At LPL Focus 2018 in Boston, LPL Research Chief Investment Strategist, John Lynch, and Senior Market Strategist, Ryan Detrick, discuss highlights from the Midyear Outlook. As referenced in the Midyear Outlook, we expect continued growth, but there is also the potential for greater market sensitivity due to the late cycle concerns that can emerge when the economy is doing well. So indeed, the plot has thickened. But that doesn’t mean we’ve taken a turn for the worse. The underlying forces are still forging ahead and this expansion and bull market have not been defeated. Right now, there are many positive fundamentals, like business investment and corporate profits, supporting economic growth and potential market gains.
Read the full transcript below:
John Lynch: Good morning everyone. This is John Lynch, Chief Investment Strategist for LPL Financial. Welcome to the LPL Research Morning Call podcast live from Focus. Focus, as you know, is our premier advisor conference. We've got approximately 6,000 people, record advisor attendees, record new attendees. We started the event yesterday, and it's been going very well. I'm privileged to be here today with you with my friend and colleague, Ryan Detrick. Ryan, good morning.
Ryan Detrick: Good morning, John. I'm glad to be here. Even though it is technically day two of Focus, a lot of us got in on Saturday, was the pre-day on Sunday, so a lot of us ... I've seen some tired people this morning, but nonetheless the excitement is still in the room, and we are ready for one more fun day of Focus.
John Lynch: That's something to keep in mind because it is a tiring time. It's very time consuming, but it's all vibrant and all energy all the time, so it's amazing how we can all tap in to our inner source of strength because it's just so much fun talking to the advisors. I love the fact that everybody's here because they want to be here. No one is compelled to be here. Everybody wants to be here. I think that's really important. It's really wonderful seeing old friends, making new friends, working with our advisors, working with our partner firms, hearing from leadership yesterday. We had some great commentary yesterday if you want to highlight some of those speakers.
Ryan Detrick: That's right, John. One of my highlights of Focus so far, and I've joked about this, we're at the booth, we get to meet with our advisors but just walking to the bathroom, just how many people come up to us and want to talk to LPL Research. It's an honor and a delight to just connect to people that maybe you know through Twitter or LinkedIn or a different way, and [inaudible 00:01:40] just say, "Hey, I remember your voice from the Morning Call." It's a lot of fun. Yesterday, definitely one of the highlights was Ron Insana from CNBC and MSNBC came on. He used humor along with market history. Kirby Horan-Adams did a great job from our research team, interviewing with him on the main stage in front of 6 or 7,000 people. It was great. But Ron, he was a riot. He told some funny stories from the back in the day. It was very comical but also very enlightening.
John Lynch: I enjoyed his intellect, his humor, and his humility. He really is kind of a Forest Gump of the financial services industry if you think about the last three or four decades and all he's seen, all he's experienced and all he's reported on, so it was really wonderful to hear some of his insights. We've got more talent today. We'll hear from our good friend, Burt White, who always puts on a spectacular performance, so everyone's excited about that as well as well as another full day of breakouts with our partner firms and meeting with advisors yet again.
Ryan Detrick: I was going to chime in, John. That's right. One of the favorite breakouts is obviously your breakout is later today where you do the Midyear Outlook.
John Lynch: Oh, stop it. You're embarrassing me, Ryan.
Ryan Detrick: Speaking of the Midyear Outlook, John, I know yesterday we touched on the Midyear Outlook which we released here about a month ago, and we looked at policy and the economy. So today we're going to take a second page two of that and look at stocks and bonds. John, why don't you give us the overview of ... What do you want to start with, stocks or bonds? What do you want to do?
John Lynch: Let's start off on fixed income. I think it's a good way to flow from policy and the economy because if you do any, as you know, top-down analysis, macro-analysis on bigger picture of policy and economic, it really comes down to the impact on interest rates, clearly the big concern for all investors, a lot of the advisors we spoke to yesterday and the day before. Clearly it has to do with a flattening yield curve. Our talented research team has worked really hard on this. Colin Allen has provided great insight for us as well on this.
We're confident that the yield curve is not pointing toward a challenging environment or looming recession rather. I think we can always view volatile markets as a challenging environment. But if you think about the yield curve historically, it has pointed ... When the yield curve flattens, many investors get scared historically about the possibility of recession. We believe that given what the monetary policy makers have done globally, really artificially suppressing interest rates over the past decade or so, that kind of adds a different dynamic to it, wouldn't you agree? What we've seen with the flattening yield curve ... when the yield curve is flattening because interest rates are rising, that may be bearish for bonds but tends to be bullish for stocks. So I think that's something that investors need to keep in mind.
