IronBridge Private Wealth

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markets

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!

Ukraine War: Market Update

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

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

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

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

Ukraine War: Informational Resources

Let’s get started.

Sanctions against Russia (aka, the Financial War)

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

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

Let’s focus on the financial war.

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

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

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

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

There are essentially four types of sanctions being imposed:

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

Here’s our overview of these sanctions:

All of these sanctions have two goals:

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

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

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

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

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

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

S&P 500 Index

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

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

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

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

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

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

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

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

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

But this pullback feels worse, doesn’t it?

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

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

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

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

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

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

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

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

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

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

Dictators have one goal: to remain in power.

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

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

Let’s refocus on the financial markets.

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

What should we expect from the Federal Reserve now?

The Fed

What might the fed do now?

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

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

Here’s how to read this table.

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

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

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

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

That could create a tailwind for stocks as well.

But they are definitely behind the curve.

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

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

Six months ago, these rates were the same.

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

This is their dilemma.

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

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

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

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

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

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

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

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

Invest wisely!

Ares: Forever Quarrelling

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

In Greek mythology, Ares was the God of War.

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

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

In the Iliad, Zeus tells his son, Ares:

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

zeus to his son ares, in Homer’s iliad

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

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

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

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

But we digress.

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

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

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

Let’s get to it.

Timing of a Potential Invasion

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

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

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

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

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

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

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

Are Financial Markets Pricing in an Invasion?

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

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

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

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

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

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

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

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

The stock market isn’t much different.

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

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

What about in Europe?

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

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

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

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

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

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

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

What Happened in Previous Geopolitical Events?

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

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

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

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

stock market reaction following major geopolitical events since pearl harbor

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

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

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

Surprising, huh?

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

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

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

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

This is the biggest wildcard.

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

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

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

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

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

Conclusion

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

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

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

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

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

Invest wisely!

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!

Houdini’s Hole

The Paramount Theatre in Austin, Texas is a city treasure. It has an amazing variety of shows, and the list of notable performers is unmatched. It was built in 1915, and began mostly as a vaudeville house.

Just a few of the notable performers in its history are Miles Davis, the Marx Brothers, George Carlin, Ray Charles, Billy Joel, Don Rickles, Chuck Berry, Gladys Knight…the list goes on. Learn more about the Paramount Theatre: https://www.austintheatre.org/

Harry Houdini

One of the most famous performers to grace the Paramount stage was Harry Houdini. And his presence can literally be seen to this day.

Houdini performed there in 1916. At the time, he was one of the most famous people in the world. His slight-of-hand tricks mesmerized audiences worldwide.

One part of his performance was a suspended levitation trick.

He would dangle from the ceiling and escape a straightjacket or chains or some other kind of concoction.

He most likely performed this trick at the Paramount during his eight shows in Austin. To accomplish it, the theater operators drilled a hole in the ceiling of the Paramount and dangled the global superstar over the audience.

The hole they drilled is still in the ceiling today, over 100 years later, as shown in the picture below.

Houdini’s hole can be seen in the green area to the top-right of Saint Cecilia’s right hand. Photo courtesy of the Paramount Theatre website.

The details of Houdini’s trick that night are unknown.

But as with any kind of “magic” trick, it’s not about how the performer escapes. It’s all about distracting the audience to create an illusion of making the impossible possible.

This same type of “magic” is happening in financial markets today.

Suspended Levitation

Harry Houdini mastered the art of the suspended levitation tricks.

In today’s markets, there appear to be two Houdini’s: the Fed and the mega-cap tech stocks (such as Tesla, Facebook, Google, Amazon, Apple and Microsoft).

We’ve discussed the Fed a LOT in these reports.

But we came across a new chart that shows just how big of an impact the Fed may have had in market growth over the past decade.

Bank of America Global Research did some very interesting analysis.

What they did is look at how much of the market growth can be explained by earnings growth, and how much can be explained by the Fed’s balance sheet.

