April 5, 2019 – We may soon know…

Following a rough fourth quarter of 2018, which included the worst December for the S&P 500 since 1931, market
participants seemingly regained their appetite for risk in the first three months of this year, with the S&P 500
recovering almost all of its lost ground by posting the best January since 1987 and the best first-quarter return
since 1998.

Interestingly, however, the appetite for safe haven investments like US Treasuries and gold that understandably
picked up in response to the fourth quarter market turmoil has not abated. In fact, when the two quarters are
viewed together, we can see that those safe havens have outperformed by a considerable margin. What could
this hesitance by investors to jump back into stocks with both feet be telling us about this relief rally? Is it time
to sound the “all clear” or is it possible that the first quarter’s tremendous stock market rally is just a head fake
within a bear market that began at last fall’s market peak? We may soon know.

In order to zero in on which is the most likely scenario, let’s revisit a few of the topics that we have touched on
in our recent letters: the US Federal Reserve’s monetary policy and the yield curve.

We opened last quarter’s letter with a warning that in the intervening time between the day the letter had been
written and the day that you were reading it the financial markets may have moved substantially in either
direction. That warning turned out to have been appropriate, as equity markets rallied swiftly off of their late-
December lows on expectations for progressively easier monetary policy from the Fed.

We would echo that same warning this quarter, as the domestic stock markets are just a few percent below their
52-week highs set last fall despite the United States’ unresolved trade dispute with China, continued frustrations
in Brexit negotiations, and an ongoing global economic slowdown that has yet to show signs of abating. If

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market participants catch a whiff of good news on any of these fronts and can successfully push the S&P 500
above it’s recent highs, it could be off to the races for at the least the next few months. If, however, good news
does not materialize and the market stumbles at or below that recent high it could be taken as confirmation that
what we have experienced since late December is indeed a bear market rally. In that case an eventual retest of
the December low or worse may be in the cards.

Whatever the stock market has done by the time you hold this letter in your hands and in the weeks to follow,
the incrementally released hard data regarding the current and expected health of the economy over the coming
12-24 months is likely to be the more important factor on which long-term investors should allocate their
portfolio. Markets will swing day-to-day on trade deal headlines or Fed commentary, but the hard data will tell
the tale of whether a near-term recession is in the cards.

We closed last quarter’s letter with a vote of confidence that for the first time in this now 10-year-old bull market
the Fed may not be immediately bowing to a market drawdown by reversing course on its intended
normalization of monetary policy. That hope faded quickly, as the following assessment of the FOMC’s late
January meeting, statement and press conference outlined. From Bloomberg.com:

Chairman Jerome Powel signaled that the Federal

Reserve won’t raise interest rates again until
inflation accelerates, in a dovish pivot that left many
investors betting against any further rate hikes this
economic expansion. Not only did central bankers
drop a reference to “further gradual increases” in
their statement on [January 30th], they implied the
next move could just as likely be down as up. They
also announced a more flexible approach to
shrinking their bond portfolio, another
acknowledgement of the recent market angst over
tighter monetary policy.”
Many described the Fed’s actions as a capitulation
to worried financial markets… It was a sharp
contrast with a much more hawkish Fed in
December.
-Bloomberg.com, January 31, 2019

As mentioned earlier, the stock market rallied on the prospect of a looser Fed, but bond markets also rallied.
Many commentators’ initial reaction to the Fed’s 180-degree policy pivot was to assume that once again the Fed
had kowtowed to the faltering stock market, or perhaps Jerome Powell had heeded the none-too-subtle
suggestions from the White House that policy was getting too tight, too quickly. It appears that the bond market
was instead interpreting the Fed’s pivot as a defensive reaction to a worsening economy.

In our April 2018 client letter entitled “What is the Yield Curve Telling Us? (archived at
www.UlmanFinancial.com) we reviewed the nature of the US Treasury yield curve and the signal that has been
historically sent to markets by a flattening and eventually inverted yield curve.

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 As can be seen in the chart to the left, with the Fed having raised rates
four times in 2018 (0.25% each time) and expectations for economic
growth domestically and globally waning, the yield curve has officially
inverted. What investors are tasked with determining now is what this
inversion will mean for the various assets in their portfolio and whether
it is time to start planning for the next recession.

