IronBridge Private Wealth

Forward with Confidence

interest rates

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!

Fed Raises Interest Rates: Implications and What We’re Watching

After reducing rates from 2.5% in 2019 to zero at the onset of the pandemic, the Federal Reserve has hiked rates by 0.25%. What does this mean and what should we be watching?

This was about as surprising as dropping a bowling ball on your foot and realizing it hurts.

While there are still MANY risks in the current market environment, this at least removes one uncertainty for now.

The Fed DID raise rates. They DID raise only a quarter-point. And they DID say they were going to raise more this year. (In fact, they hinted that they would likely have a rate increase at each remaining meeting this year).

What does this mean for the markets?

Frankly, not much.

  • Inflation won’t change with a single quarter-point rate increase.
  • Monetary policy isn’t going to change the global dynamics of the Ukraine war.
  • Global supply chains won’t change due to this.

Granted, the mainstream media will make it sound like this is the most important development in the history of mankind, and will bring on “experts” to discuss it ad nauseum. The markets have initially moved higher on this news, which is a good start.

But given the cross-currents around the globe affecting the markets, this interest rate increase is fairly minor in the list of things influencing prices.

As we’ve said many times, markets are extremely complex. Global politics are also extremely complex.

Combine the two and you have an enormous matrix of potential outcomes.

When that happens, it’s best to simplify.

Here is a chart of the S&P 500 Index with the most simplistic view we can think of.

In this chart we show three basic scenarios:

  1. First Bullish Sign: If the market wants to move above the green line (the recent high from early March), then we would have the first sign that a trend change from down to up may be happening.
  2. Chop Zone: In between the green and red lines, there is very little reason to assume the market will ultimately move higher or lower.
  3. Bearish Continuation: If the market falls below the red line, then it is telling us that the volatility is not over and lower prices will follow.

So while we’re in this chop zone, we should consider the daily moves in the market to be noise.

Granted, when markets move 2% and 3% in a day, those are big moves. But until we see a move above or below the levels on this chart, it’s hard to become overly bullish or bearish.

Why do we mark these particular levels? Why might they be important?

Simple: We find it to be an easy way to determine the trend.

In downtrends, each time the market rallies, it stops at a lower level than where it stopped previously. For example, the all-time high was in early January. When it tried to rally in late January and early February, it stopped at a lower price than it was at the start of the year. The same thing happened in early March.

Each time it tried to rally, it made a “lower high”.

Having “lower highs” is the ultimate characteristic of a downtrend. And the market has definitely been in one since the first of the year.

The market can’t sustain a move higher if it doesn’t stop going down. (Thank you in advance for the Nobel Prize in Economics for that statement.)

On the flip side, if the trend of the market continues to move lower, it will make a new low in price below the red line.

That’s another characteristic of downtrends…lower lows.

We use more complex tools than this in our investment process. But this is one ways for you to think about the current market environment.

What are we Watching?

We’ll talk about this more in the coming weeks, but there are some major developments that we are watching right now.

I. Ukraine

This obviously remains the biggest wildcard and by far the biggest risk for markets.

So far, the market’s low (the red line in the chart earlier) occurred the morning of the invasion.

If we get a cease-fire, expect markets to respond favorably.

However, we need to be on guard for continued volatility and potentially lower prices if tensions escalate.

II. De-Globalization of the Economy

This is something we have been thinking about a LOT lately. We will discuss it in a future report as well.

One of the concerning outcomes of the sanctions imposed against Russia is that we have seen a shift to protectionism across the globe.

The globalization of the world economy that began post-World War II was designed to reduce the likelihood of another global war. The idea was that if countries were economic partners, they would have vested interests in maintaining peace.

So far, it has worked.

But since the sanctions were announced, multiple countries have decided to reduce trade. This has the potential to further reduce global supply of everything from oil to grains to semi-conductors.

Maybe these countries are simply responding to inflation and taking a temporarily cautious stance. If reduced trade is a temporary action, then things may go back to normal if inflation falls over the next few months.

However, if we are at the start of a longer-term cycle of de-globalization, there are many negative outcomes that could occur.

These include stubbornly high inflation, shortages of various goods, increased social unrest across the globe and a higher likelihood of more wars.

III. Stagflation

This is another topic we’ll discuss in a later report, but stagflation is becoming a real possibility now.

Stagflation occurs when inflation is high but the economy is in a recession.

It seems strange to think that it could occur in today’s world, but the possibility of stagflation is real.

IV. Market Recovery

We’re obviously watching risks, but not everything is bad right now.

Corporate earnings, for example, were at a record high last quarter.

The Leading Economic Index (LEI), as shown in the next chart, is also at record highs.

This chart goes back 20 years.

One thing to not is that leading up to the financial crisis of 2008, leading indicators were showing signs of weakness. In fact, this indicator peaked in mid-2006, more than two years before things really unraveled economically in 2008.

Note: The leading economic index is made up of ten components, including hours worked, various manufacturing data, building permits, stock prices, yields and expectation for business conditions.

Further supporting the potential for optimism is that both corporate and personal balance sheets are strong, employment is good, and the housing market is on fire.

It will be important to see data that includes the Ukraine war, and what affect (if any) it has had on this data in the coming weeks and months. We will especially be watching the earnings reports closely that begin in early April.

So while there are many reasons to be pessimistic, there are reasons the market could recover and move higher for the remainder of the year.

Bottom line

Ultimately, the market price is what’s important.

Let’s keep watching these levels on the market to see if it can sustain a move higher, and we’ll adjust your portfolio accordingly.

