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Headwinds

The first quarter of 2022 was the most volatile period for markets since the start of the pandemic, and the second quarter isn’t looking any better!

Last quarter I mentioned 4 risk factors. I should have mentioned the fifth: war.Two of the risksreceded, covid and slowing earnings. Of the other two risks, inflation is proving stickier than many expected, but the Fed has yet to do anything that could be construed as a mistake.

As the second quarter of 2022 begins, there are four major issues to watch:

The Russia-Ukraine War: Will the conflict expand, (Russia vs. NATO?) and, if not, how long does it continue to elevate commodity prices and choke off economic growth to a greater extent?

Inflation: It keeps getting worse. Higher inflation isn’t just making the Fed more aggressive with rate hikes, but at some point it will begin to compress corporate margins or destroy consumer demand.

Quantitative Tightening: In the next month, the Fed will announce its plans to reduce the balance sheet, known as Quantitative Tightening. That will be another form of tightening policy – one that could slow growth if it happens too quickly.

The Fed: The Fed is raising interest rates. At the start of the year, the market expected four 25 bps rate hikes. Now, the market may get four 50 basis point rate hikes between now and year-end.

We can also expect to hear headline speculation regarding an inverted yield curve. The important factor is the level of real interest rates. When interest rates are a couple of percent over inflation, that is the kind of monetary tightening that can slow an economy. We are a long way from that. However, since rates will be rising coincident with the Fed’s balance sheet runoff, the effect could tip us into recession sooner than it otherwise would.

Bottom line, we should all brace for more volatility in the second quarter. The outlook is not bearish, but I expect short-term market volatility. Realistic expectations are important. Prepare adequate liquidity to weather the storm as your circumstances require.

These issues that will drive near-term volatility. Longer term, earnings will drive markets higher.

Investing involves risks witch may include loss of principle. Past performance does not guarantee future returns.

The Underlying Strength of the Economy Is Unchanged

The underlying strength of the market has not changed. The pandemic is likely to end soon, perhaps by Memorial Day. Disbursement of the just passed $1.9 trillion stimulus is pending, with an additional likely $2.2 trillion coming with Biden’s just proposed American Jobs Plan to be spent over the next 10 years. Finally, the Fed remains committed to keeping rates low until they can persistently hit the inflation target of 2%.

With rising inflation concerns and a 4th COVID wave, crosscurrents made it a bumpy ride. At the end of the first quarter of 2021 the S&P 500 gained about 6.2%. I will spare you the economic scenario analysis and leave it at this. The long-term trend is up, but the short-term is impossible to know. I think the US equity markets are about 5% overvalued. Given the amount of stimulus and the fading pandemic, valuation is not a big concern.

About That Little Correction

I attribute every stock market correction or bear market to one of two reasons. Either valuations were too high and needed to correct to reconnect valuations with reality, or there could be a real-world problem (pandemic, war, recession, taxes, regulation, rising interest rates, etc.) that creates concern about the value of future cash flows.

In my last quarterly update from July 1, I observed, “Near term, the market does not seem to have a lot of upside until we have a Covid-19 vaccine.” Now we know how bad I missed on that prediction. The S&P 500 rallied 14.9% from July 1 to September 2, with the help of the best August returns in about 30 years.

Using the Morningstar Market Valuation chart, the market was about 1% overvalued on July 1. Earnings in July and August were strong, and analysts’ estimates moved higher. Still, by September 2, the chart indicated that the market was overvalued by 8%. The greater the variance of the market from fair value, the more likely the market price is to correct to the analysts’ more rational view. That is what just happened. As of the close on September 8, the market was back to 1% over fair value. However, the S&P 500 was still 6.9% higher than on July 1, when the quarter started. The difference is that earnings exceeded analysts’ estimates and fair value estimates were adjusted accordingly.

What does this mean? It means we need to buckle up for the ride, considering all the reasons to run for the hills. Volatility will not hurt you. As I described, that uncomfortable market experience you just had made you better off. Today the S&P 500 tacked on another 2.01% gain to rebound from part of the correction. That puts us about 3% over fair value, but well within the normal range. For reference, I usually cite 10% above or below fair value as a level to make tactical allocation adjustments, sometimes called market timing, because I think risk becomes materially asymmetric.

