IronBridge Private Wealth

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IronBridge Insights

7 Lessons for Any Bear Market

Vienna, Austria - May 20, 2017: Main hall of the historical Austrian National Library in Vienna (Austria) on may 20, 2017, with an ancient globe map

That is the great fallacy: the wisdom of old men. They do not grow wise. They grow careful.

Ernest hemingway, “A farewell to arms”

Bear markets are not fun.

We all know that.

But there are valuable lessons from bear markets if you learn them.

Fortunately (or maybe unfortunately), we’ve lived through quite a few over the past 25 years. And given the volatility experienced during that period of time, our investment “age” would place us as old men. (The women of IronBridge remain obviously youthful.)

So Hemingway’s line from “A Farewell to Arms” resonates with us.

Bear markets may or may not create wisdom, because each one is different.

We don’t know how this one will play out. No one does.

But we have learned to be careful.

This got us thinking about various lessons we can learn from previous bear markets, and how we can apply them to today.

Below, we look at some higher-level lessons that relate to you and your well-being, as well as those learned from financial markets directly.

Let’s dig in.

Lesson #1: Keep Your Financial Plan on Track

The worst possible outcome of market volatility is not a decline in your wealth…it is a decline in your LIFESTYLE.

Don’t let that happen.

A good financial plan will factor in volatility in your portfolio. It is called stress-testing, and it is a statistical analysis using variable portfolio returns.

The chart below shows an example of hypothetical return projections for an actual client’s financial plan.

Real life future return projection including variability in returns and statistical analysis of a financial plan.
Source: IronBridge

This is just one of a thousand different potential scenarios our planning software uses to stress test someone’s probability of success in a financial plan. (Please do not hesitate to reach out if you would like us to update your individual financial plan.)

Two major things we notice about this projection:

  1. Returns are not linear. Our software does not assume the same return every year.
  2. Returns aren’t always good. Four of the first five years in the chart show negative returns. The worst projected decline is negative 28%.

Assuming variability makes your plan more realistic.

By projecting that bad years will happen, your portfolio can better weather the storms when they happen.

Lesson #2: Avoiding Large Declines is Key

This seems like the most obvious lesson, but avoiding large declines is the SINGLE MOST IMPORTANT thing you can do when investing.

Why?

Because when you experience large declines (which we define as 25-30% or greater), you don’t only sacrifice your financial plan, you lose the most valuable investing commodity there is: time.

You lose time by requiring huge gains to get back to where you were before the bear market began.

The next chart shows the return needed to get back to breakeven for various portfolio declines.

Returns needed to recover after various portfolio declines on a percentage basis.
Source: IronBridge

This chart shows that if your portfolio is down 10%, you need an 11% return to breakeven.

What stands out to us is that if your portfolio declines 30%, you need a whopping 43% return to breakeven. This is a huge return that takes multiple years to accomplish.

If you have a 40% or 50% decline, you need incredible future returns to get back to where you were.

These types of declines are not only painful emotionally, but will have hugely negative effects your long-term financial health.

Having the ability to move to cash is critical in our opinion.

Cash and short-term fixed income are the only predictable places to hide when major volatility hits the market.

Lesson #3: Diversification is Not Risk Management

Having different assets in your portfolio does not mean your portfolio is protected against large declines.

This year is a perfect example.

As of today, long-term bond prices have fallen MORE than stocks on a year-to-date basis, as shown in the chart below.

Stocks and bonds all down so far in 2022.

Maybe this changes in the second half of the year.

But relying solely on diversification as your primary risk management tool is not a good strategy to avoid large declines.

Lesson #4: Prices can Fall Further than You Think

There’s an old saying in the markets:

“How does a stock fall 90%? Easy, first it falls 80% then it gets cut in half.”

The lesson is that prices can be extremely volatile in bear markets, and can fall well beyond what may seem logically possible.

Let’s look at an extreme example of this today: Zoom stock.

Zoom was a darling of the COVID period as people abandoned the office and went remote. We at IronBridge became Zoom clients, and still use it many times per day.

Their earnings have consistently increased over the past two years, as shown on the bottom half of the chart below. The top half is price (blue line), and the orange is earnings per share.

Zoom stock has fallen 86% despite earnings increasing substantially.

Not only have earnings increased, but they have massively increased (up more than 8-fold).

Over the same period of time, however, the stock has been crushed.

It was down 86% from peak-to-trough. Ouch.

This illustrates perfectly that the market is not always logical. We would go a step further and say that more times than not it is very illogical.

But if you are prepared for it, both strategically and emotionally, you can handle the fact that it will probably do things that don’t make sense.

Lesson #5: Markets Lead, Economic Data Lags

One of the most common arguments during the early stages of a bear market is that the economic backdrop is strong.

The problem is that economic data is backward-looking.

In 2008, the initial GDP numbers were positive for most of the year. It was only until late 2008 (when the market was down nearly 40% on its way to being down over 55%), that GDP was revised lower for previous quarters.

It showed that the actual recession started nearly 12 months before, in late 2007. But in real time, GDP didn’t go negative until the market already declined.

Don’t rely on forecasters to give you any help, either.

Here are forecasts from the 12 largest investment firms in 2008. This was published in Barron’s magazine in early 2008 after the market had already peaked and was down nearly 20%.

Just over a year later, the S&P 500 bottomed at 666 (this still freaks us out a bit). Most of these forecasts were wrong by over 1,000 points. Nice work.

Instead of looking at the economic data itself, like the fine prognosticators above were, pay attention more to the trends of the data:

  • Is economic data improving or deteriorating?
  • Are companies lowering forward guidance, or do they foresee continued strength?
  • What are leading economic indicators doing?
  • Is previously reported economic data being adjusted higher or lower?

