IronBridge Private Wealth

Forward with Confidence

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2023 Mid-Year Outlook Webinar

View the recording of our 2023 Mid-Year Outlook webinar.

Here are the topics we discussed and the time in the recording it happens so you can fast-forward to topics you find most relevant:

  • Recession probabilities (1:29)
  • S&P 500, Dow Jones & Russell 2000 (4:51)
  • Concentrated performance contribution YTD (8:48)
  • S&P 500 Index (10:11)
  • Russell 2000 small cap stock index (14:37)
  • Fed Balance sheet vs S&P 500 (16:14)
  • Banking stocks still under pressure (18:01)
  • Commercial real estate loans maturing over the next 5 years (19:24)
  • Yield curve (24:56)
  • Manufacturing PMIs and activity (29:10)
  • Portfolio Equity Positioning (31:27)
  • Scenarios, Risks & Opportunities (35:00)
  • Upside and Downside potential performance based on three scenarios (39:40)

Invest wisely!

Are the Dog Days of Summer Over?

A calm summer for the markets was interrupted today with a large selloff. Is this just a blip, or is it the start of a bigger decline?

What happened:

  • Dow Jones Industrial Index closed down 725 points, or 2.09%
  • S&P 500 was down 68 points or 1.59%
  • The media blamed COVID fears, but it looks more technical in nature
  • VIX Index rose nearly 40% at one point during the day
  • Bonds had their best day of the year, with long-term US Treasury prices up over 2%

Near-Term Market Assessment:

  • Numerous warning signs have been happening over the past three months:
    • Lumber prices have fallen 68% from their highs.
    • 10-Year Treasury Yields have dropped from 1.76% in March to 1.19% today.
    • Fewer stocks have been participating in the slow drift higher since mid-February. Today, more than 50% of the stocks in the S&P 500 are below their 50-day moving average (more on this below). That number has been steadily rising since April.
  • It is too early to tell if this selloff will continue. Bull markets tend to have short, sharp declines like this.
  • The S&P 500 Index is only 3% off its all-time highs. So the fear seems somewhat unwarranted at this point.

Portfolio Implications:

  • We have been systematically raising our stop-losses over the past few months.
  • We sold two positions today, one stock ETF and a high-yield bond ETF. Both moved to cash equivalent ETFs.
  • We may get further sell signals this week. If we do raise cash this week, it may not remain in cash very long if the market decides to resume its move higher.
  • We do not know when a short-term decline will turn into a long-term decline. That’s why we have rules and don’t try to guess. This kind of environment has the potential for a “whipsaw”, where we move from invested to cash and back to being invested. This is definitely not the favorite part of our process, but it is a natural consequence of having disciplined rules and not just winging it.

Market Discussion

Markets were down over 2% today. The primary (and easy) explanation is COVID. Every state in the US is showing a rise in cases. Los Angeles reinstated mask requirements this past weekend (even for those fully vaccinated). Other parts of California and possibly New York City may follow suit with mask requirements.

Naturally, any volatility in the markets is blamed on the most recent “thing”. It’s natural to assume that the rise in cases we are seeing now would result in a market environment like we saw in early 2020. We’re human and that’s what we do…extrapolate past events and assume they will happen again.

But the reality is that there were plenty of factors to explain the move lower today.

And they are mainly technical in nature.

First, market breadth has been very narrow the past few months.

This simply means that fewer and fewer stocks have been in uptrends, despite markets drifting higher. In fact, many stocks have been in downtrends since April.

The chart below shows the percentage of the S&P 500 Index that has been above its 50-day moving average (50dMA).

S&P 500 Index components above 50 day moving average following the market decline of July 19, 2020.

The 50dMA is simply the average price of a stock over the last 50 trading days. A stock above that level is generally considering to be in a rising trend (or a bull market). A stock that falls below that level is considered to be in a declining market.

