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The Exit Strategy Update

| June 15, 2022
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The Exit Strategy Update!

Over the last thirty years I have tracked many economists, indicators and data points looking for who, or what, was most correct in predicting what was "around the corner" for our investment positions.  It was this lengthy trial and error process that resulted in The Wealth Strategies Group proprietary research we named The Seven Signs of a Changing Economy™.  Combined, these seven source-named and fact-based data points have proven surprisingly accurate in suggesting what the economic backdrop is, as well as what it might be a few months into the future.

If the economic backdrop is positive, as it is right now and has been for several years, it suggests that Corporate America should be selling more "stuff", generating more revenues and likely earning more profit.  These increasing profits support increasing market values of the companies in Corporate America.  This is much like what we have been seeing for the last ten years and 19,745 points up on the Dow Jones Industrial Average (DJIA), that many missed out on due to fear of, well, I’m not sure what.

The Seven Signs of a Changing Economy is our "strategy" for determining what the economic backdrop is at the time.  

That said, I would like to share with you what I have named The WSG "Three Points to Ponder".  These points are our early warning "system".  If violated, it could be a very early warning sign(s) that the values of Corporate America could be facing a headwind or worse, a reversal to the downside.  These three points would most likely cause me, as your trusted advisor, to begin our exit strategy "process", in our effort to preserve your principle and current gains.      

Here are "The Three Points to Ponder":

1) An inverting yield curve.  The measuring stick here is to simply subtract the 2-year U.S. Treasury yield from the 10-year.  As of 1/31/2018, the 10/year is yielding 2.73%.  The 2-year is yielding 2.13%.  The delta is +.60%.  If the result of this math is 0%, or less, it could cause me to initiate the exit strategy "process".

2)  A research piece I recently read was titled “Daily Wealth” by Dr. Steve Sjuggerud.  In this issue, Dr. Sjuggerud presented research that added the price/earnings (P/E) ratio to the 90-day T-bill.  This is a tool that accounts for the cost associated with borrowing money, i.e. it accounts for the impact of low interest rates on a company’s ability to earn profits.  The research quantifiably showed that when the total is below 20 the investment allocation outlook is positive.  If above 22, we are in the danger zone.  I very much respect Dr. Sjuggerud’s research and will track this as a point to ponder.  Based on this, I did some quick math to see the forward price/earnings ratio calculated for 2018 (source: Yardini Research) is 17.24.  The 90-day T-bill as of 1/31/2018 is 1.44%.

At present, 17.24 +1.44 = 18.68, below the average of 20 and very much below Dr. Sjuggerud’s 22 level danger zone.  A result above 22 would cause me to initiate the exit strategy "process".

3)  Many investment markets do not do well with inflation.  A key input to calculating inflation is the employment rate.  At a 4% unemployment rate our labor markets are considered at full employment (Source: Okun’s Law: Economic Growth and Unemployment, Investopedia, 4/25/2022)..  At full employment labor costs tend to trend up causing inflation to trend up.  A great way to track this, and we will, is via the St. Louis Federal Reserve 4-week moving average of initial claims for unemployment. 

If you were to search “4-week moving average of initial claims, St. Louis Fed/FRED”, you will see a chart that shows points of peak employment, i.e. the fewest claims for unemployment benefits.  In the chart, the St. Louis Fed also has gray boxes for when recessions start and stop.  These are clearly accurate as they are history.  We can look back and see exactly when they start and stop as the Fed has done.

Once at the Fed site, take a moment to observe what happens shortly before each gray recession box.  Ugh!  It is a low in initial claims for unemployment.  We are there.  Are we “there” there?  I don’t think so, but we are close enough to say “this cannot be overlooked”!

If we dial the microscope down one more notch to see what the correlation of the recession was to the stock market performance, you will likely become nauseated, like I was.  By the end of the gray box recessions, which you would see on the Fed website noted above, the average stock market reduction was -30%, the worst -44% and the best -19%!

Without question, inflation affects market performance negatively, but like a big ship in the ocean, you can hit the right rudder hard and the nose will not start to move for several minutes.  Like a big ship, I suspect we have plenty of time to plan and reallocate our investment positions if this data continues to point toward an increase in the inflation rate.  If it does, this will cause me to initiate the exit strategy "process"!

