Syncing the Cycles: Economic and Market Cycles in ...2019-02-23)pugh.pdf · Inc., an independent...

Syncing the Cycles: Economic and

Market Cycles in Investment

Planning

Presented by

Bob Pugh, CFA, CFP®

President, Insight Wealth Management, Inc.

The AAII Washington DC Metro Chapter

Saturday, February 23, 2019

Disclaimer

www.insightwealth.com

This slide show, presentation, related discussion, and all other materials provided are to

be considered general educational information rather than investment advice for any

individual or group of individuals. Specific investment advice for any individual or group of

individuals must be based on a detailed evaluation of their personal needs and

circumstances.

Nothing in this presentation should be considered a recommendation to buy or sell any

securities.

Past performance is no guarantee of future results.

Investors should research the various asset classes and available securities to find those

that are most suitable to their specific needs. While this presentation and related

discussion may refer to specific ETFs and other securities, other products in the same

categories are available from other providers. Investors should ensure that the product(s)

they select suit their specific needs.

Bob Pugh, CFA, CFP® Brief Biography

◼ President, Insight Wealth Management. Inc., an independent Registered Investment Adviser in Gainesville, VA, providing fee-only,fiduciary wealth and investment management, and financial planning services to individuals, families, businesses and non-profit organizations since 2005. Member of the Schwab Advisor Services network of select independent advisors for custody and brokerage of client assets.

◼ National Association of Personal Financial Advisors (NAPFA) – member and Registered Financial Advisor (www.napfa.org), member of the Financial Planning Association (www.fpanet.org), CFA Institute (www.cfainstitute.org) and the National Association for Business Economics (www.nabe.com). Member of American Mensa, and former Testing Coordinator and Public Relations Officer for the Metropolitan Washington Mensa chapter (www.mwm.org).

◼ President of the CFA Society of Washington, DC, 2005 to 2007, and Eastern Region Presidents Council Representative, CFA Institute, 2009 to 2011.

◼ Over thirty years of experience as an economist, financial educator and analyst, portfolio manager, and personal financial planner in the private and public sectors. Experience includes serving as an economic analyst with the Central Intelligence Agency, director of investment research at another firm, and senior financial analyst in municipal government.

◼ Graduate degrees in global political economy from The Johns Hopkins University, School of Advanced International Studies, and infinancial economics from the University of North Carolina at Greensboro

◼ Full-time and adjunct faculty member experience with numerous colleges and universities, including nine years as a member of thePractitioner Faculty in Finance with The Johns Hopkins University’s (JHU) Carey School of Business, and with the JHU School of Medicine, teaching graduate-level courses in investment analysis, portfolio management, and corporate finance, and continuing education in the JHU Business of Medicine program. Taught CFA Exam review for twenty years, including all three levels of the CFA program for the CFA Society of Washington, DC, the World Bank, Fidelity, Merrill Lynch and other organizations.

◼ Community Volunteer, currently serving as Chair of the board of the Health Systems Agency of Northern Virginia.

◼ Contact information available at www.insightwealth.com


http://www.napfa.org/

http://www.fpanet.org/

http://www.cfainstitute.org/

http://www.nabe.com/

http://www.mwm.org/

Introduction

Those who have knowledge, don't predict. Those who predict, don't

have knowledge. Lao Tzu

◼ Predicting or timing the economy or markets with consistent accuracy over

the long-term is impossible.

◼ Our goal is to learn and apply analysis of economic and market

fundamentals in a probabilistic manner to increase the likelihood of success.

◼ This process is analogous to the card-counter at the blackjack table.

Remembering the cards that have been played increases the chances of

making the correct choice going forward. The player will still not be correct

every time, but will be correct more often.


Economics

“Positive economics is in principle independent of any particular ethical position or normative judgments. As Keynes says, it deals with

‘what is,’ not with ‘what ought to be.’ Its task is to provide a system of generalizations that can be used to make correct predictions about

the consequences of any change in circumstances. Its performance is to be judged by the precision. scope, and conformity with

experience of the predictions it yields. In short, positive economics is, or can be, an ‘objective’ science, in precisely the same sense as

any of the physical sciences.”