Markets will price in risk before the economic data reflects the risk.

Sometimes the markets are wrong. After all, not every bear market results in a recession.

But if you can identify how economic data is trending, you can better assess the overall risk in the market.

Lesson #6: Bear Markets Don’t Repeat, but They Tend to Rhyme

No bear market is exactly like a previous one.

But there are similarities.

For one, there tends to be excess speculation somewhere in the economy or markets.

In 2008, it was real estate. In 2000, it was tech companies. Today, central banks have printed our way into a complete mess. In addition, crypto is one area where we are seeing excess speculation turn into massive losses in value.

In addition to working off excesses, bear market patterns tend to look similar.

The first chart below compares 2008 to 2022.

Current market looks similar to 2008.

Looks pretty similar to us.

In 2008, there was a 22.5% drop before the bottom fell out of the market. Today, markets are down 23.5%. Maybe this suggests we are close to a similar outcome.

But there are plenty of chart comparisons that don’t result in massive declines.

In 1984, there was a recession, and the Fed was fighting inflation.

The next chart compares 1984 to today.

Current market looks similar to 1984

The pattern here looks pretty similar as well.

While both comparisons pass the eye test, each environment was different than today.

So while looking at these types of charts are interesting, they shouldn’t drive your behavior one way or another.

Lesson #7: Bear Markets can Happen in either Price or Time

When most of us think about a bear market, we naturally think of 2000 or 2008.

These were bear markets in PRICE.

In 2000, the Nasdaq fell over 70%. In 2008, the S&P 500 fell more than 55%.

Those of us in the markets then will remember those periods for the rest of our lives.

At their core, bear markets work off excesses of the previous economic and market expansion.

Prior to both 2000 and 2008, markets grew at rates that were were unsustainable. By the time these bear markets were done, prices collapsed and all the excesses were removed.

Price corrections tend to happen over the course of 1-3 years.

But markets can correct in TIME as well.

We haven’t seen a correction in time in quite a while.

In fact, the 1970’s were the last real sideways bear market.

The final chart looks at the Dow Jones index back to the late 1800’s.

Long term chart of the Dow Jones shows longer term bear markets.

This chart shows 5 major periods of sharp price declines: 1929, 1987, 2000, 2008 and 2020 (circled in red above).

The tamest of these periods was 1987, when the market “only” lost 34%. Each other time, markets fell well in excess of 40-50%.

Additionally, there were 3 major bear markets that occurred in “time” (the blue shaded areas above):

  • 1900-1915
  • 1934-1950
  • 1968-1982

Each of these periods lasted either 15 or 16 years. That’s a long time to have to wait for returns to start moving higher again.

Fortunately, these major bear markets don’t happen all that often.

But one thing in common with the previous bear markets that corrected in “time”: rising interest rates.

If we are going into a period of rising rates, which seems like a good assumption, the likelihood of a bear market in time seems to be a higher likelihood than a bear market in price.

Don’t let that scare you, though…there are ways to make money in a choppy sideways market.

It requires two components:

  1. Tactical exposure in the markets.  You don’t want to buy-and-hold in a “time” bear market.  The volatility will chew you up and spit you out.  You must have the ability to move to cash to limit volatility when downturns happen, but be able to increase exposure to areas performing well.  This is the basis of our investment philosophy at IronBridge.
  2. Increase exposure to yield-generating assets as interest rates rise.  As yields go up, you can earn more on a variety of assets to compliment your tactical market exposure.

We are preparing for this exact scenario, and have already begun having discussions with a number of our clients about what this means in your particular situation.

Bottom Line

In summary, there are always lessons to learn from any market environment.

But it does appear that we are in a bear market that may not reverse as quickly as those that have occurred since 2008.

Thus, us battered old investment men at IronBridge will echo Hemingway’s quote and be careful and cautious until the situation tells us not to be.

Invest wisely!

Gimme Shelter

A Directional Sign in Front of Storm Clouds indicating the Storm Evacuation Route. Arrow on sign is directing to the right.

Ooh, see the fire is sweepin’
Our streets today
Burns like a red coal carpet
Mad bull lost its way

– Rolling Stones, “Gimme Shelter”

The mad bull has lost its way.

And an historically volatile year is getting worse.

Last week it appeared that the market may have saved itself from more volatility.

But out-of-control inflation numbers once again show that this environment is anywhere from over.

In fact, it’s getting worse.

We don’t say this lightly, but the risk of a major market melt-down is extremely high right now.

The way the market structure looks right now is concerning.

Here are four of our major concerns:

  1. The Fed wants to reduce inflation, despite the consequences to the market or the economy.
  2. The bond market is cratering.
  3. Positioning in the market still remains bullish, despite very bearish sentiment.
  4. Patterns within the market are mirroring previous major declines.

We’ll briefly discuss each of the above, but let’s talk about portfolio positioning first.

Portfolio Update

Two weeks ago, the market rallied, and caused us to add measured equity exposure to portfolios.

As of today, all of that increase has been reversed, and equity exposure is now lower than it was three weeks ago.

Overall, we are extremely underweight exposure to stocks. And we expect that to be reduced throughout the week as well.

The next chart shows how your equity exposure looks relative to the maximum amount of equity you could potentially have in your portfolio.

The remaining balance is in cash and short-term fixed income.

NOTE: When we say “cash”, we are referring to cash and cash equivalent ETFs in your account. The following tickers are considered either cash equivalents or short-term fixed income, with very little volatility: FTSM, BIL, GSY, RAVI, SHV and PSDYX.

