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How To Avoid A Shark Attack

How To Avoid A Shark Attack

Key Points
  • A shark attack could take a big bite out of unprepared investors’ portfolios who don’t rebalance.

  • It’s time to be a contrarian and rebalance between three stock market asset classes: U.S. and International, Growth and Value, and Small and Large.

  • We don’t know exactly when a shark will attack, but we can take actions to prepare. A disciplined approach to rebalancing is important to achieving long-term investment goals.

Summer trips to the beach are approaching so it may be time to think about sharks. Sharks can be found all across the globe from sub-polar to tropical regions and from shallow waters to deep open oceans. A good way to tell if you are in shark habitat is to look down; if your feet are wet then the odds are you’re in Bruce’s house. Mick Fanning, 3-time world surfing champion, fought off a Great White shark in a surf contest a few years ago. We don’t want to fight a shark—we want to avoid them.

Three rules to avoid a shark attack:

  1. Avoid swimming at night.
  2. Avoid swimming with open cuts or jewelry.
  3. Don’t swim alone.

We don’t know exactly when a shark will attack, but we can take actions to prepare. They aren’t hard to do, as you can see in the list above. However, in our portfolios we have to be a contrarian to avoid a market shark attack. It sounds great to swim against the trend while buying low and selling high, but that behavior isn’t easy for most people to do. And it doesn’t always work—sometimes the trend keeps going longer than expected. When does it make sense to be a contrarian? When trends are at an extreme, or, in other words, when the shark’s jaws are wide open.

In our opinion, there are at least three major shark attacks that could take a big bite out of unprepared investors’ portfolios who don’t rebalance (trimming what has been outperforming and buying what has been lagging). It’s time to be a contrarian and rebalance between three stock market asset classes: U.S. and International, Growth and Value, and Small and Large.

US and International

The chart below shows us what stock market shark attacks look like using the relative performance of US and international stock indexes. The lines are just one index divided by the other. When the blue line is rising international stocks are outperforming U.S. stocks. When the orange line is rising U.S. stocks are outperforming international stocks. They are mirror images of each other.

Shark attack: U.S. versus International

MSCI EAFE Index vs MSCI USA Index

Source: Charles Schwab, Bloomberg data as of 5/13/2018.  Past performance is no guarantee of future performance.

In the early 1970s, the jaws were gaping wide. As international stocks began to outperform, the jaws began to close and take a big bite out of the portfolio of investors who hadn’t rebalanced. The jaws opened again in the late 1980s as the outperformance of international stocks became extreme, only to see them bite down again in the following years. Now, the shark’s jaws are open wide again after 10 years of U.S. stock market outperformance. We could again be on the cusp of a shark attack.

No one knows for sure if we have seen the peak of U.S. stock market outperformance of international stocks; the shark jaws could open wider before biting down. But the risk of a shark attack appears to us to be pretty high. Prepared investors should be thinking about being a contrarian and rebalancing their portfolios from the U.S. to international stocks after a decade of U.S. outperformance.

Growth and Value

Another shark attack could result from the wide gap between the performance of the equity investing styles of growth and value, as you can see in the chart below.

Shark attack: Growth versus Value

MSCI World Growth vs MSCI World Value

Source: Charles Schwab, Bloomberg data as of 5/13/2018.  Past performance is no guarantee of future performance.

Growth outperformed value in the late 1990s, led by the Information Technology sector. Then as Tech stocks crashed, value began to outperform from 2000 to 2007 and the jaws again widened, led by the Financials sector. As the financial crisis erupted, stocks returned to growth leadership, again led by the Tech sector. From a sector perspective, we recommend an overweight to both Tech and Financials, reflecting a balance between styles. While the jaws may widen further before aligning with the levels where they began to bite down in the past, being prepared and rebalancing from growth to value now may turn out to be wise.

Small and Large

Small capitalization stocks have been outperforming large caps since the bull market began in 2009, but the jaws now seem to be stretched.

Shark attack: Small versus Large

MSCI EAFE Large Cap vs MSCI EAFE Small Cap

Source: Charles Schwab, Bloomberg data as of 5/13/2018.  Past performance is no guarantee of future performance.

