I have been looking forward to sharing May’s Perspective with you. Included is also a bit of a personal/family update.
Ellie continues to work and has delayed ‘retirement’ as she really enjoys working in the business and taking care of clients.
Paul has finally gotten detailed orders. As a reminder, he was commissioned into the Air Force in December after graduating from University of Dayton. He will be going to Hanscom AFB outside Boston in early June. He is very excited!
Catherine just finished her Freshman year at Grand Canyon University in Phoenix – she loved it and did well. We love having her back in the nest for the summer!
Bernadette and Bridget are working hard in High School. Berns will be a senior this year – hard to believe she is going to college next year?! Bridget will be a sophomore. They both love playing volleyball and we are busy taking them to tournaments. Bernz loves her XC and Track events and Bridget starred as the Mother Abbess in The Sound of Music!
Little John continues to be a pleasure – and we love having a ‘little guy’ around. He enjoyed Track and Field and Basketball this year. He also participated as Kurt in The Sound of Music!
High Level Summary
The markets have gotten off to a rocky start. While there are plenty of new and concerning things in the world – in a certain sense – this is all normal. The big thing we are dealing with is high inflation. We have been adjusting the portfolio to the changing trends.
The bottom line on inflation is that it is always and everywhere a problem of money printing. We have inflation to the degree that the government/ Federal Reserve created too much money. The way that it gets moderated is that the government has to stop printing and spending money.
The last time we had this much inflation, the government was fighting a war in Vietnam + the war on poverty + the lunar missions. When the government does too much, it creates inflation, and we all suffer.
In the sections below, I get into the details of why we have inflation, how it is affecting stocks and bonds and how we are adjusting and the corresponding results. I also share thoughts into where we go from here.
The key is to know that everything will be ok. We specifically construct each client’s portfolio to buffer as much as necessary against market declines. All the market needs is time work through all these issues.
If you have any questions or thoughts, I would love to discuss with you. It is key to us that you have a customized portfolio based on your goals and specific considerations.
Keep reading for a more detailed outlook.
“This is most complex investment environment I have experienced in my career.”
Dr. Claus te Wildt at Fidelity
I would agree with this sentiment. Specifically, we are working our way through:
- A War in Europe
- Shortages in energy, food and everything else, including baby formula
- Global Pandemic which has largely settled down in most parts of the United States, but that many parts of the world are struggling with as we can see in China’s Zero-Tolerance policy
- Unprecedented government spending and Federal Reserve monetary policy (printing).
- Skyrocketing interest rates
- Global Supply chain problems
The common denominator is inflation.
At the same time, not all is gloom and doom. For example:
- Labor market is strong
- Consumers are strong
- Consumers have a lot of money
- Home values are strong
Below, you can see ClearBridge’s Recession Risk Dashboard. There are many strong signals to the economy with the overall being positive.
Whether there is a recession or not, it is important to remember that while each downturn is new and painful, it is normal and all part of the investment process.
There is no free lunch anywhere – the way you pay for returns is through tolerating volatility – especially downturns.
This is normal
I’ve included a history of the S&P. Going back 100 years, the S&P is down one out of four years. You will notice that the last down year was 4 years ago so we are right on track. What might not be obvious is that the average downturn is 14%/year.
In other words, at some point during the year the S&P is always down. Some years it is a lot, and some, like last year it is not much. But it averages 14%. And even though the S&P is always down at some point throughout the year, the S&P only finishes down one out of 4 years on average.
I also included a chart showing the S&P since the year 2000 and you can see how much the market as grown even with a dot com bubble, 9/11, great recession, the war on terror, and COVID.
Normally, downturns are followed by a strong recovery.
That is not to say that we are done with this downturn as there could be still some additional downturn.
Black = Returns for the year Red = Maximum drawdown for the year
Stocks in the S&P have reached the point where many, including Warren Buffet are starting to find them attractive. As I’m sure many of you saw, he bought $700M of Apple stock. He has also bought many other strong companies including Amazon and Bank of America.
CEOs buying stock
Additionally, many CEOs are buying significant amounts of their own company stock. For example Spotify’s, Daniel Ek just bought $50M. While there are many reasons insiders sell, there is only one reason they buy – they think the stock is going up.
Here is an interesting interview with Jamie Diamond, the CEO of JPMorgan Chase. Many consider him one of the most talented CEOs / financial minds in the world. https://www.youtube.com/watch?v=Q-5US4J03Wo
You will notice that he has a similar calm, long-term mindset about markets and the US economy.
The greatest investors don’t ponder much about the economy or even the Federal Reserve, but focus on companies and valuations.
It is important to remember that an effective process will often produce undesirable results in the short-term, but will ultimately produce excellent results. And sometimes, a horrible process can produce good results.
An example of this is, buying excellent companies at good prices. There are times when this will not work because short-term trends in the economy or market, put a sector out of favor.
How Our Planning Process Works For You
- Make sure to have short-term money (less than 5 years) in low risk strategies.
- Make sure your income needs are covered.
- Have a highly diversified equity portfolio using a combination of passive and active strategies.
- Look for short-term opportunities while keeping our eye on the long-term.
- Consider longer-term higher growth opportunities.
- Rebalance on a regular basis to ensure proper allocation.
For the last 40 years we have experience lower inflation, but then everything changed during the pandemic.
It is helpful to know where the government gets money:
When the government needs money they impose a tax. When then need more money than they can raise through taxes, they borrow. And lastly when they need more money than can be borrowed, they print.
