Want To Know About The Current State Of The Market? Read This.

June 9, 2017

Want To Know About The Current State Of The Market? Read This.

  • A quick look at the economy points out a few risks, but there are also some positives.
  • Unfortunately, savers have gotten the short end in this environment, but average investors haven’t done much better either.
  • It’s important to understand what’s going on and how will it affect your long-term returns. If you only think about the short term, your returns will be below average, thus below 2.3% per year.

Introduction

J.P.Morgan (NYSE: JPM) recently released its Q2 2017 Guide To The Markets. As this report is very long, with a total of 71 slides and a lot of correlation charts, I’ll take out the most important things an investor should know about the current state of the markets and the economy.

The Stock Market

The first slide is already impactful as it describes how the current market behaves in trends.


Figure 1: Inflection points, and bull and bear markets. Source: JPM.

As our Investiv Daily readers probably already know, the previous two bull markets weren’t much different from the one we’re in now. Therefore, we have to be very scared of the next inflection point and subsequent bear market.

It seems like the majority of investors have never seen the above chart or don’t want to see it because the market has entered into extreme complacency. In the last 37 years, the average yearly drop was 14.7%. In 2017, the largest drop was barely 3% and the VIX index is at historical lows. The maximum market drops in the few years before the dotcom bust and the financial crisis were also measured in single digits, so don’t be fooled by the apparent stability as things usually change very quickly.


Figure 2: Maximum market drops per year and yearly returns. Source: JPM.

The most important reason behind such complacency is that we haven’t had a recession in 8 years, so recent market drops have been based only on fear and thus weren’t big.


Figure 3: Market drops in the last 8 years. Source: JPM.

The Economy

With low interest rates, corporations and households have loaded up on debt where corporations did more buybacks and households bought more stuff. Both actions are great for the economy and stock market in the short term. However in the longer term, at some point, the corporations and households become over-leveraged and consumption declines, corporate earnings decline, the economy enters a recession, and the market turns to a bearish mode.

This is natural, has happened many times before, and will happen many more times in the future. However, it seems the market doesn’t care about the natural economic cycle. Corporate debt has slowly approached unsustainable levels as the percentage of debt to GDP is similar to what it was leading up to the previous two recessions.


Figure 4: Corporate debt to GDP. Source: JPM.

The current economic expansion is already twice as long as the average expansion period, but it’s also the weakest historical expansion. And, again, markets simply don’t care.


Figure 5: Length and strength of economic expansions. Source: JPM.

Also consider this, government deficits are piling up, household wealth is up mostly due to inflated asset prices, the bulk of GDP is based on consumption while it seems that the only thing that is keeping things stable are low interest rates.


Figure 6: Interest on mortgages are at historical lows. Source: JPM.

To switch to the positive side a bit, the unemployment rate is really low. This is extremely important for the social state of the country and for the general quality of life. I strongly hope that such a remarkable result will be sustained and isn’t just a result of financial engineering and monetary stimulus.


Figure 7: The unemployment rate is below the historical average. Source: JPM.

Fixed Income

Savers are getting the short end of this whole scenario and if you have been properly brought up and told to always save a bit, well, I feel sorry for you.

Real ten-year Treasury yields have been around 0% for more than 5 years now.


Figure 8: Nominal and real U.S. 10-year Treasury note yield. Source: JPM.

Unfortunately, those who are used to saving through a saving account have lost a significant amount of their purchasing power in the last 5 years. However, this doesn’t mean that savers have to jump into stocks now. What would be more appropriate is an all-weather portfolio.

Conclusion

As long as interest rates stay low, unemployment declines, and consumers feel confident, all should be fine. More people working and strong consumer confidence will lead to more investments into the S&P 500 which should keep stock prices high. Huge and constant positive fund flows is exactly what has pushed the S&P 500 in the last 8 years.


Figure 9: Fund flows into the S&P 500. Source: JPM.

However, the average investor didn’t take advantage of the asset bubble we are in as their 20-year yearly return is 2.3% while the market’s is 7.7%.


Figure 10: The average investor usually achieves terrible returns. Source: JPM.

It really pisses me off when I see that average investors’ returns are just above inflation. My goal is to help people achieve higher returns by telling them about the economy, financial markets, and the risks and rewards inherent to specific investments.

From all of the above, I can conclude that an investor should be prepared for everything. This means there should be gold, short term treasuries, emerging markets, defensive and cheap U.S. stocks, and a lot of cash in one’s portfolio at the moment.

The economy will probably enter into a recession in the next few years as it would be natural for it to do so. Therefore, it’s too risky to bet that such a thing won’t happen by being overweight U.S. stocks. As for fixed income, short term bonds should give enough capital protection. Gold is the jack-pot part of a portfolio as it will shoot up in case of severe financial turmoil. Emerging market stocks should be the growth motor of a portfolio, especially since you can still buy them on the cheap.

Keep reading Investiv Daily for more ways to beat the market with less risk. I won’t even bother telling you how to beat the average investor as such returns are too low and really disgraceful.