Happy Spring! I have to admit, this is definitely my favorite time of year. I no longer have to endure the risk of concussions/broken limbs due to ice while on my stress-reducing, doctor-mandated walks. The weather is near perfect, and the humidity is still months away. The NBA and NHL playoffs are in full force, and a brand-new baseball season has begun. Life is good…
I wake up just about every morning with these sentiments. Then, I arrive at my office and turn on the TVs. Unfortunately, my job requires as much. I witness what may very well be the beginning of World War III. Inflation has gone truly out of control. The country is as divided as it has ever been – something I didn’t think possible after the last two years. Financial markets have been absolutely brutal to begin the year, understandably in light of all of the above.
I’m guessing that many of you reading this experience much of the same see-sawing of emotions. If so, remember – you pay us to consume all of this news for you, at least in terms of how it affects your money. Please, do us a favor, and consider turning your TVs off. At the very least, keep the TVs off until the Red Sox or Celtics games start that day…
Many of you may not even be aware of just how brutal financial markets have been to begin this year. As of this writing (4/15/22), the S&P 500 is down nearly 8% YTD (per CNBC). That’s not fun, but I wouldn’t call it brutal, as stocks experience drawdowns such as this quite regularly. What has been breathtaking is the carnage in bonds – which are traditionally considered the “conservative” part of one’s portfolio. As interest rates have risen in the first quarter, investors using bonds in an effort to avoid the volatility of stocks have found themselves - in some cases - with even bigger losses than equity investors. I won’t quote any specific funds in order to get this swiftly through compliance, but pick your favorite bond fund and look at YTD performance for confirmation of this statement.
Add in the lack of interest rates on cash holdings, and you will understand our description of these markets so far this year. There have been few places to hide, and it has caught a lot of investors offside – pondering whether or not the oft-used “60/40” (60% stocks/40% bonds) portfolios still offer the risk/return profiles they had assumed. Never mind the “target date” funds found littering virtually all 401k accounts. Imagine preparing for retirement next year, and responsibly (according to HR reps) having your entire 401k nest egg in a “Target Date 2023” fund – then seeing that fund down 7% or more in just the first quarter of this year.
We bring this up not as a “told you so” exercise. Believe me when I say we know that all of this could reverse course tomorrow, though we find it unlikely for reasons we will describe in a moment. The point of bringing this up here is that we are constantly harping on the importance of risk management, and truly understanding not only the potential risk that you are assuming with your chosen investments – but also the amount of risk you can truly afford, be it mathematically or psychologically. The 3+ months we all just experienced have been a rather striking reminder of such.
Thankfully, as I mentioned previously, I’m guessing many of you reading this might not even be aware that this has been happening. There have been pockets – though few and far between - of opportunity that have not only been sheltered from much of this turmoil, but actually have performed quite well. Generally speaking, commodities – including that rascal gold (as an asset class), of which I described in our last update as possibly being “the death of me” – have shined (catchy, right?) so far this year. Additionally, managers employing long/short or market neutral strategies have also held up relatively well in many cases – in some cases even providing meaningful gains.
We are happy to report that our exposure to these asset classes – along with our decision to minimize duration (interest rate risk) coming into the year – has allowed us to weather this storm thus far. In fact - when we look back at our internal “best/worst/expected case” scenarios we constructed heading into the year – the actual results have been better than even our best-case projections in many cases. A very important note on this to follow later in this update.
Which leads us to what we are most closely looking at right now. We came into this year describing the environment as one with “maximum uncertainty”. That description certainly has not changed. If anything, we were wrong on the “maximum” part of the description, as things have seemingly become even more uncertain. Let me describe what we mean by “maximum uncertainty”. In short, it means an environment where it is very difficult - in fact foolish in our view - to have high conviction on any one particular outcome, especially with a shorter-term view.
At the same time, we have much higher convictions on what I will describe as the “sequence of outcomes”. In other words, that “b will lead to c, while y will lead to z”. Unfortunately, and not unexpectedly, it’s the “b and y” above that are so difficult to see clearly, and what we spend most of our energies in the office these days analyzing. For your benefit/entertainment, it is also what we will spend the remainder of this update sharing with you…
Let’s get one thing out of the way first. Understandably, the majority of the news cycle these days – including the financial media – focus most of their attention on the Russia/Ukraine conflict. While our hearts certainly go out to the millions of people affected, we disagree that this should be the focal point of the investment narrative at home. For one, it is our belief that most of the global, supply-related effects are now priced in – or at the very least well into the process of doing so. Next, we don’t expect any of this to end anytime soon. When you combine those two assessments, it makes us want to focus on more important matters going forward, and as it pertains to your money. Oversimplified yes - yet still relevant in our view.
