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Where Oceans Meet but Don’t Mix

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He released the two seas, meeting side by side. Between them is a barrier neither of them can transgress.

– The quran 55:19-21

Financial markets work in cycles.

Some cycles are short, lasting only hours. Like those following Fed meetings.

Others, however, last decades.

And when longer-term investment cycles change, things don’t always mix well.

Like many characteristics of financial markets, we see this phenomenon in nature as well.

What implications will this transition of investment cycles have on financial markets?

The Meeting of Oceans

At the southern tip of South Africa, the warm currents of the Indian Ocean meet the frigid currents of the Atlantic Ocean, as seen in the illustration below.

The dividing line between the Atlantic ocean and the Indian ocean is similar to when long-term investment cycles change.

Unlike geographic boundaries, the dividing line where these two oceans meet is determined by the CONDITIONS on each side of the line.

And despite their proximity, the composition of nearly everything in each respective ocean is different from one another.

Lifeforms, currents, temperatures, and mineral composition of the water all differ depending on which side of the boundary you look.

What is common place and normal under one set of conditions is abnormal and unusual in the next cycle.

Today, we are dealing with the transition from a falling interest rate cycle to a rising one.

The investment cycle, much like the meeting point of the Atlantic and Indian Oceans, is a place where forces collide, currents shift, and the landscape changes in unpredictable ways.

The transition between cycles is not always a clean one, either.

It can be messy.

This is because with longer-term cycles, investors become engrained in their belief that the underlying causes of the previous market cycle will continue into the next cycle.

Inflation & Interest Rate Cycles

The cycle we’re dealing with today is the inflation and interest cycle.

Historically, the full cycle lasts 60 years.

That’s 30 years of rising rates followed by 30 years of declining rates.

We can see this cycle on our first the chart below, courtesy of Tom McClellan.

The declining interest rate cycle that likely ended last year is actually quite late getting started.

According to the 30-year cycle, rates should have begun moving higher in 2010.

But the Fed had a different idea, and placed their thumb on the scale to keep interest rates at zero for another decade.

The decline in rates began in 1982. And began moving higher again in 2022.

That’s 40 years of a financial tailwind of declining interest rates supporting higher and higher asset prices.

When interest rates fall, the cost of money decreases. And when the cost of money decreases, profits rise.

This creates a “virtuous circle” of investment, where the declining cost of debt makes investment projects more and more appealing as rates fall.

But the inverse is true also.

Rising interest rates push the cost of capital higher, putting downward pressure on profit margins.

This pressure on profits results in many stocks struggling to grow during rising rate environments, mostly due to the influence of interest rates on valuations.

Stock Valuations and Interest Rates

One of the easiest places to visualize the effect of interest rates on the stock market is via valuations.

The next chart shows a scatter plot of the P/E ratio of the S&P 500 versus the 10-year US Treasury yield.

The yield of the 10-year Treasury is shows on the x-axis from left to right. The y-axis is the forward P/E ratio of the S&P 500 index.

Each blue dot shows the P/E ratio at the end of each month for the past 20 years, along with the corresponding 10-year US Treasury yield.

What this chart tells us is that there is a DIRECT correlation between interest rates and valuations.

And the formula is pretty easy: higher rates = lower valuations.

Most of the market is respecting this phenomenon.

The “Magnificent 7” is a term used for the largest seven companies in the index: Apple, Microsoft, Amazon, Nvidia, Meta, Google and Tesla.

This “Magnificent 7” is still trading as if interest rates were almost zero.

In the chart above, the red dot shows these seven stocks.

At an average valuation of 29.5, they are 72% more expensive than the rest of the S&P 500.

They may have better future growth prospects than other stocks, but this is still a very obvious data point where investors are assuming the lessons of the previous cycle will repeat in the next one.

The implication is that at some point in the next few months or years we should see reality start to set in for these big tech stocks.

That means that eventually we will start to see mid-caps, small-caps, international stocks and other investments start to outperform big tech stocks.

We’re seeing this in our system. We have recently added small caps, mid-caps and international stocks to client portfolios.

If interest rates put downward pressure on valuations, what does that mean bigger picture for the stock market?

Let’s look at the last two rising rate cycles for clues.

Rising Interest Rate Cycle (early 1900’s)

The last two times US markets experienced a rising interest rate cycle was in the 1970’s and the early 1900’s.

Let’s look at the early 1900’s first.

The next chart shows the Dow Jones Industrial Average from 1895 to 1925.

During this time, interest rates moved from a low of 3.7% to a high of over 6%.

This was the last interest rate cycle that happened before the existence of the Federal Reserve.

Over this period, stocks returned a whopping 1.4% per year compounded return.

Not great.

Interestingly, both GDP and earnings grew over the same period of time, much faster than the overall growth in equities.

This is because higher rates kept valuations low compared to the low rates of the previous cycle.

That’s great, but can we really compare today’s world to the one 100 years ago?

After all, isn’t everything different?

Sort of.

The one common denominator is us.

Humans are the key to the investment cycle.

With all of our flaws, behavioral oddities and penchant for making the same mistakes over and over and over, we bring our inherent biases to our actions whether we know it or not.

Sure, we think we’re smarter. After all, we have all the information in the world at our fingertips via our smart phones. But we tend to use it to view cat videos. So are we really that much more advanced?

But we digress.

So what about a more recent rising rate cycle?

Rising Interest Rate Cycle (1970’s)

The last time the US economy went through a rising rate cycle was in the 1970’s.

How did this compare to the period in the early 1900’s?

Answer?

Not any better.

In fact, stocks returned 0% over nearly 20 years.

Stocks had a nice move higher post-WWII, but ran into the same valuation wall as it did in the early 1900’s.

Higher interest rates simply make it more difficult for stocks to grow over time.

There are many factors that go into the relationship between interest rates and valuations:

  • High interest rates compete for capital. Cash paying 5% has attracted dollars that otherwise would have gone into stocks.
  • The current value of a future stream of cash flows goes down as the discount rate goes up.
  • Financing costs increase, reducing profitability.

One thing is for sure: we must pay attention as these cycles change.

Mini-Cycles Within the Larger Cycle

If we have indeed made the transition from a declining rate environment to a rising one, we should expect broad stock markets to struggle more than they did in the previous cycle.

In these environments, bull markets will likely be measured in months instead of years.

In both previous rising rate cycles, stocks had mini-bull markets that lasted from 24-36 months.

They were typically followed by bear markets lasting 18-24 months.

During the 1970’s, we saw 5 mini-bull markets, and 5 mini-bear markets, shown in the next two charts.

During each mini-bull market, prices met or slightly exceeded new highs on each subsequent move.

But each time markets would try to push to new highs, inflation would rise and a mild recession would occur. Stocks would fall to the low end of the range, and a mini-bear market would ensue.

This is the definition of a choppy market.

And this is the market that we may very well have over the coming decade.

Flash forward to today, and we’re in a bull market that has lasted 13 months thus far.

If the current cycle is anything like previous ones, we could see this mini-bull last a bit longer, possibly into mid-to-late 2024.

But chances are we should not expect a long-term bull market like we had during the 1980’s, 1990’s and 2010’s.

Bottom Line

The ebb and flow of interest rates and inflation create a dynamic environment that demands careful navigation.

In the coming years, it will become increasingly important to adjust exposure to risk based on non-emotional signals.

It will also become increasingly important to generate yield and not just rely on market appreciation to meet your financial goals.

A higher interest rate environment allows you to reduce risk and volatility over time.

But this rising interest rate cycle is not a two-year cycle that began in 2022 and ends in 2023.

Higher interest rates will likely be with us for many years into the future.

Invest wisely!

Market Video: Orderly Correction & Commercial Real Estate Risks

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In this Market Insights video, we discuss the current state of the market and delve into the stress that is starting to show in the commercial real estate sector.

We also analyze the GDP for the third quarter and present three scenarios that could unfold in the coming months and years.

Join us as we explore these topics and gain valuable insights into the market’s performance.

  • 00:45 S&P 500 Index
  • 02:13 Russell 2000 Small Caps
  • 04:54 Performance of Different Markets
  • 05:46 Delinquent Loans in Commercial Real Estate
  • 06:33 Delinquency Rates in Retail, Lodging, and Office
  • 09:23 GDP for the Third Quarter
  • 10:29 Scenarios for the Future

Please don’t hesitate to reach with any questions.

Invest wisely!

Price versus Earnings

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The stock market is never obvious. It is designed to fool most of the people, most of the time.

Jesse Livermore, stock trader and author

Stock markets are complex.

Unfortunately, there are many variables that move markets higher or lower.

However, not all variable are created equal.

Two of the big ones are the P/E ratio and earnings.

The P/E ratio (or price-to-earnings ratio) is a simple measurement that takes price per share of a stock or index and divides it by the earnings per share.

If a stock trade at $100, and earns $5/share, its P/E ratio is 20. ($100 divided by $5).

Another way to think about this is that the P/E ratio is a gauge of how much an investor is willing to pay per dollar of earnings.

One interesting aspect of the market increase this year is that it has been exclusively due to an increase in valuations.

Last October, the P/E ratio for the S&P 500 index was 16.3.

Today, it is 20.6.

Meanwhile, earnings for the S&P 500 have fallen 9.3% since last summer.

The chart below shows this discrepancy.

In this chart, the P/E ratio of the S&P 500 (shown in green) has mirrored the price of the S&P 500 (shown in blue).

Meanwhile, earnings (in orange) have consistently fallen over the past year. Granted, there is a glimmer of hope with the slight increase so far this quarter.

This discrepancy between the P/E ratio and EPS is the result of market participants paying more per dollar of earnings, and is essentially a sign of speculation.

However, this discrepancy could actually be a good sign.

Why?

This type of behavior typically happens when markets exit a recession.

Prices tend to move higher first, before the fundamentals start to reflect a more positive environment.

The next chart shows this same dynamic coming out of the 2009 lows.

The S&P and its P/E ratio rose in tandem after the lows in March of 2009, while EPS continued to fall.

There are major differences to consider in the comparison with 2009:

  • Today, valuations are elevated by historical standards at 21. In 2009, the P/E ratio was 12.
  • Interest rates today are over 5% and rising. In 2009, they were zero with no expectation of going up anytime soon.
  • We had one of the largest recessions in history in 2009, while we haven’t had one at all today.
  • Sentiment was extremely pessimistic in 2009, with optimism the overwhelming sentiment today.

So while today’s environment is very different from that of 2009, the behavior of the markets is very similar.

If earnings can start catching up to valuations, that will help remove the risk of a major decline in stocks.

Bottom line

While we are not out of the woods just yet, there are many positive developments happening.

With elevated valuations like we have now, the possibility of entering a long-term bull market seems low.

But the possibility of a major bear market is decreasing as well.

That means a sideways, choppy market for a long period of time could be what ends up happening.

In that type of environment, income and dividends will be important.

It will also be very important to not chase every market rise, and to not feel FOMO when markets go through periods of positive price action.

In a sideways market, the turtle wins the race.

Invest wisely!

Scrooged?

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stern looking mature man in victorian costume carrying a cane . Model is wearing a dark suit , top hat, glasses and prosthetic make up , the look created is also similar to a Dickens victorian type character .

Men’s courses will foreshadow certain ends, to which, if persevered in, they must lead,” said Scrooge. “But if the courses be departed from, the ends will change.”

charles dickens, “A christmas carol”

In Charles Dickens’ famous book, A Christmas Carol, Ebenezer Scrooge begins the story as a mean-spirited and angry old man.

But he undergoes a transformative experience that changes him into someone who cares for others and embraces the spirit of giving.

The quote above by Mr. Scrooge is not the easiest quote to read.

If we paraphrase it, it may read something like this:

“If you go down a dangerous path, bad things will probably happen. But if things change, they might not be so bad after all.”

Currently, equity markets are trying to show more of a giving spirit like that of the transformed Scrooge.

But there are still MAJOR macro-economic signals with a grumpy, “old-Scrooge” like demeanor.

But will they will turn into positives in the coming months?

Grumpy Scrooge

First, let’s look at the more concerning indicators.

Specifically, there are three data points worth watching that are showing elevated risks for 2023:

  1. The Inverted Yield Curve
  2. Leading Economic Indicators
  3. Money Supply (M2)

These indicators tend to be excellent predicters of recessions when they turn negative.

And right now they are VERY negative.

Inverted Yield Curve

The yield curve is simply what a specific investment instrument yields at different maturities.

To understand the current yield curve environment, think of it like this:

Let’s say you want to invest in a Certificate of Deposit at a bank. You speak to a banker, and ask for the rates on a 2-year CD and a 10-year CD.

Logically, you expect the 10-year CD to be at a higher interest rate. You are, after all, committing funds to the bank for a decade.

But the banker tells you that the 2-year rate is paying 4.6%, while the 10-year rate is only 3.8%. This is an “inverted” yield curve.

When the yield curve on US Treasuries inverts, it has been the single best predictor of a recession in the past 100 years.

Right now, the yield curve is more inverted than anytime in the past 40 years.

The chart below shows the difference between a 2-year US Treasury bond and a 10-year one.

US Treasury yield curve is the 2-year yield versus the 10-year yield. It is currently inverted by the most in nearly 50 years, signaling a deep recession is likely in 2023.

When the line is above zero, the curve is “normal”. Below zero and it is “inverted”.

The past three times the yield curve was inverted was in 2008, 2000 and 1987. It became inverted before the markets had extreme stress, and each time led to a recession and tremendous market volatility.

This chart above only goes back to the 1970’s, but it’s the same well before that as well.

The depth of this inversion is worrisome too.

At roughly 0.83%, this is a very steep inversion, and one that is signaling not just a recession, but a deep one.

Leading Economic Indicators

Another key data point to monitor is the Leading Economic Indicator Index (LEI). We discussed this in our Thanksgiving report (read it HERE).

The LEI is another excellent recession predicter.

It’s so good, in fact, that EVERY time in the past 70 years we’ve seen the LEI at these levels a recession has followed.

The chart below, courtesy of Charles Schwab and Bloomberg, shows that the negative LEI is below the average level where recessions begin.

Schwab Bloomberg leading economic indicators showing negative data and at a level below where recessions typically begin.

LEI is telling us that a recession is imminent (unless this time is different, which is a dangerous assumption in financial markets).  But LEI is not a good timing tool…it does not tell us when a recession might begin.

It only tells us that one is close. 

And the rate of change does in fact suggest that a recession is likely to be worse than “mild”.

Another way to look at LEI is to look at the diffusion of the data.

Diffusion measures how widespread any strength or weakness is within the data. In the next chart, the diffusion index ranges from -50 to 50.  A reading below zero tells us that the majority of the data is weakening. 

Leading economic indicators diffusion index has an active recession signal.

When the diffusion index is below zero, it is indicating that a majority of the underlying data is weakening.  A reading above zero tells us the opposite, that most data is improving. 

When the diffusion goes below zero, it is a warning sign that economic trouble could be happening.  But a recession has not followed every time diffusion has turned negative.

Only when the index gets to minus-4 has it signaled that a recession is imminent.  The index is currently at minus-6. This is another excellent predicter of a recession, and it tells us that one is very likely to occur in 2023.

Money Supply (M2)

Another important, but little discussed aspect of financial market performance is the money supply.

There are various ways to measure the overall supply of money in a society. One of the broadest definitions is called “M2”. It measures the total amount of liquid funds in cash or near cash within a region.

This number includes cash, checking deposits and non-cash assets that can easily be converted into cash, like savings accounts and money markets.

If you’d like to learn more about M2, Investopedia has a nice article about it HERE.

M2 has a very high correlation to inflation. More accurately, changes in M2 have a very high correlation to inflation.

The next chart shows this phenomenon, courtesy of our friends at Real Investment Advice in Houston.

The black line is the year-over-year change in M2 (moved forward 16 months), while the orange line is CPI.

M2 is telling us that inflation is likely to head much lower in the coming 12 months.

On the surface, this would appear to be a good thing. After all, isn’t inflation one of the problems that markets face right now?

Maybe it is a good thing.

But the real problem is the extent of the decline.

After a massive increase in M2 during COVID, the rate of change has collapsed.

The problem arises in how big this decline has been.

It is not signaling that inflation should moderate. It suggest that inflation may turn into outright deflation.

The only way this happens is if we enter a moderate-to-deep recession. When major data points align like these three do right now, we must pay attention.

The New, More Giving Scrooge

While there are plenty of reasons to believe that 2023 is going to be a bad year again for stocks, not everything is bad.

Let’s look at some good data points right now:

  • The consumer remains strong. Shoppers spent a record $5.29 billion this Thanksgiving, an all-time record high. Yes, inflation had some to do with this, but at this point inflation is not having a meaningful impact on the consumer, at least; not yet.
  • Unemployment is low. The unemployment rate remains below 4%, primarily due to the services sector being strong.
  • Inflation is slowing some. CPI for October came in at 7.7%, below estimates of 7.9%. November’s CPI data will be published tomorrow. As we can see from the M2, we should expect inflation to slow in the coming months.
  • The Fed may be close to pausing. The market is anticipating a 0.50% increase at their meeting next week, with an additional 0.25% at their February meeting. Currently, markets expect that to be the end of interest rate increases for now. Historically, when the Fed Funds rate gets above the 2-year treasury yield, the Fed pauses interest rate increases. This will likely happen this week, so they very well could be done raising rates for a while.

Unemployment is a big data point here. Once the unemployment rate starts to rise, it has a direct impact on spending.

And consumer spending is roughly 70% of the US economy.

The main problem with looking at unemployment and other actual economic data is that they are backward-looking.

Once unemployment increases, we are already likely in a recession (even if it is not officially announced yet).

Which makes the forward-looking data points that much more important to consider.

Bottom Line

Despite the recent calm in markets, this is not a time for complacency.

Over the past 50 years, every time markets were volatile and NOT in a recession, NONE of the three indicators listed above were negative.  

Now, all of them are negative. And all of them were negative prior to recessions.

This tells us that the likelihood of a recession next year is extremely high. In fact, the data suggests that it should be more of a question about the extent of the decline, not whether one occurs.

Fortunately, it is not a foregone conclusion that a recession will be deep and painful. There is still plenty of time for things to change into something more positive.

Hopefully, this angry Scrooge-like data will transform to be something less angry and more joyous towards everyone.

But as we always say, hope is not an investment strategy.

For now, we must deal with the realities of the environment at hand.  And the current environment has major risks that should not be ignored.

Invest wisely!

Women and Money: An Evolved Approach

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Inspired mature grey-haired woman fashion designer thinking on new creative ideas at workplace. Smiling beautiful elegant classy middle aged older lady small business owner dreaming in atelier studio.

Women at all age levels are redefining how they think about their financial journey. This includes career paths, planning for flexibility, taking charge of family finances, or being successful on their terms.

There are some generational differences among Gen Z, Millennial, Gen X, and Boomer women—but not as much as you’d think. And two main differences that set them apart from men hold across generations:

  1. Women are better investors than men1
  2. Women are more likely to approach financial planning as a partnership with a trusted advisor2
  3. Women value a financial advisor that listens to them more than men do3

Women tend to outperform men partly because they are more patient investors and trade less. This results in better performance over time and lowers costs.

As to the second result, the easy reach is to point out the men are reluctant to ask for directions when driving too. But it’s a little more complicated than that, and the reasons why women seek financial advice change as they move through their lifecycle.

How they want to partner with a financial advisor is also different. Women want to be sure that the advisor listens to them and understands and respects their priorities.

Gen Z and Younger Millennials

Younger women (Gen Z and younger Millennials) are generally comfortable and confident about money and financial planning.

They’ve grown up with more salary transparency, the proliferation of money-related apps to help with budgeting and investing, and the optimism of youth. They are interested in financial planning that fits their busy lives. They make good salaries, still have debt, are single or newly partnered, and want to get a good foundation in place.

They gravitate to financial planners that offer the planning they need in a way that they can relate to. This includes cash-flow planning, debt reduction strategies, maximizing employee benefits, and above all – helping them improve their financial literacy.

This generation of women understands the value of starting early on the path to financial independence and wants financial planning advice that can help them build a solid foundation.

Older Millennials and Gen X

Portrait of smiling beautiful millennial businesswoman or CEO looking at camera, happy female boss posing making headshot picture for company photoshoot, confident successful woman at work

As women approach the mid-point of their careers, money becomes more complex.

Careers are in full swing, and growing wealth brings to the fore the costs of making a mistake.

These women may not have worked with a financial advisor before. Whether single or partnered, they realize that all the different pieces of their financial lives need to come together in a comprehensive plan.

For them, it’s about creating the option to stop work, scale back work, start a business of their own, or do more meaningful work that may not be as highly paid – while maintaining a current lifestyle and still save for financial goals in the future.

They realize the value of working with a financial advisor that can help them put together all the pieces of their lives:

  • Equity compensation
  • What to do with an annual bonus
  • Tax planning
  • Saving for education
  • Taking the right amount of investment risk
  • Buying a second home or income property
  • Creating opportunity with their wealth

These women want a trusted partner that explains the “why” to them, and guides them to make choices that are right for them.

As things change, they value being able to make changes to a plan to accommodate new goals or different circumstances.

Older Gen and X-Boomers

These women are driving the decision to work with a financial advisor for themselves and their families. Very often, something has sparked the need to partner with a financial advisor to solve an immediate problem.

  • A change of job
  • A spouse’s health issue
  • Aging parents
  • Imminent retirement
  • Death of a spouse
  • Tax issues

Having a trusted partner to help them sort through the issue calmly in a non-judgmental way is paramount. They want someone to help them fix problems, provide solutions, and ensure that no other avoidable situations are on the horizon.

They may realize that a spouse has always done the financial planning and that it may be time for them to understand the specifics of their wealth. They may want to plan for a retirement that allows them the time they have always wanted with their family.

This group has the most anxiety around money and the least excitement.4 They need to develop trust and have an investment plan that helps them achieve their goals – without taking on too much risk.

The Bottom Line

Women are taking control of their and their families’ wealth at all points on the age spectrum.

They value working with a financial advisor, but they are clear in their need to have someone who listens, prioritizes their goals, is a trusted partner, and truly understands how they want to build and maintain wealth.

1.Fidelity 2021 Women and Investing Study.

2, 3, 4. U.S. Bank. Women and Wealth: Exploring the Gender Gap. 2021.

This work is powered by Advisor I/O under the Terms of Service and may be a derivative of the original.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.

A Recession or Not a Recession, That is the Question

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“To be or not to be–that is the question: Whether ’tis nobler in the mind to suffer the slings and arrows of outrageous fortune or to take arms against a sea of trouble and by opposing end them.”

hamlet, act 3, scene 1

July was a nice month in the markets.

Which begs the question…have we seen the lows in this bear market?

Should we expect markets to continue to rise and suffer the slings and arrows of outrageous fortune? Or is this yet another fake-out like we’ve seen twice already this year and we go back into a sea of trouble?

The answer? It depends.

In most environments, it “depends” on a complex series of data points could shape the direction of the markets.

However, today’s environment seems more simple on the surface.

It depends primarily on only one variable: whether we are in a recession or not.

The reason is very simple…markets respond differently to pullbacks similar to what we’ve seen this year based solely on if it happens during a recession or not.

Let’s look at some historical context.

S&P 500 Performance: Recession vs No Recession

Markets can decline without the economy being in a recession. Since 2009, we’ve seen this happen a few different times:

  • 2011: US Debt Downgrade
  • 2016: Chinese Yuan Devaluation and Oil Crash
  • 2018: Random 20% decline in the 4th quarter

Each of these times, markets fell roughly 20%.

And each of these times, markets recovered losses within 18-24 months.

But there was no recession during these periods.

Our first chart below, courtesy of Ned Davis Research, shows this dynamic. The chart shows declines of at least 18% and separates it between two categories: whether it occurred during a recession or not.

The black line is the performance of the S&P 500 when there was no recession, while the blue dotted line shows the performance if there was an official recession.

We are currently two months past the recent lows, as indicated by the red dashed line.

Based on what the market has done historically, the results are very clear: if we’re not in a recession, we should expect the next 12 months to be pretty good. If we are in a recession, we should expect more volatility and a retest of the lows.

Which begs the question…are we in a recession or not?

Are We in a Recession?

Normally, determining a recession is pretty straight-forward: it is two consecutive quarters of negative GDP growth.

Both Q1 and Q2 this year were negative.

So by historical definitions, yes, we are in a recession.

But it may not be quite that simple this time.

We don’t like to get political in these reports, because the world focuses way too much on the self-absorbed, sociopathic political class.

But with mid-term elections around the corner, the incumbents are trying to change the definition of a recession.

It’s an overly transparent pre-election tactic. But we will reluctantly admit that in this case, they may have a point.

(To be fair to our politician friends, many economists agree that the first quarter did not resemble a typical economic recession.)

Let’s look at the data.

The first quarter GDP came in at a negative 1.4%, mostly because of two things:

  • Defense spending fell 8.5%
  • A trade imbalance due to a strengthening US dollar resulted in a negative 3.2% from total GDP.

Remove these two factors, and GDP is positive. In fact, if you simply remove the trade imbalance, GDP is positive.

Economic data in the first quarter was fairly positive as well, led by consumer spending, which was up 2.7%.

While the first quarter showed relatively good economic data, the second quarter was recessionary without question.

Second quarter GDP was negative 0.9%. And the negativity was more widespread.

  • Inventory investment decreased 2.0%
  • Housing investments decreased 0.7%
  • Federal and State spending both decreased slightly
  • Business investment decreased 0.1%
  • Consumer spending rose by a more moderate 0.7% (down from 2.7% in Q1)

With the underlying strength in the first quarter, it’s not out of bounds to assume that we’ve only seen one quarter of truly negative GDP growth.

(For the record, we don’t think we should change the traditional definition of a recession, but we should always put GDP data in context, both positive and negative.)

Which makes the current quarter especially important.

If we have negative GDP this quarter, there is no question that we are in a recession. The question then becomes how bad it is and how long it lasts.

Atlanta Fed GDPNow

One way to keep track of current GDP estimates is through the Atlanta Fed’s “GDPNow” tracker. (You can view the site HERE.)

As of Thursday, August 4th, they are projecting a 1.4% GDP for Q3, as shown in the next chart.

Granted, the estimate has steadily declined since the start of the quarter, and we still have almost 2/3 of the quarter left. So anything can happen.

And this data is also based on human estimates, which can be skewed.

But it should at least give us some hope that maybe we don’t see a formal recession this year. And if we do see one, it would likely be fairly mild.

This morning’s jobs report adds to the hope that we may not be in a recession just yet. The economy added 528,000 new jobs this quarter, and as of July has officially recovered the number of jobs lost during COVID.

However, we shouldn’t get too complacent at this point.

While GDPNow is showing positive estimates for current GDP, there are huge warning signs right now that should give us cause for concern.

Inverted Yield Curve

Historically, one of the best recession indicators has been an inverted yield curve. This occurs when the 10-year yield on US Treasuries are LOWER than the 2-year yields.

The next chart, courtesy of Bloomberg, shows this inversion.

When the line goes below zero, the curve is inverted.

Right now, it is more inverted than at any time since Paul Volker started fighting inflation the early 1980’s.

It is more negative than COVID, than the global financial crisis, the tech bubble, and various recessions during the 80’s and 90’s.

We strongly believe that it is imprudent to ignore this data point.

But this data point isn’t a very good timing indicator of when a recession may happen.

In reality, it is when the curve starts to steepen AFTER it has been inverted that is a better indicator that a recession is imminent, and we haven’t seen that happen yet.

Housing Market Concerns

While the inverted yield curve is a bit more theoretical in nature, there are real economic data points that are showing signs of stress.

The housing market plays a huge part in economic activity, accounting for 15-18% of US economic activity on average.

Leading indicators in the housing market are showing reason to be concerned.

One of these is cancellation rates, as shown in the next chart from Redfin.

Cancellations happen when an accepted offer is withdrawn by either party.

In this case, the majority of cancellations are due to buyers backing out.

There are legitimate reasons for this happening:

  • Mortgage rates have increased, making it unaffordable for a buyer to proceed;
  • Property taxes have been reassessed higher, increasing the cost of housing;
  • People anticipating that prices may fall, causing buyers to withdraw offers.

Here’s a link to the article discussing cancellations:

The Deal Is Off: Home Sales Are Getting Canceled at the Highest Rate Since the Start of the Pandemic

Another reason for cancellations is a drop in consumer confidence, which has a big effect on economic conditions in the US.

Consumer Confidence

While the housing market is a large part of the economy, the consumer as a whole is much more important. Approximately 70% of the US economy is driven by the consumer in one way or another (this includes housing).

So when consumer confidence slows, economic activity typically slows along with it.

And the consumer is in the dumps right now, as shown in our next chart.

Right now, the consumer is the least confident they have been at any time in the past 60 years. This includes the Vietnam era, the inflation of the 1970’s, the tech crash, the global financial crisis, and COVID.

That is concerning.

But what does all of this tell us about the near-term direction of the market?

S&P 500 Index

All of the data listed above is not news to the market.

Despite these concerning data points, markets have rallied over the past seven weeks.

But the move higher since June looks almost identical to the one in March, as shown in the chart below.

Specifically, the pattern is a three-leg move higher into previous highs.

There was an initial leg higher, a move lower of roughly the same timeframe, then an extended move higher in both time and price.

The move in March followed the Ukraine invasion.

The move in June really didn’t have any catalyst, other than the overall market being incredibly pessimistic.

In addition to the S&P 500, nearly every major US stock index looks identical.

The next chart shows the S&P 500, the Russell 2000 small cap index, the Nasdaq Composite and the S&P Mid Cap index.

Every one of these indices are at the same resistance level. This means that the market thinks these levels are important.

Regardless of the reason for the move in June, it has been strong. Earnings reports have been more positive than expected, and the market is starting to predict that the Fed will become more accommodative and “pivot” by slowing the rise of interest rates.

If the market is going to do it’s own pivot and head back lower, it must do so very quickly.

If it breaks above this resistance area, then we can begin increasing equity exposure in client portfolios, at least for a period of time.

If it heads lower, then we should expect a fairly quick move to test the lows from June.

Bottom Line

While a big consideration for the market is the current recession debate, markets are extremely complex systems. Relying on only one data point for decision-making would be foolish.

When looking at a variety of data points, it truly is a mixed bag out right now.

Recent market strength and earnings reports have been mostly positive. As such, the market seems to believe the Fed will slow down the pace of interest rate increases. (Frankly, this expectation seems to be unwarranted, especially after today’s employment numbers.)

For now, the move higher over the summer appears to be a typical bear market rally. As such, we have been intentionally slow to add equity exposure.

Why?

Mainly because there is still plenty of upside if the market wants to keep pushing higher. For example, the Nasdaq is down nearly 23% this year, even after a big rally over the summer.

And big stocks like Google, Microsoft, Facebook and Netflix still have massive upside potential at current levels.

If the market can get above the levels noted in the S&P chart above, there starts to be more proof that this rally may be more than just another temporary rally.

But if we do go into a recession, all bets are off. And there are many indications to suggest we are headed in that direction.

Bottom line is that we believe it is prudent to underweight risk right now, given the massive uncertainties in the market and the economy.

Invest wisely!

7 Lessons for Any Bear Market

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Vienna, Austria - May 20, 2017: Main hall of the historical Austrian National Library in Vienna (Austria) on may 20, 2017, with an ancient globe map

That is the great fallacy: the wisdom of old men. They do not grow wise. They grow careful.

Ernest hemingway, “A farewell to arms”

Bear markets are not fun.

We all know that.

But there are valuable lessons from bear markets if you learn them.

Fortunately (or maybe unfortunately), we’ve lived through quite a few over the past 25 years. And given the volatility experienced during that period of time, our investment “age” would place us as old men. (The women of IronBridge remain obviously youthful.)

So Hemingway’s line from “A Farewell to Arms” resonates with us.

Bear markets may or may not create wisdom, because each one is different.

We don’t know how this one will play out. No one does.

But we have learned to be careful.

This got us thinking about various lessons we can learn from previous bear markets, and how we can apply them to today.

Below, we look at some higher-level lessons that relate to you and your well-being, as well as those learned from financial markets directly.

Let’s dig in.

Lesson #1: Keep Your Financial Plan on Track

The worst possible outcome of market volatility is not a decline in your wealth…it is a decline in your LIFESTYLE.

Don’t let that happen.

A good financial plan will factor in volatility in your portfolio. It is called stress-testing, and it is a statistical analysis using variable portfolio returns.

The chart below shows an example of hypothetical return projections for an actual client’s financial plan.

Real life future return projection including variability in returns and statistical analysis of a financial plan.
Source: IronBridge

This is just one of a thousand different potential scenarios our planning software uses to stress test someone’s probability of success in a financial plan. (Please do not hesitate to reach out if you would like us to update your individual financial plan.)

Two major things we notice about this projection:

  1. Returns are not linear. Our software does not assume the same return every year.
  2. Returns aren’t always good. Four of the first five years in the chart show negative returns. The worst projected decline is negative 28%.

Assuming variability makes your plan more realistic.

By projecting that bad years will happen, your portfolio can better weather the storms when they happen.

Lesson #2: Avoiding Large Declines is Key

This seems like the most obvious lesson, but avoiding large declines is the SINGLE MOST IMPORTANT thing you can do when investing.

Why?

Because when you experience large declines (which we define as 25-30% or greater), you don’t only sacrifice your financial plan, you lose the most valuable investing commodity there is: time.

You lose time by requiring huge gains to get back to where you were before the bear market began.

The next chart shows the return needed to get back to breakeven for various portfolio declines.

Returns needed to recover after various portfolio declines on a percentage basis.
Source: IronBridge

This chart shows that if your portfolio is down 10%, you need an 11% return to breakeven.

What stands out to us is that if your portfolio declines 30%, you need a whopping 43% return to breakeven. This is a huge return that takes multiple years to accomplish.

If you have a 40% or 50% decline, you need incredible future returns to get back to where you were.

These types of declines are not only painful emotionally, but will have hugely negative effects your long-term financial health.

Having the ability to move to cash is critical in our opinion.

Cash and short-term fixed income are the only predictable places to hide when major volatility hits the market.

Lesson #3: Diversification is Not Risk Management

Having different assets in your portfolio does not mean your portfolio is protected against large declines.

This year is a perfect example.

As of today, long-term bond prices have fallen MORE than stocks on a year-to-date basis, as shown in the chart below.

Stocks and bonds all down so far in 2022.

Maybe this changes in the second half of the year.

But relying solely on diversification as your primary risk management tool is not a good strategy to avoid large declines.

Lesson #4: Prices can Fall Further than You Think

There’s an old saying in the markets:

“How does a stock fall 90%? Easy, first it falls 80% then it gets cut in half.”

The lesson is that prices can be extremely volatile in bear markets, and can fall well beyond what may seem logically possible.

Let’s look at an extreme example of this today: Zoom stock.

Zoom was a darling of the COVID period as people abandoned the office and went remote. We at IronBridge became Zoom clients, and still use it many times per day.

Their earnings have consistently increased over the past two years, as shown on the bottom half of the chart below. The top half is price (blue line), and the orange is earnings per share.

Zoom stock has fallen 86% despite earnings increasing substantially.

Not only have earnings increased, but they have massively increased (up more than 8-fold).

Over the same period of time, however, the stock has been crushed.

It was down 86% from peak-to-trough. Ouch.

This illustrates perfectly that the market is not always logical. We would go a step further and say that more times than not it is very illogical.

But if you are prepared for it, both strategically and emotionally, you can handle the fact that it will probably do things that don’t make sense.

Lesson #5: Markets Lead, Economic Data Lags

One of the most common arguments during the early stages of a bear market is that the economic backdrop is strong.

The problem is that economic data is backward-looking.

In 2008, the initial GDP numbers were positive for most of the year. It was only until late 2008 (when the market was down nearly 40% on its way to being down over 55%), that GDP was revised lower for previous quarters.

It showed that the actual recession started nearly 12 months before, in late 2007. But in real time, GDP didn’t go negative until the market already declined.

Don’t rely on forecasters to give you any help, either.

Here are forecasts from the 12 largest investment firms in 2008. This was published in Barron’s magazine in early 2008 after the market had already peaked and was down nearly 20%.

Just over a year later, the S&P 500 bottomed at 666 (this still freaks us out a bit). Most of these forecasts were wrong by over 1,000 points. Nice work.

Instead of looking at the economic data itself, like the fine prognosticators above were, pay attention more to the trends of the data:

  • Is economic data improving or deteriorating?
  • Are companies lowering forward guidance, or do they foresee continued strength?
  • What are leading economic indicators doing?
  • Is previously reported economic data being adjusted higher or lower?

Markets will price in risk before the economic data reflects the risk.

Sometimes the markets are wrong. After all, not every bear market results in a recession.

But if you can identify how economic data is trending, you can better assess the overall risk in the market.

Lesson #6: Bear Markets Don’t Repeat, but They Tend to Rhyme

No bear market is exactly like a previous one.

But there are similarities.

For one, there tends to be excess speculation somewhere in the economy or markets.

In 2008, it was real estate. In 2000, it was tech companies. Today, central banks have printed our way into a complete mess. In addition, crypto is one area where we are seeing excess speculation turn into massive losses in value.

In addition to working off excesses, bear market patterns tend to look similar.

The first chart below compares 2008 to 2022.

Current market looks similar to 2008.

Looks pretty similar to us.

In 2008, there was a 22.5% drop before the bottom fell out of the market. Today, markets are down 23.5%. Maybe this suggests we are close to a similar outcome.

But there are plenty of chart comparisons that don’t result in massive declines.

In 1984, there was a recession, and the Fed was fighting inflation.

The next chart compares 1984 to today.

Current market looks similar to 1984

The pattern here looks pretty similar as well.

While both comparisons pass the eye test, each environment was different than today.

So while looking at these types of charts are interesting, they shouldn’t drive your behavior one way or another.

Lesson #7: Bear Markets can Happen in either Price or Time

When most of us think about a bear market, we naturally think of 2000 or 2008.

These were bear markets in PRICE.

In 2000, the Nasdaq fell over 70%. In 2008, the S&P 500 fell more than 55%.

Those of us in the markets then will remember those periods for the rest of our lives.

At their core, bear markets work off excesses of the previous economic and market expansion.

Prior to both 2000 and 2008, markets grew at rates that were were unsustainable. By the time these bear markets were done, prices collapsed and all the excesses were removed.

Price corrections tend to happen over the course of 1-3 years.

But markets can correct in TIME as well.

We haven’t seen a correction in time in quite a while.

In fact, the 1970’s were the last real sideways bear market.

The final chart looks at the Dow Jones index back to the late 1800’s.

Long term chart of the Dow Jones shows longer term bear markets.

This chart shows 5 major periods of sharp price declines: 1929, 1987, 2000, 2008 and 2020 (circled in red above).

The tamest of these periods was 1987, when the market “only” lost 34%. Each other time, markets fell well in excess of 40-50%.

Additionally, there were 3 major bear markets that occurred in “time” (the blue shaded areas above):

  • 1900-1915
  • 1934-1950
  • 1968-1982

Each of these periods lasted either 15 or 16 years. That’s a long time to have to wait for returns to start moving higher again.

Fortunately, these major bear markets don’t happen all that often.

But one thing in common with the previous bear markets that corrected in “time”: rising interest rates.

If we are going into a period of rising rates, which seems like a good assumption, the likelihood of a bear market in time seems to be a higher likelihood than a bear market in price.

Don’t let that scare you, though…there are ways to make money in a choppy sideways market.

It requires two components:

  1. Tactical exposure in the markets.  You don’t want to buy-and-hold in a “time” bear market.  The volatility will chew you up and spit you out.  You must have the ability to move to cash to limit volatility when downturns happen, but be able to increase exposure to areas performing well.  This is the basis of our investment philosophy at IronBridge.
  2. Increase exposure to yield-generating assets as interest rates rise.  As yields go up, you can earn more on a variety of assets to compliment your tactical market exposure.

We are preparing for this exact scenario, and have already begun having discussions with a number of our clients about what this means in your particular situation.

Bottom Line

In summary, there are always lessons to learn from any market environment.

But it does appear that we are in a bear market that may not reverse as quickly as those that have occurred since 2008.

Thus, us battered old investment men at IronBridge will echo Hemingway’s quote and be careful and cautious until the situation tells us not to be.

Invest wisely!

Value Your Business like it’s Your Retirement Plan, Because it is.

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Building a successful business can take decades. While working to grow, it’s common to use all available assets above the salary you pay yourself to fund future expansion. Where does that leave you on the retirement side of things? For most business owners, the retirement plan is some form of exit and monetization of your investment.

As you get close to a transition, valuing the business is paramount. The value comes first, and then the sale, and only then do many business owners think about how the sale proceeds will fund retirement. 

There’s a better way. Start with the amount of money you need to live the retired life you want. That’s your benchmark of the value you want to get for your business. Then work from there to create the value you need.

A Different Valuation Metric: What Do You Need to Retire?

Creating a retirement lifestyle should be about your goals, dreams, and plans for what you want to accomplish in the last several decades of your life. It shouldn’t be about plugging a number into a glorified spreadsheet and then eking a life out of whatever income pops out.

Think of it in three stages:

  1. What’s most important to you in the early stages of retirement? Travel? Family? Starting another business? How much will that cost?
  2. As you age, what do you want your life to look like? Where will you live? How will you spend your time? Do you want to be able to help children and grandchildren? Do you want to devote time to philanthropy? What level of income do you need in these years?
  3. What will your legacy be? How will you fund it?

Once you’ve thought through what your retirement looks like, you can begin to think about the amount of money you’ll need to make that happen.

As you begin transitioning your business to an exit, you’ll want to get a comprehensive, accurate valuation. Bridging gaps between what your business is worth and what you need should be your focus. It should guide your timeline and business investment decisions for several years before getting to a liquidation event.

Increasing Your Value

You’ve likely been focused on the long-term growth of your business and are used to planning and taking steps to keep a consistent upward trajectory in place, even if it’s not profitable right away. Value is a different mindset. You want to position your business to be the most attractive to a buyer, which means focusing on profits and getting everything else in place and ship-shape.

Increasing value breaks down to making improvements across several essential functions:

  1. Improve cash flow – lease instead of buy, reduce expenditures
  2. Increase profitability – improve margins from both cost and revenue
  3. Lower your risk – diversify revenue streams and create recurring revenue streams
  4. Streamline operations – inventory management, payroll control, etc.
  5. Attract and retain high-quality talent – qualified retirement plans, cash balance plans, stock plans
  6. Build or refresh your sales/marketing process
  7. Get your books in perfect shape

If you’re wondering how you’re supposed to do all that while running the business, that’s where it gets interesting. You’re not. The sales process has a very truncated timeline. The value of bringing in outside expertise is correspondingly greater. Even if you could do all those things yourself, you can’t do them all at the same time.

Creating the Team You Need

The best approach to getting ready for a sale is to create a team that can work with you to determine what needs to be done systematically, build a schedule to do it, and identify the right sources. Whether outsourcing or hiring in-house, you’ll need to create a working group of consultants – business, marketing, pension, etc. – along with investment bankers, CPAs for the company and those focused on tax structures, and a legal team that can handle the transaction.

Because your business, both now and in the future, is your source of wealth, it makes sense to work with a financial advisor that specializes in transitioning business owners to liquidity. Decisions should be made with your long-term wealth in mind, whether it is valuation, taxes, sales structure, monetizing assets, or your compensation for ongoing involvement. A fee-only financial advisor doesn’t have a conflict of interest, so they can develop the needed expertise to look across the entire transaction, quarterback your team, and then structure your resulting liquidity to create the retirement you want.

The Bottom Line

Selling a business to fund a retirement should start with the retirement part – that’s the goal. Everything else should be in service to that, and good planning can ensure that takes place. Working with a financial advisor to get your ducks in order can help you navigate the transition.

This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.