Are you managing money naked? There is an old adage on Wall Street — never go home long and naked. Traders either need to close their positions by the end of the day or fully hedge the risk of maintaining their long position overnight. Now is a critical time to not manage money naked. Let me explain.
We are in the midst of the second-longest bull market run in history that’s approaching its ninth year. For those who pay close attention, there are warning signs that a recession could be imminent. Protecting clients’ capital from large losses is the most important responsibility a financial advisor has. Right now, because markets have been rising for a long period of time, some investors have come to believe that “this time may just be different” — that the market can avoid bear market declines forever. Unfortunately, it’s never different; the bear market rampage just hasn’t begun yet.
Warning signs started flashing after Q4 2014, Q1 2015, and Q2 2015 all showed negative corporate earnings and revenue trends. Considering that four consecutive negative quarters can trigger a bear market, signs of a weakening economy were evident when the S&P 500 fell 10% in the first half hour of trading on Aug. 24, 2015. However, the Federal Reserve intervened, keeping the asset bubble intact so the carefully nurtured “wealth effect” endured and consumer spending continued.
Markets rallied until a second attempt at a bear market decline on Jan. 8, 2016. Again, the Fed intervened, and over the past year or so, the markets have climbed higher despite the clear evidence that the economy is weak. This false sense of economic stability is dangerous for investors, and as advisors we need to take the higher road to protect our clients’ capital.
What’s made matters worse is the proliferation of assets crowding into passive index funds. This has created one of the most potentially dangerous liquidity traps yet, reminiscent of the crowd into technology stocks in the late 1990s, just before the dot-com bubble burst and shred investor capital with 70% and 50% declines in the Nasdaq and S&P 500 respectively. I fear the current bull market cycle has dulled investors’ memory of the battering losses they incurred during the dot-com market crash and the 2008 financial crisis. Furthermore, the Federal Reserve’s zero interest-rate policy and quantitative easing have lulled investors into a hopeless state of denial about today’s elevated risk factors and the high probability of a dramatic pullback in equity markets over the next few quarters. With markets already historically overvalued and continuing to rise, it is important not to “go naked” — it’s time to mitigate risk now.
A bright spot over the past few quarters has been the resurgence of earnings and revenue growth. Earnings and revenue trends turned positive in Q3 of 2016 and have been posting significant earnings beats on year-over-year comparisons. And while second-quarter 2017 earnings look strong, let’s keep in mind, they are against last year’s easy-to-beat negative-trend earnings.
Let’s also not forget that earnings and revenue growth rates are being made to look better than they actually are due to corporate share buybacks. Companies have spent trillions buying back their stock to engineer per-share earnings reports that look higher.1 Even with these massive stock buybacks, advisors and investors should be disturbed that a large number of companies are guiding their Q3 projections lower, not higher.2
The Dow Jones industrial average recently hit an all-time high of 22,000, causing investors to cheer. But those who are paying attention are getting more nervous by the minute, because the fundamentals clearly don’t support the market moving higher. Advisors need to re-evaluate the risk they are taking in their clients’ portfolios and avoid relying on diversification as a method of reducing risk. With asset correlations at historically high levels, diversifying across asset classes will only serve to diversify losses.
Advisors need to remind their clients that market overvaluation is extreme, the Fed is tightening, the economy is weak, geopolitical concerns are growing, and the U.S. political system is dysfunctional. Overseas, the European Central Bank and Bank of Japan have signaled a near-term change in course from massive monetary easing to tightening. China is trying to rationalize its extreme debt problems without stopping growth. Now is not the time for clients to get complacent or increase risk by chasing returns. Advisors need to tell their clients that hope is not an investment plan.
1Birstignl, Andrew. “Buyback Quarterly.” FactSet.com. FactSet Research Systems, Inc. 17 Mar. 2016. Web.
2Butters, John. “Earnings Insight.” FactSet.com. FactSet Research Systems, Inc. 11 Aug. 2017. Web.