After almost 70 years of success, the 60/40 portfolio investment approach has become too risky and structurally incapable of meeting its intended objectives. It needs revisiting.

First, a bit of background; A 60/40 portfolio, which divides assets between equities and bonds, has been the standard for most personal investment portfolios. It is the starting point for many bankers and brokers who might recommend a percent adjustment based on age; whereas, for instance, a higher equity allocation is recommended for younger people.

Foundations of the 60/40 portfolio emerged from Harry Markowitz’s Modern Portfolio Theory (MPT) work in the 1950’s, which won him the Nobel Prize. It is also the basis on which today’s robo-advising algorithms are written. Yet, MPT never envisioned a world where someone has to pay to lend money.

 

The Anatomy of the Coming Recession

Nouriel Roubini makes an important distinction between the 2008 crisis and the crisis that may be coming. This one will be different but no less severe. It could even be worse because, as he explains, neither monetary nor fiscal stimulus will be sensible options this time.

Key Points:

  • The world faces three separate negative supply shocks, any one of which could trigger a global recession.
  • The first is the US-China trade and currency war, which recently escalated as Trump raised tariffs.
  • Second is a slower-brewing US-China cold war over technology. Breaking those supply chains would be highly disruptive to the economy.
  • Third is a potential oil shortage, should the US-Iran confrontation escalate to a military conflict.
  • All these possible shocks would have a stagflationary effect, raising consumer prices and reducing output.
  • Global tech, manufacturing, and industry is already in recession. Only strong private consumption is sustaining the expansion.
  • The trade and technology supply shocks would be more or less permanent, as would the reduced potential growth.
  • Attempts to manage these with fiscal or monetary policy would raise both inflation and inflation expectations.

Bottom Line: The 2008 crisis was mainly a demand shock that depressed growth and inflation. Aggressive monetary and fiscal response was appropriate. That will not be the case in a sustained negative supply shock, which means we could face a crisis that authorities lack the tools to manage. They may still use the tools they have and only make the damage worse.

 

Warren Buffett

Berkshire Hathaway was holding a record $122 billion position in cash at the end of last quarter.

This massive cash hoard works out to more than 50% of the value of Berkshire’s entire portfolio of public companies. In other words, Buffett already has more than a third of his portfolio in cash. The only time it’s been higher was right before the financial crisis.

His favorite market valuation metric – total market capitalization-to-gross domestic product (“GDP”) – sits at more than 150% today.

By this measure, the broad market is currently more expensive than it was at either of the last two bull market peaks in 2000 and 2007.

 

US-China Trade War

“Logic” isn’t a word often applied to the US-China trade war, but George Friedman looks at it differently. Considering the situation and incentives on both sides, each government’s decisions make sense from their perspective. Unfortunately, it doesn’t make a resolution any easier or more likely.

Key Points:

  • The US-China trade dispute is, in some ways, comparable to US-Japan trade relations in the 1980s, when Japan had closed off much of its market to imports from the US. However, there is a key difference.
  • At the time, Japan was a critical partner against the USSR. This helped contain the economic friction. That is not the case with China now. China is not a military ally and is increasingly viewed as a strategic threat.
  • Large US companies invested in China have long pushed Washington to maintain a stable relationship. This was profitable for those companies but not necessarily best for the US economy.
  • The post-2008 displacement of the US working class changed political incentives, reducing corporate influence and removing the option of continued, ineffective talks that had no effect on Chinese policy. Hence, the Trump administration’s use of tariffs to force the Chinese to open their markets to US competition.
  • The problem: China’s economy can’t withstand such competition. Beijing must increase domestic consumption to absorb excess capacity. This is no easy task in the first place. Allowing US competition would make it even harder.
  • Reducing the Yuan’s value helps in the short run by making Chinese exports cheaper, but this is not a full solution.
  • Trump’s recent threats to force US companies out of China makes sense for him, politically, but is a major threat to US businesses as well as China.

Bottom Line: Friedman concludes, “The US is unlikely to back down without concessions that China cannot make.” If so, it is the formula for a trade war that will drag on for a long time, possibly getting worse before it gets better. Investors should beware.

 

Inverted Yield Curve

The curve is now fully inverted, with the Treasury notes and bonds yielding less than the short-term bills.

