I have now rewritten this opening sentence no fewer than eight times – never a good sign for the project I have in front of me. Most times this occurs, it is because I am finding myself in a spot where I have nothing new to say from the previous updates. That is not the case this time. There is so much happening at once, and at a rapid clip, that I find my head swirling with thoughts about which topics are most important cover here – and which order and in what level of detail to go into them.
Yet, because of this rapidly changing environment – and my desire to get this update through compliance and out to our clients this week – I also know that I will need to fight one of my biggest ongoing demons:
Brevity, or the lack thereof in my case.
So, what I am going to attempt to do is to break this update into two parts. The first will be a (hopefully) concise update on what is transpiring with markets and the overall economy – and our analysis of why we believe it is transpiring the way it is. The second part will entail a brief discussion of various asset classes and how they fit (or don’t) into our strategy. Finally, I will conclude by wrapping all of it into what it means for our current positioning of assets on your behalf.
The approximately 50 square feet of dry-erase board on the wall across from me is completely full of notes, numbers, and what would surely be considered entirely incoherent scribble to anyone who stumbled upon it. But to us, that incoherent scribble represents the now countless hours of discussions, research and analysis ongoing within our group. My hope for this update is to turn that 50 square feet in my office into an organized and coherent summary for all of you.
Let’s give it a go…
The “Macro”
(in other words – “what’s going on”)
I’ll begin this section by taking a sentence directly from said board in my office:
“Get the macro right – it’s the only thing that matters right now”
There are three main questions to be answered – all related, and ones we tackled in the last update. First, are we in a recession? If so, how bad is it? And finally, how bad will (can) it get? Forget about the technical definition of recession, it simply doesn’t matter. The question becomes whether or not the economy is going to fall off the proverbial cliff or not. That’s it. Sounds simple, right? I wish it was…
There are many players involved in ultimately determining the answer. First, and of course, there is Jerome Powell and his absolutely brilliant team of monetary experts at the Federal Reserve. They are supposedly now all-in on controlling the inflation that, ironically, they and their predecessors in no small part created in the first place by keeping interest rates at zero for a decade. If they continue to decide that sending the economy into a depression by increasing interest rates indefinitely – then yes, we will likely experience a “worst case” economic (and market) outcome. Unfortunately, if they don’t keep raising interest rates, the combination of monopolistic corporations and their pricing power along with Wall Street speculators in commodity markets might very well make inflation a very much lasting problem. They are now damned if they do, and damned if they don’t.
The second player in all of this is the consumer. Yes, I’m talking about each and every one of you reading this! If the Fed keeps hiking – and ultimately “breaks something” – we know what happens then (it’s not good). The more interesting question is whether or not the consumer can even handle the higher costs of goods and services that are already here – coupled with the now much higher borrowing costs. We say this all the time and remain perplexed as to why it’s never discussed – inflation “going to zero” does not mean that prices are going back to where they were. It only means that they have stopped increasing. And we are nowhere near “zero” on inflation by the way. Based on the explosion of both credit card issuance and balances this year, we have our doubts that the consumer can even handle the inflation that is already here without significantly altering their spending habits (or worse) going forward.
Our final player is, of course, our friendly neighborhood politicians. They can solve the economy problem rather easily – simply print more money and hand it out to everyone again! Worked so well the last time, why not? I’m not going to waste three paragraphs explaining why this doesn’t work – it doesn’t matter. And the reason it doesn’t is that the politicians in charge can’t even get anything along these lines passed now. If the fall goes the way most expect, the current party in charge loses their majority – so it’s essentially dead on arrival from there. Even though “Republicans” piss away almost as much money as the Dems these days, they don’t do it when the other team is living in the White House…
For the sake of time, I am leaving the macro discussion there for this update. Rest assured, the above is a woefully inadequate summary of all the conflicting macro issues at the moment – including but not limited to geopolitics, earnings, elections, demographics, etc, etc, etc…
But you can probably surmise our position on the “macro” at this point – I wouldn’t exactly call it a positive one. That said, and this is important, there are graves (both literal and figurative) full of investment professionals molding their investment strategies around their own macro-analysis. Yes, we have our theses – and spend countless hours trying to confirm (or more importantly contradict) them. But we acknowledge that we too cannot possibly know the unknowable with any level of confidence. So, we use our macro analysis as more of a “guiding light” in terms of what we will now spend the remainder of this update discussing: the risks and opportunities we see amongst various asset classes, and why.
