Focus on Safety, Despite New Highs

06/25/2019 5:00 am EST

Focus: STRATEGIES

James Stack

Founder, InvesTech Research

This coming month, the current economic recovery will become the longest in U.S. history — surpassing both the 1960s and the decade-long expansion of the 1990s, notes Jim Stack, money manager and editor of InvesTech Research.

Meanwhile, the Federal Reserve is scrambling to stabilize and maintain economic momentum by walking a tightrope between imbalances that have developed during this record-long recovery, and early signs that the economy could be heading for trouble, cautions James Stack, money manager and editor of InvesTech Research.

A serious misstep could either help precipitate a downturn, or instead inflate an asset bubble on Wall Street – similar to what occurred after the Fed eased in response to the collapse of Long-Term Capital Management in 1998. That miscue fueled false optimism that culminated with the popping of the Tech Bubble 17 months later.

The majority of economic recoveries lasted between 2-5 years. Currently at 10+ years, this recovery is three times longer than the 3.1 year norm. Another observation is that the 2nd and 3rd longest recoveries were the decades of the 1960s and 90s which both ended badly for investors, with larger than average bear market.

Non-financial business debt retreated to reasonable levels in the aftermath of the 2008 Financial Crisis. However, as central banks kept interest rates near zero for much of the last decade, corporations have predictably re-leveraged their balance sheets.

This has put the Federal Reserve in a tough position where they cannot renormalize interest rates without potentially causing a wave of collateral damage in the process.

In and of itself the high corporate debt level is a concern, but it’s especially worrisome that the majority of this debt has been added in low-quality and junk-rated companies.

The share of companies with high debt-to-EBITDA ratios comprise far more of the debt market than at any other time in recent history.  A deterioration in economic conditions or an unexpected rise in interest rates would likely bring with it a significant amount of default risk.

In 2007, we warned of a housing bubble and impending crisis. Historically speaking, median family home prices have tracked relatively closely with long-term cumulative inflation, as measured by the Consumer Price Index. However, this relationship became significantly disconnected in the years leading up to the 2008 Financial Crisis, eventually resulting in a 33% collapse in nationwide home prices.

Today, median family home prices have once again run away from broad inflation measures, and soared over 75% above the 2012 low! Unfortunately, history suggests that when the next recession strikes, this is going to end badly — especially in the most overheated real estate markets.

Although major blue chip indexes have hit new incremental highs, today’s evidence indicates that we are in a late-cycle environment and further gains could be limited. Because of this, there has rarely been a more important time to manage risk in your portfolio.

Investing isn’t always about hitting home runs, it’s about capturing profits in a bull market while minimizing downside risk. Simply put, one doesn’t invest the same in the 10th year of a record-long bull market as they did at the beginning of the cycle.

There will come a point when investors will measure their profits over the full cycle, regardless of what they captured near the top. The yield curve is inverted, and the market is calling for a rate cut in July.

We will soon find out if Jerome Powell’s Federal Reserve is willing to reduce interest rates when the market is near an all-time high and unemployment is at the lowest level in nearly 50 years.

While recent market action suggests that investors are excited by the idea that lower interest rates could be on the horizon — we are less convinced that the Fed ultimately has control. It is far more important to concentrate on the longer-term risks and position tour portfolio according to our safety-first philosophy.

Subscribe to InvesTech Research here…

Related Articles on STRATEGIES