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IronBridge Private Wealth

Forward with Confidence

markets

It Came from Left Field

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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

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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.

The Federal Reserve Trading Scandal: Just the Tip of the Iceberg?

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In the past three weeks, there have been three prominent Fed officials who have been caught in trading scandals.

For those not familiar with this scandal, you can read about it here:

https://news.yahoo.com/a-timeline-of-the-federal-reserves-trading-scandal-104415556.html

In summary, last week, Robert Kaplan and Eric Rosengren, Presidents of the Dallas and Boston Federal Reserves respectively, both “retired” amid revelations that they had actively traded stocks and investments that directly benefitted from the Fed’s actions.

Last Friday, yet another official, Richard Clarida, reportedly moved millions of dollars out of bonds and into stocks the DAY BEFORE the Fed announced trillions of dollars of market stimulus.

This is a conflict at best, and flat-out criminal at worst.

If an employee of any financial institution did this, they would be fired. And probably banned from the financial industry for life.

But the Fed officials simply “retired”.

The End Game: Losing Confidence

The financial markets have risen on the back of Fed printing for over a decade now.

For many years, our clients have been asking (and we have been wondering), “When will the next bear market begin?”

And for many years our answer has been, “When the market loses confidence in the Fed.”

Well, this may very well be how it starts.

In our opinion, the single biggest risk in global financial markets is a mistake by the Federal Reserve.

Thus far, they have consistently erred on the side of being supportive of financial markets. And prices have gone up in response.

But the recent tumult inside the Fed has a different feeling.

The blatant and intentional actions of these men were for one reason: to make money.

By itself, there’s nothing wrong with that.

But when you “front-run” major announcements intended to change the direction of global financial markets, you go from simply trying to make money to committing acts that violate any basic conflict of interest rule. And likely go far beyond that.

These men should be investigated. Just like any other member of the financial industry.

But unfortunately, they probably won’t.

Neither will the many people in Congress who do the same thing every week.

It’s almost as if there is a ruling class that is above the law.

Stock Market

What effect might this have on the stock market?

Markets have become volatile once again. Maybe it’s just a long overdue pause, or maybe it’s because of this scandal.

Either way, the Fed is such a HUGE part of the markets these days, anything they do (good or bad) will likely have an impact.

The extent of that impact is still unknown.

On the one hand, this could be the first domino to something bigger. A weakened Fed opens itself up to major criticism, and rightfully so.

Up to this point, the Fed hasn’t had to deal with much criticism. Trump was a vocal critic of the Fed, until he became president and wanted markets to remain strong. Ron and Rand Paul have both been critical, but their voices have quieted since COVID began.

And when new Fed chairs get appointed, they may or may not have the stomach to fight such criticism.

On the other hand, maybe this criticism causes the Fed to double down on their printing machine. Maybe they announce continued support of the markets because they don’t want the one-two punch of both bad publicity AND a weak stock market.

At this point, weakness in the market appears to be normal.

After all, we went nearly a year without a 5% correction. That’s pretty abnormal, as these types of declines happen 1-2 times per year on average.

But if the stock market has peaked (which we’re not certain that they have), then we very well may look back at these trading scandals as the moment the Titanic first ran into the iceberg.

Invest wisely.

The Wolf and the Crane

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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?”

We’re All Cats on a Hot Stove

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Waiting for a correction in the stock market? It may have already happened.

If a cat sits on a hot stove, that cat won’t sit on a hot stove again. That cat won’t sit on a cold stove either. That cat just don’t like stoves.

mark twain

It’s hard to believe, but the COVID market crash ended 16 months ago.

It was truly a black swan event. Something that came out of nowhere and was unlike anything the global financial markets have seen in over 100 years.

One of the most common questions we receive is, “When is the next crash going to occur?”

This is a good question, and a very logical one. And one we think about quite often.

After all, we are seeing a rise in the Delta variant, many cities are re-instituting mask policies, and there is discussion of additional lock-downs. Sounds like February and March 2020, right?

On top of that, we have the random 1,000-point decline that happened on July 19th. Read our comments in our article “Are the Dog Days of Summer Over?“

So there are valid reasons to be expecting a sharp market decline.

But we have been receiving this question for well over a year now.

In the past year, there has been a great deal of hesitation to put cash to work in the stock market. Granted, some people were very quick to put cash to work, but most were very hesitant. And many remain so to this day.

