It was a nasty week for investors with almost no place – or at least no logical place – to hide. Of the 16 broad market ETFs I monitor on a daily basis, only one, was higher on the week – IWM, the Russell 2000 small cap ETF. That’s what I mean by no logical place to hide. When the S&P 500, EAFE, every bond on the planet, gold, REITs (domestic and international) and commodities are all down for the week, how in the world does it make sense for small cap stocks to be up? I have no idea but that’s just the kind of curveball I’d expect from this market. It doesn’t make sense but then whoever said markets had to? Last I checked markets were comprised of a bunch of irrational, emotional humans so when markets do irrational, emotional things we shouldn’t be surprised.
Actually, it isn’t just the last week that investors have been having trouble finding something going up. Looking at my same list of broad market ETFs on a monthly basis only yields three that are higher and one of those only marginally. (IWM (+3.77%), SCZ (+1.24%) and SPY (+0.42%)) Expanding the time frame to three months only adds three more: EFA (1.45%), EEM (0.60%) and SHY (0.17%). Six months? Only 3 with returns greater than 2% (SCZ, IWM & EFA). It has been a rough time for diversified investors. But of course, that isn’t any different than it has been the last few years. It’s been a narrow, momentum market for some time with the greatest rewards going to those willing to concentrate their bets – particularly in the US stock market – and the prudent getting punished for doing what we’ve always been told was right. People seem to be ignoring – again – the best investment practices that, while not necessarily the optimal short term path, do serve investors well over the long term.
I think there are some pretty clear warning signs for long term investors that are just being ignored right now. High levels of margin debt, high valuations using a variety of reliable methods, high levels of stock buybacks, an M&A market en fuego, a Dow Theory warning with the Transports diverging from the Industrials, weak market breadth from several perspectives (# of stocks over their 200 day MA, new highs/lows, etc.) and waning momentum all point to potential problems for the bulls. But since nothing bad has happened yet while some of these indicators have been flashing warnings for months, a tolerance, a dismissive attitude has developed. As if it’s different this time and CFOs are smarter and wouldn’t think of buying back their own shares unless they were cheap. As if CEOs have suddenly figured out how to pay top dollar for acquisitions and make them pay off.
Last week’s crummy market action was driven by the economic data which has been improving a bit over the last two weeks, at least relative to expectations. To be fair, there have even been some pretty good reports mixed in too, not just better than severely reduced expectations. Last week’s construction spending report was a bright spot and personal incomes continue to improve although Americans do seem more interested in saving right now than spending. And of course, the employment report Friday was lauded as solid if not spectacular. It does little though to change the fact that this has been and still is a very weak recovery from a labor perspective.
The better than expected economic data hit the bond market rather hard and stocks decided that good news was bad news since it might move up the schedule for rate hikes. In a market so dependent on low rates, anything that moves rates higher is a threat I suppose. Frankly, higher rates driven by an improving economy and a more aggressive Fed looking to head off inflation seem a little far fetched to me. I’ve been talking about this for years now but I’ll say it again; better growth isn’t happening as long as productivity and population growth are depressed. And higher inflation isn’t happening unless the dollar falls a lot harder than it has recently. The New Normal, the Great Stagnation or whatever you want to call it is here until we start to see some real investment that can pay off in better productivity gains. We are a long way from that right now.
And if the economy is improving so much why aren’t we seeing that reflected in my favorite stock market indicator? Credit spreads at the junk level started moving wider last summer and although they’ve improved somewhat since the beginning of the year, they are nowhere near their lowest levels of this expansion and way off the best levels of the last two expansions. In fact, one of the oddest things I’ve noticed recently is that it isn’t only junk bond spreads that are moving wider now. AAA spreads versus the 10 year Treasury are sitting at 18 month highs. It might be that this is a result of reduced liquidity in the corporate bond market but I would just point out that the best levels in this expansion are, so far, nearly a full percentage point higher than the last two expansions. A small difference maybe but an important one I think. (Why are credit spreads my favorite stock market indicator? Because they have a correlation of -0.80 to stocks; credit spreads widen and stocks go down. That’s about as good as you’re going to get from a macro indicator.)
All those things I mentioned above that don’t seem to matter right now? Well, they will, probably just when everyone decides they don’t anymore. Are we there yet? I don’t know but it sure feels like we’re getting close. I can assure you that high valuations today mean the same thing they’ve meant in the past – lower future returns, probably a lot lower. Record buybacks? No CFOs aren’t any smarter today than they were the last time they were buying record amounts of their own stock at a market peak. Daily M&A announcements? No CEOs aren’t any smarter either and most alleged merger synergies will not be realized. In short, no it isn’t different this time.
And yes, diversification is still the right thing to do even if it seems like a sucker’s bet the last couple of years. Foreign stocks have been outperforming since the beginning of the year – contrary to almost all expectations – and I expect that to continue. Europe still has big problems and Greece may still get kicked out of the Euro, but talk about something that doesn’t matter. Greece is not the black swan you’re looking for. Asia is still the best place for growth despite the slowdown in China. Japan and China, both of which have been consistently panned by most investors, are near the top of any list of best performing equity markets over the last year. Even bonds, despite the recent setback have performed well over the last year. Of the 16 ETFs on my broad market list, six of the nine best performing over the last year are bonds. Bonds are still, despite near universal loathing, the best portfolio diversifier available. When the economy does finally succumb and enter recession, high quality bonds will provide, as they always have, a safe haven.
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