Let’s hope the 3rd quarter ends on a good note.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns. Sources include Yahoo Finance and Morningstar.

We Had a Good Year, Now What?

We finished a strong year, but perhaps not as strong as the numbers appear. Remember, we started from a low point after the market tanked in the 4th quarter of 2018 when the market decided the Fed was tightening too fast. The Fed reversed course, and after a few zig-zags rallied to finish strong.
I look for the stock market to return around 10% per year ON AVERAGE. Rarely does it go up 10% in any given year. It seems to be either +20% or more or -10% to flat. Furthermore, on average it goes up about 2 out of 3 years. That means it goes DOWN about 1 in every 3 years. We emphasize planning for liquidity to reduce the need to sell when the market is down. Financial planning helps define when, and how much you expect to need from your portfolio, at least for major events you can plan for.
A good year in the market does not change affect the probability that the next year will be up or down. Much like flipping a coin, the market has no memory. The market reflects what is known and expected at any given time. You can’t time the market and go to cash after years the market goes up by more than average and expect to improve the odds. That’s the gambler’s fallacy.
I view the current rally as a high risk, risk-on market. The rally is high risk because it occurred while 3 significant geopolitical events were happening: impeachment, trade war, and Brexit. A negative outcome from the market’s perspective in any one of these events could have precipitated a market correction. The trade war and Brexit appear to be moving toward a positive direction. Although pro-business Trump has been impeached by the House, the market appears to discount the possibility of conviction in the Senate.
Where do we go from here? The key variables include interest rates, valuation, and earnings. Economic indicators point to continued slow expansion rather than recession. Generous valuation is a function of low interest rates. Low interest rates coupled with continuing slow expansion can sustain current valuations. The wild card seems to be inflation. Although there is little indication that it will accelerate, it is notoriously hard to predict. The Fed wants higher inflation, and inflation could erase some Government debt (they pay it off with cheaper dollars). The Government would benefit from higher inflation. Inflation drives long-term interest rates and that would challenge valuations. Fortunately, as the last 10 years indicate, it is hard to generate inflation without stronger growth, but faster growth would help offset the effect of higher interest rates.
This starts to look like a circular argument, and that’s good news. Much like Newton’s Third Law, for every force there is an equal and opposite force, the economic forces driving markets tend to revert to long term averages. However, caveats include non-economic events such as wars, plagues, systemic failure, and meteor strikes. Sleep well!

Cross-Currents

The cross-currents of economic data are all over the place. The good news is that there is no clear indication of a recession. More specifically, indications are that the economy will continue in slow-growth mode of around 2%.

Personal consumption is about 70% of GDP and is currently the strongest component. Business investment and labor force growth are the keys to productivity, and this is the more worrisome factor. Political uncertainty discourages capital investment. Workers need better tools if they are to increase output. Labor supply, on the other hand, is constrained by birth rates, demographics, and immigration policy.

Trade war issues are contributing to weakness in manufacturing. While that could spill over into other areas, the weakness appears to be within the bounds of normal volatility. The best news on the trade front is that the pain does not discriminate. There are no winners. Consequently, trade wars are generally short-lived. The bad news is that neither China nor the U.S. has much incentive to compromise before the next Presidential election.

Finally, the Fed has worked itself into a position that raising interest rates appears to cause the stock market to decline. That’s logical since interest rates factor into stock valuation. However, the real issue is whether higher rates would dampen economic activity. I believe higher rates would be healthy and lead to a stronger economy. Any economic activity that would cease due to a 4 or 5% interest rate is probably an inefficient or unwise use of resources anyway. Getting to higher rates will cause market tantrums, but the end is nothing to fear.

And Now a Word from Our Sponsor

I was watching CNBC with the sound muted when I noticed an interview. I saw a woman and the graphic, 30 Years of Industry Experience. Wow! That’s all CNBC can say about their distinguished guest? While experience is necessary, it is hardly sufficient. One might expect something more substantive. It’s true that I only have 25 years of industry experience, so what do I know?

I know that the length of time I’ve been a financial advisor says very little about me. In my case, I think the 13 years as a financial analyst, before the last 25 years in financial services, was far more influential in my professional development. The role of a financial analyst is that of a paid devil’s advocate.