I am interjecting here a “macro prediction” of mine, as I sit here writing this on Tuesday morning before the Fed opens their disingenuous mouths again tomorrow. My prediction is that the Fed hikes as they have promised through the media, BUT they also throw in one or two designed and intentionally “dovish” comments at the same time. They know that the markets will react to any such comments – and I have a feeling that they are getting a little squirmy at being blamed for continued market deterioration, especially with elections looming. So, I’m betting on a short-term, face-ripping rally tomorrow – which may or may not bleed into the rest of the week (or beyond) – based on this projected “Fed speak”. I will interject later in this update with how I did with this prediction, though I will say that the market down 1%+ this morning ahead of the announcement lends itself to my being wrong. We will find out soon…
Risk & Reward
“You have to say to yourself, ‘If I’m right, how much am I going to make? If I’m wrong, how much am I going to lose?’ That’s the risk/reward ratio.”
- Peter Lynch
I ran into that quote the other day, and thought (1) that it summed up almost perfectly our entire investment strategy, and (2) why don’t I ever come up with quotes like that? Anyway, circling all the way back to our earliest discussions around valuations, the statement sums it up. Valuations themselves have never been proven to be useful for timing purposes – but they have been very useful in making projections for longer-term returns. In other words, just because a security or asset class is over-valued today doesn’t mean that it is about to crater tomorrow. Instead, it might suggest that it’s longer-term return potential based on its current price should be muted (which often occurs because the investment does “crater” back to reasonable valuations at some point).
So that’s one (the main) way we incorporate a risk/reward ratio as described into our strategies for clients. From there, we use similar methods to analyze “sub-sectors” of each asset class. For equities, we’d first analyze risk/reward on the entire asset class (think the S&P 500) – then move onto doing the same for the different sectors and then maybe (rarely) even individual stocks within those sectors. We do the same for fixed income, etc. What is about to follow is a summary of our above analysis, attempting to make it as concise and “easy to read” as I can.
First things first. A reminder – we do not run “models” for clients. That means that no two portfolios look the same – they are based on each client’s goals, timeframes, tolerance for risk, etc. For that reason, I cannot make blanket statements in these updates as to specific actions taken. That said, the analyses I will describe below will still apply to all clients – just to different degrees based on what each is trying to accomplish. Hopefully that makes sense.
I will now summarize our “risk/reward” analyses on the asset classes we deem most worth discussing at the moment. Here goes…
Stocks in General (the market)
This is going to be woefully unsatisfying to a few of you, but much easier to read for the majority and also – importantly - much easier to get through compliance in a timely manner. For those left unsatisfied, please give me a call, and we can go through in as much detail as you like…
For some 12 years now, stocks have continued to reach historically high valuations – even in the face of largely lackluster overall economic growth. No one really had a good explanation for this, other than “don’t fight the Fed”. Over those 12 years, we had very little (measured) inflation, and the Fed kept on printing money while inexplicably continuing to keep interest rates near zero. Corporate margins (profitability) also reached all-time highs.
Today, everything has changed. Inflation is here, and margins are about to get compressed (we think). More importantly, the Fed is (supposedly) now on a mission to not only increase interest rates until they get inflation “under control” – but they also likely have little to no wiggle room to reverse course without inflation rearing its ugly head again. Wash, rinse, repeat.
Even if one wants to take the stance that stock prices are no longer a function of earnings or the economy – and are instead solely a function of “Fed speak” and the corresponding actions of the algorithms run by hedge funds (a possibility we do not rule out by the way) – we just don’t see how the risk/reward proposition on this asset class isn’t terrible. And terrible is an understatement. “Don’t fight the Fed” can’t work on the way up, but be ignored when the narrative shifts, right? I doubt it, but I won’t be shocked by anything ever again at this point.
Needless to say - and consistent with our previous outlooks where we “ranked” asset classes – stocks (in general) rank at or near the bottom of our risk/reward profiles. Enough said.
