Material discussed is meant for general/informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss.
After reversing its gains from July and the first half of August, the S&P 500 closed out the quarter down 5.3%, bringing its year-to-date decline to 25%. The first 9 months of 2022 have been a struggle. One particularly difficult component of 2022: Bonds have fallen alongside stocks, giving investors few places to hide. Shares of the iShares Core U.S. Aggregate Bond exchange-traded fund, which tracks investment-grade bonds, lost 5.3% during the quarter and is down 16% in 2022, on pace for the worst year since 2004. See https://www.bloomberg.com/markets for current data.
Few strategies have helped investors this year. On Sept 13 Reuters noted – Fund managers are “super bearish” with average allocations to cash at the highest since 2001 and allocation to global stocks at an all-time low, according to Bank of America’s monthly survey of global fund managers for September. This can turn to be an optimistic point in that the cash may fuel the next leg of buying.
Each of these commentaries could be exclusively focused on the Federal Reserve. The actions of the central bank of the United States, European Central Bank and various other global entities that regulate interest rates and the supply of money have significant impact on markets. As we emerge from an era of historically low capital costs, interest rate increases have been rapid. This abrupt shift is creating waves of selling and a torrent of discussion regarding the perceived “safety” of fixed income.
The narrative for 2022 has focused on inflation, supply chain disruption, and Russian invasion of Ukraine. These headwinds are linked together: price increases, global instability and shortages all reinforce one another. The markets, poised at high levels to begin the year, had further to fall from the high prices of the end of 2021.
The convulsions of the current downward move are the result of the Federal Reserve’s efforts to combat inflation through the Fed Funds Rate. This was like a massive dose of financial steroids. Historic support administered by the US central bank to assist the economy during the pandemic was destined to change the value of money. Markets are now facing an abrupt end of monetary support. The financial steroids have been suddenly removed, the clinic is closed, and the patient is told to forge ahead and not come back.
This 180-degree reversal is a rug pull of global proportion. Traders have leaped in to exploit the unanticipated rapidity in which The Fed has changed course. Currently, most news flow, good and bad, sparks negative market reactions. Robust employment = bad. Wage increases = inflation pressure. New product introductions = supply chain deficiency to produce. These dynamics and many others are driving fear, and economic growth is bad news for the markets as the idea of robust economy is now perceived as a catalyst of further inflation.
Inflation is the new “underwater mortgage”. Endless financial media commentaries involve the threat of rising prices, interest rates and federal reserve statements and actions. In 2008, there was persistent worry regarding a significant portion of mortgages in the United States were in excess of the value of the underlying homes. This financial statistic led to numerous theories that predicted mass dislocation in housing and the entirety of the US financial system.
The dire fears of 14 years ago proved to be excessively negative as the housing markets proceeded to recover. The economic cycle washed away these conversations of doom and the crucible of US and global markets proceeded to sort success and failure. Today’s peaking negativity regarding inflation and rising interest rates is likely to dissipate as the markets force businesses and consumers to adjust and adapt, resulting in productivity increases which may alleviate shortages. Freakouts regarding interest rate increases have historically dissipated as the perceived risks often turn out to be less or different than feared.
Perspective is crucial: the S&P 500 was up 31.4%, 18.4%, and 28.7% in the preceding three years. This is important as the price level of a broad spectrum of assets had been bid up to levels that were vulnerable to profit taking. Waves of buying inevitably crest and recede. Frightening news causes agitated trading that tends to be overreactive and paint the world as a place that will remain in a dire state for the foreseeable future.
Revisiting conversations about loss has been a revelation as the markets had been on a largely uninterrupted upswing since 2008. Investors had not experienced negative reports for most quarters proceeding 2022. In these times of downswing there are crucial questions between advisor and client that must be addressed with a clear view of the long-term investing process:
Do you consider a decline from the high water mark a “loss” when longer term results remain positive?
Are you looking to redeem all the shares of your portfolio, or do you have a span of time in which to incrementally distribute income and withdrawals?
