At BCM’s recent July Insight gathering held at the Lafayette City Club, we reviewed Ray Dalio’s video presentation titled “How the Economic Machine Works” (you can watch it here @ https://www.youtube.com/watch?v=PHe0bXAIuk0). This 30-minute video was (and is) entertainingly done, packed with information explaining why the economy cycles. For investors such as us, that seemingly dry topic is terribly important, as economic cycles are a huge driver of asset class investment returns.
You may be familiar with our graphic (https://billeaudcapital.com/investment-management) showing how the major asset classes typically are affected by where we are within the economic cycle.
As illustrated above, economic growth is usually good for stocks and economic contraction is usually good for high-quality bonds.
Here at BCM, our Market Risk Model, undergirds the risk management of our investment portfolios. At the risk of repeating myself (at the risk of repeating myself), a favorable outlook registered by our model results in a full allocation to the stock portion of our chosen allocation (Tactical All-Weather or Tactical Growth). An unfavorable outlook results in a reduction of portfolio risk, realized by reducing our stock allocation.
So why are we discussing this now? Our Market Risk Model has maintained a favorable “low-risk” outlook since the Spring of 2009. Financial markets have obliged by rising nicely. The economy, not coincidently, has also been of the upswing over virtually the same period of time. Forward looking (leading) measures for the economy continue to hold a favorable outlook as of this writing. All of that bodes well for the near-term.
BUT, as Dalio’s video clearly showed, the economy is cyclical. Growth is followed by recession which is followed by growth which is followed by… You get the picture.
It’s been said that business expansions do not die of old age. Rather, they are typically (and inadvertently) murdered by an overactive Fed. Since interest rates bottomed in 2015, the Fed has moved to raise rates six times. Furthermore, they have publicly stated that there are likely two more rounds of increases scheduled for this year.
While the Fed never intends to kill the golden goose, the lag time between their policy moves in Washington and the effects down here on Main Street (typically nine to twelve months), has often resulted in the Fed ultimately overshooting its target. Outcome – tempered growth and possible economic recession. Sad!
Let’s hope that as this current cycle of raising interest rates continues, the Fed does not again overshoot their mark. The potential recession that would likely result would probably lead to an attention-getting adjustment for stock prices should they revert to a more normalized (i.e. lower) level of valuation.
So that’s why we reviewed Dalio’s video. And that’s why we pay such close attention to economic cycles. They are an integral component in our overall assessment of market risk.
If you’d like more information on the subject, or would like to discuss, please give us a call or stop by the office.
*We hold our Insight events quarterly. If you’ve not been receiving your e-mail invites, please do let Madison Berrio know at 337-233-7758.