MARKET STRATEGY: The opinions outlined in this 2020 forecast reflect the views of the portfolio management team as we enter into a resumption of the unprecedented eleven-year bull phase. We were correctly positioned over the last eleven years on the long-side of the market. However, the length of the bull phase, the amount of global uncertainty, the start of the election year, the uncorrelated state of global interest rates and the increased possibility of an unforeseen tail event has us cautious with respect to directional certainty.
The market cycle above has played out over a longer than normal eleven-year bull phase and will either continue on its growth trajectory or will finally roll over if the financial markets reset due to the concerns stated above. If momentum weakens, due to uncertainty and the weakening of internal market variables, markets tend to reset or revert to the mean. This market has continually advanced at a pace well above the mean for an extended period of time with the exception of the fourth quarter of 2018.
Our goal is to evaluate opportunities, be aware of systemic risks and prepare to take action in an effort to protect our portfolios through risk mitigation while seeking income and growth appreciation by careful deployment of capital in markets that may become increasingly chaotic with the continued volatility we have seen over the past year.
Throughout 2018 and 2019 we believed that the markets (and the FED) were complacent, and in our opinion, were in need of a reset. We felt it would be healthy if the market had a technical correction of -10% to -15% to take some of the froth (potential bubble) out of the market which happened in the late fourth quarter 2018. If the market corrects in 2020, and can withstand the headwinds stated above, then we believe that the foundation of a continued bull cycle will remain in place. So, we remain cautious but bullish for the first half of 2020 and will monitor the market behavior closely as we move through the first half of 2020.
Market Cycles: Markets move in cycles and now is a great time to plan for the next few years. These cycles repeat themselves and we believe the market has broken out of the 16-year secular bear market and is still within a secular bull phase. The stock market appears to remain in longer-term secular bull market that may have many years of potentially positive results ahead. However, past secular bull periods have not been straight-up affairs and tend to have many pullback periods that can keep the trend confusing for investors, but in time can become more obvious once the business cycle and the economic backdrop improve. For now, we suspect that further gains in the market will continue to be met with a fair amount of skepticism and even pessimism which justifies the recent increase in volatility.
In the next few years the markets have the potential to confirm the shift into a secular bull phase that could last for multiple years. Our strategy is to position our portfolios properly to take advantage of the next cyclical change
Equity Market Environment. In the beginning of 2018 the markets finally saw volatility return to the market with a correction in the first quarter and again in the fourth quarter, as seen in the graph above. It took only four months in 2019 for the markets to rally back and test the previous highs made in September 2018.
During that time frame, the markets had built a strong base of consolidation as represented by the blue shaded range. However, even with the break to new lows in December of 2018 we felt the market was poised for a rally to new highs in the first two quarters of 2019.
As the rally to new highs occurred, a new technical bull channel developed, as seen in the second graph above, which held through 2019 and continued into the beginning of the first quarter. The stock market has made a string of new highs that gives it an almost parabolic look and with some of the leading stocks in the rally the pattern is even more pronounced. There is no way to call a top in such a move before it happens, but they have often led to equally sharp corrections in the past as has been frequently recognized in the recent press. Generally, we think these types of rallies are fueled by bullish sentiment that eventually reaches a peak and then reverses. Investors may be more optimistic but we believe the news of the world is not so positive, which makes recognizing changes in the overall tone that much more difficult.
There now is a host of conflicting signals that is accompanying this latest momentum channel. We are into the early part of the fourth-quarter earnings reporting season and while the consensus for the S&P may be for a negative comparison to the same period last year, these lower expectations also create the backdrop for some positive surprises that could balance off the news into a muted and neutral market response.
U.S. economic growth slowed in 2019, pulled down by weak business investment and manufacturing activity. Although strength in consumer spending and services persists heading into 2020, we expect stabilization, at best, in growth next year. A myriad of uncertainties are clouding the outlook, including earnings and the presidential election. Ongoing trade war ambiguity could further depress corporate confidence and investment.
A key risk in 2020 is that manufacturing weakness and business investment fatigue could hurt services activity and consumer spending, by depressing job growth. Although the U.S. unemployment rate (a lagging indicator) remains low, weekly initial jobless claims (a leading indicator) in manufacturing-oriented states have been rising. As such, U.S. payroll growth may weaken if limited headway is made on a comprehensive trade deal. However, global economic stabilization could be positive for U.S. growth.