Why?

To fully answer both the question “Why?”, and the question of whether we should expect another market crash soon, we need to understand the human behavior factors at play.

We’re All Cats That Sat on a Hot Stove

As humans, we don’t arrive at skepticism by accident.

In fact, being skeptical is an extremely valuable survival tool. Especially when we see conditions that were similar to past experiences that caused us pain or harm.

The are three basic components of skepticism:

  1. You perform an action.
  2. You experience pain.
  3. You learn to avoid the conditions that caused the pain.

It isn’t rocket science. In fact, we can probably just file this alongside the long list of other things we’ve said that won’t win us a Nobel prize.

In the quote that we referenced at the beginning of this report, Mark Twain presents the ultimate completion of this three-step cycle:

  1. A cat sits on a stove.
  2. The cat burns his you-know-what.
  3. The cat never sits on a stove again, regardless of whether it is hot or cold. Because every stove now looks like a hot stove to the cat.

Pretty simple, right?

Sort of.

Most problems in life arise when we forget to do Step 3: Learn from past experiences.

We have all experienced situations that may have caused us pain that we ended up right back in for no good reason.

Substance addiction, bad relationships, a bad job…there are all sorts of examples of people forgetting about Step 3.

Many times we’re cats who sit right back on top of that stove. And many times we are once again burned.

But what happens if learning from past experiences is the REASON we are harmed in the future?

What if we perform Step 3 beautifully, learn to avoid the situation that caused harm, only to then be harmed MORE by the fact that we avoided the situation that previously caused us pain?

This is what happens in financial markets.

When you lose money in the stock market, you have to go back on the same exact stove that burned you if you want to get back in.

This is where the complexity starts to set in.

In markets, you have to think about Step 3 differently.

The lesson learned cannot be one of complete avoidance.

You must have the cognitive ability to reshape HOW you learn lessons about what got you in trouble in the first place.

After losing money in a big market decline, most of us think that the lesson should be to NOT get back onto the market stove. After all, it looks pretty hot, right? Delta variant, super high valuations, a massive rally from last March and an out-of-control Fed all make us think the temperature on the stove is pretty darn hot.

But just because these things are happening doesn’t mean you should avoid it altogether.

Don’t Avoid the Stove, Just Start to Use a Thermometer

Instead of avoidance, you must begin to use tools that can assess both the current temperature of the stove (markets), as well as the direction and rate of temperature change of that stove.

It is a rational response to avoid the stock market after getting walloped by it. In fact, it is the exact response that would help you avoid that pain in the future.

Many investors go through a big decline and turn into real estate investors. Or private equity investors. And that’s okay.

Markets are not for everyone.

But don’t believe that getting burned on stove means that there is something inherently wrong with stoves.

There is an opportunity cost to avoiding the stove.

The public financial markets provide access to fantastic investment opportunities with a tremendously high degree of liquidity. The primary benefit of liquidity, or the ability to get out of your investment quickly at little to no cost, is that you don’t have to be right all the time. You can change your mind and you can easily get out of things that aren’t working.

You simply need to start using tools that allow you to assess the temperature of the market.

At Ironbridge, we use a wide variety of tools. We won’t get into the specifics, but we use momentum analysis, trend analysis, RSI, MACD, DeMark Signals, and many other data points that help direct our decision-making. We have then developed sets of rules that drive our actions.

The whole point is that it’s important to have some gauge of the temperature of that burner, and not not simply guess when we jump onto it.

So Is the Stove Hot or Cold Right Now?

Okay, enough of the long analogy about stoves. Let’s get to the market analysis.

Bottom line, while the S&P 500 has not seen a correction since last November, we have already seen a correction in many assets.

Let’s look at the following charts to show what we’re talking about:

  • Russell 2000 (Small Caps)
  • China Stocks
  • Emerging Market Stocks
  • Big Tech Names
  • S&P 500 Sectors
  • S&P 500 Index itself

Before we start, a brief note on stock corrections.

Corrections can take two forms. They can happen via TIME, or via PRICE.

A price correction is what we usually think of when we think about a market pullback. Stock prices were going up, then they fall anywhere from 5% to 30%. Then resume their move higher.

But markets can correct in TIME as well. This simply means that they go through an extended, multi-month period with little price movement up or down.