Over the decades, I have learned that many people tend to confuse brains with a bull market.  Most of the ownership values of Corporate America rise in the rising trend of a bull market, just like all ships rise in a rising tide.  I have also learned that a smarter approach is to attain market returns during these uptrends, but with lower risk (as measured by standard deviation, which is a historical measure of the variability of returns relative to the average annual return. If a portfolio has a high standard deviation, its returns have been volatile. A low standard deviation indicates returns have been less volatile) and lower volatility (as measured by Beta, which measures a portfolio’s volatility relative to its benchmark. A Beta greater than 1 suggests the portfolio has historically been more volatile than its benchmark. A Beta less than 1 suggest the portfolio has historically been less volatile than its benchmark).   At The Wealth Strategies Group™, our goal is to do this using an asset allocation that adds in sectors we believe will outperform the indices combined with the low risk “shock absorber” income producing investments.  In this current uptrend, most of our clients should see sectors like technology and emerging markets adding that little bit of extra kick to the overall performance.

For sure, upward trending markets can become a very powerful net worth magnifier.  That said, I have also learned that limiting our participation in down markets is equally, if not more important, than capturing market plus returns in an uptrend.  By optimizing both the uptrend, and the down, we believe you are more likely to improve compounding and potentially increasing the odds of achieving your goal.

Over the years, I have also observed that most investors place too much importance on macroeconomic themes and events and pay little, if any, attention to the skills, knowledge and strategies that are time tested to work toward delivering less risk and anticipated results.  This is where the skill set of The Wealth Strategies Group really shines.  It shines because we actually do what we promise our clients we will do on their behalf.  For example, in this current uptrend of nine years, and +19,745 points on the Dow Jones Industrial Average (DJIA), since March of 2009, we have used "the calm" to plan and update our exit strategy "process".  As we continue upward into this rare air, it seems prudent to have a two-pronged approach as our exit strategy "process"

Method One:  Assumes market valuations reverse and head down.  Thus, a revisit to the exit strategy I named The Retracement Reality™ way back when.  Should any or all of The Three Points to Ponder, cause us to initiate the exit strategy "process", this is what the points of action could look like. Keep in mind, this is a moving parade versus a snap shot.  As valuations "trend" up, or down, so will these numbers.

As of 1/31/2018 the S&P 500 trades at 2,828.39.  (I won't bore you with what a Fibonacci "Retracement “number sequence is, but this is the arithmetic I have used for these action points.)  If you choose to learn more just go online and search: Fibonacci Retracement.

-4.95% to 2,689.48 (Action:  Do Nothing)     

-8.07% to 2,600.12 (Action:  Do Nothing)

-10% to 2,545.55 (Action:  Reallocate 5-10% to cash reserves)

-15% to 2,404.12 (Action:  Reallocate an additional 15%-25% to cash reserves)

-20% to 2,262.71 (Action:  Reallocate an additional 25%-40% to cash reserves)

-20% + Depending on circumstances prepare to be 100% cash reserves)

Method Two:  Assumes market valuations continue higher.  In this method I have chosen to use the Fibonacci "Projection" number sequence as our decision point(s) for taking action.

As of 1/31/2018 the S&P 500 trades at 2,828.39 

Each increase of 100 points on the S&P 500 would suggest we sell the following percentage of a portfolio into the continued upward trend.

at 2,929 (Action:  Reallocate 3% to cash reserves)

at 3,029 (Action:  Reallocate 5% to cash reserves)

at 3,129 (Action:  Reallocate 8% to cash reserves)

at 3,229 (Action:  Reallocate 13% to cash reserves)

at 3,329 (Action:  Reallocate 21% to cash reserves)

It is very important for each of our client relationships to understand these are guidelines.  A thoughtful approach to implementation will include each client’s constraints for time, risk and volatility.  Yes, I know that I often refer to this process as an "if this, then that" type of a surgical decision tree, but as you can see it is just a little more complex than that, but not really!

The Three Points to Ponder combined with the exit strategy "process" will be a key focal point going forward.  That said, history has proven that you don't usually have a 2008-2009 level value reduction when the economy is strong, like it is now.  Yet, it is possible, and it is likely, that we will hit a speed bump sooner or later.  Thus, it makes sense to have thought this process out well in advance and while all is calm.

I am interested in your thoughts, comments and discussion.  Call, email or just stop by the office and say "HI"!

Jim Lunney, CFP®

303.933.2107

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results.  All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

 

 

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