The following succinct analysis of past yield curve inversions and the
subsequent equity market response was published by Liz Ann Sonders,
Chief Investment Strategist at Charles Schwab, on March 27, 2019:

Every recession since the mid-1960’s has been preceded by an inverted

yield curve, so it’s little wonder recession fears have elevated… [March
20th] brought the Federal Open Market Committee (FOMC) decision to
keep rate hikes on hold; with a definitive plan to halt the shrinking of the Federal Reserve’s balance sheet… but
weak US economic data also aided the inversion by contributing to the decline in longer-term Treasury yields…
From last year’s second quarter real gross domestic product (GDP) growth rate of more than 4%, we are now
looking at a fairly anemic growth rate expectation of 1.2%... Concurrently global growth has weakened; with
negative interest rate policies of the European Central Bank (ECB) and Bank of Japan (BOJ) also contributing
to the inversion of the US yield curve. This is because low (and/or negative) yields outside of the United States
make US Treasury bonds more attractive; and that buying pressure causes Treasury prices to rise and yields
to fall.
The relationship between yield curve inversions and the economy is well known. When shorter-term rates are
below longer-term rates (a normal curve), banks can lend profitably as they earn the spread by borrowing at the
short end and lending at the long end. But once the curve inverts, the absence of profitability leads to a
compression in lending; with the resultant tightening in credit conditions contributing to a recession…
There have been myriad analyses done on the history of yield curve inversions; with the data often expressed in
median or mean terms. Because of the wide dispersion in past experiences – both in terms of duration-to-
recession and stock market performance terms – I want to share details around each of the past seven inversions:
 [Since the mid-1960’s, the] average span between inversion and subsequent recessions has been 11 months,
with a range of five months (1973) to 16 months (2006-2007).
 The average return for the S&P 500 during the span from inversion to recession has been +2.8%, with a
range of -14.6% (2000-2001) to +16.5% (2006-2007).
 By looking only at the spans between inversions and recessions, it masks much of the equity market weakness
associates with the end of each of these cycles (see below).
 Maximum S&P 500 drawdowns [following cycle peak]
 -36.1% from November 1868 to May 1970
 -48.2% from January 1973 to October 1974
 -17.1% from February 1980 to March 1980
 -27.1% from November 1980 to August 1982
 -19.9% from July 1990 to October 1990
 -36.8% from March 2000 to September 2001
 -56.8% from October 2007 to March 2009

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The average of these seven post-expansion S&P 500 selloffs is -34.5%. That average-sized selloff would drop the
Dow Jones Industrial Average from its current level above 26,000 down to approximately 17,000, a level it first
reached in 2014. However, this expansion has been anything but average.

In just a few months the current economic expansion will have surpassed the booming 1990’s as the longest
post-WWII, but it has produced the weakest average annual real GDP growth of any in that post-war era (top
left chart below). Over the course of this longer than average expansion, equity valuations this cycle have been
pushed to among the highest in the past century, comparable to the massive 1999-2000 tech bubble and the pre-
Depression bubble that ended the roaring ‘20s.

As was the case at those prior peaks, the most historically predictive long-term equity valuation metrics are
suggesting that once this cycle finally ends it could be a decade or more before we recapture pre-recession highs.
Whether the absolute highs have already been set for this cycle or the markets have higher to run before rolling
over into the next bear market, prudence suggests it would be unwise to press your luck.

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It will only be with the benefit of hindsight that the Bureau of Economic Analysis will be able to declare when
this expansion will have officially ended, but weakening global economic data coupled with the numerous trade
and border disputes being waged suggests that now is the time for caution.

As we have since before the yield curve began to flatten in earnest one year ago, we recommend a strong
underweight to equities and an overweight to safe haven assets like US Treasuries and precious metals. We also
continue to recommend an increased cash position that can be deployed back into equity markets as they near
more favorable valuations. The time to resume a more traditional allocation to equities will come, but according
to all available historical data that time is not now.

Thank you for taking the time to read our thoughts. We would love the opportunity to hear your response;
please do not hesitate to call or email with any questions or concerns.

Sincerely,

Clay Ulman Jim Ulman

CBU@UlmanFinancial.com JWU@UlmanFinancial.com
410-557-7045 ext. 2 410-557-7045 ext.1

*The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure
performance of the broad domestic economy through changes in the aggregate market value of the 500 stocks representing
all major industries. The Dow Jones Industrial Average (Dow) is a price-weighted index of 30 significant stocks traded on
the New York Stock Exchange and the Nasdaq. Indices such as the S&P 500 Index and the Dow Jones Industrial Index are
unmanaged, and investors are not able to invest directly into any index. Past performance is no guarantee of future results.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or
recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial
advisor prior to investing. The economic forecasts set forth in the presentation may not develop as predicted and there can
be no guarantee that strategies promoted will be successful.

All indices are unmanaged and cannot be invested into directly.

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