What the chart above shows us is that while the market has been drifting higher, over 50% of the stocks in the index were in bear markets in June. This is referred to as “breadth”.

This indicator is similar to a game of jenga. When there are many blocks supporting the tower at the start of the game, the tower is strong and sturdy.

But as the game goes on, there are fewer blocks supporting the ever increasing height of the jenga tower.

This is happening in the stock market. When there are a lot of stocks supporting the index, it is more sturdy. In April, over 90% of the stocks in the S&P 500 Index were above their respective 50dMA. But as more and more stocks begin to reverse trend and fall, the index get wobbly.

This is very similar to mid-2018. We wrote about breadth in our “Soldiers are AWOL” report. After a weakening breadth environment in mid-2018, the market corrected by 20% in Q4 of that year.

The big tech stocks have been doing the heavy lifting in the past three months. The same exact thing happened in 2018.

The next reason is simply that the market is overdue for a correction.

So while COVID is to blame, the fact remains that we are due for a pause following the massive rally from the COVID lows last year. The market has had very little pauses, and is well overdue for a correction.

We shared the next chart in our last email newsletter, but it’s worth sharing again.

This shows the market rallies from previous major bear market bottoms. Three environments are shown here (1982, 2009 and 2021).

This chart suggests we are due for a natural pause given the strength of the move from March 2020’s lows.

So while the news is blaming COVID, the reason for today’s selloff seems to be much more technical in nature than simply worry about the delta strand.

The next few days will provide tremendous insight into what may happen over the coming weeks and months.

We had two sell signals today, selling one stock ETF and a high-yield bond ETF.

There is a chance we get many more sell signals this week.

However, no one knows if this is just a blip or if it is the start of something bigger.

Given the positive trends in the economy, continued massive support from the Fed, and the very technical nature of the market selloff today, we should assume that the bull market is still in tact, but due for a pause.

Risk management is a priority for us and our clients. Therefore, we will not wait to see what happens. We will act on our signals, and adjust course as necessary.

That could mean increased cash, but it could also mean that cash on the sidelines today gets put back to work very shortly.

Either way, the dogs days of summer could indeed be over for the stock market, even if it simply means a temporary pause in the bull market.

Please do not hesitate to reach out with any questions or concerns you have.

Invest wisely!

The Fed is Stuck

Despite economic data showing massive improvement from the COVID recession and inflation running hot across all parts of the economy, the Fed continues to pump trillions of dollars into the financial system. Why? They know that if they stop, things will come crashing down.

It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

Henry Ford

The Federal Reserve board met earlier this month to discuss their interest rate and bond purchase strategy.

Following the meeting, markets fell nearly 2% on terrible news that surely signaled the Fed was going to finally pop the massive bubbles across the markets and economy.

What news was that?

Instead of raising interest rates in 2024, they were considering doing it in 2023 instead.

WHAT???

You can’t make this stuff up. Markets sold off hard because the FIRST interest rate hike might occur 2 years from now instead of 3.

Granted, markets (as they often do), reassessed the situation and realized that the Fed just brought a huge case of booze to spike the punch bowl even more, despite the party-goers being ragingly inebriated and in no shape to consume more. Markets promptly recovered those big losses.

But inflation is obviously running hot. The economy is obviously improving. There are millions of job openings. Employment data would be incredibly strong if government stimulus had not made it more profitable for people to not work than getting many lower waged jobs.

Despite things being in much better shape than it was a year ago when the Fed flooded the market with liquidity, they continue to add $80 Billion each WEEK into the financial system.

Why?

The answer is pretty simple…they are stuck.

They will tell you the reason is that inflation is “transitory”. (This is a word you are likely to hear way too much of in the coming months.)

In some ways, inflation is transitory. We recently shared a brief blog post “The First Wave of Inflation is Receding“, where we showed that lumber prices fell over 50% from recent highs.

Let’s share the chart of lumber in case you missed that report. (We published it on social media, so be sure to follow us for the latest reports.)