By the end of this week, it may make sense to use inverse ETFs to hedge equity exposure for a short period of time, while holding certain positions that are still showing favorable risk/reward metrics. (We did this during the COVID crash in March of 2020, and it proved to be a very effective risk management tool.)

So while we have already reduced your equity exposure dramatically, it could get even lower as the week goes on.

As always, please reach out to us directly with any questions.

The Fed

The Fed meets this Wednesday.

They are in a bind.

Earlier today, the market was projecting a 72% probability of a 0.50% rate hike, with a 28% probability of a 0.75% hike.

However, after the market, the Fed apparently leaked data suggesting they would do a 0.75% hike instead.

Probabilities immediately rose, and the market is now projecting a 93% chance of a 0.75% hike on Wednesday. All in the matter of a couple hours.

The next chart shows the probability earlier today, courtesy of the CME group. Click on the chart to be taken to their website. The bar on the left is the probability of a 50 bps rate hike, and the one on the right is for 75 bps.

And here are the probabilities now…

Just over a week ago, the probability of a 0.75% rate hike was only 3%. So in a few short days, the Fed changed their mind.

They have a fundamental choice to make: do they crash the markets and economy and reduce inflation, or do they blink and let inflation get further out of control?

It seems pretty clear which approach they want to take: fight inflation and the markets be damned.

Frankly, they are sleeping in the bed they made.

They let the bull market get crazy, and now the mad bull has lost its way.

The Bond Market

Bonds typically are a hiding place during volatility.

But when the Fed is raising rates, bonds have had more volatility than stocks.

In fact, long-term US treasury bonds are down over 58% over the past two years, as shows in the next chart.

This is not a sign of a healthy environment.

Positioning versus Sentiment

One of the things we’ve been watching as a positive for asset prices is sentiment.

Sentiment is a contrary indicator.

When sentiment is extremely positive, market prices can be near a top.

Conversely, when sentiment is extremely negative, like it is now, it can be a sign that a low in prices are near.

However, new data has come out showing positioning by investors.

And what is shows is that what people are saying versus what they are doing is very different.

The next chart, courtesy of All-Star Charts, shows this variance.

The orange line is positioning. This shows the current allocation to stocks by a survey from the AAII (American Association of Individual Investors).

The blue line is sentiment. It shows the University of Michigan Consumer Sentiment readings.

Previously, there has been a very strong correlation between the two.

Now, this correlation has broken down completely.

This suggests one of two things:

  1. Consumers are overly pessimistic, and will ride out this storm.
  2. Investors are overly allocated to stocks, and a massive shift out of equities is about to occur.

Our guess is that the second scenario is the likely outcome.

Market Patterns are Similar to Previous Major Bear Markets

First of all, every decline is unique. We do not use this type of analysis in our day-to-day investment management process.

But it is interesting just how closely the current market environment resembles major bear markets from the past.

The final chart, from Nautilus research, shows how the current environment compares to other major bear markets in 1937, 1973, 2000 and 2008.

(Our apologies for the small print…click to view a larger version.)

The correlation of the current market to each of these previous bears is very high.

In fact, the current market has over a 90% correlation with each of these environments.

Again, we don’t have any direct inputs based on analysis like this, but it does suggest that the overall pattern is similar to other major tops. And we should be aware of these types of correlations.

Bottom Line

We were hoping the volatility was over, and that the extremes in sentiment that we have seen recently were going to be good signs of an impending low.

However, our concerns now are “how much further can this fall”?

We wish we knew.

The bottom could have happened today. We doubt it, but it could have.

However, the bottom may very well be much, much lower from here.

And we’re not going to wait around to see what happens. We’re not going to HOPE things change. We’re not going to stand by and let an out-of-control market destroy your hard-earned capital.

We are going to ACT. We have already taken major steps to reduce risk, and are prepared to take even more as warranted.

We’re in a time of MAJOR risk for markets.

Today felt a little panicky. Our guess is that it starts to feel much more panicky in the coming weeks and months.

If we are wrong, we will gladly admit it and add equity exposure back into your portfolio.

But if we are right, we will help you avoid what is potentially one of the largest bear markets in history.

When the mad bull finds its way again, we’ll be prepared.

But in the meantime, we’d rather protect your portfolio than stand by and watch it fall.

Invest wisely!

Stick Save

A stick save occurs in ice hockey when a player uses his stick at the last second before the puck enters the goal.

We realize that an ice hockey reference may be considered blasphemous. We’re in Texas, after all.

But a stick save is an excellent reference for what happened this week.

Just when it looked like the bottom was about to fall out of the market, prices reversed higher.

In our recent webinar, we discussed scenarios where the market moved higher to test 4100, and the real information would be gathered if/when that happened.

(Here’s our webinar in case you missed it…our scenario discussions begin at minute 13:31)

Right now, most of the economic data is heavily skewed to suggesting more downside in prices, mainly due to persistently high inflation and a slowing economy.

As we mentioned in our webinar, the one thing that could support the market here is sentiment.

And it looks like sentiment is coming to the rescue.

When we say “sentiment”, we are referring to two things:

  1. Investor optimism and pessimism
  2. The positioning within the market

The first item above is simply a gauge of investor attitudes. It can give good information about the overall environment, but it doesn’t have any direct impact on stock prices.

The second item does.

“Positioning” within the market refers to the actions being taken by market participants.

This is essentially the “plumbing” of the market.

When more money flows in one direction, prices follow. Just like water in a pipe.

If more money is buying, prices go up. And vice-versa.

This may sound simple, but this plumbing refers to how markets actually work. It doesn’t matter what the P/E ratio is, or what GDP is doing, or what interest rates are.

