"Statistically, the current set of market conditions looks more 'like' a major bull market peak than any other point in the past century, with the possible exception of the 1929 peak," John Hussman said, adding that the combination of "extreme valuations, unfavorable market internals, and dozens of other factors" give him comfort in having a bearish outlook on the stock market.
Families are still feeling the pinch of inflation and consumer spending is starting to slow. Household debt is increasing, as post-Covid savings are depleted. The labor market is beginning to show signs of weakness, as evidenced through less jobs being added and downward revisions in data from previous months. On top of domestic economic issues, we’re nearing a historically unpopular election and we’re debating who will be on the ballot in November. Oh, and don’t forget about the likely escalation between Israel and Hezbollah in southern Lebanon.
Not going to lie, it sounds pretty scary when put into a paragraph. I'm halfway convinced of a stock market crash. So, do I recommend moving your investments to cash?
If you've been following me for more than a week, you probably already know my answer...No. Definitely not.
Timing a market top is essentially impossible and even worse, successfully moving to cash and then reinvesting means you have to time both the bottom and the top correctly.
I've seen too many investors move to cash, successfully sidestepping a downturn, only to miss out on years of growth because they were too worried to get back in the market. They would have actually had more wealth if they had stayed fully invested through the downturn and then caught the growth as well.
That's the short answer.
The longer answer is a bit more nuanced.
I'm not saying that you shouldn't do anything. Keep reading and I’ll explain how I’m looking at the market and the moves I’m making to address the risk I see.
Warren Buffet's first rule of investing is Don't lose money
When I'm managing funds for my clients, I take a proactive approach to risk. I can’t say that I won’t lose money, that’s not possible, but I manage risk to protect the money my clients worked hard to save. So, what am I doing to manage risk, right now?
I’m taking gains off the table by rebalancing. The S&P 500 is up over 18% this year and it has hit all-time highs 37 times this year. This is a great time to rebalance, selling some winners and rebalancing into bonds that still have solid yields. It’s also a good time to move from riskier sectors into sectors into a more defensive posture.
Just to reiterate, I’m not selling and moving to cash. I’m lowering my overall allocation to equities and I’m positioning the remaining equities more conservatively.
Avoiding a Stock Market Crash
Bonds
The first place the rebalance happens is by looking at income needs. For clients who are taking income from their portfolios, I’m ensuring that they have 3-5 years’ income in a bond ladder. The goal here is to protect their income in case the market does pull back.
By using a bond ladder, I can match the amount of income they need each year to a bond (or bond fund) that matures in that year. By matching the duration of the bond to when they need the income, we’re effectively immunizing the bond against interest rate risk. Remember, when bond yields go up, bond prices go down. Since we’ve immunized the bond portfolio, the bonds will mature at par (face value) and rates going up (or down) isn’t a concern.
Equities
Let me first mention my philosophy on equities again. For an all-equity portfolio, it’s broken down into a core position that stays the same, and a satellite position that I use to manage risk.
The core position makes up 70% of the overall equity portfolio, with holdings diversified across the following categories: Large Cap Growth, Large Cap Value, Small Cap Growth, Developed International, and Emerging Markets (without China). This allocation doesn’t change, it’s just rebalanced as necessary.
The satellite position is how I manage risk for my clients. If you’re still reading, this is likely the interesting part. So, what am I doing in the satellite position?
First, I’m lowering my exposure to big tech names. Despite a bit of recent volatility, tech stocks have had a solid year. They’re also the companies which are most exposed to volatility, as much of their stock prices are based on future earnings. If we have a recession and future earnings drop, that will hit tech stocks fairly hard.
Tech stocks have really outperformed in the 15 years since the Great Financial Crisis, but there’s no guarantee they’ll continue to lead for the next 10 years. The point here is that we can’t get attached to stocks because they’ve done well in the past. In the current situation, we need to look at both the short-term outlook and the 10-year outlook to define the forces that will most affect the markets.
Four Forces Shaping our World: Invest 2035
I see four strong forces effecting the market over the next 10 years.
Artificial Intelligence – AI is a once-in-a-generation shift forward in technology. While implementation today is still in its infancy, we’ll soon be seeing companies-built ground up to maximize the benefits of artificial intelligence. Much like the Industrial Revolution sprung from the invention of the water frame, I believe that AI will lead to revolutionary changes in our economy.
We’re still in the early innings and it is yet to be seen which AI companies will be the next Google…It’s quite possible that the new Google is Google, well Alphabet, as incumbents like Microsoft, Amazon, Apple, and Google are all-in on AI. They also have the benefit of massive amounts of training data on which they can build foundational models.
I think that the foundational models, like OpenAI or Claude, will end up as commodities. It’s going to be incredibly hard for a startup to compete, as the sheer amount of computing power, energy, and data needed to build a model is incredible. Instead, I think much of the value will come from startups combining foundational models with unique datasets for finetuning, then building a company around the updated model. For example, if I were a tax-preparer with H&R Block, I would be concerned that a startup might fine tune a model using tax data to automate simple tax preparation.
Another winner will be the companies selling the shovels, so to speak. In the case of AI, I’m talking about those providing the computer power, data, and infrastructure needed to implement AI at scale.
