Countless macroeconomic indicators suggest that the U.S. is in the late stages of the current economic cycle. Strong earnings growth, low unemployment (approaching 4.0%), high consumer sentiment, record-levels of debt with overwhelmingly friendly lenders, you name it, can conditions get any better (except perhaps retail)? These strong indicators will deteriorate in response to some event/reversal in the business cycle, but that timeframe is impossible to predict. In previous posts I conclude that equities markets are overvalued, and do not necessarily retract that opinion, but now explore the prudent investment strategy for the prevailing market conditions, whether you’re tired of winning or not.
I imagine three potential returns for the markets over the next 12-18 months, listed in descending likelihood: moderate growth (S&P returns 10-15%), a modest correction (S&P takes a ~10% hit), or a significant drop in the markets (S&P drops more than 30%). While this range of outcomes is very wide, it is important to acknowledge these scenarios when considering how to invest. How would each portfolio composition perform in each scenario? It is highly likely that the markets continue their expansion, as long as earnings continue to grow and macroeconomic indicators do not deteriorate in the near term. The opportunity cost of selling now is missing out on an extension of this bull market. Thus, how do you invest to participate on the ongoing upside, but protect yourself from the possibility of a drop?
Broadly, diversify. In every sense of the word. Asset class, domestic versus international exposure, value versus growth, you name it (although overweight value makes sense in expensive markets). Market neutral strategy typically does not produce stellar returns, but fits today’s market conditions. Valuations remain more attractive in Europe on a relative basis, and even more so in the Pacific. An allocation to foreign markets makes sense given such ~relatively~ discounted prices. While it is against conventional wisdom to buy bonds in an increasing rates environment, a fixed income ETF with a steady yield (BND: 5 bps fee and 2.5% yield) will balance the risk profile of your portfolio. A small commodities allocation (5% or less) is also an effective hedge in the event of a substantive correction. And then there is a new asset class that might be important to include:
Cryptocurrency. I have been skeptical about cryptos since I initially heard about their existence, mostly because I adhere to Buffett’s principle: do not invest in something that you do not understand… but I have educated myself. The most remarkable thing about a crypto like Bitcoin is its finite supply, and seemingly endless demand. Currently, Bitcoin’s market cap is over $200 billion. This is nothing for a currency. If demand for Bitcoin continues and its applications broaden, the price could easily soar to $100,000+ (hovering below $20,000 now). If a crypto ETF is approved, expect Bitcoin/Ethereum/Litecoin to catapult even higher. That said, if governments get serious about regulation, cryptos could take a hit and an entry point might present itself. Although Bitcoin’s technology is inferior to competitors such as Ethereum (faster payment processing and slightly upgraded security), its first mover advantage is significant. I am not entirely sure how these currencies fit into a well-diversified portfolio, but they are here to stay, and investors must take them seriously.