Both time and price corrections serve the same purpose: remove excesses from the markets and get the ratio of buyers and sellers more in balance.

Okay, on to the charts.

Russell 2000 (Small Caps)

First, let’s look at the Russell 2000. After a strong surge following the Presidential election, small caps have been little changed since February/March.

The Russell 2000 small cap stock Index has been in a sideways consolidation for most of 2021.

The blue box in the chart above is a classic correction in TIME. Small caps have been choppy with no direction for six months now. These patterns tend to resolve themselves higher, so we should expect that as the base case scenario.

However, a break below 208 in the chart above would be a more ominous signal. This could lead to selling pressure expanding across the market, and not just be isolated to small caps.

International Stocks

Next, let’s look at China and other international stocks.

The next chart is that of China Large Cap Stocks, using the ticker FXI.

China large cap stocks are down 25% from the 2021 highs. Ticker FXI.

This is a classic correction in PRICE. Stocks are down 25% since February. There is little doubt the direction of this trend.

The same is true of other, more broad international stock indices.

Emerging market stocks are down over 15%, as shown in the next chart. This is no real surprise since China is the largest component. But it is another example of a major global equity market component that is experiencing a correction right now.

International stocks have been weak. There is no question about that.

U.S. Stocks

What about some of the major U.S. stocks?

Well, here is when we start to see what is really happening in U.S. stocks right now.

The next chart shows four of the largest U.S. stocks: Amazon, Apple, Microsoft and Netflix.

These charts show us that each of these stocks went through some sort of TIME correction in the past year.

  • On the top left of the chart is Amazon (AMZN). It was in a sideways move for almost a year. It broke higher, but fell back into it’s chop zone last Friday after a 7% decline following earnings. This is called a “false breakout”. Meaning it may have longer to go before it breaks out of its sideways correction.
  • Apple (AAPL), on the top right, shows a classic break higher from a sideways correction. It also spent over a year in a TIME correction before resolving higher.
  • Microsoft (MSFT), on the bottom left, was in a TIME correction for the second half of last year. It has steadily been moving higher since the start of the year.
  • Finally, Netflix (NFLX) is shown on the bottom right. This was a darling of the COVID period, and remains in a TIME correction since this time last year.

Each of these stocks experienced a correction. And these are major components of the S&P 500.

The fact that these stocks are breaking higher suggests we should have a bullish tilt to our thinking.

S&P 500 Sectors

Looking some of the sectors in the S&P 500, we see a similar picture.

The next chart looks at the Energy, Industrials, Tech, Financials and Consumer Discretionary sectors. We could have chosen more, but the chart gets way too busy.

Each of these sectors have all seen some sort of correction in the past year. Most have been correcting in TIME.

Energy has been the biggest winner since the election. There is an excellent lesson here. The pundits on CNBC and elsewhere all predicted a Biden presidency would harm energy companies. That would make sense logically. But the market responded in exactly the opposite way. The lesson? Using the financial media for investment decisions is not a sound strategy.

This sideways movement of the major S&P sectors suggests that corrections are actually happening under the surface of the market.

But what about the overall market itself?

S&P 500 Index

But here’s the strange thing: Despite corrections happening in both the major stocks and major sectors within the index, the S&P 500 Index itself has been very strong.

Despite the underlying TIME corrections happening in various sectors, and despite the obvious PRICE correction in international markets, the S&P 500 is up. In a very, boring, beautiful pattern higher.

So What Does All of This Mean?

It means that if you’re expecting a stock correction, it may have already happened.

As strange as this sounds, the underlying components in the markets have all mostly corrected already. Without an overall market correction.

Chalk this up as a win for indexers.

This is also why at IronBridge we have both active and passive strategies in place.

In fact, we have had the highest exposure to the S&P Index in our four-year history. We could only go about 5% higher in our portfolio weighting to the S&P 500 Index based on our rules. At the high point, clients had exposure of anywhere from 25-35% of their portfolios, depending on the risk level.

While the S&P has been boring, it’s more interesting to look at the small caps and international stocks.

Earlier this year, our clients had exposure to both of these areas. And both were stopped out at relatively small losses.

For small caps, that wasn’t such a big deal. Prices are similar to where they were when we exited.

But for international stocks, they are down 15-20% lower than where we exited.

