The Fed Is Set To Cut Interest Rates, Which Means It Might Be Time To Embrace Boring!
Recession risks are growing. Investors should start considering ways to protect themselves.
Remember one year ago at this time? Investors talked themselves into the idea that a new aggressive Fed rate cutting cycle was imminent. The markets priced in 7 quarter-point cuts for 2024 at one point. The S&P 500 rallied by nearly 30% from November through April.
Flash forward 12 months and it looks like the Fed is finally going to cut rates for the first time next week. Not counting Japan, which is a unique situation in and of itself, the United States will be the last major central bank to begin lowering interest rates.
And, quite frankly, it’s time. Not because inflation has normalized, but because recession risks are growing.
How about some evidence:
The unemployment rate in the United States has climbed from a cycle low of 3.4% in April 2023 to 4.3% in July 2024. The Sahm indicator suggests the onset of a recession when the unemployment rate rises by 0.5% over a 12-month period.
When people talk about weakness in the commercial real estate sector, they often contain the discussion to office space, which has obviously taken a hit during the post-COVID work from home boom. Now, the struggles are extending to most areas of the commercial real estate market, including hotels, retail and housing.
Consumer spending has been one of the pillars of the recent economic expansion, fueled of course by the huge stimulus packages injected into the economy around the pandemic. Today, however, consumers look fatigued and running out of the resources to keep this up. Consumer debt default rates are at their highest levels in 12 years.
Jerome Powell at a recent presser was correct in saying that the Fed’s primary concern going forward should be economic growth instead of inflation. Not that we’re out of the woods on inflation yet, but it at least appears to be under control for the time. Plus, if recessionary trends continue, the inflation problem will take care of itself quickly.
For investors, the markets are starting to behave as if recession is becoming a bigger risk too. The days of domination by the magnificent 7 stocks are over. Not only are we in the midst of a rotation away from tech stocks and a general broadening of the market, we’re seeing a lot of that rotation moving into traditionally defensive sectors and themes.
Long-term Treasury yields, a long-standing flight to safety trade (2022 being the historically one-off exception), have been declining steadily for months. They’re now at their lowest level in nearly a year and a half.
How about the aforementioned magnificent 7 stocks? They’ve not collapsed completely, but the Roundhill Magnificent Seven ETF (MAGS) has only been matching the S&P 500 lately and is well off of its highs relative to the broader market.
Low volatility stocks are another group that’s been having a strong run. There’s unquestionably been a lot of chop relative to higher beta stocks since the mid-July bottom, but they’ve been delivering their best relative performance since the 2nd half of 2023.
In summary, the financial markets are taking much more of a risk-off tone. Utilities, consumer staples and dividend stocks are doing well. Treasuries and gold are rallying. Investors may not be abandoning risk assets altogether, but they definitely appear to be taking some risk off the table. If the current recessionary trends being signaled by the latest economic data continue (and there’s enough evidence from enough different corners of the economy to think that it will), these segments of the market probably have much more room to run.
Let’s take a look at a couple more charts that I think are particularly important to consider right now.
High yield credit spreads are a measure of how much extra return investors are requiring for taking on adding risk. It’s also a good indicator of overall market risk sentiment. This number has been, in my opinion, far lower than it should be given the risks that have been present for a while. They’re still at historically low levels today, but they are on the rise again, another sign that investors are growing more risk averse.
Here’s the heavy hitter - the 10Y/2Y Treasury yield spread. Historically, it turns negative ahead of a recession. This number has been negative for more than two years, so investors have kind of gotten used to it. That’s not news, but the fact that it just turned positive again is.
Why is it important? When the 10Y/2Y spread remains in sustainably positive territory, that unofficially starts the clock on recession watch. In the past, a recession has traditionally begun roughly 6-12 months after this number flips positive and stays there. Maybe this time will be different, but the fact that the data is generally getting worse and the Fed is about to start cutting interest rates suggests it won’t be.
I think the markets are paying attention to this and are preparing themselves accordingly.
How To Protect Yourself From The Next Bear Market
Now that we’ve identified the problem, what do we do about it?
There are any number of ways to take risk off the table in your portfolio, but one of the worst things you can do, in my opinion, is take it ALL off the table.
The solution for most people is to “get out of the market”. Unless you’re a successful market timer in the way that 95% of traders aren’t and have the discipline to sell high and buy back in when market conditions are at their worst, this strategy is very unlikely to work.
Instead, try tilting your portfolio in a safer direction. You can take some risk off the table, yet take advantage of a rising market in case things don’t work out the way you planned.
Here are a few ETF ideas that can potentially help out.
Sectors
These are three sectors that traditionally hold up very well in economic contractions. These are the products and services that consumers will need regardless of economic environment. They have below average risk and may even throw in a higher dividend to provide an extra cushion.
Strategies
Invesco S&P 500 Low Volatility ETF (SPLV)
Invesco S&P 500 Quality ETF (SPHQ)
Vanguard Dividend Appreciation ETF (VIG)
VanEck Morningstar Wide Moat ETF (MOAT)
All of these different themes involve targeting big durable companies with strong cash flows and healthy balance sheets. In other words, the kinds of companies that are financially well-positioned to handle tougher environments. Low volatility stocks should decline less than the broader market during a downturn. The quality factor makes sense in almost any environment. Long-term dividend growers tend to be ideal for those looking for predictable income and more safety. Companies with wide moats have competitive advantages relative to their peers that add another line of defense.
Buffers
FT Vest Laddered Buffer ETF (BUFR)
Innovator Laddered Allocation Power Buffer ETF (BUFF)
iShares Large Cap Max Buffer June ETF (MAXJ)
There are literally hundreds of buffer ETFs available that cover all sorts of indexes, markets and asset classes at varying levels of protection, so you need to go shopping for exactly the right fit for you. BUFR and BUFF are fairly broad buffer ETFs that use a series of different funds to help balance out risk and protection levels.
MAXJ is the shiny new object of the buffer ETF universe in that it’s designed to provide 100% downside protection over the outcome period. Keep in mind, more downside protection generally means more upside potential that is sacrificed.
Hedges
AGF U.S. Market Neutral Anti Beta ETF (BTAL)
Cambria Tail Risk ETF (TAIL)
ATAC U.S. Rotation ETF (RORO)
These are funds that you probably don’t want to go overboard with, but they can provide ways to hedge your portfolio. BTAL invests in low volatility stocks while simultaneously shorting high beta ones. In other words, it can produce positive returns in any environment where low vol if outperforming, which down markets usually qualify. TAIL uses put options that would deliver gains when stocks decline. RORO uses market signals to rotate between stocks and Treasuries depending upon what conditions are indicating at the time.
Final Thoughts
I’ve always been a fan of tilting portfolios gently in one direction or another based on what the market is doing instead of the “get in or get out” process that most people use. The latter almost never works and investors generally lose out on a lot of gains doing this.
Adding one of the ETFs above to your existing portfolio can be a good compromise between protection and long-term wealth creation.
I don't get why people don't just practice INVESTING! But a s&p500 or total market etf and hold that bitch forever and funnel money in to it on red days & green days. This buying high selling low nonsense is the dumbest thing ever.