 

 

It took one to three years for the economy to go into recession after the previous episodes of yield curve inversion.  The stock market rises around 22%, on average, after the yield curve inverts. That means if history is any indication, the S&P 500 would reach an all-time high of around 3,500 before the next bear market begins in February 2021.

Of course, relying on averages doesn’t always work. Sometimes, recessions come much sooner. (Back in 1980, the stock market peaked less than three months after the yield curve inverted.) And, sometimes, they come much later. (The yield curve inverted around 22 months before the dot-com crash of 2000.)

 

 

The Federal government will be limited in its ability to stimulate the economy in the next recession because the fiscal policy is already extraordinarily loose. Given the current economic expansion, the level of government stimulus is unprecedented.

 

US Banks

The financial sector was cruising along just fine last month. By the end of July, the Financial Select Sector SPDR Fund (XLF) had scaled a new 52-week high. Everything looked dandy in the banking world. Then, the bottom dropped out of the markets. Funny thing is that a similar pattern surfaced in September 2018. The financials were humming along and looked poised to notch a 52-week high… and then the markets crashed.

 

 

A closer look at these patterns reveals a telling clue: just prior to both of these market sell-offs, a divergence between the direction of prices and market technicals appeared. The XLF share price kept climbing while both relative strength and momentum—the top and bottom panels of the chart—kept falling. This technical behavior often points to a price trend reversal ahead. Notably, the S&P 500 did not show this pattern ahead of its big declines. Keep an eye on the action in the financial sector.

Sticking with financials, today’s interest rate environment is a tough one for banks. Banks earn a profit from what is known as “net interest margin.” It is the difference between what they payout in interest and what they receive in interest from borrowers. Greatly simplified, it is the margin between borrowing short term and lending long term. With interest rates already low and headed lower, net interest margins will get squeezed.

 

 

In a rate climate like today’s, one positive trait to look for in a bank is the percentage of non-interest-bearing deposits. This is money on which a bank pays no interest but can earn interest by lending. This table from FACTSET lists some of the large bank holding companies in the US and their percentage of deposits that do not earn interest.

 

US Economy

We continue to see signs of slower business investment amid persistent trade uncertainty. As a result, economic expansion (including global growth) is increasingly dependent on the US consumer. The good news is that at least for now, American households appear to be in good shape and willing to spend. Strong employment, rising wages, and falling mortgage rates have been a tailwind for the consumer.

Core durable goods orders were weaker than expected, pointing to softer capital investment.

Manufacturing is in contraction mode (PMI < 50).

 

 

A more troubling trend, however, is the deceleration in services.

 

 

US Interest Rates

30 year Treasury is now below 2%!

 

 

If you want a better rate, Argentina capped its short-term rate at 75%. Kidding. Argentina is ready to default, and actually, technically DID default on Friday.

 

 

Bonds

Cumberland Advisors chairman, David, watches the bond market closely, and he sees a bunch of trouble signs. He sees opportunities as well.

Key Points:

  • Globally, about $17 trillion in government and corporate debt is now trading at negative yields. Adjusted for inflation, some real yields are -2%.
  • In the US, the yield curve is either flat or inverted, depending which maturities you use.
  • Almost all developed world ex-US sovereign debt now trades at yields below the US overnight risk-free rate. There is no historical precedent for this.
  • The 30-year US TIPS yield has dropped from about 1.1% in February to 0.5% now.
  • Only six other times have US yields declined as fast as they did in August, and all were during or close to recessions.
  • Tax free muni bonds tell a different story, though. David mentions a Texas tax-free bond that yields more than taxable Treasury bonds. Default rates remain low. A similar pattern exists in junk bonds.
  • Inflation is ticking higher, with some measures now above 2%. Real yields in the US are practically zero.

 

Stock Buybacks

Share repurchases have provided much of the lift for large-capitalization stocks over the last couple of years.

Corporate share buybacks currently account for roughly all ‘net purchases’ of U.S. equities in recent years.

 

 

Market Data
  • On an average day over the past month, the S&P 500 has moved 1%, one of its widest ranges since the financial crisis.
  • Historic uncertainty: The wide swings in stocks are due, in no small part, to a historic level of uncertainty regarding the U.S. administration’s economic policies. An index of that uncertainty has spiked to a level that matches other major financial or geopolitical events.