Such is the nature of risk management.

We don’t know when things will reverse higher, chop sideways, or continue lower. Guess what, no one else does either.

But was has been interesting about this year is that there has been both volatility and no volatility at the same time. The stove is both hot and cold.

So it would be completely logical to expect the S&P to experience some sort of correction, either in PRICE or TIME.

But the underlying components suggest that we shouldn’t bank on it either.

There is a chance we have already seen the correction via the underlying components and the selloff in other areas.

If this is the case, the second half of this year should be strong. And will likely extend into next year.

If the S&P 500 does start to experience a correction, the likelihood is that it is relatively mild and most likely happens via a TIME correction.

In the meantime, look for opportunities to put cash to work, and stick with a disciplined risk management process.

Invest wisely!

The Fed is Stuck

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

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

Henry Ford

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

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

What news was that?

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

WHAT???

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

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

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

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

Why?

The answer is pretty simple…they are stuck.

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

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

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

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

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

These are crazy price movements.

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

Human Behavior and History

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

This thesis is based on both human behavior and history.

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

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

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

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

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

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

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

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

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

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

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

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

Here’s a great article from Reuters about it:

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

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

But higher prices also can be sticky.

Why? The expectations of sellers increase.

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

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

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

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

Thus, we have our first inflation wave.

Simply from human behavior.

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

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

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

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

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

The Wildcard: The Fed

There are smart people on the Federal Reserve Board.

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

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

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

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

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

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

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

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

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

But why would increasing liquidity support stock prices?

Simple…it increases valuations.

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

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

Fed balance sheet causes stock valuations to increase.

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

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

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

The primary way valuations are affected is by investor sentiment.

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

Exactly like Mr. Bernanke said.

And here lies the problem.

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

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

So far it is working.

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

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

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

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

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

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

The Fed knows this as well.

Thus, they are stuck.

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

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

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

And that’s what we’re dealing with.

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

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

And inflation is the likely culprit.

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

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

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

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

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

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

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

Invest wisely!

Why We Believe in Active Management

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A businessman holding a compass to navigate the business with marketing of icons and business growth graphs, Stock market and data exchange.

In 2019, the amount of money invested in passive funds in the United States surpassed that of active funds for the first time.1 Over the last decade, passive funds have increased assets under management to $11 trillion, from $2 trillion.2 Given the title of this piece, are we saying that all that money is in the wrong place?

Our issue isn’t necessarily with passive funds – we deploy some ETFs in our investment management strategies. Our issue is with the sea-change in portfolio management that the availability of low-cost index-tracking funds has brought about. It’s the prevailing idea that you can create an effective, all-weather asset management strategy by buying a bunch of different funds that represent different asset classes.

The Commodity Trend

Our foundational insight is to turn on its head the belief that asset management has become commoditized. We believe that for much of the asset management industry, investors are the commodity. Most advisors use a one-size-fits-all pie chart strategy. They do a little tweak for your age and how far you are from retirement, and their tools spit out a portfolio recommendation with a bunch of different funds in it. Their theory is that these magical beans funds are going to work together to lower risk and maximize return.

They believe this because they are using data mostly since the early 1980’s to support their recommendation. The problem, as we discussed recently in our “Inflation Waves” report, is that almost every asset class has risen since then.

So they are looking at data that does not include some major market cycles. Specifically the one that we believe we are entering into now…one of rising interest rates and rising inflation.

The words “broadly diversified” have become a mantra, used by large and small firms alike, recommending that investors should be in all asset classes at all times. And meanwhile, broad market indexes like the S&P 500 are only getting more concentrated. It’s hovering around 27% in the IT sector, as defined by GICSs. But if we include companies like Google, Amazon and Facebook, tech exposure is close to half of the index. So, what is that doing to asset allocations?

The notion that diversification is an investment strategy that can replace a disciplined, rules-based investment process is where we draw our line in the sand.

Market Cycles are King

An asset allocation based on age is going to bump up against the realities of the world. Economies and businesses have cycles. Add in the natural human behaviors of fear and greed and you have the market cycle.

And the market cycle doesn’t care how old you are.

If you are lowering your risk during a period when market cycle signals indicate risk is low already and the potential for return is high, you are leaving money on the table. And vice versa.

