Market Musings

Picking up the Pieces…

“The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

“The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.”

The quotes above are from Peter Bernstein’s “Against the Gods: The Remarkable Story of Risk” which is a master class on man’s evolving understanding of probabilities and how they influence our decision making in day-to-day life, especially with markets. While no “Liar’s Poker” or “The Big Short” which seem right out of Hollywood script, Bernstein’s well researched effort is a true must read for the serious investor. I find myself back to it about once every 10 years when the hubris is palpable and speculators are convinced this time is different. Published in 1998 in the heady days of the internet bubble, the piece has surely withstood the test of time and I suspect will be just as valuable in another 20 years as it is today.

2022 has been by most standards an abject disaster for investors, that is unless you have been overweight the Energy sector (up 37%) and by overweight, I mean materially. Even doubling your position size, where today the sector accounts for 4.5% of the S&P 500, would have meant adding about 1.67% to your total return, hardly enough to offset the declines in the other 10 stock sectors or just about any other holding in one’s portfolio.

Well fixed income surely must have provided some cushion right??? With the Bloomberg Barclays Aggregate Bond Index down 11% I suppose that is a factually accurate statement though hardly the source of any solace. With that the countless obituaries for the 60:40 portfolio have been trotted out ad nauseam.

I suppose I am stating the obvious, you are well aware of these facts, if not precisely, at least generally and in my 21+ years in the business it is safe to assume I have never seen investors so attuned to the daily price action. It is debatable whether or not that is a good thing, my instincts tell me one’s mental energy is perhaps best directed elsewhere if you are a long-term investor.

Well enough of rehashing the recent past, where do we go from here is a better use of everyone’s time though let me just preface this by acknowledging I know as little or as much as the shoeshine boy or the Uber driver when it comes to the next several months where the data is moving quickly and emotion is the primary pricing mechanism.

I am not sure where I read it, as I do read a lot and find myself citing others clever comments though rarely recalling the source, so sincere apologies to those whose comments I may plagiarize, just take solace in knowing imitation is the highest form of flattery. “Too late to sell, too early to buy…” does a pretty good job of summing it up, though if forced to choose between one or the other I’ll take my chances with nibbling at the edges.

You can attribute the volatility to any number of things, but it appears that there are a few very clear sources of angst, which I’ll unpack below. Any one of these, or a few others causes could fill a spiral bound notebook worth of analysis but I’ll look to condense this into simplest terms

High commodity prices, specifically food and energy: It is true that over the last 30-40 years consumable commodities, like the fuel for our body or for our car, now represent a smaller percentage of household spending. But that assertion distorts the facts, when looking at this across different socioeconomic strata there are many people that reside in the cohort where these costs may account for as much as 40% of their monthly outlays. The fragility here is one of, if not the key reason the Fed seemed to abandon the dual mandate with their focus almost entirely on the labor markets up until just recently. With higher prices the affect is both psychological and real and the fact that these figures are front and center when commuting to work or while running errands makes the pain that much more acute. An aside, my parents who are retired have for years joked about life revolving around visits to the doctor offices and grocery stores in your golden years, another reason to work until I am 80. Perhaps there are some positives to take out of this, less money spent on indulgent items is both good for the budget and the belt line, and skipping the trip saves some gas and perhaps going for a walk instead has some cardio benefits.

There is ample evidence that there is some degree of market manipulation driving prices. Companies today are overearning, especially considering we are still consuming less oil than prior to the pandemic while prices have more than doubled in that same time. Soon enough the old adage that the cure for high prices is high price will surely be the market’s medicine it’s just a matter of when. Look for owner’s equivalent rent, the shelter component be driver of elevated inflation, for the next 6-12 months. The combination of demand destruction driven by those high prices and suppliers cheating a bit on the margin to gain share mean this phenomenon is likely to dissipate in the back half of 2022 and into early 2023. The wage price spiral from the 70s still seems like an unlikely outcome though the odds have increased from the beginning of the year which is why the word stagflation has become part of the vernacular.