Energy / Commodity Related Stocks
While our own risk/reward analyses of stocks overall might be some 90% in favor of risk over reward, there are a few sectors for which this is not the case – this being the best of them in our view. To us, there are quite a few items to be listed under the “reward” column in this space. First and foremost, in an irony at the highest level, governments around the world have successfully demonized commodity producers enough over the past decade to where there simply isn’t enough supply. Add to that the complications around Covid, and many commodities – from energy all the way to food – are facing serious supply constraints. Economics 101, when demand exceeds supply, prices go up. If you are a commodity producer, higher prices mean higher profits. And if stocks still trade at all on the premise that higher profits mean higher stock prices (still admittedly an “if”), then you can start to see why we like the space. Additional reasons for optimism would be the dividends, the momentum (also a risk as described below), and this is one of the few areas where geopolitical turmoil actually favors rising commodity prices. Finally – getting into the weeds a bit here – we have been in a “low interest rate, growth over value” cycle for more than a decade. If we are in fact heading into a new cycle favoring the opposite (these cycles tend to run for long periods of time), commodity related stocks are often some of the best to own.
There are certainly risks. First and foremost, while I already discussed supply characteristics as one of the biggest benefits – there is also demand to consider. Simply put, if the world economy collapses, demand for commodities will suffer – offsetting the supply issues. Additionally, we have to weight the fact that investors generally – be it the retail investor or the algorithms chasing price – tend to “buy higher prices”. There is a lot more interest in this space than there was coming into the year. A lot. Every smoking pie-hole that opens their mouth on CNBC these days tells you how much “they love energy stocks” (of course, they didn’t coming into the year). That can work both ways if things go south. Finally – and this is a much longer-term risk to consider – there is no question that governments will continue to push for less reliance on fossil fuels. This is a conversation for another day, as we remain near-certain that we are nowhere near a point where this risk materializes (even if the morons running governments can’t figure that out) – but it belongs in the discussion for down the road. In other words, we won’t have this preference forever…
The Commodities Themselves
See above – without the dividends…
Gold / Gold Mining Companies
I can’t (beep) properly explain just how (bleep) (bleep) sick and (bleep) tired I (bleep) am with this (bleep) stuff. Feel free to fill in the blanks with whichever expletives you prefer. While I cannot stand censoring myself, it’s just going to cause more delays with compliance – so be it…
If I were writing this a month ago, this would have been the area that we suggested had the best risk/reward profile in terms of magnitude. In other words, the potential reward was massive, while the risks were minimal in our view. Since that time, however, gold prices have continued south – taking out very significant technical levels in the process. At the same time, interest rates have somewhat surprisingly continued higher. The combination of those two - for reasons more technical than will be helpful toward achieving my goal here – have managed to both increase our assessment of its risk profile while at the same time decreasing our assessment of its reward profile. Of course, that’s the polar opposite of what we are looking for. (bleep).
Still, gold tends to have one very important attribute – an attribute that is important for our current positioning. That attribute is that both the price of the metal – followed by the miners shortly thereafter – tend to bottom before the overall market does. Somewhat related and interesting, the same can be said for high yield (more aggressive) corporate debt. It is for this reason – even though this space has become markedly less attractive to us (short-term) since our last update – that (bleeping) gold remains an important piece of our overall positioning puzzle. Let’s leave it at that for now…
Fixed Income (bonds)
If trying to navigate the equity markets weren’t challenging enough this year, the real story has been in fixed income. As of this writing, most “core bond” strategies are down more than twelve percent this year. Keep in mind, for an investor using the ever-popular (that might very well be about to change) “60/40” strategy, that means the “60” is tied to stocks and the “40” is supposed to be the part that “zigs when the market zags”. Not a pretty picture when the “40” is down almost as much as the stock portfolio. Ouch.
We have been fortunate in that we had very little “duration risk” in portfolios coming into the year – escaping a lot (not all) of that volatility. Much more important, however, is that we are now finally at a point where fixed income going forward might actually be able to produce some…income.
I will not venture into the “inverted yield curve” and all of its jargon/complexity today. Instead, I will point out that the risk/reward on treasury securities – especially the shorter durations – has become significantly greater over the course of this year. Intermediate and longer-term treasury positions certainly offer greater reward propositions than they did coming into the year, but they still carry a hefty risk profile as well if the central banks around the globe are unable to reign in inflation in both meaningful and lasting terms.
