The Age of Indulgence is Over
In January we wrote that we expected 2022 would be a year of significant change. This was part of our thesis in describing the markets’ transformation some months earlier into a late-stage cycle. Such a stage is marked by higher inflation, higher interest rates, and slowing growth.
But much more is afoot. Sampling CNBC periodically during our commute, it seemed to us that the media has been narrating the implosion of the crypto-currency markets at least as much as they have been covering the bear market that has gripped stocks and bonds lately. Endless opinion untethered to any fundamentals or even economic relevancy about whether Bitcoin can hold at $20,000 permeates the financial news. We even heard an anchor ask (with a straight face) if perhaps crypto was a leading indicator for what’s ahead for the stock market! It seems no market update these days is complete without a check-in to the crypto world.
This got us thinking about other instances in recent memory that seem equally surreal, and in our view are best described as indulgences sprung out of an abundance of cheap money. Profiles-in-courage interviews of teenagers and twenty-somethings—some from their parent's basements—to share their deep insights into the Meme-stock phenomenon. Meatless meat seemed to be a path to financial independence at one point. Special Purpose Acquisition Companies (or SPACs), deservedly left for dead back in the 1990s as opaque, costly and investor-unfriendly came roaring back with offerings from electronic vehicle manufacturers. Heard about the $50 billion exercise bike company? Who knew a pandemic coupled with an exercise bike (first invented around 1932, but now with a wifi connection) could make investment geniuses of us all?
The list of indulgences goes on and includes seemingly countless IPOs juiced by their venture firms for most of their foreseeable future growth before they are foisted upon the markets at nosebleed valuations. Has anyone found that must-own cannabis stock yet? We were told that Federal legalization of marijuana was “imminent”—over half a decade ago (nicotine-less cigarettes are more imminent now). We even include some tenants of the “ESG” movement (a heresy to some perhaps), especially among Wall Street firms, which increasingly feed on investors’ altruistic proclivities, but rely on their naivete to earn higher fees than those available in the crowded indexing markets.
Market cycles are real, and throughout history, each has its idiosyncratic profiles. There was the oil boom of the '80s, the internet/.com revolution of the '90s, and the housing boom and bust of the ‘00s. The common thread lies in the currents of money that fund growth and innovation. These currents share a pattern in each market cycle, beginning with a firehose of cheap money to revive businesses ravaged by the recessionary end of the previous cycle. Green shoots emerge, growth gradually reappears, unemployment begins to fall, and growth accelerates and ultimately spreads among ever broader swaths of the economy. Controlling the spigot, of course, is the Federal Reserve.
Our lawn has a similar cycle. All looks beautifully green and healthy in May. But indiscriminate watering and a lack of attention to those curiously fast-growing shoots leave us with a patchy lawn riddled with crabgrass by August.
About two months ago we spoke with a client who wanted our opinion on a technology company that recently announced a stock split. Among other considerations, she was curious about the price, having fallen some 15% from recent highs—was this a good entry point (this question often highlights the conflicts of self-identified long-term investors)? We’re not normally given to sports analogies, but this is what came to mind: you’re coaching a football team and you just failed to convert on a fourth-down. The other team now has the ball. Do you trot out your next play to the quarterback, whose offensive line is still on the field? Things likely will not go well for your team if all you have is an offense.
Of Bear Markets & Recessions
The case for a near-term recession has been made incessantly in the media of late. While we believe that indicators like Consumer Sentiment, inflation the Federal Reserve’s aggressive attempts to correct a clear policy mistake have raised the odds of recession, we do not believe it is imminent in the near term. So, we will give a couple of points to bolster the other side of the argument.
But first, remember Paul Samuelson’s famous quip from decades ago: “The stock market has predicted nine out of the last five recessions”. It is important to remember that the market isn’t the economy. Recessions are horrible because their ultimate cost is unemployment. Unemployment is a hardship no one wants to see foisted on themselves, their family members, friends, or neighbors. But from a pure investment standpoint, recessions most often mark the end of preceding bear markets—and the beginnings of new bulls. A recession is when you trot your offense back onto the field.
- Recessions are commonly defined as two consecutive quarters of declining GDP. Recall that Q1, 2022 GDP released in April showed a (surprise) decline in GDP of 1.4%, after the robust 6.9% reading for Q4 last year. Some cite this negative Q1 reading as setting us up for certain recession in the near term, with only one additional negative quarter needed to confirm (Q2 GDP is scheduled to be released on July 28th). In other words—we’re already in a recession.