Volatility (VIX): Volatility, as measured by the VIX, is a statistical measure of the dispersion of returns for the S&P 500 index. Sometimes it’s important to remember that some of the biggest moves in a trend come at the end of a trend, and it may be best to watch how things unfold rather than succumbing to the “Fear of Missing Out” that often occurs after the market has made a strong move to the upside. We believe the recent pick-up in volatility, coupled with the derivative volatility measures referenced in the charts above is a possible sign of a near-term trend change.
The recent parabolic strength in the averages paired with the technical view of the VIX Index, lends credence to our belief that the markets have a higher than normal probability of a short-term correction. We feel that a near term spike in the VIX to the 20 to 25 range is imminent which would correlate to a 5% to 7% corrective move in the indexes. This should be a normal corrective phase that will take some of the froth out of the market early in the first quarter of 2020, which in turn will create opportunity to deploy additional capital to the market. This will also allow for proper rebalancing of portfolios.
The VIX has had a weighted average over the past several years between 12-15. This means that there is a 67% chance the S&P 500 will fluctuate in a range between 12-15% over the next year, either upward or downwards. We are expecting that this range over the next 2-5 years will increase thereby increasing the weighted average of the VIX to 15-18. This is a most significant change representing an increasing importance on individual stock selection, risk mitigation and the increased potential for overall systemic failures. We do not believe passive investing, or buy and hold, will prove beneficial either financially or psychologically over the next 2-5 years or the foreseeable future. Volatility among all asset classes will rise, creating opportunities in the active equity management, commodity and futures management and hedge fund landscape.
The chart above is one of the more compelling charts in this report. It compares the price-to-earnings ratio (P/E) for the Standard & Poor’s 500 Index with the 30 day average for the Chicago Board Options Exchange Volatility Index, or the VIX. As you can see in the chart, the indicator line has recently rallied well into the Complacency range, matching levels not seen since September of 2018 (prior to the sharp sell-off that year). A steady rise in corporate valuations (P/E ratio) without a commensurate decline in volatility (VIX index) has led to this effect. This data further confirms our assumption that a short-term corrective move should take affect early in the first quarter of 2020.
The chart above represents an overlay of the S&P 500 Index and the spread of the VIX spot (current) price minus the VIX 3 month futures price (as represented by the green and red shaded areas on the chart). In 2018 it showed the VIX in the term structure known as “contango” (in green). The term structure when combined with the other volatility indicators can represent a near-term reversal (rally) in the equity markets. Conversely, when these series of indicators show a discount (shown in red) with a large spike lower, a short-term reflex sell-off ensued. What is currently at play is a probability of a near-term correction. We will be watching this closely.
Investor Sentiment (AAII Bears vs Bulls): The American Association of Individual Investors is an organization that polls its members weekly on whether they believe the market will be up, down, or unchanged, six months in the future. The graphs (above) indicate the percentage of the members who gave a bullish response, measured with a 50-week moving average in red plotted against the S&P 500 in black. The first graph was the end of 2018 and the second graph is current.
Short term indicators related to investor sentiment appear to be showing “too much” bullishness (since mid-2019), but the longer-term measures continue to be of a more skeptical nature. Many short-term technical indicators are also into overbought territory while the long-term trends remain bullish. The bottom line to all this is that we expect to see a near-term pullback within the long-term bull market with the depth and duration of a possible correction still to be determined.
Strategy Buying Dips or Selling Rallies: The overplayed trading style of consistently “buying the dips” (RED) was replaced in the fourth quarter of 2018, as seen in the first graph above, with “sell the rallies” (BLUE). “What could go wrong” may be overshadowed with “I need to get out”. Complacency may yield to fear as volatility ratchets higher. This is exactly what we witnessed in that fourth quarter. However, we felt that this will revert back to “buying dips” in the first and second half of 2019.
There is a counterintuitive argument to make in favor of US equities specifically and in particular. This argument is in parallel with the tenet that the USD (US Dollar) will remain the global reserve currency. So long as the dollar remains preeminent and so long as the sovereign interest rate spreads favor the US treasuries, then dollar assets will be sought after for investors worldwide seeking a haven for their wealth and diversification from their homelands’ currency. Coupling this “bid for USD’s” and the possible repatriation of trillions of dollars held in non-US banks if those monies have some form of tax amnesty for US multi-nationals; the most probable benefactor of a significant amount of those dollars would be invested into US equities.
As mentioned in the discussion regarding volatility above, equities globally could be in for a roller coaster ride. One thing for certain, passive investing in equities will not be rewarded anywhere near the value of a seasoned active money manager or advisor. Buy and hold strategies may get tossed out the window in favor of periodic, if not frequent, rotations of industry groups and individual stocks held within as the stock market’s gyrations occur with more frequency and greater amplitudes.
