August 21, 2018

With summer vacation season coming to a close, the stock market back within striking distance of its highs after a bout of volatility early in the year, and the economy by most measures firing on all cylinders, now is the perfect time to take a step back and ensure that our portfolios are positioned for environments that are not so sanguine. Pilots and military personnel agree that the best time to plan for adverse events is when conditions are calm, and heads are clear. The same applies in investing.

"...now is the perfect time to take a step back and ensure that our portfolios are positioned for environments that are not so sanguine."

In last summer’s newsletter, we noted that U.S. stocks were doing very well in both absolute and relative terms. The broader market, as measured by the S&P 500 Index, was trading near all-time highs. Valuation multiples, or stock prices in relation to corporate earnings, were generally in the upper quartile relative to history. Fortunately, the market’s performance could be tied to economic reality. Employment, retail sales, incomes, and industrial production were moving higher. The number of S&P 500 companies exceeding revenue and earnings estimates for the second quarter of 2017 was at a 13-year high. We noticed, however, that investors seemed to be experiencing some fatigue, as the stocks of companies beating earnings estimates were not reacting as favorably as they had over the past 15 years. While we avoided making a directional call on stocks, our tone was cautious.

Since then, the S&P 500 has returned approximately 15% with dividends reinvested. That performance came amid various global developments that threatened to kill the bull rally. Every month, Bank of America issues a global survey of fund managers that asks what the biggest risk is to stocks. In early fall of last year, the answer was tensions over North Korea. In the winter, it was fears of aggressive central bank interest rate hikes. More recently, the survey stated that tariffs and potential trade wars are the most significant risks facing investors1Still, despite a brief but dramatic correction earlier this year, the market resumed its upward climb.

Second-quarter 2018 earnings again showed that corporate financial results are living up to, and often exceeding, expectations. According to Thomson Reuters, as of early August, 79% of S&P 500 companies have reported earnings above analysts’ estimates, compared with the long-term average of 64%2Further, analysts project earnings for the third-quarter 2018 through the second-quarter 2019 to continue growing well above the long-term trend3. As earnings ultimately drive stock prices, and as the economic backdrop ultimately drives earnings, it follows that a strong labor market, high consumer and business confidence, and healthy corporate capital spending plans show that the case for the continuation of the current bull run can be argued.

"...a strong labor market, high consumer and business confidence, and healthy corporate capital spending plans show that the case for the continuation of the current bull run can be argued."

What could go wrong? What might derail the earnings train? A survey by FactSet Research asked the companies themselves, polling management teams on which factors either negatively impacted second-quarter 2018 earnings the most, or were expected to act as headwinds in the near future. The results showed that unfavorable currency movement (i.e. a stronger dollar) was the biggest concern, followed by inflation of raw materials, transportation and freight costs, oil and gas prices, and wage and labor costs4. The common thread among these concerns is that they are traditionally developments that occur late into an economic cycle. Typically, the late-cycle narrative involves a strong economy and tight labor markets causing inflation to pick up, which prompts the Federal Reserve to raise rates, which shrinks the money supply, which combats inflation but leads to a stronger dollar and a slowing economy.

Historically, economists and investors have a poor track record of predicting economic cycles. At the same time, at Clifford Swan, it is our job to protect, as well as to grow, capital. Our portfolios need to be appropriately defensive and able to withstand a variety of market conditions. Not only is the timing of a downturn uncertain, but the causes of one are as well. Those could involve a tariff war slowing the worldwide flow of goods and services, a geopolitical crisis, or countless other events.

"...it is our job to protect, as well as to grow, capital. Our portfolios need to be appropriately defensive and able to withstand a variety of market conditions."

Evidence of a lack of defensiveness is showing up in many areas of the capital markets. The volatility index, also known as the “fear index”—a measure of expected future S&P 500 volatility is back down near record lows after spiking earlier in the year. “Covenant-lite” loans—loans that place fewer restrictions on the borrower when it comes to collateral and financial health characteristics required—are widely used by lenders and in high demand by investors, as covenant-lite’s share of the loan market keeps climbing5. Venture capital funds and start-ups are raising money hand-over-fist, with questionable companies like Theranos receiving funding without multiple stages of deep due diligence6Bitcoin, though off its high of just under $20,000 reached in December of last year, still trades north of $6,000 as of this writing. These developments are uncommon in risk-averse markets. 

"Evidence of a lack of defensiveness is showing up in many areas of the capital markets." 

It is even difficult for investors to remain defensive in one of the most traditional asset classes—the S&P 500. Led by Apple, Microsoft, Amazon, Alphabet (Google), and Facebook, the technology sector now comprises roughly a quarter of the S&P 500 Index by market value. Defensive sectors, such as utilities, consumer staples, health care, and telecom services, now make up just over 15% of the index7. That ratio is down from approximately 35% in the early- to mid-1990s, a level which it again approached in risk-averse periods such as the post-9/11 market and the March 2009 post-financial-crisis low. The implication for the average investor is significant. Part of the pull of S&P 500 index funds—broad company diversification—gives the investor comfort that he or she is taking risk off the table. The reality is that, today, the risk profile of the index is much different than it was in the past. Consequently, the same applies to funds that track the index.

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At Clifford Swan, we believe that the market’s lack of cautiousness in the ninth year of an economic expansion and bull market run should serve as a signal for investors to look closely at how their portfolios are positioned for a variety of future economic conditions. Our strategy of building portfolios security by security, with an uncompromising focus on the quality of the companies in which we invest, allows us to manage your exposure to a range of economic outcomes with confidence.

1. Kawa, Luke. “Investors with $542 Billion Fret Biggest Risk since Euro Crisis.” Bloomberg, 17 July 2018.

2. Aurelio, David. “S&P 500 Earnings Dashboard.” http://lipperalpha.financial.thomsonreuters
.com/2018/07/sp-500-17q1-earnings-dashboard/ 3 August 2018

3. Otani, Akane. “The Bull Market’s Next Test: Slower Earnings Growth.” The Wall Street Journal, 17 June 2018.

4. Butters, John. “More S&P 500 Companies Seeing Negative Impact from FX than Tariffs in Earnings Calls for Q2.” Insight.factset.com, 6 July 2018.

5. “Leveraged Loans: As Cov-Lite Levels Grow, Debt Cushion Shrinks.” Leveragedloan.com, 28 June 2018.

6. Rowley, Jason. “Inside the Global Q2 2018 Venture Market: New Records and Titanic Late-Stage Rounds.” News.crunchbase.com, July 2018.

7. Otani, Akane and Michael Wursthorn. “Investors Double Down on Tech in Rocky Quarter for Stocks.” The Wall Street Journal, 29 June 2018.

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