A Financial Professional's Perspective: What's the Current Market Volatility Signaling?

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By Adam Taggart  /  Peak Prosperity

Given the recent volatile gyrations of the markets, we thought it an opportune time ask a full-time financial advisory firm whom we respect for their take on the current environment.

As most PeakProsperity.com readers are aware, we highly advise investors to work in concert with a professional financial advisor whose strategy takes into account the “Three E” macro risks highlighted in our foundational series, The Crash Course.

If folks experience difficulty finding such a professional, we refer them to Peak Prosperity’s endorsed financial advisor: New Harbor Financial. The folks at New Harbor have been mindful of our analysis — as well as that of other experts we admire, such as John Hussman — for over a decade now.

We aked them for their latest evaluation of the current situation in the markets, how they’re positioned right now, and what guidance they’re offering to their clients.

Here’s what they have to say:

Environment

Risk in global stock markets is exceedingly high at the present time in our opinion. Much of the work that we do in evaluating risk levels in the stock market at any given time is derived from valuations, and other key market metrics like stock market breadth, sentiment, and technicals.  Valuations, measured the way that we think they should be, have never been higher. Both the cyclically adjusted price earnings (CAPE) ratio developed by Robert Shiller, and the margin-adjusted CAPE, as developed by John Hussman, are at or near historic extremes.  Valuations cannot be used to precisely time the short-term movements of stock indices, but over the long-term of 5 to 10 years or more, valuations have a very high correlation to actual realized returns over those timeframes.  At present valuations, we expect negative annual returns over the next five to ten years or so.  Of course, we can’t predict the path of those returns, and these return forecasts could be realized by a rapid stock market crash or a slow drip lower in equity prices year after year. Either way, we don’t recommend having much stock market exposure at present, and believe one should seek safety and modest returns in cash equivalents while waiting for a better opportunity.

Highlights of recent portfolio activity

Because of our robust defensive posture, approximately two-thirds of our portfolio is invested in short-term treasury bills or equivalents. For our typical client, we have less than 10% net exposure to the stock market.  Our largest exposure to market risk comes from our position of about 12 to 18% in precious metals and precious metal mining shares, the latter of which we have hedged to protect against further downside.  We also have hedged exposure to emerging markets equities to the tune of about 10%, favoring this class as they have what we believe are much more compelling valuations than the US and most other stock markets.   This long exposure is further offset with a 5%-10% short/inverse position in the US stock market.  We recently took a profit in an exchange traded fund that tracks oil and gas production companies.  We sold this group because of the breakdown in the broad stock market a few weeks ago, and because the oil and gas sector violated some short-term technical zones that we monitor, in no small part due to the recent sizable pullback in crude oil prices. Overall we achieved a greater than 10% return in that position over about a year’s time.

Performance

We have been preemptively defensive over the last several years in the face of historically reliable data that has suggested very little durable upside potential with significant negative downside risk.  As a result, we have lagged the market over the last several years.  However, our own experience is that a defensive position needs to be established before a change in market character is apparent to the masses, as history shows that sudden elevator drops in the market can and often do happen from the set of conditions we presently observe.

Because of our current defensive posture, client portfolios will tend to outperform in down markets.  For example, since the S&P 500 high on September 21, 2018, our portfolio return was -0.3% on average for clients, versus the S&P 500 return of -6.8%.^†

Current Outlook

The character of the market changed early this year, when in January the S&P 500 dropped around 10% in a matter of days. The rebound from those lows stretched for many months, and lasted longer than we expected – straight into September.  It seemed like the “buy the dip” mentality would prevail yet again. In fact, the S&P 500 made a new marginal high on September 21^st, though only by about 2% or so versus the previous high in January. The S&P 500 then dropped by 10% or so again over a couple weeks in October, yet this barely budged market valuations off their all-time extreme highs.  Last week we saw a furious rally, but then over the last several days the bounce has failed.  This type of behavior is different than what we’ve seen over the last several years.  For a change, it seems like the market is walking up an ice mountain, slipping backward two steps for every step it moves up.

We urge investors, especially those that are not our clients, to dramatically reduce risk in the stock market if they have not already done so.  Our recommendation is to reduce equity exposure to as low as is comfortable, but below 30% is ideal in our view.  It is easy to overestimate one’s ability to time their shift to a risk-off posture, and if having failed to do so, sit through a long, multiyear drawdown.

We would be happy to offer a free portfolio review at any time, with an eye to helping to dramatically reduce stock market exposure for those accounts that are over exposed.

^{†Important Disclosures: New Harbor Financial Group, LLC registered as an investment adviser directly with the SEC in January 2011.  The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements.  SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability. Information presented is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned.  The content of this article does not involve the rendering of personalized investment advice.  No current or prospective client should assume that the future performance of any specific investment or strategy will be profitable or equal to past performance levels.  All investment strategies have the potential for profit or loss.  Changes in investment strategies, contributions or withdrawals, and economic conditions may materially alter the performance of your portfolio.  Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s investment portfolio.  Historical performance results for investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. There can be no assurances that a portfolio will match or outperform any particular benchmark.  The results portrayed reflect the reinvestment of dividends and capital gains.  Performance is shown for a composite of accounts managed by New Harbor with balances of $250,000 or greater.}

Beyond the high degree of overlap between their outlook and ours, we’re pleased to see New Harbor’s focus on risk management remains validated by their relative outperformance vs the major indices (S&P, Dow, NASDAQ, Russell, etc) during the recent market downdraft. Their heavy focus on ‘preservation of capital’ is a major reason why we endorse them.

If you’re interested in learing more about New Harbor, talking with them, and/or receiving a (completely free) portfolio crash-test consultation, just click here.

But whether you work with New Harbor, another financial professional, or do-it-all-yourself, we think it wise to prepare your portfolio for a rocky 2019. Reduce your risk exposure, and draw up contingency plans for a multiyear drawdown.

https://www.peakprosperity.com/blog/114538/financial-professionals-perspective

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