By Jack Brady
Now that the dust has settled and we’re back at school, we here at Williams Insight are publishing our “gameplan,” so to speak, for trading a volatile 2019. Think of this as our macro-view, and how we plan to trade developments in financial markets.
The difficult part about publishing beginning-of-the-year pieces is that nobody gets it exactly right. Frankly, I’ve stopped reading anything where a financial commentator claims to know anything resembling the path of risk assets. That’s why we’re referring to our inaugural commentary of 2019 as a gameplan. As in the world of sports, the world of investing moves quickly and any good “coach” (portfolio manager) needs to be able to respond to changing and unpredictable conditions to correctly deploy their assets on the field.
This piece will have two sections. First, we will lay out our base-case assumptions for 2019. Most of these have been discussed at length in other articles, so we won’t get into the “why” of these assumptions so much as the “what”.
Second, we will lay out how we plan on trading various developments that could materialize this year, based on our assumptions about the macroeconomy. Let’s get started!
2019 Base Case:
1) Massive contraction in global liquidity. This has been a favorite topic of mine, and has been discussed at length in several different articles. Suffice it to say that global financial tightening is now in full effect, and it will take nothing short of a recession to stop it. I believe this will be the key theme of 2019, in the same way it was the key theme of 2018. It’s no coincidence, in my view, that December was one of the worst months of stock performance since the Great Recession (depending on which index you track). Once the ECB stopped QE, liquidity simply began to vanish from markets.
2) We’re late cycle. Central banks are tightening, equity markets are volatile, valuations (and possible even earnings)Â have peaked for the cycle, most economic indicators have either peaked or are at cycle highs, and interest rates have been rising for about two and a half years with few pauses. It doesn’t take a rocket scientist to realize this cycle (which was artificially prolonged by CB liquidity which — you guessed it — is getting pulled back) is getting long in the tooth.
3) Powell is no Volcker. As we’ve seen over the past three months, Powell’s claims that he would ignore political pressure and signals from the stock market were… well they were overstated. We expect balance sheet tightening to continue, but we (like the Federal Funds Futures market) don’t have a strong view on the path of rate hikes, as they’re likely to be data dependent. Relatively easier or tighter policy from the Fed will certainly have the power to bend the edges of this cycle a bit (I’m talking months here, not years), which makes them important to consider. That being said, the writing is on the walls in the form of $50B a month in balance sheet reductions from the Fed.
What To Do About It.
So we’re late cycle. But that leaves the question of what to do about it. It is often observed that the tail end of bull markets experience the most ferocious rise in asset prices, so there’s definitely an argument to be made that one should maintain a reasonable amount equity exposure. On top of that, equities seem to be temporarily bottoming as we speak, so selling everything now might not be the best bet.
Our mantra for 2019 is simple: hold on to what you have for now, and selectively sell rallies. As we’ve pointed out before, late-cycle dynamics often create volatility to the upside, as well as to the downside. That is why we advocate lightening up on high-beta exposure when the market does happen to exhibit strength. When I say high-beta, I’m referring to volatile, economically sensitive positions that have been doing very well during this bull market and are likely to get creamed in the event of a recession. For example, I am looking to get out of my position in QQQ (Nasdaq ETF) at a reasonable level.
What constitutes a reasonable level is tricky, but we have a few helpful tips in mind.
1) Define your “target” exposure levels for the end of the year, and work towards that goal. For example, I hope to own only my core, longer term positions by the time the year is out, and park the rest in Robin Hood where I earn 3% risk free. These core positions include SDY (Dividend Aristocrat ETF), VWO (Emerging Markets ETF), and my 2-10 steepener position (shorter term, but still one of my core positions as of early December). Everything else is up for sale at the right price. Certainly this is more art than science, but here are some useful levels:
2) Begin sizing out of positions quickly if the S&P hits overbought territory (RSI over 70). This is not likely in my view, but a move up as violent as this would certainly provide an exceptional opportunity to sell.
3) Begin sizing out of positions quickly if the S&P approaches 2018 highs. Roughly 2900.
4) The tricky part is knowing when to sell if markets don’t exhibit a late-cycle mini boom. This is why it would be prudent to sell off a little bit of equities every time the S&P has a “notable” day or two. A rough metric for measuring this would be that you should sell every day Bloomberg or the Wall Street Journal has a headline about how well the markets are doing.
5) Develop your own view, and modify your portfolio accordingly. We’re better sellers right now because our bias is to be short the market. If you think that the recent correction was overblown, then buy the dip — after all differences of opinion are what makes a market! Just make sure to set up your own “guidelines” for when to sell or when to buy more.
Finally, a note on buying the dip. Since we’re on the bearish side, we’re not looking to fade 5% moves down in the S&P because we think the biggest moves in 2019 will be down. We’re currently selling our equities, collecting 3% interest on cash, and waiting for the “big dip” (Full Disclosure: this may not happen in 2019). Our “big dip” needs to check three boxes:
1) Markets fall at least 35% from their peak. Recessions (look at the last 2) typically entail a 50% drawdown, peak to trough (although how long this takes varies from several months to years). Whatever comes next will be following an unprecedented rally in equities, so it could actually be more than that 50% figure. Regardless, a dip of less than 35% is likely to be ephemeral.
2) The yield curve should steepen like crazy during the big dip as shorter term rates collapse relative to longer term yields. This is characteristic of a recessionary bear market, and will coincide with any big, career-making dip-buying opportunities.
3) People will be terrified. Even though this is totally subjective, it’s a useful metric nonetheless. The next “big dip” will almost certainly coincide with policymakers scrambling to figure out what to do, pundits declaring an inevitable “lost decade” of stock market returns in the 2020s, and President Trump going far crazier than normal. If Trump punches Powell on national TV, you have our blessing to lever up and go long.