Diversification Doesn’t Manage Risk

We aren’t suggesting that risk management isn’t necessary…quite the contrary. We believe the management part is important. Volatile markets require a system to manage risk. Being 50 years old or five years away from retirement isn’t a system, it’s a statistic.

Unfortunately, diversification fails exactly when you need it to work. Data shows that asset correlations rise when volatility rises. This means that when markets undergo stress, most assets fall at the same time.

The reported benefits of diversification (having assets that perform differently during different periods) simply isn’t true. In fact, the opposite what happens in the real world.

Rules Are Good

So if passive investing is not the way to go, and broad diversification isn’t all that great, what can you do?

First, we must recognize that investing is inherently emotional. We spend a lot of time with our clients to ensure that their emotions will not impinge on their investment plans. The best thing a client can say to us is that they don’t worry about the money we manage for them, and we strive for that with every client. 

We do the same thing with the money we invest. We are tactical investors that follow a rules-based process in each of our portfolios. Simply put, we look at the underlying trends and momentum in the markets to determine good and bad environments. And then we make adjustments to our client portfolios, daily, weekly, monthly – whenever we identify either an opportunity to exploit or a risk to avoid.

That might mean we are broadly exposed to different asset classes; it might mean we are relatively concentrated in our exposures. We just don’t believe that identifying asset classes and then keeping exposure to them through every environment is a successful strategy.

The goal of our process is to participate in up markets and mitigate risk in down markets. Said a different way, our goal is to do more of what’s working and less of what’s not.

Passive management cannot do that. It can only allow you to participate in up markets while also participating fully in every down market.

Ultimately, a passive investment strategy works in up markets. But that is only part of the market cycle. When the down market comes, your (or your advisor’s) emotions take control. That’s when mistakes happen.

The answer is simply to develop, test and implement a rules-based process.

If you can prove a process works in different environments, and stick to that process, then you can have confidence that your system will work during all parts of the market cycle.

That is active management. And that is what we believe works.

  1. Lowery, Annie. Could Index Funds Be ‘Worse Than Marxism’? The Atlantic. April 5, 2021.
  2. Ibid.

The Icarus Market

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The myth of Icarus warned of the dangers of over-confidence. If we compared the markets to the flight of Icarus, how close are we to the sun? Close enough to melt our wings?

“Well, I think we tried very hard not to be overconfident, because when you get overconfident, that’s when something snaps up and bites you.”

-Neil Armstrong

The myth of Icarus we know today has its roots in the classical narrative poem, Metamorphoses, written by Ovid in the year 8 AD. In it, Icarus flies his wings of feathers and wax too close to the sun, and pays the ultimate price when the sun melts the wax and he plummets from the sky and drowns in the sea.

Before his flight, Icarus had warnings. His father, Daedalus, tested the wings and instructed him to fly neither too close to the sun, nor to the sea. Icarus, like most young adult children, ignored his father’s advice. But there must have been other warnings as well. Surely he felt the heat of the sun or the drip of the wax as his wings came apart in flight.

But filled with excitement and over-confidence, he kept his arms flapping as the wax melted off, and soon realized that his feathers were gone. He fell past his father to his demise.

It’s a tragic story of personal hubris that led to self-destruction.

Many people throughout history have suffered from the same flaws that Icarus did so many centuries ago. Napoleon invaded Russia. Japan bombed Pearl Harbor. People bought GameStop stock.

The classic lesson we can learn as investors is “don’t fly too close to the sun.”

But there is another lesson in this story as well. Daedalus’ not only warned Icarus to avoid flying too high…he warned him to not fly too close the sea as well.

What if Icarus was too cautious with his wings? What if instead of flying too high and drowning, he simply flew too low? He would end with the same fate of drowning in the sea, but it would provide a much different perspective. This would be a lesson in under-confidence instead of hubris.

Not only does this myth teach us of the dangers of arrogance, but we could argue that there is also a lesson of the dangers of timidity.

When investing, we are constantly dealing with our inner Icarus. How much risk is too much? How much is not enough?. How much risk is too much? How much is not enough?

In order to effectively assess risks, we need to do the same analysis on financial markets as we do with your personal risk tolerances.

Which leads the the obvious question…are financial markets closer to the sun or the sea right now?