Invest wisely!

Fed Meeting: Popping the Bubble or Normal Volatility?

So much for the New Year’s wish of putting 2020 and 2021 behind us and getting back to normal.

Or are we?

The markets had one of the calmest years in history last year, mainly on the back of the mega-cap tech firms.

But that calm was shattered as the market fell over 12% in a few short weeks.

Which begs the question…”Is this normal, or is this a sign that the biggest bubble in the history of the world is popping?”

Before we dig in, we’ll mention that the Fed met today and not much came of it. Yes, markets reversed lower after the announcement, but there were no surprises today.

They reiterated that they plan to raise rates by 0.25% in March. And reiterated that the balance sheet is way too big for the current economic environment. Both of these are accurate and prudent.

The markets were hoping he would say that all potential rate hikes are off the table, but that was an unrealistic expectation. And one mostly fabricated by the financial media.

So the reality of the Fed this evening is exactly the same as the reality of the Fed at noon today.

Let’s move on to the markets.

The S&P 500

Markets have had a terrible start to the year. In fact, we’re off to the worst January in history.

From peak-to-trough, the S&P fell 12% (so far at least).

Let’s look at the chart.

December was actually a fairly choppy month, but as soon as the clock struck midnight on New Year’s Eve, markets began to drop without much relief.

The last time the market had any sort of mild correction was last September. It chopped around for a few weeks and moved higher into year end.

Now, the market is testing those levels, as shown in the blue shaded rectangle in the chart above.

The other thing the market is trying to do is to rebound during the day from a very weak start.

The market has had two consecutive reversal days. The bulls are trying to show that they aren’t ready to give up just yet.

On Monday, Jan 24th, the S&P was down as much as 3.99%. However, by the end of the day it was actually positive. That’s a HUGE reversal day that only has a few precedents.

Since 1950, there have been 88 times the S&P fell by this much in a single day.

Only 3 times (including Monday) it finished positive on the day.

The other two times? October 2008.

Yikes.

On the surface, this doesn’t appear to be very good.

October 2008 was the thick of the financial crisis. Banks were failing, the housing market was tumbling, and there was economic and market chaos.

We aren’t seeing anything close to that right now.

Outside of the supply chain bottlenecks, the overall economy is doing fine.

The bond market isn’t showing any signs of stress either.

In fact, the bond market is typically the better market to watch if you’re concerned with the potential for a large drop in equities.

Yield Curve and Yield Spreads

The yield curve and yield spreads are the two major bond market data points that have been the best indicator of economic and widespread financial market stress over decades.

The yield curve measures the difference between longer-term bonds and shorter-term bonds. Specifically, the difference between the 10-year Treasury yield and the 2-year Treasury yield.

When the 10-year yield is LOWER than the 2-year yield, the curve gets “inverted”. An inverted yield curve has preceded EVERY recession over the past 50 years, as shown in the next chart.

The yield curve isn’t showing ANY concern.

What about the other major data point…yield spreads?

Yield spreads measure the difference between yields on the safe bonds (US Treasuries) versus the yields on unsafe bonds (junk bonds).

Specifically, we look at the Baa Corporate Bond Yield and the 10-Year Treasury yield.

This spread is shown on the next chart, which goes back to the late 1990’s.

Every time the market fell 20%, yield spreads widened well before that happened. There has been NO widening of yield spreads this year.

Bottom line, the bond market isn’t worried.

So why all the volatility recently?

The answer is pretty easy. They even met this afternoon…the Fed.

The Fed

The Fed met today, and despite a late day market selloff, no real news came from the meeting.

They reiterated that they anticipate a 0.25% rate hike in March.

This was expected.

They said they would remain aware of economic and financial conditions, and would adjust their approach if the situation warrants.

This was also expected.

So there was actually very little “news” that came of the meeting today.

The real news happened a few weeks ago, when they released their minutes from their last Fed meeting of 2021.

In these minutes, they discussed a faster tightening that what the official messaging has been to the market.

The chart below shows when the minutes were released.

Oops. Since the release of the meeting notes, the market has gone pretty much straight down.

There were a couple of nice reversal days this week, but after the Fed meeting this afternoon, markets again fell.

So we’re getting mixed signals.

On one hand, the very speculative areas of the market are essentially collapsing:

  • Bitcoin is down almost 50%
  • Speculative tech stocks are down 70-80%
  • A whopping 42% of the stocks in the Nasdaq Composite Index are down over 50%

We’re seeing risk at the edges of the market.

Major stock indexes are also showing weakness. The S&P as we mentioned above fell 12%. The Nasdaq has been worse, falling 19% from peak-to-trough.

We’re NOT seeing risk at the core of the global markets…bonds.

Which side should we choose?

For now, we must assume that the volatility we have seen this year is normal.

10% corrections happen on average every 12-18 months. It’s been almost 2 years since we’ve seen one. So this type of volatility isn’t all that unusual.

It FEELS a little worse, because we had such low volatility last year.

And it may continue for a while longer.

But until we start to see risk show up in the more important areas of the market, we should expect an ultimate resolution higher.

That said, we have been taking steps to modify client portfolios. After all, we never know when a small correction will turn into the big one.

We increased cash two weeks ago. We have been rotating out of the more aggressive areas of the market into the traditionally more conservative areas.

International stocks have shown a tremendous amount of strength relative to their US counterparts. We have increased exposure there as well.

If the markets continue to show volatility, we will more aggressively raise cash. And we’re not far from those levels.

But the weight of the evidence, at least for now, suggests this pullback is normal. And frankly we should expect more of this type of volatility going forward.

