The investment clock patterns - at extremes

Fidelity provides some interesting graphics for clients. The investment clock compares the z-score of financial conditions (positive is tight) against earnings growth. One would expect that loose financial conditions will lead to higher earnings growth. It does, but there is a pattern to the link. We are seeing looser financial conditions and a strong increase in earnings growth, but we do not seem to be at an extreme, with financial conditions starting to tighten. We should start to see earnings growth decline. 

Comparing the CAPE model to past periods and current PE shows that values are stretched, and if you look at the timing of secular bull markets in the past, we are likely to hit peaks in early 2027 or sometime in 2028. I am not a fan of this type of analysis. We cannot forecast shocks, and overvaluation can last longer than expected. All we can say is that the markets will be more sensitive to downward shocks, but that is not the same as saying there will be a down shock.

 

Will bonds provide the cushion desired?

Are you going to get protection from bonds during a down market? The answer is yes, but not to the degree that you may hope. Mainly, there will be positive gains in bonds during down equity years, but there is no guarantee. The most recent year equities were down was 2022, and bonds were also down. During the stagflation years of the early 1970s, there were no gains to be made from holding bonds. When equity downturns are coupled with inflation, bonds will not likely provide a positive cushion. 

Best performance with commodites and and EM

The classic combination of large-cap developed-market equities and fixed income does not perform as well as a combination that holds commodities and EM equities. Call it the power of diversification, or the problem of complacency, with a simple 60/40 mix. The continued energy shock from war, coupled with improved fiscal responsibility in EM countries, suggests that holding what were once considered the riskiest assets is now a better strategy. Better value outside the US in a rising rate environment calls for diversification. 

 

Concentration risk is a global problem

 

If you thought that concentration risk was a US problem, you are wrong. It may not be as significant as we see in the US, but whether in Europe, Japan, or emerging markets, the number of stocks that will drive the benchmarks is limited. If you need to have an opinion on some stocks, focus on these. If these names start to turn, it is likely your "diversified portfolio will be following these key names.