Macro Environment & Upcoming December Rebalance

Jitters

October’s price action seems to have given many investors the jitters. Mr. Market doesn’t quite need a defibrilator or even Pepto Bismol, but he is at least popping a Tums. This expansion and bull market have been long. They are going on 10 years now, which is relatively unprecedented. Unemployment is at historic lows. Meanwhile, the Fed is raising rates, which is usually the beginning of the end.

Valuations don’t help with the anxiety. Everyone knows that valuations are stretched. The CAPE ratio currently stands at 30.94, giving the market an earnings yield of 3.23%. The average investor allocation to equities is presently 44%, giving us an expected 10-year return of 2.3%. In other words, the realistic return that investors can expect over the next 10 years is probably somewhere in the vicinity of 2-4%. This does not provide much of a premium to the 10-year treasury yield, which is currently 2.993%. The AAA corporate bond yield is now 4.14%, a significant premium to what we can expect from equities.

yields

A 2-4% return for US stocks isn’t going to happen in a straight line and it isn’t going to be evenly disbursed across all stocks. Stock market return averages are an average of abnormal returns. There are going to be years when stocks will advance by 30%, and there will be years when they decline by 50%. The decline will likely coincide with a recession.

Recession Watch

At the same time, while it’s evident to me that valuations are stretched, I do not believe we are going to have a recession in the upcoming year. This is the main reason I am comfortable remaining 100% invested in stocks that I feel are at attractive valuations, including cyclical stocks.

I believe that the Federal Reserve is the cause and cure of every recession. Right now, the yield curve is flattening but has still not inverted. The Fed typically chokes off an economic expansion by tightening too much. They then usually save the day by aggressively responding to the downturn by cutting rates, often overshooting and causing other problems. This seems to have been the case in the mid-2000s.

Despite the tightening of the last year and the flattening of the yield curve, the curve is still not flat and it is still not inverted. Scott Grannis recently had a great post about this here.

curve

Typically, once the yield curve inverts, we get a recession within a year or two. Right now, the 10 year is at a .22% premium to the 2 years. This implies that the Fed hasn’t yet taken things too far with rate increases. A recession, therefore, does not appear to an imminent danger. To put this in historical perspective, this is where the yield curve was in 2005, 1997, and 1988.

Another thing that tends to happen before a recession is that the unemployment rate shifts its trend. The unemployment rate began to change direction back in 2000, long before the beginning of the recession in 2001. It also did this in 2007 before the Great Recession went underway. There is no sign that the unemployment has shifted course.

unemployment rate

This is further evidence that a recession is not imminent.

Another indicator that I look at is household debt payments as a percentage of disposable income. This shows you the sensitivity of households to rising interest rates. This is not worrisome at all.

households

December Rebalance

Hopefully, this gives context to decisions I am going to make in my portfolio in the upcoming month.

I am currently gearing up to rebalance my portfolio in December. I will sell many positions that are on their 1-2 year birthday and replace these positions. I have my eye on many stocks, which are listed below. If anyone has done any work on these securities, I would love to hear from you.

I’ve spent the last few weeks researching the below positions. They meet my quantitative criteria, and I am attempting to determine whether or not I feel they are likely to recover from the problems that the market perceives.

candidates

My opinion on the likelihood of a recession impacts what kind of stocks I own. In particular, it will determine whether or not I will buy stocks that are cyclical and closely tied to the performance of the macroeconomy. An example of this would be a company like Micron (MU), a cheap position that bears suspect is cheap because it is at a cyclical peak. Another example would be Thor (THO). These would be positions I wouldn’t own if I thought a recession was going to occur in the upcoming year. Some examples of cyclical positions on the above list that I am looking at include Manpower Group (MAN) and Hollyfrontier (HFC).

I’m also looking at cheap retail positions like GAP (GPS) and Chico’s (CHS), even though they have been historically graveyards for my portfolio.

It also determines whether I am comfortable holding cash. When a recession is imminent, I will likely move more of my portfolio to short-term treasuries while I wait for compelling bargains to appear. A 1-year treasury is expected to yield 2.69% right now, which compares favorably to what I expect from US markets over the next decade.

Of course, I fully acknowledge that my predict the future is as good as anyone else’s. This is the reason that I always attempt to purchase undervalued securities with a margin of safety. A margin of safety is very much a margin for error.

I’m also eagerly anticipating the next recession. While I would like to avoid some of its damage, I suspect this is the moment when I am going to find truly compelling bargains, which are now in short supply in the US. It will be an opportunity to buy sub-liquidation net-net’s extraordinarily cheap security on an earnings basis, as well. It will be an opportunity to do very well, and I’m looking forward to it.

Hopefully, this sheds some light on my thought process as I select new stocks to fill my portfolio in the upcoming month as we look to 2019 and my portfolio (and this blog) turn 2 years old. Let’s hope the “terrible twos” doesn’t affect my money.

Random

  • I have been reading Paul Volcker’s book, Keeping at It. It’s a great book from a man that I believe is the greatest Fed chair of all time. I wrote about it here.
  • Work has been extremely stressful lately, especially because of issues in my personal life that I’ve hinted at previously in this blog. My main struggle these days is maintaining a positive attitude, mainly because I am in a leadership position at work and it is important for me to keep everyone’s spirits up. I’ve slipped up recently, but I want to make more of an effort to stay positive this month, especially with the holidays coming up.
  • I gave up sugar back in October. So far I’ve lost 10 pounds since making that choice. I fell a bit off the rails on Thanksgiving when I ate a significant amount of pie, but what the hell? That’s what Thanksgiving is for. I haven’t eaten any sugar since.
  • I started watching “The Man in High Castle” and have really been enjoying it. It makes me really appreciate the sacrifices made by the Greatest Generation. If it weren’t for their efforts, the horrific world featured in that series would be a reality.
  • I was saddened to hear about the loss of George H.W. Bush. Looking back on him, whether you disagreed with him or not, he was an exceptional human being who treated the opposition with respect. He was the last President of the World War II generation, and that’s why I think his Presidency feels like a distant, bygone era. That generation had a better perspective on life. That’s why their passing brings a real sense of loss. I think their perspective comes from seeing a World War and living through a Depression. These were experiences so intense, so palpable that Boomers, Gen Xers, and Millennials can’t relate to these experiences on any level. Our worries are trivial compared to worrying about the Nazis winning World War II, or starving to death in the Depression. After going through times like a Depression and World War, they didn’t sweat the small stuff the way that we do. They realized that the stakes weren’t so high and you didn’t need to vilify people because you disagree with them about minor things like taxes, budgets, whatever. I really believe that things were better with that generation in power. People who vehemently disagreed with each other, like Tip O’Neal and Ronald Reagan, could hang out after work and still get along. I wish things were like that now. We weren’t entrenched into competing camps convinced that the other side was evil or bent out to destroy the country because they happen to disagree. I wish that’s a perspective that we could bring back. I wish I could have that kind of perspective. I worry that’s not possible, because it’s a perspective you can only earn from going through the sort of horrible times that they went through in their youth.
  • I’ve been listening to a lot of a synth band called Electric Youth. They sound straight out of 1984, and I love it.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

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