Let’s look at three primary factors in today’s market that could melt the stock market’s wings:

  1. Valuations
  2. Rising Bond Yields
  3. Inflation
Valuations

One of the least debated aspect of the stock market today is whether stocks are overvalued or not. (Spoiler Alert…they are). By all historical standards, valuations are elevated. And in many stocks, outrageously so.

The most common valuation metric to analyze is the P/E ratio. This simply calculates the Price of the S&P 500 per share (P) and divides it by the total earnings per share over the past 12 months (E). So if the price of the S&P is 3000, and the earnings are 100, the P/E ratio is 30.

For over a century, this ratio oscillated between a low of 8 and a high of roughly 23. Currently, the PE ratio is almost 40.

With a reading this high, you would assume that the market should be on the cusp of a large decline, right?

But a closer look shows something different. A strange thing started to happen in the 1980s and ’90s. Valuations appear to have gone through a regime shift higher.

The chart below shows the trailing 12-month P/E ratio for the S&P 500 since the early 1870’s. (Data was extrapolated prior to the S&P 500 inception in 1957.)

For over 100 years, P/E ratios oscillated between very predictable levels of 8 to 23. During the early and mid-90’s, things started to shift higher.

Since 1990, it had a low of just below 15 and a high of over 80! Technically, the P/E ratio was not able to be calculated, because earnings were negative in the first quarter of 2009. So in actuality it was like much, much higher than 80.

We’ve been conditioned to believe that stocks are over-valued if the P/E ratio is over 20 or so. Pundits on CNBC say that all the time. After all, the people in charge of the financial media and the large investment corporations learned about stocks and investing when there was no reason to question the validity of this predictable valuation range.

But a closer look suggests this regime shift may not be a temporary phenomenon. After all, 30 years isn’t exactly a short amount of time.

But more importantly than the actual levels of the P/E ratio is the timing of when this ratio was elevated. The high points in valuations did not occur at tops. They occurred near a LOW point in the market.

Going back to the late 1800’s, nearly every time P/E ratios peaked were very poor times to sell stocks. The 1890’s, early 1920’s, mid-30’s, early 60’s, early 90’s, 2002, 2009 were very bad times to sell your stocks. Bull markets had years to run before prices ultimately fell.

Let’s take a closer look at this phenomenon. The next chart, courtesy of Bloomberg, supports this thesis that high valuations may not be as much of a warning sign as well. It shows the P/E ratio plotted against earnings-per-share for the S&P 500 since the mid 1990’s.

There have been four major spike in valuations since the mid-90’s. Three of these four times happened at a market low, not a market high. Granted, these are only a handful of data points, but it is still valuable information nonetheless.

Another interesting thing to note on this chart is that P/E ratios actually declined during the bull market from 2003 to 2007.

Maybe that is because valuations were SO extreme in 1999 that they could only go down. Makes sense. But it also suggests that levels once considered “expensive” from a valuation standpoint are more opinions instead of facts.

Instead of arguing that high valuations means that markets are near a peak, one could argue that the data supports exactly the opposite conclusion…that with the spike in valuations over the past year, a bull market may just be beginning.

But this conclusion just doesn’t feel right. Maybe it’s because we’ve been told for so long that these P/E levels are expensive. Maybe it’s simply because stocks ARE expensive right now. Either way, it’s tough to argue that using this ratio as a major part of a decision to buy or sell isn’t supported by the historical data

Which leads to the next logical question…why are valuations so high?

There are many theories. One is that low interest rates support higher valuations. That makes some sense if you factor in a low cost of capital. Another theory is that the easy money policy from global central banks have caused stocks to be the only investment in town that can make any real returns.

Those are both valid. However, the primary reason we are seeing the actual P/E levels in the S&P 500 increase is the massive increase in technology exposure in the S&P 500 over the past 30 years.

Currently, tech makes up 27% of the index. This doesn’t even include companies like Amazon, Facebook or Google, which are not considered a part of the “tech” sector. (Amazon is in the Consumer Discretionary sector, while Facebook and Google are in the Communications sector). Depending on how loosely you define “tech”, you could get 40-50% of the S&P that could be categorized as “technology”.

Tech companies have very high profit margins. So as tech becomes a larger portion of the overall market, net profit margins for the market as a whole increase.

This is a very clear trend. In fact, since the early 90’s, profit margins have nearly tripled, as shown on the chart below from Goldman Sachs.