After international large cap stocks outperformed in the late 1990s, small cap stocks closed the gap and since 2008 have outperformed by a wide margin—with the MSCI EAFE Small Cap Index doubling the performance of the MSCI EAFE Large Cap Index (247% versus 118% respectively from the end of 2008 to April 2018). Rebalancing from small caps to large caps may help avoid a shark attack.

Great White shark attack

So we’ve looked at market shark attacks and where the jaws may be wide open for different asset classes. Now for the big Great White shark attack we all worry about—a bear market—that could take down all the asset classes together. Those tend to accompany recessions. So how far away might the next global recession and Great White shark attack be?

The chart below is the yield curve, which has indicated the ending of past cyclical bull markets. The blue line is the yield on the 10 year U.S. Treasury less the yield on the 3 month U.S. Treasury. The orange line is the opposite, the 3 month yield minus the 10 year yield. But, unlike the other shark charts, this one isn’t about how wide the jaws are—it’s about not being trapped inside when the jaws close.

Shark Warning: yield curve

Treasury yield comparisons

Source: Charles Schwab, Bloomberg data as of 3/30/2018.  Past performance is no guarantee of future performance.

In this chart, it actually doesn’t really matter how wide or narrow the jaws get. When the lines cross over each other (and the yield curve inverts) it has signaled death for the market and economic cycle (noted by shaded areas on the chart). The lines have crossed seven times in the past 50 years, taking place near the peaks of the stock market before a cyclical bear market, or Great White shark attack.

Fortunately, the jaws aren’t closed yet. Historically, in the years before the jaws closed, global stocks have tended to do very well—they posted double-digit gains on average and never suffered a loss since the inception of the MSCI World Index in 1969. But, the jaws could close as early as next year so we should be on shark watch.

Another indicator of where we are in the market and economic cycle is the gap between the inflation rate and the unemployment rate. When those jaws close, watch out since it usually marks the peak of the cycle. There isn’t a global unemployment rate so we will show you a few countries to make the point that the jaws aren’t closed yet.

Shark Warning: United States

Inflation vs Unemployment rate - US

Source: Charles Schwab, Bloomberg data as of 3/30/2018.  Past performance is no guarantee of future performance.

Shark Warning: United Kingdom

Inflation vs Unemployment rate - UK

Source: Charles Schwab, Bloomberg data as of 3/30/2018.  Past performance is no guarantee of future performance.

Shark Warning: Japan

Inflation vs Unemployment rate - Japan

Source: Charles Schwab, Bloomberg data as of 3/30/2018.  Past performance is no guarantee of future performance.

These charts show that there may still be some time before the jaws close and signal the death of the global market and economic cycle.

Three rules

Three rules for avoiding a stock market shark attack:

  1. Be prepared: rebalance your portfolio—we don’t want to be doing this during a shark attack, the time to prepare is before it happens.
  2. Think like a contrarian: the jaws appear to be wide open for U.S. over International, Growth over Value, and Small over Large—these are some areas where it may be time to swim away from the trend.
  3. The cycle isn’t over yet: stay invested—no need to be afraid of the water, signs do not point to an imminent Great White attack in the overall stock market this year.

Investors often pay a lot of attention to the direction of the overall market and may miss changes in asset class trends that shape how their diversified portfolio performs. A disciplined approach to rebalancing is important to achieving long-term investment goals.

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The MSCI ACWI captures large and mid cap representation across 23 Developed Markets and 24 Emerging Markets countries. With 2,495 constituents, the index covers approximately 85% of the global investable equity opportunity set.

The MSCI World Index captures large and mid cap representation across 23 Developed Markets countries. With 1,649 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI World Growth Index captures large and mid cap securities exhibiting overall growth style characteristics across 23 Developed Markets countries. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.

The MSCI World Value Index captures large and mid cap securities exhibiting overall value style characteristics across 23 Developed Markets countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.  The MSCI EAFE Index is an equity index which captures large and mid cap representation across Developed Markets countries around the world, excluding the US and Canada. With 928 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI EAFE Large Cap Index is an equity index which captures large cap representation across Developed Markets countries around the world, excluding the US and Canada. With 404 constituents, the index covers approximately 70% of the free float-adjusted market capitalization in each country.

The MSCI EAFE Small Cap Index is an equity index which captures small cap representation across Developed Markets countries around the world, excluding the US and Canada. With 2,307 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country.

The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 622 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.

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