Merk 2018 Outlook
Merk 2018 Outlook by Axel Merk – Merk Investments
With the stock market and Bitcoin reaching all-time highs, what can possible go wrong? In offering my thoughts on 2018, I see my role in reminding investors to stress test their portfolios. Is your portfolio built of straw, sticks or brick?
First, let me allege many investors have portfolios built of straw and sticks rather than brick. How do I know this? Here’s a brief check:
- If a robust portfolio is a diversified one (the only free lunch on Wall Street), then please check whether you have rebalanced your portfolio of late. If not, odds are equities have taken on an oversized portion in your portfolio, thus making it more vulnerable than you might have intended in a downturn.
- Equities are part of the so-called risk assets in a portfolio. But what about the rest of the portfolio? Have you been chasing yield by extending duration of your fixed income portfolio? Have you accepted less creditworthy issuers? Have you been lured by the promise of higher yields by financing something in a private placement? I have news for you: without judging the merits of those investments, odds are high that the value of these investments are more correlated with risk assets than you might be aware. Read: just because the label says fixed income doesn’t mean you are diversified.
Without a doubt, equities have had an extra-ordinary run. There is the view that, without a recession, you cannot have a bear market. In our analysis, that’s true for the most part – but is “for the most part” good enough? The notable exception is the Crash of 1987 where a bear market was not accompanied by a recession. In today’s context, the buy-the-dip crowd will remind you that the ’87 crash was, well, a buying opportunity. As such, if you are an asset manager interested in keeping your job, you buy. It reminds of the 1980s where buying IBM office equipment was the sure way to keep your job, as no one would question your choice. Here’s a chart that shows the S&P 500 with the percent drawdown from any peak, with recessions shaded:
Keep in mind that we may not know about whether we are in a recession until we are well into it; also note the above chart is based on monthly data, thus not showing the maximum drawdown intra-month. That said, few economic forecasters are predicting a recession in the near future. Below is the quarter over quarter, seasonally adjusted GDP in black, then in grey the so-called Atlanta Fed GDPNow indicator, an indicator trying to predict the current quarter’s GDP reading:
So why be concerned? In a recent discussion with market veteran David Kotok (Chairman & CIO of Cumberland Advisors) regarding the views of an analyst who is optimistic about the outlook, he paraphrased Ronald Reagan’s debate with Walter Mondale: “I am not going to exploit his youth and inexperience…”, adding, “we will see if he knows how to swim.”
What are the optimists missing? First, let me make clear that you do not have to be a pessimist to be concerned. Risk assets are called risk assets for a reason: if you aren’t concerned, that should be the very first sign why you should be concerned. The prudent investor manages risk. However, risk management has become more complex in an era where central banks have helped propel asset prices to new highs; in an era where very low, if any returns can be had in so called risk-free assets. For European investors, returns are negative for many investment grade fixed-income investments, not just government securities. Monetary policy is indeed designed to encourage more risk taking. All the more so, when “risk is off”, i.e. when risk assets re-price lower, investors may be losing more money than they signed up for. If history is any guide, this could amplify any downturn as investors re-calibrate their portfolios to match their risk tolerance in an era when risk levels may be elevated once again.