GDP may cause more investors to buy or sell, but GDP is not a direct input to stock prices. It is an indirect input.

What matters is flow.

The volume of money moving throughout the market is the only direct input that matters.

Despite the legitimate worries about inflation, the economy, geopolitics, etc. (indirect inputs), enough people acted on it before last week (by selling stocks) that prices moved lower (direct inputs).

It looks like sellers were finally exhausted last week, so buyers were able to push prices higher in the face of deteriorating economic data.

Which puts the market right into the middle of an important resistance zone, as we also identified as a possibility in our webinar.

The next chart shows the S&P 500 this year.

S&P 500 Index at critical resistance. If it breaks higher, markets could rally 10% or more. If it stays below current levels, the bear market could continue. Next week is very important.

A couple weeks ago, the critical 4100 level broke to the downside. However, markets staged a rally and are now testing the resistance area.

It’s akin to a hockey player swiping away a puck right as it is entering the goal.

Stick save.

This rally makes the next two weeks critically important.

Markets were closed on Monday is observance of Memorial Day, but the shortened week should be one of the most important weeks of the year. It may end up carrying into next week, but the market should tip its hand soon.

If it can break higher from here, chances increase that we may have seen the low point for this bear market.

We are definitely not out of the woods if the market breaks higher, but it does start to suggest that the majority of the bad news has indeed been priced in.

However, if we see a selloff this week, then we need to be prepared for another major leg down.

The initial target for the S&P 500 Index on a move lower would be 3400, with another support level at 3100. (The S&P 500 is just over 4100 currently.)

So we can’t be blindly bullish here, but we can’t assume that things are all negative either.

If the market does keep rising, we will begin adding stock exposure back in client portfolios, and take on more of a cautiously optimistic tone.

We’ll provide another report late this week or sometime next week to provide an update.

Invest wisely!

Wise Men and Fools

The fool doth think he is wise, but the wise man knows himself to be a fool.

“As you like it”, Act v scene i, by william shakespeare

Markets are never easy.

Granted, there are times when things seem easier than others.

Over the past 13 years, investors have grown increasingly complacent about how easy investing can be. After all, every time there was a blip in the market, prices came roaring back quickly.

When data and trends align well, we can make higher probability conclusions about the direction of the market.

But when we have conflicting data, as we have now, it becomes more difficult to identify the direction with any real confidence.

Shakespeare’s quote is appropriate for this environment.

To think we know for sure what will happen is foolish. It is much better to acknowledge that we don’t know what will happen, so we can view developments with objectivity.

There are strong reasons to be optimistic about the markets over the coming months and years.

However, there are strong reasons to be incredibly pessimistic about the markets as well.

An important skill in this type of environment is to be mentally flexible. To know that you don’t know what will happen.

Let’s look at both the positive and negative data in the economy and markets right now to get a better understanding of the investing environment.

Bullish vs Bearish Data

First, let’s take a high-level look at the bearish and bullish arguments.

On one hand, we have plenty of reasons to be concerned:

  • The Fed is tightening
  • Inflation is extremely high
  • Ukraine War continues to be drawn out
  • Supply chain issues and food shortages globally are concerning
  • Valuations in many areas (stocks and real estate specifically) are still very high

We just need some turmoil in the Kardashian family and we have a cable news executive’s dream.

On the other hand, not everything is bad:

  • The US economy is strong
  • Corporate earnings and balance sheets are solid
  • Liquidity is still readily available
  • The US consumer is strong, on the back of high real estate valuations and increased incomes
  • Investor sentiment is very pessimistic (this is a contrarian indicator where this much pessimism tends to happen at market lows)
  • Some areas of the market have fallen 50-70% in value from last year, so some of the froth has been removed from various areas of the market.

Here’s an overview.

Bullish versus bearish data in the economy and the stock market.

Let’s look at two paths: one to lower stock prices, and another to higher ones.

The Path to Lower Stock Prices

Looking at the issues above, the biggest one by far is the Fed.

Yes, the war in Ukraine continues to be drawn out. Yes, inflation is very high. Yes, supply chain issues continue to be a problem.

Recession risks have increased in the past few months as well. Goldman Sachs currently places a 35% likelihood of a recession this year.

But the Fed has been the 10,000-lb gorilla in the room for a decade.

And their policy of massive monetary stimulus has now officially ended. They are no longer printing money, and they have started to raise interest rates.

This is not a small change.

We would argue that the Fed is the single most-important reason the market has been so incredibly strong over the past decade.

A reversion of policy should have an impact.

Their belief is that the US economy is strong enough to not depend on their artificial liquidity as support. Maybe they are right. After all, the economy is pretty strong.

The main problem is that the inflation cat has left the proverbial bag.

And it’s still too early to know how much of a negative affect it will have on the economy.

In all reality, it will take a number of months before inflation has a notable impact on economic data.

But the longer that inflation stays high, the more we will start to see reduced demand for a variety of goods.

For those with an economic background, it’s called “elasticity” of demand. Consumers are only willing to pay for something up to a certain price.

When the price gets too high, consumers stop buying it. We haven’t seen this just yet, but it’s hard to imagine we’re too far away from it.

Here is the pickle the Fed finds itself in: reduced demand will help lower inflation, but it will also cause a recession.

Not only is inflation rising, but so are interest rates. The combination of these two could wreak havoc on both the economy and financial markets.

But in an inflationary environment, not everything falls in price. There are many areas right now that are pushing to new highs, despite stock prices being lower.

The Nasdaq Composite index (mainly comprised of tech stocks) is now down over 20% from its highs. But consumer staples stocks pushed to new all-time highs last week.

