Volatility returned in 2018 and likely will continue into 2019. It’s late in the cycle but we still see opportunities. Taking advantage of them will require discipline and a strong decision-making process.
Is the juice worth the squeeze?
It’s a question that often gets asked in our investment meetings and one that should have added emphasis in 2019. Do the potential returns justify the risks? It’s the most fundamental investment question. With the U.S. Federal Reserve (Fed) now comfortably ensconced in a quarterly rate hike groove, the risks are getting larger. It’s not hard to feel that the last return drops are being extracted.
There are no easy choices. Cash returns are low everywhere, the U.S. equity market is overvalued, credit spreads are narrow and profit expectations are dangerously optimistic. Government bond yields are under threat from late cycle inflation pressures.
It’s a challenging environment for managing portfolios. We know the long-term return outlook is poor, so we need to make the most of opportunities. But it’s unwise to think that we can time the market well enough to get out at the top.
The best response is to focus on the three essential aspects of portfolio management: (1) diversification, (2) implementation and (3) decision-making process. We believe investors need to maintain exposure to a wide range of return sources, have effective implementation that saves basis points, and use a dynamic process that leans out as risks accumulate.
Our cycle, value and sentiment (CVS) decision-making process for every investment decision asks:
- Is the investment cheap or expensive?
- Is the cycle a tailwind or a headwind?
- Is market sentiment overconfident or over-pessimistic?
Our CVS process has served as a reasonable guide. We like cheap asset classes over expensive ones, but we have been prepared to hold expensive ones, like U.S. equities and credit, if the cycle is providing support. And sentiment has helped us take advantage of market corrections. We identified a good buy signal from our oversold contrarian sentiment indicators in February and we’re watching for another to develop in late 2018.
For 2019, our strategists think it is too early to become overtly defensive given that 2020 seems the recession danger zone for the United States. They are moderately bearish on government bonds as late-cycle inflation pressures emerge, more so outside of the U.S. given the low yields in the rest of the world.
The challenge is to make the most of late-cycle returns while preparing for the inevitable downturn. It means relying on a structured and disciplined process. Ultimately, it’s about assessing the value of the squeeze.