Q1 2019: PFM Quarterly Commentary
What a difference three months can make. The contrast between the fourth quarter of 2018 and the first quarter of 2019 could not be more striking. By reversing from a year-end Great Depression-like selloff to commencing a near record-setting rise to start this year, the equity markets undoubtedly reinforced their characteristic fickleness.
We are pleased, although not surprised, to see the robust recovery in global equity markets thus far in 2019. Recollecting last year’s “Market Volatility Review” penned in December during the depths of the bear market, we cautioned clients against succumbing to the media’s fearmongering and one’s natural inclination to sell. We highlighted the stock market’s upward persistence over time and the importance of staying the course during turbulent periods. Unfortunately, the anecdotal and empirical data collected from the last quarter in 2018 illustrated that many undisciplined investors were unable to emotionally weather the storm and, in doing so, committed investing’s cardinal sin: selling low.
Looking back, our words seem prescient, but it’s important to remember that we stand committed to our investment philosophy both in rising and falling markets. We subscribe to well-worn, historically informed market truths rather than the error fraught, emotionally-charged short-term decision making that guides many investors. The history of the investment markets’ behavior is well defined: markets rise, periodically contract, and then move on to new highs. Recognizing this pattern is critical to long-term investment success.
To understand the reason behind the markets’ sudden resurgence, look no further than the Federal Reserve. Peak has been cautioning in our market commentaries for nearly a year that the Federal Reserve has been overly optimistic in its economic forecasts. This resulted in a monetary policy which increasingly became too restrictive. Furthermore, we surmised that their restrictive stance would eventually cause a deterioration in market conditions, forcing their capitulation and a policy reversal. Our prediction rang true when the Federal Reserve announced on March 20th that it would not raise interest rates for the remainder of 2019 and would wind down its Quantitative Tightening Program by this September.
The Federal Reserve’s current stance deviates sharply from just three months ago, when Chairman Powell said that the Quantitative Tightening Program was on “automatic pilot” for the foreseeable future and that six more interest rate hikes remained scheduled for 2019 and 2020 thanks to the “remarkably positive” economic outlook. However, the Fed Chair did not recognize the economic headwinds that had long been intensifying overseas, which we cited in our Q3 2018 Quarterly Commentary as “reasons for a potential change in monetary policy.”
Perhaps the most appreciable side effect of the Federal Reserve’s insistence on aggressively tightening amid a global slowdown is that the yield curve inverted. You may recall that in the second quarter of 2018 we wrote that the Federal Reserve’s policies were setting the groundwork for specifically this event. By definition, a yield curve inversion occurs when long term interest rates are lower than short term interest rates. Said more simply, investors expect future growth and inflation to fall.
The yield curve officially inverted on March 22nd and has been front page news ever since due to its well-earned reputation as a recession predictor. We agree that the inversion is concerning and the media is correct to report on it even though we believe their analysis is somewhat misleading. The pundits repeatedly broadcast that the yield curve has inverted five other times since 1950 and that a recession has always followed (this is largely true, although technically there was one false positive in the mid-1960s). The pundits, however, rarely tell the whole story.
Reported less is that previous recessions have not occurred on average for another twenty months from the time of inversion. The longest period was nearly thirty-five months from 1998 to 2001 and the shortest period eleven months from 1980-1981. Interestingly, the average return on the S&P 500 from the initial inversion until the start of a recession is 12.7%, with the highest return being 28.5% from 1988 to 1990 and the lowest return being 6.1% from 1998-2001.
Precisely predicting the future is a fool’s errand, so we instead focus on the facts. Since 1950, from the time of inversion, equity markets have historically continued rising, often for quite some time. And while it’s true that a recession is likely in the cards, this should hardly be a surprise. Inversions occur at the end of economic expansions, and currently, the U.S. economy is in its tenth year of expansion – the second longest on record. It’s worth remembering that recessions are a healthy and natural part of the business cycle, and at this time we certainly do not see a contraction comparable to the Great Recession of 2007-2009 on the horizon.
Looking forward, it seemingly would be easy for us to turn bearish based on weakening global economic indicators, but we think there’s more at play. The Federal Reserve’s dovish pivot means that excess liquidity will remain in the financial system, an important condition that we know has helped fuel asset price increases over the last decade. Moreover, our conviction that the current U.S. economic expansion will continue for the time being is strengthened by the similar monetary policy shifts announced by the other major Central Banks during the first quarter of 2019. The European Central Bank (ECB), the Bank of Japan (BOJ), Bank of England (BOE), and the People’s Bank of China (PBOC) all recently committed to maintaining or expanding their pro-growth policies for the foreseeable future, placing a powerful wind at the market’s back.
We always look forward to hearing from you, so please do not hesitate to contact us should you have any questions, comments, or concerns.
Regards,
Peak Financial Management
Asset Class Quilt of Total Returns
Peak has created a monthly “quilt” of returns to track the performance of the major areas of the investment markets over time: We believe that this table best illustrates the fundamental tenets of Peak’s investment philosophy, namely the futility of predicting which investments will outperform over the short term and the unremitting cyclicality of markets. These truths support our firm belief that broad based diversification over many areas of the world economy is the best path to investment success over the long term.
This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This presentation may not be construed as investment advice and does not give investment recommendations. Any opinion included in this report constitutes the judgment of Peak Financial Management, Inc. (Peak) as of the date of this report, and are subject to change without notice.
Additional information, including management fees and expenses, is provided on Peak’s Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Peak does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results.