In short, here is the million-dollar question that everyone in the fixed income world (including ourselves) is trying to answer:
If stocks continue to deteriorate, will longer-duration income finally go back to acting as a hedge (move inversely), or will the painful correlation of this year continue?
We tilt ever so slightly toward the former, but our level of conviction is as low as it could be – confirming our risk/reward preference (for now) tilted toward shorter maturities.
Positioning – What Are We Doing
The purpose of the 1st two sections of this update was to give everyone a better understanding of what is to follow – that is, what we are doing with your money in light of everything described. I want to start with three important observations that didn’t really fit into the “macro” or any particular “asset class” discussion – yet are very important items of note:
Everything is now seemingly correlated (inversely) with the strength of the US dollar (vs global currencies).
Put much less cryptically – as the dollar rises vs other currencies – asset prices (stocks, bonds, etc) fall. This inverse correlation has been strengthening as the year wears on.
“Credit Spreads” tend to lead the markets/economy.
“Credit spreads” are basically the difference in interest paid on risk-free (treasury) securities vs corporate income securities. The spread between the two widens during periods of economic uncertainty and shrinks during periods of economic strength. Widening spreads tend to lead stocks lower, while tightening spreads tend to occur closer to market bottoms.
“Volatility” – at least as measured by the VIX – has remained muted.
Put another way, “there hasn’t been as much ‘panic’ in markets as one might assume”. Abnormal for a market to bottom without the “fear” kicking in.
I’m guessing that I am going to circle back to one or more of those as I write from here – but if not – I wanted to mention each as they are items that we are acutely focused on in our daily discussions…
OK, getting to it. As I mentioned on the phone to many of you recently – and because of the reasons I have hopefully laid out above (admittedly in much less detail than is adequate) – we are in what I call “protect first, ask questions later” mode. This has been done through a combination of reducing or removing some positions, hedging others, and utilizing both long/short and market neutral strategies. Additionally, we have stayed away (so far) from adding duration (interest rate risk) on the income side. I am not going to go any further into the “how” we are doing what we are doing – too long, too complicated, and too difficult to get through compliance expeditiously. That said, I am more than happy to go through it in as much detail as anyone would like – so please just pick up the phone if you want the detailed version!
Instead, I’m going to focus on the “why” – and then move on to “what” we are looking at most closely that might change our thought process. Let’s start with the “why”. It all boils down quite simply to our risk/reward analysis that we spend all of our time analyzing, reviewing and revisiting – and I have laid that out as succinctly as I am able in the beginning of this analysis. Additionally – and this is where I will once again reiterate that this is not said for self-serving purposes – our strategies have held up very well this year. So, because we have avoided large losses at the early stages, we can look at it one of two ways. First, we could decide to add more risk now – knowing that if markets continue to deteriorate, we are still well ahead of the game – and just “hope” that we are wrong in our thinking, and stocks start trucking higher. The problem with that course of action is that it would contradict all of our analysis, and subject us to more significant losses should markets continue lower as we expect.
Conversely, we can decide to get slightly more conservative – remaining consistent with our thinking. If our analysis proves wrong, and markets just start marching straight up from here, we are still ahead of the game, and we adjust accordingly (see below). But if we are right, we’ve then protected even further, and – just as important – given ourselves even more dry powder to add growth potential at even better prices (or interest rates).
We have chosen the latter. Now, it is extremely important to note – this does not mean that we removed all growth (or risk) from your strategies!! As I have stated a million times in these updates – “never all-in, never all-out”. What we did is what I call “trimming around the edges”, in favor of being more conservative.
So, that is the positioning now – again, generally speaking and specific to each individual client. But that is only half of the story. We have to be prepared for how we will adjust based on what transpires from here. This is where it is imperative that we not solely focus on our “macro outlook” – as we recognize that we could be wrong. To reiterate what I said previously, we will use our own analysis as a “guiding light”, but at the same time – and this is important – respect what the market is doing. What follows is going to be general and without using specific “levels” that we are watching. I only want to convey the thought process as simply and understandably as I can.