The first chart below shows how much of the returns of the S&P 500 can be explained by changes in the earnings of the companies within the index.

Earnings Contribution to changes in the S&P 500 Market Cap

This chart paints an interesting picture.

Traditional investors assume that when earnings increase, so should the stock price. That’s what we’re buying after all, right? Shares in a company whose business should grow?

But the chart above tells us that’s not quite the case.

It tells us is that from 1997 to 2009, only 48% of the changes in the index can be explained by earnings growth.

And after the 2008 Financial Crisis, earnings only accounted for 21% of the changes in the S&P 500!

That’s pretty amazing. Only 21% of the increase in the market over a decade-long period is due to earnings?

What would explain the rest of the growth?

There are a variety of things that impact stocks:

  • Earnings: Higher profits or revenue can lead to more valuable companies.
  • Flows: More money chasing stocks makes it go higher, less money makes it go lower.
  • Sentiment: Optimism creates more buyers, while pessimism means more sellers.
  • Investing Alternatives: When stocks have competition for returns, less money goes into the stock market.
  • Liquidity: When there is more money in the system, there is additional capital to put to work that is not tied up in other areas like inventories.

We could write dissertations about each of these categories.

But let’s focus on the last item, liquidity. This is the main avenue where the Fed has an impact.

Fed-Driven Market Growth

Bank of America also did the analysis on how much of the price changes can be explained by changes in the Federal Reserve balance sheet, which is shown in the next chart.

Fed Balance Sheet Contribution to changes in the S&P 500 Index

Here we really start to understand just how much impact the Fed has on markets.

From 1997 to 2009, literally zero percent of the return of the S&P 500 can be explained by changes in the Fed balance sheet.

Granted, the Fed’s balance sheet wasn’t that big before the financial crisis. But that’s kind of the point.

Since 2010, a whopping 52% of market performance can be attributed to the Fed. That’s even more of an impact than EARNINGS had in the 12 years leading up to it.

No wonder the Fed is nervous about what happens when they start to reduce the size of the balance sheet. (Read our article earlier this year The Fed is Stuck.)

They are creating an illusion, just like Houdini.

What started in 2009 as proper policy to keep the financial system operational, has since turned into a permanent juicing of the markets to keep them chugging higher.

The Fed starts to talk about tapering, and reverses course at the slightest whiff of risk.

Case in point…the Fed started to talk about tapering right before Thanksgiving. Markets fell a quick 5%, and next thing we know it’s off the table.

We’re not talking about the COVID Crash, where stocks plummeted 40% in a few short weeks. We’re talking about a normal 5% correction. They blamed the Omicron mutation, but that was just an excuse to postpone making tough decisions.

Our job as investors is to make money. So we appreciate what the Fed is doing.

And it may continue to work for a long time still. But we have to think about what happens next.

But the Fed isn’t the only one doing the heavy lifting. Tech stocks have helped tremendously this year.

Big Tech Stocks

The other market magician is the biggest-of-the-big tech stocks.

There have been increasing acronyms that represent these stocks:

  • First it was FANG. Facebook, Apple, Netflix and Google.
  • Then it became FAANG. Add Amazon to the mix.
  • Then it was FANMAG. Microsoft needs love too.
  • Now we can include Tesla and Nvidia. Who know what that will spell.

Whatever it spells, it’s yet another way the market is levitating.

We discussed the 5 largest stocks in our Strategic Growth Video Series, which you can view HERE.

To view just how much of an impact the 5 largest stocks have had this year, look at the following chart from S&P Global Research.

This chart is quite shocking.

As of December 6th, when this chart was published, the Nasdaq index was up almost 20% for the year.

Without the largest 5 stocks, the index is DOWN over 20%.

Let’s hear that again. The index goes from UP 20% to DOWN 20% by removing only 5 stocks.