The other thing to note on this chart is that the decline in profit margins that occurred during last year’s COVID-crash were nearly identical to the declines that accompanied the recessions and bear markets of 2001 and 2008.

Higher margins don’t just mean an increase in profits. They result in an increase in value for the companies involved.

Let’s say you were going to buy a company that makes breakfast tacos. One company makes $0.20 per taco, and the other makes $1.50 per taco. Assuming the tacos are relatively similar in quality and each company sells similar quantities, you would buy the company that makes more money off of each taco they sell. You would be willing to pay a higher price for that taco company as well, because your payback of invested capital will happen more quickly from the excess profits.

And if you could borrow money at very low interest rates, you could probably pay even more for that taco company.

That’s the other factor with the higher valuation regime. Interest rates have steadily moved lower over the past 40 years. (We’ll talk more about that below.)

This analysis doesn’t even get into the vast numbers of companies that don’t even have earnings. Tesla fell into this category for years.

But there has to be a limit to everything. No stock keeps going higher…it ALWAYS works in cycles. As legendary investor Howards Markes says, “Trees don’t grow to the sky.”

But, as the next chart shows, trees can grow to be pretty damn tall. The price levels of the stocks that aren’t making money is flat-out ridiculous. In what may end up being one of the most interesting charts of the year, let’s look at the Goldman Sachs Non-Profitable Tech Index, courtesy of Jim Bianco of Bianco Research.

This chart measures the performance of publicly traded companies who don’t have profits. Basically they lose money. The price has skyrocketed since the COVID lows a year ago.

This index was overvalued at 200. It went to 400. Heck, it was overvalued at 100 if you look at traditional valuation metrics.

But it kept going higher.

Analyzing this chart is not an exercise in valuation analysis. This is an exercise in sentiment analysis. No valuation level is too high, because they are ALL too high. But that doesn’t mean the price will fall.

These investors are not looking at valuations. And ultimately a stock price is what someone else will pay for it, not what some formula thinks it should be worth.

Many of you reading this may disagree with the following conclusion, but P/E ratios are simply NOT a useful tool to help identify the future direction of the market.

The data just doesn’t support it. Maybe the past 30 years are an anomaly, and P/E’s will again provide actionable insights for investing decisions, but not now. And maybe not in the near future either.

In fact, not only do valuations not provide much benefit when making investment decisions, they don’t even provide that much information about the current state of the market in general. We’re sure that would go over well on CNBC.

What really happens when you analyze valuations is that you are trying to make a prediction about someone’s REACTION to the valuation. It’s not the valuation itself that could drive the stock price, it’s other people’s perception of the valuation relative to current market prices that matter.

So essentially valuation analysis is trying to predict stock prices by predicting company earnings and then predicting people’s reaction to what the changes in price may be. You’re multiple steps removed from actual stock price analysis, which is all that matters at the end of the day.

As with all things, the current poor usefulness of valuation metrics is probably temporary. So while it does not provide much useful information now (and hasn’t for at least the past 30 years), it will likely provide excellent information as soon as everyone decides it doesn’t work. Like all things, it will likely prove to be cyclical. So we’ll continue to watch them.

Back to Icarus, it feels like valuations this high should mean we are pretty close to the sun. But the data does not support being very confident in that, especially with a 40% market crash only 12 months ago.

What it does mean is that we should expect anything. If we saw a valuation spike last year that marked a major low, then prices likely move higher for quite a while longer. But if valuation measurements start to become important again, then caution is warranted.

Yes, that’s a cop out. But it’s true. It’s okay to own stocks right now. Just use stop losses to keep your losses small, and use trailing stops on the profitable stocks.

Rising Interest Rates

The next thing we hear quite often is that higher interest rates may “pop” the equity bubble.

Not much analysis needed here. The data simply doesn’t support that theory.

The chart below, from LPL Research, shows extended periods of time when the 10-year US Treasury yield rose.

There were 14 periods since 1962 when this happened. 11 of those 14 times resulted in higher stock prices. And the other three were down, but all less than 20% during the same time period.

It seems the same conclusion about valuations can be applied to higher interest rates…it’s just not a good indicator of increased risk. Like the valuation spikes, one could argue that rising rates are bullish for stocks. Maybe it’s going to matter, but there is not a statistical reason why we should ACT on the potential for higher rates. At least not when it comes to stock investing.