Have you reviewed historical data from previous down markets and seen that the majority of bear markets resolve into subsequent periods of recovery and positive returns?
The job of an investment advisor is to provide perspective, coaching and insight along with thoughtful portfolio construction. It is the process of investing over time that produces the potential rewards of patience, diversification, and selection of quality management.
Discussions regarding safety, stability and shelter from the downswing are now flowing across most investor lips. Historically, running from bear markets has been like installing fire prevention after the dwelling has burned. The recoveries from these bouts of negativity are a crucial component of the successful long-term investing process. “The Process” is a set of beliefs combined with quality money management, patience, and courage to stay the course in the face of temptations for perceived safety.
Bonds, money market accounts, and CDs often surge in popularity during periods of negativity and downswing. Our long-term investment process is at greatest risk in these periods as the desire for stability will grow the longer the bear market persists. Selling volumes often increase as prices go lower. This makes little sense, yet the psychic pressure rises and the desire to “stop losing” grows. Once you decide to rent your wealth for interest, it caps the upside and may result in lower results in exchange for reduced volatility.
Barrons recently published a piece titled Stocks Are Sinking and Rates Are Rising. It’s Painful, But We’re Heading for Normal. The author points out, “we’re moving toward normal, not away from it. The average monthly fed-funds rate in data going back to 1954 is 4.6%. Mortgage rates are turning more ordinary, too. The 30-year fixed rate recently spiked to 6.3%, versus 2.9% a year ago. But the average in data going back to 1971 is 7.8%.”.
On September 26 the Fed Funds rate stands at 3-3.25% and the 30-year mortgage is around 6.5%. The current pace of change is causing volatility, yet the price of money, interest rates, and debt levels do not indicate the level of gloom that has taken hold. Rates are reverting to historical norms. The whipsaw of this sequence of disruption since 2016 cannot be overstated. Just as the 2000s were shaped by 9/11, it is apparent that the current economic and political environment is undergoing an era that will be shaped by populism and activist central banks that sought to shield the globe from the pandemic and then shifted 180 degrees to combat the very inflation that the monetary actions caused.
Examining history, we can make a case that disruption is constant for Democracy and Capitalism. The Red Scares of the 1950s, Anti-war movements of the 1960s, race relations and so many other examples are the challenges that democratic capitalism grapples with. The American system has great resilience in the face of many challenges just as daunting as the current populist disruption. The Biden Presidency has little answer for this as some of the most damaging policies of the previous administration are still in place. From immigration curbs to tariffs there has been nothing but a disappointing status quo.
Bad news is like gravity. It holds us to the economic baseline as we cannot live in perpetually growing times without pauses and mitigation of the adversity that is always lurking. The oxygen of all of this is innovation, pursuit of quality living standards and growth of family. The tough times always seem to resolve, we grow, and then face the next challenge. Shortage is opportunity. Rising prices eventually become rising profits for business.
The numbers show that the run-up prior to 2022 was robust. The reveal of shortage, price spike and tragic war in Ukraine are the negative catalysts that may be more fleeting than current predictions. Investors need to ask what were the predictions one year ago? Wasn’t it obvious that 2022 was going to be terrible? We can all rationally agree that crystal balls are in very short supply. History demonstrates that after a downswing there is often bargain hunting that begins the recovery process. Good years may cluster around the bad and there is some evidence of this in past economic patterns.
Market Watch recently focused on all the “macro” of broad forecasts circulating. The piece begins by stating; “Their probability of being right is exceedingly low because of the complexity of the world”. It Is illuminating to see data that shows money managers that pursue broad prediction have had subpar results according to the data provided in the article. It may now feel intuitive that we were due for a downturn. This false sense of prediction is a cognitive bias that consistently looks back with the clarity of hindsight.
A stark demonstration of the folly of prediction for investors can be found in The Callan Periodic Table of Investment Returns. The table documents the variation year to year in what is the best sector and returns. From this table we can see in the ancient times of 2002, the sector “Large Cap Equity” declined 22.1% while Global Ex-US Fixed was up 22.37%.