Lumber prices skyrocketed but have fallen over 50% since earlier this year.

In just over one year, lumber prices went from under $300 per unit to over $1700.

These are crazy price movements.

As soon as everyone was predicting that inflation was here to stay, lumber prices fell 52% in a matter of weeks.

Human Behavior and History

The price of lumber is exactly what we are talking about when we discuss inflation waves. Our thesis is that inflation will not just immediately come upon us and stay. Instead, it will ebb and flow into the economy in gradually increasing levels.

This thesis is based on both human behavior and history.

The impact from human behavior is pretty easy to think about. Let’s look at the recent increase in home values and lumber as our primary example:

  • The pandemic locked people in their homes.
  • People became tired of their homes. They wanted a bigger/nicer/different place from which to live and work.
  • Demand for homes started to increase.
  • Increased demand for homes caused increasing demand for lumber.
  • Homebuilders and other opportunists saw the price of lumber increasing and started to purchase lumber for future projects. Aka, “hoarding”.

This is how inflation works. Prices begin to rise, and it makes more sense to buy something now, because it will most likely become more expensive in the future.

Inflation can, in fact, be self-fulfilling. High prices tend to lead to even higher prices. It’s FOMO, the “fear of missing out”.

While at first inflation supports even more inflation, there comes a point where it is also self-correcting.

Prices reach a level where it simply doesn’t make any sense to buy it. Whatever “it” is.

This is what happened with lumber. Prices simply became too expensive and people stopped buying it.

We’re not winning any Nobel prizes in economics for this one.

The pace of home building slowed down, and people stopped hoarding lumber. Things just got too expensive. When demand slows, prices tend to fall. Voila. Lower prices.

This is what the Fed is banking on. They believe that inflation is “transitory” because they believe in the self-correcting mechanism of inflation itself. They believe that human behavior will naturally keep a lid on the inflation rate.

Janet Yellen, the US Treasury Secretary and former Fed Chair, said last week that she expects to see 5% inflation this year, but that it will drop to 2% by sometime later this year or in 2022.

Current Fed Chair Jerome Powell blamed inflation on supply bottlenecks in various ports across the globe. He suggests that once this bottleneck gets resolved, inflation will decrease as a result.

Here’s a great article from Reuters about it:

https://www.reuters.com/article/us-usa-debt-yellen-inflation/yellen-says-inflation-should-be-lower-than-current-levels-by-year-end

In the short-term, they are probably right…inflation does tend to self correct.

But higher prices also can be sticky.

Why? The expectations of sellers increase.

Let’s say you are going to sell your home. Over the past few years, homes have sold for $800k-900k pretty regularly in your neighborhood. So you list your home for $900k.

But you just saw ten of your neighbors’ homes sell for $1.2MM. Two even sold for over $1.4MM, but maybe they had done some upgrades. What would you do? Probably increase your sales price (either officially or just mentally) to $1.2MM. That is the new floor.

Homes didn’t stay at the peak sales price. But they stuck at a level higher than the previous prices. Not quite as high as the highest price point, but significantly higher nonetheless.

Outside of a crisis, either personally or economically, you’re probably not going to ask for less than what the average or most common sales price has been. Your expectations have caused a stair-step higher in price. Two steps forward, one-step back.

Thus, we have our first inflation wave.

Simply from human behavior.

These inflation waves happened before. We are no different than previous generations, other than the fact that our access to information is much more easily and quickly accessible than in the past.

We discussed the historical reasons for this theory in “The Coming Inflation Waves“, so we won’t go back over the details. We’ll only say that every inflationary cycle over the past 300 years has started in this way, so it’s a pretty easy bet that it will happen the same way again this time. Humans are, after all, still human.

That does not mean the coming inflation cycle will be easy to predict with regards to timing and magnitude.