- However, Capital Economics’ Neil Dutta provided input on this negative number in a note titled: The Data are Real, but the News is Fake. "…the decline was entirely the result of two components, inventory investment, and net exports. That's important because these two components tell you nothing about the near-term economic outlook.
- Furthermore, economic output and activity indicators suggest GDP rebounded in the second quarter—though evidence of slowing growth is present. As we write, Durable Goods (for May) came in a 0.7% (m/m), a significantly more robust reading than many surveys anticipated. The National Bureau of Economic Research (NBER) uses coincident indicators to identify economic turning points—and yet these indicators are still showing (slowing) growth, rather than decline.
- The University of Michigan Consumer Confidence survey plunged to a record low last month, reflecting widespread misery caused by high inflation. As we have pointed out before, consumer activity accounts for roughly two-thirds of GDP in most developed countries, so their financial health is paramount to economic health. Poor sentiment can also be a self-fulfilling prophecy.
On the other hand, while Consumer Confidence has plummeted, actual consumption has held up, with real consumption likely coming in at 3% (q/q annualized). Weakness in items like Auto sales is likely more due to supply-chain issues rather than plunging demand. Consumers have also been flush with savings in recent years because of pandemic relief programs, though much of this surplus had been eliminated lately, most likely a result of consumption outpacing real income growth. Importantly, while consumer savings has dropped below pre-pandemic levels, consumer balance sheets are as healthy as they’ve been in decades.
So again, as it pertains to consumer health, the available data tells us a story of slowing growth, rather than contraction. We must admit though that persistently high levels of inflation will test this relationship, and likely quite soon.
One last thought on Consumer Sentiment—and it gels with our earlier comment that the market isn’t the economy. Consider the last 51 years of low ebbs in Consumer Confidence, sentiment peaks, and recessions. We write from the perspective of investors—not economists:
The nearby chart makes the case that forward investment prospects could be generally good based on the last 8 low-ebbs of this measure.
Our intent is not to dismiss the difficulties of the current investing environment. Inflation—and especially stagflation—are particularly galling economic times to live through. Federal Reserve Chairman Jerome Powell spoke some truth last week (some might say, finally) when he told Congress there was no guarantee of a soft landing, and that risks of a recession were much higher than in previous quarters. But our role in portfolio management is to assess what our investment prospects are given where we are in the cycle. We must elicit from history—not just popular opinion. We believe the Fed when they say all stops will be pulled out to topple inflation as a primary objective. So yes, we expect another 0.75% move in July. We remain below consensus for a year-end target of 3.46% (Fed Funds rate), and we maintain our opinion that inflation is likely to be significantly reduced as the second half of this year proceeds.
One other thing about the challenges posed by inflation—and those of taming it. We’ve been critical of the Federal Reserve’s policy mistakes. Acknowledging the problem, belatedly, and then doing exactly nothing about it for an additional 3 ½ months needs calling out. But the truth is that inflation is not just of the Fed’s making. Congress and the executive branch hold much of the blame for continually shoveling cash into an economy that was already very much on the mend. This increases the risk of the Fed’s role in engineering a soft landing. The Fed sopping up liquidity created by the Fed is one thing. The Fed trying to sop up all the additional liquidity which came in the form of "fiscal stimulus” by Congress (with interest rate hikes) likely leads to another policy mistake.
Recession? Whether yes or no, history suggests the investment outlook for the next 12 months could be better than the last 6.
One of the biggest challenges for investors this year has been the lack of ballast normally expected from the bond markets during difficult times. Bonds have been a drag on performance for over a year, and the Bloomberg US bond index is down 11.25% year-to-date through June 27th—the worst start to a year for the bond market on record.
CCR Wealth Management’s playbook included a re-allocation across our bond portfolios into various short-duration alternatives (duration is a measurement of interest rate sensitivity, often synonymous with length of time to maturity). We began this process in the fourth quarter of 2021. By May, a 0–5-year Treasury Inflation-Protected ETF was one of this firm’s largest and most widely held positions. While we are happy to report this position was generally flat for the year through the end of May (as opposed to the double-digit negative return of the broader markets)—such is the world we’ve been living in. Being happy about a 0% return (a roughly negative ~4% real return) is not where we want to be!
The good news is that bond portfolios that provided virtually no yield in the prior two years leading up to 2022 once again pay their investors' interest! We have even seen some of our bond managers raise distribution pay-outs because of the higher yields they have been able to pick up in this market. To be sure, one does not receive a positive yield in real terms (after inflation) just yet—but with a slight rebound in oversold sections of the bond market, a real positive total return may again be within reach for investors going out 12-24 months.