It does not look like the start of the bursting of the bubble. At least not yet.

Invest wisely!

5 Themes for 2022 and Why We Hate Year-End Predictions

Fortune teller reading future with crystal ball. Seance concept.

We hate year-end predictions.

Maybe “hate” is the wrong word…it is far to kind.

We absolutely despise the cringeworthy year-end predictions that accompany this time of year. (Feel free to imagine other colorful adjectives we may use to describe them.)

Why?

  1. Because they are worthless.
  2. There is no accountability whatsoever for those who make them.
  3. There is no way to accurately predict such a complex system as the global financial markets with any consistency, other than using the most commonly occurring outcome of an historical return bell-curve.
  4. Did we mention they were worthless?

Case in point…the six largest investment firms in the world missed last year’s performance by nearly 20 percentage points on the S&P 500. Oof.

Our apologies in advance if you’re looking for our wild-ass guess expertly modeled estimate of what the S&P 500 will be on December 31, 2022.

As our clients hopefully know, we don’t try to predict what will happen. Instead, we try to listen intently to the markets and let our rules drive the investment decisions.

So instead of sharing our predictions, let’s instead share the five themes we’re tracking for the upcoming year.

Theme 1: The Fed

For those who regularly read our reports, there’s no surprise here that the Fed holds the top spot in themes we’re watching this year.

The Fed is the Alabama Crimson Tide of the financial world. They are always among the top few drivers of what will happen during the season. And unless you’re on the team or an alumni, most people are pretty tired of you by now.

More accurately, the Fed IS the driver of the market. It has been since 2009. So we MUST pay attention to what they are doing.

Right now, despite the talk from Chairman Powell about tightening and raising rates, they are still expanding their balance sheet.

Federal Reserve Balance Sheet has been increasing despite Powell saying they are tapering.

The increase in the Fed’s balance sheet is the single biggest contributor to both the increase in the stock market, as well as the re-emergence of inflation across the globe.

It is also a reason why we’ve only seen minor pullbacks since COVID began.

The eventual reduction by the Fed is very likely to lead to a much choppier environment for stocks, and at some point an outright bear market.

Whether that happens in 2022 or not is anyone’s guess.

But as of right now they are scheduled to begin reducing their balance sheet this year, not just slowing down the increase of it.

Paying attention to global markets when the Fed ACTS, instead of when they SPEAK, will be key for risk assets this year.

Theme 2: Inflation

The second theme to watch this year, and the natural follow up to the Fed, is inflation.

We’ve all seen it recently. From cars to steaks to milk to $10 packets of bacon. Everything costs more.

In fact, inflation just recorded the largest year-over-year increase in 40 years. It rose 7% in the past 12 months, as shown in the chart below.

On the surface, this looks ominous. We haven’t seen an inflationary environment since the 1970’s, and that decade was not a good time to passively invest in stocks.

However, our belief is that inflation will not increase and stay at elevated levels.

Instead, we think it will occur in waves.

We wrote about inflation numerous times last year (click to read):

Lumber is a good example of our inflation-wave thesis.

After skyrocketing the first part of 2021, lumber prices subsequently collapsed. Now, they are skyrocketing again.

Take a look at the extreme moves in lumber recently.

This chart is pretty amazing. We’re talking about the price of LUMBER. Not some phantom crypto-coin being schlepped by a Kardashian.

Lumber is an excellent case study for this environment. There are demand influences, supply chain issues and quality differences in various types of lumber that contribute to this massive volatility. And for the most part, it does not have governmental influences on it like the cost of healthcare does.

Inflation has far-reaching ramifications. Not only for asset prices and the economy, but for society as a whole.

Higher prices hurt consumers. They hurt businesses without pricing power. They cause massive price adjustments in all sorts of areas. Inflation also has massive political implications as a disgruntled populace focuses its frustrations on political leaders.

This quote by John Maynard Keynes is fairly long, but worth the read:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

– John Maynar Keynes

Sounds pretty applicable to today. It was written in 1920.

We don’t expect inflation to cause massive societal disruptions this year, but we sure can see the foundation being laid for that to happen.

Inflation needs to be near the top of things to watch this year. And the coming decade for that matter.

Theme 3: Interest Rates

The third major driver of markets and the economy is the prevailing interest rate environment.

The COVID Crash in March 2020 pushed yields to their lowest levels in history. Not just recent history. All-time history. In the entire history of recorded financial records, dating back to ancient Egypt 4000 years before Christ, interest rates were never lower than they were two years ago.

Since then, they have marched higher. And they are currently trying to move beyond their highest levels since COVID began, as shown in the next chart.

Higher interest rates affect many areas. Real estate, fixed income markets and global currencies all have some sort of tie to interest rates. Not to mention more complicated instruments like derivatives and futures contracts.

Stocks are a bit different.

Higher interest rates aren’t necessarily bad for stocks all the time.

In fact, stocks tend to do just fine when rates rise.

The next chart, courtesy of LPL Financial’s Ryan Detrick, shows the performance of the S&P 500 each time the 10-year yield has risen by more than 1.00% (or 100 basis points).

Since 1962, there have been 14 times when the 10-year Treasury yields has risen by more than 100 basis points. Stocks were higher 11 of those times by an average of 17.3%.

Granted, most of these periods occurred during the massive bull market we’ve had over the past 40 years, but this is still an impressive statistic nonetheless.

While parts of the market are likely to suffer as interest rates rise, we shouldn’t assume that higher interest rates will automatically make stocks go down.