The price of lumber should not have risen by THAT much over the past year. But it did. And we have one group to thank…the Fed.

The Fed’s easy money policy for over a decade has put massive amounts of liquidity into the markets and economy. And that makes the inflation cycles much more difficult to predict.

The Wildcard: The Fed

There are smart people on the Federal Reserve Board.

The people at the Fed know that the financial system has become dependent on the easy money policies instituted over the past 13 years.

And they know that if they start to reduce the amount of liquidity they are injecting into the markets that they will lose control of both the narrative of financial stability and the upward support of asset prices.

Let’s look at a couple charts that shows results of the Fed’s actions.

First is a chart of the Fed’s balance sheet versus the S&P 500 Index, courtesy of Lance Roberts of Real Investment Advice.

Fed Balance sheet versus the S&P 500 index. Stocks are highly correlated with the Fed's actions.

It doesn’t take a professional statistician to see that there is a correlation between how much money the Fed is printing and stock prices.

This chart is all over the investment industry, and the Fed certainly knows of this correlation as well.

Former Fed Chair Ben Bernanke said back in 2010 that stock prices were a way to deliver confidence into the economy. Read it HERE.

Ever since then, the Fed has viewed their role as the driver of stock prices.

But why would increasing liquidity support stock prices?

Simple…it increases valuations.

The next chart, courtesy of Bloomberg, shows an even higher correlation between the Fed and stocks. And it shows the REASON why stocks prices have gone up with the Fed balance sheet.

This chart shows the Fed’s balance sheet versus the P/E ratio of the S&P 500. P/E ratios are the most common way to show valuations in the stock market by taking the price per share of a company’s stock and dividing it by the earnings per share.

Fed balance sheet causes stock valuations to increase.

This chart is much more in sync than the first chart. For example, in the chart above of the Fed vs the S&P 500 Index, there was a period between 2017 and 2019 where the Fed’s balance sheet declined, but stock prices rose.

When we look at the chart of valuations, we can see that between 2017 and 2019 valuations actually declined as prices rose. Valuations reflected the reduction of the Fed balance sheet while prices kept moving higher.

The secret to the Fed’s ability to impact stock prices, it seems, is by increasing valuations.

The primary way valuations are affected is by investor sentiment.

So what this really tells us is that the Fed is driving investor behavior by flooding the market with trillions of dollars of liquidity.

Exactly like Mr. Bernanke said.

And here lies the problem.

The Fed needs to pump the markets with so much liquidity that the economy becomes so strong that stocks will remain stable even if they stop asset purchases. God forbid they actually go so far as reducing their balance sheet.

More accurately, the Fed needs to pump so much liquidity into the market that they generate so much CONFIDENCE in the economy that the Fed can taper without crashing the system.

So far it is working.

Markets have become dependent on the Fed to keep prices afloat. They expect it.

If the Fed tells the market that they will raise rates in two years, it is similar to telling a drug addict that they are going to rehab in a couple months.

What would that addict do? They would binge on everything they could get their hands on and roll into Betty Ford in a stupor.

That’s what we’re witnessing in financial markets. Risk taking is everywhere. Assets of all types have been sought after. Prices across the board have gone up. We’re in an environment where even fake digital assets with dog memes are being coveted.

This speculative attitude towards risk could contribute to a massive rally over the coming months or years. Similar to the tech mania in the late 1990’s. Unbridled speculation would lead to one final blow-off top that puts a cherry on top of the bull market. Chef’s kiss.

Unfortunately, the same support of massive risk taking today is laying the groundwork of the volatility that will follow.

The Fed knows this as well.

Thus, they are stuck.

Do they rip off the Band-Aid now and stop the party? Or do they continue to support the craziness?

It comes down to one thing: they don’t want the party to stop on their watch.

It is easy to criticize from the outside. But no one wants to be in charge when it comes crashing down.

And that’s what we’re dealing with.

