2 Major Investment Cycles Are Nearing Peaks, Here's How To Prepare (2024)

If you don't know where you are going, any road will get you there."

- Lewis Carroll

Unless you take a completely passive approachwith your investments, it's important to maintain a sense of direction.

The primary goal of tactical asset allocation is to stay on the right side of major market trends. That means diagnosingthemostprobablepath ahead, using a mix of empiricism and common sense.

The two biggest opportunities I see for U.S. investors over the next 5 years are: (i) protecting capital ahead of the next bear market, and (ii) subsequently overweighting international assets.

1. TheStock Market Cycle

Throughout history, thereare multi-year cycles in which stocks have seesawed between two basic environments:

• high return/low volatility
• low return/high volatility

The table below depicts these cycles, using the S&P 500 Index as a proxy.

You don't have to be a financial professionaltosee the recurring patternanddiagnose what type of regime likely comes next.At some point, probably not in the too distant future, we’re going to see a flip back to lower returns and higher volatility.

Hedge fund heavyweight, Ray Dalio, drove home this point last week in an interview with CNBC. He said the economic cycle is probably in the "seventh inning,"implying there is less remaining upside relative to downside risk.“Whatever your strategic risk is ... I’d be more defensive rather than more aggressive,” Dalio said.

When it comes to multi-year cycles, Dalio is one of the market's brightest minds.

I follow Hedgeye Research for quarter to quarter guidance.They maintainapredictive tracking algorithm which measures and maps the trajectory for growth and inflation.In recent years, they've been spot on.

Next quarter,Hedgeye iscalling for both growth and inflation to slow.They callthis macro setup "Quad 4."Historically, it'san environment which favors defensive plays (i.e. bondsand defensive sectors).

Things that normally don'tperform well in Quad 4? Pretty much everything that hasworked well over the last two years. Namely momentum, technology, and high-beta. These factors may see a bearish rotationinupcoming months.

Even if Dalio and Hedgeye's forecasts don't materialize right away, I'm perfectly comfortabletrimming risk.

For most people, money management is a long-term compounding game. Viewed through that prism, it's not how much you make during a bull market that counts,buthow much you keep and roll into the next cycle.The average bear market wipes out over halfof a prior bull market's gains.That makes preserving capitalparamount in a late-cycle environment.

2. The GlobalLeadership Cycle

Imagine being a Japanese investor with all your moneytied up in domestic stocks. That market peaked in 1989, and still has not recovered.This illustrates whyforeign diversification is important.

Canterbury Consulting advises institutions and high net worth investors on asset allocation. I recently caught up with MatthewLui, Canterbury's Global Equity Research Committee chair. He said,"Investors who ignore international stocks due to 'home country bias' are missing out on growth opportunities in other parts of the world."

Case in point:After adjusting for purchasing power parity, China became the world's largest economy in 2014.China is growing GDP four times faster than the U.S.

Nonetheless, theU.S. has significantly outperformed this cycle. This year is a continuation of that trend. The S&P 500 is up about 10%, whileforeign markets like the German DAX (-7%) and China's Shanghai Index (-22%) have faltered.

But if you're a long-term investor,Mr. Lui would recommend maintaining at least some foreign diversification. "IncludingbothU.S. and non-U.S. stocks can result in a smoother overall performance pattern," he says.

Here's atable that demonstrates why that's the case.Similar to howreturn and volatility regimes mean revert, so do globalleadership cycles.

No single region always outperforms.If that were the case, everyone would overweight the best market,andit would become prohibitively expensive.

So, it's not surprising thatdeveloped countries in the MSCI EAFE Index performed similar to the S&P 500from1970-2017. Within that long span, however, there have been multi-year periodsof high dispersion.

Since 2008, foreign stocks have lagged U.S. stocks. That'smade developed and emerging markets cheaper versus U.S. stocks, prompting many on Wall Street to recommend going overweight foreign stocks. So far,that recommendation has been early.

Investors oftenconfuse valuationasa catalyst. It's not. Foreign stocks will not lead just because they're cheaper than U.S. stocks.

The spark for a rotation is usually a mix of buyer/seller exhaustion, combined witha fundamental catalyst that reverses sentiment.Flows follow.

That's when valuation starts to matter. The cheaper an asset or market is at the turn, the longer its runway for potential excess return.

Studying the above table, there'sanother subtle pattern, which I think provides a valuable timing clue.That is: global leadershippivots occur during bear markets.

TheMSCI WorldIndex includes both U.S. and foreign markets. If you track that index's return history, you can see itwas engulfed in bear market drawdowns (declinesover 20%) during key years when global leadership cycles reversed, i.e. 1970, 1990, 2002 and 2008.

Europe and China's economiesbegan slowing early this year, and their markets have followed.

The U.S. economy is still riding high on fiscal stimulus. But as those effects fade, my guess is the U.S. will follow the trend taking shape in the rest of the world.

Will this be enough to push the MSCI World into a bear market? Hard to know.

But whenever that time arrives, chances are foreign markets will bottom first, because they're already further along in their economic downshifting.

However, I'mnot aggressively buying foreign stocks yet. Reason: sequencing matters.

For now, I'm still overweight theU.S.,because whentremors hit capital markets, the U.S. is normally a safe haven destination. I think tremors come first, thena big leadership rotation.Probably one of the bestchances to overweightforeign stocks I'll see in my career.