While macro-economic trends point to a continuation of strength in US equities, macro-economic levels point to elevated risk. A late cycle reduction in equity risk for portfolios must be balanced against the opportunity cost of better-than-average returns.
The final year of a bull market is often uncomfortably profitable, as the S&P 500 averages a return of 15% in these years. Above average returns reveal the higher risk at this stage of the cycle. This high return vs. high risk reality compounds the importance of accurately managing equity risk late in the market cycle.
To achieve this objective we explore the lessons of history. While not perfect, the coexistence of high cyclically adjusted valuations, low unemployment, strong economic growth, and high inflation has historically been a precursor for negative equity returns (i.e. the prerequisite for a big fall is a long climb). As reviewed below, these precursors are in place and extended from the mean.
Currently, the S&P500 cyclically adjusted price to earnings ratio is 27.8x. From a levels perspective, this equates to the 83th percentile relative to the last 20 years (relatively high). From a trend perspective, this valuation measure has increased, or expanded, 2.8 points over the last 6 months. (see chart 1)
Chart 1: S&P500 Cyclically Adjusted Price to Earnings Ratio
Likewise, the current ISM Manufacturing Index level is 59.1 (any readings above 50 suggests economic expansion, below 50 suggests economic contraction). This level equates to the 95th percentile relative to the last 20 years. The trend in ISM Manufacturing is also positive, increasing 2.6 points over the last 6 months. (see chart 2)
Chart 2: US ISM Manufacturing PMI
Furthermore, US unemployment is very low. The current level of unemployment is 4.1%, which equates to 95th percentile relative to the last 20 years. Once again, the trend here is positive, with unemployment moving 0.2% lower over the last 6 months. (see chart 3)
Chart 3: US Unemployment Rate
The extreme levels are the qualifier, but the challenge for investors is in measuring and monitoring the persistence of these trends. As long as valuations and the economy keep expanding, equities can continue inflating.
So what does all this mean for portfolio strategy? What must be done to manage the price risk now inherent and building up in US equity markets? Considering the elevated levels and strong trends, we recommend the following strategies:
1. Diversify Globally. The US economic cycle (as judged by age, magnitude, valuations and unemployment) is more mature than those in Europe, Japan, and most Emerging Markets. Increasing portfolio exposure to international economic cycles mitigates the risk inherent in the US market cycle, while maintaining exposure to global economic growth – the primary driver of equity returns. Non-US countries with accelerating economies and attractive relative valuations include: South Korea, Turkey, Italy, Mexico, Spain, Poland, Austria, Brazil, Australia, and Taiwan. (For more information on Country Rankings visit Accuvest.com)
2. Trust in the Consumer. Personal consumption (PCE) is resilient to economic and market cycles. While the patterns of personal consumption shift, aggregate consumption rarely retreats (see chart 4). To best exploit the resilience of personal consumption we recommend a core US equity portfolio constructed with multi-factor security selection and attention to shifting brand loyalty and pricing power. Blending undervalued sustainable dividend payers with emerging brands exhibiting sales growth and margin expansion has been especially effective. A final advantage of the “Alpha Brand” approach to late cycle risk is the increased investor conviction that comes with highly recognizable investments. Capital appreciation, over a full market cycle, necessitates a willingness to endure price volatility and an ability to maintain a long-term investment focus. (For more information on Alpha Brands visit Accuvest.com).
Chart 4: Personal Consumption Expenditure & Sub-Components vs. US Recessions (Shaded in Red)
3. Follow the Trend. With anything cyclical, there is value in monitoring the trend. If equity valuations and the economy begin to contract, broader re-allocations will be warranted. It is near impossible to say how much longer these measures will trend higher or hold their ground. Act accordingly, and use the trend following to stay properly exposed and manage late cycle risk.
Historically, asset price exuberance and extended economic momentum has come with higher inflation. Higher inflation tends to coincide with higher interest rates and “hawkish” monetary policy. More often than not, bull markets die by high interest rates and cost inflation. Bubbles follow patterns, but maybe this time will be different…stay tuned.