We are likely to find out if this holds true again this year.

Theme 4: Risk Makes a Comeback

The S&P 500 had an excellent year in 2021. CNBC and most financial news outlets primarily focus on the performance of this behemoth index.

But last year did have its share of risk if you looked outside of the large cap growth stocks.

The chart below shows the performance of various assets since last February.

The S&P is the leader by far. It was up almost 22% before the turn of the new year, since last February alone.

However, other assets didn’t perform so well during that same time:

  • International stocks were barely higher (Up 3%)
  • Small Caps lost value (Down 7%)
  • Emerging Markets down big (Down 13%)
  • China was substantially lower (Down almost 30%)
  • Even the high-flying ARKK investment ETF, run by Cathie Wood and epitomizing the speculative edges of the markets, fell by nearly 50% since last February.
  • Bitcoin is down nearly 40% in the past two months (not shown on the chart above). Not what we consider to be an effective a store of value, especially with inflation at 7%.

Why did the S&P returns exceed other areas of the market so much?

Simple…nearly 30% of the index is in the top 5 stocks. And those stocks did amazingly well last year.

The rest of the financial world experienced weakness or outright bear markets already.

The main question for this year is whether the rest of the world can do well if the top stocks in the S&P 500 do poorly.

If they can, which is an excellent possibility, then there will be more opportunity in owning things outside of the big tech companies. In our view, this is the likely path forward.

But if they can’t, and the rest of the world remains weak while the heavy lifters in the S&P 500 deteriorate, then it could be a difficult year across the board.

There are mixed messages here, and the answers are not clear. So you must adapt as the things develop, whether they become bullish or bearish.

Theme 5: Another Damn Election

It’s a mid-term year, and the fully saturated political environment is going to soak us once again.

In an ideal world, politics shouldn’t influence asset prices. But in our world they do.

Remember the performance of Chinese stocks from the chart above? A number of Chinese companies have excellent business models, fantastic customer bases and thriving businesses, but political influences caused massive declines in the performance of their stock last year, and it brought down the entire stock index in that country.

With this being an election year, there are some key areas of the market that could be made into whipping boys this year.

The two most likely targets? Big Tech and Big Oil.

We’re starting to hear rumblings from Washington about their intentions.

The big social media companies are scheduled to testify to Congress soon. And our beloved politicians won’t miss the opportunity to send an outlandish quote hurling through the echo chamber to get on the front page nationwide.

Same with big oil. We’re already hearing from President Biden that oil companies are gouging the American people. Maybe he’s right, maybe not. But we should expect them to be a target this year as well.

Despite of whether there is political influence or not, midterm election years tend to have increased volatility on average.

The next chart, again courtesy of LPL Financial, shows This chart shows the average return of each year of the 4-year Presidential Cycle since 1950.

Specifically, it shows that Midterm years have an average drawdown of 17% during the course of the year.

It also shows that on average, stocks are higher by 32% a year after the lows.

While each year has its own specific characteristics and abnormalities, the Presidential Cycle data suggests we should see some volatility this year, but should expect a nice recovery.

Bottom Line

Bottom line, the market is finishing up a strange year in 2021. The S&P 500 did great, but other areas didn’t do as well.

And markets are off to a fairly rocky start to the year so far. But the overall trend still remains higher, at least for now.

Where the market ends up at the end of the year is anyone’s guess. But we’ll keep adjusting portfolios as the data warrants, and will work hard to both protect and grow your hard-earned wealth.

Invest wisely!

The Wolf and the Crane

Aesop was a Greek storyteller who lived from 620-564 BCE. His stories were verbally passed down through time, and often included tales of animals and inanimate objects that could speak and solve problems.

Many of Aesop’s Fables are commonplace even to this day. We are all familiar with the story of the tortoise and the hare.

But a lesser known fable is that of the Wolf and the Crane.

In the fable, the Wolf gets a bone stuck crosswise deep in his throat. He asks the Crane, with her long neck and lengthy bill, to reach in and pull the bone out. If she successfully removes the bone, he promises to reward her very handsomely in return.

So the Crane uneasily put her head into the Wolf’s throat, and removes the bone.

But when the Wolf felt that the bone was gone, he started to walk away.

The Crane anxiously asked, “But where is my reward?“

The Wolf whipped his head around and snarled, “Haven’t you already got your reward? Isn’t it enough that I let you take your head out of my mouth without snapping it off?”

The moral of this story is that you shouldn’t expect a reward when you are serving the wicked. (FYI, the full text of the fable is at the bottom of this page.)

This may seem harsh, but it is appearing more and more that the Fed is the Wolf.

And we are the Cranes.

We have benefitted from 12 years of strong markets on the back of the Fed printing press. The excesses of the banking and housing expansion before 2009 were never truly worked off. Only covered by a tsunami of digital dollars.

The Wolf, aka the Fed (and more broadly the largest U.S. banks), asked us to do something for them: increase consumption by using low-interest debt. Oh, and to buy stocks.

And we consumers obliged.

Total consumer debt has consistently risen over the past 30 years, as shown in the chart below.

Total consumer credit since 1990

Consumers benefitted in the form of easier access to credit and interest rates that are literally the lowest in recorded human history.

Investors benefitted as well.

The next chart, courtesy of our friend Lance Roberts with Real Investment Advice, shows the Federal Reserve balance sheet versus the S&P 500 Index. We discussed this chart in our Strategic Growth video series HERE.

Each time the Fed turned on the printing press since 2008, stocks went up. After all, this was the goal of their policy. They wanted stocks to go up in order to create confidence in the real economy.