Ryan Detrick: That's right, John. Colin Allen mentioned this before, but the last time we saw a yield curve that was this flat, again with yields going higher, was 1994-95 so obviously a period of substantial growth still and still stock market gains. Now, you talk about this year was one of the main things, of course, tariffs if we can get into more when we talk about stocks, but the yield curve's the other one.
We did in a study just recently on our blog, lplresearch.com, that took a look at after the yield curve inversed. Now, let's stress this. The yield curve has not even inverted yet. You got 21 months on average before a recession hits, and the S&P peaks on average 13 months later up over 20% so if and when we eventually invert, yes, nine of the last nine recessions started ahead of an inverted yield curve, or there's an inverted yield curve ahead of the recession. I'm sorry. So it's a warning sign, but it doesn't mean that you just panic and sell everything. As history says, there still can be some growth. But the key thing, like the mid-90s, yields are going higher right now, which is a potentially positive sign.
John Lynch: What's the old line? Economists have predicted nine of the past four recessions so we have to be mindful of that.
Ryan Detrick: They've been right every time.
John Lynch: To your point about 1994-95, I think it's important to provide perspective to our advisors and our investors to keep in mind that 1994-95, it was a very secretive Fed. It was until '96 that Alan Greenspan may that comment about irrational exuberance. If I remember correctly, even with [inaudible 00:05:50] and Russian ruble crisis, the late '90s were a pretty good period for the market. I think we need to keep that in mind.
Then the historical average from a 50 basis point spread between twos and tens to recession or bear market has been almost four years to your point, so it's something we have to keep in mind for investors and in the fixed income market, therefore. The way we're positioning portfolios and advising our investors is that we want to take less risk for those bonds that tend to be interest-rate sensitive whether you're looking at treasuries or municipals, for example, and then take more risk on the credit side. If you want to be geeky and say short duration long credit risk and really look for opportunities in high yield investment grade corporates, we think there's an opportunity there.
Ryan Detrick: Yeah, John, an interesting stat on the fixed income. Today on our blog, lplresearch.com, we're taking a look at the Barclays Ag so your average bond fund. It's actually down on a two-year basis on a total return basis for the first time since about 40 years ago in the early '80s. That sums up really how tough the environment has been for fixed income in general and just your average bonds when you consider the Barclays Ag is down over the past two years. I know you've got a comment on the blog, you've got a quote in the blog today, what do you think about that stat by itself there?
John Lynch: I think it's something to keep in mind because for the ... I've been at this for over 30 years, and the bond market has been in a bull market my entire career and how many younger analysts and portfolio manager out there experiencing this and have never experienced a rising interest rate environment. That's something, I think, people need to keep in mind of. It's very consistent with the message we were delivering yesterday with our weekly market commentary about the importance of more active strategies going forward.
I don't know if we're convinced the bull market and bonds is over nor are we convinced the bear market and bonds has begun, but I do think we should embrace this as an opportunity to recognize that we're in the income generation phase of the credit cycle. That's why it's really important to remain diversified and fixed income. Bonds play an important role in portfolios. They provide liquidity. They provide a source of income. But they can also smooth out volatility during periods of market stress. I mean you and I may think the 10-year's expensive, but global investors see three basis points or potentially 300 basis points on the 10-year treasury and they see an opportunity there.
Ryan Detrick: That's right, John. Maybe let's turn gears here to equities now. You mentioned the late '90s and volatility. Three main points from our Midyear Outlook were policy, which we just kind of talked about, but also peaks and volatility. Maybe I'll talk about volatility and if you want to talk about peaks here. So volatility. The late '90s was a volatile time. Why is that? Well, it was later in the economic cycle. Clearly, this is a nine-year-old economic cycle, but as we discussed yesterday, we think it could have at least another year, maybe two years left here of economic growth.
But the key thing is in volatility. You have to embrace this volatility. We've already seen two 10% corrections this year. Historically, we're entering August, September, two of the weakest months especially during midterm years. You can have some volatility and corrections ahead of those midterm elections. The good news, though, as we noted yesterday, a year after the lows of the midterm year, like we've probably just made in February, has been higher every single time going back to World War II. So be on the lookout for a potentially rocky couple months here, but the bull market still looks good.