We see a particular opportunity in the municipal bond market which retains a greater spread (lower valuations) relative to other sectors of the market (investment-grade corporates (IG), asset-backed (ABS), mortgage-backed (MBS), etc..). As a recent Wall Street Journal article pointed out, individual bondholders’ share of the muni market is down to 40%, which implies a much greater share of bonds held by mostly mutual funds. These funds faced significant out-flows as interest rates spiked earlier this year. As with the sentiment indicator/S&P 500 chart earlier, such outflows can create a significant opportunity for value-minded investors.
The furious sell-off of muni bonds earlier this year had the feel of a credit crisis. But the fact is that States and municipalities are generally in fine financial form. Massive financial transfers were made to support States and municipalities during the Covid pandemic ($745 billion over 4 bills) under the assumption that their tax revenues would crater due to the lockdowns. Tax revenues barely dropped 1% in 2020. Furthermore, the Biden administration has loosened restrictions on how these funds can be spent. Add to that the booming real estate market (a lagging tax-revenue source to municipalities), and it becomes clear to us that the value apparent in the municipal bond market is significant
CCR Wealth Management has spent the last four weeks or so slowly unwinding our short-duration positions back into the beaten-down areas of the bond market. Our deliberate pace acknowledges that there remain near-term risks, and we are data-dependent in terms of our inflation thesis.
|Russell 1000 Growth (large-cap growth)||-27.35%||-17.86%|
|Russell 1000 Value (large-cap value)||-11.83%||-5.66%|
|S&P 500 (large cap)||-19.22%||-9.63%|
|Russell 2000 (small cap)||-22.09%||-24.25%|
|MSCI EAFE (developed markets, non-US)||-17.28%||-16.81%|
(Data through 6/28/2022)
There it is…try not to look away.
We articulated our strategy in January (which we began implementing in Q4,'21) of moving large-cap growth and small-cap equities into large-cap value. As with our short-duration trades in the bond market—you can be "right" without it feeling good.
Drawing on our decades of experience—it is in markets that look like these that the most successful investment stretches have their root. Unfortunately, markets like these are also the “devil’s playground” of Behavioral Finance. The most important input we think we can add here is that we do not believe the disparity shown between growth and value is a “blip”. They say the first stage of processing grief is denial. Investors holding onto the indulgences of the last 12-13 years need to pivot, at last. Value (vs. growth), Large-cap (vs. small cap), and quality (vs. concept) are likely to be persistent themes of more successful portfolios for the foreseeable future.
Despite their precipitous fall from grace, large-cap growth stocks are still not cheap. From here, either earnings must increase (in a slowing economy, this is unlikely), or there could be additional multiple contractions ahead.
As mentioned earlier, one of the most challenging aspects of this market has been the surprisingly high correlation between stocks and bonds. CCR Wealth Management took a page out of our Low Correlation playbook to apply to our broader model portfolios to tamp down on volatility. In February we added a broad commodity ETF (an asset class with a high correlation to inflation), and in May, we added a managed futures position (an asset class with a higher correlation to volatility). Together, these positions amount to ~12-15% of client portfolios, but this varies from client to client based on their portfolios’ construction (including the availability of tax-deferred accounts to accommodate such a weighting). We urge our clients to discuss the position sizing individually with your financial advisor.
In truth, we do not know what the future holds for cryptocurrency or meatless meat for that matter. Our commentary on what we call “indulgences” is meant to focus the mind on the reality that we have entered not just a new stage in the market cycle, but a new investment era, one that does not come with a “Fed Put”. We have given our opinion that the US economy is poised to bend—but not break (into a recession), but readers can likely spot our low conviction between the lines. The data ahead (particularly CPI and PCE inflation indicators) will likely answer these questions soon enough. We believe we have already done the "heavy lifting" in terms of portfolio positioning and are confident our clients will weather the storm. And on the question of recession—remember, bear markets precede recessions, not the other way around.
The views are those of CCR Wealth Management LLC and should not be construed as specific investment advice. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Investors cannot directly invest in indices. Past performance does not guarantee future results. Additional risks are associated with international investing, such as currency fluctuations, political and economic stability, and differences in accounting standards.
Securities and advisory services offered through Cetera Advisors LLC, member FINRA/SIPC, a broker/dealer and a Registered Investment Adviser. Cetera Advisors LLC and CCR Wealth Management, LLC are not affiliated companies. Cetera Advisors LLC does not offer tax or legal advice.
CCR Wealth Management 1800 W. Park Drive, Ste 150, Westborough, MA 01581. PH 508-475-3880