The reason to own equities as a substitute for the relatively low yield environment of debt instruments will become increasingly harder to justify due to the dramatic expected rise in the standard deviation of returns owning stocks. As a subclass within the equity space, the dividend stocks may cause the most concern in the months and years ahead due to that fact that this is a crowded trade. Buying stocks for “yield” while ignoring the fundamentals of the company’s balance sheet leverage and price multiples are sure to catch many investors off guard.
Now one year later, we expect bouts of market volatility will persist in 2020. Trade news may continue to drive market swings in both directions, absent a comprehensive U.S.-China trade deal. Investor sentiment should also be a factor in market swings, with late-2019’s new highs ushering in elevated investor optimism (a contrarian indicator at extremes). Investor sentiment also may continue to swing more widely than usual, with new highs elevating optimism, only to be dented by negative trade news.
Earnings are expected to accelerate in 2020, but that expectation is partly predicated on a positive outcome to the U.S.-China trade war, which remains uncertain. In addition, due to the effects of tariffs and rising labor costs, profit margins could come under pressure in 2020. The macroeconomic environment, including easier monetary policy and lending conditions, supported price-earnings (P/E) expansion in 2019, but those effects are fading. The wide gap between stock market performance and corporate after-tax profits suggests the latter needs to accelerate.
Sectors Allocations: Based on historical data with a low and or slightly rising yield curve in place, the best sectors in later stage bull cycles are growth related sectors that are rewarded by continued economic expansion.
In 2019, Technology, Consumer Discretionary, Materials and Industrials (if China Trade issues get resolved) were over-weighted in the portfolio. Non-growth related (defensive sectors) such as Health Care, Utilities and Consumer Staples were under-weighted in the portfolio.
In 2020, Technology, Financials, Industrials and Consumer Staples will be over-weighted. Non-growth related (defensive sectors) such as Health Care, Utilities and Consumer Cyclicals will be under-weighted in the portfolio.
The charts above highlight our basic framework of over weighted and under weighted sector allocations and show the significant change over the last year. This further reinforces our strategy on a corrective move in the short run allowing for re-allocation of sector weightings.
The Future of Interest Rates: The charts (above) reflect the historically low interest rates that have been reached in the last few years. Last year, we felt that rates would stall or flatten throughout the year then begin to move higher in 2020. Typically, and again in a normalized yield curve structure, money that exits (leaves) bonds typically find its way into equities furthering a bullish strategy to own stocks. Again, the charts above shows just how low rates are relative to history.
The new highs in the stock market are capturing much attention of late while other areas of commodity prices and interest rates have been moving lower over the past month. It could be that the lower rate and inflation trends are helping to boost the stock market to some degree, but considering the already-low levels of these economic indicators, there might not be that much room for them to move substantially lower. However, the near-term trends are still down. The yield on the 10-year Treasury note has trended back to the technical support level of 1.7% which is not a particularly strong level of support with the next support being in the 1.4%–1.5% area. The long-term low of 1.43% on the 10-year could be challenged in the months ahead.
Curve flattening over the past two years has signaled investors’ concern that potential rising interest rates against a backdrop of slowing global growth could harm the U.S. economy. Inversion of the 2 year-to-10 year treasuries (as seen in the first graph above) — where 2 year yields at the short end of the curve rise above those at the long end — has been a reliable indicator of recessions. Currently there is no indication that the 2 year treasury will invert versus the 10 year treasury.
The entire yield curve over 2019, flattened and shifted downward as seen by the second chart above. This was due to the Federal Reserve reducing rates three times in 2019.
Crude Oil: Big short-term moves in securities can be deceiving when taken by themselves as it is tempting to translate the move into something meaningful for the long term. Such is the case for oil, which has rallied to 66 from 51 over the past three months on international news, but in the longer-term picture this rally has brought oil up to the previous peak and resistance in the 65–66 area and the high end of the overall range that it has been in for the past year.
It is at these resistance areas where the security either breaks out or not, and by the typical nature of resistance areas to be formidable barriers, the higher likelihood is that the resistance will prevail and a pullback could develop. Yesterday’s trading on oil saw it pop to a new recent high but then reverse to close lower on heavy volume which is often the sign of a peak. A clear breakout above 66 is what we think would be needed technically to signal a larger uptrend may be developing.
Current Trading Update: The following is our Short, Intermediate and Long Term trading strategy.
