Rebalance away from US equities
On Monday, the S&P 500 closed at a year-to-date high of 2,094, up 14.5% from its February 11 low. Now comes the real test of investor confidence. At its current level, the index is just 1.7% below its all-time high, set on May 21 last year. Since then, the market has tried and failed on four occasions to surpass that level, in June and July, and then following the summer’s sell-off, in November and December. With the market apparently poised for yet another attempt, should investors load up in anticipation of a break higher? Or should they take the opportunity to sell out entirely?
Neither. At this stage in the cycle, investors should not be making drastic risk-on or risk-off bets, but should instead maintain balanced portfolios. As the index dipped in January, I recommended that investors Keep Calm And Rebalance Into Equities. Today, the same balanced portfolio approach requires a partial shift out of equities, and into either cash, gold or bonds, all of which are all roughly flat since February.
Why a balanced portfolio now? The answer is based on a framework I introduced late last year to assess where the US economy is in its cycle, the chance of recession, and the relative attractiveness of risk assets. It relies on the simple observation made by Knut Wicksell in 1898 that there is a natural upper limit to the interest rate that entrepreneurs are willing and able to bear—and that rate is the expected, marginal return on invested capital.
If the cost of capital rises above its expected return, entrepreneurs will stop borrowing to make new investments. This will weigh on economic activity (because of less investment and fewer hires), as well as on money supply (the result of less borrowing in a pro-cyclical fractional reserve banking system). In such circumstances, a recession is almost inevitable, and equity markets are likely to reflect the coming slowdown.
Today, the spread between the return on capital and its cost is shrinking, which makes it clear that the US economy is in the second half of the cycle. First quarter data confirmed that The Returns On Capital Are Deteriorating (a trend which is likely to continue for the reasons outlined last December in The State Of The US Economy). Meanwhile, although credit spreads have narrowed from the extremes seen in February, the cost of capital for businesses is now considerably higher than it was 12 months ago. As a result, the spread between the return on capital and its cost continues to shrink—which is characteristic of the latter half of the cycle. However this ROIC-COC spread remains positive, which indicates it is too early to expect recession, or to sell-out of equities altogether.
This way of viewing of the cycle suggests a three stage investment strategy:
1) Recovery phase: go all-in, risk-on! This stage is defined by a positive ROIC-COC differential, with the spread either stable or widening.
2) Late cycle phase: maintain a balanced portfolio. This stage occurs when the ROIC-COC spread starts to narrow, but remains significantly positive—like today. In this environment, equities tend to outperform cash, although cash holdings can be used to reduce portfolio volatility as the cycle matures.
Better yet, investors can hedge with gold or long bonds. Since the early 1980s, the persistent decline of inflation and bond yields has made long bonds the better choice (as Charles has shown). This long term trend may hold for a while longer, but at current levels the risk-reward proposition for betting on a continuation is poor. If inflation rebounds and bonds sell off, gold will be a better hedge than bonds, as it was in the 1970s.
3) Recession phase: get out! When the cost
capital exceeds returns, get out. Go all into cash, safe bonds or gold. But not yet.