While the broad market may not be very good right now, there are underlying pockets of strength.

These pockets of strength could be an indication that stock prices overall may resume their push higher soon. So let’s look at reasons we might need to be optimistic about the overall market environment going forward.

The Path to Higher Stock Prices

Yes, the Fed, inflation and interest rates are headwinds. But not everything is bad.

Earnings season picks up this week, and we should get more clarity on how companies are weathering the inflationary and uncertain geopolitical environment. So far, earnings have been good. Most estimates call for an increase in earnings of 4.5% year-over-year. Not great, but not bad either.

Just because we assume data should be negative doesn’t mean it will be.

One way that negative data isn’t quite showing up in the real economy has to do with mortgage rates.

The average 30-year mortgage is now above 5% for the first time in 11 years. But it hasn’t had a negative affect on homebuilders and home buyers just yet.

The next chart shows housing starts and building permits, one of the leading indicators of the housing market.

US housing starts and new building permits suggest that mortgage rates are not having much effect on the housing market yet.

In this chart, the blue lines are housing starts and the green lines are new building permits. In the past few months, they have been steady. New housing starts have actually risen a bit.

This could be a last minute push of people trying to build homes before rates get too high. But if nothing else, it tells us that mortgage rates may not be high enough to cause a housing slowdown. Time will tell.

With home-buying season about to start, we should know a lot more about the health of the housing market in the next few months.

This points to a consumer who has had both asset values and incomes rise.

And the consumer accounts for 68% of the US economy.

We should not ignore the positive impact that an optimistic US consumer can have on the economy and stock prices.

S&P 500 Index Levels

Let’s now look at the market itself.

Here’s an updated view of the S&P 500 Index, with the important levels to watch right now.

S&P 500 Index levels to watch for bull or bear market. Bullish above 4600, bearish below 4100. Chop zone in between.

We’ve broadened out our chop zone from a month ago, as the market seems to be stuck in a range between 4100-4600. (We had previously identified the chop zone as a range between 4100-4400.)

The real risk now is a break below 4100, or the lower end of the red area in the chart above.

There is very little support below this level, and we could easily see a scenario where markets fall another 10-20% if 4100 does not hold.

If it does fail, we will aggressively raise cash further.

Until that time, however, we should not assume that it will fail. We should assume that the chop zone will continue until we start to see whether the Fed/inflation/interest rate combo starts to have negative effects.

Either way, we expect that increased volatility will continue for a while longer.

Bottom Line

There are risks out there right now. Major risks that should not be ignored.

But there are still reasons to not bury your cash in cans in the backyard, at least not yet.

At this point, most clients have roughly 20% of their portfolio that normally would be allocated to stocks in cash right now.

If markets do fall further, we want to be able to have cash available to take advantage of that decline. Which is why we created the ability to move to cash as a part of our base investment process.

And during times like these, it is imperative to have a process.

We find comfort in our processes, because we know we don’t have to try to predict or guess what will happen next. There are no perfect investment systems, and we don’t claim to have one.

Be creating a process, we like to think that we are smart enough to know we are fools, as Shakespeare references.

The primary focus is to avoid big declines in your portfolio. We can’t avoid declines in general. There will always be volatility, and account values will go up and down. No process can avoid that.

When the market is choppy and messy like it is now, we can get signals that are quickly reversed.

That’s okay, in our opinion.

Because at some point a trend is going to reassert itself, either higher or lower.

And when that happens, we have confidence that we can identify it and either benefit from a positive trend or avoid the large downtrends.

In the meantime, we’ll remain diligent and make adjustments to your portfolio as our signals tell us to.

As always, please do not ever hesitate to reach out with questions.

Invest wisely!

Ukraine War: Portfolio Update

We shared two other reports this week regarding the Ukraine War:

Today, we’ll give a brief update on our clients’ portfolio positioning given the uncertainties in Ukraine.

This report will be brief. Please reach out to us directly if you would like to discuss your individual portfolio in more detail.

We will provide another market update next week.

For now, let’s focus on three primary asset classes:

  1. Cash
  2. US Equity
  3. International Equity

We will look at two basic portfolios today: Balanced and Aggressive Growth.

We do have clients with custom portfolios, so please reach out if you would like a detailed snapshot of your account.

Balanced Portfolios

Let’s look at balanced portfolios this year.

Specifically, let’s look at the change in allocation from the start of the year.

The chart below shows three major asset groups (Cash/Fixed Income, US Equities and International Equities), and how much of a balanced portfolio was invested in each on three different points this year:

  • December 31
  • January 31
  • Current (March 4)

In this chart, the dark blue is the exposure to each asset class on December 31st. The lighter blue shows exposure on January 31st, and the gold is the current allocation to that asset class.

Broadly, this chart shows the following changes from the end of last year to now:

  • Cash/Fixed Income: increased from 31% to 59%
  • US Equity: decreased from 58% to 37%
  • International equity: decreased to 0% once Russia invaded Ukraine.

Since the start of the year, overall stock exposure (US plus International) fell from 66% to 37%.

This is very large increase to safer assets this year, especially given that there has only been roughly a 10% decline in the S&P 500 so far this year.

Now, let’s look at the same chart for more aggressive portfolio.

Aggressive Portfolios

Here is the same chart as above, only for portfolios that are more aggressive.

This tells the same story:

  • Cash/Fixed Income: increased from 6% to 40%
  • US Equity: decreased from 82% to 55%
  • International equity: decreased to 0% once Russia invaded Ukraine.

For both portfolios, clients should expect to see lower volatility now than in the first few weeks of the year.

