I spend a lot of time listening to podcasts – normally 2-3 hours per day. Along with Twitter -which is much more harmful to one’s soul and more difficult to decipher fact from fiction -podcasts are the single best place to get relevant information these days. I bring this up because I heard the title above mentioned while listening to one of these podcasts (credit to Vitaliy Katsenelson as heard in the “Hidden Forces” podcast), and I knew the second I heard it that it was the title of this piece. It was just that good.
I view today’s update as a particularly important one. I don’t think I need to draw anyone’s attention to the volatile times (both financial and otherwise) we currently find ourselves in – though based on the continued lack of correspondence from clients, I’m comforted that most reading this are not experiencing any sense of panic. This is likely due to some combination of our strategies weathering this storm well so far, and the fact that you all have been hearing me talk about this stuff for just about forever by now. Regardless, let’s keep it that way – there is no need for panic, and what you are about to read below should not make anyone feel otherwise.
Anyway, because of the importance of this update, I am going to attempt to make this both the “easiest to read” update I have ever written – and at the same time attempt to keep it on the shorter side. As I write that sentence, I find myself more confident in being able to achieve the former rather than the latter. Let’s see how I do…
The First Half of 2022
What we just witnessed in terms of financial markets in the first half of this year is truly historic on some levels. I’m going to pause here and say how much I hate those “historic” headlines – even though I just reiterated it myself – mainly because the headlines always read “the worst _______ performance to start a year since ______”. The reason I hate the headline is that I fail to understand (because there is no plausible reason to understand) why something occurring in the first 6 months of a calendar year is different than any other 6-month period. The answer, of course, is that one headline sells and the other doesn’t. Nonetheless, it’s been a pretty brutal 6 months regardless of how one looks at it.
Couple of highlights – well, lowlights – from the first half of this year:
- The S&P 500 had the worst 1st half of any year (-20.6%) since 1970
- The Bloomberg Aggregate Bond Index was down more than 10% at the same time
- The average 60/40 portfolio (60% stocks/40% bonds) was down9% in this period
Yes, it has been bad. Quoting from the same source cited above, “if it holds, the performance of the 60/40 portfolio would rank only behind two depression-era downturns – 1931 and 1937 – that saw losses topping 20%”. As I sit here writing this first draft on July 5 – with the S&P down another 2% - an unfortunate reminder that we have another 6 months to potentially break those records…
What makes this so rare is that – especially since the Fed got in the business of propping up financial markets some 30 years ago – bonds tend to do well when stocks are falling. This has not been the case this year, and it is why so many investors who might have thought they were being conservative with their investments are unfortunately waking up to see double digit losses instead.
Now, I’m going to add a disclaimer that Gary in his role as marketing coordinator (correctly) implores me not to make – but it’s in my nature to do so:
What I am about to say is not us taking a victory lap.
As you know by now, we don’t run “models”, and therefore cannot quote specific performance numbers. That said, most of you reading this (clients) will look at your performance this year and see that you are down only a fraction of what we just quoted above for the markets and/or 60/40 models. That is good news for sure.
But again, the above is not said for self-serving purposes – it is more as a prelude to saying there is much work to be done – and that work will be described in the following section. Still, it is much easier to navigate from a position of strength – which is the “wiggle room” that I had described in previous updates and will describe again below. Before getting into what we are seeing/doing looking ahead, let me explain why this is important.
We have reiterated constantly – and will continue to do so – that any investor’s goal should be to not outlive their money. Not to beat an index. Not to have better returns than your neighbors or co-workers. Again, your goal should always be to do everything you can to ensure that you do not outlive your money.
There are many components that go into reaching that goal. The first – and most important – is to save your money. That comes from managing your expenses, both while working and into retirement. There is very little – outside of advice – that Dave or I can do for you toward that end. Then, once you have saved said monies, you are wanting those savings to work for you – which comes down to both growing and protecting those savings. This is where we enter the picture. In our view, too much emphasis is placed on the growing – with not nearly enough on the protecting. Everyone’s situation is truly different, but here is a simple truth:
If, based on a simple cash flow analysis, you can demonstrate that you already have enough money saved to never run out of it – the ONLY way you can screw it up is by losing too much of it, either through increased spending or more commonly by assuming too much investment risk.
