The current economic expansion entered its 11th year in July (the longest in recorded history) and there are currently enough early warning indicators of recession to justify a quick look at what that means for markets and your portfolio. What is a recession and why do they happen?

After the brutal flogging the market took late last year, few expected such a strong start to 2019, with world equity returns registering one of the best first halves in more than 20 years. Also notable, however, was the backdrop of deteriorating economic growth and softening earnings data during the period.

As we discussed in our last letter, the sudden plunge in equity markets in Q4 seemed to be at odds with the solid economic fundamentals in the US at the time. Since then, the soft patch in data we witnessed in January and February – data that seemed to confirm the recessionista’s worst fears - has turned out to be a passing phenomenon, largely attributable to severe winter weather and the prolonged government shutdown. The soft data have been replaced by robust economic numbers in retail sales, employment, industrial production, and wage growth, while inflation remains tame.

When the market plunges, investors immediately begin searching for a new narrative to replace the old one. In Q4, the narrative of solid economic growth and earnings, low inflation, a robust job market and improving wages quickly gave way to one of too much Fed tightening, slowing global growth, escalating trade frictions with China, a strong dollar, stretched valuations and an impending recession. All off this in the course of less than one week. This sudden change in storyline belies the fact that large, open economies – unlike financial markets - simply don’t roll over that quickly.

•Volatility in early October is more likely the result of high valuations and tightening financial conditions, not necessarily a flattening yield curve •Trade tensions with China are compounding valuation anxiety

The spat between the US and Turkey is currently roiling various markets, with the greatest impact being felt by other emerging market economies. While there are fundamental reasons to be

If you’re wondering what is driving markets right now you’re not alone. 2018 has been characterized by a lot of noise and the pace of today’s news cycle makes it seemingly impossible for markets to fully digest current events before new ones crowd out yesterday’s news.

Strong wage growth in January ignited inflation concerns and sent equity markets tumbling   Talk of tariffs and trade barriers in March further dented already fragile investor sentiment   The

2017 was a good year for markets, almost too good in fact.  For the first time in history, the S&P 500 Index had no negative months during the calendar year.

Equity-market volatility hit an all-time low in Q3 Low volatility and strong equity markets were likely the result of improved economic fundamentals during the period On the other hand, policy

Trump’s agenda of regulatory rollback, infrastructure spending and tax cuts is all but stuck in Washington’s ideologically fractured environment. Strong earnings made up for stalled policy and a lack of

The so-called “Trump Trade” began to lose steam toward the end of Q1 as it became clear that single-party control in Washington wouldn’t necessarily translate into quick results Events abroad

Markets had a hard reset in Q4 with the election of Donald Trump on November 8th. Initially global equity markets plunged, but within hours began to recover and rallied strongly throughout the quarter, mostly on speculation that the new president would usher in tax cuts, deregulation and a sweeping fiscal spending program.

In the wake of “Brexit,” central banks reasserted themselves over markets in a big way in Q3, sending bond yields to historic lows. The recent wave of populism in the developed world is targeting institutions that have been supportive of capital markets for the better part of 70 years. To the extent these political movements prevail, they would likely carry negative economic consequences.

Events in Q1 took the Fed off message and “Brexit” further complicated its story Given the limited set of policy tools, the Fed seems to want to play it safe and is reluctant to raise rates until it has strong evidence of inflationary pressures

The smooth December lift-off in rates was derailed in January by a rolling set of concerns that culminated in markets pricing in (at least for now) a more gradual pace of interest rate tightening than previously expected.

The Central Bank divergence story – the idea that instability in capital markets would be driven by diverging monetary policy among the world’s largest economies - is alive and well but evolving, with more pain in store for interest-rate sensitive investments

As of this writing, the S&P 500 has gone 1,302 days without a correction of 10% or greater, the second longest run since World War II. As far as the untrained eye can see, risk appears to have disappeared from markets.

Larry Cao, of the CFA Institute, writes that risk factor diversification - like that used at Rain Capital - is one of the most important advances in portfolio construction techniques in recent decades and is increasingly used by sophisticated institutional investors.

The inflation conundrum dogging the US economy right now has a lot of observers scratching their heads. The economy clocked 5% real GDP growth in Q3:2014 and an estimated 2.6% in Q4. Unemployment at 5.6% is at levels that have historically begun to generate wage inflation, but there is little to speak of. Explanations range from labor market slack to deflationary pressures from abroad, but economists at the Fed are pointing markets to a simpler answer: zero interest rate policy.

Regulators are (correctly in our opinion) focusing a great deal of attention on the very different legal and ethical standards that brokers and Registered Investment Advisors (RIAs) are held to. The SEC’s concern stems from the fact that investors generally aren’t aware of the meaningful differences and their legal implications. Barry Ritholtz does a nice job summarizing these differences in a recent Washington Post column.

The market isn’t hearing the Fed’s increasingly hawkish message, according to researchers at the Federal Reserve Bank of San Francisco. The take away? The authors reiterate Chairwoman Yellen’s words from earlier this year “. . .investors may underappreciate the potential for losses and volatility going forward.”

A flurry of communication has come out of the Fed in recent days – from hawks and doves alike - all focused on the need to change forward guidance on interest rates.

Federal Reserve officials have very nearly written our letter for us this quarter. Earlier this year we worried economic data were increasingly at odds with the Fed’s policy stance, a conflict that would eventually result in a sharp change in tone from the central bank.

A new interest rate cycle is upon us. The Fed has said – and the market is largely in agreement - that within a year short-term interest rates are likely to rise. We have already spent considerable effort purging interest rate risk from portfolios.

