July 2018 Market Update

Brian Johnson

Brian Johnson
CIO and Shareholder

Written By Brian Johnson, CIO

Summary: Our investment strategies have been “overweight” equities (stocks) for several years now. We’re currently in the process of reducing client portfolios exposure to a more “neutral” stance. The bull market is not necessarily over, but the risk of a substantial correction has increased enough to warrant a more neutral stance for the time being, and we will watch for circumstances that would warrant further equity reductions (e.g., to “underweight” levels).

We use the term “weight of the evidence” a lot in our office. That term represents the collective status of hundreds of economic and market indicators, as they become either more positive or negative. Rarely do all economic and market indicators agree, but some have proven to be more reliable than others, and for shifts in the weight of the evidence to suggest taking action, stock-market indicators alone aren’t enough; they must also be confirmed by reliable economic indicators getting better or worse, too.

Those of you who have been clients for years, have met with me recently, or have been avid readers of this newsletter, know that we don’t pretend to be omniscient, and one of the valuable tools we utilize is Ned Davis Research (NDR). Specifically, NDR’s models and indicators help us gauge shifts in the weight of the evidence. Those shifts can suggest that our portfolios should be bullish (i.e., overweight stocks), bearish (underweight stocks), or neutral (maintaining each strategy’s “normal” allocation to stocks). When we’re overweight or underweight stocks, the first move in the other direction is usually not to the other extreme, but to neutral (meaning that the near-term outlook is neither strongly bullish nor strongly bearish).

NDR has been recommending an overweight/bullish equity allocation for over two years, since April of 2016, and that analysis has been right on the money; it has been an incredible time to be overweight equities. From 4/1/16 to 7/13/18, the S&P 500 Stock Index (as measured by the SPY ETF) rose 41%, while the Barclay’s Aggregate Bond Index (per the AGG ETF) rose less than 2%. When NDR’s models suggested overweighting stocks like that, we not only put more into stocks (for strategies that aren’t already 100% in stocks), but our sector purchases are more growth-oriented and cyclical, rather than defensive.

For the first time since April of 2016, NDR’s indicators now imply lower expectations for (and exposure to) equities. This does not mean that they—or we—are bearish on equities. We simply see several signs of a less bullish outlook, including:
• Weakening breadth (the number of stocks rising vs. falling) globally;
• An increase in the number of stocks with neutral to bearish price movement—over both intermediate and longer time frames;
• Less bullish sentiment indicators;
• Global markets that have been, mostly range-bound or trending lower this year;
• The possibility of negative earnings surprises (i.e., a growing percentage of companies failing to meet or beat earnings estimates) during earnings season.

Taken together, these—and other NDR market and cyclical economic indicators—mean that the weight of the evidence is no longer strongly bullish, and it is therefore hard to argue for maintaining an overweight equity allocation.

We are, accordingly, making some portfolio changes. In our balanced strategy, for example, we’re reducing relative stock/bond allocation—from overweight stocks/underweight fixed-income, to a neutral allocation. Going a step further, in all our strategies with a stock allocation, our we’re making a shift from some of our cyclical/growth sectors to more defensive stock sectors.

What would it take for us to adjust allocations further…to actually become bearish on (and underweight) stocks? Well, a further downgrade could be possible if we see more deterioration in economic fundamentals, and if market breadth continues to weaken, earnings disappoint, tech leadership gives way, defensive sectors begin to outperform, and the market is unable to withstand the resulting selling pressure. Broad deterioration like that would likely foreshadow a cyclical bear market, albeit still within a very long-term (“secular”) bull trend. If, on the other hand, those negative issues fail to develop, and the economy improves despite the budding trade war, we would likely avoid a cyclical bear market, and any correction would be viewed as temporary in nature. Either way, we will be watching over your investments, and taking action as seems warranted.

NOTE: The above is meant to enhance your general understanding of our investment approach. As always, we remind you that our intention is always to invest your money according to your goals, and that means using the Viridian strategies that make the most sense for you, based on your Viridian Advisor’s counsel. If you have short-term cash needs, our investment of that money is necessarily much more cautious, with limited (or no) stock exposure. For money with a long-term time horizon, on the other hand, higher ongoing stock allocations make sense. If your goals change, or you have any questions, please let your advisor know as soon as possible.

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