Episode #24: [Market Update] What to Expect Over the Next 3-6 Months and How to React


As industrial production across the world continues to accelerate and corporate earnings continue to recover, it's important to look at where your assets are positioned and how they may perform relative to your investment process. In this episode of Money Script Monday, Robert breaks down the current state of the economy and gives his perspective on where the markets may go as we finish out the year and head into 2018.


 

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Video transcription

My name is Robert Reaburn and welcome to another episode of "Money Script Monday." Today we're going to be going over two key things in particular.

The first is our overall view on the market and the direction that we see markets heading over the next 3 to 6 months. The second thing that we're going to be going over is our investment process, which arguably is the most important thing to understand. In other words, how do we actually get to the decision? How do we get to the views that we get to on the market?

Investment process

Let’s start off real quick with our view on the market. Our view on the market over the next 3 to 6 months remains optimistic. As industrial production across the world continues to accelerate and corporate earnings continue to recover, we are quite optimistic as to where risk-based assets are positioned right now in the economic cycle relative to more safe assets such as bonds.

But how do we actually come up with that decision? How do we gather the evidence to make these decisions?

Traffic Light System

It's really based on our investment process that we call the traffic lights system. In other words, red light, yellow light, or green light.

Street Light System - Investment Process

Right now, we're on green light, which means we're fully invested into the market. Now, at some point of the future, though, we're going to grow more cautious, it's just a natural evolution of every market cycle, but it's really important to understand how that process unfolds.

Market Risk Barometer

Our investment process is based on three core indicators. Those core indicators are the credit cycle, the inventory cycle, and a series of market internals that we follow that track the overall health of the market underneath the surface.

Market Risk Barometer

The credit cycle really measures the health of corporate America. In other words, how much debt are on the balance sheets of corporate America? And are they paying a wider and wider risk premium in order to borrow from the banks and from other investors?

The second thing we look at is the inventory cycle. How much demand exists in the economy? And are companies over ordering and therefore they're having to cut future orders?

These are the type of things that we track in order to gauge the likelihood of demand sustaining itself in the future.

And the lastly, as we mentioned, the market internals. The market internals are really important. It's sort of the health check of the market. And, we'll get into greater detail of that.

There are series of great tools that we can use to really understand how risk is being perceived in the marketplace and how that's unfolding in terms of the behavior of risk-based assets such as stocks.

So, what really happens is, these three indicators all come together into what we call our market risk barometer.

And when we put all the points of evidence together, we really can do a judgment. Are we increasing risk, inclining portfolios, or are we decreasing and growing more conservative? In other words, are we raising the level of cash in client portfolios?

As we mentioned at the very beginning, right now all the evidence that we track points to continued optimism for the market.

Credit cycle

The first thing that we look at is the credit cycle. And when we think of the credit cycle we really think of two things, corporate America and, of course, the federal reserve, and then other central banks across the world.

Credit cycle LifePro Asset Management

Right now, monetary policy remains extremely accommodative. In other words, what that means is relative to how we're growing across the world, how the global economy is growing.

Interest rates, despite increase in a little bit year over year, are at record lows relative to economic growth. That is great for risk-based assets such as stocks.

The second thing we look at, of course, is the health of corporate America. How leveraged are corporate balance sheets? In other words, how much of debt is on corporate balance sheets, and is that becoming a hindrance for those companies to continue investing in future growth?

Right now, we see a very healthy state in corporate America. While there are certain pockets that we're avoiding, the areas that we're investing in are extremely healthy, characterized by levels of low debt, but high earnings growth.

The other thing we look for is the financial plumbing. What that means is, we actually look at the banks in our system, and is there anything clogging up the lending pipeline? So, the same way that a broken oil pipeline would prevent oil going from point A to point B, is there anything in the financial pipelines that existed that's blocking credit from going...coming from the banks to consumers and businesses? And right now we see none of that.

One of the things we look at in particular are called the TED spreads, which are inter-bank lending spreads. Are banks lending to each other overnight? When we see risk premiums go up, that means banks are really suspicious of each other, and that is a sign that something is wrong in the banking system.

We're not seeing anything like that right now, and that's a really positive thing.

The other thing we look at are corporate credit spreads. In other words, how much more is a company, such as Microsoft, paying to borrow money versus the U.S. government?

When those spreads increase, it is a sign of investor worry that is increasing in the background, and that tends to occur ahead of stock market downturns.

Right now, we are seeing the opposite. We're actually seeing corporate credit spreads decrease. In other words, risk premiums are decreasing, and that's really optimistic for stocks.

Inventory cycle

The second thing that we look at is the inventory cycle. One example I like to use is Apple, because we all understand what Apple is and what Apple sells.