2002 was an early step in the post 9/11 timeline that was filled with fear. Few commentaries make mention of the arduous path investors sought to navigate. The muddled US military response to the tragic attacks of 9/11 drove investors to deep fear for an extended period.
In 2003 the recovery began. The Callan Large Cap Equity category returned 28.6% and in 2004 10.8%. Down years are often followed by better results. Equities tend to deliver volatility along with the opportunity for the best returns. It is crucial to look to the past for reassurance and avoid prediction of future action as noted above, forecasting is folly.
The sheer variance of what each year of the last 20 in terms of what sectors did best is the most important takeaway of the Callan Periodic Table. During downturned markets, it is crucial to have this historical data on what has occurred during previous difficult periods. Past perspective allows the long-term mindset to remain confident in what has happened will potentially repeat. This process is fortified through this knowledge of the past. The best results are generated by time, not timing of what the safest or best sector is each year.
Take a ride on any interstate in America and you may notice that there is an unlimited supply of hamburger outlets. On a recent trip to visit family, it was no surprise that every exit between Detroit and Minneapolis along the I-94 corridor has various options.
We are all aware that fast food is a staple of the “American Road Trip”. Yet it is interesting to contemplate…why so many hamburgers? The immense supply of the burger may not be because that is what people demand. The American burger is of dubious nutritional value. I have been known to enjoy my share, yet I would recommend that serious consideration should be given before the consumption of the modern fast-food burger. Particularly on a road trip.
The economics of the business of grilling animal protein and serving it with condiments on a bun along with fried potatoes has been industrialized to the highest degree. These organizations are like any other in their pursuit of profit. This is a stark example of supply creating its own demand via compelling economics rather than consumers demanding all those burgers.
The challenge for society is that the economics are much more powerful than the rational pursuit of quality nutrition or more broadly, societal good. There are many examples of this in 2022 America; bloated SUVs lining highways, social media filled with misinformation, infotainment disguised as “news” and numerous additional profitable businesses that seem to work against public good.
Thinking of the “cheeseburger” as a product that exploits the human craving for warm, zesty and rapid satisfaction at the expense of nutrition is a shorthand mechanism for understanding business and profit seeking enterprise. The deeper societal challenges faced by citizens and government are much more intractable.
Investing for the greater public good is constantly challenged by the search for profits. Take the idea of “helping American workers”. The recent legislation passed by the Biden administration is entitled, the Inflation Reduction Act. New programs and complex ideas being construed as actions to reduce inflation is ironic and naïve at best. The definition of Federal action is often inflationary in and of itself.
According to The White House Fact Sheet:
The Inflation Reduction Act lowers prescription drug costs, health care costs, and energy costs. It’s the most aggressive action on tackling the climate crisis in American history, which will lift up American workers and create good-paying, union jobs across the country. It’ll lower the deficit and ask the ultra-wealthy and corporations to pay their fair share. And no one making under $400,000 per year will pay a penny more in taxes.
These attempts by the federal government to create laws that are supportive of the economy while pursuing ideological initiative are fraught with challenge and unintended consequences. As if a wand can be waved without economic cost is insulting to our collective intelligence. This is another struggle for democracy as the complexity of federal action is persistently increasing and causing potential regulatory overreach. Commercial activity is also impacted by the uncertainty of political change repealing the rules as often as the pendulum swings from left to right and back again.
Is the decline of Russian kleptocracy a potential outcome of Putin’s megalomania in Ukraine? What about the dismal state of Covid in China? President Xi has implemented persistent lockdowns an order of magnitude unimaginable in The United States and much of the Western World.
There is a current dynamic on the right in the USA for a certain regard for “strongmen” as evidenced by the recent appearance of Hungarian leader Orban being cheered at a “CPAC” gathering. This is a troubling trend, although there have always been segments of our political spectrum cozy up to thugs. Cheering for dictators is quite disturbing and counter to American values. It is reassuring that the evidence shows that Russia is a failed state. Just witness the streams of people recently leaving in lines miles in length.
