“Stuck in the Middle with You” – (1972, Stealers Wheel)
“Yes I’m stuck in the middle with you,
And I’m wondering what it is I should do,
Clowns to the left of me, jokers to the right,
Here I am, stuck in the middle with you”
Media outlets today have their own version of who are clowns and who are jokers, but despite the volume of their opinions, and some daily ups and downs due to the hype, the financial markets are to an extent, politically tone deaf and tell us a little more concretely on an economic basis, what has actually happened and what the current concerns are. And to a large extent, like the song above, the markets are stuck somewhere in the middle.
S&P 500 (with dividends)+2.52%
All Country World Index -Ex US -3.96%
Global Bond Index-1.29%
Representative Result of index returns:
Blackrock Growth Allocation -.89%
Blackrock Moderate Allocation -.90%
Blackrock Conservative Allocation-1.11%
With news feeds following every Fed announcement, presidential tweet, and now seemingly every foreign leader’s statements, we either think the US and Global economy is righting itself and ready to take its next leap forward or a global recession is just around the corner. Yet to this point, whether you have invested conservatively, moderately or aggressively, most “Allocation” funds resulted in you being down about 1%. Yes, you could have put all your money in Amazon and Netflix and claim to be a genius or have big amounts in 3M or General Mills and are singing the blues (Even Warren Buffet’s Berkshire Hathaway is down 6% YTD). But most investors are “stuck in the middle” and wondering what it is they should do.
If we take a deep breath however and look at “what we know” instead of “what might be happening”, things look a little saner, hopefully leading to some rational decisions. After two years of very high stock market returns and bond returns that were protected by easy money policies of the Fed, we should remember where we came from. We’ve looked at returns for the last 20 years and found that while on average the S&P 500 with dividends returned nearly 10% per year, it has had significant ups and downs, sometimes taking 4 or 5 years to recover from a big down. We believe we will see strong U.S. growth continuing this year and even helping international markets move forward, but the markets have already baked this in and with the big returns of 2016 and 2017, we probably should expect a few less than stellar years. Essentially 2016 offset a poor 2015 and returns for 2017 were high due to the hopes of what tax reform could do. Now we are settling in and seeing what happens.
While some things remain in historically normal ranges, others have changed and we need to take notice. The Federal Reserve is making a concerted effort to increase interest rates for the first time in over 30 years making US fixed income investments problematic. Foreign governments are working hard to reduce the value of their currency in order to make their goods cheaper and more attractive to others. That will lead to headwinds for both foreign stocks and bonds. In fact, we have already seen a fairly dramatic drop in international stock and bond returns in the second quarter of this year. Trade wars make us wonder about increasing inflation and potential recession and companies buying back stocks with new money from lower taxes rather than making new investments make us wonder about the effectiveness of the tax reform that helped bid up the stock market in 2017. The question is will the current trend of a strengthening US economy and dollar continue and will trade problems settle down or will global uncertainty and increasing corporate debt derail the progress made in 2017. Signs of wage growth and increased corporate investment were expected to be seen at this point but so far are slow to develop.
It seems clear that the trend of a strong dollar resulting both from current trade tactics and Central Bank actions, both U.S. and foreign, will be headwinds for International Stocks and Bonds. So we have reduced our international exposure on both fronts and are focusing on the U.S. markets. Global equity markets appear to be cheaper than the US markets and could produce higher returns going forward, but right now the risk from trade wars, negative global events and the headwinds from currency effects don’t seem to make large positions in “ex-US” investments a smart bet. We also don’t see bonds as a great place to wait out the uncertainty as yields are still relatively low and rising interest rates will reduce any return we get from them. So, as you will read from many investment sites, shortening the maturity of our fixed income holdings makes sense in this environment. The flat yield curve we find ourselves in give us little advantage trying to get more yield by going out to longer maturities. So as GDP and economic indicators continue to show that the U.S. economy is fundamentally strong but also recognizing the risks of trade wars and a potentially slowing economy from those events, as well as increasing interest rates, we think the best “risk-adjusted” returns come from an overweight on U.S. stocks versus international stocks, an underweight in both U.S. and Foreign Bonds and an allocation to investments tied to the stock market but with downside risk controls (Modern Alternative Strategies).
At this point the U.S. stock market (while certainly bumpy) seems likely to grow this year but not “break-out”. And like that outlook for the market, we are optimistic but cautious of the many political and geo-political events going on. So until we resolve things like trade disputes with China and our traditional Allies, the NAFTA negotiation with Canada and Mexico and how companies are spending their gains from the new tax law, we think it best to protect against downside risks. Staying “in the middle” is sometimes the right thing to do.