Apple, before they sell to you and I, they have to order those phones. Those phones go into inventories. When companies over order, in other words they overestimate the level of demand for their product, those inventories become elevated in what we call stuffed.

And what that means is that Apple is not going to order from companies like Samsung, the microchips that go inside those microphones or into those iPhones and demand a slash across the supply chain.

Inventory Cycle LifePro Asset Management

Something similar occurs across the broader economy. And we track that by looking at industrial production, we look at what we call the ISM leading indicator. In other words, what are new orders that companies are receiving relative to the amount of inventories that they are taking on?

When new orders are growing faster than inventories, that's a really optimistic sign, and it's a leading indicator for future industrial production growth. And that is exactly what is occurring today.

Now, that can change from quarter to quarter, and that's why we track that every single week that we enter into the offices here. Right now, that's healthy, and so we remain optimistic.

Market internals

The last thing that we look at are what we call market internals. That's really similar to like going to the doctor's office for an annual checkup. The only difference is we do an annual checkup on the market every single day.

When we look at underneath the hood of the market, and we look at what's going on, not only in the just in the stock market, but in the bond market, are risk assets behaving the way they should if the economy is expected to continue growing?

Market Internals LifePro Asset Management

One of the things we look at is what types of stocks are rallying right now, and what we see are economically sensitive stocks, in other words, stocks that rely on economic growth, are outperforming stocks that can do well during a recession. And that's a great leading indicator and confirms the rally that we're seen in the stock market today. If we saw the opposite occurring, we would actually start to raise cash in client portfolios.

The second thing we look at is are most stocks taking part in the rally?

It's really important to have what we call strong breadth in the stock market.

I kind of compare this to a battlefield. If an army advances and pushes the front line forward, but they have fewer and fewer soldiers as that front line continues to push forward, eventually, that front line is going to break.

The stock market is very similar. You want to see the market hit new highs with most stocks participating.

When you see a few stocks, just a handful of stocks pushing that market higher, eventually that's a sign that we're near a near term top for the stock market.

Fortunately, we are seeing strong market breadth across the stock market right now. So that gives us a little bit increased confidence to remain positioned long in stocks relative to bonds in client portfolios right now.

And then, lastly, we always like to tie in that monetary policy and what interest rates are doing in the broader market. And what we're seeing is that interest rates remain low, despite rising a little bit, are low relative to what we're seeing in corporate earnings growth.

Then the other thing we're seeing is not only is the U.S. stock market acting well, but European stocks are rallying, Japanese stocks are rallying, and Chinese stocks are rallying. And this is really important, here is the reason why.

The big thing that has changed in U.S. stocks over the last 20 years is that close to 50% of U.S. earnings now come from overseas.

So, even if the U.S. would remain strong, if China or Europe starts to weaken, it could really be a developing headwind for U.S. stocks to push higher.

Fortunately, for now, we continue to see optimistic signs coming from across the globe.

Key Risks to Look Out for Right Now

Now, with all of this said, what are some of the risks? You know, one of the core risks, of course, is that something happens that we don't just see coming. We call that an asymmetric risk. You know, war in North Korea would be a great example.

These are risks that are pretty hard to prepare for, so we kind of actually throw that out of our process. But stuff that we can prepare for, like an inflationary shock, that is certainly something that we're looking out for.

Because right now most people are positioned for deflation. So if we saw an inflationary shock in the market, that could be a sign that we enter into a risk off market. So that is something that we are watching right now.

The second thing that we are watching is investor sentiment. A process in...ever since 2008 and 2009, investors have remained indifferent toward the stock market. In other words, I know as soon as I put money in, the stock market is going into crash again. And as long as that attitude remains pervasive across the U.S. and across global markets, it's really hard to see how we're gonna have a rational exuberance to push the market to that final top. In other words, investor sentiment remains indifferent at best. So the second that we see exuberance enter into the market, we will grow more cautious.

And then the last thing, and I think this is probably the risk that we need to watch for the most, is that the returns that were expected to occur in 2018 get pulled forward into 2017.

The fourth quarter of most years is seasonally the strongest period for the stock market. As of right now the S&P 500 is up around 14 and a half percent. If what we expect to happen does occur, we could see the S&P 500 really push materially higher over the next two to three months.

And so the concern would be how much of the 2018 returns have been pulled forward into Q4.

So those are really the key risks that we're looking at right now. But even with all that said, we remain optimistic on stocks until the end of the year. We are positioning client portfolios in that fashion.

Thank you very much for watching. I know that your day is very busy, and if you have any questions, please feel free to call or email us using the information on this page, and we'll be more than glad to assist you. Thank you.

About Robert Reaburn

Robert Reaburn is the Managing Director and Head of Wealth Management at LifePro Asset Management. He works with financial advisors building diverse financial portfolios that best prepares their clients for their financial future and provides peace of mind.