As always, I do not claim to know for certain what's going to happen, and even less certain when they will occur. Nevertheless, I'd like to share my perspectives and thought processes in hopes that it will be informative, and with a little bit of luck, profitable.
To start with, I want to clarify what I mean by "the economy", which consists of various interconnected markets. Roughly speaking, there is a market for any good or service, which includes tangible commodities like rice and gold, as well as intangible financial assets like stocks and bonds.
The price in a given market is determined by the laws of supply and demand. In the long-run (>5 years), price movements are caused by changes to both supply, such as manufacturing improvements, and demand, such as an increased need for computers. These changes are slowly driven by human productivity and innovation.
However, in the short-run (0-5 years), productivity and innovation is roughly constant. What matters most in the short-run is the impact of credit (i.e. borrowing) on demand (i.e. spending). Credit is the reason why the economy moves in cycles. Ray Dalio summarizes this concept in his 30-minute video "How the Economic Machine Works".
Borrowing allows people to spend more than they earn, at the cost of spending less than what they earn at some point in the future. It's good when it helps increase your future productivity, such as getting a car loan so you can go to work. But it's bad when it finances unproductive spending and potentially disastrous when it finances a bubble (e.g. sub-prime mortgage crisis).
The cost of borrowing is called the interest rate, and it varies greatly based on the borrower and the purpose of the loan. However, all interest rates (for US dollar denominated debt) are tightly coupled to the federal funds rate set by the Fed; colloquially called "the" interest rate. The federal funds rate is adjusted eight times a year, with the expressed goal of stimulating the economy with low interest rates during recessions and cooling the economy with higher interest rates to combat inflation.
Ever since the Great Recession, we've been in an era of unprecedentedly low interest rates and quantitative easing (QE), which is the injection of money into the economy through the purchase of bonds by the Fed.
These two factors have several effects on investments
- a decrease in fixed-income yields (savings account interests, bond yields, etc)
- low mortgage rates lead to increased housing affordability and house prices
- an increase in stock market investments as a result of (1)
- an increase in riskier, "alternative" investments as a result of (1) and (3)
In other words, it doesn't pay to save and it pays to borrow. And since your spending is someone else's income, they end up with greater spending power, and the cycle becomes self-reinforcing. The demand curve is fueled by this low interest environment, prices soar, and we have inflation.
In any inflationary environment, you want to avoid holding cash. In today's environment, bond yields are pitifully low, due to being artificially suppressed by low interest rates and quantitative easing. While interest rates are finally rising again due to improved economic signals (CPI, unemployment, etc), they still have another year or so before returning to any semblance of historic normalcy. I expect stocks to continue to rise during this period and perhaps even a while longer, as people continue to pour money into them.
Now that I've laid out the overall US economic landscape, I think it's time for some words of caution related to point (4) above. Over the past few years, there's been a dramatic increase in riskier investments, which I believe has contributed to inflated asset prices. I see this in a few different areas
- Private equity
- Venture capital
- Cryptocurrency / ICOs
- "High yield" bonds
- Student debt
I am not calling the end to these "bubbles", since as is often the case, momentum can keep the party going long after the music stops. At the same time, I'm not sticking around for when the lights come on to be caught with my pants down. These risk factors, combined with historically high asset prices, lead me to believe that the easy money has been made and that uncertainty going forward is high. Avoid investing in times and areas when it doesn't pay to take on the risk.
In summary, the investment allocation I'm using right now is the following
- Leaving existing stock investments (~60% of investable capital, mostly in retirement accounts)
- Putting cash and future income into 1 month US treasury bills (~25% and growing)
- Betting on market melt-up while hedging against a melt-down using ETF call options (~10%)
- Betting against certain highly overvalued tech stocks using put options (~5%)