Once again, going to be oversimplified and leave some wanting more – please call if you are one of them. First and foremost, please understand one universal truth – we cannot time or predict market tops or bottoms. No one can. In recognition of this truth, we have intentionally designed portfolios to allow for “stages” in trying to best navigate the current turmoil. The first stage would be the reduction or removal of any “direct hedges” (positions moving inversely to stocks). The second stage involves the reduction or removal of what we consider “indirect hedges” – positions that can move either way with stocks (market neutral, trend following, etc). Finally, we can simply add growth-oriented positions. Any of those three actions adds both growth potential and additional volatility (risk) to the portfolio.
If we are correct in our assessment, and markets continue to deteriorate over the short to intermediate-term, then we will gradually take those actions (likely in the order laid out) to take advantage of now lower prices. The reason for the “stages” is that it is unlikely we will be particularly fond of the prospects for stocks – particularly at the timing of those first stages. Still, since we know that we cannot predict the bottom – and with the “wiggle room” we have already built in – it is the responsible thing to do. Buy low, sell high. It really is that simple when it comes down to it. Important to note, the final “stage” – adding actual positions – will likely only occur at such point where we deem valuations have now justified longer-term potential in our view.
If we are incorrect, and markets turn higher from here (in sustained fashion), this is where we have to be disciplined and respect “what the market is saying”. Same stages, different mindset. It’s a different mindset because instead of “buying low”, we are technically “buying high” (as markets have moved higher). In this scenario, we would be more inclined to remove hedges – requiring the market to hold the technical levels that triggered the removal – but have a harder time adding positions, assuming nothing had significantly changed around valuations, etc. There is so much more I want to say here, but I’m going to cut it off for now.
Some final notes that I think are important, but couldn’t figure out how to incorporate into the above – in no particular order of importance or relevance:
- Do not be alarmed if seeing trade confirmations more frequently – including the same positions being bought or sold with frequency. No, we have not turned to day-trading. In fact, you will note that the “base” of your portfolio hardly trades at all. We are actively trying to navigate through the current environment, and that may (or may not) involve more frequent trading.
- There may be spots (particularly in the energy/commodity space) where we decide to add positions even before we have removed our more “conservative stance”.
- Do not assume that huge market rallies are an “all clear” for stocks. The biggest single/multi-day rallies tend to occur within bear markets.
- Listen to the Fed – but don’t make absolute assumptions. Yes, if the Fed speaks this afternoon and announces that they are done hiking rates, the market will likely explode higher. Remember, short-term rates are now at or near 4% - starting from zero. The economy lags interest rate hikes – meaning the true effect of rates even where they are sitting today will likely not be seen for another 6-12 months. This will be the most difficult area to navigate, I don’t care what anyone says.
- In addition to technical levels – which we pay more attention to than normal because of the market environment we find ourselves in – we are paying very close attention to movement in credit spreads, words coming out of the Fed’s pie-hole(s) and corporate earnings (beginning in October). These things matter much more than technicals for the longer-term, while not so much in the short-term.
- This update likely has a more negative tone than intended. Valuations have definitely become more attractive in many areas. Interest rates are significantly higher, which is a huge benefit going forward to most all reading this. Remember what I always referred to as the “dumbest comment I would ever make to you, that you want to see your portfolio lower, because either stocks went down (better long-term value), interest rates went up, or both…”. Well, this year we got both. I’d like to see a little more on the equity side, but by and large, I will enter next year a heck of a lot more optimistic long-term than I have in quite some time…
As for my prediction on the Fed-speak today, and the market’s reaction to it. This is going off to compliance before they make their decision / statement. So you will have to watch the rest of the week to find the results for yourself…
I’m sure there are items I’ve unintentionally omitted, but that’s going to have to do it for today. These are normally two-week projects for me, and I’ve condensed into a day and a half for expediency. So, again, I apologize for the over-simplicity and/or lack of depth. And in case I have not made this clear, please reach out if you would like to discuss anything further – I truly enjoy every conversation, and more than happy to go into as much detail as you like…
With that, and as always, we thank you for the continued trust and confidence you have placed in us!
Sincerely,
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Statements of forecast are for informational purposes and are not guaranteed to occur. Trends discussed are not guaranteed to continue in the future.
All performance referenced is historical and is no guarantee of future results. Investments mentioned may not be suitable for all investors.
Equity investing involves risk, including loss of principal. No strategy – including tactical allocation strategies - assures success or protects against loss.
Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time. There is no guarantee that any investment will return to former valuation levels.
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