No matter how well-intentioned the people at the Fed may be, they are still human too. And they don’t want to go down in history as presiding over the end of the golden era of speculation investing.

So we’re likely to continue on the current path until someone is forced into action.

And inflation is the likely culprit.

The Fed will likely change the narrative before they start to tighten. They will start to blame something other than their own policies. They will blame bottlenecks or China or Congress or us. Anything but their own policies.

And that’s when we’ll know the cycle is truly changing.

When the consequences of the Fed’s actions are eventually felt, Henry Ford’s quote in the beginning of this report will most likely prove significant. For there is likely to be a backlash against the Fed for the reckless behavior and influence.

Until then, we must be prepared for volatility, but we must be prepared for an out-of-control stock market first. And out-of-control markets can be a lot of fun.

But now is not the time for complacency. And it is not the time to be stubbornly bullish or bearish.

Now is the time to be stoic. Be completely in tune and at peace with reality. When investing, that’s a good state of mind to be in anyways.

We can’t unstick the Fed. But we can try to navigate the consequences of their actions, whether good or bad.

Invest wisely!

The One Thing

Successful investing over time comes down to one thing: markets work in cycles.

In this issue we take a deeper dive into a topic we discuss relatively frequently, but one that is not addressed as much as it should be in the investment world…the idea of cycles. Once we get comfortable with one key claim, that the markets are cyclical rather than linear, we can then get comfortable with having an investment strategy that adjust to cycles. Not only that, but we argue that recognizing that markets work in cycles is THE most important factor when developing and executing an investment plan.

Specifically, we discuss the following topics below:

  • Stocks & Cycles
  • Missing the 10 Best Days vs 10 Worst Days
  • Stocks & Gold
  • Stocks & Inflation
  • Stocks & GDP
Market Update

We’ll dig more into recent market developments in our next issue of IronBridge Insights, but wanted to pass along a very brief summary of the markets.

Bottom line, the stock market continues to ignore any sort of bad news. Since last October, markets have been incredibly strong with very little volatility. The primary catalyst is most likely the fact that the Fed started printing money again late last September. And the market has gone straight up since then.

Despite threats of World War 3, impeachment proceedings, and the recent threat of a pandemic virus sweeping the globe, markets have been resilient. Earnings have been positive for the most part, and there have been no major surprises economically. Essentially the market has been saying “No Big Deal” to every potential downside catalyst.

S&P 500 index has been resilient so far

The move higher will not go on uninterrupted, and we expect volatility to rise and markets to become choppier than they have been.

However, our clients continue to participate in this move higher, and we are holding very little cash exposure, as has been the case for the past 4-5 months. Our signals continue to show strength, and only as recently as last week have we seen any remote type of weakness show up in our signals.

Bigger picture, the move higher does not appear over. While we do expect increased choppiness, and are prepared for a deeper move lower, signs of strength far out-weigh any signs of weakness. At least for now.

“The whole history of life is a record of cycles.”

-Ellsworth Huntington (1876-1947), Professor of Geography, Yale University

Are Markets Cyclical?

At the beginning of every year we like to take a step back in an attempt to see the proverbial forest through the trees. In this issue we focus on the macro with a goal of identifying where we are within an investment cycle.

One of the most important building blocks on an investment strategy is having an idea where you are within a cycle. It should be a huge input on how you invest.

Unfortunately, for most people (and investment firms) this concept is never even considered. And if even when it is discussed, there is no real action taken as a result.

Why is the investment cycle important?

Most individuals have 20-30 years to invest once they have accumulated their wealth. Some longer, some shorter. Over the course of most people’s lives, they spend the first 20 years learning, the second 20 years earning, the third 20 growing, and the final 20 spending.

The problem is that most investment strategies are based on theories that work only if you have an incredibly long time frame to invest…like 100 years or more. With ultra-long-time-frames, the downside of ignoring investment cycles aren’t as punitive. It isn’t as efficient as adapting to cycles, but it isn’t as punishing either.

