Tag Archives: recession

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The markets got you on edge? This post is for YOU.

THE SITUATION

The current economy, marked by the combination of high and rising inflation, low unemployment, and the near-zero interest rate policy by the Federal Reserve is like none that investors have experienced, at least over the past 40+ years.  The uncertainty of the situation has resulted in falling prices of both stocks and bonds at the same time–also a first in a very long time.

 At this writing the aggregate U.S. Bond market (AGG) is down nearly 12% year-to-date, Treasury Inflation Protected Securities (TIP) down 8.4%, and U.S. stocks as measured by the S&P 500 (SPY) are down 22.4%, what is known as correction territory, defined as -20%.   

THE PROBLEM

If you are feeling uneasy about your investments, rest assured that you are not alone.

Now, most investors, and many professionals, follow the routine that has been popularized as asset allocation. You likely know the drill: own a basket of individual securities and / or funds of traditional asset classes such as cash, stocks, and bonds.   Allocate the entire portfolio across those asset classes and periodically rebalance the portfolio back to those prescribed allocations. In this strategy, you wash, rinse, repeat and your investment portfolio will be safe, or so it goes. The portfolio objective of this strategy is to achieve market-like returns within the particular asset classes while reducing volatility of the entire portfolio by holding securities that move counter-cyclically with each other. In other words, the theory assumes that total upside and downside volatility, not loss of capital, is the chief risk that we investors face.  But let me ask, won’t we accept, even desire, all the upside volatility we can find?  It’s the downside that keeps us awake at night, right?  But what happens when all the usual asset classes are declining at the same time?  Turn to cash?

Thanks to Federal Reserve policy, the interest rate on cash remains at nearly zero.  With inflation running rampant at about 8%, holding cash while we wait for the markets to settle down means that purchasing power is evaporating. 

Remember that the Fed only controls short term interest rates.  The bond market controls the rates of longer-term bonds.  The interest rate on a bond is fixed at the time it is issued. The bond market fulfills its function by bidding up or down the price at which it is willing to buy bonds.  As interest rates that the bond market considers attractive increase, the price of the bond must fall to provide that rate. That is why your portfolio of bonds decreases in value as interest rates rise.

I am sure that you probably think the current market only presents a problem.  However, we invite you to join us in seeing it as an opportunity.  Please look at your portfolio performance (both the percentage return and the number of dollars gained or lost) for the trailing twelve months.  Assess how you feel about that.  There is a strong chance that current stock and bond losses will get worse before the markets turn around.   If you are losing sleep now, just know that although not guaranteed, things can get worse and that you have a wonderful opportunity to accept or adjust your risk tolerance. Now is a good time to assess your risk tolerance and to inform your advisor so that he or she can take steps to align with reality.

OUR SOLUTION

In 2002, while still attending to the tenets of traditional asset allocation, we began to select stock and bond mutual fund investments based, in part, on momentum. Each asset selected for the portfolio was growing at a faster rate than its peers. We likened our analysis to watching a horse race and seeing a particular horse moving through the pack toward becoming the leader. (Just to be clear, we don’t invest in race horses or advise that our clients do that, despite being from Kentucky.) Often we found the need to get on a fresh horse (investment) at the quarter-mile pole. Initially, we invested in this way without imposing risk controls of selling those securities that lagged the others.  We called it our Momentum Growth Strategy. This subjected the portfolio to drawdowns consistent with the market.

In 2007, we became aware of the work of Dr. Mordecai Kurz at Stanford University.  Dr. Kurz posited that most of the risk in the market is endogenous to the market and not to some outside forces. This discovery has far-reaching significance. We then asked our clients with which they were most concerned: a) failing to achieve market returns or b) losing their capital.  Many responded that they were more concerned with the latter.  In response, we developed the Wealth Preservation Strategy just in time to prevent significant losses in the 2008 downturn for those clients who chose that strategy over the Momentum Growth Strategy.  This strategy also worked very well to protect capital in the downturns of 2011 and 2018.    

One aspect of the Wealth Preservation Strategy has been the use of technical analysis to determine the entry point for adding new securities to the portfolio mix. Attention to risk controls for each individual security and position sizing are other aspects of the strategy designed to control drawdown. We did not allow small losses to turn into big ones. The strategy also usually carried a rather significant allocation to cash. This works as long as inflation remains low or non-existent. But now we are at a different place and a different time.

As the markets’ access to free capital via the Fed’s zero interest rate policy kept driving up the stock market, it was quite normal for some investors to totally abandon Wealth Preservation for the sake of seeking higher returns. 

At times like the present, when all the usual asset classes are turning down, we instead hear investors clamoring for more Wealth Preservation. By the way, when it comes to investing, any inclination to either “throw in the towel” or “to go all in” is usually a mistake.

So, what is a person to do?

  1. Invest the Wealth Preservation strategy to minimize volatility and in such a manner that will preserve purchasing power with capital appreciation at least as much as inflation.
  2. Adjust Momentum Growth Strategy to a higher risk / higher return portfolio using technology and market trends along with fundamental analysis designed to pick top performers.
  3. Blend the two strategies in proportions that will attend to your individual tolerance for drawdowns while seeking a return that addresses your objectives.