Flooding the financial system with liquidity worked, and it continues to work to this day. If we look at all the problems in the world right now, it is easy to see that U.S. stocks simply don’t care about any of them.

GDP cratered over 30% in the second quarter of 2020. We’re in a global pandemic that is nearly two years old. There is massive unemployment, huge inflationary pressures, supply chain disruptions, major tax legislation, self-induced geopolitical messes, natural disasters, generational social discord, increasing wealth disparity…the list goes on.

Despite all of this uncertainty, we haven’t had a 5% pullback in almost a year.

As Jay-Z might say, “I got 99 problems but the market ain’t one”.

At least not yet.

This summer we wrote The Fed is Stuck. In it, we discussed the mechanisms that allowed the Fed to have a direct impact on financial markets.

Now, there is discussion that the Fed will start to reverse course.

Over the next few months, you’re going to hear a LOT of the word “taper” from the financial media. And rightfully so.

The Fed has created an economy and financial system completely dependent on its easy money policies.

If we can agree that the massive liquidity injections had a positive effect on the markets, one would also assume the opposite to be true.

So it is logical to begin to discuss the potential consequences as the Fed begins to reduce its support of the financial markets.

What Happens when the Fed Tapers?

Merriam-Webster defines “taper” as a verb that means “to diminish gradually”.

When the Fed “tapers” its asset purchases, it simply means they will slowly reduce the amount of money they are force-feeding into the financial system.

This HAS to happen at some point.

There is no way to continually print trillions of dollars and expect to not have any consequences.

So far, the only “consequences” have been mostly positive.

Inflation has been a consequence, but up to this point it has only been in the form of asset price inflation. Stocks have risen, bonds have risen, and real estate of all kinds have risen.

Federal Reserve Chair, Jerome Powell

What we haven’t seen is the negative inflation that will inevitably stall the economy. But it is starting to appear. In Austin, multiple restaurants have started to raise prices. Your grocery bill is likely a bit higher this fall than it was a year ago. Let’s not even talk about housing affordability.

At first, we the consumer will absorb the real economic inflation. But as these inflationary pressures build, the Fed simply can’t continue on its current path. We are nearing a point where the Fed must stop doing what it is doing.

So what is the Fed actually doing?

It is doing two things: shoveling $120 billion per month into the financial system and keeping interest rates artificially low.

So there are technically two things the Fed could start doing: reduce the $120 billion number, or increase rates.

Taper or Raise Rates?

At their meeting next week (September 21-22), it is widely expected that Jerome Powell will announce a tapering program.

This means that they are likely to reduce the $120 billion number. That leaves two very simple questions: By how much will they reduce it, and over what timeframe?

While most people are predicting the Fed to taper, it actually might make more sense for them to raise rates first.

The financial markets have been focused on the flow of assets into the system. The $120 billion per month results in a net increase in demand. When demand outpaces supply, prices go up. A reduction of the $120 billion would then logically either slow the rate of increase in the market, or at some point lead to an actual price decline.

But an increase in the interest rate environment would have a more subtle effect.

Adjustable rate debt would go up. The interest rates on new loans would likely go up. And what would essentially happen is the cost of funds would get slightly more expensive to slow down major purchases and leverage.

This would be a good thing in the early stages of an inflationary environment.

It also would result in a positive surprise to the financial markets.

That said, it’s very difficult to predict what the Fed will do. And even more difficult to predict how the market will react to it. We’ve yet to read much about the potential for the Fed to raise rates before slowing down their asset purchases.

Either way, it would be more of a surprise if they did NOT act next week.

So we should expect a clearer path forward from Mr. Powell next week, and a path that includes a slow down of Fed activity.

The Wolves Inside the Fed

One other reason to expect a tapering announcement next week is less grounded in economic reality, and has more to do with political grift.

Members of the Federal Reserve do not have major restrictions when it comes to their own personal investments. Or at least they didn’t until last week.

As former employees of large investment firms, we have dealt with trading restrictions for many years. Heck, even a small, independent firm like IronBridge has trading restrictions and requires disclosure of investment holdings. These are important so that we aren’t abusing our knowledge of future trades that we may do for all of our clients, and “front-run” the trade hoping our investment actions will boost the price of that stock.

However, the Federal friggin’ Reserve bank, the most powerful financial institution on the planet, does not have restrictions on what their active, policy-creating members can and can’t do.

Case in point…last week it was revealed that the Federal Reserve Bank of Dallas President Robert Kaplan (pictured below) owned nearly 30 positions in individual stocks valued at over $1MM per stock. He had 22 stock purchases last year of over $1MM per trade.

Dallas Federal Reserve President Robert Kaplan, aka a Wolf

Mr. Kaplan actively sets monetary policy. And that policy is designed to literally make stocks go up.

Conveniently, as the Fed is about to change course and start to taper, he announced that he magically found his ethics and will sell all of his individual stock holdings.

Funny how that works.

Mr. Kaplan isn’t the only one either.

Boston Fed President Eric Rosengren conveniently found ethics as well. He announced he would be selling all of his individual stock holdings by September 30th.

There are only 12 people who officially vote on Fed policy. And two of them (that we know of) are going to liquidate their holdings at the same exact time the Fed is changing their easy money policy.

This is a different kind of wolf, but a wolf nonetheless.

Maybe it is coincidence. Maybe these gentlemen are noble, ethical people. Maybe the Fed won’t reverse course and will keep pumping. Maybe stopping the massive amounts of liquidity going into the system isn’t going to slow this market down.

Or maybe they know exactly what they are doing.

And maybe like the Wolf, they won’t care what happens to the market and economy when they stop.

After all, we Cranes escaped the financial crisis and COVID crash with stock prices and home prices higher than when it all started.

Cognitive Dissonance

The other thing to watch in next week’s meeting is that the Fed will likely blame everything but themselves for the inflationary pressures building in the real economy.

This cognitive dissonance is important because it allows them to change policy without worrying about the negative consequences of what their change in policy might do to asset prices and the real economy.

This allows them to sleep at night believing that what they did was noble.

And maybe it was noble.

But if there begins to be negative fallout from the Fed stopping the printing presses, we should not expect the Fed to reverse course this time. In fact, we should expect the opposite going forward.

The Fed believes we have already received our rewards. We were “saved” from the jaws of the financial crisis and COVID crash.

The Fed didn’t chew the heads off of us Cranes. They “let” us escape unharmed.

And for the first time in many, many years, it appears that they are truly about to change from an easy monetary environment to a less accommodative one.

Therefore, now is not a time for complacency.

The markets are getting closer to a major top. We may not be there just yet, but we are definitely getting closer.

We don’t know if it will be three months, six months or five years before things change, but we are closer today than we were yesterday.

So stick to the basics:

  • Stay disciplined. Don’t let a small loss turn into a big loss.
  • Do not let your emotions get the best of you. Don’t become overly bullish or overly bearish…anything can happen.
  • It’s okay to be wrong. We can’t pick the top. And we won’t try. But if things are not working you need to change course. What’s not okay is to stay wrong and try to fight the market.
  • Use data to make decisions, not narratives. Always remember that the media exists to sell commercials, not give you objective investment advice.

So let’s watch what the Wolves will do next week with great interest. Whatever the Fed may do, we will be prepared.

Invest wisely!

The Wolf and the Crane

“A Wolf had been feasting too greedily, and a bone had stuck crosswise in his throat. He could get it neither up nor down, and of course he could not eat a thing. Naturally that was an awful state of affairs for a greedy Wolf.

So away he hurried to the Crane. He was sure that she, with her long neck and bill, would easily be able to reach the bone and pull it out.

“I will reward you very handsomely,” said the Wolf, “if you pull that bone out for me.”

The Crane, as you can imagine, was very uneasy about putting her head in a Wolf’s throat. But she was grasping in nature, so she did what the Wolf asked her to do.

When the Wolf felt that the bone was gone, he started to walk away.

“But what about my reward!” called the Crane anxiously.

“What!” snarled the Wolf, whirling around. “Haven’t you got it? Isn’t it enough that I let you take your head out of my mouth without snapping it off?”

The Coming Inflation Waves

Symbolic waves of inflation could crash the US economy, but only after years of a gradual increase.

Inflationary pressures have been steadily building over the past year. That can easily be seen in the price of lumber, residential houses and various raw materials. Recent data showed that CPI increased a whopping 4.2%. What implications does this have on your portfolio?

The first panacea for a mismanaged country is monetary inflation. The second one is war.

Ernest Hemingway

There is no question that we have seen massive inflation in various parts of the US economy since the end of the COVID-related market crash last year.

Homes in Austin are regularly being offered 20-30% above list price. The price of lumber has quadrupled over the past year. Used car prices are at all-time highs.

Some of the side effects of an inflationary environment are fairly obvious. Prices at the grocery store will go up. Gas prices will go up. Generally speaking, the cost of all kinds of “stuff” will rise. After all, that is what inflation is.

But there are other, less obvious things that are likely to happen during the period of rising inflation and interest rates that we have likely already entered.

There are two that we think are of primary importance:

  1. Non-linear price and interest rate increases.
  2. Dispersion in asset returns.

Both of these characteristics are critical to understand the investing environment over the next 20 years.

The non-linearity of the coming inflationary cycle simply means that it isn’t likely to hit us all at once. It will likely come in waves. We don’t need to know the exact timing and duration of each wave to properly navigate the next “rising” environment. We simply must be aware that it won’t come out of nowhere…there will be plenty of signs, many of which we’re seeing now.

We’ll go into more about dispersion below, but let’s first look at the historical cycle of rising interest rates to better understand what to expect.

The Interest Rate Cycle

Everything works in cycles. The Earth circles the sun. The seasons regularly change. Humans are born, age and decline.

Interest rates are no different.

In fact, interest rates typically rise and fall on a 60-year cycle. That’s a 30-year cycle of rising interest rates, and a 30-year cycle of declining rates.

The chart below, from Tom McClellan of McClellan Financial Publications, is one of the best examples we’ve seen that shows this cycle in action.

The 60-year cycle of interest rates going back to the mid-1700s. Yields consistently move in 30-year cycles up and down.

This chart goes back to the mid 1700’s. We can fairly easily see the regular rise and fall of rates over this period of time. With the exception of a few wars here and there that artificially affected interest rates, the 30-year rhythm plays out pretty well.

The current period of declining interest rates began in the early 1980’s. Inflation peaked at 14.3% in 1980. Interest rates peaked in June of 1981, with the prime rate at an incredible 21.5%. Many of you reading this likely had mortgages at 13% and 14% at the time.

Paul Volcker, the chairman of the Federal Reserve at the time, famously declared a war on inflation and took steps to “pop” the inflation bubble. And he was ridiculed for it at the time.

Since then, however, inflation and interest rates have been on a steady decline, as we can see on the “Black Diamond” ski slope downward on the right-side of the interest rate chart above.

But interest rates began declining in 1980. It’s 2021. We’re now 40 years into a 30-year cycle. We’re on borrowed time for when interest rates should be moving higher.

But what will this transition look like from a declining interest rate and inflation cycle to a rising one?

Slowly then Suddenly

One of the expectations right now is that inflation will hit us like a Mack truck. That’s a logical conclusion, given that lumber prices are four times higher than this time last year.

But this is a mistake that many people make when thinking about rising interest rates and inflation.

It doesn’t happen all at once, especially at the start.

Let’s look at the same interest rate cycle chart, but focus on the beginning stages of each rising cycle. There have been four major turning points in the last 260 years, as noted on the chart below.

The 60-year interest rate cycle with annotations showing the gradual increase in interest rates.

If we look at the red circles, interesting patterns starts to emerge. Rates don’t have any initial spikes higher at first. It takes time for long cycles like this to turn, much like steering a cruise ship.

In fact, we notice three distinct similarities in these periods of rising rates:

  1. In all four cycles it took 7-10 years for the first 1-2% rise in rates to occur.
  2. During this first 7-10 years, there are multiple “squiggles”, where rates take two steps forward and one step back. They ebb and flow like waves.
  3. Following the gradual rise, there is almost always a large spike higher in rates. Unfortunately, this has consistently been associated with a major, generational war.

If interest rates bottomed last year during the COVID crash, we are literally at the very beginning of this rise.

If the cycle of higher rates is indeed beginning now (which is our primary thesis), then we should still be a few years away from the period of rapidly rising rates.

But as with all things market-related today, the Fed is once again the wild card.

The Reckless Fed

We have discussed the Federal Reserve many times over the past few years. As recently as January in our “Twin Risks” report we discussed the possibility of Fed missteps. And last June’s “COVID vs the Fed“, we expected that the Fed would win when it came to rising asset prices, and that was indeed the case.

But even with improvements in economic conditions and the pandemic seeming to be much more under control with the highly effective vaccines, the Fed continues to print and print and print some more.

In our next chart below, we can see that the Fed balance sheet continues to expand dramatically.

The Federal Reserve (Fed) balance sheet as of May 2021 is almost $8 trillion. Courtesy of Bloomberg.

The spike higher in 2020 was the obvious and appropriate response to the COVID lockdowns. However, since late last year, the Fed has printed another $1 Trillion and force-fed it into the financial markets like a goose being primed for foie gras.

Last week alone the Fed printed nearly $100 Billion. All while the economy is obviously recovering and financial markets are at all-time highs.

During COVID, it was logical for the Fed to step in. Now? Frankly, it doesn’t make any sense.

It seems like we now have the first ingredients of a misstep. Continued massive monetary expansion WILL eventually have unintended consequences. What we don’t know is when the consequences will show up and what exactly those consequences will be.

The Fed is obviously signaling that it wants inflation. It is showing up all over the economy. Yet, the “official” inflation numbers are low.

Following the further injections of liquidity into the markets, pretty much every asset has risen in price (predictably). Some assets have risen more than others, but for the most part they all have gone up.

This simply can’t continue indefinitely. As Howard Markes says, “Trees don’t grow to the sky”. Everything works in cycles, especially asset prices.

And if everything works in cycles, and we are in a cycle where everything went up, what do we think might be next?

Well, it could be a cycle where everything goes down. But more likely it will be a cycle where instead of everything performing in unison, it could be a cycle where nothing performs in unison.

Which brings us to our second major theme for the coming decade: the return of dispersion.

What is Dispersion?

The official definition of dispersion, as it relates to our purposes here, is “the extent to which values of a variable differ from a fixed value such as the mean.” 1

Okay, so what does it mean in non-statistical terms?

It means that everything won’t go up at the same time.

It comes from the root word “disperse”. As when police officers instruct a crowd to go about their separate ways.

For our purposes, it means there will be areas of the financial markets that perform very well over the next 10-20 years, but there will also be many assets that decline in price as well.

In the definition above, the “values of a variable” simply mean different parts of the market. The “fixed value such as the mean” is the index.

So if the performance of S&P 500 is the “mean”, the underlying stocks and sectors within the market are the variables.

We would not be surprised if broad markets didn’t perform very well in the coming cycle. They could easily have flat or even negative returns over the next decade.

But that doesn’t mean you can’t make money. The “mean” is the average. But underlying that average are components that went up in price, and components that fell in price.

Since the early 1980’s, nearly every asset class has been in a bull market. Outside of the bear markets in 2000 and 2008 (and the COVID crash last year), stocks in general moved higher.

Guess what? So did bonds, commodities, homes, office buildings, international stocks, gold, and just about everything else on the planet as well.

Everything went up. The only difference was how much each investment went up.

And it makes sense that they all went up. As we noted earlier, both interest rates and inflation have been steadily declining since the early 80’s.

Declining interest rates almost always help asset prices go up. After all, many things are purchased with debt. Real estate is the most common use of debt to finance an acquisition, but debt is also used for all sorts of different financial activities. It is used to acquire companies, both large and small. And to build manufacturing facilities. And to purchase stocks. And to improve infrastructure. And to build high rises.

As interest rates fall, the cost of debt decreases. And that gives a purchaser the ability to buy more real estate, companies, manufacturing facilities, etc.

The opposite is also true.

As interest rates rise, the cost of debt increases. It takes away the purchasing power of everyone, from your new neighbor to the federal government.

This is why the Fed is so hell-bent on keeping interest rates low. And for a while now they have been successful.