That said, there are two outcomes that could prove us wrong on this front. The first would be escalation into full-blown (and apparent to all) WW III. Obviously, if that were to occur, it would leapfrog to the top of our list of concerns. The second outcome would be a truly global peace agreement – one where not only the fighting stopped, but the entire world then welcomed Russia back with open arms. If that were to happen, we would expect a short-term, rip-your-face-off rally in stocks. At the same time, we would expect a similarly aggressive (and short-term) move lower in oil and commodities in general. Fortunately, or not – depending on which scenario we are referring to – we find the likelihood of either miniscule. At least anytime soon. As such, we are moving on to what we view as more important, short-term questions to be answered.
Probably better to remove the plural and simply say “question” to be answered. Yes, this is the moment you’ve all been waiting for. It’s time for us to discuss…
Jerome Powell and The Federal Reserve.
Patting ourselves on the back for the moment, our analysis of the Fed over the past 12 months has been spot on. It is now clear and almost undeniable that the Fed only cares about stable money and inflation (you know, their job description) over stock market returns when the politicians tell them to care. There simply is no other explanation for inflation to be as out-of-control as it is, with the Fed Funds rate still only targeting 0.25-0.50% as of this writing. Let that sink in the next time you go to the grocery store. If you are not pissed off, you should be. And if you disagree with that statement, then I need to hire you as my therapist…
(By the way, your Grandma may have told you “not to pat yourself on the back too hard, else you might hurt your back”. But my Grandma told me to “pat yourself on the back, because no one else will”. So there….)
Digressing. The question of the day, of the month, of the year, and maybe of the decade:
Will the Fed follow through on the 6-8 interest rate hikes – along with reduction of their balance sheet (selling bonds) - that the market is now pricing in? Or, will they instead find a reason to once again reverse course – and decide to protect financial markets above all else?
That’s it. That’s the question.
If they do follow through with their newfound acceptance of higher rates, things could get outright nasty. We have already beat this horse to death in previous updates – feel free to pull them up on the website for a refresher – so we won’t go into a ton of specifics. But let’s just say today’s valuations are not built to withstand a significant and sustained rise in interest rates. And the valuations to which we refer not only apply to stocks these days – they apply to near everything. We’ve already witnessed what can happen to bonds from these levels in a rising rate environment. Then, there is real estate. I’ve been fortunate (or unfortunate, depending on one’s perspective) enough in the past 6 months to acquire some first-hand knowledge of what is going on with house prices these days – reasons for which I will explain at the end of this update. But let’s just say that when the fed-facilitated cash buyers dry up – and mortgage rates have near doubled – it doesn’t exactly bode well for one of the single most important sectors of our economy. To be sure, there is a lot of building going on right now in reaction to the current state of housing. And the prices? Good. Lord.
But what if the Fed doesn’t follow through on raising rates as aggressively as most now (somewhat comically) assume? This should be everyone’s base case, after some 35 years of watching as much. It certainly is ours. Yet, as we spent the bulk of our time discussing in the outlook for this year – the present circumstances are ones the Fed has not had to grapple with in years past. Not only is inflation out of control, but they have also completely lost control of the narrative. There is simply no one still breathing who is not witnessing - and suffering from - the effects of today’s inflation. As we will discuss momentarily, it is the narrative that we should be focused on…
Still, let’s just assume for now that the Fed finds a way to slow their roll on raising rates. It is this scenario that has been the primary driver of “asset prices go boom” over the past decade…or three. It might be the case this time around as well. But, what will then happen with inflation? Will it continue to march higher in the face of a more dovish Fed – and if so – how long can the consumer keep up? Our guess is not long. Even if the Fed is lucky – and inflation subsides without them having to follow through on rates (a huge “if”) – remember, they measure inflation year over year. So, “inflation subsiding” does not mean that the price of your groceries or water tank go back to “where they started”. It simply means that the new, much higher prices are not going even higher from here. Can the consumer – or house-buyer, or manufacturer, etc – handle even the current price levels without changing behavior in a way that would negatively impact the economy? Our guess, again, is that they cannot. But we must at least acknowledge that the Fed reversing current course could be a boon to asset prices once again – at least in the short term. So, we are watching it ever so closely, and will react accordingly.
One then might ask, what exactly will we be looking for? The answer is quite simple:
Narrative. Then narrative. And from there, the narrative….
Everything in our world today boils down to controlling the narrative. While I will not (for self-preservation purposes) delve into the dangers to society overall that have evolved from our media no longer being “free and honest” – and therefore at risk/willing to be pawns toward this end - it is important to note that the Fed and the politicians who appoint them understand this game fully. Right now, the Fed is looking for any news on inflation that will allow them to back-off of their newfound religion for higher rates and less accommodative monetary policy. I mean any news. Once again, as discussed previously, it is now clear as day to us that the Fed does in fact fully understand that the economy and markets are a “house of cards, built on maintaining artificially low borrowing costs (interest rates)”. Unfortunately for them, at the same time, the politicians are none too happy with having to deal with this very real inflation problem – so something has to give.
Here is how we see it playing out:
In the coming months, the Fed will be looking for any sign at all (manipulated or otherwise) that prices are beginning to stagnate. If markets continue trending lower, they will begin looking for this sign a whole lot harder and a whole lot faster. This will most likely come in the form of year-over-year CPI measurements as described previously. I mean, prices can’t continue to rise at this pace forever. Once they have their chosen data points, they will force-feed the media the message that “inflation is under control”. The media, dutifully, will hammer that new narrative into our heads on a daily basis. Remember, they will leave out the part that the already inflated prices aren’t going anywhere. Yes, while you continue to stare at your grocery bill in disbelief, the media will then be telling you that “inflation is under control” per the politicians who control them.
At that point, J-Pow and his minions will make the media and political rounds, saying things such as “…we may now not have to be as aggressive with rates as initially assumed.” If they want to be really bold (meaning they are really scared about the state of markets and the economy), they might even throw in the “…we are most worried about the risk of deflation.” Remember, this was the language being used only 12 months ago when they told you that creating inflation was their new goal. Mission accomplished – well done J-Pow!! Now, about that transitory part…
So, this is the “big unknown” that we currently spend our days pondering. Oversimplifying once again, if it becomes more and more clear that the Fed is unable to gain control of the inflation narrative (not inflation itself) – we in turn will remain focused on carefully monitoring “risk exposure”, with the assumption that the Fed will in fact have to follow through on rate hikes. Stock positions – along with longer-dated and lower quality fixed income positions – would be the least attractive in our view. At the same time, we would continue to view gold – along with market neutral and long/short strategies – more favorably, but certainly not without risk. Broad based commodities are in “no man’s land” in this scenario, as they can continue to work in a “stagflation” environment – but will almost certainly not be one’s friend once the inflation part of “stagflation” finally runs its course.
If you find yourself thinking, “wait a minute, you basically just said everything is at risk if the Fed keeps on hiking” – unfortunately, you got the point. There is a lot of risk in the system right now. I’m not doing the Jeremy Grantham thing here, and telling you with certainty that the “mother of all crashes” is coming. Instead, we are choosing to focus on what we believe to be facts – rather than opinion – and unfortunately, acknowledging the reality of it all. Importantly, however, all of this “risk” does not necessarily have to materialize into something catastrophic. In other words - while we certainly agree with Mr. Grantham’s analysis and sentiments – we also acknowledge that it is foolish to predict anything with certainty, and make huge “bets” toward that end.
All of that said, remember our prognostication from previous updates – “inflation, leading to significant deflation” (in asset prices). In our view, the current environment is ripe for just this outcome – the economy (and asset prices) finally “break” under the weight of inflation and removal of Fed stimulus. Put another way, the Fed is forced to raise rates until “something breaks”.
However, if we are right, and the Fed manufactures a way to change the narrative away from inflation this summer – this will be a different conversation. Kind of. If it becomes clear that the Fed has once again shifted gears – as they have done without fail for some 30 years – we then must acknowledge the possibility of yet another manufactured, “crack-up boom” in asset prices. At the same time, valuations remain stretched – and reversing course too early might unintentionally (or intentionally) cause inflation to truly spiral out of control, putting us right back to where we have been for the past 6 months or so.
The reality of the situation is this, at the risk of broken record syndrome:
The Fed could have (and should have) prevented this countless times over the past decade plus. Quantitative easing should have been “temporary” as initially promised. Rates should have been hiked many times after the banks were bailed out following the Great Recession – also as promised. It wasn’t temporary, and rates are still near zero. So here we are…
On that inspiring note, an important reminder that we remain confident in our ability – and relentless in our efforts – to navigate said chaos on your behalf. Speaking of which, I promised earlier to revisit something important in regard to your investment experience with us so far this year. “That something” is this:
Unfortunately, we still don’t have a crystal ball. And we never will.
