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December 21st , 2018

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Our entire process and framework is driven by the belief that investors should position portfolios in harmony with where we are in the business cycle. The issue is that determining where we presently exist within the business cycle is a difficult undertaking. Hindsight bias would have us believe it is easier to identify than it truly is. The definition of hindsight bias, according to Investopedia, is as follows:

“Hindsight bias is a psychological phenomenon in which past events seem to be more prominent than they appeared while they were occurring. Hindsight bias can lead an individual to believe that an

event was more predictable than it actually was, and can result in an oversimplification in cause and effect. Hindsight bias is studied in behavioral economics.”

Essentially it is easier to recognize what stage of the business cycle we were in by looking into the past. Identifying the current stage can be somewhat subjective and uncertain. As we learned last week, dealing with uncertainty takes discipline and probabilistic thinking. That is why our framework uses four components that have empirically done a reasonable job of signaling the various stages in the business cycle.

Valuations compare the intrinsic value of an asset to the current value of the asset. We find historically that markets tend to be valued well below intrinsic value during early cycle environments, often signaling high future returns. On the contrary, market valuations can get rather stretched to the upside relative to fair value during the latter part of the cycle, where future returns will most likely be lower. Valuations pick up on the psychology of market participants in that it gives us a good look at current investor sentiment. When valuations are high, market participants are typically extremely optimistic, and when valuations are low they tend to be pessimistic.

Economic growth trends also shift relative to where we are in the cycle. During early business cycle environments, we find that growth often rises after being depressed during a contraction. At the end of a cycle, we tend to observe growth falling after a sustained acceleration. The direction of growth and inflation (acceleration and deceleration) are coincident with the business cycle and often dictate the Federal Reserve's policy response.

© 2018 WealthShield LLC. All Rights Reserved. This is provided for informational purposes only and should not be considered a recommendation to buy or sell a particular security. Past performance is no guarantee of future returns. Please see attached disclosures.

https://www.investopedia.com/terms/h/hindsight-bias.asphttps://www.investopedia.com/terms/b/behavioraleconomics.asp

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Monetary policy directly affects the business cycle and can often be a catalyst for a

regime shift. For instance, after growth and inflation start to accelerate together, the

Fed will often respond by tightening policy. Eventually, tightening policy can cause an

economic growth slowdown. On the other hand, when economic growth is declining

and the Fed acts to ease policy, this can often be an early catalyst that spurs growth

and inflation.

Intermarket trends, such as the spread between high yield bonds and intermediate

term Treasuries, can often signal changes in the business cycle. The reason is that

intermarket relationships, at least by our estimation, do a good job of accounting for

changes in the psychology of market participants. For instance, during the later part

of an economic contraction, spreads are often extremely wide (suggesting credit

tightness and pessimism). When spreads start to tighten from being wide, this can

often be a signal of an early business cycle environment as psychology shifts to

support risk taking. On the flipside, when spreads are extremely tight and start to

widen, this can signal a late business cycle environment.

As Howard Marks stated in his book, Mastering the Market Cycle: Getting the Odds on

Your Side,

When there are indications that we are in the early stages of a business cycle

environment, we should be aggressive. In a late cycle environment, it would be prudent

to be defensive. Our whitepaper, Can You Time Alternative Investments, illustrates this

concept with a simple rules based process. We organized assets into return

enhancement strategies and risk mitigation strategies and then used one component of

our business cycle framework, credit spreads, to determine the switch between the

two. The idea is that positioning offensively or defensively according to the market

environment could have merit.

© 2018 WealthShield LLC. All Rights Reserved. This is provided for informational purposes only and should not be considered a recommendation to buy or sell a particular security. Past performance is no guarantee of future returns. Please see attached disclosures.

https://www.google.com/url?q=https://www.amazon.com/Mastering-Market-Cycle-Getting-Odds/dp/1328479250&sa=D&ust=1545406664340000&usg=AFQjCNHIdIgbP0kg434Gbp1IVux5AZytmA/Users/cmleggett/Desktop/WealthShield/WealthShield%20Whitepapers/Can%20You%20Time%20Alternative%20Investments?.pdf

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Market cycles can often take the most astute and logical investors by surprise. The reason is that

swings in emotion can strongly influence the cycle. Here is Howard Mark’s take:

Emotion is the most important aspect to attempt to ascertain when determining where we are in

the business cycle (shifts in emotion, in particular). Valuations can tell us how euphoric or

pessimistic investors may be, but the level of joy or despair can persist longer than we would care

to endure. Identifying when market participants are rotating from euphoric to pessimistic and the

movement along that spectrum is ideal.

There is a continuum of sorts in that there is no start or end to the cycle. Marks says that,

As investors move to extreme optimism, they are more likely to be disappointed, and that

disappointment can have a disproportionate effect on perception. The same is true for extreme

pessimism: investors can be more prone to positive surprises when in the depths of despair.

What we are witnessing today, according to our framework, is a regime shift in the business

cycle. We are coming from an environment where market participants have been extremely

optimistic, and now negative market trends, declining growth and inflation, tight monetary policy,

and high valuations are signaling future disappointment. The market reaction to this shift has

created a negative feedback loop whereby negative market news creates further disappointment

which creates further losses in the markets.

According to our framework, we believe we are still in a late business cycle environment, where

market psychology could move to extreme pessimism before signaling the start of the next

cycle. Anything can happen and we hope this is short-lived, but for right now we believe

defensiveness is appropriate.

© 2018 WealthShield LLC. All Rights Reserved. This is provided for informational purposes only and should not be considered a recommendation to buy or sell a particular security. Past performance is no guarantee of future returns. Please see attached disclosures.

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Past performance is no guarantee of future returns. This is WealthShield’s current assessment of the market and may be changed without notice. The visuals shown are for illustrative purposes only and do not guarantee success or certain level of performance. This material contains projections, forecasts, estimates, beliefs and similar information (“forward looking information”). Forward looking information is subject to inherent uncertainties and qualifications and is based on numerous assumptions, in each case whether or not identified herein.

This information may be taken, in part, from external sources. We believe these external sources to be reliable, but no warranty is made as to accuracy. This material is not financial advice or an offer to sell any product. There is no guarantee of the future performance of any WealthShield portfolio. The investment strategies discussed may not be suitable for all investors. Before investing, consider your investment objectives and WealthShield's charges and expenses. All investment strategies have the potential for profit or loss.

Benchmarks: The index / indices used by WealthShield have not been selected to represent an appropriate benchmark to compare an investor’s performance, but rather are disclosed for informational purposes. Detailed information regarding the indices is available upon request. The volatility of the indices may be materially different than that of the portfolio.

WealthShield is a registered investment adviser. Registration does not imply a certain level of skill or training. More information about WealthShield including its advisory services and fee schedule can be found in Form ADV Part 2 which is available upon request.

Sources:

Marks, Howard S. Mastering the Market Cycle Getting the Odds on Your Side. Houghton Mifflin Harcourt, 2018.

© 2018 WealthShield LLC. All Rights Reserved. This is provided for informational purposes only and should not be considered a recommendation to buy or sell a particular security. Past performance is no guarantee of future returns. Pleasesee attached disclosures.