But as we mentioned above, they can’t keep doing that forever. So we must start to think about what the next cycle may hold so we can make sense of the signals we may get from our investment process.

What Assets may Benefit from Rising Rates?

This is the $64,000 question. And if you’ve followed our reports at all, you probably know our answer. We have no idea.

While our investment process is designed to pick up on these changes over time, let’s look at some key characteristics of assets that could benefit from higher rates and inflation.

Pricing Power

In an inflationary environment, the costs of goods go up. That means that companies who are selling those goods are selling them at higher prices. Which naturally means that the revenue to these companies are also going up. Granted, input costs also rise, but if they can pass along higher prices to their consumers, it means they have pricing power.

Pricing power is critical to a company being able to successfully keep profit margins at current levels, and even being able to increase their margins. Without pricing power, companies have to increase efficiency or reduce costs to maintain profit margins.

Many companies will not be able to keep profit margins at current levels. The companies that can’t will likely have their stock price suffer.

The next chart shows that profit margins on the S&P 500 are at all-time highs.

S&P 500 profit margins have been increasing since the mid 1990's and as of May 2021 was at an all-time high.

As we discussed in our previous report “The Icarus Market“, we discussed how P/E ratios were elevated due to the increased concentration of technology stocks in the S&P 500 Index.

This also applies to profit margins.

Technology companies tend to have both higher profit margins and P/E ratios. So as technology becomes a larger portion of the index, profit margins should naturally increase.

To assume that profits margins can stay at these elevated levels seems like an optimistic assumption. And if they can’t stay at these levels, it is most likely due to tech not being able to keep pace.

Low Reliance on Debt

Another characteristic of a potentially good investment is a low reliance on debt.

As we discussed above, as interest rates rise, so does the cost of capital. Companies with lower debt loads, companies not dependent on financing activities to support their business, and recipients of higher interest rates could all benefit.

Banks are one area that may do well. Most banks make money off of a spread. They pay you nothing on your savings account, but charge you interest to take a loan. The difference in what they pay versus what they receive is called the “Net Interest Margin” or NIM.

As interest rates go up, their NIM should also go up. Because they are quicker to pass along higher rates to you as a lender than they are to you as a saver. Be prepared for continued frustration for a few years if you’re expecting the yield on your savings account to go up much.

But the big banks are turning into dinosaurs. There are many companies looking to disrupt this industry, so it may be areas in the financial sector outside of the behemoth banks that ultimately do well.

Other investments are much more dependent on debt. Real estate, for example, is one such asset.

Traditionally, real estate is expected to benefit from inflation. But it is also hurt by higher rates. So the dynamic between the inflation waves and the interest rate waves is key when it comes to housing prices.

We’re seeing home prices skyrocket now, partially due to demand, but also due to the fact that inflation is starting to appear, but higher interest rates are not.

So when inflation rises and interest rates stay low, home prices should continue to rise. But in our wave theory, there will be periods where inflation goes down and interest rates go up. That would not be favorable for real estate, and may provide opportunities to increase exposure to real estate.

This is exactly what we are talking about with the coming inflation and interest rate waves.

Stuff

The last area that may benefit is simply “stuff”. Commodities, materials, lumber, chemicals, and many other things that are used in real life things.

The reason these areas do well is the mindset of consumers during inflationary periods. The expectation is that what you are buying today is going to cost much more next year. So while it is more expensive than it was a year ago, it’s probably going to be more expensive next year. So you might as well buy it today.

As this mindset permeates the economy, the prices of stuff get more expensive. At first, higher prices tend to self-correct.

Earlier this month, the price of lumber fell 30% in a couple of weeks. It had gone up so much that people simply stopped building that new home. So prices corrected.

In this first inflation wave, this is expected. We also expect that it won’t get down anywhere close to the prices from last year. Prices will fall, and people will start to build again. And the next wave higher begins.

Alternate that same behavior over the coming years and we have the exact scenario we are describing…waves of inflation that gradually get higher over time. Until BANG! inflation is out of control, and we go into the steepening phase of the cycle.

Bottom Line

It simply appears that we have begun the next cycle of higher interest rates and inflation.

While it will likely take many years before it starts to get out of hand, there are easy ways to prepare yourself for this environment.

  1. Make sure any debt you have is at a fixed rate. Expect to pay more interest on new debt as time goes by. There is plenty of time to prepare, but now is the time to think about and prepare for higher rates.
  2. Dispersion favors active management. We’ll discuss this more in the future, but passive index investing and broad asset diversification is likely to be a poor choice in the coming market cycle. Your portfolio must become more focused.
  3. Re-evaluate your income strategy. Bonds are likely to be the worst performing asset over the coming years, unless we see an outright market collapse. You will need to be very tactical with your bond strategy. Cash rates will eventually move higher, but likely slower than we think.

In the immediate future, however, we should expect higher prices. Given that the Fed is still recklessly throwing gallons of gas on a market that’s on fire, higher prices should be expected in the near term.

But we think that this reckless behavior by central banks ultimately will be viewed in a very negative light. Primarily because of the skewed asset prices it is creating now. But while the party is still raging, more spiking of the punchbowl seems fun. And for now, it is still working.

But as this new phase of rising inflation starts to take hold, the Fed will likely find it more and more difficult to keep asset prices afloat.

That’s when the waves of inflation start becoming bigger and bigger until they simply can’t control it any more.

Our investment process was designed to handle any environment, including the ones that are most uncertain. Let us know if you would like to discuss this in more detail and how your portfolio may be affected.

Invest Wisely!

References:

  1. “Dispersion” definition from the Oxford English Dictionary online