Milton Freidman, “Essays in Positive Economics,” 1953

But on the other hand;

“The economic world is driven primarily by random jumps. Yet the common tools of finance were designed for random walks in which the

market always moves in baby steps. Despite increasing empirical evidence that concentration and jumps better characterize market

reality, the reliance on the random walk, the bell-shaped curve, and their spawn of alphas and betas is accelerating, widening a tragic gap

between reality and the standard tools of financial measurement.”

Mandelbrot and Taleb, 2005

"If you lined all the economists in the country up end to end, they would still point in all directions."

President Harry S. Truman

“Probability is not a mere computation of odds on the dice or more complicated variants; it is the acceptance of the lack of certainty in our

knowledge and the development of methods for dealing with our ignorance.”

Nassim Nicholas Taleb


Economics

Economics is an art rather than a science. Some try to

quantify economic relationships in the same way as

physicists analyze the natural world, and to assume

away all other aspects of human existence, but such

efforts are in vain. The best economic analysis comes

from those with the broadest view of the widest range of

factors, and who are able to integrate and synthesize

that information into a coherent, actionable conclusion.


The Nature of Cycles

◼ Economies and markets are subject to irregular, unpredictable

cycles.

◼ Short-term equity market fluctuations are not correlated with

economic market cycles nor indicators.

◼ Equity markets provide a leading indicator of economic or business

cycles.

◼ In recent history, all economic cycle inflection points have been

preceded by equity market inflection points, but not all market

inflections precede economic inflections.

◼ Long-term, equity market performance is highly correlated with

economic fundamentals.


Equity Markets and the

Business/Economic Cycle◼ If you expect a turning point in the business/economic cycle, expect the

equity markets to turn first.

◼ The best time to reduce equity market exposure is just prior (varying

amounts of time) to the peak of the business/economic cycle.

◼ The best time to increase equity market exposure is just prior (varying

amounts of time) to the trough of the business/economic cycle.

◼ This is a buy low/sell high strategy rather than market timing.

◼ An asset allocation strategy with regular, methodical rebalancing is

consistent with this pattern without the need to forecast or predict.


Equity Markets and the

Business/Economic Cycle


Top-Down Investment Analysis

Global, Regional or National Macro

Economy/Market

Asset Class/Sector/Industry

Firm


Business Cycle

Peak Peak

Contraction/

Recession Expansion

Trough


Investing Styles and Allocations

During the Business Cycle

◼ Early Expansion – aggressive, cyclical, growth

equity, small cap; avoid fixed-income as yields

rise

◼ Expansion – increasingly conservative as peak

nears; value, large cap equity; increase fixed-

income as interest rates stabilize

◼ Peak through Contraction – defensive, counter

cycle, high-dividend equity; increased allocation

to fixed-income as yields fall


Business Cycle and Sector Rotation(graphic courtesy of iShares/Blackrock)


Business Cycle and Sector Rotation(graphic courtesy of iShares/Blackrock)


Time Horizons and Economic-

Based Investing

◼ If you are going to invest for a long time horizon

and have no concern about volatility in the

meantime, structure an aggressive equity

portfolio, forget about it, and go fishing.

◼ Problem is that most portfolios have a much

shorter time horizon, need to generate income,

have risk constraints, and can’t ignore volatility.


Time Horizons and Economic-Based

Investing - Short-Term

◼ Neither technical analysis nor fundamental analysis works because

short-term market fluctuations are largely random and unpredictable.

◼ Economic fundamentals have little or no impact over short periods.

◼ Generally, less than a full business cycle or even a phase of the

cycle.

◼ Indicators can fluctuate wildly.

◼ Examples: Volatility (VIX)

Fund Flows

Relative Value

Fed Model (spread between Treasuries and AAA or BBB bonds)

Sentiment Surveys

Insider Trades



Investing – Medium Term

◼ The medium-term is defined as a single, full business

cycle.

◼ The business cycle is the context for which economic

indicator analysis is most useful.

◼ Put together the pieces of a complex, dynamic puzzle to

project a picture of the economy.

◼ Different analysts use and/or emphasize different

indicators

◼ Process is largely a “Rorschach Test” and people derive

different conclusions from the same indicators



Investing – Medium Term

◼ Residential construction and home

sales

◼ Consumer confidence and sentiment

indexes, and consumer spending

◼ Retail trade and food service sales

◼ Personal income and spending

◼ Prince indexes

◼ Commodities data

◼ Federal Reserve and monetary data

◼ Trade

◼ International

◼ Others

◼ GDP and components

◼ Indexes of leading, lagging, and

coincident indicators

◼ Employment

◼ Productivity

◼ Industrial production

◼ Capacity utilization

◼ ISM indexes

◼ Manufacturers'’ shipments, inventories

and orders

◼ Inventories and sales

Useful indicators fall into several

categories:



Investing – Long-Term

◼ The long-term refers to time periods longer than a single business

cycle. Likely the most rewarding for the patient investor.