The Economist recently highlighted that, “Dictators are often seen as ruthless but effective. Official GDP figures support this view. Since 2002 average reported economic growth in autocracies has been twice as fast as in democracies… the data showed that dictators’ reported GDP tended to grow much faster than satellite images of their countries would suggest.” In other words, they are LYING.
Our crucial wish is that the catastrophe of death and destruction in Ukraine can foster more cooperation by The West for a resolution and end to the war. It is a viable thesis to state that command economies like China and kleptocracies like Russia have no competitive edge versus market-based democracies. Societal structures are ultimately enhanced or destroyed by the living standards produced by such systems. The Cold War was largely decided by the superior prowess of western capitalism.
Mathematics is the language of calculation. This means that the search for “truth” is the basis of all that we utilize in our daily lives. From the food that we consume to the heat that allows winters to be tolerated. Math is the language of the engineering which constructs our modern lives. Math is logic, thinking and calculation. It is evidence. Awareness of lack of math, of evidence, can allow for better decisions in crucial areas of our lives, investments, and all manner of choices.
This language is sadly obscure to the masses who proclaim that, “I am not a math person”. This has placed many people in a pervasive state of innumeracy. Witness a bustling casino and you are viewing a river of mathematical ignorance. Followers of conspiracy theories need blindness to any logic as they move from allegation to accusation without a shred of rational thought.
As we contemplate the dynamics of finance it is not the specific calculations that matter. Appreciation and respect for the math that underlies the process of growing wealth is crucial. We seek evidence, aggregation of source material and logical plausibility. Scares, innuendo, or marketing is met with healthy skepticism and staunch belief in ignoring spin or sales-speak.
“Process” is based on the courage to invest, patience and belief that employing our wealth in the pursuit of diversified equity portfolios creates the conditions for the greatest outcome. Investment math kicks in as we stay patient, re-invest dividends, and resist the fear to flee during downswings.
Societal mathematics, otherwise known as economics, is the combination of sociology, psychology, economics and math. This intersection may be folly in that the complexity is beyond any scientific method’s ability to create theories and predictions that are useful for humanity. The renowned author, Naseem Taleb is alleged to have said, “Economics make homeopath and alternative healers look empirical and scientific.” I would say that economics is poker and math is chess.
Deficient scientific utility aside, there are economic truths that are as consistent as gravity. Supply and demand flow towards sustainable levels of price along with the supply of goods and services produced by market-based systems. The current challenges of shortage and rising prices are likely to be met many times over by innovation and human ingenuity. The current inflation spike is a challenge that will be overcome by the relentless progress of capitalism, freedom and rising living standards. This is documented with ample historical evidence.
The idea that a person who trades their account will miss the best market days is an interesting statistical game that has been presented in a variety of ways. Financial media has created charts for years that attempt to demonstrate what can happen to a hypothetical investment that misses out on the biggest up days of a given period. This is a mathematically manipulative way to communicate the importance of staying invested even when it feels frightening, as we watch the decline in value of a portfolio.
It may be useful to think of missing out on days where the market moves up dramatically. It is crucial to consider uninvested capital during the best years. These upswing periods tend to follow bouts of selling and negativity. It is impossible to know in advance when the negativity is clearing. Market history presents numerous examples of dire downswings giving way to greater stability and positive conditions for equity investors. The long-term mindset of staying invested through the down times allow us to be there for the good days, months, and years that are impossible to predict in advance.
Investment success is difficult. Thinking past fear and short-term disruptions is not natural for the human brain. Most do not achieve it due to fear and pursuit of the idea of “safety”. Passionate belief in the process of long-term investing is the most crucial trait that allows portfolios to stay invested. This may be the safest path as it has the potential for the greatest outcome.
Material discussed is meant for general/informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss.