IronBridge Private Wealth

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Wise Men and Fools

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

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

Markets are never easy.

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

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

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

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

Shakespeare’s quote is appropriate for this environment.

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

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

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

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

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

Bullish vs Bearish Data

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

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

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

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

On the other hand, not everything is bad:

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

Here’s an overview.

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

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

The Path to Lower Stock Prices

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

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

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

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

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

This is not a small change.

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

A reversion of policy should have an impact.

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

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

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

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

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

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

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

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

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

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

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

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

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

The Path to Higher Stock Prices

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

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

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

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

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

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

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

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

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

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

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

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

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

S&P 500 Index Levels

Let’s now look at the market itself.

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

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

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

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

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

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

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

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

Bottom Line

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

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

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

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

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

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

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

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

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

That’s okay, in our opinion.

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

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

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

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

Invest wisely!

Ukraine War: 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!