The most common basis for investment strategies today is called “Modern Portfolio Theory” (learn more about it HERE.) The creator of this theory, Harry Markowitz, won a Nobel prize for it.

Nearly every large investment firms, and most smaller ones as well, base their entire investment philosophy on this theory.

Unfortunately, it doesn’t work unless you have ultra-long-time-frames. Even Mr. Markowitz himself said that this shouldn’t be used for individual investors. He suggested that its use should be limited to institutions like university endowments and life insurance companies that have 100-year-plus investment horizons.

Today’s growth of passive investing and indexing is an extension of Modern Portfolio Theory, and is also incredibly flawed.

Its theory is based on the falsehood that stocks (and bonds) always do well over the long run. While it can work for many years in a row, history shows us that there are very long periods where markets do not consistently go up.

If investment decisions are made based on poor data/inputs (in this case, that markets always move higher), then any good results that may come of them are pure coincidence or based on luck rather than being skill based.

Let’s say you’re on the golf course, and use your 9 iron to hit a shot from 130 yards away. But instead of a crisp, well-executed shot, you instead duff it and hit the ball just 90 yards…but it bounces off the cart path and rolls up next to the hole.

The outcome was good. But was that skill or just luck?

We would say it was lucky because you were trying to hit a 130-yard shot.

We think index investing is no different. Those practicing it believe in one key concept, that the market “over the long run” will always go up. In our opinion investors are making a grave mistake if they think this passive investing strategy is their saving grace. At best, they will be lucky and catch the markets at the right time. At worst, they will be exactly wrong at exactly the wrong time and suffer badly.

At IronBridge we make our investment decision based around one concept that we hold as truth, that the markets are indeed cyclical.

If this is not true, then the way we invest could be flawed, and if so then the passive investors who are grounding their theories in the opposite, that the market is linear, will be the ones who prevail.

So, in order to figure out the better direction to take, active or passive, let’s first prove the cyclicality of markets. If we can all agree that the markets are cyclical, then we can move on to investment strategies that take this into account.

If we cannot agree on the cyclicality then we must go back to the drawing board and admit that passive investing may be as good a strategy as any.

Stocks & Cycles

First, let’s start at the highest level. What is a cycle? Cycle is defined as a series of events that are regularly repeated in the same order. Cycles that are generally agreed upon are the lunar cycle, the solar cycle, the life cycle, and the business cycle.

The chart of the Dow Jones index below shows this cyclicality in markets.

The Dow Jones Industrial Average (100 Years)

Generally, there are large periods of time when price is moving up and to the right (a time to be fully invested), but those periods have been interrupted, sometimes for long periods themselves, by sideways or down movements (a period not to be fully invested).

Overall the equity markets seem to have periods of 20-30 years of generally upward moving stock prices followed by typically shorter, 15-25 years, of falling stock prices.

There have been 4 major stock market up-trends and 3 major stock market drawdowns over the last 100 years. The first major drawdown started in 1929 and took until 1954 (25 years) for prices to make new all time highs again. The last 100 years shows a roughly generation cyclicality to the markets.

But how long is “long term” to you? Is 25 years long term to you? Could you imagine investing your entire net worth during the roaring twenties only to have to wait for 20+ years just to get back to breakeven? That’s almost a lifetime! On the other hand what if you just waited a few years and instead invested in 1932? In this example the cycles of the market affected outcomes vastly differently.

The second long period of negative cycle occurred from 1966 to 1982 (16 years). On the chart it may not look like much, but there were three 50%+ drawdowns during this period. Avoiding even a portion of this period would have provided significant outperformance.

There’s a case to be made that we just finished a 3rd period of negative cycle from 2000 to 2015, with two similar 50%+ drawdowns. Generally, though, there have been long periods of good times for investing, but there also have been long periods of bad times for investing, and where you started your investing “career” matters greatly to your results.