Short term (days to weeks) – Bullish and extended with Caution. The major indexes have continued their rallies of the past three months into new high ground but as a result of the move are now in a technically overbought condition that makes it more likely that a pullback or correction could develop soon. We would consider any pullback to be a normal move within the longer-term bullish trend and would also expect a pullback to be in the 5%–10% neighborhood with the possibility of a larger correction if the news warrants such a move. The measures of stock momentum, volatility, and short-term investor sentiment are largely positioned near the high end of the scale from which previous pullbacks have developed.
Intermediate term (weeks to months) – Bullish. The Dow Industrials and S&P 500 have broken out from their ranges of the past 18 months and we believe are now positioned for further upside potential in 2020. Other than normal pullbacks and corrections along the way, we see the possibility of continued new highs during the year with possibly more volatility and gains that may not be as great as they were in 2019. The various groups and sectors continue to send mixed messages regarding the market trend with this lack of confirmation being a possible indication of rotation between various areas of the market that could make for a choppier pattern for the markets going forward. However, we think the overall trend is positive, and we see any dips or pullbacks along the way as being opportunities to add to equity exposure.
Long term (months to years) – Bullish. The secular bull market that began in 2009 remains intact as it moves higher in a larger rising channel that is 25% wide. The major indexes are in the higher end of their channels which suggests to us that there could still be plenty of movement in both directions while remaining positive for the longer term. These secular bull markets tend to go on until the measures of stock valuation and investor sentiment are at much higher levels than they are today. These secular bull markets also track the trends in the economy and although some measures of economic growth are in positive trends, the overall trend continues to be in a slow but steady recovery which has allowed stock prices to do the same. A booming economy can lead to a boom-and-bust stock market, but that kind of scenario could still be years in the future.
Highstreet utilizes a team approach to the overall investment management process. We understand investing and the responsibility that goes along with prudent management. We are committed to forming a long-term relationship with our clients and providing them with the best possible client service experience. If you have any questions regarding our firm, please contact one of our staff members.
Disclosures: Highstreet prepared this report and takes sole responsibility for its content and distribution. Data was prepared with the assistance of our research sources. The content may have been based, at least in part, on material provided by our third-party research provider. Our third-party research provider has given Highstreet general permission to use its research reports as source materials, but has not reviewed or approved this report, nor has it been informed of its publication. Our third-party research provider may from time to time have long or short positions in, effect transactions in, and make markets in securities referred to herein. Our third-party research provider may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any company mentioned in this report. Highstreet endeavors to make all reasonable efforts to provide research to all eligible clients, having regard to local time zones in overseas jurisdictions. In our investment advisory accounts, Highstreet will act as discretionary investment manager for our clients and will initiate transactions for those accounts. These transactions may occur before or after your receipt of this report and may have a short-term impact on the market price of the securities in which transactions occur. Highstreet research is posted to our Web site to ensure clients receive coverage initiations and changes in our investment strategy in a timely manner. Additional distribution may be done by marketing and consulting personnel via e-mail, fax, or regular mail. Please contact Highstreet for more information regarding Highstreet research. Highstreet is registered with the State of Florida Office of Financial Regulation as an investment adviser, offering investment advisory services. Highstreet Policy for Managing Conflicts of Interest in Relation to Investment Research is available by request and conflicts of interests related to our investment advisory business can be found in Part II of the Firm’s Form ADV. Copies of any of these documents are available upon request through our office. We reserve the right to amend or supplement this policy, Part II of the ADV, or Disclosure Document at any time. The author(s) is/are employed by Highstreet Financial a division of the Highstreet Group, LLC with principal offices located in Tampa, Florida USA.
Additional Disclosures: This comment is prepared by the portfolio managers of Highstreet. All views expressed are the opinions of the portfolio managers based solely on the historical technical behavior (price and volume) and their expectations of the most likely direction of a market or security. No guarantee of that outcome is ever implied. These opinions may differ from the fundamental research view(s) of Highstreet, its affiliates or its research providers. The issuance of this report does not constitute coverage of any of the issuers referenced herein and the technical opinions contained in this report are subject to change without notice. Highstreet has no obligation to inform you of such a change. The information contained in this report has been compiled by Highstreet and the portfolio managers of Highstreet, from sources believed to be reliable, but no representation or warranty, express or implied, is made by Highstreet, its affiliates or any other person as to its accuracy, completeness or correctness. All opinions and estimates contained in this report constitute Highstreet judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. This report is not, and under no circumstances should be construed as, a solicitation to act as securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice. This material is prepared for general circulation to clients, including clients who are affiliates of Highstreet, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Highstreet nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Highstreet. Copyright © Highstreet, 2020.