This also speaks directly to one of our core objectives at IronBridge: to eliminate the big downside scenario.

We cannot avoid volatility, nor do we want to. You must have volatility if you want to try to achieve decent returns over time.

But by reducing exposure to risk on a total portfolio basis, you can greatly reduce the risk of having large, damaging returns.

Changes in the Composition of Equity Exposure

If the first tool in your risk management toolbox is your overall exposure to cash, the second tool is the characteristics of the assets that are still invested.

The charts above show that overall stock exposure has decreased this year.

The other thing that has happened is that the stocks in which you were invested changed as well. Specifically, the characteristics of those stocks changed.

Here are various ways the amount invested in stocks has changed this year:

All of the items listed above should contribute to lower volatility in the stocks you are still invested in.

Sector exposure changed from aggressive (technology) to defensive (consumer staples).

Stocks with lower P/E ratios and price-to-book ratios typically have lower volatility.

And we have had a very distinct shift from growth to value in your portfolio as well.

Why we like Cash for Risk Management

As shown above, cash exposure for all clients has increased substantially this year.

We strongly believe that cash is THE BEST way to manage risk.

Why?

Cash is predictable.

There are other ways to manage risk: hedging, asset allocation, derivatives in futures markets, certain options strategies and shorting stocks.

Each of these can be effectively used. But they are complex and have various other risks that come along with them.

To do this effectively, you MUST have a process. You cannot have emotion be a part of the decision.

Why? Because we are humans and we are not very good at combining rational actions with emotional feelings.

Bottom Line

We have continued making portfolios less aggressive and less exposed to risk. As long as the market is showing volatility, we will continue doing that.

Given the continued approach by Putin to dig in his heels and extend the duration of this war, markets are likely to remain volatile.

We are positioned for volatility now, and may become more defensive as time goes by.

As always, please let us know if you have any questions.

Invest wisely!

Ukraine War: Market Update

There is a LOT happening in markets this week. As we said in our email on Monday, this may be the most important week since the 2008 financial crisis.

Today we’ll discuss a few of the major issues we’re watching:

  • Sanctions against Russia (the Financial War)
  • S&P 500
  • The Fed

As a note, we’ve put together a series of resources that we have been tracking, which you can reference here:

Ukraine War: Informational Resources

Let’s get started.

Sanctions against Russia (aka, the Financial War)

Once Russia invaded Ukraine last Thursday, the U.S. and the European Union announced a series of initial sanctions against Russia and various Russian companies. These sanctions were quick and were very coordinated among nations.

This immediately caused Putin to fight three separate wars: a military one in Ukraine, a financial war with the global financial system, and a war of perception at home.

Let’s focus on the financial war.

Frankly, once the initial sanctions were announced last week, we perceived them as basically useless.

Nearly every one allowed the entities and individuals sanctioned a 30-day window to comply with the sanctions. This meant that they weren’t going to take effect until potentially AFTER the war was over.

However, over the weekend, the sanctions became much more punitive.

They were also universally approved by the US, European Union, and the UK. Other countries such as Switzerland, Australia, Japan, New Zealand and Taiwan have all made their own sanctions against Russia as well.

There are essentially four types of sanctions being imposed:

  • Financial
  • Trade-Related
  • Sanctions on Individuals
  • Travel

Here’s our overview of these sanctions:

All of these sanctions have two goals:

  1. Punish Russia financially by freezing financial resources and removing them from the global financial system.
  2. Turn global and Russian sentiment against Putin.

So far these are working well in the short time they have been in effect.

Russia has $640 billion in foreign reserves that have now been frozen. The war is costing them approximately $20 billion per day. By most estimates, Russia has $200 billion of unencumbered assets within Russia that have not been frozen by sanctions.

That means that financially, Russia could possibly run out of money in 10 days.

We shall see, but the initial response is that the sanctions have indeed put Putin in a tough situation.

But what impact has the war had on the stock market?

S&P 500 Index

Historically, when wars begin, the stock market tends to bottom near the time of the initial invasion. This has been true for every major war since the Germans invaded Poland at the start of World War II.

So far, markets have responded to the Russian/Ukraine war as markets historically have done…by rallying higher against almost every ounce of common sense any of us possess.

As of today (March 2nd), the low point of the market happened on Thursday, February 24th. This was the day that Russia invaded Ukraine.

Since then, the S&P 500 is UP nearly 7%.

The chart below shows the S&P 500 Index since last June.

The first thing we notice is that the low point of the market thus far was immediately following the invasion. Despite the onset of this war, markets are essentially the same place they were in mid-January.

The second thing we notice is that the market was down “only” 2% the morning of the invasion.

That sounds like a lot, but relative to the volatility that occurred during the COVID crash, when markets moved nearly 10% any given day, a 2% move isn’t overwhelmingly bad. Especially given the fact that many people think this could lead to a nuclear war.

However, during the COVID crash, and also during the bear market of late 2018, markets regularly moved 2% a day.

But this pullback feels worse, doesn’t it?

That could be because we have been lulled to sleep by a very calm market in the past couple of years. It also could be that the risk of nuclear war seems like a reality for the first time in decades, which is obviously nothing to ignore.

Either way, people in general seem to have a more negative feeling towards these developments.

While the invasion itself didn’t cause much volatility, markets definitely anticipated volatility prior to the onset of this unnecessary war.

In fact, the S&P 500 was down 14% from peak-to-trough intraday in 2022, while the Nasdaq and Russell 2000 were both down over 20% peak-to-trough.

Does the fact that we didn’t see much volatility since war began mean we’re in the clear?