Missing the 10 Best vs 10 Worst Days

One narrative purported by the investment industry is that if you miss the 10 best days in the market your investment results would be greatly negatively impacted. This is indeed true.

But they are (purposely) leaving out an equally important second half to the equation.

If you miss the 10 worst days in the market you substantially outperform. In fact, the amount of outperformance by missing the 10 worst days is much better than the outperformance of getting the 10 best days.

The table below (from LPL) shows if you avoided the 10 worst days each year from 1990 to 2017, your average return of the S&P 500 would be an extremely impressive 38.4%, outperforming by and hold’s 9% by 29.4%. Compare that 29.4% difference to the difference between the 9% buy and hold return and the -12.8% average loss if you missed the best days. -12.8% to 9%=21.8% while 9% to 38.4%=29.4%. It’s far better to miss the worst days than it is to miss the best days.

This “10 best days” quote is the biased narrative attempt at convincing you that “over the long run”, the market goes up more than it goes down and that trying to “time” it and be out during those periods of drawdown is a futile attempt.

However, the facts reveal that the 10 worst days each year do much more harm than the 10 best days do good. In addition, “long term” is a biased term with no substance. You need to define your timeline in order to truly appreciate the cyclical implications.

Miss the 10 best days versus missing the 10 worst day. Risk management is better than being invested always.

Another reality is if you can avoid drawdowns, you should (we know, easier said than done, right).

But are drawdowns random?

The table above also helps show that generally the biggest drivers of this disparity between the good days and the bad days occurs during periods of volatility.

The average disparity is 51.2% (38.4% average year outperformance +12.8% average year underperformance=51.2%). The periods where this variance is large are generally during those periods of cyclical market drawdowns and increased volatility (Year 1999 = 50.4% + 7.1%=57.5%, Year 2000 = 58.8%, Year 2001 = 56%, Year 2008 = 96%, Year 2009 = 107.5%, you get the picture).

Not only is it better for your portfolio to miss the biggest down days more so than it is to be in the market for the biggest up days, but during those periods the market is in a cyclical drawdown is typically when the largest disparities occur, and, thus, the potential for more outperformance can occur. This makes sense as those who have been in the industry through a full cycle know that volatility is generally more present during drawdowns than it is during meltups. Stock Market crashes happen much quicker than market tops as an example.

So, if we know we want to avoid the down days the most, and the disparity between the up days and the down days is the greatest during market drawdowns, then there is certainly a case to be made to try to avoid those periods where the odds are greater for down days. If we can prove that the market is cyclical then it gives us a base for trying to avoid those periods of drawdown. Again, getting grounded in the fact that the markets are cyclical is an essential step in building an investment strategy “for the long term”.

Stocks & Inflation

Looking only at charts of stocks that only focus on price ignores one of the biggest hurdles to investing success…inflation.

The next chart below shows 100 years of the Dow Jones Industrial Average, the same as the previous Dow chart, just this one is adjusted for inflation (using the CPI).

The Dow Adjusted for Inflation (CPI)
Dow jones index adjusted for inflation

It’s pretty clear that there are times the Dow is moving up and times it is moving down, even more so when we adjust for inflation. This up and down motion makes it cyclical by definition. If the Dow moved only up and to the right, then it would be non-cyclical, but to us it is pretty clear it moves in cycles.

Sometimes it outperforms inflation; other times it does not. If it wasn’t cyclical then it would outperform at all times, and that simply is not the case.

This chart confirms the 3rd period of underperformance discussed above, from 1999 to 2008. It shows the uptrend in stocks versus inflation is also now back in vogue. Is this the start of a new up cycle? Those periods have been as short as 10 years and as long as 19, so we are already in the sweet spot for longevity, but even during these periods of uptrends there were substantial drawdowns over shorter periods.