The reason I mentioned earlier that our allocations have held up even better than we could have expected was not to congratulate ourselves. In fact, just the opposite - it was to remind everyone to keep realistic expectations. What has been working well for the past several months can – and likely will – reverse course. Especially in short-term spurts. No, not likely – it will definitely occur in spurts. It always does. Please read these updates. Please call or email with questions. Please remember why you are investing in the first place. That is, investing in an effort to achieve your long-term goals. With that in mind, and in an investment environment this chaotic – with “maximum uncertainty” – carefully mind your risk exposure. Don’t make big bets on any one outcome. And never let short-term outcomes – positive or negative – affect your long-term thinking…
Wrapping this update up on a personal note. I mentioned earlier my “first-hand” experience of what is currently going on with housing. I will preface by saying I have never, ever (including 2007-2008) seen anything like what is going on right now. In many areas, house prices have risen 50% or more in the last one or two years alone! I assure you – even though good ole Ben Bernanke told us otherwise a decade ago – this ain’t normal folks. And with mortgage rates near doubling over this same time period, I have absolutely no idea how anyone expects this to end well. It truly is breathtaking, and honestly quite frightening.
I know I have already spoken with some of you about this – in various stages – over the past 6-8 months, but wanted to share an update with everyone at the same time now. For personal reasons (kids), our family has decided to explore moving out of Illinois. It has been a long (you have no idea) and insanely complicated (you have even less idea) process. We began looking in Tennessee last summer – and upon seeing the prices outside of Nashville – immediately moved on to explore parts of Ohio, Indiana, Oklahoma, Wisconsin, Florida, Texas, Massachusetts, New Hampshire, North Carolina, South Carolina, Maine, Alabama and Mississippi. Though much of the “exploring” has been done via the internet and from our couch, it still has been educational to say the least…
All of that said - and because of the real estate environment as discussed – while we have decided that moving is in fact in the best interest of our kids, the reality of said move remains uncertain. It is truly a 50/50 proposition at this point – but we have narrowed the spot down to either Spanish Fort/Daphne/Fairhope in Alabama or Ocean Springs in Mississippi. While I will not go into any greater specifics as to the reasoning behind our decision on here – I am more than happy to discuss with anyone in greater detail individually should you be interested. Just be prepared for an anxiety and stress-provoked earful before you make that decision! Of course, I will proactively communicate with everyone if/when we know for certain that it is happening…even if you’re not overly interested.
Anyway, I am closing with this for two reasons. One, some of you have been graciously asking for updates – and I haven’t obliged due to the continued uncertainty. More importantly, for the majority of you hearing about this for the first time, is to reiterate that absolutely nothing changes from a business standpoint.
Most of you have been with me for a long time now, and (hopefully) know – without me having to say it – that I am very “old-school” in my views on life. As such, responsibility, loyalty and priorities are very near and dear to my heart. So, please believe me when I say that I would never do anything that would cause me to intentionally violate those principals when it comes to our clients – who have always demonstrated those same qualities toward myself and my family. Please excuse the sappy sentiments – it’s just something I need all of you to hear…
Back to it. IF my family does end up moving - the business and office stay here. Dave and Gary are still here. I will still be here, regularly visiting - and certainly anytime you need to meet with me in person. Our annual reviews – which most of you have preferred over the phone anyway - will still be here (for those that prefer it). Events will continue as normal, and I will be here.
As I’ve said to those with whom I’ve discussed this possibility, “if I didn’t tell you, you would never even know that we moved…”. I told Lauren from the moment we first discussed – it was a non-starter if I didn’t know that statement to be true. I’m a planner and control-freak by nature, and a planner for the worst-case to boot – so I’ve studied this from every possible angle. I still can’t come up with a single scenario where this would not be the case. Finally, locking down for 6+ months during Covid – where none of us were in the office, seamlessly working through of one of the most chaotic market environments of our careers – gave us final peace of mind that this would most certainly be the case.
So, after more thought, reflection, and stress than I can possibly express in the two paragraphs above, Lauren and I have decided that this is what is ultimately best for Reagan and Logan. But for now, we wait, and let it sort itself out as it will – nothing is certain, even at this point.
(The kids are 1000% FINE by the way, in case I am making it sound otherwise!! OK, “fine” might be a stretch – after all, they are 10 & 12 years old…)
With that, and circling back to where we once came – wishing you all a joyous spring season! As always, a reminder that we truly appreciate and enjoy all feedback, questions or concerns.
And always most important, we thank you for the continued trust and confidence you have placed in us.
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