(By the way, these 5 stocks are Amazon, Google, Tesla, Facebook and Nvidia.)

Jiminy Christmas, Houdini, that’s some trick.

We can interpret this two ways. And these two ways have extremely different outcomes.

On the one hand, this could be positive.

The fact that so much of the index has fallen means that a large majority of stocks have actually gone through a pretty tough stretch. Many have gone through outright bear markets when viewed individually.

Maybe these stocks are ready to begin to move higher.

That would provide excellent investment opportunities outside of these big tech stocks.

On the other hand, if these stocks do start to falter, watch out.

If these handful of stocks start to weaken, and there is NOT a rise in the majority of the other components of the index, we could start to see a market that shifts from slowly drifting higher to quickly falling.

Reality is probably somewhere in between.

If the magicians of the market stop rising, but a majority of the other stocks start to do better, we could see an environment where the overall indexes are choppy and flat, but without any major losses.

That seems like the likely outcome while the Fed remains accommodative.

So far, every little dip has been bought. The scary 5% correction that we saw a couple weeks ago really didn’t amount to anything.

So the slight of hand continues and the performance goes on.

The market Houdini’s have escaped harms way for quite some time now. But if the Fed doesn’t continue to escape, they could leave a hole that we will be able to see for generations to come.

Invest wisely!

It Came from Left Field

Confused baseball player

Last Friday, the day after Thanksgiving, the market fell almost 1000 points. What was that all about?

First off, let’s put this move in context.

Volatility Spikes

The VIX rose 54% on Friday. This was the fourth largest spike in the history of the volatility index, as shown below.

Largest 1-day increase in the volatility index (VIX) in history.

There are some interesting things that we find in this data:

  1. Surprisingly, the 3rd-largest spike happened this past January. Not pre-COVID January 2020, but this past January of 2021. (Like you, we don’t remember that either.)
  2. Three of these happened during the COVID crash (items 10, 17 and 18 in the chart above).
  3. Only 4 of these 20 spikes (20%) occurred during true bear markets. The other 80% occurred randomly during up-trends.
  4. The largest spike in VIX history happened a few years ago. It led to a 20% pullback in stocks.
  5. The 2nd largest spike happened in early 2007, nearly 8 months prior to the market top before the 2008 financial crisis.

This list tells us that the spike in the VIX last Friday was indeed historic. Let’s now look at this VIX spike on a chart, not just in a list.

The next chart looks at the VIX since just before the COVID crash.

Well, that’s pretty strange. Friday’s spike higher was both historical and barely noticeable.

On first glance, it would appear that the VIX has done this many times during the past year.

Should we be Concerned?

With this volatility, should we expect Armageddon? According to mainstream media the Omicron mutation is going to be the worst mutation so far. But they are paid to sell commercials, not provide rational guidance.

Their constant hype of selling fear appears to be backfiring. Viewership is dramatically lower, and trust in the media is at an all-time low, and rightfully so. But we digress.

Bottom line, it’s easy to “blame” some kind of news for big market declines.

But the move on Friday looked to be more technical than anything else.

The day after Thanksgiving has notoriously low volume. Not many institutional traders are at their desk all day, and a small number of large trades can cause big dislocations when volume is low.

In addition, the market hasn’t had much volatility in the past year. So in a way, it made up for lost time.

So back to the question…should we be concerned?

Maybe.

Any time these types of moves happen, the most important development is ALWAYS whether we see follow-through or not.

As of this writing, markets are up almost 2%. We didn’t see any follow through lower just one day later. That’s a positive sign.

As the week goes on, we should start to get more clarity on what the market wants to do next.

We didn’t make any moves on Friday. Those are not the types of days to act upon.

That said, we do anticipate taking action in client portfolios this week:

  1. Our monthly trend signal resets on Wednesday, and that could cause us to raise cash.
  2. Big moves lower offer the potential to realize tax losses on certain positions. We can then offset some of realized gains that have occurred this year by selling some losers and rotating into different positions to avoid wash-sale issues.