The answer is both “maybe” and “absolutely not”.

There are a number of positives that could result in a strong market if the Ukraine war comes to a peaceful and quick resolution:

  • The economy is strong.
  • The consumer is strong.
  • The Fed is now likely to slow down their pace of interest rate increases, resulting in continued support of financial markets.
  • The world is unified against Russia, making a coordinated effort to overcome the fallout from sanctions more economically and politically realistic. (Supplying Europe with gas from the US, for example.)

So if we get a peaceful resolution, there are reasons to be optimistic.

However, the elephant in the room is Putin. More accurately, he is the wild animal who is cornered and scared.

Dictators have one goal: to remain in power.

And Putin’s reputation has been greatly diminished both globally and domestically.

If he can’t get out of this situation peacefully, save face, and retain power all at the same time, there is no telling what he might do. And this is the risk we all fear.

Let’s refocus on the financial markets.

Prior to the Ukraine mess, the markets were selling off because concerns on inflation and the speed at which the Fed might act.

What should we expect from the Federal Reserve now?

The Fed

What might the fed do now?

The easiest way to look at this is what the anticipation of Federal Reserve rate hikes might be.

The next chart, from Bianco Research, shows the probability of Fed rate hikes at each upcoming Fed meeting.

Here’s how to read this table.

On the top left, the FOMC Meeting on 16-Mar-22 shows (from left to right across the table) a 100% probability of a hike of 0.25-0.50%, a 21% probability of a 0.50-0.75% hike, and so on. (FOMC stands for “Federal Open Market Committee”)

This tells us that the market is now pricing a 0.25% hike in March, and a total of four rate hikes this year.

Three weeks ago, there was a probability of over 90% of a 0.50% rate hike in March, with 6-7 hikes likely this year.

So the Ukraine situation is causing the Fed to pause slightly, at least for now.

That could create a tailwind for stocks as well.

But they are definitely behind the curve.

For the past 30 years, the Fed Funds rate has essentially mirrored the 2-year US Treasury yield, as shown in the next chart.

But if we zoom in to the recent rise in the 2-year Treasury yield, we see just how far the Fed needs to go to catch up.

Six months ago, these rates were the same.

Now, the Fed would need to hike 6 times to catch up to the 2-year yield.

This is their dilemma.

The other thing to note on the chart above is that the 2-year Treasury yield barely moved in response to the Ukraine war.

Globally, investors have not been moving into safe havens like we would normally expect.

Bottom line, we are not seeing the type of volatility that we would probably expect in a conflict with the implications of this one.

That leads us to believe one of two things will happen:

  1. Markets are correct. This implies that the Ukraine conflict will come to a conclusion within a week or two.
  2. Markets are unprepared. This implies that the real volatility is yet to come.

We don’t like to think about what happens in scenario 2.

But we must think through it and be prepared for any scenario, for that is our job as fiduciaries of your capital.

On Friday, we will give you a portfolio update and look at the specific levels on the markets that we are watching.

Invest wisely!

Ukraine War: Informational Resources

During times of uncertainty, information is critical. We have been tracking multiple resources to follow developments in Ukraine, and wanted to share these with you.

Unfortunately, the major US News outlets are filled with partisan slant. It is distracting, and more resembles propaganda most likely found within Russia than what should be presented by an unbiased and informed media (and we’re referring to both sides of the political aisle).

Instead, we have been following a variety of different informational resources that we have found to be objective and informative.  We hope that you find these helpful if you’re interested in tracking developments in the conflict. They are listed below.

BEST NEWS OUTLET:

BEST ARTICLES ON SPECIFIC TOPICS:

BEST REAL-TIME MAPS & DATA TO TRACK THE CONFLICT:

BEST FREE DAILY MARKET UPDATE:

BEST SOCIAL MEDIA FOLLOWS:

Major General Mick Ryan is a former officer in the Australian Army, and has had excellent perspective on all things Russian, particularly the possible use of nuclear arms by Russia.

Bookmark or subscribe to these resources and you’ll get a better sense of the full scope of this conflict.

Invest Wisely!

Ares: Forever Quarrelling

Ares, the god of war, statue representing both the valor and brutality of war. Ares was one of 12 original Olympians and a son of Zeus.

In Greek mythology, Ares was the God of War.

He was one of the 12 original Olympians, and a son of Zeus. He symbolized both the valor and brutality of war.

Much of Greek mythology comes from ancient writings, such as Homer’s Iliad.

In the Iliad, Zeus tells his son, Ares:

To me you are the most hateful of all gods who hold Olympus. Forever quarreling is dear to your heart, wars and battle.

zeus to his son ares, in Homer’s iliad

It is telling that the Greeks chose to have War represented in their 12 primary deities. But it is most telling that they portrayed the God of War as the worst one of the bunch.

28 centuries later, humanity still faces those who feel the pull of Ares. Specifically, Vladimir Putin. And his drumbeats of war are growing louder by the day.

The possibility of a Russian invasion into the Ukraine has been increasing for at least two months now. It now appears almost inevitable that Russia will invade.

(Unless, of course, this was a pre-planned show of force with a pre-negotiated peaceful resolution that helps both Putin and Biden with their constituents.)

But we digress.

We will not discuss the human impact of a potential invasion or war. We only hope that if an invasion occurs, death and destruction are minimized as much as possible. And we hope it does not escalate into a more broad conflict that includes China, European nations or the United States.

What we will do is focus on the potential impact on the markets. Specifically, we discuss:

  • Timing of a Potential Invasion
  • Are Markets Pricing in the Risk of War?
  • What happened after Previous Geopolitical Events?
  • What is the risk of Russian Attacks on our Infrastructure?