This introduces the concept of over the “intermediate term” and refers to the fractal nature of the markets. There are cycles within cycles, such as generational cycles, intermediate term cycles, business cycles, and/or the presidential cycle.

Do you want a strategy that performs well over the “intermediate term” or just over the “long term” or both? The reality is most investors want a strategy that performs well over the short, intermediate, and long terms, and in order to even attempt at providing this, one must agree that cycles indeed exist and stocks do not just go up and to the right!

The Dow is adjusted for inflation in order to help take out of the equation another variable, the value of the U.S. Dollar. The U.S. Dollar has been devalued by the issuance of money throughout its history, resulting in inflation (and its own cycle). Therefore to get a cleaner look at an asset it can often be beneficial to change the denominator.

Stocks & Gold

One way to do this is to use CPI, another is to use the price of Gold. By taking the Dow and dividing by the Price of Gold, the U.S. Dollar is completely taken out of the equation. And, if gold is assumed a proxy for inflation, then inflation is also taken out of the equation.

That chart is shown below and also reveals an even more long term cyclical nature of the equity market. The drawdowns here are absolutely massive as are the periods of equity outperformance. Could you imagine the performance of a portfolio that moved into equities during the uptrends and moved into gold (or a safe-haven such as cash), during times of cyclical drawdowns?

The Dow Priced in Gold
Dow Jones index priced in gold

The most interesting thing to us about this chart is the Dow’s price today compared to Gold, at around 18x, is the exact same as it was at the peak of 1929. In other words if you owned an ounce of gold in 1929 it would be worth exactly the same as if you bought the Dow at that time and held them both for 90 years. Extraordinary!…or you could have not bought the Dow in 1929 at 18x the price of gold and waited until 1932, when it was just 2x the price of an ounce of gold. The point being, the cycle affected a static portfolio’s results massively.

We use this chart more to prove the cyclicality that does indeed exist in the markets, but it sure is interesting to look at the Dow priced in other assets than the U.S. Dollar. This chart shows even further the cyclical nature of the markets and how when you make an investment decision, where you are in the cycle is absolutely crucial to your potential return. For better or worse, the cyclical nature of the market demands you pick the correct time to invest “for the long term”.

Stocks & GDP

Finally, the stock market moves quicker than U.S. GDP and historically has gone through incredible over and under valuation periods. Currently the S&P’s total market value is around 125% of U.S. GDP, which is expected to be around $21.2 Trillion. The S&P 500 is valued at around $25.6 Trillion today. Small businesses, government, and other non-publicly traded companies are also reflected in the GDP indicator which is one reason why Warren Buffett likes to use it as his gauge of where the markets are within an investment cycle. The “Buffett Indicator” also shows the cyclical nature of the markets historically. Historically, a reading over 90% (the S&P 500 is valued at 90% or more of GDP) in this indicator suggests overvaluation. Extremes have historically been hit near current levels as the 1960s saw a peak around 125% while the year 2000 ran to 150%. The 1940s, 1950s, and 1980s saw troughs around 50% S&P 500 value to GDP.

From a generational perspective, are we to expect the next 30 years to be robust, modest, or negative? Who knows, but what we do know after looking at these charts (and thousands of other charts of history) is that the markets indeed are cyclical, and they are cyclical at multiple different time frames. Within generational cycles there are smaller, multi-year cycles, and within those cycles there are even smaller cycles. This market to GDP chart shows a roughly 15 year peak to trough cycle (7 extremes in 100 years).

Agreeing there are cycles in the market is a necessary first step in building an appropriate investment strategy. Hopefully you agree with us that cycles indeed exist. If not, you may find a passive investment strategy appropriate (but please know our door is open when it’s time to look at something different).

The S&P 500 as a % of US GDP
The ratio of the S&P 500 to GDP works in a 35-year cycle.

Do you know what your advisor thinks about cycles and how they will respond to the changing of them? We know what we think about them and have built strategies to properly navigate them as they arise.

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Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.