Other than that, it appears for now that the move was simply random and out of left field.

The likely scenario is that we slowly move back towards all-time highs.

However, as always, we are going to stay vigilant in managing risk. And if that means increasing cash, we will do so as our signals tell us to. But for now, the move appears to be a random event that we should probably come to expect more of in the coming months and years.

Until then, we’ll keep watching the markets for clues.

Invest wisely.

The Secret Downsides of Diversification

As of March 2021, Amazon had over 12 million different non-book products for sale (if you count books, it’s more than 75 million). Having an incredibly diverse product set is a vital part of Amazon’s business strategy.

Investors are often told diversification is a critical part of their investment plan. But is it really?

Taking numbers from 2019, there are approximately 4,210 equity mutual funds. The average number of stocks in each fund is about 38 for a large cap fund, and about 50 for a mid-cap fund. A broad asset allocation based on mutual funds could potentially have an investor owning hundreds of different stocks.

What happened to your portfolio in March 2020? Did broad diversification pay off?

Diversification Doesn’t Limit Losses Like People Think

There’s a saying that diversification is the “only free lunch in finance”. The premise is that a diversified portfolio will contain assets that move in different directions during periods of market turmoil.

For example, growth stocks may struggle when value stocks are doing well, as we saw earlier this year. It goes from style to asset class, sector, capitalization, and geography – all potential sources of diversification. Building a diversified portfolio is supposed to reduce risk, which will potentially increase return.

In theory, all well and good.

But what happens when there is systemic risk, as we saw during the early days of the pandemic?

Diversification can’t hold back a tsunami. Granted, black swans like 2008 or the pandemic are fortunately rare. But what isn’t rare at all are market cycles. They are predictable and regular. As the market moves through different cycles, different risks and opportunities emerge.

The problem is that asset allocations built on the principle of diversification aren’t built handle changes in the market cycle. They don’t see risk or opportunities coming, and don’t effectively react to these cycle changes.

Worse and More of it: Diversification May Limit Gains

Adding non-correlated investments to your portfolio is supposed to lower risk and increase return – but you can have too many. The result is that the risk-return profile decreases – you take more risk and get less return.

It’s called “deworsification.”

Deworsification is caused by creating a portfolio in which too many assets are correlated with each other. It can be caused by investing in multiple funds that hold many stocks, as described above. It can also be the result of combining different strategies in a portfolio. Investors need to be aware of hidden sources of over-diversification, such as target-date funds held in a 401(k).

Adding an additional asset allocation in a brokerage account can result in a portfolio that is simply duplicating efforts.

The problem here is that the portfolio isn’t just vulnerable to systemic risk – it’s also missing out on potential gains. The fear of concentrating in any one position often means investors lose out on potential sources of alpha because their asset allocation doesn’t allow for building a position or letting it run.

Said another way, assets tend to not perform the same in up markets, but perform identically in bad ones.

So having too much diversification hurts returns in good times without providing much protection in bad times.

A Different Approach

An ideal portfolio would seek sources of alpha and would be sensitive to risk – but only when risk exists in the market.

Limiting positions when the market cycle is indicating positive signals means reducing return. And risk management that reacts to changes in the market by reducing exposure to riskier assets can both protect your portfolio, but also allows for cash to be redeployed when signals turn positive again.

Creating this kind of portfolio isn’t about investing in stocks according to a static asset allocation – it’s about having rules that take the emotion out of investing.

Successful investing means you own right exposure, in the right amount, during the right point in the cycle. And when necessary, going to cash.

The Bottom Line

Investors have many options now, and investing can be deceptively easy – until markets change.

The free lunch quote above is attributed to Harry Markowitz, who developed modern portfolio theory – in 1952. There might be a better way than relying on traditional methods of portfolio management that haven’t kept pace with the realities of our investment universe.