Fed Chairwoman Janet Yellen joked in her speech today at the Economic Club of New York, “if the economy obediently followed our forecasts, the job of central bankers would be a lot easier and their speeches would be a lot shorter.”

One perplexed Fed watcher recently observed that “Fed policy. . .is maddeningly disconnected from their [sic] forecasts.” After all, how can the Fed legitimately be concerned about unemployment and low inflation while simultaneously winding down bond purchases?

We have expressed concern for some time that markets have been too sanguine about the eventual ‘lift off’ from zero rates, ignoring a recurring Fed narrative that has attempted to guide toward an earlier exit should economic progress (as narrowly defined by the unemployment rate and inflation) justify it.

Unemployment and inflation generally work against each other. The Fed was counting on that relationship holding up when it established a dual threshold based on those indicators in late 2012. The idea was that as the two converged (or diverged), markets would better understand the future direction of monetary policy and adjust accordingly.

At Rain we talk a lot about what we call ‘information days,’ brief periods of time that are extremely rich with information. We find that evaluating narrow time periods of isolated stress (or euphoria) can be just as informative about manager positioning and underlying risks as longer-term statistics, if not more.

From a diversification standpoint, understanding how a hypothetical pair walking down the middle of a street together might be related (or integrated) is enormous; is it a man and his dog tethered by a leash, a husband and wife, two neighbors going to the same yard sale around the corner, or complete strangers?

After evaluating a great deal of data, a statistician finds that as ice cream sales increase, the rate of drowning deaths increases sharply. Based on this strong correlation, the scientist concludes ice cream consumption causes drowning.

As the data tells us today, interest rate risk has bled across asset classes in a way that resembles how credit began to dominate asset prices in 2007.  The biggest

The first half of 2013 was a startling reminder of how poorly traditional asset allocation diversifies actual investment risk. For most, it proved to be an extremely difficult period to make money using the traditional approach because a single risk factor – interest rates – largely drove returns across asset classes.

A quick look at the July employment report seems to reinforce the importance of participation rates in the path to the 6.5% unemployment threshold Fed Chairman Bernanke laid out last December. As we’ve speculated, meager gains in employment can have a material impact on the unemployment rate because so many people are leaving the workforce due to demographic changes.

Those of you who have followed our thoughts about evolving Federal Reserve policy here and here and here will appreciate a forthcoming paper by economists at the Federal Reserve Bank of Chicago which concludes that changing demographics have dramatically lowered the number of jobs it will take to impact the unemployment rate in the future.

There may be more to unemployment numbers than meets the eye. Conventional wisdom has it that as the economy rebounds and jobs are created, people begin to reenter the labor force, making the unemployment rate a particularly stubborn number on the way down.

The job of the Federal Reserve is ‘to take away the punch bowl just as the party gets going’ as one Fed Chairman once said. Typically the process has started with a hike in short-term interest rates, a step toward the exit with the punch bowl in hand indicating the economic party was getting raucous.

As part of what one of our managers described as “a bull market in fear,” 2012 was a year in which central banks around the world ganged up against savers and forced them to choose between monetary debasement and navigating a minefield trying to escape it.

We believe many of the uncertainties that clouded the horizon in 2012 are slowly being resolved or constructively contained. In fact, we also see domestic economic strength that would indicate an earlier hike in interest rates than is currently priced into the market.

Investors can often mistake the asset diversity in their portfolios for adequate risk diversification. Author Jason Hsu, of Research Affiliates, argues many investors who are diversified around investment products may be poorly diversified by risks.

It’s been said physics explains 99% of the world with three laws, while economics explains 3% of the world with 99 laws. We found the data in the table interesting for a number of reasons, but namely for the fact that it would be nearly impossible for a trained economist to make sense of the past five or so years given these snapshots in time.

The professional investor who is benchmark agnostic, who doesn’t seek to eke out every penny of return at the expense of risk, who focuses on downside protection, and who is not handcuffed by a certain business model – be it active, passive or otherwise – has better odds of controlling for volatility.

Of all the experts that we would expect to undermine the basis of passive (index) investing, Standard and Poor’s, the creator of the widely-followed S&P 500 Index, was not high on our list. However, in a recent piece The Low-Volatility Effect: A Comprehensive Look, the company inadvertently does just that.

Indexing has always been peddled as a cheap, tax-efficient and safe way to get market returns. While it is unquestionably the cheapest and among the most tax-efficient ways to invest, safe it is not, the research shows.

Because of their formulaic nature, many indexes are prone to distortions over time (as we saw in the late 90’s, valuations on tech stocks drove up their market capitalizations and caused the tech weighting of the Russell 1000 Growth Index to hit 50% by 2000. Again in 2007, high flying financials rose to 36% of the Russell 1000 Value Index the year before delivering crushing losses).

We seem to live in a world where the markets believe bad news is good news. The worse things get, the more excited markets become about yet another round of stimulus by the Federal Reserve. Whether it’s uncertainty around Greek elections or weak economic data, markets have supreme confidence in the willingness of the Fed to support financial markets during economic weakness.

During market turmoil, traditional portfolios often decline more than investors expect, due to different, seemingly unrelated, asset classes moving in unison. As Ben Levisohn and Joe Light of the Wall Street Journal write, traditional asset allocation fails to achieve stable and robust diversification.

Today, the Fed has engineered a situation in which the really unattractive asset classes are the ones we have always thought of as low risk: government bonds and cash. And unlike the internet and housing bubbles, this time it isn’t a quasi-inadvertent side effect of Fed policies, but a basic aim of them.

Our goal is to grow your wealth with the most robust and stable diversification possible. Risk limits, stress testing and so on may be very useful tools, but can’t overcome fundamentally flawed portfolio construction any more than a seatbelt can solve the problems inherent in reckless driving.