, 2019). Short on VIX at Record. @DavidInglesTV, Twitter.

Corporate profit levels are barely above those set back in 2014, while the S&P 500 value is almost 50% higher. The last time a significant gap between valuation and profit existed (2000 and arguably 2007 as well), recession and market calamity soon followed.

Source: Sonders, L. (December 16, 2019). 2020 U.S. Market Outlook: Ramble On? Charles Schwab.

The above data points represent a small sample of the numerous information sources your CWM team examines when discerning how to properly allocate client assets. First and foremost, our goal is to protect the portfolio value already present, and then take responsible risks to grow that portfolio value.

A Federal Reserve (and Global Central Banks) in Panic Mode

Despite all of the above data, it can be noted that the last few months have been good for markets. If things are deteriorating rapidly, as shown above, what gives?

Investors are not the only ones paying attention to deteriorating economic data— so are the world’s central banks, whose governments have tasked them with achieving “economic stability” (an arguably impossible task). In response to data like that shown above, global central banks have now made more rate cuts in tandem over the last six months than at any point since the start of either of the last two recessions. Those cutting actions did not stave off a recession in either case.

Source: Slok, T. (December 9, 2019). 2020 Global Macro Outlook. Deutsche Bank.

Cutting rates isn’t the only tool in the Federal Reserve’s toolbox. It can also expand its balance sheet through the process of printing money and buying a variety of debt instruments (like treasuries, T-bills, etc.) in order to lower borrowing costs. The last three months has seen the Fed expand its balance sheet more quickly than at any point during or after the 2008 financial crisis.

Source: The Long View. (December 6, 2019). Monthly Change in Fed Balance Sheet. @HayekandKeynes, Twitter.

The effect of this money-printing action is that the Fed’s balance sheet has expanded so rapidly that it has undone almost half of the normalization process that had occurred over the last five years!

Source: Total Assets Held by the Federal Reserve. (December 9, 2019). The St. Louis Federal Reserve.

Keep in mind that the above emergency-level actions are occurring at a point with all-time low unemployment and stock markets near all-time highs, which hardly seems like an environment where extreme Fed actions should be needed. This beckons the question, “What do the Federal Reserve Board governors know that the general public does not?” Your CWM team’s belief is this has to do with the out-of-control levels of borrowing and indebtedness of the U.S. government and corporations, debt levels that could result in economic calamity at even slightly higher costs of borrowing. The below graphic show just how dramatically debt levels (in billions) have grown over the last 70 years.

Source: Gundlach, J. (December 10, 2019). A Rolling Loan Gathers No Loss. DoubleLine Funds.

The demonstrated growth in U.S. corporate debt has resulted in the highest corporate debt-to-GDP ratio on record. High levels of debt to national economic output have been associated with major market tops/recessions in the past (red shaded areas).

Source: Gundlach, J. (December 10, 2019). A Rolling Loan Gathers No Loss. DoubleLine Funds.

Based on all of the above debt data, no one should be shocked that fewer and fewer debt offerings are highly rated for investment purposes. In 1988, over 65% of the corporate debt market was graded A (investment grade) or better; today, that number is just above 40%. This suggests that default levels (companies not paying on their debt) in the next downturn could be higher than usual.

Source: Gundlach, J. (December 10, 2019). A Rolling Loan Gathers No Loss. DoubleLine Funds.

Your CWM team believes that the Fed is taking extreme actions to try and stave off the economic eventuality of recession, which has resulted in some notable short-term market positivity over the last few months. We do not expect this to last.

The CWM Outlook: Have a Plan, Not Fear

The above analysis is not meant to cause fear or any other negative emotion. What should be taken from this information is that the current data suggests that portfolio conservativism is the appropriate approach to responsibly protect value and prepare for potentially better future opportunities, and that a disciplined plan better be in place to achieve that purpose. The CWM plan utilizes market data (a.k.a. factor groups) to make that determination. Only one group remains in positive territory, while the others, especially value, are flashing warning/caution signs.

Source: CWM Data Analytics

To demonstrate just how extreme valuations have become, below is the historic chart of our favorite valuation measure, total market capitalization to U.S. gross domestic product. The current ratio is over 1.5x the market cap-to-GDP, a level higher than the extreme high valuations seen prior to the 2000s dot-com crash, which wiped away half of the S&P 500’s value over the following two years.

Source: The Federal Reserve Bank of St. Louis. CWM Data Analytics. (December 16, 2019).The Wilshire 5000 Stock Index total market capitalization divided by reported United States GDP data.

The two-year forward interval range, based on the above factor groups, is still decidedly negative for stocks. The treasury range is not much more appealing, though it has improved slightly versus the recent past as rates have risen a bit on the longer end of the treasury curve.

Source: CWM Data Analytics. (December 13, 2019). CWM Two Year Asset Intervals. CWM.

As it stands, your CWM team believes that protecting the bird in hand is the primary concern as we head into the new year and new decade. Opportunity, with less downside risk potential, will eventually reveal itself and patience continues to be the most important attribute for the foreseeable future.

Please pass this article on to anyone you know who may be interested in or might benefit from the information. We are always looking for more great clients like yourself and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter @MorganArford.

P.S. For those of you who made it out to CWM’s annual holiday Gingerbread Build, THANK YOU! Turns out not everyone is a big fan of Santa, especially my daughter.


1 A Bird in the Hand is Worth Two in the Bush. (n.d.). The Phrase Finder

2 Sonders, L. (December 16, 2019). 2020 U.S. Market Outlook: Ramble On? Charles Schwab.

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