John Lynch: Absolutely. I think that's something to keep in mind. Again, embracing volatility, employing more active strategies in portfolios. I mean it is year nine of the economic cycle, year nine of the profit cycle, the market recovery rather. I think it's really important for investors not necessarily to focus on the market multiple myopically, I don't want anyone to focus just on PEs purely. I think you have to look at PEs relative to interest rates and inflation. Even though central banks have quintupled the size of their balance sheet, we're barely getting inflation toward targeted levels for the Federal Reserve after almost a decade of extraordinarily accommodated monetary policies.
Then when you look at interest rates, when you look at inflation, inflation historically 3.5, 4%, we're about half that, 10-year treasure historically, going back to the 1950s, about 675. We're 400 base points or so below that currently. So there is some tailwind there, but we just want to position portfolios purely toward earnings and income compounded annually. You want to look at those companies and those industries positioned to benefit from what we term the return of the business cycle, more normal drivers of the business cycle whether that includes small caps or benefiting from the tax cuts. Don't have to worry about currency translation largely because of their domestic focus. They've got some momentum there certainly.
Value's starting to gain some traction thankfully. Small value out performs small growth in the second quarter, and we think that's a good lead indicator for large value versus large growth. From a sector standpoint, financial industrials, technology to some degree, benefiting from immediate expensing, tax cuts, infrastructure spending, reduced regulations. So there are a variety of things going on. We think we're looking at about a 20% profit growth this year, 10% profit growth next year, and we're really looking at market growth to rise commensurate with profit growth.
Ryan Detrick: That's right, John. One other thing I wanted to touch on that I mentioned, policy, volatility, and peaks. Manufacturing very well could have peaked earlier this year. Profit growth very well could potentially have peaked when you look at year-over-year profit growth with that 24% gain in the first quarter. Should investors be worried if a couple different peaks are happening in the yield curve as we just talked about?
John Lynch: I'm glad you brought that up because peak doesn't mean plunge. I think that's something to keep in mind. We've seen data where ... we already talked about the yield curve and flattening, how long it takes before you see a potential comeuppance for the economy. Looking at profits, we looked at the last 12 profit cycles. We found that from a peak in profits to recession typically takes approximately four years, but over that four-year period, the market is up by more than 50%. Those investors who fail to embrace volatility during periods like that did not participate fully. That's why we really think more active strategies to complement the passive strategies in portfolios because we certainly employ both but really take advantage of that volatility to return portfolios toward target allocations.
Ryan Detrick: That's right, John. Just a couple more quick comments here on today's action and the rest of this week. The Bank of Japan actually came out with their interest rate policy this morning. It was a little more dovish, I think, than some people expected especially last week. Only minor changes to policy and they left the quantitative targets unchanged. Remember, last week, we talked about it yesterday, relatively large spike in Japanese yields even though they're so low. But global yield spiked on that news. So it seems like that's more of a calming, nonevent. Then, of course, tomorrow we have the Fed coming out, probably going to be a nonevent towards interest rate policy, but it's always important to see what the Fed has to say. Then, John, if I can make a comment, June income and spending is today. Then July consumer confidence are also today. [inaudible 00:12:54] investors should be looking for those events out later today.
John Lynch: The income and spending report has an inflation component to it. That is actually the Fed's favorite inflation indicator, so I'll be very curious to see how that ... I suspect that will be still be under the 2, 2.5% type on a year-over-year basis, so that should be very important also for monetary policy makers to ... Although they probably made their decision about tomorrow already. It'll reinforce their decision going forward.
Ryan Detrick: Thank you. John, I'll add a couple comments. I'll let you sign off. I've really enjoyed these past few days doing these podcasts with you, John. I've had a blast at Focus. We've got one more full day to go, and it should be a lot of fun. If anyone is out there is listening, definitely come to our booth at LPL Research and come say, "Hi." John, take us away.
John Lynch: Absolutely, Ryan. You and I are very fortunate. You and I both share a labor of love whether it's being market junkies or geeky analysts.
Ryan Detrick: We'll say geeky.
John Lynch: That's right. Geeky is cool now I understand. Certainly the vibrancy of this room and the relationships we have with our investors, LPL's a very special place, so I'm very privileged and honored and delighted to be here. It's been very exciting. Just to close, if any investors are listeners, advisors want more or continued insights, please follow us @LPL or @LPLResearch or #LPLFocus. Thank you all very much. We hope you have a wonderful day. Enjoy Focus. We'll look forward to talking to you soon on our ongoing podcast series over the next several weeks. Thank you everyone.
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