Taxing and Borrowing do not create inflation because it is just rearranging existing dollars. Printing money does cause inflation because it puts new money into the system. More money chasing fewer goods creates higher prices/inflation.
Because of this, you can think of inflation as a wealth and income tax.
The chart shows the process of creating inflation and the resulting rising interest rates. Follow by the number:
- Covid shutdowns begin.
- The Federal Reserve starts ‘printing’ massive amounts of money they then ‘loan’ to the Federal Government.
- The Federal Government spends that. This did not result in inflation because people were unable to spend the money because of the shutdowns.
- Another spending package ($2T) is passed as the economy reopens which lead to a spike in inflation.
- Higher inflation lead to higher interest rates.
Rates will likely continue to rise
Historically, interest rates on government bonds have been 1% more than inflation. (source)
Right now, as you can see, inflation is 8.3% and rates are at 2.9%. This is a distortion that will likely close over the next couple of years. Hopefully, inflation will come down to 4-5%. But this means that interest rates may attain 5-6%.
As interest rates go up, bond values go down. This is because bonds issued today at a higher rate are more valuable than old bonds with a lower interest rate.
You'd have to go back hundreds of years to see the kind of movement in bonds that we have seen this year. As you can see below, the bond index (Bloomberg Agg), the value has dropped 9.8% YTD.
We have dramatically restructured the portfolio.
- Moved to floating rate bonds, which can hold up well when interest rates go up.
- Moved to alternatives that are uncorrelated to the stock and bond markets.
- Increased the cash position
- We recently shortened the duration of another fund to 2 years.
We continue to closely monitor the strategy and want to be positioned for no matter what comes.
Companies are worth the amount of their future earnings.
For stocks a common metric of valuation is Price/Earnings (P/E) ratio. This is the price of the stock divided by the earnings of the stock. Earnings are simply how much money the company is making.
Company valuations have reached an attractive level, but the price can still go down from here as the market tends to over-compensate – it takes valuations too high & too low – this is one of the many things that makes timing the market difficult.
Apple is priced at about $150/share and makes about $6/share. This makes the P/E = 24. In other words, if the earnings stay the same it would take 24 years to get your original investment.
One of the challenges of the market is that people have Fear Uncertainty & Doubt (FUD). When people have FUD they don’t count on or pay for growth. Hence, growth stocks are getting hammered, even though they are performing well.
As you can see above, the stock is reacting to all kinds of things that have very little to do with the day-to-day performance of the company. Perhaps this is the reason Warren Buffet has started to go shopping!
The most dramatic example that comes to mind is Amazon – In 1999 the stock dropped, ultimately losing 93% of its value (shown in the inset below). None of this had to do with company performance, but with larger market conditions. While a 93% loss is traumatic, it turns out to be $100, which is now a rounding error to its current price of $2,200. On April 28 the stock dropped by more than this in one day!
“The stock is not the company and the company is not the stock.”
Jeff Bezos, founder of Amazon
Growth vs. Value
As the market is not willing to pay for growth, we are adjusting the portfolio. It is a matter of balancing the short-term trends with the long-term opportunities.
This year we have moved significantly towards value, and added commodities. We will be shifting a small percentage to a fund that invests in food related companies. With Ukraine unable to ship their current wheat supplies and Russia unable to export fertilizer we are seeing massive inflation in food. By investing in this sector we can help capitalize these companies while hopefully realizing an attractive return.
This is a classic opportunity of doing well by doing good.
The bottom line
We have made significant changes to the portfolio to adjust to the market conditions. This has allowed us to remain having some exposure to the equity markets while providing some downside protection for the defensive part of the portfolio.
Where do we go from here?
Guessing where the markets go is tricky business to say the least. It is interesting to look at historical markets and how they have performed after pullbacks similar to what we have gone through so far.
I'm sharing some interesting facts from LPL as well as a "dashboard" – historically, recoveries from similar type pullbacks are attractive over the next 12 months.
Upside Potential Appears Larger than the Downside Risk
We recognize this selloff may have further to go in the short term but it’s worth noting:
- The average S&P 500 gain over the next 12 months after a 10-15% selloff has been 22% historically, with gains in 12 of 13 periods back to 1980. The current selloff is 14% (as of Friday’s close).
- The average gain over the next 12 months after a 15-20% selloff has been 24%, with gains in 11 of 12 instances back to 1980.
- Non-recessionary bear markets on average lose 24%, based on S&P 500 data back to 1950, suggesting about 9 percentage points of potential downside from current levels (not our forecast), assuming no recession.
Source: LPL Research, FactSet 05/13/22
My sense is that we could see another 10-20% decline and I don’t think a recession is out of the question – in fact, it might be a relief to just have one so we can get back on track.
Recessions are healthy for the economy as it allows the best businesses to become better, it reallocates people and capital for greater productivity & Opportunity. It is much like a forest fire or cutting a bush back – painful in the short-term but also healthy in the long run.
Historically, when the Fear Index starts to max out, that is when the market often gets better. Investors have reached ‘Extreme Fear’. This bodes well going forward!
History in Perspective
In this chart, you can see that GDP and the S&P 500 are volatile but continue to grow through thick and thin.
As the world transforms, it seems to me that the opportunities are bigger than they ever have been.
There is so much to be grateful for.
As always, if you have any questions, let me know and I’d be happy to discuss. And if you found this information helpful, I'd love for you to share it with a friend!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All performance referenced is historical and is no guarantee of future results.
All indices are unmanaged and may not be invested into directly.
To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.