A corporate financial analyst is a gatekeeper. Any advocate in a company promoting a project or strategy that requires investment needs to demonstrate the financial effects of the idea to management. That requires a financial analysis of the project to determine the net present value and internal rate of return based on projected investment and the resulting cash flows. The financial analyst must be sold on the assumptions that will drive his models. Garbage-in, garbage-out.

The analyst must drill into the underlying data to verify everything. The marketing, engineering, and new product folks become emotionally invested in their ideas. The analyst must vet the projects as the gatekeeper to funding and balance the interests of zealous advocates against the numbers.

I view investing like project analysis. They both need to pass the expected return on investment hurdles and scrutiny of the underlying assumptions.

Many financial advisors, in fact, the most successful ones in my experience, are successful because they are well-connected and are great relationship managers. They impress, like any good salesman.

Who’s watching your wallet?

An autobiographical perspective from Robert Higgins

Spooked

Sometimes the herd gets spooked, but sooner or later things settle down. Sometimes there’s real cause for concern and other times it is mostly rumor blown out of proportion. But whether it’s a world war or a banking crisis, it usually gets resolved in less than 5 years. Then everybody gets back to business building the earnings of companies that drive markets higher.

In last quarter’s note, I referred to my blog post from September 26, Recession Strategy,

“The real issue is not how deep the correction will be. The real concern is the duration of the decline. How long will it take to get back to even? The problem is not that the stock market will go down. The real problem is if you need to sell stock when valuations are low to fund current living expenses. That converts a temporary loss of capital into a permanent loss of capital.”

The good news is, we’re not in recession although growth is slowing. Much of the problem is tariff/trade driven and compounded by China’s slowing growth. Case in point, Apple, recently the most valuable company in the world, is down about 9% today (1/2/2019) because of Apple’s 7% growth and Tim Cook’s comments about business in China.

I often refer to a Morningstar Market Valuation Analysis that tracks a ratio that represents the average of market to fair value (premium or discount) for the more than 2000 companies they cover. That’s a powerful statistic that includes a tremendous amount of rational, systematic analysis. It is instructive to see what the chart looks like for the last 90 days (as of 1/2/2019).

Source: Morningstar

According to the ratio, the market has gone from about 4% overvalued to a 12% discount. That’s a swing of 16% in terms of market price to fair value, and potentially more in absolute terms if analysts have reduced fair value estimates because of weaker economic data. Despite that, these types of corrections are more common than you might think if you focus on the last 10 years. A 10% decline represents a “correction” and a 20% decline counts as a “bear market”. Whatever you call it today, it doesn’t feel good, but it will pass. The main question is how long will it last?

The Market Correction of 4/10/14

Yesterday the stock market had a bad day. The S&P 500 index lost 2 percent and is now negative for the year. The NASDAQ was down more than 3%.

Bear markets and corrections tend to be shorter and steeper than bull markets generally. The cacophony on CNBC featured technical analysts drawing channels on charts showing how far above trend the market is. Using these minimum and maximum points to draw channels presumes that the overvaluation and undervaluation of markets, at extremes, is equal. I believe that is flawed logic.

In 2009, the bottom fell out of the market, in large part due to illiquidity. Leveraged funds were forced to sell what they could, which in many cases were the better capitalized public companies that predominate major indexes. I believe the overshoot on the downside, from panic and illiquidity, tends to exceed the wall of worry melt-up climb and climatic exuberance of bull markets. In other words, don’t assume the middle of the channel is the deepest part (to use a boating metaphor), or the best representation of intrinsic value.

Commentary was quick to draw comparisons to 2000 and 2009 corrections. I see little to compare. In 2000, valuations were about 50% higher on average than today. The internet bubble burst. In 2009, we experienced a banking crisis precipitated by a collapsing housing and mortgage market, with repercussions few imagined.

One legitimate concern today is the effect rising interest rates will have on corporate earnings and the economy in general. To the extent companies use debt to finance operations, and consumers use credit to buy from companies, the rising cost of money will be a drag on profits from the expense side, and consumption from the revenue side. That is certain to squeeze net margins, and suggests today’s historically average price/earnings multiples may be optimistic.

However, a big offset is the improving job and housing markets that point to a normalized economy. With improving housing and jobs, we may continue the slow healing of the economy from the mortgage crisis. As for yesterday’s sell-off, I see no need to panic. In fact, I see a clearance sale.