Let’s get to it.

Timing of a Potential Invasion

First of all, Russia has a history of invading countries when the US is preoccupied with other things.

  • They invaded Afghanistan on Christmas Eve in 1979.
  • They invaded Hungary two days before the Presidential election in 1956.

Russia’s two biggest adversaries, the US and China, are both pre-occupied right now.

  • China is hosting the winter Olympics, and are trying to look good on the world stage (although nobody seems to be watching).
  • The Super Bowl is this weekend in the US. It is annually one of the most-watched television events of the year.

So it appears that this weekend may make sense if they are going to invade.

However, people said that in December as well, projecting that Russia might again invade around Christmas and that didn’t happen.

We are no geopolitical experts, but we would not be surprised if an invasion happened this weekend.

Are Financial Markets Pricing in an Invasion?

Bottom line, no, they are not. And if they are, they simply don’t care.

Typically when financial markets are concerned about a negative potential event, money flows into US Treasuries, causing yields to go down. However, yields have risen recently, and there has been no flight into the safety of US Treasuries.

In fact, US Treasury yields have continued moving HIGHER, and are now back to pre-COVID levels, as shown in the chart below.

10-year us treasury yields have been moving higher, despite tensions between russia and ukraine

The spike higher on the far right side of the chart shows a bond market that is decidedly NOT pricing in any global instability.

If the global financial markets were concerned about this invasion, we would first see it expressed in lower yields, not higher ones.

In fact, since late November and early December (when rumors about a Russian invasion began), yields have only risen. They are up over 65 basis points in that time, which is a very large move in yields for the Treasury market.

Simply put, this is not a bond market that is concerned about an invasion.

The stock market isn’t much different.

Yes, we have seen volatility this year. But it appears for now that the choppiness this year is simply a market working off the froth after large gains over the past two years. Not an anticipation of further escalation in the conflict.

As invasion rumors have continued to gain momentum over the past couple of weeks, US markets have rallied.

What about in Europe?

Germany appears to be the biggest loser (besides Ukraine) in all of this. They get energy from Ukranian pipelines, and their economy appears to have the most to lose.

Well, European markets are basically telling the same story…that there isn’t much to worry about.

The next chart shows the Euro STOXX 50, an index of the 50 of the largest companies in 8 European countries, and the German DAX, which is Germany’s equivalent of the Dow Jones Index.

euro stoxx 50 index and the german dax leading up to a potential russian invastion of ukraine.

This chart shows European markets that have been choppy since last summer. You’d never know by this chart that there was about to be a war any day.

In fact, European stocks have fared much better than US stocks over the past month, despite having much more to lose if Russia invades Ukraine.

Bottom line, financial markets across the globe simply aren’t predicting any lasting impact of the potential conflict.

What Happened in Previous Geopolitical Events?

This isn’t the first time we’ve had geopolitical scares.

In fact, we wrote about this exact thing in 2017 when there was sabre rattling as tensions with North Korea began to flare. Read it HERE.

Somewhat to our surprise, we found that geopolitics simply don’t have the negative effect that many people think.

The next table shows the performance of the S&P 500 Index following major geopolitical shocks, courtesy of S&P Capital and the Wall Street Journal.

stock market reaction following major geopolitical events since pearl harbor

Essentially there were 3 events in the past 100 years that caused markets to fall more than 12%:

  • Lehman Bankruptcy (that started the global financial crisis)
  • The minor bear market in 1997 during the tech bubble
  • Nixon Resignation during the sideways bear market of the 1970’s.

In fact, EVERY war in the past century was a non-event to markets.

Surprising, huh?

Pearl Harbor, the Cuban Missile Crisis, JFK assasination, the first Iraq war, 9/11…all resulted in only moderate declines the day it was announced, and all resulted in completely normal pullbacks.

In January, we saw the S&P 500 fall 12%. It has recovered about half of that move so far.

So maybe the market ALREADY priced in Russia invading Ukraine, based on how stocks have responded to the start of previous wars.

What if Russia Attacks Infrastructure in the U.S.?

This is the biggest wildcard.

One of the concerns by some is if the United States put punitive sanctions on Russia, they would retaliate with an attack on our infrastructure.

An attack on our digital infrastructure would be a problem, but it appears that would be a temporary one. There is not just one internet or communication provider. There are many. So while a localized attack may cause localized disruption, it would be very difficult to stop the “web” of communication that exists across this country. Landlines, cell towers, satellites, all provide data to people. It is a very decentralized system that would be hard to attack.

Water and electricity resources is another potential target. But as we’ve witnessed in Texas over the past year, the power grid going down or water supply being compromised does indeed cause inconveniences. But it would not necessarily cause permanent or irreparable damage to the country.

So what would Russia have to gain? They cause major inconveniences to us? Just keep robo-calling us about our expired car warranties and call it a day.

Is the inconvenience worth starting World War III? It doesn’t seem like it.

Conclusion

Bottom line, financial markets aren’t concerned. There isn’t enough tension, risks and potential benefits to Russia to warrant expanded conflict. And expanded conflict is the real risk.

Ukraine is a strategic benefit for Russia, but is not crucial to the global economic or market infrastructure.

Financial markets are taking the approach that there will always be conflict. Humans will be forever quarreling. And they are taking the view that minor conflicts are not important enough to change the overall market and economic cycle.

We’re not saying that it for sure WON’T turn into something bigger. If it does, we will adjust portfolios accordingly. After all, the market can change its mind anytime.

But for now, it appears that if Russia does in fact invade Ukraine, there is not much to worry about when it comes to your portfolio.

Invest wisely!