The 10-second version: We are likely in the late-stage of the business cycle, so buckle up for some continued volatility. Despite this, you should not try and actively manage your portfolio to time the market, but should pay attention to key hotspots in the news to stay up to date on market moves so you don’t panic when swings occur.

The vast majority of moves that I make in my portfolio are passive and occur regardless of economic conditions, but it helps me to know what is going on in the market to avoid being too surprised by swings in my savings from time to time.

You may have seen a pretty grim picture in your investment accounts the past 3-6 months. Here were the returns across various types of assets (Stocks, bonds, commodities, etc.) in 2018. Total return just means price change + dividend/interest payment:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018 total returns (%) across assets

*caveat – depending on what index you use to measure each of these, returns could look slightly different. If you want to know what I used as benchmarks, I am happy to share in the comments.

In order to avoid getting surprised (or worse panicking), let’s talk about why that happened and what you can expect going forward.

Fair warning – I usually call out when I’m about to go on a finance nerd tangent…but this whole post is pretty much me nerding out about finance – so hope you are ready 🙂

What’s going on now?

So step 1 to figuring out what will happen in 2019 is to figure out where we are in the business cycle now.

The business cycle is the result of natural swings in the economy as costs of borrowing (i.e. interest rates) rise and fall over time. In the US, the Federal Reserve controls short-term interest rates in order to maintain level inflation and low unemployment and that often determines the cycle. This cycle usually repeats every 5-10 years.

Here is what that cycle looks like at a high level:

Business cycle –

1. Growth stage
   • Interest rates are low
   • There is a lot of slack in the economy
   • Companies start taking on debt to fuel expansions due to plentiful opportunity
   • Personal spending and borrowing increase
   • The economy grows and asset prices rise
2. Mid-stage
   • Companies and individuals take on more debt
   • Inflation stays relatively low, however, increasing amounts of money are flowing through the economy and unemployment levels shrink
   • Incomes rise faster than debt-service costs (the amount of interest you have to pay on your debt) and growth continues
   • Stock prices soar, in fact, a lot of the stock market growth in the upswing is in this part of the business cycle because entities are increasingly leveraged (have taken on debt to fuel growth) and individuals are getting more risk-seeking because they are seeing strong returns from riskier assets
3. Late-stage
   • Inflation starts ticking up as more money flows through the economy, strong demand fuels increasing raw material usage, and low unemployment increases wages
   • The central bank starts increasing interest rates to put the brakes on inflation
   • The increased cost of borrowing (i.e. increased interest rates) causes debt-service costs to rise faster than incomes
   • Volatility in markets increases as people become increasingly worried about a potential recession
4. Final stage
   • Increasing interest rates both mechanically decrease the value of stocks and bonds at the same time as disposable incomes are shrinking due to rising debt service costs
   • Individuals have to pull out of riskier investments, which further contributes to falling asset prices and higher costs of borrowing
   • Eventually, companies/individuals are unable to service their debt –> defaults and the economy continues to spiral down into a recession as entities are impacted by these defaults and growth contracts
   • The Fed is forced to lower interest rates as they seek to restart economic growth
5. Rinse, repeat

We can see this process play out through history at an aggregate level, although the proximate causes of a recession usually vary:

 

 

 

 

 

 

 

 

 

 

 

 

We have been in a period of growth for an extended period of time – around 9 years. This has been especially long due to a variety of factors with how we have grown since the ‘08 recession that contributed to stubbornly low inflation rates, which delayed the schedule of rising interest rates.

That being said, inflation is picking up and as a result the Fed raised interest rates 4 times last year and sold off of some of the debt they bought during the post ’08 period. This places us at likely at the ‘Late-stage’ of the business cycle.  

Given that, we can see increased volatility in markets (e.g. every other day the Dow is up or down several hundred points) as people are increasingly worried about the oncoming final stage (the recession) to hit.

Here is a great article that dives into more detail about the various economic cycles that drive the economy.

Now to preface this next section – do I think this means you should sell off all your investments – NO! Trying to call the peak or trough of the business cycle usually costs you more than it saves. See my post The sky is falling for more reasons to not sell. This is especially true if you have a long investment horizon. The best move is to trust that over time you will be compensated for lending your money out and continue to invest systematically.

What do I think are going to be major hotspots in 2019?

Well if you noticed in our historical look at recessions, while they seemed to occur at relatively even periods of time and many were kick-started with the Fed increasing interest rates, the proximate causes were very different and the way assets did as a result was different through each.

Identifying major trends that will impact the upcoming year can help focus the way we read the news to identify when major changes are going to occur.

Some major hotspots that I see coming into play (this list is not holistic):

1. Protectionism – After decades of increasing globalization, we are seeing a massive movement across countries towards more protectionist measures. Everything from Brexit, to rising US-China trade tension, to the rise of populist parties in Europe/the US spells bad news for free trade as individuals are getting increasingly nationalistic. Read ‘The Great Convergence’ by Richard Baldwin to more fully understand globalization and its beneficial impacts on society at large.
   • Specifically, trade tension between the US and China is having a massive economic impact
     • Impact on markets – China is the US’s largest trade partner and the second largest global economy so a US-China trade war would have massive implications for global markets
     • Example – Just look to recent news about Apple cutting revenue projections for the first quarter as a result of fears over weak iPhone sales in China and the ensuing ~10% decline in Apple’s stock price. Apple is ~3.5% of the S&P 500, ~4.6% of the DOW, and ~9.7% of the NASDAQ by weight so this has a massive impact on US stock markets
2. Oil price volatility – oil prices have been extremely volatile since 2015 driven by changes in the supply side dynamic of the market. Between the US shale boom, OPEC supply cuts, dollar strength, and Middle Eastern instability there have been a variety of factors that have moved the price of oil. Keep an eye on what happens to OPEC supply and how US supply changes, as a result, both well output declines and the breakeven drilling price to determine when fluctuations in this market will occur
   • Impact on markets – Oil is both a major input to most companies and individuals, so prices rising lowers profitability/discretionary income, as well as a major source of income for a variety of countries (Saudi Arabia/Canada) and correlates to their economic health. Major changes here have a big impact on almost every industry
   • Here is an article I helped write a few years ago that goes into the dynamics of the oil market in more depth
3. The decline of privacy – Between the rising use of drones, social media data leaks, and the necessity of information in proactively combating terrorism, privacy issues are cropping up everywhere. I project that in the near future we will start to see these issues both cropping up more frequently as well as losing out to the argument that there are reasons for some breaches of privacy
   • Impact on markets – Regardless of how you feel about this, it has major implications for markets. Just take the increased revenue streams for user heavy companies like Facebook/Snapchat or the potential uses for drones in security
4. Some more hotspots/areas to keep an eye on:
   • The polarization of US politics and the role of media in elections
   • Ballooning debt and an underfunded US social security budget at the same time as countries are weening themselves off of the dollar and engaging in more bilateral trade
   • The proliferation of media content producers and what that means for traditional telecom giants
   • Slowing growth in the developed world and an aging workforce
   • Disruption to traditional forms of banking – i.e. uber visa cards, Robinhood trading accounts, etc.

As always, I would love to hear your input on what you think the most important areas are going to be going into 2019!

Stay positive and invest smart!

Readwritemoney

Full disclosure: The Great convergence is linked through the Amazon associates program to help me fund this blog!