Bond investing is a totally different story. Rising rates mean that bond prices are falling. So if there is any kind of investment action to take, it’s to be very cautious about owning bonds right now.

Extremely low interest rates rising to more normal levels does not suggest markets are too near the sun to melt any wings yet.

Inflation

We’re going to take a deeper dive into inflation pressures in the near future, so we’ll only do a high-level overview here.

Outside of the Federal Reserve, inflation will most likely be the biggest single driver of markets in the coming years.

In the United States, markets haven’t had to deal with inflation in over 40 years. There has been a steady decline in both interest rates and inflation since the early 80’s. That has allowed assets of all types (stocks, bonds, real estate, commodities, etc.) to experience a tailwind for rising prices.

But contrary to what many people think, inflation isn’t likely to just show up on your driveway unannounced like Cousin Eddie in Christmas Vacation.

After 40 years of declining/low inflation, it won’t suddenly jump to 10% per year. There will be a transition.

So we can think about the coming inflation in two phases:

  1. The Transition to Higher Inflation
  2. High Inflation

The transition phase could take years, maybe even a decade. Right now, we are likely in the early stages of the transition phase.

The most common investment consideration of the High Inflation phase will be the massive separation between winners and losers in the markets. The transition phase will be the gradual split between these two camps.

What this means is that there will be areas of the markets that will provide awful returns. The easiest one to predict is the bond market.

Bonds and inflation are angry neighbors. They hate each other. Bonds hate inflation, and inflation hates bonds right back. . When the cost of goods and services rise, a fixed rate investment loses both nominal and real value. Even if you have a nice little muni bond paying 2% tax free, you still lose money in the form of purchasing power over time as inflation rates increase. If you have a bond fund, you get both small yields and declining value, with no maturity date to get your money back.

The other easy place to identify as poor investment options are companies that don’t have pricing power, or whose valuations were elevated because of a low interest rate environment. High growth companies, including many tech names, are included in this group.

So right as we think that valuations don’t matter, inflation could be the very spark that makes them matter once again.

As we said, we will dig more into the inflationary winners and losers in the near future.

But it’s not just assets or companies that will be affected in a rising inflationary world.

From an overall investment standpoint, many of the core tenants of today’s investment world will be upended in the coming environment:

  1. Broadly allocated portfolios will suffer.
  2. Index investing will lose it’s appeal with investors.
  3. An increasing dispersion in returns will favor active over passive investing.

In an inflationary environment, portfolios must become more focused. If you invest 40% of your portfolio in bonds, expect negative returns on 40% of your assets for a very long time into the future.

Likewise, if you invest in index funds (many of which have 40% in tech stocks), expect mediocre returns at best. With such high exposure in tech and growth stocks, index funds will have massive exposure to underperforming companies with high valuations and little pricing power.

As we discussed above, profit margins have been expanding for a long time now on the back of the technology revolution. One of the negative potential effects of inflation is the potential for it to reduce margins substantially.

Inflation is definitely a factor that could melt the market’s wings. When that starts to affect the broad stock indexes in very unclear.

But if we break apart the market into different subsets based on their potential impact from inflation, we then start to realize that certain assets are poised to do very well over the coming decade, while others are likely to struggle mightily.

In the very near term, the Federal Reserve IS the sun. Massive monetary stimulus, combined with massive direct stimulus into the economy in the form of direct payments to individuals, is THE recipe for inflation. And is THE primary source of heat that could make the market soar or melt its wings.

If for some reason inflation does not show up in the coming years, then all theories about inflation are dead. If it does not happen, then we will likely see a massive deflationary shock. This is not a good scenario for anything or anyone.

But in the meantime, it sure does appear that inflationary pressures are building.

In our opinion, being nimble is always a good thing when investing. But as we transition into a phase that separates winners from losers, it graduates from being a “good” thing to have to becoming a “necessary” part of any investment strategy.

Bottom line, there is sufficient data to suggest that the market is closer to the sun that to the sea right now. But not enough data to warrant an intentional shift to a lower risk portfolio.

Let us heed the advice of Daedalus, on both fronts. Don’t be too risky without proper risk controls, but also realize that this environment may still be conducive to excellent returns. So don’t fly too close to the sea either.

Invest wisely!

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