Rather than mandate the allocation to particular asset classes, i.e., stocks and bonds, we might allocate a portion of assets to each of the two strategies. The amount to allocate to which strategy will solely depend on one’s risk profile that has been mathematically determined i.e. tolerance times capacity. Regular rebalancing is also important and should be done quarterly or quantitatively when the total portfolio gets out of balance.  The more risk tolerant you are, the greater percentage of your overall portfolio should be invested in Momentum Growth.  Wealth Preservation will protect from further drawdowns. We have made a concerted effort to ascertain our clients risk tolerance on a 1-5 scale of Conservative, Moderately Conservative, Balanced, Moderately Aggressive, or Aggressive. 

We will also choose assets that we believe will perform well in the current economic environment.  Consequently, you will likely be able to retain some of your current investments, but we may also invest in ETFs that track commodities, precious metals, and real estate, rather than exclusively in traditional stock and bond ETFs. We may also recommend that, at times, you invest in a reverse-index ETF that moves in opposite direction of its index. Hopefully, these are not long-term investments as they are expected to perform well while the market is going down and inflation / interest rates are rising.  We can only hope that policy makers will soon get our economy back on track for sustainable growth.  Meanwhile, we must all dance to the music we hear.

You are likely to have questions about this and, as always, we welcome them.

May 25, 2022 and updated June 20, 2022

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This is not your father’s economic recovery

Technically, the economy is still in a recession. The National Bureau of Economic Research (NBER), the arbiter of recessions and economic recoveries, has yet to declare that the recession is over. When it does, it will likely backdate the end of the recession, as it has done in the past. Remember 2008. It took the NBER over a year to tell us that the recession really started in October 2007.

Regardless of when the NBER makes its declaration, this economic recovery has been far from what might be considered a normal recovery. The pandemic that led to the steepest slide in quarterly GDP on record (U.S. BEA, quarterly records began in 1947) has also shaped one of the most lopsided recoveries we’ve ever experienced.

Look no further than service-based industries that require the personal interactions to thrive, which is something we took for granted pre-Covid.

Social distancing restrictions and fear of contracting the virus have severely impacted airlines, hotels, travel, restaurants, concerts, and movie theaters. Obviously, these industries and more have struggled to adapt to the new normalcy. Some will never recover.

Even health care has suffered. According to data from the U.S. BEA, spending on health care is down 12% versus one year ago (Q4 2021 vs Q4 2020). Health care spending accounted for over 10% of GDP in the final three months of last year.

But other industries have adapted. For example, real estate and home building relies heavily on the personal touch. But record low interest rates have spurred strong demand for housing.

Essential retailers, home improvement, auto sales, and grocery stores have experienced robust numbers. Consequently, manufacturers were caught off guard by the resurgence in sales.

A February 22 story in the Wall Street Journal sums it up well: Consumer Demand Snaps Back, Factories Can’t Keep Up. Snarled supply chains, labor shortage thwart full reopening; “Everyone was caught flat-footed.”

Can you guess what happens when demand outstrips supply? Inflation. And what the mere fear of inflation brings on? Higher interest rates. Many people mistakenly think that the FED controls interest rates. That is only true for the very short term rates (like money markets). I have long said that the bond market is in charge. Last week, the bond market started bidding up long term interest rates. It is important to remember that as interest rates go up, bond prices come down. This phenomenon also put the brakes on the stock market rally.

Reopening various sectors of the economy has helped fuel recovery. Generous jobless benefits and two rounds of stimulus checks have left many with ample cash to spend. While the final touches aren’t yet on the latest relief package, more cash than we have ever seen in one package is likely to be on its way to the vast majority of people.

But here lies the problem. Government restrictions prevent most of us from attending sporting events, museums, and the theater. I think I speak for many who are not fully comfortable traveling on airplanes, spending a night in a hotel, or enjoying a meal at a restaurant. It will likely take a few months for a lot of people to get comfortable with these things again.

The extra government support that has helped fuel growth has been funneled into some industries or into savings, which I recognize are needed, but it has severely hampered others.

You might consider your own circumstances. Have you noticed smaller balances on your monthly credit card statements? Have you noticed a different mix in your outlays versus pre-pandemic? Are you streaming more movies rather than going out to dinner or enjoying the theater? Has your choice of recreation been altered or completely eliminated?

A new and bigger relief package, currently pegged at $1.9 trillion seems likely to get out of Congress and onto the president’s desk very shortly. Expect the new cash to support the economy and to continue to support various sectors that have benefitted at the expense of other sectors. We are looking closely at cyclical stocks right now.

What might help the beleaguered industries that have suffered under today’s restrictions? (First quarter 2021 is likely to show significant year-over-year results but future quarters are still in question.) Only one thing we can likely truly count on: more volatility in both GDP and the markets.

Here are six factors identified by economist Dr. Woody Brock that will lead to continued growth in the economy:

  • The vaccine rollout goes smoothly.
  • There are no new strains of the virus that cannot be immunized against.
  • Significant new fiscal stimulus is provided soon.
  • At least a 70% success of Biden’s $1.9 million package.
  • Public confidence in the future is restored.
  • Huge pent-up demand translates into catch-up spending.

If all these things come to pass, significant economic growth will likely occur from April into 2022. Then guess what happens to the reporting for 2022? The numbers may once again turn negative. The notion of long run averages will be stood on its head.

Cautiously, Dr. Brock warns that if only half those conditions come to pass, growth will stagnate at around 1.5%. If none are met, we are probably in for a long-lived recession. We will know which it is long before the NBER tells us so. Stay tuned.

Updated March 9, 2021