In that light, the most important piece of the puzzle for us is attempting to limit our (your) downside exposure when markets turn south – especially early on – while still allowing for sufficient growth potential. When successful, we are not then left “scrambling to protect after the fact” – which is the worst position to be in. Just as important, we are in a better position to add growth potential where we see opportunity without having to worry as much about the additional downside should markets continue to weaken.
This is the first time I’ve felt like I am violating my promise to make this update more readable for all – so let me throw out a simple hypothetical:
Fictitious investor - Sol Rosenberg - comes into this year with his monies invested in a traditional 60/40 model. After 6 months, consistent with the numbers cited above, he finds that he has lost nearly 17% of his investment monies. Oversimplifying, he really finds himself with 2 options…
First, he can simply do nothing. He’s been told countless times over the past decade that he should “buy the dip”. While he is surprised that his portfolio consisting of 40% bonds has lost this much over a 6-month period, he’s confident that Jerome Powell has this under control. So, he will let his chosen manager rebalance back to target (by buying more stocks), and let it ride. If the market pops right back up, all is good – he will gradually begin making up his losses. But, if it doesn’t (see 2000-2002, 2008), he risks potentially losing a lot more of his money as it plays out.
Conversely, he can think “WTF is going on here?! I was told this was a ‘relatively conservative’ strategy – and I’m down 17% in 6 months?? Get me out…” So, he sells some (or all) of his stocks and/or bonds, and moves to cash. If the market then bottoms and begins it’s recovery, it will take him much longer to recover those losses – and he then of course has to decide when to get back in (at now higher prices). If the markets continue lower, then he will have protected himself from some (or all) future losses – but he's already down 17% and will again have to decide when to get back in in order to recapture those losses.
Now, imagine another hypothetical investor – Frank Rizzo - was only down 5% (give or take) with his strategy, instead of being down 17% like his friend Sol. I don’t need to lay out an entire scenario here for you to imagine the flexibility he would have to react (or not) as warranted. He feels no “panic” to de-risk in case it gets worse, nor does he feel “panic” to add more risk in an attempt to reverse significant losses. As we move onto the next section, we are going to be looking at it through the hypothetical lens of Mr. Rizzo and his “wiggle room”…
What Truth Will Time Tell?
Sorry, I had no choice – those words are just too superb at describing the entirety of investing. I haven’t even written a sentence in this section, and I am already feeling helpless in an attempt at making this either readable or brief. I’m going to just start typing, and see what happens…
Fourth attempt at opening this section – still impossible. Screw it, I said brief and readable, so I’m going to give you brief and readable.
In our view, there is one question that rises above all others as it pertains to the next 6-24 months:
How deep (bad) will the recession be?
You will note that I didn’t ask “if” we would have a recession – our view is that we are already in one. While we are at it, let’s talk about “recession” and what it means. Technically, it means two consecutive quarters of negative GDP. Of course, I promised readable, so let me rephrase. It means “the economy is getting significantly worse”. Much like the term “bear market” (a drop of 20% or more in stocks) means next to nothing in reality (is there really a difference between -19% and -20%?), the term “recession” is better for headlines than anything else. If the economy is slowing – and not growing – it’s not good.
So, why does this question matter above all else? It seems simple on the surface – stocks are supposed to rise and fall based on the profitability of the companies they represent. So, a growing economy would generally lead to higher potential profits and be good for stocks, while a slowing economy would produce the opposite result. That’s the way free-markets used to work – you know, when they used to be “free”. Oh, but the world has changed my friends. More on that later…
Meantime, let’s talk about why this question does matter so much. We came into this year with valuations (stock prices compared to their earnings) at or near all-time highs. As stock prices fall, valuations then become more attractive – as stocks are then “cheaper” based on those earnings. However, and this is important, valuations are only more attractive to the extent that the stock price is falling at a faster pace than the earnings. In other words, if a stock price falls 20% - but its earnings are also expected to drop by 20% - then the stock is no more or less expensive than it was in the first place. The worse the economy gets, the more problematic it becomes for earnings – which means that stock prices *should have to fall even further to reach “attractive valuations”. When you come into the period already historically expensive valuations, one can see how this becomes even more dangerous for stocks overall.
This is where I stop and remind everyone once again that I promised brief and readable. Each of these topics would warrant 10+ pages to go through them in sufficient detail – so save your questions for the Field of Dreams event next month!!
Back to it. Oversimplifying, there are two main drivers that affect earnings. First, there are company revenues (sales) – which would be most affected (generally) by the state of the economy as described above. The second is the costs associated with a company’s sales. Remember, earnings are determined by taking the total sales of a company, and then subtracting all of their costs. So, yes, costs are a big deal. Which leads us to the second most important question to be answered going forward – one that we have spent significant time already discussing:
What about inflation?
I’m back to feeling overwhelmed with even the idea of tackling this part in a brief and readable fashion – but let’s give it a go. Here is a moronically oversimplified way of looking at inflation. The costs (material, labor, etc.) to companies for producing goods or services rise, and they then raise their prices for said goods and services to offset those increasing costs. In essence, that is what you are experiencing when you go to the gas station or grocery store these days.
We came into this year, generally speaking, with historically high “profit margins” for corporate America. In other words, they were keeping a historically high percentage for every dollar sold vs what it cost them to produce their products. As their input costs rise – mainly due to either material or labor (or both) costs rising – they then attempt to pass those increased costs onto us by raising the prices they charge for their goods or services. This is where the critical intersection between inflation, the economy, and stock prices all come into play…
If a company can increase their prices at the same rate that their costs are rising – without affecting how much they sell – then their earnings are not affected. Essentially, they just passed all of their costs on to us. At some point however, you and I are going to reduce (or eliminate) the amount of their goods are services that we are able or willing to purchase based on these higher prices. When that happens, they are in trouble. Businesses then have to decide to eat more of the costs themselves in order to sell the same amount – therefore negatively affecting their profits (or margins). Conversely, they can attempt to keep raising their prices – but then the amount that they are selling is reduced – which also affects their earnings negatively. Damned if you do, damned if you don’t.
Another option is to reduce your labor costs, with the assumption (or hope) that you will be able to produce the same amount of goods and services – just with fewer employees (and therefore lower costs). Of course, that’s when the layoffs start. The problem we are facing these days? Businesses are still under-staffed in many cases. In other words, not only do they not have the flexibility to start laying employees off – they are actively hiring (and at higher wages to boot!). I’m going to stop this here is I can already feel many of you zoning out on me – but I hope you can see what a precarious situation this “inflation loop” presents both to the economy as well as financial markets.
Once again, I would like to congratulate Mr. Powell and his cackle of followers at central banks around the world, along with the oligarchs everywhere. You got the inflation you asked for – well done! Again, about that “transitory” part? Morons…
Sorry about that, and back on-topic and to our hypothetical friend Mr. Rizzo - who has done a decent job of protecting his monies so far this year, but is reading this update wondering if I will ever get to the point. Frank came into this year underweight stocks, and with minimal duration (interest rate risk) in his portfolio. Instead, he repositioned some of that “risk” into commodity-related investments – worried about the threat of inflation. Not only did these investments hold up better than the other asset classes, but they instead produced significant gains. His relative performance this year is in no small part due to these allocations.
Still, he remembers this snippet he read from our 2022 outlook – reiterated again in the last quarterly update:
“Our longer-term thesis remains – inflation leading to (significant) deflation – at which point commodities almost certainly will not be your friend.”
Generally speaking, commodities have been showing signs of the above for a couple of weeks now. To be fair, they have had spurts of acting up on us on a few different occasions – only to rally to new highs shortly thereafter. This time, it feels different. That feeling might be justified, it might be proven wrong – but it led us to reduce (not remove) our commodity exposure in the past couple of weeks. Depending on just how long the current direction and strength of this move lasts, we may very well end up adding it back sooner than later – but that is a conversation for another day.
Moving onto gold and the wonderful mining companies that pull the bastard stuff out of the ground. Not sure how many times I’ve said this now, but I’ll say it again – I’m convinced our shiny yellow friend is going to be the death of me. It held up nicely for most of the year – even in the face of a strengthening dollar and currency hurricane the likes of which we have rarely seen – but has finally succumbed in the past few days in particular (in spectacularly bad fashion). Not looking to reduce at the moment but monitoring levels to potentially add. Our best guess is that Mr. Gold will have its moment to shine (boom!) at the same time that the Fed – which we will get to – finally pivots and goes back to protecting the market. Either way, with the absolute craziness going on in currencies (which I am not getting into as there is 0.0 way for me to make readable), we are keeping a place for it while I continue to cuss loudly and break things around the office…
Before discussing stock and bond positioning, let’s get to the Fed – and attempt our answer at the two critical questions I listed at the beginning, as they are all related.
How bad will the recession be? Many won’t like the response, but I strive always for transparency. My answer is that I don’t know. That said, I can make a slightly better case for “bad” than I can for “not bad”. That explanation would take 10 more pages, so I’m giving you the abbreviated version as promised. While I tend to think that inflation has “peaked” for now, I struggle to believe that the increased cost of living that is already here is sustainable for our debt-laden economy. Again, if inflation goes to “zero” next month – it only means that prices have stopped rising – not that your grocery or gas station bill goes back to 2021 levels. In order for that (deflation) to happen, the economy would have to get significantly worse from here.
Which leads us directly into the question on inflation – which I pretty much just answered in my last response. That said, you may have noticed my emphasis on “for now” in my belief that inflation has peaked. Readable, readable, understandable, brief – here we go…
I have spent literally hundreds of hours reading, listening to and analyzing experts around various commodities. First, it is important to understand that “commodities” and “inflation” are largely one and the same. Regardless of what the current chief oligarch tries to tell you, oil companies don’t set the price of oil. Nor does the local gas station. Similarly, cereal companies don’t determine the price of grain or wheat. But all of the various commodities – energy, metals, food, etc – are all input costs for producers that need them. As we discussed previously, when those costs rise, businesses will first pass those costs on to us as consumers.
So, the commodities themselves are driven quite simply by supply and demand. What is supposed to happen is that, as commodity prices rise, commodity producers will increase their supply to take advantage of the higher costs. As supply goes up, prices eventually start to fall. In other words, my favorite quote “the solution for higher commodity prices is higher commodity prices.” Hopefully that makes sense, as this is where it gets interesting…
As you all know by now – agree or disagree – we have been on a decade plus crusade against “climate change”. We tend to think of this as picking a fight with the oil companies, but it goes much deeper than that. Believe me when I say that most all commodity producers – from oil to metal miners to those cow farts – have been under attack by the “ESG crowd”. When that happens – coupled with the fact that we were in a decade long period of suppressed commodity prices – capital spending by these companies comes to a halt. In other words, they stopped spending on projects that would lead to future supply.
Now, we find ourselves (unsurprisingly) in a period of rising commodity prices. Add to it the situation in Ukraine, which certainly strains supplies of many commodities itself. We need supply! As one analyst I listened to said, “believe me, you can’t just stick a fork in the ground and expect to pull something out – it takes years…”. You can probably see where I am going with this – we are ill-equipped to produce the additional supply needed to bring prices down. As such, you have to attack the problem with demand – in other words, kill the economy. Again, this is what the Fed is trying to do now…
OK, all well and good – but can anyone tell me what is coming this November? Ah yes, those pesky midterm elections. Anyone reading this think that the oligarchs here might have a few words to say to the Fed about intentionally tanking the economy into these elections? I do.
The point being, the Fed and their decisions on interest rates (and liquidity) matter. A lot. Circling back to my comment about the markets no longer being “free” above – they are increasingly driven by how much free money the Federal Reserve is going to have floating around the system. We have just gone through a decade where it was near endless. Now? They are attempting to take it away, at the same time the economy is weakening before our eyes. Something has to give…
If (when) the Fed does blink, and claim that “inflation is now under control”, we (and the world collectively) will certainly take notice. Does it make stocks more attractive? Maybe, and largely depending on whether or not they have become “cheaper” in the interim. Going back to our conversation around commodities and producers – if the Fed is done stifling demand, and we still don’t have the necessary supply – I’m a lot more interested in that space. The risk the Fed has in front of them is that pivoting too early – say, just for the sake of elections – risks having commodities and inflation get away from them again. That then pressures corporate profits. Rinse and repeat. A near perfect definition of “stagflation”.
The summary above works for analyzing bonds as well. One can actually earn a little interest on treasuries these days – but at what cost? We are not yet convinced that the risk/reward profile of a 10-year treasury bond at 2.8% is a great one given this backdrop, but it’s closer than we were to begin the year for sure. Remember, interest rates up means bond returns down – and vice versa.
We are also eagerly awaiting the next earnings season, which will be here soon. We should hear a whole lot about “profit margins” as discussed previously, as well as what kind of “demand destruction” the Fed (and politicians) have successfully achieved. Most importantly, we will begin to learn (and see) how much earnings estimates are taken down – and can then more appropriately measure valuations on stocks overall.
We continue to monitor “technicals”, which as described in my last update, become increasingly important in periods which lack liquidity. Because of my readability mandate, I will not be including charts or descriptions today. But for those playing along, 3900-4050 would be upside resistance in our view – followed by the 200-day moving average should it get through there. Conversely, 3400-3500 we think would have some support – followed by 2900-3100 if it broke through those levels. We become more interested in stocks from a valuation standpoint at these levels, and even more so should they continue lower.
Warning, the following paragraph is going to intentionally be “less readable”. If you do find yourself thinking “I have no idea what he is talking about” – skim through the words and allow yourself to think “that sounds awfully confusing”. If you do, you have gotten the point that matters…
Volatility in bond markets is historically elevated. Credit spreads have not yet blown out, but they are showing signs of it. We are witnessing some of the most bizarre currency movements in recent history. Liquidity – both stocks and bonds – is shit. There has been a clear downward trend over the course of the year, with significant rallies built in. The “shit-cos” (stocks with little to no earnings carrying previously high valuations) are already down 80% or more in many cases – and they tend to be the ones that rally when the time comes, only to be taken to the shed again in the next sell-off. Catalysts (inflation) are present. The Fed is removing liquidity in rapid fashion. I could go on.
I’ve been doing this for some 30 years now. I have been fortunate – or unfortunate – enough to practice my craft through two similar yet very different “market collapses”. The first time it happens to you, you are completely blindsided – staring in wild disbelief at what is unfolding before your eyes. The second time it happens, you think to yourself “this feels familiar”, but then get reminded that the first one was supposed to be “once in a lifetime”. To be fair, the same applies with every over-extended bull market – of which I’ve also experienced two in my career. I’ll just put it this way for the sake of brevity – you learn a whole lot each time.
Which leads me to this:
Something doesn’t feel right at the moment.
To be sure, I’m not calling this moment in time as the early stages of the collapse of the “everything bubble” – though one could (and do) rather easily make the case. At the same time, I’m not calling this the “buying opportunity of a lifetime” for any asset class – though I could lay the case for one or two. There is very little panic, yet there is very little optimism – which is odd in and of itself given the backdrop. Again, something just feels “off”…
There are times when one is better off just “watching it all play out”, rather than making large bets on any given outcome. We believe now is one of those times – especially for the hypothetical Mr. Rizzo and his “wiggle room” – for all of the reasons I have hopefully explained. Not all-in, not all-out. Little concentration into any one asset class. Defense over offense. Take a few small shots when we see opportunity along the way.
In other words, Mr. Rizzo, let’s give time some space to discover the truth…
Finally, the personal update as promised – and I’ll tell you right now I am not happy with those of you that skipped right to this section again! We have decided – or at least God has – that my family and I will be staying in IL…at least for another school year. Not going to bore anyone with the details, as this is already long enough. But I do want to take a minute to thank every one of you that I spoke with about this for your time, guidance, encouragement, empathy and understanding. I’ve always stated that I view our clients as extensions of my own family – and you certainly made me feel like an extension of yours…
With that, and as always, we thank you for the continued trust and confidence you have placed in us!
Sincerely,
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
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.
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