Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder and is a U.S.-registered Commodity Trading Advisor.
Most of the time markets are in sync with economic trends, but occasionally they overshoot reality. We could be seeing that right now.
Understanding that the probability of a recession occurring in any given year is essential to having any chance at figuring out if a market is going to have an up year or a down year. The average recession since the end of the Second World War lasted about 10 months and occurs about once every five years. The longest stretch is about 10 years and more recently they have averaged closer to seven years. So the odds of a recession in any given year is about 15 per cent to 20 per cent. We are clearly in the late innings from the 2009 recession low, so the odds of a recession in the next year or two is probably closer to 50 per cent.
It's also helpful to know the odds of a market going up or down on any given year by looking at historic trends. On a daily basis, the market goes up about 50.9 per cent of the time, so literally short-term forecasting is little better than a coin flip. The longer your forecast horizon, the more historic probability analysis can help. The market goes up on average 29 weeks in an average year. It has historically risen two years out of three, or about 65 per cent of the time. So forecasting a bear market (greater than 20 per cent decline) is hard, but it statistically gets easier in the late innings when valuations are high.
If history is a guide, therefore, a recession appears imminent.
But one always needs to tweak the current forecast for unknowns. Enter the Trump administration and the general "animal spirits" that have been released as it pertains to expectations for lower taxes, higher government spending and job growth.
Two things that directly contribute to the profitability of companies are lower taxes and higher government spending. While that could support job growth, the worst labour-market recovery in history appears set to continue down an anemic path. Real wage growth is not likely to improve much despite Mr. Trump's mantra on bringing jobs back home. Blame it on the fintech, robotics, artificial intelligence and other job-killing technologies that are growing at a rapid pace. By some estimates, more than 50 per cent of jobs are at risk to these productivity trends.
Markets are often viewed as a discounting mechanism. A tenet of the investment theory known as the efficient-market hypothesis suggests all information – past, present and future – are fully discounted in the market.
So how much are those "animal spirits" – a phrase made famous by John Maynard Keynes to describe human emotion that drives consumer confidence – priced in?
My bet would be the U.S. Congress will only be able to get the tax rate down to about 25 per cent from 35 per cent over four years. The Tea Party debt hawks will look at the trillions Mr. Trump wants to spend on infrastructure and they will be unlikely to get much more aggressive with U.S. debt to GDP at over 105 per cent. The market is trading as if these things are all going to boost earnings in 2017, but they will not. Expect more stock- and bond-market volatility as policy uncertainty trumps – if you pardon the pun – market confidence.
I still see the U.S. economy and market as the best dirty shirt in the laundry. My favourite way to play the U.S. market is with the BMO U.S. High Dividend Covered Call ETF (ZWH) – which provides exposure to a dividend-focused portfolio with the benefit of collecting additional yield through a covered call write strategy – as well as the BMO U.S. Put Write ETF (ZPW), which can produce extra income by writing put options on U.S. large-caps.
I see downside risks in Brexit negotiations and Italian, French and German elections that could surprise the political shift to the right we are seeing globally. Eventually, the common euro currency is likely to lose some members and that process will be very destabilizing for global growth. At some point in the coming years, Europe will be very attractive, but I think it needs to break apart first before it can turn the corner.
China may be even a bigger risk. Capital flight and a loss of confidence in their ability to manage the economic transition complicated by Mr. Trump on trade concerns should make for a volatile year in 2017.
I expect the U.S. Federal Reserve will raise rates one more time in 2017, but I would not be surprised to see them cut rates, too, if an election or two finds a right-wing party emerging to power in Europe.
The Canadian and U.S. markets are not quite priced for perfection, but they are not priced for any disappointments, which we see as a much bigger risk than the market.
With the global risks of a recession building, I'm going to continue to be defensive in portfolios. It's not bearish, it's just prudent.
Do you want to learn more about how to do this in your portfolio? I talk about how to build smarter ETF portfolios in my 2017 educational seminars. Registration is free at a city near you and you can follow me on my new blog www.bermanscall.com or watch me at Berman's Call Monday's at 11 a.m. ET.
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