Q2 2018 Commentary - Is the Market Telling Us Something About Where We Are in This Cycle?
One of the tenets of PYA Waltman Capital’s Investment philosophy is that markets continuously move through repetitive cycles. While we may not know where we are going, we attempt to have a good idea of where we are in the cycle. As the first half of the year drew to a close, our investment committee observed several potential signs of late stage activity within the stock market.
- A flattening of the yield curve
- The underperformance of the financial sector
- A narrowing of the leadership within the stock market
- Lax credit conditions
- Tightening of monetary conditions
Flattening Yield Curve
While the U.S. economy has been doing quite well and may have even grown in excess of 4% during the second quarter, the yield curve doesn’t appear to be forecasting the recent robust growth to continue. During periods of rapid economic growth, the yield curve is normally very steep, meaning long-term interest rates are much higher than short-term interest rates. In early July, the interest rate differential or spread between 10 year treasuries and 2 year treasuries was down to just 30 basis points. With the Federal Reserve (the Fed) on track to increase short-term interest rates at least a few more times in the next 6 to 9 months, the risk of an inversion in the yield curve, or short-term interest rates being higher than long-term interest rates, is growing. Most, but not all, recessions have been proceeded by an inversion in the yield curve.
The Underperformance of the Financial Sector
Historically, the financial sector is quite strong in the early phases of a cycle and then begins to weaken as the cycle grows long in the tooth. We certainly saw very strong performance from the financial sector coming out of the Great Financial Crisis, but more recently the sector has begun to struggle. As of June 30, 2018, the Financial Select Sector SPDR Fund was down nearly 4% on the year. Some of the funds top holdings include Bank of America, J.P. Morgan Chase, Citigroup, Wells Fargo, and Goldman Sachs, all of which had declined anywhere from 2% to 10% on the year.
A Narrowing of Leadership Within the Stock Market
The Standard and Poor’s 500 (S&P 500 index) is a market capital weighted index whereby the companies with the highest market valuations are assigned a larger percentage share of the index value. While the S&P 500 index gained 2.65% in the first half of the year, this gain was mostly concentrated in a few stocks, namely Netflix and Amazon. The New York Stock Exchange (NYSE) composite index, which is comprised of more than 2000 stocks that trade on the NYSE, was down 2.4% through the first half of 2018. A narrowing of a stock market advance to just a handful of names, while many stocks begin to stall or falter, is often a sign present in the late stages of a bull market.
Lax Credit Conditions
We have previously written about the explosive growth in the number of covenant light loans. These loans are defined by Investopedia as follows. “The issuance of covenant-lite loans means that debt is being issued to borrowers with fewer restrictions on collateral, payment terms and level of income.” Credit conditions are always the toughest after a financial bust, when creditors have just experienced losses. As the economy expands and time passes, memories of those painful losses begin to fade. This normally translates into creditors loosening the conditions under which they will extend credit. Typically, this happens late in a cycle when unemployment is very low and economic growth is strong. Who wouldn’t want to extend credit in such an environment, right? The nearly parabolic growth in covenant-lite loans signals that a growing number of creditors aren’t too concerned about the repayment risk they are bearing.
Tightening of Monetary Conditions
The Federal Reserve has begun to tighten monetary conditions through both the increase in short-term interest rates and the selling of treasuries and mortgage-backed securities from its balance sheet (quantitative tightening or QT). This one-two punch has the effect of draining liquidity from the financial system and making the cost of credit more expensive. This is the opposite environment of the last 8 years where the Fed was injecting massive liquidity (quantitative easing or QE) into the financial system to re-inflate asset prices. Historically, one of the late cycle risks to financial markets is an overly aggressive Fed. Will they continue to increase short-term interest rates, risk an inversion in the yield curve, and a possible recession? One would think not, but the risk of a policy error is not negligible.
Do these signs of potential late cycle market behavior mean the end of the bull market is imminent? Absolutely not. How long the current cycle can last is unknowable. Numerous things could happen to lengthen this cycle even more, from the Fed becoming more dovish, to a new unexpected form of stimulus. We do know, however, financial assets are expensive by most historical metrics and this is now the second longest economic expansion in the last 100 years. If the U.S. economy continues to grow through 2019, it will be the longest economic expansion on record since the Civil War. If history is any guide, a softening of economic conditions within the next few years wouldn’t be a surprise.
Given this backdrop, our mantra remains proceed with caution. While we are positioned near the lower band of our risk exposure in our model portfolios, we stand ready to increase this exposure as valuations improve and future return expectations increase.
As always, we remain committed to helping you achieve your financial goals.