Central bank policy: I am glad I am not Jerome Powell, where we have reached “peak Monday Morning Quarterback” mode, if I had a nickel for every time someone said the Fed is behind the curve I would be able to make a sizable dent in the Federal budget deficit at this rate. I am sure he is regretting not passing the baton to Lael Brainard and working on his golf game or lucrative speaking engagements right around now, after all being a public servant is not about the paycheck. The market has lost confidence in the FOMC’s ability to orchestrate a soft landing, there is a lot of a truth to the idea they are pushing on a string when it comes to the addressing some of the inflationary issues, specifically around the supply chain. They have surely cooled off the housing market which is structurally sounder today than it was 17 years ago, but that doesn’t mean sentiment won’t be impacted by declining household equity. At this point the futures market is pricing in another two 75 basis point hikes in July and September taking the overnight rate to 3% and whether it’s 25 bps or 50 bps for November or December is a little difficult to handicap, but frankly what is the difference. Money is getting tighter but is it really vacuuming money away from equities? I am not sure I am buying that. Using the Fed Model (courtesy of Ed Yardeni), where you compare the earnings yield between stocks and bonds, with the 10 year at 3.10% and the P/E on the S&P at 16X you have about 300 bps of spread which generally means being overweight equities is worthwhile. We have become accustomed to a passive Fed, look forward to a more active Central Bank, harkening back to the 1990s when the Maestro Alan Greenspan rarely took a year off as he tried to calibrate monetary policy. Higher terminal rates are not necessarily a bad thing for the markets, they just may take some time to adjust t0 initially. Recall that throughout the 80s and 90s where often rates were 300-400 bps higher than where they are today yet we saw some very impressive returns through those two decades. Higher borrowing costs may force corporations to be much more shrewd with capital allocation and where the look to drive higher ROI & ROE
Earnings: With corporate earnings supposedly set to grow 10% this year, that may be stretch, but remember we report earnings nominally so if inflation is running at 8% is it a reach for companies to growth top line in the high single digits and low double digits. It’s probably safe to assume estimates are a bit too high for this year and likely a bit more optimistic for 2023. If you took earnings down by 5%, you’d take the S&P to a multiple of about 16.5-17% so not exactly all that demanding. In the long run stocks are propelled higher by the capacity for companies to grow earnings whether it is a bigger slice of the pie (comparative advantage), finding a whole new pie (nascent markets) or having fewer pie pieces to share the spoils (financial engineering). When investing you are looking out into the earnings stream out into the future, even if earnings growth is high single digits, below the long-term average it still suggests you’ll be compensated for the extra volatility.

At the risk of regretting this statement in another few weeks or months, it seems like a fair amount of the bad news is priced in and unless your scorecard or p/l is measured week to week or month to month, this too shall pass. Coming full circle to Mr. Bernstein’s work on probabilities, investing is about asymmetry and a good selloff like we have experienced creates those opportunities. An investor can be shrewd today and not simply take what the market has on offer by buying the index. With growth stocks still up cumulatively nearly 300% to value’s 110% return over the last 10 years there may just be some appealing investments if you turn over enough rocks.

Notable reads:

https://www.aqr.com/Insights/Perspectives/Value-Investing-Is-Not-All-About-Tech

https://www.ft.com/content/01ac1d52-6932-486d-9f1b-bcf9d5100600

And for those that equate reading with running a marathon, some good listens

https://podcasts.apple.com/us/podcast/jim-chanos-on-why-some-of-the-worst-hit-parts/id1056200096?i=1000566614549

https://freakonomics.com/podcast/does-the-crypto-crash-mean-the-blockchain-is-over/

I welcome other perspectives and opinions.

-Jeff H

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Sources: Data/Statistics from Factset, Charles Schwab & Co & "Against the Gods" P. Bernstein, published August 1998