◼ Market and economic indicators are generally useless this far out.

◼ Relevant factors include secular trends such as globalization,

climate change, politics, demographics, and flows of capital and

other resources.

◼ Based on growth of productive capacity in economies and industries

around the world.

◼ Study of history vastly more useful than mathematics and statistics.


Equity

◼ Equity (Stock or index) Price Composed

of:

Earnings per share – objective, measured

from financial statements, depends on

economic and sectoral performance

Price multiple – psychological, difficult to

predict, expectations driven by economy to

some extent


Earnings Growth


$20.00

$25.00

$30.00

$35.00

$40.00

$45.00

$50.00

OPERATING EARNINGS/SHARE(Q4 2018 forward are estimates)

source of data: S&P Dow Jones Indices, S&P Earnings and Estimate Report, January 31, 2019

Price/Earnings Ratio


14.00

15.00

16.00

17.00

18.00

19.00

20.00

21.00

22.00

OPERATING EARNINGS P/EAverage since Q4 1988 - 18.86

(Q4 2018 forward are estimates)source of data: S&P Dow Jones Indices, S&P Earnings and Estimate Report, January 31, 2019

Interest Rates


Debt to GDP Ratio


Unemployment


Inflation


Demand


Demand


Monetary Policy


Monetary Policy


Yield Curve


Real GDP


Current Risk Factors

◼ Federal Reserve policy

◼ U.S. Politics, especially the 2020 election

◼ Geopolitical - China, North Korea, Russia, Iran, etc.

◼ Overheating Economy

◼ Trade

◼ Valuations

◼ Earnings growth

◼ Debt and deficits (longer term)


Conclusions

◼ Economic recovery, earnings growth and bull market since 2009

continues

◼ Market volatility increasing

◼ Preponderance of economic indicators do not point to significant

slowing of economic growth soon

◼ Economy may be over heating

◼ Federal Reserve “normalizing” monetary policy

◼ Establish your view of where we are in the business/economic cycle

and structure your portfolio to get ahead of expected changes


Sources of Free Economic Data

◼ Federal Reserve Economic Data

◼ http://research.stlouisfed.org/

◼ Federal Reserve Board

◼ http://www.federalreserve.gov/econresdata/default.htm

◼ Census Bureau Economic Indicators

◼ https://www.census.gov/econ/

◼ Census Bureau

◼ http://www.census.gov/

◼ Bureau of Labor Statistics

◼ http://www.bls.gov/

◼ Bureau of Economic Analysis

◼ http://www.bea.gov/

◼ Bank for International Settlements

◼ http://www.bis.org/about/index.htm

◼ International Monetary Fund

◼ http://www.imf.org/external/data.htm

◼ S&P Index Data

◼ https://us.spindices.com/indices/equity/sp-500


http://research.stlouisfed.org/

http://www.federalreserve.gov/econresdata/default.htm

https://www.census.gov/econ/

http://www.census.gov/

http://www.bls.gov/

http://www.bea.gov/

http://www.bis.org/about/index.htm

http://www.imf.org/external/data.htm

https://us.spindices.com/indices/equity/sp-500

Further Reading – Web Sites

◼ St. Louis Federal Reserve Publications

◼ http://www.stlouisfed.org/publications/research_and_data.cfm

◼ Federal Reserve Board

◼ http://www.federalreserve.gov/publications/default.htm

◼ National Bureau of Economic Research

◼ http://www.nber.org/

◼ National Association for Business Economics

◼ http://www.nabe.com/


http://www.stlouisfed.org/publications/research_and_data.cfm

http://www.federalreserve.gov/publications/default.htm

http://www.nber.org/

http://www.nabe.com/

Questions and Answers

Questions?

Bob is available for a free, no-obligation initial consultation and portfolio review.

Insight Wealth Management, Inc.

7250 Heritage Village Plaza

Suite 101

Gainesville, VA 20155


(703) 753-6082


http://www.insightwealth.com/

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