Energy – Simply put, our current energy grid can’t handle the increased load from added data centers and AI computing. One data center can require 50 times the electricity of the average office building, according to the US Department of Energy. Virginia, with data centers handling 70% of global internet traffic, projects a 4x increase in energy consumption by 2035.
While we’ve heard about the switch from fossil fuel to renewable energy for the last twenty years, the low cost of fossil fuels makes them likely to survive and even thrive in the coming years.
Nuclear energy is also an interesting option, as reactors have advanced lightyears beyond Three Mile Island and Chernobyl. Nuclear has the potential for being a relatively safe, clean, and inexpensive source of power. The biggest issue it has is regulatory…states are hesitant to permit new nuclear facilities, making new plants an even more expensive investment.
Finally, utilities are beefing up their transmission capabilities in response to the increased demand…but it’s going to take time and investment for them to meet the need.
Manufacturing – The ongoing move from a world order dominated by the US to a bipolar world split between the US and China, will have incredibly ramifications on our supply chain. As we all experienced post-Covid, a hiccup in the Chinese supply turns into a shortage in the US. If we lose access to cheap Chinese (and southeast Asian in general) manufacturing, we’ll have to look elsewhere and rebuild.
I believe it’s likely that some of that manufacturing comes back to the United States in the form of AI driven factories. TSMC, the world’s leading manufacturer of advanced microchips, has already automated their semiconductor fabs. They’re able to run “in the dark,” as manufacturing is handled by robots from start to finish. In the US, as the cost of AI drops, we have an opportunity to integrate AI into manufacturing. Manufacturing technology would need adaptation, but it’s not a pipedream. Likewise, such a move would require massive investment. A fanciful idea, maybe, but one rooted in both possibility and reality.
The other winners in a move from Chinese goods are likely to be Mexico and Colombia. Mexico has significant manufacturing capacity already, as evidenced by the number of car manufacturers building trucks and cars there. Their lower-than-US wages and young, relatively skilled workforce, and quick shipping to the US provide them with advantages in manufacturing. Another potential beneficiary of a bipolar world is Colombia. Colombia isn’t the same place that Pablo Escobar knew. They’ve done a great job of modernizing and opening up lines of trade. Combine their trading relationships with a young workforce and lower wages than Mexico and you have a great option for cheap, low-skill manufacturing.
Infrastructure – We have an aging infrastructure in the US, with one study putting the potential lost GDP from our infrastructure investment gap at $10 trillion by 2039. This comes from a combination of transportation, water, electricity, and internet issues.
Transportation is the easiest issue to spot. According to the American Road and Transportation Builders Association, 1 in 3 bridges in the US needs repair or replacement, and 7% are structurally deficient. Ports and waterways are another factor creating shipping delays. Across the board, we need investment in updates.
I’ve already talked about our electrical needs, so I won’t rehash the point. Instead, I want to mention our systematic water issues. The EPA estimates that water and sewage systems will require an additional $744 billion in upgrades over the coming decade. Flint, Michigan is a well-known example of a failing water system, but it’s certainly not the only one. Martin County, Kentucky has fought water issues for years, with some residents going days without running water. Anecdotally, Georgetown, Kentucky has had to slow development in some areas, thanks to a sewage system unable to cope with the increased demand from a growing city.
Broadband isn’t typically thought of when thinking of infrastructure, but in the 21st Century, it’s a necessity. Broadband provides access to the wider world, enabling learning and remote-work opportunities for those in rural communities. Without access to broadband, rural and low-income communities will suffer.
(To be completely honest, there are two others that I think will have huge effects on the economy, rapidly rising wealth inequality and also our rapidly rising national debt, but those aren’t investible in the same way as the four above.)
Invest 2035 Thesis
My approach in the satellite portfolio combines investments aligning these forces with some shorter-term tactical opportunities. With the 30% of the portfolio in the satellite portion, I typically invest evenly in the sectors I believe will outperform. Some of those I think will outperform in the short-term, particularly as hedges against overall market risk, and others are longer-term plays on the forces I explained previously.
For the longer-term plays, I use sector funds in the following areas:
Energy
AI-Focused Tech
Infrastructure
For the tactical side, I’m looking more defensively at the moment:
Gold – As both a hedge against inflation and market volatility
Defense Companies – The world is getting evermore volatile and I believe the risk of global war is higher now than ever before in my lifetime.
Short-Term Treasuries – Not particularly exciting, however they are a welcome port in a storm. Keeping funds available in liquid investments, particularly ones with solid yield, gives an investor the ability to reinvest during a market downturn.
Commodities – While inflation has cooled, there are quite a few potential flashpoints that could cause commodity prices to increase. Commodities are a hedge against both potential geopolitical risk and a bounce in inflation.
So...Should You Go To Cash?
Going back to the original question, you can see that I’m not moving my clients into cash. That’s not to say that we won’t keep a bit more on the sidelines, as dry powder for the future, but it’s not a wholesale move to cash.
The important part is to remember that investing isn’t based on weekly, monthly, or quarterly returns. We’re investing for our future and market downturns are a part of the process.
It isn’t fun, but that volatility is a big part of why stocks have long-term returns higher than bonds. Remember that, and keep a sufficient cash reserve to keep from having to sell stocks when the market is down, and things will work out.
-Jeb
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